This will never work (Vol. 5, No. 20)
As we wrote in our previous post, we have been thinking long and hard about the “Balanced” 60/40 portfolio. For the last 40 years, the balanced portfolio had worked well, delivering an average return of 11.1%.
But like most investment themes, they work until they don’t.
With rising rates hitting both bonds (higher yields => lower price) and equities (PE compression => lower price), the 60/40 portfolio has just had its worst 1H since like forever.
“Alternatives” to the Balanced Portfolio
Having seen a significant portion of their portfolio vaporised in the 1H, investors are now asking what they should do? Private bankers’ advice have generally fallen along two lines:
(1) Stay invested – “Rather than pull funds from the balanced mandate, others are increasing now…” The FOMO persuasion technique aside, this strategy would make sense if we believe the stock market correction has run its course and the Fed is within 6-9 months of finishing its rate hike cycle.
(2) Look to Alternatives – By “Alternatives”, this refers to (i) commodities, (ii) hedge funds, (iii) private equity (and private credit).
With the exception of structured products, private banks rarely pitch commodities since they do not generate hefty fees like funds. Hedge funds are normally a private bank favourite but with several high profile blow ups, they have become a tough sell.
So, how will the private bankers get their fee? The key is “private”, specifically private real estate and private credit funds.
The fear of missing out is a powerful motivator but before we set more of our money on fire, let’s take a look at some numbers.
Be Early Bird or Be Bag Holders? You Decide
Over the past five years, this private real estate fund has done very well. In addition to paying out close to 5-6% in dividends, it has also grown its NAV 50%, giving it an annualised total return of some 15%.
Given its pedigree and investors’ search for yield, our private real estate fund has been a magnet for funds. Net assets have grown from $1.8bn at end 2017 to $54bn at end 2021. At the gross level, total assets have ballooned from $4.8bn in 2017 to $106.5bn at end 2021.
To our fund’s credit, it successfully navigated the 4Q 2018 stock market crash and 2020’s Covid lockdown with a 2.2% and 1.0% NAV growth for those two years.
Will it be so fortunate in 2022?
For that we have to consider its growth trajectory. If we scroll back two charts, the first point to note is that roughly half of the past five years’ NAV growth came from 2021 (23.5%).
Since property values are essentially driven by (i) rental growth and (ii) change in discount rates, we also have to consider how much of our fund’s 50% NAV growth was due to falling rates (which are no more) and how much was down to increased earnings?
Reflecting the overall interest rate environment at the time, our fund’s assumed discount rate was largely flat in 2018 and 2019 but as Central bank cut rates close to zero, the fund’s discount rate also compressed. If one were to compared end-2021 discount rates to end-2017 levels, the compression in discount rates would have lifted multiples by some 16-18%.
Just like with a tech company, real estate funds also need to assume a terminal value for their properties. This is where the exit cap rates come in.
Here we see a different trend where cap rates have compressed steadily, down 100bp-170bp over the past five years. This would have contributed to a 21-35% uplift in valuations.
Although one could argue that the current 4.70-4.9% cap rates still offer some buffer against 10 year treasury yields at 3.0%, the public markets suggest a more cautious outlook is warranted.
The Public Has Spoken, Will Private Follow?
Helped by the same zero interest rate and a reach for yield environment, a large public industrial reit saw its FFO yield compress from 5-6% in 2017 to as low as 2.5% in 2021.
Through the first four months of 2022, the real estate alternative theme continued to work and this industrial REIT remained immune to the stock market sell-off.
That worked until it didn’t.
Since mid-April, this industrial reit has fallen close to 30%. As the denominator got smaller, the FFO yield rose some 125-150bps.
Although our private real estate fund never took valuations to the same extreme as the public REIT’s shareholders (cap rates only compressed from 6-7% to 5% Vs. public FFO from 5-6% to 2.5%), with Central banks still aggressively combating inflation, cap rates are unlikely to compress further. Future NAV growth will depend on rental growth alone.
Is it Time to Add or Trim Real Estate?
Having wondered very far into the woods, we still need an answer to the question that brought us here.
In the current inflationary environment, are private real estate funds a good addition to a balanced portfolio?
The answer should be obvious from the following chart.
In the words of a famous technical analyst, this looks like S**T.
This will never work.
Eiuol Ideas 