If we are being honest, there aren’t likely to be more than a few Altus Insight recipients that are excited to read the Insight on a Sunday night in the middle of the holidays. It isn’t an easy Insight to write either, as we try and juggle time with family and friends while keeping the cogs of Altus turning. But things happen. I will try to keep it short in discussing three December surprises that may have broader implications to our investing decisions in the coming months.
Softness or…
Any time we use observatory evidence on broad matters like economic activity or investment trends, we have to be careful that our inherent biases or myopic existence (we are after all only one in several billion) don’t provide false signals. Even if our observations are accurate, we can also fall prey to conflating causes and effects and/or causations and correlations.
With this awareness, I am hesitant to read too much into my December observations, but it sure seems like something is off. The third quarter GDP reading came in showing hot growth, but does it feel like that on the ground? While the extra week between Thanksgiving and Christmas could certainly be skewing activity, stores did not seem as busy as normal in the lead up to the Christmas weekend. Two different ski shops my family visited both said they have been extremely slow. We skied the Saturday before Christmas, usually a pretty busy ski day, and the mountain was empty. My neighborhood is normally lit up like a runway with Christmas lights. This year only one house has lights. Shoot, even the wall where we hang holiday cards is lighter than usual. Our on-site property managers are reporting increasing difficulty in collections. Savings rates are falling and are now well below the long-term average. A recent survey done by CNBC found people drawing down savings are most often (78%) doing so to cover fixed expenses like mortgage or car payments and common everyday necessary expenses like groceries.
What does it mean? Who really knows. But it well could be the tip of the reduced spending spear. Credit card balances have skyrocketed, most people’s school loan payments have restarted, and things cost more than they did before. This isn’t enough to say we are entering a recession, or that a recession is imminent, because there are many more factors at play. But it’s still something interesting to watch.
Since the original writing, holiday sales estimates have been released indicating 3% year-over-year growth, well below the 5% consensus, in line with year-over-year inflation, but still growth all the same.
A really, really, big deal
Colorado’s (and now Maine’s) decision to exclude Donald Trump from the ballot is a disaster. I do not have the legal expertise to weigh in on the legality of the decision, but purely from the perspective of the US as a democracy, it is a slippery, slippery slope. Don’t get me wrong, nothing about my discomfort has anything to do with Trump himself. My belief in the importance of a democracy is more important than my distaste for Mr. Trump as a candidate. In a democracy, the ends simply cannot justify the means, and Mr. Trump has not yet been found guilty of any crime. One of the core tenants of America as the greatest country on earth is “Innocent until proven guilty.” As soon as the ends (a terrible candidate not being allowed to run) justify the means (finding a way to keep a not yet guilty person from running) we are no longer a democracy. This is by the very definition of a democracy.
But this maneuver opens the door to retribution. The governor of Arkansas was in Trump’s cabinet. What keeps her from kicking President Biden off the ballot due to using his position of power to enrich his family members? And then more blue states kicking Trump off the ballot. And the more blue states that kick Trump off the ballot, the more red states will kick Biden off the ballot in retribution. I hear the screams of protest – It hasn’t been proven true yet and is a big conspiracy. Well…technically Trump has not been proven guilty yet, so this is an apples-to-apples argument. Let’s follow this reasoning further. If we assume purple states (one Republican senator, one Democrat senator) stay neutral or at least otherwise cancel each other out, and the red and blue states kick the other party’s leading candidate off the ballot, then no candidate ends up with the required 270 electoral votes. This then pushes the decision to the House of Representatives, where each state gets one vote. Assuming the purple states split the votes (or something thereabouts), Donald Trump would win the election because there are more red states than blue states. I am guessing this is not the outcome the Colorado or Maine elites had in mind when making their highly non-democratic decisions.
As my personal philosophy and a core belief, I don’t think there is a better system of government available to us than a democracy. But in terms of investing, it is pretty clear that broad investment success depends on a level playing field. This is, after all, the entire mandate of the SEC. A level playing field needs clearly defined property rights and consistently interpreted rules of law. Consistent interpretation of the law is also a key tenant of democracy. As soon as anyone in a position of power, such as the judges (Colorado) or a single unelected election official (Maine), uses that power to pick winners and losers, we no longer have consistently interpreted rules. Tyranny is defined by an arbitrary use of power or control. There is no other way to describe what has happened in Maine – one person arbitrarily dictating the voting for an entire state.
We have discussed the dangers of the political extremes in past Insights (Obama – Solyndra, Trump – Ford), but there was always the safety of the courts as the last line of protection. The Colorado Trump decision, and the mayhem sure to follow, completely throws the level playing field out the window. Investors will be less compensated based on their investment ability, and more compensated by being in the know of the arbitrary decisions that those in control will be making. And this will further increase the rich/everyone else divide. We have a pretty clear example of the results if we go down this road far enough. Russia. There are the incredibly rich oligarchs, a very small middle class, and then a huge percentage of the population that lives in what would be considered poverty in any 1st world country.
