Key takeaways
- All signs point to us being even later in the economic cycle
- We continue to take precautions to manage risk across our portfolio
- As we discussed in our letter last June, this is likely to result in it taking longer for returns to ramp up in the short term…
- ...but we believe it will ultimately produce better returns in the long run (something we have already seen pay off)
All signs still point to us being even later in the economic cycle
Last year, we noted that “the current US economic recovery was the second longest economic expansion in American history.” This year it officially became the longest on record, posting an unprecedented 105 months of consecutive job growth.
And like last year, it bears repeating that economies operate in cycles, with periods of expansion ending when asset prices reach unsustainable levels.
Looking at the same economic indicators that gave us concern 12 months ago, we don’t see a market that is coming back in line with fundamentals, but instead one that’s gotten even more out of touch with reality.
As of July 16, 2019 the Shiller S&P 500 price-to-earnings (PE) ratio was 30.63 (as compared to 32.65 in June of last year), once again at a point surpassed only by the dot-com bubble of 2000 and still comparable to Black Tuesday in 1929.
Again, to frame this another way, if you were to buy into the stock market today, you would be investing at a 3.3% annual return in terms of the actual current earnings produced by the companies whose stock you are purchasing.
Simply by looking at absolute price as exhibited by the S&P 500 index, many rational investors would likely come to the conclusion that the record high stock market prices that resulted from the last decade of continuous growth aren’t sustainable.
Although not impossible, we believe it’s extremely unlikely that the next few years resemble the past run up in values. With earnings multiples already at historic highs, and unemployment at nearly record setting lows, we have a hard time seeing what slack is left in the economy to sustain the ongoing expansion. On top of that, the $1 trillion federal tax cut passed in late 2017 — which arguably spurred the markets’ most recent records — isn’t likely to be repeated anytime soon.
The big red flag: The inverted yield curve
We’ve also shared previously that one of the most reliable early warning signals of a recession, the inversion of the yield curve, was inching ever closer to occurring. If you’re unfamiliar with the concept, the yield curve is based on the principle that the longer the term of a loan, the higher the interest rate should logically be for that loan, given that time is money (and risk).
When the yield curve inverts it means that this fundamental principle of finance has flipped, and rates on long-term debt actually fall below those of short-term debt. This is a consequence of increased demand for long-term debt as investors attempt to lock-in today’s yields for the next several years, because they expect a future recession to drive rates down.
Above are the yields on the 3-month vs. 10-year US treasury note. In Q2 2019, the yield curve inverted.
This phenomenon is felt throughout the economy. According to Freddie Mac, as of the end of June 2019, the 15-year fixed interest rate was 3.16%, while the 5-year was 3.39%.
A homeowner today taking out a mortgage can pay a lower interest rate for a 15-year term than a 5-year term …under normal market conditions, that makes no sense.
So, what is going on?
If the inverted yield curve means the credit markets are expecting a recession, then why is the stock market at an all-time high, reflecting an assumption of continued corporate growth? In short, there is a disconnect in logic.
Historically, when the credit markets and stock prices are in “disagreement,” the credit markets have proved a far more reliable indicator of future market conditions. An inverted yield curve has correctly predicted the last seven recessions going back to the late 1960s.
How we invested (and will continue to invest) as a result of rising concerns
In our June 2018 investor update, we espoused a very similar market commentary, noting all the signs of excess in the market. We warned then that the stock market and the real estate sector appeared overpriced. As we indicated to investors, we slowed our rate of deployment and kept more cash on hand than typical, which lowered our current returns for the second half of 2018 and the first half of 2019.
When the stock market collapsed in Q4 2018, dropping roughly 15%, we looked prescient. In 2018, stocks were down -5.13%¹, while Fundrise as a whole produced a 9.11%² return — beating the market by more than 14%.
To be clear, we weren’t attempting to time the market (and we still aren’t). Instead, we simply chose to maintain a standard of quality in our investment fundamentals, even if that meant holding back in the short run.
Specifically, we wrote that:
Based on the data we’re seeing firsthand, we believe that prices are generally too high, given that interest rates have been rising, a trend which is likely to continue. Typically, interest rates move inversely with multifamily property values. In other words, as rates go up, you’d expect property values to come down, keeping overall equity returns relatively constant.
However, over the past two years, we’ve seen the opposite. As interest rates increased by approximately 20%, purchase prices for apartment buildings have also risen, driving down expected cash flow and overall returns.
