Fear. Uncertainty. Challenging Economic Times.
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For many Americans, these feelings and beliefs have embedded themselves into our cultural fabric. Reminders of uncertain, and for many, challenging times are plentiful. Gas pump prices have soared over the past 12 months. A gallon of milk is 11.2% higher in the same time period. Your favorite morning coffee tastes a little less fulfilling with the higher price tag. Our society has shifted from one cultural extreme to another – enduring a long stay-at-home mandate that stressed the core of human interaction needs to an economy flooded with out-of-control inflation. Why is this happening? What comes next? Our team of experts has thoughts and ideas. Before reading further, please know these thoughts, beliefs and predictions may make you uncomfortable. They are observations and beliefs; not a crystal ball reading. Time will tell how things play out.
Inflation is the new frowned-upon visitor knocking on doors around the country.
Rich or poor, black or white, urban or rural – nobody is immune from its unwanted presence and the corresponding challenges it creates. Every month, the federal government reports inflation data in several different ways. As commercial real estate specialists, our Black Diamond Realty team pays close attention to the CPI, which stands for Consumer Price Index. The CPI recently hit multi-decade highs at 9.1% or (https://www.npr.org/2022/07/13/1111070073/no-retreat-in-the-summer-heat-prices-likely-topped-40-year-high-last-month). For perspective, dating back to 1913 (but first published in 1921), the CPI’s historical average is ~3.3%. For even greater perspective, the decade from 2011-2020 experienced total inflation of 17.3% which is an average of 1.73% per year. Reflecting upon recency which tends to dominate human thinking, in the past 12 months, we have experienced the equivalent of five plus years of inflation packed into one year (1.73% x 5 years = 8.65%).
9.1% inflation is at a four decade high!
Most of our nation’s current inflation can be pinned to two primary factors. The first factor is stimulus money. The federal government injected over $5 trillion into America’s money supply over a 24 month period via Covid relief funds. This amount represents roughly 27% of the current money supply in circulation. More money in citizen pockets led to increased spending. The higher velocity of spending creates inflation. To combat this velocity, the federal government utilizes one of its key control levers, interest rate fluctuation, to control spending habits. The goal of increasing interest rates is to decrease spending in an effort to slow down the economy. The Feds recent rate increases illustrate the government’s concern that inflation is running too hot. The impending challenge is the Fed’s interest rate hikes are only geared toward addressing the demand (spending habits) side of the equation. It does not address the supply side. The Fed faces an unprecedented task of reining in high inflation with 40% additional money in play.
Simply put, our dollars today are significantly less valuable (lower purchasing power) than they were 12 months ago. Stimulus money aims to help those most in need; those individuals most vulnerable and lowest on the earning potential food chain. The irony is disheartening… Our government over-injected for short-term benefit, thereby creating a long-term inflation challenge. The band aid (government stimulus checks) has been pulled while the wound has intensified. Printing money and more government spending is it the answer to stop the bleeding.
The second factor is energy costs.
Under President Biden, an extreme focus on sustainable, clean energy has resulted in an under supply of oil and gas. In the long run, most agree this will be better for our planet and the sustainability of our nation. Others will point out this goal is a multi-decade process to reach a level of production and reliability to avoid power shortages and blackouts. In the short term, President Biden’s regime eliminated the ability to drill on most federal lands. The recent stay-at-home mandate also resulted in lower power consumption which led drilling companies to halt operations. Sanctions placed on Russia are also in play. The following article goes into great detail about how high energy costs greatly affect inflation: https://www.nytimes.com/interactive/2022/06/14/business/gas-prices.html
Where are we heading? How will commercial real estate valuations be affected?
It is impossible for any individual to look into their crystal ball to decipher the outlook 1, 3 or 5 years out. Nonetheless, our team has put together a list of educated guesses.
- Our team believes the federal government will continue to push interest rates higher. The government’s goal is to decrease inflation by slowing our economy. Black Diamond Realty projects a 1.5-2.5% increase over current rates within the next 9-12 months. If you are facing a refinance event within the next 2-3 years, lock in rates now. Most likely, they will not be lower 2-3 years from now.
- As interest rates continue to rise, CRE valuations will experience downward pressure. The following two sub-bullet points explain why.
- Cost of borrowing funds, a buyer’s expense, directly ties into debt service coverage ratios. Many banks seek a minimum 1.2-1.25 DSCR while amortizing loans over 15, 20 or 25 years. We anticipate banks will quickly enter a period of greater scrutiny in which “stress testing loans” will become more laborious similar to policies and procedures observed following 2008-09’s Great Recession.
- Cap rates will go up. As the cost to borrow funds increase, a similar rise can be expected to cap rates. Institutional grade deals should retain value while more mom/pop tenants and shorter lease terms will pose greater risk and a corresponding heightened cap rate.
- A transition from “cash is trash” back to “cash is king” in the CRE marketplace. Cash has been trash for the past dozen years. Bank and government loans could be achieved at rates slightly above historical inflation figures. This provided tremendous purchasing power to less sophisticated and lower capitalized individuals. Black Diamond Realty observed many deals 90-95% leveraged with creative financing and bank loans leveraging the asset. It is anticipated some investors will still highly leverage assets but we predict at a much lower frequency. Greater cash down will become a returning norm. Cash offers with quick closes will carry greater weight. In summary, rising interest rates will make cash more powerful in the months and years ahead.
- Real estate will remain one of the greatest wealth building tools known to mankind. The deal structure and valuations are changing but the fundamentals behind real estate investing’s power remain intact. Real estate is a tangible asset. Historically, real estate has been a tremendous investment tool to hedge against inflation. This centuries long truth will remain strong albeit with changing deal structures and valuations compared to the past half decade.
Please note that statements based on forward-looking estimates may not materialize; there are no guarantees of future economic performance.
Warren Buffet has profited billions with a simple, straightforward investment strategy. Fear creates irrational decisions which lead to opportunities. “Buy when there is fear in the market.” The world’s current fear, uncertainty and challenges will result in tremendous buying opportunities.
The fundamentals of successful commercial real estate investing is changing. Our team of experts recommends keeping the following tips in mind.
- Create a 12 month rainy day fund. Calculate your monthly expenses and multiply by 12. Make sure you have this money “set aside” in the event you need to draw from it.
- Have some of your liquidity positioned in relatively low risk investments which will allow you to access cash any moment an investment opportunity presents itself.
- Take advantage of one of the greatest wealth building tools offered by the federal government – IRS Code 1031. Lever up into larger, higher cash flow and appreciating assets.
- Know the asset class you are investing in. Understand the current fundamental strengths, weaknesses, opportunities and threats (SWOT) for each sector of commercial real estate that you are considering.
- Look for stabilized, cash flowing opportunities while not shying away from value add plays if the ROI and time/effort required make sense for your personal situation.
We live in a world of challenges. Fear and anxiety are at all time highs for some. We survived the 1973-81 recession and will certainly overcome the present day’s hurdles. The United States has proven, many times over, to be a dynamic and resilient culture with the ability to overcome adversity. Proceed with caution, be prepared to pounce and consistently monitor opportunities. Buckle up. Remember rainbows only show after periods of rain. Challenging times present wealth building opportunities.
Our Black Diamond Realty team can help guide you. Please call Black Diamond Realty’s Morgantown (304.413.4350) or Martinsburg (304.901.7788) office to set up a consultation with one of our experts.
Article by:
David Lorenze, Principal
