David Pascale, Senior Vice President at George Smith Partners, joined us on the podcast to discuss how the Federal Funds Rate impacts real estate.
Mr. Pascale joined George Smith Partners more than two decades ago, leaving behind a successful career in intellectual property rights management. Now, as GSP’s most Senior Vice President/Deal Manager, Mr. Pascale has directly overseen the placement of nearly $4 billion capital into commercial real estate. He has an expertise in virtually every aspect of commercial real estate debt placement with distinct specializations in CMBS, bridge loans, credit tenant leases. He has worked extensively on retail, multifamily, hotel, office, and mixed use transactions. With a background in law, Mr. Pascale also brings loan document expertise and is able to explain and negotiate deal points and structure. He serves as an advisor to new company members.
In addition to his primary responsibility of client management, Mr. Pascale has been involved with the marketing of the firm in a number of different capacities and is primarily credited with transforming the firm’s highly regarded FINfacts newsletter from a quarterly to a weekly publication. Mr. Pascale now offers his expertise via a weekly column in FINfacts known as the hugely popular “Pascale’s Perspective.” This column provides readers detailed information on trends affecting the United States Real Estate Markets by combining national/international macro overviews with specific microeconomic events.
Mr. Pascale is an alumnus of the University of California Los Angeles.
David’s Favorite Resources
David shared with us his go to news sources for market information (posted below).
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Tyler Stewart – All opinions expressed by Adam, Tyler and podcast guests are solely their own opinions and do not reflect the opinion of RealCrowd. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. To gain a better understanding of the risks associated with commercial real estate investing, please consult your advisors. Hey listeners, Tyler here. Before we start today’s episode I wanted to quickly remind you to head to realcrowduniversity.com to enroll into our free six week course on the bfundamentals behind commercial real estate investing. That’s realcrowduniversity.com, thanks.
Adam Hooper – Hey Tyler!
Tyler Stewart – Hey Adam, how are you today?
Adam Hooper – Tyler, you know I’m doing good but fall is threatening to set in a little early here in Portland.
Tyler Stewart – A bit cloudy today huh?
Adam Hooper – A bit cloudy. But we had a ray of sunshine on the podcast today.
Tyler Stewart – We certainly did, yes.
Adam Hooper – Tyler, who do we have on the podcast today?
Tyler Stewart – We have David Pascale of George Smith Partners.
Adam Hooper – Yes, so David started there long time ago, mid 90s. He now runs their FINfacts in Pascale’s perspective. They used to fax these things out, back in the 90s, they’ve been at this for a while. I know we say it a lot, but again, this is a really, really good episode. We talked about a whole bunch of stuff today.
Adam Hooper – Very, very pertinent in our current environment, kind of where things are going, talked about Federal Reserve System, we went a little CMBS tangent.
Tyler Stewart – Yep.
Adam Hooper – Talked about commercial real estate as an inflation hedge, a lot of really good information in this one today.
Tyler Stewart – Yeah, we covered a lot and David shared his favorite reading materials that listeners can go to and research the market on. Overall just a fantastic episode, David has a unique ability to take complex topics and speak to them in layman’s terms and I don’t know about you but I learned a ton, from this episode.
Adam Hooper – And in the show notes, please, we’ve got a link down there to where you can sign up for George Smith Partners, theire FINfacts, email and Pascale’s Perspective.
Tyler Stewart – Must reads.
Adam Hooper – Yeah, I’ve had that, I’ve been subscribed to that really long time, would highly, highly recommend that if you’re interested at all, in what’s going on in the commercial real estate capital market. So I think that’s probably enough of us talking, friendly reminder as always, if you like what you’re hearing, please leave us a review or rating on iTunes, Google Play, SoundCloud, wherever you listen to us and with that Tyler, I say we get to it.
RealCrowd – This podcast is brought to you by RealCrowd, the a leader in online real estate investing. Visit realcrowd.com to learn more about how we provide our members with direct access to commercial real estate investments. Don’t forget to subscribe to the podcast in iTunes, Google Music or SoundCloud. RealCrowd, invest smarter.
Adam Hooper – David, as I was saying offline, been a longtime subscriber of FINfacts and your Perspective so we’re honored to have you on our podcast today, thanks for joining us and we look forward to digging into all things financing.
David Pascale – Oh, thank you, I appreciate the opportunity to be on the show.
Adam Hooper – Well, why don’t you tell us a little bit about kind of how you got started with George Smith Partners, your background in real estate and how you’ve come to build such a following with your economic perspective.
