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What is Negative Leverage?

What is Negative Leverage? 

Understanding how borrowing affects your investment returns is essential. Our latest video, featuring Scott Williams, breaks down negative leverage and explains how to calculate it so you can avoid it. Tune in to make smarter real estate investment decisions!

Aline Capital Represents KM Fabrics on Industrial Property Acquisition in Greenville, SC

Aline Capital is proud to announce our representation of KM Fabrics in the purchase of a ±161,214 SF industrial property in Greenville, South Carolina!

Founded in 1979 right here in Greenville, KM Fabrics has become one of the world’s leading producers of premium velvets.  Their drapery fabrics can be found in America’s theatres, concert halls and performing arts venues…including the Peace Center in downtown Greenville!

 

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Computing the Discount Rate

Computing the Discount Rate
By: Christian O’Neal

The discount rate is the most fundamental concept in the commercial real estate investment industry to master, and it is widely regarded as a pillar in finance and investments in general. Investors use discounted cashflow analysis to solve for their maximum purchase prices when analyzing prospective investments. In doing so, investors can underwrite deals to their minimum required rates of return so they can meet equity return obligations to their capital partners. But what exactly is the discount rate and how does it work?

Let us examine what the discount rate is, how it works, why it is so relevant, and why it is especially hard to compute in the environment we find ourselves in today.

To understand its relevance, it is crucial to understand the ‘time value of money’ concept. The time value of money simply refers to the value of money today versus its value out into the future. Since our dollar is “fiat,” or no longer tied to gold, its value decreases throughout time because of inflation. A dollar today is worth more than a dollar tomorrow because you can buy more with it today, and its purchasing power is greater today than it will be tomorrow. As our currency is debased through money printing, the amount of total dollars in circulation (demand) rises faster than the amount of goods there are (supply) for the dollars to chase after. Therefore, we get rises in prices such as energy, food, housing, and commodities. Since 1960, the total money supply has expanded exponentially, as shown in the chart below:

Now that we understand the implications of inflation on our purchasing power, we can rightfully assume that investors would expect a higher return in the future on each dollar invested, relative to that return today. The discount rate factors this in as all future cashflows are not treated equally. The further out into the future cashflows are, the less they are worth.

In addition to inflation, the other item we must account for in computing our return requirements (discount rate) is something called opportunity cost. Opportunity cost refers to the missed returns or opportunity that one accepts by choosing an alternative. To further illustrate, imagine you have $10,000. By putting that $10,000 into a money market fund or savings account, you lose the opportunity to earn a higher rate of return elsewhere, such as in the private real estate market, REITS, or the stock market. Investors account for this and inflation in producing their annual return requirements.

The discount rate is simply the unlevered required annual return hurdle investors expect to receive from an investment, but it factors in the time value of money concept discussed above. Investors demand an annual return above ‘risk free rates,’ often pegged to US treasury rates since these bonds are as close as one can get to a “risk free” guaranteed return vehicle as possible. They are backed by the faith and credit of the US government through the world’s reserve currency, the US dollar. By applying a risk premium over and above these rates, investors can capture the perceived risk/reward opportunity through additional required return. This additional premium, or spread, corresponds to the amount of risk an investment strategy or type of investment has to offer. Core, stabilized properties with investment grade anchor tenants, or fully occupied Class A multifamily properties, for example, will demand the lowest risk premium over the risk-free rate. Vacant, older properties are inherently riskier and therefore require higher rates of projected return, made possible via lower purchase prices. Investors are willing to accept lower returns via a lower risk premium spread, in exchange for lower risk.

If we put it all together, we now know that the unlevered discount rate is made up of A) a risk-free rate & B) a risk premium rate. Cashflows in the future will be discounted by this annual discount rate hurdle. By using debt to capitalize a project, returns on equity should be larger than the unlevered discount rate because of the additional leverage on each dollar. If levered returns are not higher because of debt, then that implies the deal is negatively levered and the borrower would be better off using all equity to capitalize a project to generate higher returns.

