“Things can go bad and make you wanna run away.” – Jack Johnson, The Horizon Has Been Defeated
Part 1 of this series was a bit more “Blend” than “Alt” in favor of a much-needed reminder of how vital “time horizon” is for proper investing – mainly as a response to recent questions and concerns of our clients. And this is clearly not only my experience. While our team collaborates on many fronts, we tend to write our respective blogs independently. Yet, Trevor Cummings (Stay in Your Lane, also from 9/6/23) and David Bahnsen (If Only One Could Predict the Future, it Still Wouldn’t Matter, from 9/8/23) took a similar stance on some of the most dangerous things investors can do:
- Mismatch investment choices and timeframes of goals
- Fail to develop an appropriate long-term framework (rooted in planning) and then stick to this (“lane-changers,” as Trevor so pragmatically described it)
- Pretending (or having the audacity to believe) they can a) predict the future and/or b) pick winners and losers based on that prediction
At their core, #1 and #2 are really outcomes of #3. Don’t. Do. It.
Instead, make an appropriate, goals-based plan, implement it with a trusted advisor (and Alts wherever prudent 😊) to help mitigate emotions (aka bad choices) during volatile times, and then stick to it.
Distress Test
One of the other consistent inquiries I’ve received relates to the distress in commercial real estate (CRE), if they should also be concerned about banks, and how can we overcome these “dire” circumstances?
The first thing to do, which is always a good idea (aside from, perhaps, actual “fight-or-flight” situations), is to stop and take a deep breath. As usual, the world is not ending, and we spent a lot of time (11 editions of Alt Blend, to be precise) focusing on real estate between February 8th (Part 1) and June 28th (Part 11) of this year, partially to be able to add a meaningful amount of nuance to the ongoing media (hyperbolic) coverage of challenges within some commercial real estate property types in some markets. Now let’s focus more on the path forward. Here we go!
The leased they could do
In addition to the CRE “meltdown” being limited in scope, also keep in mind that distress equals opportunity, and – while the thought of some investments going bad can “make you wanna run away” – there are always savvy investors waiting in the wings to take advantage of those willing to sell at a loss. As I mentioned in Part 6 of the real estate series, “Markets will eventually find an equilibrium between supply and demand…it could mean conversion to something other than commercial office space” [emphasis added]. Well, Voila! New York City is taking action, as this 8/17/23 NYT article points out:
“The plans, outlined by Mayor Eric Adams at a news conference in a vacant office building, would allow for more housing to be built by rezoning manufacturing areas between 23rd Street and 40th Street from Fifth Avenue to Eighth Avenue. A separate plan focusing on conversions of office buildings into residential could allow for 20,000 new homes, the city estimates.”
The above plans still require City Council approval and represent a limited area of NYC. However, utilizing a similar approach for other parts of the city and locales across the US could make a dent in our current housing supply shortage. If owning an (affordable) home is still part of the American dream, it will require some creative thinking.
One challenge of converting office space to residential space is that the basic infrastructure of each is so different. For example, residential setups require very different kitchens, bathrooms, and general layouts vs. a typical office; this substantially impacts how plumbing, HVAC, and electrical services are implemented. But, for all our shortcomings, people adapt, and markets find solutions. I caught a recent article (h/t to Blaine Rollins and the Hamilton Lane team) about non-residential office conversions where layout changes may be less arduous – e.g., spas, breweries, and indoor farms. Could we have more affordable urban housing that is ever closer to food sources, self-care facilities, and social interaction hotpots? Early evidence points to “yes,” and it would represent a genuine win-win outcome.
Bank failures are like I-95 collapses in Philly
These things are simply a part of life. Going back to Y2K, the US has endured 567 bank failures, averaging about 25 per year. Fortunately, that’s a VERY misleading stat. When we ignore the years during and after the Financial Crisis (i.e., 2008-2014), annual bank failures have generally been between zero and mid-single digits. Most failures are banks that 99% of Americans have never heard of, and they aren’t worthy of national headlines, so 2023 has been a statistical anomaly. If Silicon Valley Bank, Signature Bank, and First Republic weren’t household names, they were close to it and very well known within the financial industry – but they were also the second, third, and fourth-largest failures in US history!
Failures are but learning opportunities
I won’t say that “failure” is an ugly word, as I find it no more physically attractive or off-putting than other words. Still, I believe it’s a misleading word, as it implies a complete event (i.e., “you’ve failed – game over!) rather than highlighting the opportunity that comes with a given setback. We all know well that life has a way of turning the events we label as “failures” into some of the most important for shaping character and steering the course of our existence. That is not to downplay the emotionally challenging circumstances many people are enduring at a given time because of so-called failures. Short-term pain is real and, well, painful, while the positive elements of a “failed” situation tend only to reveal themselves over longer timeframes. Without contemplation or the gift of hindsight, we may miss such blessings altogether.
In the Alts universe, an asset class that exploded since the 2008 Financial Crisis is that of Private Credit. Also generally known as “direct lending,” private credit has opened the door for investors to fund loans directly to private companies (and individuals) instead of being relegated to buying bonds on the open market (aka “public credit”) to fulfill their fixed income needs. In private credit, the lender – typically via a fund manager and robust underwriting team – sets the terms of the deal. That’s in contrast to public bonds, where investors must accept the pre-determined terms of the bonds they purchase. In client situations where it has made sense to implement private credit, it has helped to provide high current income while mitigating public-market volatility we’ve seen elsewhere (particularly in the rising-rate environment since the start of 2022).
Perpetually mismatched
We’ve hopefully exhausted the point of aligning goals and investments in one’s personal situation, but what became front-and-center in the context of the 2023 bank failures is the fatal flaw of the depository banking model. Banks make money by accepting deposits (which are short-term, as bank customers can demand them on any given day) and then lending multiples of those deposits over longer timeframes. After viewing it through that lens, bank failures don’t seem very surprising (yet they are vitally important to our financial system).
Thus, the notion of banks loaning money to illiquid private businesses is seemingly not structurally well-aligned, so private credit a) is better served by private markets (e.g., private individuals and institutions with no need for liquidity) and b) probably never should have been a part of the banking model in the first place. It’s also not surprising, then, that we’ve seen such robust private credit markets develop. Unfortunately, it took a banking crisis and tighter restrictions on bank balance sheets post-2008 to get the ball rolling, but here we are. Whether that outcome could have been achieved more proactively and without a global financial meltdown is a fun topic for speculation that we won’t get into here.
Synthesizer
Bringing it all together, I believe all these areas will continue to evolve for the better. We’ll collaboratively address outdated office rezoning, private credit is only in the early innings, and banks will enhance their model in favor of greater resilience – holding what they can and selling off the rest. Some examples were outlined in this Bloomberg article from over the summer, citing that banks have been “flooding private credit firms and hedge funds with requests to buy the debt at a discount.” The impact is likely just higher rates across the board (our new normal) – benefitting the opportunity set of private credit and structured credit managers for investors while also leading to higher costs for borrowers.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
P.S. Giving credit where credit is due – impressively, PennDOT reopened I-95 just 12 days after the fiery collapse back in June, and the permanent reconstruction remains underway. Perhaps an outcome of this “distressed asset” will be learning for more timely and successful triage of construction catastrophes.
