Real Estate Investing in a Rising-Rate Environment
by Ray Alcorn
(This article was written by Ray Alcorn in 2000)
With interest rates headed upward yet again with the latest round of belt
tightening by the Federal Reserve, and the stock market falling with no bottom
in sight, many people are crying doom and gloom. I hear talk of watching for a
rise in foreclosures due to stock market losses. Builder friends are convinced
they are about to be ruined. In my opinion, this is no time to rush for the
exits. The fundamentals of real estate investments are sound. A short history
lesson may prove worthwhile.
My experience goes back to 1980-82, when I was a single-family homebuilder. Now
that was tight money. With prime in the high teens, very few deals made any
financial sense for lender or borrower. Then came the 5 years of favorable tax
treatment that made dumb and dumber deals look good... until Congress pulled the
plug on passive losses. Then we had to re-learn an old lesson, if it doesn't
cash flow, it's not a deal. The recession of 1990-91 was a cakewalk for those
who weren't over-leveraged... I wasn't one of them, and paid dearly for the
mistake.
Fast forward to 1998, we were riding what has now become the longest economic
expansion in history. Asia went ape, the Russian ruble turns to rubble, and the
markets gave a physics lesson… what goes up, does come down. The Fed cut rates,
everything settled down, and for the most part it was business as usual on Main
Street. But for the first time we got an up close and personal look at how
interconnected this global economy has become.
Now it’s the year 2000. Y2K turned out to be a non-event, though it took the
blame for a general slowdown in activity in fourth quarter 1999. Gas prices are
at record levels, yet spending remains strong. Why? Are we heading for
recession? Does it matter? How do we plan for the next five or ten years?
One fact remains constant for the real estate industry. Our health and
well-being has always been tied to the availability and the cost of debt
capital. That is to say that as long as we as investors have access to
reasonably priced financing for our properties, we can survive in any market. I
learned in 1991 that it wasn’t enough to have equity, property has to cash flow
as well. I also learned that when I can present my company as a stable
enterprise, insulated from the uncertainty of highly speculative investments,
lenders will roll out the red carpet for my deals.
Always Follow the Money
If then we are dependent on debt capital to fuel our operations, it is important
that we as investors understand what influences and moves the markets in way
that affect the cost of our funds.
The first thing to know when listening to the gloom and doom reports in the
media, is that they have little knowledge about any business other than
reporting what people tell them is important. When they report the Dow Jones
Industrial Average (DJIA), they are using the implied credibility of a well
known financial measuring stick for a good news/bad news sound bite under the
assumption that you know what it means. Most of us don’t. The DJIA is made up of
thirty companies, picked to represent a cross section of the economy. To put
that number in perspective, there are 3090 companies listed on the NYSE, 771 on
AMEX, and over 6500 on NASDAQ. The DJIA companies represent approximately one
fifth of the value of all US stocks, and about one fourth of the value of the
stocks listed on the NYSE. This "average" isn't designed to predict anything,
but rather to track the general trend of where the market has BEEN. Trying to
gauge where the economy is headed by watching the stock market is much like
dressing for Alaska with only the knowledge that it has an average temperature
of 55 degrees.
The result, as Nobel-laureate economist Paul A. Samuelson put it: "The market
has predicted nine of the last five recessions."
But the market is an indicator of the collective perceptions of the investment
world. When political turmoil hits, as we saw in Asia and Russia in 1998, money
will flee quickly to safety and liquidity. Money doesn’t care who owns it, but
it despises instability and uncertainty. “Tight credit” is another way of saying
“minimize risk”. Stocks carry risk, and therefore when things get dicey, money
moves into low-risk investments, causing the price of stocks to fall. The
present tech-stock fallout is another indication that the market perceives the
risks to outweigh the potential rewards.
Conversely, as the low risk investments, namely government bonds also known as
T-bills, come into higher demand because they are both safe and liquid, the
price of those bonds will rise. As the price of a bond rises, the yield drops.
Many commercial and residential mortgage loans use the yield of government bonds
(or T-bills) as the index for the interest rate charged on the loan. The
interest amount over the index rate is known as the spread, generally quoted in
basis points (100 basis points = 1 percentage point) over the index rate.
This is the element of commercial lending that falls into chaos in a scenario
like we witnessed in 1998.
Again, a lesson from our recent past can best illustrate the point. As the
benchmark 30 year and 10 year T-bills soared to record prices, the yields
dropped to record lows. Lenders, especially the conduit programs for Commercial
Mortgage Backed Securities (CMBS) on Wall Street, were caught in a classic
squeeze. They had untold millions of dollars committed at spreads agreed upon
months earlier with no warning of any trouble on the horizon, and were faced
with funding these commitments at interest rates below their cost of funds. The
market took six months to readjust to the new paradigm, and spreads have
returned to manageable levels.
But the most interesting development to the Wall Street debacle was the way
commercial banks and credit companies moved quickly to fill the void. Since the
waves in the market were not from any instability in the collateral, i.e. real
estate, the money became available from other sources. In short, the markets
corrected the inefficiencies, and money flow resumed when certainty and
stability were again in place.
What does this mean to the average real estate investor? It means that money
continues to be available for deals that make sense. That rates are a tick or
two higher will not in general make a strong deal weak, or a weak deal undoable.
It must make sense.
So how do we determine which investments actually do make sense?
Main Street vs. Wall Street
The fundamentals of the real estate industry have not changed. The Wall Street
players, and the relatively recent use of the CMBS to capitalize real estate,
have not captured so much of the market as to control access to debt capital.
