Central banks like the Federal Reserve battle inflation – the general rise in prices—by boosting interest rates. In a benign environment, the rate of inflation is low, but as the economy heats up, inflation increases and robs the local currency of some of its buying power. By lifting interest rates in small increments, the Fed moderates the economy by increasing the cost of capital, that is, how much interest you have to pay to finance a project with borrowed money. Some potential projects will not go forward because they can’t generate the required rate of return necessary for investment due to the higher cost of capital. After all, the more of the project’s revenues that must be spent on interest and higher costs leaves less to compensate investors for committing their money to the investment.
As inflation and interest rates rise, what happens to multifamily real estate investment? In general, real estate values rise along with, and act as a hedge against, inflation. But the devil is in the details, and it takes the right combination of management, financing and location for a particular real-estate investment to benefit from inflation.

Make Inflation Your Friend 

Inflation and its accompanying interest rate increases affect a multifamily real estate investment in several ways. Let’s break it down.
This is how stock markets sometimes operate, with seemingly endless trends suddenly interrupted and/or reversed. A long bull market tends to attract ‘’weak” investors who are not accustomed to, and can’t stomach, a sudden sell-off. Weak investors are the first to sell their stocks when prices begin declining, which can have a snowball effect that causes volatility to skyrocket.

Net Operating Income (NOI) 

A property’s NOI is its revenues from rents and fees minus the costs of operating the property. For a property to benefit from inflation, its income must grow faster than its expenses. In the context of a multifamily property, this means that the rent increases must at least keep pace with the inflation rate, while costs require tight control to keep their rise below the inflation rate.
A good investment property in an inflationary environment will support sufficient rent increases with each lease renewal, which in turn depends upon the value perception of tenants, lease terms, and the availability of competing rentals. Improved property management can increase occupancy rates and rents by addressing structural and operational problems. Operating expenses can be controlled in numerous ways by better, hands-on property management, including switching to lower cost vendors and suppliers, more cost-efficient and effective marketing, and repairing costly problems. All of these are features of a value-add strategy, the hallmark of Lloyd Jones investment properties. The ideal property must pass our proprietary screening protocols that evaluate a property’s suitability for value-add. In other words, we need to make sure the value we add through rehabbing and better management will increase NOI. At Lloyd Jones, very few properties make it through our tough screening.

Net Profits

NOI does not include the cost to finance a property with debt – that is, the interest rate on the underlying mortgage. Net profits, on the other hand, do indeed depend on ensuring that financing is structured to provide maximum protection from the rising interest rates that accompany inflation. Here are several of the strategies we use:
1. Sensitivity analysis: Our screening protocol projects how a property’s value will fare if interest rates rise when we refinance the property (to unlock and extract equity) at the end of the value-add period, typically two to three years after purchase. We model the sensitivity of the investment’s return to a wide spectrum of interest rates so that we can quantify the risk involved in refinancing during an unfavorable borrowing environment.
2. Control leverage: Debt is indispensable to most real estate projects, but too much debt, or leverage, can swamp an investment with unsustainable interest expenses. We typically structure multifamily investments with a 70 percent cap on loan-to-value. In other words, our financing requires 30 percent equity contribution from investors to limit exposure to rising interest rates. We also observe conservative borrowing standards – we take only non-recourse loans (the property alone serves as collateral, and the lender cannot attach other investor assets), and never cross-collateralize our properties (meaning the default of one property doesn’t affect the financing of any other property).
3. Build a cash cushion: By specializing in value-add properties, we have the ability to build a cash cushion that wouldn’t be available from a stabilized property. This cushion can help protect the investment even if high interest rates negatively affect property values and cash flows.
4. Flexible debt: We often use a mix of fixed and floating-rate debt with staggered maturities. This helps keep interest costs low during the value-add period and helps us avoid overly-large refinancing tranches. We also like to structure our loans for terms of at least five years, which gives us a two-to-three-year cushion following the value-add period to refinance. This can come in handy if interest rates spike two to three years after property acquisition.
5. Reap what ye sow: We constantly evaluate whether it would benefit investors more to sell the property rather than hold it. This reduces our investment exposure during periods of rising interest rates. At the same time, we carefully manage our own cash position and debt facilities to weather rough market conditions without having to succumb to panic selling due to a cash crunch.

Property Value

The total return from a real estate investment is composed of the net cash flows and capital appreciation. The value of a properly selected and managed multifamily property should appreciate with inflation. Two factors are at play:
1. Higher rents: The value of a rental property is fundamentally tied to the rents it generates. Periods of high inflation produce rising wages and profits, conditioning tenants to pay higher rents for a given space and thereby boosting property values. Consumers with a greater sense of wealth will be motivated to move to nicer apartments, creating higher demand and higher rents.
2. Restricted construction: As inflation increases, construction costs rise (due to higher material and labor costs) as does the amount of interest charged for construction loans. These factors tend to restrict new construction, helping to limit the supply of competing housing.
Increased demand and decreased supply equates to higher property values and the prospect of greater capital appreciation during times of high inflation.
In summary, multifamily real estate investments can perform well during inflationary times if the properties have the right characteristics and are managed with a strong, knowledgeable hand. We invite you to speak with us about our past performance during all types of economic environments, and the opportunities we see right now in the multifamily and senior community market segment.
About Christopher Finlay
Christopher Finlay is chairman/CEO of Lloyd Jones Capital, a private-equity real estate firm that specializes in the multifamily sector. For the past thirty-seven years, and through every economic cycle, he has owned and operated successful multifamily businesses. Predecessor companies include commercial brokerage, appraisal, property and asset management, construction, and development.
Headquartered in Miami, Lloyd Jones Capital acquires, improves, and operates multifamily real estate in growth markets throughout Texas, Florida, and the Southeast on behalf of institutional partners, private investors, and its own principals.

