Dear Friends[divider line_type=”No Line” custom_height=”20″]
TwinRock and the financial markets had an unexpected year in 2017. But – if you went with the stock market’s momentum as we advised – you nevertheless did very well. The financial markets provided great returns and the real estate markets continued to make front page headlines.
However, it’s important to read between the lines, where the details are in the numbers, as we will explain in this Q4 2017 Newsletter. This year seems to be a different story, with 2018 being a year in which active investors will outperform.
First, we are proud to announce that our first two funds were fully liquidated. One yielded a 21.7% annual compounded rate of return to investors, or a 2.2X return on their investment. The other yielded a 22.5% annual compounded rate or return to investors, or a 2.1X return on their investment. Both liquidations were based on our planned holding period, along with the view that the market is topping out.
The market statistics may vary depending on which reports you read, but they all conclude that commercial real estate sales were down year-over-year (6.9% according to ARA Multi-Housing), and rent growth was slower than the prior year.
While the sources below show forecasted rent growth immediately stabilizing, it’s important to note that the chart is self-serving for its distributor, ARA, a real estate brokerage company and NKF Research and Axiometrics.
In fact, the rent growth rate continued to decline well below the average the last two times when it met the long-term average annual rate. Note that in the past 17 years rent growth during this market cycle has double the average length of time above the long-term annual average rate. In addition, capitalization rates or yields for 2017 were flat. Capitalization rates or CAP rates are a measure of valuing a property dividing the net operating income by the sales price.
The below chart shows that although the spread between the 10 YR UST and national cap rate is around its historical average, the spread is shrinking. It will be important to watch the direction of the 10 YR UST. As of today it is up 0.45% to 2.90%. At some point there will be an increase in borrowing costs which in turn will increase cap rates.
We don’t think it is a stretch to state that it is unlikely that interest rates will decrease from here on out. After all, we are entering a market where the Federal Reserve and the rest of the world’s powerful central banks have indicated that they will raise rates in the future.
The chart below illustrates not only how low cap rates are across the country, but also how close the spreads are between primary, secondary and tertiary markets for multi-housing. When you see only a 1.2% spread between cap rates in Los Angeles compared to Oklahoma City, that is a clear warning sign that there has been too much money pushing prices up without factoring in enough of a risk adjusted return. When this is taken into account, the spread should be closer to 2.5% between these cities.
When you combine slower sales volumes, declining rent growth, flat yields and rising interest rates that will likely continue rising due to strong employment and wage growth . . .
That would explain why the FTSE Nariet Equity REIT (Real Estate Investment Trust) Index was only up 1.2% for 2017 vs. the S&P at 26.5% and TRVOF at 9.4% (our fixed income and equity fund).
Financial markets are leading indicators of the future performance of the economy. So, it is only logical to conclude that a softer commercial real estate market is ahead of us – and this is without considering the new construction coming to market in 2018 and 2019.
While we may sound pessimistic, we also believe that if you have holding power, real estate values will always go up over time in well located markets. This makes real estate an asset class of choice – along with a balanced fixed income and equity portfolio.
Although as of now there are no future catalysts on the horizon, 2018 is already experiencing extreme volatility. That’s why adding more risk at this time needs to be tempered through more conservative investments. It is important to keep in mind that psychology moves markets. With most major investment banks forecasting a recession by the end of 2019 or 2020, it is prudent to except that a recession will actually arrive before then.
After all, do you really think that if the smart money tells you when an event will occur, that they won’t already be ahead of it? This is a rhetorical question, and you only need to look at January’s move in the stock market for the answer. There was no fundamental reason why stocks went down, other than sophisticated investors warning the markets that they have moved up much too quickly and that a correction was needed.
In addition, to the success of liquidating our first two funds, we have been very successful executing our investment strategies on our following four funds and our valuations of our hard assets. We are also proud that our investment thesis to invest in distressed Alberta, Canada is proving correct. We called for a rising Canadian Dollar (CAD) to the U.S. Dollar (USD) and increase in oil prices from January 2016. Since then the CAD has increased 13% and oil has increased over 100%.
While our quantitative investment strategy has proven to work in numerous investments over the years, recently we did get one wrong. We want you to understand that there is nothing more important to us than taking care of our investors. That is why we work so hard and have offered recourses that are above and beyond industry standards.
At TwinRock it is our integrity that guides us and excellence that we seek.
Chief Executive and Investment Officer