It turns out that we were wrong about interest rates continuing to rise. Instead, after reaching a peak in the second half of 2018, they’ve actually come down to their lowest point in nearly 3 years.
However, we believe that our decision not to deploy heavily into overpriced assets was the right one anyway, as it allowed us to capitalize on the fleeting window of opportunity that presented itself earlier this year.
Here is how events played out since our letter last June:
- Throughout the second half of 2018, apartment prices continued to rise along with interest rates, which made equity investments increasingly unattractive as spreads³ narrowed to on average 0.25% (see Exhibit A).
- Given this dynamic, we ceased pursuing purchasing apartments or making other equity investments in Q3 2018. Instead, we focused primarily on debt investments, while also holding more cash on hand than typical.
- Then in Q4 2018 the stock market collapsed, driving down asset prices and interest rates through early 2019. By Q2 2019, the resulting spreads between debt and equity for apartment buildings widened to 1.38% (see Exhibit A), which was 5.5x better than only six months before.
- When asset prices and interest rates changed in early 2019, we moved aggressively to invest at far better economics than were available virtually any time the previous year, deploying $83 million to acquire eight apartment properties.
Below is a summary of apartment transactions that we either invested in or considered making an investment in that is illustrative of the change in spreads from the period of Q3-Q4 2018 versus Q2 2019, and as a result that strategy we pursued in either an equity or debt structured investment.
The long-term benefits of discipline
Equity investments in apartments over past 9 months
Although holding more cash during the second half of 2018 resulted in having to accept lower returns during that period, in retrospect, to us, it was a no brainer from a long-term investment perspective.
To be specific, the additional cash we held on hand for that six month period lowered our expected short term returns by about 2%, particularly for newer investors in the Long-Term Growth and Starter plans, and to a lesser extent those in the Balanced Investing plan.
Meanwhile, by waiting to invest at better spreads, we expect those investments to earn up to 3% higher returns per year over the next 7 to 10 years (roughly a 33% increase), as a result of maintaining discipline.
The window has closed... for now
Apartment prices have since rebounded, and spreads are narrowing. We’re now seeing prices for apartments that surpass even the peaks of 2018. It appears that the window of opportunity which opened for us in Q2 2019 has all but closed… for now.
Consequently, we expect to once again shift our investment strategy away from equity investments and back towards debt, while also holding more cash if the market doesn’t present opportunities to deploy capital at an attractive risk-adjusted return.
The nature of long-term real estate investment
Last year, we were rapidly vindicated in our decision to hold back, but it won’t always come easily or quickly. This time around, we expect that it will take longer to see the benefits of discipline. Nevertheless, real estate as an investment asset is inherently a long term proposition. To achieve strong performance consistently, investors must have the fortitude to be willing to underperform in the short term.
We understand that this approach may not be a fit for every investor, so we provide a redemption program for those who feel differently or cannot wait it out.
Private real estate markets are not like public stocks and bonds. They move far more slowly with higher transaction costs. It takes time to find great investment opportunities, negotiate, and close on them. At exit, selling can require months or even years to execute well.
While the public markets are liquid and efficient, the private markets are illiquid and much more inefficient. In our opinion, these factors create the opportunities to outperform, but it requires a greater focus on long-term fundamentals.
So, as the saying goes, we like to be greedy when others are fearful, and fearful when others are greedy. The greed we see all around us in the market today makes us very fearful of what may lie ahead in the short term.
What this means for your Fundrise portfolio
Long-term returns move inversely with market sentiment
If you’ve been with us for a while, you will probably find this refrain familiar: Most investors’ expectations are highest at the top of the market, when they are most likely to experience poor returns. On the flip side, people are most pessimistic at the bottom of the market, when in fact, opportunity is the greatest.
Entering the second half of 2019 feels a lot like it did starting the latter half of 2018. Similar to one year ago, we may slow down our rate of investment again and hold more cash on hand than normal. In order to take the long-term view, at times we may hold a more cautious or contrarian position than the broader market.
In short, in order to fortify your Fundrise portfolio for times of turbulence, we may take short-term pain for long-term gain. As we were able to earlier this year, we hope to move aggressively to pursue future opportunities that arise as a result of that same turbulence. In the end, we believe that today’s restraint will be rewarded tomorrow.
Onward,
Ben Miller
Co-Founder & CEO