The short answer is that stock market volatility increases demand for multifamily real estate investment, because real estate is much less volatile than stocks. For those who don’t want to invest all their money in the roller coaster stock market, real estate is, over the long run, a relatively tranquil alternative. Let’s dig deeper into the concept of volatility to explore the differences between the stock and real estate asset classes.

Something’s Happening Here

Volatility is, according to Investopedia, “the amount of uncertainty or risk about the size of changes in a security’s value.” The higher the volatility, the greater the chance that a stock’s or index’s value will suddenly and dramatically change.
A volatility spike in February 2018 awakened many stock investors to the fact the fact that stocks also go down. It’s been a long bull market, and we haven’t had a meaningful correction in more than two years. Suddenly, the Dow Jones Industrial Average dropped more than 1,000 points twice in February, a clear sign of heightened volatility, if not outright panic.
Now, take a look at the following chart. It’s a one-year chart of the Chicago Board of Exchange’s VIX Index, which measures the volatility of stock futures and options. The spike in February is all the more startling when seen against the flat backdrop over the last year.

This is how stock markets sometimes operate, with seemingly endless trends suddenly interrupted and/or reversed. A long bull market tends to attract ‘’weak” investors who are not accustomed to, and can’t stomach, a sudden sell-off. Weak investors are the first to sell their stocks when prices begin declining, which can have a snowball effect that causes volatility to skyrocket.

The Volatility Opportunity

Sudden bouts of volatility create an opportunity for you to think about your own tolerance for risk. Perhaps you invest in the stock market to reap current dividend income, only to realize in horror that a sudden decline in stock value can wipe out years of dividend payments. By the way, the so-called safer bond market is also vulnerable to abrupt bouts of volatility, creating losses that overwhelm interest income. Which brings us to our point: Thoughtful investors look to lower their risks as they seek to achieve their investment goals, and multifamily real estate investing is one of the surest means of accomplishing this strategy, because it offers steady long-term income with very little volatility. Let’s see why:

1. Diversification: Real estate market returns are not closely correlated to those from stocks, creating an excellent vehicle for diversification. As stocks bounce higher and lower, real estate follows its own course that can help steady the value of your total portfolio. Many financial advisors recommend prudent investors allocate at least 25 percent of their portfolios to alternate investments such as real estate.
2. Rents vs dividends: During bear markets, companies that find themselves in financial distress often cut their dividends to conserve cash, which takes only a vote by the board of directors to accomplish. Tenants, especially ones living in carefully screened multifamily apartment complexes and senior communities, are highly motivated to keep paying their rent, making it a much more reliable source of income to investors. The multifamily advantage over single-family rentals is due to economies of scale: More separate rental cash flows per square foot. That translates into lower overall management costs and a smaller impact when the occasional collection issue arises.
3. Alignment of interests: It’s upsetting enough when your stock suddenly loses a good share of its value in a volatile market. Adding insult is the fact that the stock broker or analyst who recommended the stock need not own a single share. Brokers make their living from commissions, which gives them a financial incentive to favor volatility and the churn it creates. By the way, fund managers don’t have to invest in their own funds either. We do things differently at Lloyd Jones, in that we take an equity stake in every one of our properties. In other words, we align our interests with those of our investors.

