Key takeaways
- All signs point to us being late in the economic cycle
- We’re taking active steps in our investment strategy to reduce risk across our portfolio
- This is likely to result in it taking longer for returns to ramp up in the short term…
- ...but we believe it will ultimately enable us to produce better returns in the long run
All signs point to the US being late in the economic cycle
The current US economic recovery is close to ten years old, making it the second-longest economic expansion in American history. According to the National Bureau of Economic Research, the current expansion has endured almost three times longer than average.
History shows that the economy operates in cycles, shifting between periods of growth and recession. As we near the end of an expansion, like today, asset prices increase until they reach unsustainable levels. In our view, today’s market is no exception.
As of June 4, the Shiller S&P 500 price-to-earnings (PE) ratio was 32.65, surpassed only by the dot-com bubble in the year 2000.
Put another way, if you buy into the stock market today, you are investing at a 3.1% annual return in terms of the actual current earnings produced by the companies whose stock you are purchasing.
To illustrate this point another way, look at how the markets are currently pricing risk through corporate bond spreads. This is a measure of the additional return (beyond the return on a US treasury note) one earns for taking on the risk of lending money to large companies.
Corporate bonds spreads are at about their lowest point since leading up to the 2008 financial crisis. In other words, you’re receiving the lowest return for your risk in almost 11 years.
More red flags: asset prices continue to rise with interest rates
In 2017, our real estate team reviewed more than 1,100 different multifamily investment opportunities. We ended up choosing to invest in 15 of them. Though it’s time-consuming to sift through so many potential deals, it gives us a comprehensive view of the US apartment market.
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 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.
Prices and interest rates rising together drive down returns
| Year | Average cap rate¹ | Average interest rate² | Current levered return³ |
|---|---|---|---|
| 2016 | 5.79% | 3.91% | 10.18% |
| 2017 | 5.37% | 4.25% | 7.98% |
| 2018 | 5.02% | 4.65% | 5.88% |
1. Average capitalization rates of deal flow from our largest partner platform over 3 years.
2. Average interest rates on deals closed by Sponsor or term sheeted from GSE financings.
3. Assuming 70% leverage (LTC).
Although admittedly more extreme than today, the market went through similar circumstances in 2006 and 2007. In the bubble that led up the Great Recession, many real estate investors were purchasing properties whose cash flow would not even cover the cost of their debt.
Perhaps the most famous (or infamous) was the Tishman Speyer purchase of 5,600 apartment-unit Stuyvesant Town in Manhattan. When the rosy growth assumptions didn’t materialize, equity investors dramatically underperformed, or worse, lost their entire investment.
We are taking portfolio-wide steps to reduce risk
If risk is not fairly compensated, then it’s time to rethink it. At Fundrise, we consistently work to reduce risk on behalf of our investors. If you have been with us for several years, then you’ve already heard our concerns that the market is becoming overheated.
In response to these clear warning signs, we have shifted our strategies over the last six months to focus on debt investments. In contrast to equity ownership, debt better insulates you from a potential downturn in the market. In a typical debt investment, our money is senior to the equity, giving you added protection from a potential decrease in the property’s value.
In addition, a debt investment is often drawn down by the borrower over time in several installments, further reducing risk. For example, if we commit to lend $10 million to build a new apartment community, only $2 million may be funded up front. The remainder would then be drawn down in 3 to 4 subsequent installments, as construction progresses and work is completed.
While one result of our increased focus on lending is reduced risk, it also means that we expect returns to take a little longer to fully ramp up.
This is because of the time that elapses between committing to an investment in a construction project, and when the money gets invested and starts earning a return through regular interest payments. However, we believe that the tradeoff of a slightly longer ramp-up in exchange for a higher margin of safety is well worth it, given where we are today.
This is not to say that we have shifted our investment strategy entirely to debt. We will continue to make opportunistic equity investments, as long as we believe investors are being fairly compensated.
To be blunt, however, we are extremely skeptical of anyone broadly promising high returns on equity investments in today’s real estate market.
What this means for your Fundrise portfolio
Long-term returns move inversely with market sentiment
Ironically, 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.
By pursuing a lower risk, debt-focused investment strategy, we expect that the ramp-up period for returns will likely be longer. There may be periods in the near term where relative returns may appear lower than past performance.
We much prefer lower, more reliable returns for our investors in the near term, in the interest of being better positioned to capitalize on future opportunities.
We are confident that this discipline will pay off and allow you to outperform in the long run. However, we recognize that some investors won’t agree with this more patient approach, and will instead seek out higher potential risk-return investments elsewhere.
Patience can be challenging for the most disciplined investor. We’re reassured by the fact that the most successful real estate investors in history — like Donald Bren and Larry Silverstein — made their fortunes buying in downturns.
To recap, we are actively working to fortify your Fundrise portfolio for times of turbulence. At the same time, we are preparing to aggressively pursue future opportunities that may 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
