Quarterly Update – Winter 2022


I’m excited to announce that we’re launching our first investment fund in February! It’s been in the works for a long time, but we wanted to ensure we had all the pieces in place before taking on anyone’s capital. We also wanted to ensure the fund is well-diversified across industry segments, sectors, and operators. As you may realize, starting a private equity real estate firm and taking on investor money comes with a lot of rules and regulations and we wanted to take the time to button everything up. But we’re now ready, confident, and excited to start investing with you!

Look for an announcement in the coming weeks to introduce the fund and commitment process. You can also reply to this email or schedule a time to talk if you know you’re interested and ready to hear more. I’ll hold a place for you in the fund.

Market Update

Is it Groundhog Day? What year is it? Have I seen this before? No, I’m not talking about the Bill Murray movie that spans 24 hours in February. I’m talking about covid and the economy over the last 24 months. We’ve seen ups and downs, backslides and progress. But are things actually different this time? I think they are. I’ll lay out my thoughts and maybe you’ll agree with me; or maybe not and we should talk. So, why do I think things are different?

Covid is losing its grip on the economy

It’s evident that the link between waves of covid infection and slowdowns in economic activity is weakening. At least in the US and other highly vaccinated countries. Where we initially saw large decreases in mobility, airline tickets, hotel stays, and other in-person activity, the effect from recent waves has decreased. Even as we currently see the highest infection rates yet, economic activity is almost imperceptibly lower in most categories tracked by JP Morgan’s “US pandemic economic impact tracker”. There are now enough people who are vaccinated, were infected, or both that the risk is now much lower, to both health and the economy. Also, people seem to be near the end of their tolerance of restrictions or have adopted new ways of going about their lives and business. As a result, I think we’re on the backside of the pandemic. Even the New York Times is seeing the light at the end of the tunnel, take a listen to “We Need to Talk About Omicron.

And concurrent with what looks like the end of the pandemic phase and the start of the endemic phase, we’ve seen the end of the financial supports related to Covid. But what effect did all this free-wheeling financial support have on the economy and how has it changed as a result?

The economy looks strong, but in a different way

Changing preferences and restrictions are not the only reason the economy looks different. The flood of money provided to Americans over the last two years shifted and morphed the economy too. With all that extra cash, and nowhere to go to spend it, purchases of goods surged. Check out this chart showing a 40% increase in purchases of durable goods and 20% increase in other goods purchases since the beginning of 2020. Services didn’t recover until early 2021 and are only up about 10% since 2020.

And it wasn’t only the demand for goods that increased as a result of so much extra money flooding into the economy and into American’s pockets.  Savings also increased dramatically, peaking at almost 35% of income in April 2020 from the more typical 7-8%.  Americans’ balance sheets have rarely been stronger, propelling home buying and other credit expansion.  This spending, and government borrowing (more on that in a future blog) propelled a swift recovery and one of the shortest recessions on record.  It also drove surging GDP growth in 2021, the likes of which have not been seen for decades.

But all that spending sparked the word of the year last year, inflation. Or was it transitory?  Either way, we should discuss the two of them together.

Inflation is a vicious circle.  Increasing prices of everything from shoes to car washes cause workers to demand wage increases.  In turn, wage increases cause the prices of material and labor inputs to rise causing the price of goods to rise.  And on and on.  The initial price increase could be caused by several factors from shipping costs, material inputs, taxes, profit, or labor.  Shifting demand may also push pricing up the curve (dust off that econ 101 book for more details).  But when any or all those factors increase, price inflation may happen.  What happens when everything you buy gets more expensive?  You ask for a raise.  Goods get more expensive.  And the cycle repeats; it’s self-reinforcing.  And when it gets out of control, people come to expect it and try to get ahead of it.  That’s hyperinflation.  So, do we have transitory inflation, meaning short lived and caused by weird one-time events?  Or something more serious?  

Inflation, this time around, is mostly the result of two factors.  First, the increased money supply and direct payments to Americans drove the increase in demand for goods (and investments, see the record stock market valuations).  Second, as demand increased, supply of those goods hit a wall, both at production facilities and in transportation capacity.  One of the drivers of inflation, the supply/demand imbalance, is likely a short-term issue, the other, the massive Federal Reserve balance sheet, will persist long into the future.  But there may be a third issue that is becoming troublesome.  Wage growth, and workers’ associated expectations.  Due to America’s worker shortage and stagnant population growth, the US may contend with this issue for decades.  The question is whether inflation expectations become embedded in the psyche of workers, managers, buyers, and sellers or whether the Fed can control expectations and bring inflation back to earth.

