by David Scherer, Origin Investments
Last month, with the election of Donald Trump as president, we entered uncharted waters, politically and economically.
This historic event—perhaps unlike any other we’ve experienced as a country—has created a profound level of uncertainty and uneasiness. A clearer picture of what lies ahead may not emerge until we approach the first 100 days of Trump’s presidency, maybe more, maybe less.
Business owners, investors and others are asking key questions, such as whether it is feasible to make hiring decisions, launch expansion programs or make investments during this uncertain period. In a broader sense, they are asking how markets and foreign leaders will respond.
Some early signals, within the first seven to 10 days after the election, aren’t conclusive; they may only reinforce the uncertainty:
- Just after the election a prospective client announced his intention to delay investing in our Fund III until there is “greater clarity about what a Trump presidency means for the investment outlook” in the United States.
- Since election day, the Dow Jones Industrial Average has produced a 625-point-gain (3.4 percent) to about 18,957. This is far different than late election night when the futures market was down 800 points.
- Interest rates already have started to climb, increasing more than 30 percent, from 1.75 percent to 2.30 percent.
We know a lot of the president-elect’s positions and likely actions on a variety of issues, or at least we think we do. Further, we have a pretty clear understanding that a Republican-controlled house and senate will further advance certain agenda items, including:
- Repealing or at least substantially amending Obamacare. The unpopular law has gained even more detractors because of the large premium increases this year.
- Cutting corporate and income taxes. Those moves would put more money in the pockets of U.S. citizens, with gains limited largely to the wealthy. Trump also will propose a one-time repatriation of foreign taxes at the 10 percent rate.
- Renegotiating NAFTA, TPP and other international trade agreements, potentially (likely) at the expense of net GDP growth. There also can be winners and losers in the newly protected industries (steel, coal, etc.).
- Less regulation. Dodd-Frank may be repealed. In general, less regulation is seen as pro-business, a net positive.
- It is also expected that Trump will propose limiting immigration and move toward an increased domestic investment in oil and coal.
Some of these actions will bring about uncertain results. Some may be positive. Others, however, are likely to have a negative impact on GDP growth. But the net will be that the United States’ economy is worse off because of the higher import pricing and re-allocation of resources into lower-efficiency areas. The effect on the bond market will be key, as it may view these policies as increasing the deficit, U.S. debt and inflation rate. If this happens, we will see the risk-free borrowing rate (10-year note yield) increase further.
Such an increase could hurt the U.S. housing market and business expansion potential. That same increase also hurts multiples on all capital assets, as higher borrowing rates create higher discount rates of cash-flow streams.
The cumulative effect of these speculative moves only fuels the uncertainty, including their collective impact on commercial real estate investing. As an investor, it begs two big questions: What actions can you take, and how should you approach them?
Historically, real estate outperforms most other alternative investment options. Further, when private investment in real estate is used to further diversify a portfolio of stocks and bonds, the results typically have been higher risk-adjusted returns and lower volatility.
Yet who you invest with is the single most important decision when investing in real estate. A top-tier manager will put you in a great position to succeed and protect your capital in all economic cycles. They behave rationally and responsibly. An inexperienced manager without infrastructure, experience or their own capital in the venture will take outsized risks at your expense.
Before a deal is ever considered, spend your time talking to the manager and vetting them carefully. Do they have a track record of generating consistent returns—returns that outpace the vast majority in their sector? Do they have a quality team? Do they invest significantly alongside you, sharing both pains and gains? Inquire about the worst deals they’ve ever done, what they learned and how they incorporate that knowledge into how they operate. Call and speak with references and never be afraid to walk away.
There also are other factors to consider and evaluate, including
- leverage risk, the amount of debt that will be secured to buy and improve a property. While interest rates remain low and quite favorable, the 30 increase we have seen since the election quickly erodes return models. The greater the use of leverage, the greater the exposure in an uncertain interest rate cycle;
- asset-type risk, the type of properties that will be acquired and the inherent risk involved in operations; and
- project-level risk, the specific characteristics or issues of a property and how that will affect performance or the ability to influence operations. It is important to understand the operating strategy for each property they’ll acquire and the strategy for fixing solvable problems.
Real estate is complex and trying to narrow it down to a few variables to make a smart decision is incredibly challenging. When accounting for risk adjusted returns, it’s all about the ability to meet or exceed the assumptions in the underlying financial model. Investors also need to consider things like fees, growth rate assumptions, exit pricing, barriers to entry, aesthetic appeal, capital improvement costs, supply and asset history, to name a few. These all have a material impact on the risk-return profile and the decision to move forward.
As we all look to navigate these uncharted waters created by the uncertainty of a Trump presidency, it isn’t necessary to stick assets in a mattress. Perhaps more than any other time, it’s an appropriate time to make well-informed, decisions that may be aligned with a sponsor who has the experience and a performance track record to move the needle away from uncertainty.
David Scherer is the co-founder and principal of Chicago-based Origin Investments.