David Pascale – Well it’s an interesting story, I started here in 1995 and I was the main lender, the go-between between our firm and the lending community, bringing in capital market providers to our office and creating a database of capital market providers. And I learned, in that function, I learned a lot about how lending works, how rates work, how the indices work and it was a great experience in the beginning of my time here at Jordan Smith Partners. And at that time, I started writing the newsletter every week with our late chairman George Smith and we converted it from a quarterly newsletter to a weekly newsletter that became very highly read and this was in the 90s, so we were actually faxing the newsletter out every weekend with a barrage of fax servers and of course we converted it to online in the late 90s early 2000s, and it became an email bulletin…
Adam Hooper – So you guys have been in this for a long time. You said you started faxing this out back in the 90s, this is–
David Pascale – Yes.
Adam Hooper – This isn’t the new thing, you guys have been at this for a while.
David Pascale – Right, right and that’s why it’s called FINfacts, F-I-N-F-A-X was the original name and now it is called F-I-N-F-A-C-T-S, FINfacts.
Adam Hooper – Perfect.
David Pascale – And regarding the capital markets and my writing about the economy, it started because the biggest driver of commercial real estate in the 90s was a new invention called commercial mortgage-backed securities, and the securitization of loans into bonds, which allowed for high-leverage, fixed-rate, non-recourse loans, on a massive basis because lenders were able to lend a pile of money, call it five hundred million dollars, sell bonds and lend that money over and over again and keep selling bonds and the real lenders ended up being these bondholders. And this was a development that came out of the RTC, Resolution Trade, Resolution Trust out of the savings of loan crisis in the early 90s in order to dispose of the assets, a couple of very smart people, Lou Ranieri is the most notable, decided to take these assets and these loans and tranche them into bonds and we’re very successful as bond buyers were excited about the possibility of buying a diversified portfolio instead of a single loan. They then transferred this mechanism into commercial lending and so what FINfacts started to do and literally it was interesting because CMBS came into its own in 1995/1996 as I was starting, George Smith Partners originated a huge amount of CMBS because it took a lot of personal hand-holding and interface with our borrowers to do these loans and FINfacts became a place for people to learn about CMBS and the spreads, which is to spread between the Treasury and your loan rate, and how they were calculated, and what affected spreads.
David Pascale – We were kind of the cutting edge newsletter definitely in California, on this. And so George and I wrote that together and unfortunately, George passed away in 2005, and while he was sick, and during that period I started writing his column and as a tribute to George I would like everyone to know that I started writing the column imitating his writing style which was amazing. And then as time went on, I started to comment on general economic conditions that effected commercial real estate and also during the last 25 or so years, I have you know spoken and met with economists from all the major banks and investment banks, and attended countless symposiums, and I took econ in college at UCLA also so I’ve kind of become the in-house economist here and writing my column.
Adam Hooper – Perfect. Well let’s take a I guess kind of an unexpected detour down here done CMBS lane here. So CMBS for listeners out there they’ve probably heard that term, and as you mentioned that’s a Commercial Mortgage-Backed Securities. So can you walk us a little bit back to what lending was like pre-CMBS and then go a little bit more into what CMBS actually is and how that’s changed the lending landscape?
David Pascale – Yes, so when in the quote, unquote “old days”, basically all loans were portfolio loans. It meant someone like GE or Prudential, which were two of the major lenders in the 80s and 90s, would make a loan and keep it on their books until it was paid off. And it was their portfolio money either from GE Capital’s pot of investing money or in the case of Prudential and other life insurance companies, it was their life insurance policies and life insurance policy payments and deploying that money to match their obligations to pay out that money.
Adam Hooper – And which still exists today, right? And so listeners out there that have heard are…
David Pascale – That lending still exists today. But the the issue with those lenders, those portfolio lenders is they had an allocation. And we would joke that sometimes you know George and the older partners would say in the early 90s, well I just spoke to Pru, they’re out of money for the year in October for example, and might as well go home or something like that, or all the life companies are tapped out for whatever reason. What CMBS did it was a complete game changer. It allowed lenders like Goldman Sachs, Lehman Brothers, Bear Stearns to name some of the more infamous names in the financial crisis but, they had a long run of taking I’ll call it 500 million dollars or a billion dollars, lending it out, and then taking that and then bringing those loans into what’s called a securitization or a pool, they have it rated by the rating agencies and then they sell bonds just like any other set of bonds, triple A, double A, single A, triple B, etc, depending on the risk profile. Triple-A being the safest call it, single B being the first loss piece.
