DSTs, Operating Assets, & Inflation

February 10, 2021

Robert S. Smith

Back in 2008 when the single family home market collapsed and the associated CMBS (Commercial Mortgage Backed Securities) meltdown threatened global credit markets, the Fed and other central banks rushed into the breach, flooding markets with money via zero interest rates and quantitative easing.  At the time, we felt this might provide the predicate for a round of inflation similar to what the United States experienced in the 1970s.

As it turned out, we were wrong.  ‘70s like systemic inflation did not occur thanks to a clever and heretofore unused trick on the Fed’s part.  It paid member banks risk free interest to keep those monies on deposit rather than lending it out.

This clever sleight of hand on the Fed’s part kept money out of consumers hands and monetary velocity (transactional turnover) muted.  As such, we experienced financial asset price inflation while the economy itself grew very little (<2% annually).

This time it’s different.  There is a very real risk of too much stimulus in too many hands.  This has significant consequences for income property investors long term.

With monetary stimulus machinery going full tilt (and more to come with the Biden Administration’s new $1.9 trillion stimulus package) things are already beginning to heat up.  Consider the fact that even though economic activity remains depressed in the new shutdown, M2 money supply is still up by 28.3% over the past 12 months.  And that’s before the Fed monetizes the next wave of stimulus.  For comparison sake, money supply growth peaked at 13.8% in the high-inflation era of the 1970s.

The Fed has created unbelievable amounts of money, $7 Trillion this past year, approximately three times the amount normally raised from income tax.

We know this is ancient history and as a new-age social-media savant, you’re probably asking what does any of this have to do with me and why should I care?  Well, if printing all this money and putting it into circulation (unlike 2008-2009) does indeed matter, then all the factors (excess fiscal stimulus, excessive money supply growth, impaired domestic production & broken supply chains) may be present to generate higher consumer prices along with rising interest rates.

As an income property investor, rising interest rates really do matter.  This is because commercial real estate prices have historically reacted to changes in interest rates very much like bonds.

All other things being equal from a credit standpoint, as interest rates go down bond and real estate prices usually go up.  When interest rates go up, bond and real estate prices tend to go down.

Unfortunately, when it comes to DST properties you have a whole generation of syndicators and brokers whose only experience has been with rates going down, way down.  As a rising tide usually floats all boats, most commercial real estate prices have gone up. 

However, this may ultimately change.  This is why it’s critical for investors to understand the difference between operating assets and single-tenant, triple net lease assets.  This understanding may make the difference between making money or losing it in the not too distant future.

Operating assets are those property types with short lease intervals.  This can include but is not necessarily limited to; apartments, self-storge, senior living facilities, student housing and manufactured housing.  Assuming full occupancy, with their relatively short lease intervals, rents on these properties can be increased on a fairly regular basis.

In this way, they operate much like an inflation protected bond that can increase its coupon rate if need be.  This ability to increase rents or coupons in a manner roughly commensurate with rising interest rates is critical to the integrity of invested principal.

As the cost of money increases, the potential buyer pool decreases.  As demand slackens, prices go down.  As prices go down, yields or cash-on-cash returns go up.

Therefore, new buyers paying lower prices for properties, are better positioned to generate higher starting cash flows.  If you are unable to increase the rental income stream on your existing portfolio of properties in a like manner, there is a strong likelihood they will go down in value.

This is why the short lease intervals incumbent in operating assets maybe critical to maintaining the integrity of invested equity in a rising interest rate or inflationary environment.  They have flexibility that is simply not present in many single tenant, long term net lease properties.

Initially, the latter may offer investors a greater sense of security; a Fortune 500 anchor, long term commitment and predictable income stream.  However, we feel this may provide you with a sense of being safer than you really are.

If we are right this time and inflation does rear its ugly head as in the decade of the ‘70s, the lack of flexibility incumbent in long term, single tenant, triple net lease assets may prove more liability than asset.


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