“All the Money in the World “

By Arthur Budge & Mike Tonti

The recent financial crisis was fundamentally caused by too much leverage.  Credit was too easy, from debt for speculative investments for the most powerful investors to “no money down” real estate loans for the general public. 

A cycle of ever lower interest rates and looser terms translated into an inflation bubble, most broadly seen in the housing market.  If a property would yield 9% in rental income and the payment on borrowing was 8%, the property would generate a 9% yield on the equity, there was a 1% spread on every dollar borrowed.  If the mortgage was 75% of the cost, the property would generate a cash yield of 12% on the equity.

Initial Purchase

As the Fed drove interest rates ever lower, the math got even more attractive.  More money was attracted to these opportunities.  The result was that buyers would pay more thus driving up the value of the properties because they could borrow the majority of the purchase price at a lower interest rate.  The rental income might remain the same, but one could rationalize paying 10% more for the same property if the interest rates had declined proportionately, and achieve almost the same yield.  

Interest Rate Falls/Property Price Increases

As the risk free rate fell, all other interest rates declined proportionally, and assets appreciated. There was no change in underlying fundamentals.  The appreciation bubble was fueled by ever looser terms and higher loan to value levels. 

In the early 1990s, when the foundation of the asset inflation bubble was laid, the financial market and government regulators were still sensitive to the debacles of the 1980s crash of the energy sector and certain regional real estate markets such as Texas.  As Wall Street developed the structured financing market, underwriting was disciplined.  But the economy was booming due to the stimulus of declining inflation, unsustainably low energy prices and the productivity lift of the efficiencies of the widespread adoption of modern information systems throughout the business sector.  Federal policy from administration to administration was that declining interest rates provided the necessary liquidity for the unstoppable expanding economy. 

But the cost of energy recovered, and soared to historic highs.  The rate of increase in efficiency from new information technology slowed.  Interest rates declined to levels where there was not much lower to go. 

The leverage cycle discussed above had been applied to just about every asset class that generated a cash yield.  Declining interest rates were fueling real estate price increases, as well as the valuations of oil and gas properties, timber properties, income generating businesses of almost every kind, as well as the stock market through easy credit for hedge funds and private equity (LBO/Leveraged Buy-Out) funds.

When the merry go round stopped in 2008, it was a disastrous situation.  Asset values in most sectors exceeded historical norms based on traditional metrics.  Values began collapsing, and those with the most debt declined the furthest and the fastest.  The most prominent examples were the failure of Lehman and Washington Mutual and the bailout of AIG, Fannie Mae, Freddie Mac and others. 

The private sector was devastated. Only the Wall Street bailout kept the banking system and the Wall Street investment banks from collapsing. Confidence in asset values was shattered, and markets began collapsing as credit tightened.  The economy began deleveraging. 

Deleveraging is a process, not an event.  Today banks only make the most prime loans, if they are making loans at all.  As older credits mature, they are subjected to stricter credit policies, resulting in a decline in total loans.  Many businesses have record levels of cash on their balance sheet, but are cautious about making for new investments.  Federal agencies have rediscovered the discipline they lost at the end of the boom.  Credit is tight. 

Congress and the administration made the decision to borrow even more money to provide stimulus to the economy by filling the gap left by the shrinking private sector with government spending.  The Fed elected to lower interest rates to near zero in an attempt to put a floor on asset values.   The theory appears to be that if the stimulus could stop the contraction, and “0%” interest rates could starve the investment sector from returns, it would stop the price correction of the overvalued assets. 

We now have a market where it appears that all the money in the world is available at a cost of close to zero.  But the money is only available for “safe assets”.  The investment sector is seeking yield, which appears to have stopped the decline in asset values. There have even been some signs of recovery.  But there is continuing risk and fear.

Throughout history, easy money has led to inflation.   Yields currently available on risk free and lowest risk assets do not allow for inflation.  This fear is most directly recognizable in the run up in gold prices and the weakness of the US dollar. This fear of inflation is probably responsible for some of the recovery in the valuation of real estate and natural resource assets such as oil and gas properties.  It is difficult at this time to deduce the cause and effect.  Is the stabilization driven by the current government policy, or is it driven by fear that these policies will ultimately lead to inflation?   And how do we make prudent investments in this environment? 

We see the risk spread in asset valuation as the most attractive opportunity today.  The increased return available on assets that have a small degree of perceived risk compared to the “risk free” assets is very high.  For example, a fully leased class A apartment complex is considered “low risk”.  The spread between the value of a fully leased apartment complex and a comparable new property, that is held by a financially distressed owner and has not yet achieved full lease up, is as much as 30%.  A property that is not fully occupied cannot get financing in this environment.  In certain of these assets, it is not so much risk but the need for a little more capital, some time and some work.  This creates great opportunities for entrepreneurial investors such as our Five States Tonti funds.

On the energy side, the opportunities are similar.  Proved Developed Producing (PDP) oil property acquisitions, like those Five States made in the 1990s, are considered “low risk”, and the market is currently pricing them at a premium.  Properties that contain a combination of PDP and development potential are priced at much lower value relative to their income potential.  The PDP portion is pricing high, but the non-producing portion is pricing at multiples of present value.  The average results in a good investment.   These assets are more like the acquisition Five States made in the early part of the last decade.  These assets require some capital, time and work to realize the full value and yield.  This creates great opportunities for entrepreneurial investors such as our Five States Energy Capital Fund.

Markets are down.  Real asset valuations are also down.  We are making real asset investments in high quality multi-family and development oil and gas assets on the most attractive valuations we have seen in over a decade.  But we do not get all of the return we expect “at closing”.  It takes some time and work to achieve the target double digit yields.  But the returns are available through value enhancement work that is understood and quantified at the time of purchase.

Even in the worst economic times, the competition for quality income producing assets is fierce.  We believe that real property valuations are much more realistic than they were before the crash in 2008.  However, much of our competition is “fee driven” (the manager is primarily focused on the fees he will earn), and is not as sensitive to the risks as we are.  Our profits come from our profit share of the profit on the investments we make for ourselves and our investor partners.  We have no fee income profit center, so we are extremely aligned with the risk/reward interest of our investor partners.

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Deleveraging is a process, not an event.  This process takes years.  The “new normal” in which we find ourselves will be the norm for a long time.  The risk spread on asset valuations is creating the greatest opportunities.  Our professional teams at Five States Energy and Tonti Properties excel at this type of risk analysis and have the experience to make the right judgment calls. 

We will not find a unicorn under the Christmas tree at each closing.  But we are in an environment where we can build a healthy portfolio of high quality assets at excellent valuations from which we can earn attractive current yields for a long time.  This is by far our favorite environment for investing!