David Pascale – And then they would sell those bonds, hopefully at a profit, compared to the spread that they charged the original borrowers and then they would have that money back to re-lend. So as long as bond buyers were buying and the major bond buyers were pension funds and interestingly enough insurance companies that often would buy a CMBS bond instead of originating loans because it was easier and the reason these bonds were popular is it was a diversified risk profile, so you were lending on apartments, retail, industrial and all over the country and all the sponsor equity was ahead of you. This market generates about eighty billion dollars a year in volume, and this lending process allows them, allows the lenders to push what we call LTV, Loan To value, above what most portfolio lenders will allow because they have bond buyers at the very top of the stack at the first loss piece, receiving returns of for example 18, 19, 20 percent to take that risk and so therefore they’re able to lend 75 or 80% LTV as opposed to 65 to 70 percent, which is standard for the life companies. And that last bit of leverage makes a huge difference to a sponsor.
Adam Hooper – And so what it did basically is it took what was from a portfolio lender a balance sheet lenders perspective, they’re taking on all the risk of that individual deal in exchange for creating this diversified pool of assets and basically tranching up that risk. You can find buyers with different risk capital, to take those different pieces of the capital stack and create just a tremendous amount more liquidity in the debt capital markets than what was there before this existed essentially.
David Pascale – Yes, exactly. Exactly. And it started to drive all types of, so you would say, you might ask what does that have to do with construction lending? Well it had everything to do with construction lending because a construction lender, typically a bank, is always looking at their takeout and now they were able to underwrite the take out to a CMBS take out instead of a life company take out and perhaps get a little more aggressive on the construction loan proceeds.
Adam Hooper – That’s true, anytime you bring liquidity into something like that you’re going to see a pretty dramatic increase or change I guess in pricing and that’s what you mentioned before the spreads, which is essentially how a CMBS loan is quoted, right? A spread over some index.
David Pascale – Right.
Adam Hooper – Let’s maybe talk a little bit about that.
David Pascale – CMBS loan is is typically 10 years. We’ve seen five year loans, there’s a five-year loan market and there used to be a seven-year loan market for CMBS but the average call it widget of CMBS is a 10-year loan, and it is priced over the ten-year swap which today is about six or seven basis points above the 10-year Treasury, the ten-year swap, the reason the loans are priced over the 10-year swap is because of the way that the CMBS lenders hedge their risk has has to do with buying a floating rate instrument which a swap is. Because a swap is a swap of a fixed rate payer and a floating rate payee. So the fact that lenders need to need to hedge their risk before they securitize makes the swap the attractive instrument for that. Interestingly enough before the financial crisis or before the debt crisis of the late 90s, the Asian crisis and the Russian crisis of 97 and 98, they used to headge their risk by shorting Treasuries. And that turned out to be disastrous when Treasury yields and spreads went awry in their relationship during the Asian debt crisis and I won’t get into all the details right now, but it turned out to be an inefficient way to hedge and the swap has turned out to be the proper way to hedge so I’m always counseling borrowers that look at the ten-year Treasury on their Bloomberg app on their phone and I go, no we really need to look at the swap which is on our website by the way. And so it’s priced over the swap, typical spreads today it depends on leverage, product type, market and income in relation to the loan a thing called debt yield.
David Pascale – And a typical spread today is anywhere from 180 to 220 over the 10-year swap which today is very, very close to three percent. So all-in rates for CMBS right now 480 to 520 and for very, very low leveraged loans, I mean we can see that spread go down to like 130 but that wouldn’t be like for a 50% leverage.
Adam Hooper – And does the swap pretty closely track with the 10-year Treasury or how are those two related?
David Pascale – It does and for many years the swap was about the normalized swap rate was about 60 to 80 basis points above the Treasury, this is in the pre-crash era, the pre 2008 era. Coming out of the crisis, the swap is now much closer to the Treasury because the expectations of future increases in LIBOR, which is the floating rate index on the other side of the swap are very low because we’re in a kind of secular low growth, low inflation environment coming out of the crisis and something that I like to refer to as the new normal which is a phrase invented by Mohamed El-Erian, who is one of the leading economists that I personally follow, he used to be with Bill Gross at PIMCO, he was the number two there, he’s on CNBC all the time, I’m on his webpage and I’ve read his book and he is now at Allianz. So in this new normal with ultra-low rates around the world the swap at one point even was below the Treasury and it is now just about eight or nine basis points above the Treasury and it does track the Treasury, pretty closely.
Adam Hooper – Good, and then how have you seen the CMBS market, it obviously had an impact takes I guess to say the least in the the 2008 crash, there were some issues with CMBS markets then in the recovery sense and how have you seen the CMBS market change or come back or what does the environment look like now as it was maybe pre 2008 or even over the last five, six years? How has that matured or changed from what it was pre-crash?