Interest Rates Cratering
Since cresting five percent on October 23rd, the ten-year treasury rate has fallen as low as 3.79% before finishing the year at 3.88%, a reduction of 22.4% in only 66 days. As the price of money, interest rates are arguably the single largest influence on asset valuations, and the ten-year treasury is the gold standard for interest rate watchers (though shorter-term rates likely have a larger impact on the day-to-day gyrations in the stock and bond markets). The financial news reads that the drop in yields is due to the Fed winning the battle against inflation and the expectations of the Fed returning to accommodative policy in the coming year (which is backed by the Fed’s 180° change in communication from November to December). Historically, however, absent central bank interference, longer dated bonds, like the ten-year treasury, are a reliable indicator of future economic performance. We are coming off a hot Q3 GDP reading (though arguments remain as to whether the inflation measurement is accurately capturing inflation, and if not, then GDP would be overstated). But falling treasury yields indicate a flight to quality, thus fear of a weakening economic condition. The yield curve is inverted at every point along its slope other than the twenty-year treasuries returning a higher yield than the ten-year treasuries. This puts the inversion considerably more extreme than this time a year ago. Are the falling rates a return to normalcy, or an indication of a weakening economy? Is the strengthening inversion a forecast of economic turbulence, or caused by expectations of the Fed changing short term rates? Time will tell.
A twenty-two percent change in only two months is a massive change in such a short amount of time. By comparison, the 2023 run up in interest rates that has caused so much consternation averaged .8 basis points per day. The freefall from this cyclical top has averaged 1.7 basis points per day, more than twice the daily change than during the run-up.
Because interest rates are such a major impact on asset valuations; and have an even outsized impact on real estate due to the higher levels of leverage used, these sort of rapid changes need to be examined as to how it will impact business plans within the investment real estate world. The following are by no means statements of fact, but rather things I think, or maybe even think I think:
- The falling rates should reduce the pressure on many borrowers approaching a balloon payment, which in turn is likely to reduce the volume of distress in the investment real estate markets. By no means should this be taken to understand that the RE markets will avoid a period of heavy distress. Interest rates are still far above their lows, and other than with industrial properties, rents haven’t continued to increase at the rates many buyers used in their proformas. It is the marginally distressed properties that could avoid more pain.
- Many years ago, we (Altus) made the decision to have a long-term debt bias. This reduced our purchasing competitiveness during the recent market exuberance (long term debt is usually more expensive than short term debt), but the assumable nature of the debt provided pricing support over the last two years of falling prices. We haven’t been active sellers, but we have been constantly bombarded by buyers and brokers wanting to purchase our properties at prices much stronger than comparable properties without in-place debt. The higher the interest rates went, the larger the pricing spread between properties with strong assumable debt and those requiring new financing. With interest rates now reversing course, it is likely that spreads will start to narrow, though continue to be accreditive for some amount of time into the future.
- As mentioned above, there are indications of stress on the consumer. Falling rates will relieve pressure on consumers, but not yet. Credit card interest rates, car financing, etc., are more often based on the prime interest rate versus anything in bond markets, and the prime rate hasn’t yet been moved.
- However, home mortgage rates are based on the bond markets, and as such are starting to see some relief. The resale home market has been locked up for months due to the disconnect between in place rates and existing rates. The interest rate reductions we have seen thus far won’t fix that problem; but will start to soften the impact and result in increased transaction levels.
- In many asset types and in particular markets, available inventory remains low. The high interest rates of the last year, coupled with buyers’/renters’ inability to increase what they could pay, have put a substantial damper on new supply coming to the market. The high interest rates have also caused many developers (including Altus) to put a hold on a some construction projects. As rates fall, more and more projects will start to pencil again. Our projects on hold are not yet there, but we are already seeing the benefit from the falling rates on projects that are still moving forward.
- The Altus Opportunity Fund strategy was initially constructed in early 2023 with an eye on the coming distress. That was when interest rates were still increasing rapidly. But even then, we understood that the distress was going to be mostly tied to the cost of money rather than supply and demand imbalances (as was the case in the GFC). Being aware that the cause of the distress (increasing interest rates) could just as easily change course, we felt strongly we needed to be structured such to also be able to take advantage of opportunity if rates fell. That is why we built in the ability to invest in new construction or heavy value add projects. By including the GP promote (the project sponsor compensation for their efforts/expertise) into the returns of the Opportunity Fund, the Fund is be structured to thrive regardless of the direction of interest rates. Where interest rates go from here nobody knows, but we are excited about the opportunities of where things currently stand, and we are optimistic of the continued opportunities, regardless of whether they rise or fall from here.
I fully intended for this to be a shorter Insight than normal. I failed miserably. Mark Twain is claimed to have said “I didn’t have time to write a short letter, so I wrote a long one instead.” Twain was a literary genius able to shorten his thoughts. I still have much to improve upon.
Happy Investing, and have a Happy New Year!