In today’s market, it can be difficult to calculate the discount rate for a given project because of the volatility in risk free or treasury rates, as well as overall market uncertainty. When times are uncertain, investors tend to demand a higher spread as well to cushion themselves against potential future erosion in value.

Thawing, but Still Frozen

Thawing, but Still Frozen
By: Christian O’Neal

The Fed has always had a dual mandate – maintaining price stability and low unemployment. They use two tools to do so, setting short term interest rates and controlling their balance sheet. Interest rate changes either encourage borrowing by aiding economic activity and spending through lower rates, or they slow the economy by making it harder, and more expensive, to borrow and transact. On the other end, The Fed controls its balance sheet through quantitative tightening or quantitative easing, which is jargon for increasing or decreasing the total money supply, known more commonly as inflation or deflation.

A Look in the Rearview Mirror

How does the Fed and interest rates affect real estate, pricing, transactions, and returns? For starters, real estate borrowers take on debt to juice their returns. The availability, flow, and price of capital affects the demand for assets financed with debt, driving valuations up and down. In efforts to curb 2022s inflation and maintain price stability, the Fed embarked on the fastest interest rate hikes in human history, hiking rates from effectively 0% to over 5% in 9 months, an accelerative pace we have never seen before. Since real estate investors price deals by discounting future cashflows by a rate over the inflation rate, a higher rate forces borrowers to pay less money to afford the same NOI, based on higher annual obligations on debt and equity capital providers who financed the capital stack for a respective deal. The less confident participants feel in quantifying their risk in a deal, the larger the spread over the inflation rates they require in computing their return requirements.

Sellers are still on the mountain and buyers are in the valley, shouting at each other to move. Although they’ve inched closer to one another over the past 3 quarters, there is still a ways to go.

The result of that gap? A stagnant, frozen market in the latter half of 2022 and a less stagnant, more optimistic 2023. Sellers have held onto expectations that their pricing reflects values prior to the interest rate hikes, and buyers are scratching their heads waiting for discounts so they can make the mechanics work. This bid-ask spread in the market soared as high as 30% in late 2022 and early 2023, while the gap has come down some over the past 3 quarters as the Fed, and the market, accepted a higher for longer consensus on long-term inflation, and therefore, rate expectations. This allowed capital providers to place higher confidence in pricing risk, thawing some of the ice. The 10 Year Treasury moved as much as 50 basis points from January to March in 2023, not once, but twice. The market priced in as much as 200 bp rate cuts, while inflation data remained stubbornly high, causing disorder and pricing fluctuations. Market participants bought into stickier long-term inflation in Q2, Q3, and Q4, delivering some common ground to allow some transactions to occur, albeit they were minimal.

The Market Today

Fast forward to today, April 24th.

April’s CPI data release came in hotter than expected at 0.4% month over month. Coupled with the latest hot payroll report and JP Morgan’s bearish signaling, the market has reacted sharply, driving treasury yields up, reflecting a higher-for-longer interest rate sentiment that market participants have been echoing for several quarters now. The BLS data showed that prices have moved 3.5% year over year from March ’23 to March ’24, up from the 3.2% figure in February. Energy and housing prices are the main contributors to this spike, even though housing is a lagging indicator and 1/3rd of the CPI is derived from skewed housing data. Nonetheless, the Fed, and the market, prices in their expectations based on these so called leading economic data indicators and data releases. The Fed’s preferred inflation gauge, the Core PCE Index, rose 0.3%, in line with expectations in February, and down from January’s 0.4% increase. This figure is up 2.8% from last year.

Looking ahead, the market appears to be taking the Fed’s telepathy at face value, pricing in higher inflation and rates, anchored in the fact that the Fed officials need to see inflation sustained closer to their 2% annual target before considering any cuts. Although US data continues to paint the picture of a resilient US economy, data aggregators and leading investment banks continue to have a mixed sentiment on the future, with many players betting on a higher for longer theme backed by the strength of the economy, and some, a serious market disruption requiring more accommodative policy. However, as large forces converge this year, such as election implications and large amounts of commercial real estate debt maturities, only time will tell how fast and how severe rate cuts will be, if any. The Fed is sandwiched in between two forces, the debt burden and inflation expectations, and there will be inevitable disruption no matter which way they turn. The question is not if but when, and furthermore, how the probabilities of each potential outcome affect the markets’ decisions and pricing today.