David Pascale – Good question. The pre-crash CMBS, it got into a bubble environment during I would say 2005 to 2007. Very, very liberal underwriting, some underwriting was being done on a proforma basis meaning that the loan was being underwritten at future income instead of the the trailing 12 which is a major red flag. There was a surplus of what we call 80% LTV and they really ended up sometimes pushing you…
Adam Hooper – Even higher, yeah.
David Pascale – It was even higher. We called it 82.5, and it looked like 80% 10 year interest only on very, secondary markets, tertiary markets and the execution of the bonds was such that the spreads were ultra low. For example, spreads in 2006/2007 were as low as 85 basis points, 80 basis points, above the Treasury or the swap as opposed to today which I said is about 200. There were buyers taking CMBS bonds and buying them one day and flipping them the next, because there was so much ravenous appetite for them so this was not healthy in retrospect. And after the Lehman Brothers crashed and even before in 2008, all CMBS lending virtually grinded to a halt, there were no bond buyers. It emerged in 2010, and actually Steve Bram and I here at George Smith Partners originated a loan for one of our clients that was in the very first CMBS securitization in 2010, the first major regular securitization. It was done by JP Morgan, it was an asset that was an office building up in Northern California, I mean that’s not really important and it was a landmark day. There was a little bit of TARP-aided, T-A-R-P the building that rescued the toxic assets that was passed, at the depths of the recession by Congress, it was a little bit controversial. But TARP did aid that securitization to try to push the market and it did kickstart the market and the market has been very robust, I would say it really kicked into gear in 2012. And in recent years there was a new regulation put into place that’s part of the Dodd-Frank regulations that came out of the financial crisis
David Pascale – and a lot of CMBS originators and borrowers and shops like ours were very concerned about it. It required a concept of risk retention by the originator where they would hold some of the first loss piece, but that has gone very smoothly even with the regulation, the lenders figured out a way to create a first loss piece that was sellable to the secondary market in a kind of a synthetic manner where the originator was holding on to it, but there were some participants in it and the market is very, very robust today and I am happy to say that underwriting has not degenerated into the pre-crash levels. It’s now a 75% market for a commercial and 80% for apartments.
Adam Hooper – And have you seen volume? How would you compare volume currently maybe the last 12/18 months versus what we were seeing in the heyday, you know 05/06?
David Pascale – It is a little bit underneath for a good reason because CMBS is not doing every secondary and tertiary market very tough deal.
Adam Hooper – Right.
David Pascale – It’s being a little bit selective but volume is pretty robust now.
Adam Hooper – That’s a good primer on the CMBS world, let’s take a little back. I know we wanted to talk about, at a high-level Federal Reserve System, some of those benchmarks there and how that impacts the the commercial lending world, so let’s go real 101 on it. What is the Federal Reserve System? What do they do and what does that mean for investors out there that are looking at investing in commercial real estate?
David Pascale – The Federal Reserve was formed in the 20th century to regulate our money supply and also to create kind of an overarching central bank separate from the states. Because there was a lot of state regulation of moneys in the 19th century etc. And it’s played a big part in the US’s economic hegemony over the world as being one of the most robust economy in the world, although we’re being challenged by China eventually. The Fed determines the rates that the banks charge each other and these are federally-insured banks. So the Fed has a major overseeing role in regulating the banks. And they determine the cost of funds between the banks, which then is the bedrock for various costs of funds of all types. From credit cards, auto loans, home loans, commercial loans that spring from the overnight rate that the bank charges to borrow from the Fed which is called the fed funds rate.
Adam Hooper – So that’s basically the bank’s cost of capital, right? If the bank were to be a borrower, it’s the bank’s cost of capital.
David Pascale – Yes.
Adam Hooper – And so the federal funds rate, that is the the rate that you said the banks pay for that capital essentially that they get to then loan out to, they’re given as an auto loan, consumer credit or real estate, that’s the foundational rate that all of the rest of the system is based off of essentially.
David Pascale – Yes. The key thing about the fed rate, is that it is a floating rate. And that’s a common misconception when I’m talking to my fixed-rate borrowers they say, “Well the fed’s doing X, I’m worried because my rate’s going to go up on my loan that I’m going to place next month.” And so I’d like to go into a little bit of detail there. The federal funds rate is an overnight borrowing rate that mostly affects worldwide floating rates because LIBOR tracks the Fed Funds rate very closely, except during times of extreme credit crisis such as 2008 but we’ll take that out of the equation because we’re now in a normal time where for example the Fed Funds rate right now is about I’m looking through my notes.
