Marc Halpern, Part Time Investors LLC
Marc@PartTimeInvestors.com
In May 2022, the Fed started raising interest rates in an attempt to control inflation and that put in motion a series of domino effects.
In this article, I will describe some of the effects and lessons learned for private placement investments in 2023 that relate to real estate, using examples from my own portfolio. I will also discuss how well my risk management strategies are performing in 2023 and beyond in the face of rising interest rates together with inflation that jumped from 1.4% in 2020 to 7.0% in 2021 and 6.5% in 2022.
1. Exits Were Delayed - Redeployment Deal Flow Decreased
The first effect of the increase of interest rates in 2022 was that exits of some private placement investments were delayed or cancelled in 2022 and 2023.
As an example, one of my investments in an apartment complex went under contract for sale in March 2022 with a scheduled closing in July 2022. The valuation was outstanding and had the sale been consummated, the IRR would have been close to triple digit! The Fed tightened in May (between contract and scheduled closing) and the buyer that was using financing couldn’t close. The timing of the Fed increase couldn’t have been worse. It’s now a year later (April 2023) and there is no talk about a sale of the apartment complex anytime in the near future.
On the other hand, the apartment complex is cash flowing extremely well and the preferred returns are being distributed like clockwork. We do not expect any change in this reliability of distributions.
As always when owning rental real estate, as long as you have positive cash flow, you always have the choice to “hold ‘em or fold ‘em” if the market experiences a hiccup.
My portfolio of private placement investments includes several apartment complex syndications in Florida, Georgia and Indiana and they are doing very well with cash flow that are delivering reliable “pref” distributions. The growth of valuation since purchase is still there, albeit less than before the Fed raised rates. The growth just can’t be realized until the financial environment stabilizes. The fact that distributions continue uninterrupted constitutes strong evidence that the investment is healthy on top of the full transparency of the syndicators.
In contrast, there are private placement investments for which distributions HAVE been interrupted after the Fed started raising rates nearly a year ago.
A case in point is a land development lending fund in which I made a significant investment a couple of years ago.
The basis for making that investment was that there was (and still is) a large shortage of inventory of single family homes that resulted from the slowdown in new home building after the crash of 2008-2011 while new households continued to form as babies born 25-30 years ago come of age. I invested in a fund that lends money to land developers to purchase raw land and “entitle” the land with the paperwork to make it shovel-ready. Homebuilders then buy the shovel-ready land and build homes that are in demand.
I made the investment since the preferred return is a whopping 12% plus back-end kicker distributions upon liquidity events when the land developers sell entitled land to the home builders.
The double whammy of inflation of home prices plus increase in interest rates, in 2022, resulted in new homes that are unaffordable, especially for first time home buyers. The reality is that the building of new homes slowed down significantly even while the formation of new households continues to chug along. Housing starts in March 2023 were 1.42 million which is down 17% from March 2022 (1.72 million).
Now in April 2023, those of us investing in a certain land development lending fund have not yet seen the preferred return distributions for the 4th quarter of 2022 and the 1st quarter of 2023. These distributions typically hit our accounts by the end of the first month following the end of a quarter. These distributions were very reliable through the middle of 2022.
However, even though the distributions from the land development lending fund have stopped for the time being, the preferred returns continue to accumulate on paper. I’m not worried about the future of this investment because the underlying fundamentals of the home inventory shortage remain and grow. At some point this market must come back.
Since my investment was in cash (actually Roth 401k funds) with no debt (i.e., no arbitrage), and there is collateral securing my inv