Inflation Roundup from the Ground Up – Part 1

“I don’t mind going back to daylight saving time. With inflation, the hour will be the only thing I’ve saved all year.” -Victor Borge (comedian)

What a great quote to kick off Alt Blend #50! While it is a funny quip, given where inflation levels have been this year, it also, unfortunately, rings true for many people worldwide. Given my deep appreciation for Alts and the insights we’re fortunate to gain from investment managers, I thought it would be helpful to share recent perspectives across several Alts segments. Primarily, the goal is to understand the impact of higher rates and elevated inflation in some areas where we invest for clients, what challenges or opportunities this evolving environment presents, and what managers are doing about it. Here we go!

Real estate challenges…

Within real estate, lenders generally have turned more cautious, which has resulted in a) capital becoming more expensive (higher interest rates on loans) and b) reduced advance rates (lending at lower loan-to-value ratios). When lending becomes more expensive, it directly affects the potential profitability of a given project or property; thus, buyers either have to pay less for a property to maintain previous return targets, or their return targets have to be adjusted downward.

The challenge is figuring out how to optimize that simple cost vs. profit equation, and it’s the same, relatable phenomenon currently unfolding within residential real estate. People were able to pay increasingly higher prices for homes when mortgage rates declined for decades to all-time lows, but the recent reversal we’ve seen (from about 2.5% to about 6.5% on 30yr mortgages!) has had a drastically negative effect on affordability. Prices need to adjust accordingly. It will also be interesting to see how this situation plays out, as there are competing forces at work: On the one hand, sellers don’t want to leave their locked-in, low-rate mortgages (=> limiting supply), but – on the other hand – buyers cannot afford to pay the elevated prices they could have paid earlier this year (=> limiting demand). And, if input costs are higher (e.g., via materials and financing costs), plus affordability is lower, real estate developers may face significant challenges in turning profits – and that would seem to be yet another supply constraint in a housing market that already had a supply shortage.

Back to the commercial side of the picture, the changes in financing have led to managers paying lower prices for deals, as one would expect. Of course, the specifics of each deal and location matter a lot, and – similar to what we’ve seen play out in technology stocks – the hardest hit areas seem to be the ones that were relatively most expensive (those trading at the lowest cap rates) before the spike in rates occurred.

…Present real opportunities?

To thrive in this environment, a given manager may need to rely even more heavily on their specific value proposition and ability to differentiate themselves from the competition. For instance, this ongoing situation will likely create distress for some property owners, but that can create opportunities for other investors with the particular skills needed to capitalize on a given project. Utilizing a network of developers, operators, and investors can help managers source deals off-market at better prices. Having dry powder with the ability to quickly conduct due diligence and complete a purchase (weeks, instead of months, to closing) can increase the odds of winning a bid for a property and doing it at a more attractive price. With the understanding that real estate is very cyclical, managers can also look for ways of increasing resilience to stand out positively during more difficult times, like:

  • Affordability: Affordable housing can benefit from a favorable supply/demand imbalance that creates “high occupancy, persistent rent growth, and low turnover rates, which in turn contribute to stable risk-adjusted returns.” [by the way, “affordable” is defined by the US Department of Housing and Urban Development (HUD) “as households at 60% or less of area median income (AMI).”]
  • Location, location, location: There are areas with naturally more stable demand than others. Consider, for instance, the suburbs surrounding Washington, DC, that benefit from consistent housing needs of government employees and the supporting infrastructure. Or how about major universities with favorable demographics that support student housing demand?
  • Property types: All property types are not created equal. As we briefly covered in A Historic Blogpost – Part 4, some types of commercial real estate exhibit greater recession resilience than others, including medical offices, senior care facilities, student housing, self-storage, and multifamily housing. With the shift to buying goods online, I’d add some industrial warehouse properties to that list.
  • Value-add: Adding value in the right ways can create opportunities regardless of the environment. For example, if a municipality has a failed project that it MUST deliver on – like housing for local seniors – it may be willing to negotiate on multiple fronts to incentivize completion. Providing financing (issuing/restructuring municipal bonds to fund the project) or tax abatements can create a much more attractive risk/reward proposition for developers.
  • Acquisition cost matters!: Paying a reasonable price for an asset is one of the best ways to cushion against valuation declines from any cause, including rising interest rates. It’s hopefully obvious, but the importance of acquisition cost cannot be overstated regarding real estate or virtually any other investment.

Given the length of this real estate discussion, I will use this as a stopping point before this post becomes longer than anyone is willing to read. Not to worry, we still have more areas to cover, including private equity, private credit, and some liquid-Alt strategies, and we’ll get right into those in Part 2.

Until next time, this is the end of alt.Blend.

Thanks for reading,

Steve

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About the Author

Steven Tresnan, CAIA®, CFP®

Private Wealth Advisor

Steve is a Certified Financial Planner as well as a Chartered Alternative Investment Analyst®. He is also an Accredited Investment Fiduciary, which helps him offer guidance to clients with fiduciary responsibilities, such as board members of trusts, foundations, and endowments. Steve earned a Bachelor of Science degree in Industrial Engineering from Penn State University.

Steve serves on the board and finance committee of New Music USA – a national nonprofit devoted to the development and appreciation of new music in the U.S. – and volunteers as the Treasurer for Campus Fun & Learn, a child development center on the campus of Rockland Community College in New York.