June 23, 2023
Our View: Inflation and Interest Rates
BY: THE MIDLOCH TEAM
We can’t escape it
As a real estate investment firm and fund manager, we can’t escape the impacts of inflation and higher interest rates. But the issues don’t always have the impacts you might imagine. In fact, our approach to value investing at Midloch in many ways naturally acts to mitigate the potentially negative effects of the current market dynamics.
It's our nature
First, it’s our nature as value investors to shun ultra-high-priced assets in generally ultra-high-priced markets. So when pricing cools, which it virtually always does, we are less exposed to losses than many other investors because we didn’t overpay to begin with.
Second, we view debt cautiously and use leverage prudently. Simply put, we don’t over-leverage properties in the way that many other investment firms do. In fact, at this writing our debt-to-cost ratio is under 60%. This provides a number of benefits, including the ability to refinance later if a property’s business plan changes and adding debt is in the best interest of investors.
Carrying less debt also means rising interest rates are less of a shock to our existing portfolio. This is especially true given that over 90% of our debt is at fixed, not floating, rates. Also, notably, we typically seek to borrow on a medium-terms basis — think five to 10 years versus fewer — which can insulate us from immediate interest-rate spikes and provide more runway to fulfill our business plans before we have to sell or potentially refinance a property.
Now, about inflation
Given the inflationary environment, Midloch continues to prioritize acquiring multifamily and industrial properties over other asset types, because these properties have historically seen their cash flow grow with inflation versus the opposite. The supply of both these property types also remains tight in many markets, which can work to investors’ advantage.
With multifamily, rents may be reset on a continual basis as units become available and market conditions allow, offsetting some of the negative impacts of inflation. With industrial, tenants typically cover the cost of expenses related to occupancy, including utilities and improvements, so the hit to landlords from expenses that rise with inflation is minimized.
Interestingly, higher expenses due to inflation may have another benefit that accrues to investors. When construction costs are higher along with borrowing costs, it makes new construction less feasible. That can act to limit the flow of new product into the market, which puts upward pressure on existing asset prices and rental rates.
As a true value investor we look for investment opportunities with multiple ways to unlock value. That unlocked value has a cumulative effect of both offsetting the effects of inflation and higher interest rates while still creating profitable value for all investors. (We’ll elaborate on our approach in a future blog post.)
Net-net: Assessing the impacts of inflation and interest rates on income-producing real estate is less clear-cut than it may appear at first. We expect both trends will continue into 2023, and we are as prepared as any prudent investor and fund manager can be (if not more prepared than others) for what may come.
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