Altus Insight: September, 2016
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: September 30, 2016
FR: Forrest Jinks
RE: Cash Flow!
I received comments in response to last month’s article that it would be worthwhile to discuss situations where cash flow from an income producing investment can become a foe instead of a friend. This is a great topic and worth exploring, especially in light of last month’s subject of “why we invest”.
First, I want to share the quote below from Stanley Fischer after the big annual central bankers’ conference held in Jackson Hole this past month. Dr. Fischer is the Vice Chairman of the Federal Reserve and one of the most influential central banker in the world:
DR. FISCHER: “Well, clearly there are different responses to negative rates. If you’re a saver, they’re very difficult to deal with and to accept, although typically they go along with quite decent equity prices. But we consider all that, and we have to make trade-offs in economics all the time, and the idea is, the lower the interest rate the better it is for investors.”
The Federal Reserve clearly has added a third mandate to their charter, help investors. Being “only” a saver isn’t going to get us “there” any longer, the Fed is forcing our hand in active investment. With that active investment comes the risk of loss, and with the value of savings (and overall risk adjusted investment returns) being eroded by Fed policy (and to be fair most other central banks as well), losses become more dangerous and harder to recover from. While perhaps hyperbolic to say so, there may not be another time period since the Great Depression (and likely before) where investing decisions are more important; and certainly more difficult. This is a perfect lead in for our discussion of cash flow.
Not all cash flow is created equal. The obvious part of this statement is an 8% return is better than a 6% return, but that is only true if all other factors are equal. What are those other factors (please grant me artistic license with the descriptions I made up below)?
Predictability: What is our confidence level that the anticipated cash flow will show up when expected? While certainly not universal, many investors fund their everyday spending with cash flow returns achieved on their investments. If cash flow doesn’t arrive when expected, or in the amount expected, this can create difficulties in keeping bills paid.
Dependability: Many investment structures are such that investors are paid first. This is obviously the case in the ownership of debt (although that payment may be through collection on the collateral). In Altus’ world it is often through preferred returns. In many of our structures investors get paid their minimum return prior to Altus receiving payment on that same investment. This doesn’t mean that income will be received by the investors like clockwork at the preferred return amount, but it does mean that when there is income, it is distributed to the investors to catch up them on their expected returns. In the Altus Hybrid Growth Fund, which we recently (successfully) liquidated, the investors received an 8% annual preferred return (plus upside). Sometimes this was paid as 2% each quarter but other times the quarterly distribution was only 1% one quarter with a 3% distribution as a catch up the following quarter. The returns were dependable, but they weren’t necessarily predictable. With us now focusing more on leased investments (and due to continued return compression in the market place) the preferred return amounts are lower but they are just as dependable and a lot more predictable. While not a hard and fast rule, predictability and dependability will lower the expected returns of an investment, both in terms of cash flow and total return.
Volatility: Similar to Elasticity (discussed below) and an offshoot of predictability, volatility speaks to type of returns being produced by an investment. An investment with high volatility may return 16% cash on cash return for 3 out of 5 years and 6% in each of the other two years for an average cash on cash return of 12%. Another investment may return 8% every year for 5 years (for an average 8% return). Volatility doesn’t mean lower dependability (although it might). As an example, some companies transact a few high dollar items each year while other companies transact thousands of low dollar items each year. The movement within the calendar of a few of the high dollar transactions can destroy profitability one year and cause it to spike in the benefiting year, where the gain or loss of a few low dollar items within a financial year won’t drastically affect profitability of the high transaction company. Over time, the peaks and valleys of the high dollar transaction company will even out and the ensuing result may be drastically better than the low volatility, high volume transaction company. Which cash on cash return is better? Like with so many other answers in the world of investing, it depends. It depends on the needs of the individual investor.
Elasticity: The old adage instructs us to make hay while the sun is shining, which is great advice, but cash (and by extension cash flow) is more valuable during economic storms than during economic sunny days. Ownership in certain types of businesses will produce great income at some points of the business cycle, but poor income at other points of the business cycle. As an example, I own interests in some oil wells. Oil prices are volatile. The cash flow produced by those oil wells is highly dependent on those oil prices. Will that cash flow be strong during a recession? Probably not, so I shouldn’t depend on it during the economic storms, even though I might really benefit during economic growth. Understanding which is which, and which is important to you, is important for appropriately positioning your investments.
Replacementability: If the source of the cash flow goes away, how hard will it be to replace that cash flow, what will the cost be to replace the cash flow, and how long will it take? Some single tenant NNN buildings are an investing rage right now. I have discussed the example of RiteAid buildings selling for 3% cap rates. This income is highly dependable, has very low elasticity, and no volatility. All good traits, unless…RiteAid runs into economic trouble (and even the best companies do) the returns go to zero, it could be very difficult to find a replacement for the cash flow (tenant) and there will be substantial costs to get that tenant into the building (debt service, tenant improvements, leasing commissions, etc..). If RiteAid runs into trouble the income goes from “expected” to zero. Not a good situation.
