2020 December Update - An Interesting Year?
Markets & Investments
What an interesting year.
We are still in the modern era’s first global pandemic that unfortunately is still affecting many; we have yet to resolve the economic impact of this event.
We have the lowest interest rates in the last 150 years; this is forcing many to reconsider their investment plans going forward.
The broad equity investment market (S&P 500) fell just over 20% in Q1 only to rally and be at a 16.50% return at the time this letter was written; another double-digit return on the heals of last year’s 31.49%.
Aggregate bonds (Barclays Agg Bond Index) have underperformed equities but with falling rates the index is up 7.35% YTD; many are concerned that maturing debt will have to be invested at lower rates and rising interest rates would erode the unrealized value embedded in this year’s returns.
In addition, it will be exciting to see what new leadership combined with cheap money in the face of a “fiscal cliff” will bring in 2021.
Commercial Real Estate Market
Many factors are pulling and pushing at various sectors in the commercial real estate market. We made the decision in the portfolio to primarily focus on multifamily to avoid much of the ongoing uncertainty in office and retail. Of course, there is still risk in multifamily. On the top of our mind is rent collection, eviction regulation, rent levels, and economic support to help mitigate the impact of business shutdowns. With winter arrived, rising COVID numbers, worries if economic support will be enough, and unemployment still higher than it was in February of this year, we continue to be focused on risk mitigation.
One further comment on unemployment, the December 4th report showed unemployment falling to 6.7%. We hope to see this downward trend continue. For reference this is still 3.2% or 4.9 million jobs higher than February 2020. According to NMHC rental rates have flattened on a YOY basis (-0.3% change). Rental rates on renewed unit contracts have increased by 1.6%; this is a good sign. It is still important to be thorough in due diligence, and favorably structure loans while we have the flexibility.
The chart below from NMHC shows there has been steady weakness in rent collections but not to a panic causing level. However, there has been an initial drop in collections for the month of December. The data collection date was on the 6th, which was a weekend, so perhaps this data will correct itself in the next data metric of collections on the 20th.
Fund Overview
The November Kirkland Income Fund results ended strong. With increased efficiency of utilized capital, cost controls, and continued performing status of our portfolio loans the fund reported its strongest month yet with a net return to investors of 0.85%. Acceptance to an institutional investment platform has increased new investor capital. Investor interest has continued to grow as the fund continues to perform well. We are looking forward to a strong 2021.
From our monthly loan reports earlier properties in the portfolio are almost fully rented and successfully collecting rents. Other properties are partially rented as they complete renovations. One property had renovations delayed due to vandalism, but crews believe they will still meet targets.
What Generates Returns for Private Debt?
With returns comes risk. If there is an excess return being captured that return must derive from some form of risk. Excess returns of private credit are generated from several sources:
Illiquidity. Investors are often required to lock up their money for a year or longer to capture opportunities in private debt. For this inability to move capital freely investors are compensated with an excess return.
Few lenders competing for loans allows participating lenders in private credit to obtain excess return. Smaller issuer size limits supply of lenders as there is a lack of desire to process small loans rather than larger loans. Regulations that limit banks from participating is another dampener of supply. Fewer lenders competing for deals gives rise to excess returns over traditional credit investments.
Utilization of leverage can enhance return, but this is not a source of return inherent in the investment. As most of us are aware leverage can also magnify losses. Leverage can also add significant operational risk to the investment by creating scenarios of forced selling during a stress period.
The Kirkland Income Fund does capture much of this excess return for its investors.
The Fund requires a lock up to ensure there is a match between the loan term and the potential liquidity demands from investors. Many funds have failed by not matching their assets and liabilities.
The Fund also benefits from lack of lenders due to regulations and lack of lenders operating in the smaller end of the CRE bridge loan space. We often see no competition for the loans we are shown; this allows us to have pricing power with regards to the rates we can charge.
The Fund does not use any leverage. We do not expose investors to the magnified market events that might cause stress on the portfolio or the potential operational risk that can occur.
This has been an interesting year to launch an investment fund. There were many challenges, and I am sure there will be many more, but we have succeeded together. I want to thank all of you that have been there to support us on this journey. There are many exciting opportunities to come.
Thank you and Happy Holidays!