The Value of Specialization

Many stock investors seek to lower their risks through the purchase of mutual funds and exchange-traded funds. True, this will lower non-systemic risk, but at a cost – you have no control over the choices made by the portfolio manager. If you seek out the best fund managers, you should keep in mind that they will probably charge higher fees and in the long run will likely underperform the market – just ask Warren Buffet.
Purchasing an index fund doesn’t solve the control problem. They are cheap, but by definition give you average returns and average risk, meaning you don’t benefit from expert specialized knowledge since these funds run on auto-pilot.
Lloyd Jones believes you can do better than average when you apply specialized expertise to given segments of a market. We do this through first through geographical specialization, by investing in business-friendly, low-tax states in the Southeast, especially Florida and Texas. Senior and multifamily housing investments are favored in this region due to warm weather, low costs and low taxes.
Geography is a good start, but it takes a lot more to identify real-estate investments with solid cash flow prospects and low risk. We select properties with good cash flows that would benefit from more capitalization or better management. Only one percent of properties make it through our screening process. These are the ones we acquire and operate, and in doing so add value for all investors, including ourselves.
Specialization pays off in this context without sacrificing the benefits of diversification. For one thing, each property stands alone, without cross-collateralization, to isolate any problems from affecting other properties. Our funds provide diversification by spreading risk across eight to ten properties in at least four different markets, and specialization by choosing our markets, property types and properties carefully – a small subset of the total market.
There is no better time than right now to redeploy some of your stock and bond market assets to multifamily real estate investments. Recent volatility spikes are a warning of rough seas ahead, but carefully selected real-estate investments have the ability to steady your portfolio in the most turbulent times.
Post Script:  Based on the front page of the Wall Street Journal of 2/26/18, margin bets will continue to fuel market volatility.
__________________________________________
About Christopher Finlay
Christopher Finlay is chairman/CEO of Lloyd Jones Capital, a private-equity real estate firm that specializes in the multifamily sector. For the past thirty-seven years, and through every economic cycle, he has owned and operated successful multifamily businesses. Predecessor companies include commercial brokerage, appraisal, property and asset management, construction, and development.
Headquartered in Miami, Lloyd Jones Capital acquires, improves, and operates multifamily real estate in growth markets throughout Texas, Florida, and the Southeast on behalf of institutional partners, private investors, and its own principals.

“The golden era [of stocks and bonds] has now ended,” says a McKinsey & Company report issued last year.

The report suggests that returns on equities and fixed-income investments could see significant decreases – up to 400 or 500 basis points over the next twenty years.   According to the report, this will affect everybody, from pension funds that will face larger funding gaps; asset managers who will see lower fees; and insurers whose earnings depend on investment income.  And on a personal level, the new generation of retirees will retire later and with less income.

And more recently, Bloomberg reported that “U.S. markets are at their highest risk levels since before the 2008 financial crisis… according to Bill Gross, manager of the $2 billion Janus Henderson Global Unconstrained Bond Fund.” The article continues, “Gross said that ‘…returns are going to be lower.’”  These thoughts are echoing throughout the industry.

To prepare for the new era, investors are looking at alternatives.  Many are choosing real estate. And with good reason. In fact, as far back as 2012, a JP Morgan paper suggested that real estate is no longer an alternative, but rather a “way out.”  “An alternative no more.”  Just look at the endowment portfolios of major academic institutions, led by Yale whose successes are legendary. Yale has allocated 12.5% of its investment to real estate.

Maybe it’s time for you to consider diversifying your investment portfolio by adding real estate. Why?

Reduced Volatility
Real estate is stable, unlike the stock market that reacts to every nuanced whisper in politics or the economy.  It is not correlated to the stock and bond markets. Real estate offers a steady, reliable return.   Studies show that, by adding real estate to a mixed portfolio, you will see an increase in returns and, perhaps even more important, a reduction of risk based on return/unit of risk.
I’m not talking about a REIT.  A REIT is like a stock; it goes up and down with the equity markets.  I’m talking about a direct investment in private equity joint venture or a fund.

Cash Flow
Cash flow is the key.  You should receive, at the very least, six-plus percent annual return on your investment. Our goal in today’s market is yield – a reliable, on-going cash flow return.
And this is not about short term. The days of “fix and flip” passed us a couple of years ago. Now, we hold our properties for several years while enjoying the steady cash flow and substantial appreciation.

And we focus on Texas and the Southeast, home to ten of the 15 fastest growing cities plus seven of the ten “best cities for job growth.”  We like to be where the people like to be. Plus, we have existing operations throughout these markets.

Diversification
We like funds because you can spread the risk among various properties and geographic markets. A disappoint-ing performance of one asset will not affect the others. In fact, the others will most likely compensate for it.
We like eight to ten properties in four or more different markets for maximum diversification. We have operations in every market we serve, and our local presence gives us tremendous advantage in finding, acquiring, and operating properties within these territories.

Stand-Alone Entities
Our fund structure allows us to hold our investments property by property. Each one operates as a separate business. There is no cross-collateralization.  A market slow-down in one area will not affect the other properties. We prepare a business plan for each specific property, and we can choose individual hold terms and disposition times.

Alignment of Interest
We believe in our investments; we are thoroughly committed to them, so we participate financially in every one, alongside our investors.

So, what’s an investor to do?
I suggest that we all heed the words of today’s best-known economists and be prepared for the unknown future of the equity and fixed-income markets.  It would be wise to diversify your portfolio with multifamily real estate. Private-equity real estate offers protection from stock market swings and a hedge against inflation.  It provides a steady cash flow, appreciation, and great tax advantages.  What other asset class can say that?__________________________________________
About Christopher Finlay
Christopher Finlay is chairman/CEO of Lloyd Jones Capital, a private-equity real estate firm that specializes in the multifamily sector. For the past thirty-seven years, and through every economic cycle, he has owned and operated successful multifamily businesses. Predecessor companies include commercial brokerage, appraisal, property and asset management, construction, and development.
Headquartered in Miami, Lloyd Jones Capital acquires, improves, and operates multifamily real estate in growth markets throughout Texas, Florida, and the Southeast on behalf of institutional partners, private investors, and its own principals.