How Inflation and Interest Rate Increases Could Impact Real Estate-Focused Alternative Investments

by Jeff Baumgartner

Inflation is running at 8.6%, and the Fed has been aggressively raising interest rates. It is now signaling that equally large rate hikes could be on the horizon as early as next month. The Fed’s dual mandate is to keep the economy at full employment while at the same time keeping inflation under control. During the time since the financial crisis of 2008, which includes the Covid-19 slowdown in 2020, the Fed’s primary focus has been on full employment (economic growth). Since 2008 we have witnessed massive government bailouts beginning with the TARP bailouts, to combat the financial crisis, and culminating with $4.6 trillion being spent through the CARES Act and other relief measures to combat the impacts of the Covid-19 pandemic. For more than a decade after the 2008 crisis, economic growth was stubbornly slow, and the pandemic did not help matters. For all the government’s efforts to grow the economy, real economic growth averaged a paltry 2.3% per year from mid-2009 through 2019, and actually contracted by 3.4% in 2020 before growing by 5.7% in 2021. Accommodative monetary policy in the form of quantitative easing, and accommodative fiscal policy in the form of government bailouts conspired to keep interest rates (the cost of borrowing money) low. Unsurprisingly, only because economic growth never really took off, inflation remained subdued. But much like waking up from a party that went on way too long, only to find silly-string on the furniture and a pizza spinning on the record player, what comes next may be sobering.

Back to (See) the Future

None of us can predict the future with certainty, but we can look at where we are now with a bit of historical context and form reasonable expectations about what the future may look like. What should RIAs and broker dealers consider when assessing the imbedded risks of alternative investment programs in the current environment? Preferred returns, costs of capital, interest rates on debt, and virtually every other interest rate embedded in alternative investment offerings (including non-financial instrument rates, such as cap rates), have been in some way, shape, or form, influenced by government policy.

Unprecedented easy money for years on end (coupled with the war in Ukraine contributing to higher gas prices) rather than spurring desired growth, has taken us straight from slow growth to undesirable inflation. For some historical perspective, inflation at 8.6% is the highest it has been for some 40 years. According to IBD Weekly, some investors may fear that our current environment is similar to that of the late 1970s, when the Fed began unleashing massive interest rate hikes to combat inflation. By March 1982, the 3-month Treasury Bill rate stood at nearly 14%. For all you millennials still Googling, “What is a record player?” let me say it again, in early 1982 the T-Bill rate, which can also be thought of as the “risk-free rate,” stood at 14%. This was necessary to combat an approximately decade-long run of double-digit inflation that peaked at over 14% in 1980.

But Let’s Keep It Real

Every risky financial instrument (all else being equal) must pay a return at least as high as the T-Bill rate. Because T-Bills have never defaulted, they are considered “risk-free.” Why would anyone buy a risky asset that doesn’t pay more than the risk-free rate? They wouldn’t. That’s why the nominal yield (coupon) of any risky financial instrument includes the risk-free rate and a risk premium to compensate the investor for taking on additional risk. If the risk-free rate is 3% and a newly issued bond pays a coupon of 5%, 2% is the premium the issuer is paying you to accept the risk you will not be paid back (along with other risks). Ok, so the risk-free rate impacts nominal yields, but let’s keep it real. Real returns (ignoring taxes) are calculated by subtracting the inflation rate from the nominal yield. For example, if an investment yields 5% while inflation is running at 4%, the real return is 1%.

Now, getting back to alternative investments, if inflation proves to be stubborn, as it was throughout most of the 1970s and early 80s, the Fed will be forced to shift its policies away from “easy money” and toward “tight money” (by continually raising the Fed funds rate, which leads to higher T-Bill rates) to deter spending. Newly issued alternative investment programs would likely have to pay more for both equity capital and debt financing, while existing programs would be hit with higher financing costs on floating rate debt, refinancing debt, and any debt that is yet to be secured.

…Or at Least Pass It On

However, it’s not enough to simply understand the financial instruments underlying alternative investment products. Forecasting also needs to be met with an understanding of how inflation may be passed on to the ultimate valuation of the assets held in investment programs. We can think of this as the “elasticity or inelasticity” in offerings. For an example of price inelasticity, imagine a huge soap company, let’s call them P&G, if P&G experiences inflated costs in producing soap, it simply raises the price of soap and passes the inflation on to consumers. For an example of price elasticity, imagine three local coffee shops in close proximity to one another all offering chocolate caramel lattes for $5. If one shop raises its price and the others do not, its sales are likely to plummet.

If there is long-term inflation in the economy, alternative offering managers will undoubtedly be met with inflated production costs and financing costs, but to what extent will they be able to pass through such increases, perhaps in the form of higher rents and/or higher-priced asset sales? The relative elasticity of an alternative program’s underlying strategy is just one valuation topic RIAs and broker dealers may want to consider.

It Doesn’t End There…

When inflation remains persistently high, the Fed raises rates to make money more expensive in effort to tame spending and subdue inflation, if that doesn’t work it does it again until it succeeds. This is important to know because the Fed is “strongly committed” to bringing down inflation and appears resolved to do whatever it takes. As the Fed must now shift its focus to stabilizing prices, it does so at the peril of its other mandate, economic growth. In order to bring inflation under control without failing on its other mandate, the Fed must slow down economic growth without “stalling” the country into recession. Jerome Powell says that a “softish landing” is plausible. To further his analogy, the Fed's policy tools are nothing like high-tech modern airplane controls, they are much more like a rudimentary stick and rudder control that only offer unpredictable responsiveness. Inflation may be coming stubborn and persistent, causing many to be skeptical of the prospects for a “softish landing,” whereby the economy suffers only a brief recession. The risk to alternative investment offerings is that Inflation may only be able to be controlled at the cost of a prolonged recession. A prolonged recession may impact real estate-focused alternatives in a variety of ways, including decreasing the occupancy at a high-rise hotel, shrinking the demand for factory space by producers of goods, or increasing the demand for low-rent housing. When it comes to our investment expectations for alternative investment programs, risks on the horizon oftentimes never materialize, but vision coupled with hindsight helps us better prepare for all potential realities.


Contact Information:

Jeff Baumgartner


(612) 284-1069

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