Fed Funds Rate Projections

The expectation of higher for longer rates, coupled with imminent loan maturities on the horizon in Q3/Q4 of this year, has put sellers in a difficult position, moderating their pricing expectations back down to reality out of concern that rates may not work downward quite fast enough to bail them out of their capital stack gaps. As of today, over 50% of Fed governors anticipate SOFR landing between 475 and 500 by year’s end implying just 1-2 cuts, with the majority expecting a long-term landing of 2.5%-3% by 2026 and onward. In response, the market has repriced in a bearish long-term outlook consistent with the theme of higher sustained inflation above the Fed’s stated goal of 2%. If we look at the historical spread between the 10 year treasury and SOFR as a proxy, the market is whispering SOFR to anchor itself at around 3%.

The somewhat tighter market consensus this year has led to deals changing hands and sellers hedging further downside by offloading deals, very selectively. Most sellers have chosen to remain on the sidelines unless faced with a debt maturity. The lower volatility and end of the hike cycle has helped lenders quantify their interest rate exposure risk to an extent, stimulating more activity in the marketplace for participants who need to act sooner rather than later. Cap rates and interest rates do not move in lockstep, after all, since capital tends to find homes in assets with a fixed supply during inflationary times, insulating investors from the debasement of fiat currency. We expect capital to continue to flow into shock absorbing assets in search of diversification and protection as investors look for fixed-income alternatives. The forecasted long-term demand for CRE, coupled with the dry powder on the sidelines, should keep cap rates somewhat flat despite the negative leverage environment we find ourselves in. If net income growth expectations remain high, investors will solve for lower spreads above risk-free rates to account for that growth. Regardless, treasuries move well ahead in anticipation of fed cuts, so we may not see too much more movement on market interest rates. The Fed does not control the long end of the curve. Fixed rate bond holders demand a real return on their money over inflation, driving the long end of the curve.

Now, if we have a negative market event, the Fed may be forced to step in and curb the distress amidst political pressure and high stakes, leading to much lower rates. That, however, is impossible to predict. Although the fed will say that they are apolitical, their decisions and moves in history tell us otherwise.

We expect transactions to pick up as looming debt maturities meet market expectations. Rate cuts will help ease some of the bid-ask mismatch, but the biggest relief will be reserved for developers and floating rate borrowers. The timing and severity of rate cuts will impact the size of CRE distress. The longer they wait to cut, the greater the risk of the system breaking. Ultimately, if you can buy well located real estate for below replacement cost in a growing market, and cashflow it at or above risk-free rates, we feel that is a sound risk-adjusted play in today’s volatile environment. Pricing appears to be at or near the trough, as shown by capital flows and widespread risk-off sentiment, which tends to favor the contrarian investor. The illiquid nature of private real estate commands an illiquidity premium in uncertain times, for losses are only realized upon selling assets.

 

 

Aline Capital introduces the EcoSuite™, a new way of doing business in commercial real estate

Greenville, SC-based Aline Capital is pleased to unveil its refreshed branding and messaging campaign that better reflects their full-service ecosystem approach to real estate investment services. For quite some time, Aline Capital has transcended the traditional brokerage model. At the forefront of the messaging campaign is the Aline EcoSuite™, a concept that offers the firm’s high level of customer service across the spectrum of a commercial real estate investor’s needs. “We have created a true ecosystem of services that run the gamut of investment advisory including investment sales, leasing, debt and equity, insurance, and development services. Instead of these services operating in different business silos that don’t speak to each other – ours actually work together to create a seamless experience for our clients,” said Scott Williams, the Founder of Aline Capital.

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Aline Capital Brings in Clay Driggers to Steer New Development Services Division

Greenville, SC-based commercial real estate and capital markets advisory firm Aline Capital has hired Clay Driggers as senior director of development services to guide the firm’s newly launched development services division. The new division will focus on providing advisory and development services to real estate investors and developers.

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