Commercial banks, insurance companies, and to a certain extent pension funds,
are still the mainstay of real estate funding. However, some sectors of real
estate are going to be harder to finance due to the effects of other market
factors, and may be best left to those players big enough to weather the storm.
Hotels, for instance, have been on the brink of overbuilding for the past two
years, and the alarm was sounded for a slowdown in room growth completely
independent of the global financial problems or the cost of oil. This is not to
say that there will be no hotels built for the next year. But the ones that are
built will most likely have a strong franchise, a killer location, and a
verifiable market. In short, the deal will make sense from a hospitality
business standpoint, not as a speculative real estate project.
One side note on oil: We must be aware that this one commodity has the power to
move our markets in ways we don’t even fully fathom. Being in the hotel
business, I watch the price of gasoline for the obvious effect it has on travel.
I started getting nervous last December when prices topped $1.40 and no one was
saying anything. In mid-January OPEC intimated it would vote to increase
production at its spring meeting in Geneva, but that the increase would be too
late to affect prices during the summer travel season. I was still concerned,
but relieved that OPEC was not going to take a hard line ala 1973. Then the
media, in their usual clumsy manner, finally noticed the price of gas in late
March and sounded the alarm. Mind you, the problem was already solved, and now
the media and the government wanted to get in front of the crowd and take credit
for fixing a problem they hadn’t even noticed until it was over. Some say the
clumsy handling and belated pressure from Washington actually made it harder for
OPEC to do what they had already planned to do, lest it look like they were
caving into pressure from the US. I get nervous when government actually acts.
I’d much rather see gridlock.
Watch the Right Numbers
For the market as a whole, the base demographics that real estate relies on
remain solid. Looking at the industry through the lens of a few select property
types can offer insights into where we are headed in general, as well as
highlight specific islands of opportunity.
Mobile Home Parks remain strong, and are in fact category killers when it comes
to valuations. The REIT’s have scarped up most of the investment grade parks,
and are now homing in on the larger parks of B and C grade to soak up the cash
being made available for the product. This serves to drive up the valuations of
formerly unattractive parks, and ever-restrictive zoning standards across the
country combine to give this property type one of the highest potential returns
available in real estate. The demand for affordable housing continues to grow,
and mobile home sales are predicted by the Manufactured Housing Institute to
continue to comprise about 30% of single family housing sales.
Commercial growth and development remains strong. Reacting to a perceived threat
from Internet sales, traditional retailers have found they can compete in a
hi-tech, hi-touch environment, and that online activity in fact boosts in store
sales. Online spending has in fact created a mini-boom in warehouse and
distribution facilities. Commercial occupancies reported to the International
Council of Shopping Centers are averaging in the nineties. Retail spending
remains strong. Consumer credit, while higher in dollar amounts, is in fact the
least we have seen in recent years as a percentage of income. The income and
employment levels of the population as a whole are the strongest in history,
which in turn drives spending, and are the key indicators for the near term
economy.
The National Association of Homebuilders predicts single family housing starts
to fall somewhat in 2000, but still average over 1.3 million starts, more than
double the starts in 1982, and 50% higher than the 840,000 starts in 1991. This
is good news for rental property owners without being bad news for builders.
Apartments have both permanent and bridge financing products available to fit
almost any scenario. Rates can range from the mid 7% range to a point higher in
most parts of the country. Debt coverage ratios on even marginal properties are
in the 1.15-1.25 range, certainly not an indication of overly tight money. Rents
are rising faster now, due in part to rising residential mortgage rates, which
are cooling home sales. Occupancies remain strong as a reflection of the record
low unemployment rates we have enjoyed in the past several years.
These are the fundamental demographics that control our industry. In short, if a
deal is really a deal, it will make sense on these factors, and it can be funded
and profited from, global financial hiccups and market swings aside.
The Roaring 2000’s
I recently read a book titled The Roaring 2000’s, by Harry S. Dent. In it he
predicts that the greatest economic expansion in history will occur in the first
decade of this new century. He bases his predictions on the population curve and
spending patterns of the baby boom generation, and a multitude of other
long-term trends that are operative in our economy. I tend to agree with his
analysis, (and highly recommend the book) and believe that some of the highest
appreciation gains in real estate ever seen will occur in the next eight to ten
years.
Now is the time to position our income real estate for maximum valuations. That
means making capital improvements with the cheapest money we can find, and
raising rents on the strength of the completed improvements. Take this
opportunity to examine service contracts, evaluate expense trends, and check
utility consumption. If you’re looking at an acquisition, make sure it makes
good business sense. The formula for growth now, as in the past, is “Create
stability to attract funds.” Remember that lenders are in the business of
loaning money for the purpose of gaining a return… and they’re counting on us to
bring them deals that make sense for all parties.
Unless the world can solve Asia’s debt problems, bring political stability to
Russia, hold up the weather in Mexico, and turn the Eurodollar into the United
States of Europe, all in the next year, there is no where else but the US for
world money to hide. And once it gets here, it won’t be happy with a 4.5% T-bill
yield for long. Will we be ready? Will we have the product available to invest
in when the time comes? As the market weeds out the uncertainty, good deals will
get better, and the quick will reap the profits.
I intend to be in front of the line.
Bio:
Ray Alcorn is an active investor who averages over $10 million in deals per
year. He has over 25 years of experience in owning, developing and managing
commercial real estate of all kinds, including mobile home parks, single-family
subdivisions, apartments, hotels, restaurants, office buildings, shopping
centers and multi-use projects.
When not writing books and causing mayhem on internet newsgroups, Ray is the
Chief Operating Officer of and a principal in Park Real Estate, Inc., a real
estate development and investment firm with headquarters in Blacksburg,
Virginia.