Our May newsletter was sent out just hours before chairman Jerome Powell announced the 50 basis point hike. This was an expected, welcome, and necessary rate hike that frankly should have happened about a year ago. However, we are optimistic that the fed has the tools and competency to control inflation.
That being said, the actions of the Federal Reserve have shifted a fundamental building block of our industry which is debt. Each deal is going to be different, but over the past couple of months, debt has been a consistent pain point.
For most businesses, no more than a third of your free cash flow should go to service debt, meaning that the DSCR (debt-service coverage ratio) would equal three. Loans from Fannie Mae and Freddie Mac have gotten so expensive that the death-service coverage ratio is less than one. This means that there might not be enough cash flow generated from the property to service the debt. Or, what is more likely, is that the ratio is very close to one and future changes in the interest rate could leave a sponsor unexpectedly trapped.
While lenders have perhaps been a bit too eager to change their prices, brokers have lagged behind in adjusting their prices back to normal. We have a joke around the office that brokers are still pricing properties like it’s January of 2020. Combine January of 2020 asset pricing with Q2 of 2022 debt pricing, and you have a recipe for very few deals to take place.
All of this being said, our prediction is that in the next few months, we should see a reversion to the kind of market we were seeing in 2019 before the pandemic with small best-and-final rounds and fewer institutional players.
This month we are proud to announce the launch of our first Co-Gp Fund. The motivation for this new fund is very simple: we often hear from ambitious sponsors who are excited to pursue larger deals but struggle to raise the necessary funds from their friends-and-family round. This fund will allow us to come alongside these sponsors, and provide the consulting and capital solutions that they need, while also providing safe and significant returns to our retail investors. This is the kind of product that our sponsors have been looking for for years and we are so glad to finally be able to bring it to life.
We would also like to let everyone know that Our Managing Director, Francisco Herrera will be at the Real Estate Family Office & Private Wealth Management Forum in Dana Point California June 6th and 7th. If you are in town or attending the event, please reach out. We would love to meet you.
Adam Smith had this idea in the late 1700s that the origin of money must be barter. Humans want goods or services that others have and it is only natural to denominate those desires with precious metals. In Economics 101 classes everywhere, students are taught that this “double coincidence of wants” existed in society at some point… which it never did.
Instead, in proto-economies, credit was extended rather freely in what we call “gift economies”. A productive member of society would give out gifts to their community. The trust and social credit gained from the exchange were commensurate because gifts and trust would surely be returned in some way. One thing I want to highlight here is that these transactions are not impersonal. In fact, it is difficult to imagine a more personal way of exchanging goods or services…
Actually, I can. The Gunwinggu indigenous people of Australia exchange in a ceremonial practice called Dzamalag. In these ceremonies, women from the tribe flirt with and then copulate with each other’s husbands. During their private time together, the man will hand over a gift which can be anything from spears to tobacco to cloth. After they are finished, the woman will return to the community, along with all of the other couples who have done similarly, and give the gifts to their husbands. A more complicated form of exchange could hardly be imagined, but in this complexity, there is trust. There are complicated trade arrangements with no money to be found anywhere.
It is easy to make the suggestion that money does exist in these societies, it's just underneath the veil of credit. Clearly, debt existed in these societies or else what would it mean to pay someone back? The problem here is that denominating trades in a standard currency is only necessary when honor as a currency is insufficient. This means that within tribes and family structures, there was simply no need of trading this sloppily. But, when trading with other tribes or merchants that you might see just once a year, currency has its benefits.
To see this trust in action, let’s go to Hong Kong in the 1950s and meet the British soldiers that occupied the territory at the time. At local bars, British soldiers would pay their tab using a check on their British bank accounts. Instead of cashing these checks, the check would be used just like money and signed by each successive owner, sometimes with 40 or more signatures on the back. Months later, the check still might not have been cashed. Think about the implication here, effectively, new money has been created, but so has an equal amount of debt. One person’s money is another person’s debt.
In our modern world, money has become ubiquitous and, in some ways, our view of it has not changed. Money is still an impersonal method of exchange and we show our compassion for people by not exchanging money. We do not ask our kids for payment after dropping them off at soccer practice because our approach to some relationships is fundamentally different than others. By not exchanging money, and not even thinking about exchanging money, we show how much we care.
In an odd way, this world of free credit extension has bloomed into society at large. In a proto-economy, a quick nod and smile might be enough to convince the store owner that you would pay back in some way. Today a scan of the plastic card works just the same. Either way, credit is extended.
Today, credit hardly means what it used to and the mechanics of our financial system requires large asset holders to insure the validity of the credit. Money must eventually be backed up which is why our largest financial institutions must lend money overnight to each other at a rate set by the federal reserve. What has happened here is that the personal elements of trade have been sucked right out of the system. You no longer need to trust your neighbor to exchange with them. That federal funds rate went up by a half of a percentage point last month, and hardly anybody seemed to take offense to it. Nor should they.
This reflection was heavily inspired by David Graeber’s Debt: The First 5000 Years which completely changed the way I understand debt relations. I, like most, bought into the myth of barter which we have absolutely no evidence for. Graeber’s work has inspired many, including myself, to think deeper about how trust permeates society and how to build trustless systems on a foundation of trust. If you are curious about this, I highly encourage you to check out the book.