The Fed, Rose Colored Glasses & DSTs

The question all income property investors should be asking themselves now is how will inflation end?  Not well, we posit.

The Fed has misjudged this issue from the start, first maintaining inflation wouldn’t occur, then insisting it would be ‘transitory’ when it did.  This does not auger well for the Fed’s current prediction of an economic soft landing.

Their claim that they can maintain low unemployment while bringing inflation down from its current 8.5% level to their targeted 2% is both inconsistent with economic history and also current market – based expectations for inflation and unemployment.  The current inverted yield curve with the 5-year government bond at 2.56% and the 30 year Treasury bond at 2.473% is mute testimony to this effect.

Historically, short term rates being higher than long term rates has been a reliable indicator of an upcoming recession.  Since World War II, every yield curve inversion has been followed by a recession in the next 6-18 months.

In light of this, we must assume the Fed’s current prognosis for a ‘soft-landing’ in the wake of higher inflation and interest rates is simply looking at the world through rose-colored glasses.  There is simply no valid basis upon which this can be predicated.

As mentioned in our previous blog post, this is exacerbated by war.  Continuing conflict in Ukraine could result in both higher energy and grain prices worldwide, Russia being the world’s third largest oil producer at 10.5 mbpd and the world’s largest wheat exporter.

Furthermore, these changes may not be temporary.  Veteran British finance official Charles Goodhart believes that “the coronavirus pandemic will mark the dividing line between the deflationary forces of the last 30 to 40 years and the resurgent inflation of the next two decades.” (WSJ 4/6/2022)

Demographic shifts, supply chain breakdown and increased global risk may result in increased de-globalization of trade, and greater emphasis on local production.  If this occurs, it may come at the expense of the single minded focus on lower production and labor costs that have driven business investment decisions in the past.

If this prognosis is correct and we are coming to the end of a 40 year deflationary period to be followed by decades of inflation, the implications for income property investors are profound.

First and foremost, the premium historically paid for operating assets above that of single tenant net lease assets will be justified.

For years the argument has been this premium made little sense because inflation was a thing of the past.  However, this shibboleth now appears to be increasingly empty of meaning.

If inflation is the new norm, the ability to increase rents as frequently as possible will be critical to maintaining the integrity of invested equity over time.  Due to the highly structured nature of their lease agreements, this is more difficult to do with single tenant triple net properties.

Sadly, most brokers in the DST space do not understand this distinction and its potential ramifications themselves. Therefore, their ability to communicate it to investors is limited.  As such, this must be an important part of your own due diligence process.

Finally, it may be difficult to break inflations grip on the economy without recession.  In the past, it’s been necessary to raise interest rates higher than the inflation rate to subdue it.  With consumer price index inflation of 8.5% over the past 12 months, this is a very heavy lift.  Income property investors must prepare for this.

A thoughtful and thematic approach should be taken to the creation of a portfolio of recession resilient properties.  Good candidates may be medical office buildings (MOBs) and senior living.  Aging is inexorable.  Each day we all get a little older.  Demand for healthcare goods and services should increase in a commensurate manner.

Self-Storage has also proved remarkably resilient in the face of difficult socio-economic conditions.  Thriving on change, it emerged from the pandemic as the hot commercial property.

Consideration may also be given to niche property types such as grocery stores and gas stations.  Everyone must eat.  Despite the current administrations best efforts to the contrary, people still need to put gas in their cars.  Buckle-up.  It’s likely to be a bumpy ride.


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