January 2023 Newsletter
Investors are becoming more certain that inflation is under control and the Fed’s actions have helped stave off the problems. Major indices all performed well with a huge surge in support for the US REIT market. It’s not surprising to see this in public REITS since the underlying properties did not falter as much as the public selling activity would have had you believe. Public REITS can be a great tool to access real estate, but your investment will be subject to the volatility of the markets.
Why do we like private debt? Private debt can come in many forms, but we are focused on private debt in commercial real estate.
In today’s world there is more risk in traditional investments driven by the increased cost of capital. It is very likely that this volatility and uncertainty in the market will endure for years to come. That cost of capital also increases the risk of changed valuations in private equity assets, including real estate. One of the core factors of valuation in a real estate equity investment is the net operating income that is primarily generated by rents. The historical growth rates we have seen in rents is not sustainable, and many economic factors are affecting rents in the market as we head into financial tightening and recession. Without diving into every nuance and factor, if we believe that statement to be true, then we are entering a period where real estate equity is a higher investment risk. For those that are current real estate investors we have seen this firsthand already. Properties are under more stress and the cost of financing has pulled some properties without rate caps in place down into the red.
I have recently been in quite a few strategy meetings where the new plan for equity investing by managers is to discover properties that can be purchased 100% equity or close to it to ensure a more stable income return to investors. Although that might be a great idea at this time, why not just consider investment in private debt/mortgages in real estate. Private debt has historically been a source of yield that has low correlation to traditional asset classes. There are many types of private debt, but one big factor in real estate is the safety of principal. The private mortgages are backed by a tangible property. In our case for the Kirkland Income Fund, mortgages are first lien, full recourse (borrower guarantee), and on a functional property that is income producing or is to be in short order.
Capacity of this space should be a consideration. Private debt in real estate is far behind its public peers however, we are also seeing many public lenders tighten their requirements for lending. This has been going on for over a decade and here we are again in another cycle of tightening that is increasing the demand and in many cases the requirement for private lending.
What about traditional fixed income? It’s now paying out at far increased rates. Could be enticing to pick up treasuries, or high-grade corporates. However, even with inflation falling to the sixes, the yield is not enough to keep up. You could perhaps go way out on the risk curve and pick up a junk bond ETF that is yielding around 7 to 8%. The challenge will be that junk bonds historically have had volatility like equities. Might not be the best course of action right now. From an investment standpoint in our current inflation situation, traditional investments still are not pulling the weight.
Many aspects of investment opportunities in the world wax and wane with some trends lasting longer than others, but now more than ever alternative income strategies should be viewed as a longer-term allocation in investment portfolios.