Contrast that with a light industrial complex. A property like this could have 30 tenants with all of them likely to be relatively small local companies, owned and run by owner operators. During an economic downturn some of these companies may go out of business, but if there is any chance of staying in business the owner operator is going to do everything they can to make sure they do stay in business. It is their livelihood. Should spaces go vacant there are lots and lots of small businesses to take the previous tenant’s place, and while a single tenant going out of business hurts cash flow, it isn’t catastrophic like it would be to lose the tenant from a single tenant property. Residential rentals are similar to the light industrial example in that there are hundreds and thousands of people that need places to live, even during bad economic times. This doesn’t mean that residential (or industrial) properties aren’t impacted at various stages of an economic cycle, it just means they should be more stable than some other types of income investments.
Seniority: The more junior an investment position the higher the expected rate of return for that position. However, when things don’t go as anticipated the higher likelihood of loss, first of income and then of capital, the more junior the position in the debt/equity stack. Hard money financing is a good example. A first deed of trust on a relatively liquid real estate investment (such as single family home) could pay 8% in the current environment. People hoping for higher returns can provide 2nds or thirds at rates in the 12 – 14% range (note this is highly borrower specific – good borrowers = lower rates). If everything goes right, 14% is a better return than 8%, but if things don’t go right, the 8% has a much higher likelihood of being paid, and possibly more importantly, not losing capital. Seniority increases predictability.
Coverageability: Many investors, Altus often included, use outside debt to increase the percentage returns achieved on an investment. This holds true for both the cash on cash return and the total returns achieved. However, this debt increases the risk of default. If there is no debt, there is no risk of financing default. Where does it make sense to take on the extra risk for the extra return? Like in many investing scenarios, it depends. It depends on the type of cash flow being used to cover the debt, the number of sources being used to service the debt, and the dependability/replicability/etc. of the sources being used to cover the debt. We prefer investments with lots of different income sources (in our case tenants) and prefer those income sources to be highly replaceable. If an investment has fewer sources producing the cash flow, we might increase our cash reserves to be able to absorb the potential loss of income. Or we might lower our leverage percentage so that the debt payments can be covered by fewer sources of cash flow. In investorspeak, this is call debt service coverage ratio (DCR). It is the net operating income (NOI or EBITDA) of an investment divided by the debt service for that investment. Two hundred thousand dollars of annual net operating income and one hundred fifty thousand dollars of annual debt service calculates to a 1.33 DCR. For some investments this DCR may be sufficient. For other investments a higher DCR may be required. Another factor to take into consideration when determining a DCR that is comfortable for you on a particular leveraged investment is the terms of debt. If the debt is fixed far into the future, then the only concern in the DCR calculation is the NOI. However, if the interest on the debt is variable or short term, even a consistent NOI could still result in a negative cash flow situation (a DCR less than zero) due to increased debt costs.
Effortability: This is an often overlooked component of investing in general, and likewise in obtaining cash flow on an investment. One reason people pay 3% cap rates for RiteAid buildings is that the collection of the income takes very little effort. Owning treasuries requires even less effort. However, if RiteAid runs into trouble (as discussed above) suddenly the situation requires a large amount of effort, and hopefully a corresponding amount of expertise. In general, investing in debt will require less effort than investing in equity. This is more true if the debt investment is made alongside other investors as opposed to individually. Bond investing is debt investing with an extreme amount of co-investors. Within equity investing, direct investment will require less effort the fewer the tenants (source of cash flow) that are involved with the investment, although as discussed, having fewer tenants may have corresponding negative attributes. Equity investing offers the option of investing through investment sponsors who, if good (as operators – I am not referring to being good investors in this case), supply all the effort needed for the equity investment.
For Altus one rule holds true, we want to do everything we can do to avoid have stabilized property produce negative cash flow. We try to first try to insulate ourselves by owning property with lots of easily replaceable tenants and limiting interest rate risk. Beyond that we want to make sure our debt coverage ratios have enough buffer to keep debt paid and/or have appropriate reserves to weather periods of negative cash flow should we have to deal with such an occurrence. This doesn’t mean we won’t do an investment that doesn’t have lots and lots of tenants, but we definitely look at it closely. It also doesn’t mean we won’t do an investment where we can quantify the interest rate risk, but it does mean we will build in buffers in our assumptions should events move against. There is no right or wrong way to look at all this, there is only each investor’s individual comfort level, and it is within that comfort level (or investment rules) where we will make our best decisions.
The truth of the matter is none of us know how are investments are going to perform in the future, and certainly not through economic turbulence of any magnitude. But while only time can provide the answers, not knowing the answers doesn’t keep us from doing what we can to position ourselves to the best of our abilities now.