These are the questions the Federal Reserve is grappling with when it met last week: 

  • Will all the savings and spending over the last two years keep the economy red hot or will the effect fade?  
  • Will demand slacken, allowing supply chains to recover?  Or will savings keep the spending spree going?
  • Is inflation already self-reinforcing or will it be as fleeting as the memory of a goldfish?
  • Has the economy reached maximum employment?  Will workers return from retirement? How will this change wage expectations?  
  • Is the economy overheating due to the excess liquidity sloshing around the punchbowl economy?
  • How much of an interest rate rise can the economy sustain, and how fast can the Fed contract its balance sheet before the economy goes into withdrawal and causes a recession?

And that’s why the Fed will raise interest rates several times this year, while slowing, then reversing the purchase of assets and slowly unloading its balance sheet.  The Fed will come out of the gates strong to show its ability to act quickly and forcefully.  Those actions will squash inflation fears and a more normal approach to steering the economy will ensue.  If you asked me to answer these questions (and, let’s be honest, no one at the Fed is asking for my opinion), I’d say expect decelerating economic growth, slowing demand for goods, easing supply chain pressure, and inflation that peters out as 2022 progresses.  While 2023 will look a lot like a return to normal economic conditions.  And because markets operate on future expectations, recent movements are adjustments to reflect those conditions.  But these things are harder to forecast than the weather, so as always, expect animal spirits to prevail in the short run.

So, should I be investing in real estate right now?

Should you be investing at all right now?  If you have a long-term investment philosophy, the answer is, “yes, yes, always yes.”  Buy on the way down, buy on the way up.  The right time to invest is almost always now.  The question is not when, but how much and in what asset allocation.  Investing with diversification in mind is the best answer for most investors.  But is it the right time to invest in real estate?  Isn’t real estate over-valued?  

To answer this question, we need to know whether real estate is over-valued compared to the alternatives?  What do you measure real estate valuations against?  Is real estate overvalued relative to stock valuations, to gold prices, to crypto currencies?  You can find a great macro perspective of valuations here, on Longtertrends.  But to cut to the chase, real estate appears undervalued when compared to alternatives, yet like all investments, expensive when compared to incomes.

Speaking of incomes, not only are Americans’ incomes rising, so are the incomes of those who collect rent.  Over the last few months, commercial real estate has seen record levels of rental rate increases driving revenue growth.  That revenue growth is a result (and a cause) of inflation and will help to support real estate valuations.  This is one of the reasons real estate is an attractive asset for inflation protection.

Another question to ask is what tolerance you have for risk and volatility.  Real estate is one of the least volatile asset classes.  And, as we saw during the last two years, it is often the beneficiary of fiscal support due to its relationship with housing.  If you’re fearing big swings in more risky assets, illiquid private real estate may provide a more predictable outcome.

Answering these questions can help to solve the ultimate investing question:  what should your portfolio allocation be, on account of your risk tolerance?  Many financial advisors see that the traditional 60/40 portfolio is not producing the results it once did.  Moving to an allocation that includes a significant portion of private investments is becoming much more common.  In fact, there are many articles like this one from Kiplinger that advocates a 33/33/33 allocation, with the new 33% coming from private equity alternatives.  So, if your portfolio is undervalued on private equity, real estate is a great place to start investing in alternatives.  As we move into a new cycle, it’s time to re-evaluate your portfolio, set an allocation, stick to it, and rebalance regularly.  Now is as good as any time to invest in real estate.

Upcoming Content  

If you haven’t noticed, I love economics, data, and interesting perspectives and interpretations of both.  That’s why I read a lot and write about what I read here.  But, in the coming months, I’d like to share some of the metrics I watch and sources I read often to gain insight.  I’ll explain why I watch them and how they help us make investment decisions.  We’ll also describe the drivers of each metric and how it relates to real estate investments.  Keep an eye on the blog for these topics as they roll out this year.

  • GDP / Economic Growth
  • Interest and Inflation Rates
  • Fiscal and Monetary Policy Movements
  • Personal, Business, and Public Debt Levels
  • Consumer Confidence
  • Jobs and Employment  
  • Population Trends

  • Revenue and NOI Growth
  • Capitalization Rates
  • Rental Rates
  • Rental Demand, Vacancy, and Occupancy Rates
  • Utilization Rates
  • Delinquency and Default Rates
  • Special Servicing of Mortgages
  • Transaction Volume

Take Care and Happy Investing in the New Year (by both Gregorian and Lunar Calendars)

Interested in learning more about our investments?