Adam Hooper – And I was going to say, while you’re looking that up the LIBOR which we’ve talked a couple times here, that’s a loan in interbank offered rate which is basically the average interest rates by all the top banks in London, right? That’s how the LIBOR is…
David Pascale – Yes.
Adam Hooper – Is come up it…
David Pascale – Yes and it’s done by a survey. So Fed Funds rate today is 2 percent and 30 day LIBOR which is the most commonly used floating rate in the world, is at about 2.08%. So it tracks the Fed very closely. LIBOR is important because, this is hard to get our arms around but over two hundred and fifty trillion dollars of instruments and derivatives are pegged to LIBOR. And for numbers geeks that is a quarter of a quadrillion. For perspective, the entire US economy for a year output is about maybe 10 to 12 trillion dollars. So it’s a huge number and as a side note, LIBOR is probably going away as a result of price rigging scandals that occurred in recent years. The U.S. is probably going to switch to a rate called SOFR, which is an overnight cost of funds rate set by the New York Fed, based on actual transactions, instead of a survey. The British are going to have their own rate, often called S-O-N-I-A, the Japanese will have their own floating rate called T-O-N-I-A and LIBOR is scheduled to go away in the end of 2021. So we’re entering into a little transition point but these new cost of funds will also closely track the Fed rate because the Fed is so dominant. So if someone is borrowing on a floating-rate basis,
David Pascale – every time the Fed raises, their rate goes up. A fixed-rate borrower obviously if their rate was locked, there’s no change. But the question is, how does the Fed effect fixed rates? Fixed rates are based on Treasuries and Treasury buyers and sellers often watch LIBOR and the Fed for clues and direction as to the proper rate for the Treasury which is set but as a coupon, but is really set by the appetite for buyers at that rate and the more the more people buy Treasuries the lower the rate goes. Treasuries are based on, the treasury, excuse me. The Treasury rate is really an expectation by the markets as to long-term inflation and growth. So we’ve had a little disconnect lately. We’ve had the Fed raising rates, LIBOR going up, floating rates going up and fixed rates staying pretty low or in a low range so that the treasury for a long period was in the two percent range, when we’re still sub-three percent. And the reason the Treasury has not been moved up more I think is two major reasons. One is the relative value to the German bonds in the Euro. Because the Euro is a little behind the U.S. in growth and their central bank is still doing ultra accommodative measures such as buying bonds etc, which our Federal Reserve has stopped doing. So the German bond ten-year bond is about .4 right now, and the relative value between the German bond and the U.S. Treasury, the U.S. Treasury is at 240 basis point premium on that. Until the German bond breaks out of that range, I feel that the Treasury will remain under 3% because
David Pascale – there’s always going to be a buyer that sees the Treasury as a safe asset. The other thing that affects Treasuries is U.S. deficits which are really exploding right now and it’s something to watch, for everyone to watch. Because at some point the supply demand ratio can cause a problem. If there’s not enough buyers for our bonds, the yields will spike dramatically but so far that has not happened.
Adam Hooper – How often does the federal funds rate change?
David Pascale – The federal funds rate can change up to, technically it could change ten times a year. Or every time the Fed meets. The Fed has kept to a schedule lately of they started raising rates out of the crisis. The first Fed increase coming out of the crisis was December 17, 2015. That was a landmark day, Janet Yellen came out in a press conference and raised the rate and it shocked markets a little bit because the markets had grown very used to nine years of a basically a 0% Fed rate and ultra-low cost of funds, which some people called the punch bowl effect. Like whenever the central banks start to remove this ultra accommodative policy, there’s some market shock because the punch bowl’s been pulled away. There’s also what I call the training wheels effect that this is not designed to be forever but it’s supposed to allow the economy to stand on its own. And so some could interpret it and some did interpret it as a vote of confidence in the economy. So there was one raise in 2015, one increase in 2016, both of those were in December and then in 2017 there were three and in 2018 there have been two so far and we are expecting another one in September and another one in December. And I’d also like to point out speaking of the Fed the other tool that the Fed has employed during the crisis and the aftermath is something called quantitative easing, where the Fed actually entered the market place, this is very extraordinary, and bought four trillion dollars of bonds. Hundreds of millions of dollars of bonds a month, about a hundred million, in order to keep rates low.
David Pascale – They bought Treasuries and mortgage-backed securities. The Fed has stopped doing that and is actually starting to slowly sell-off that portfolio, so it’s another measure that the Fed has employed.
Adam Hooper – Let’s do a little I guess real-world compare and contrast. Pre-2015, when we had the first hike coming out of the crash of 08, what were borrowing rates for a commercial mortgage then versus now three years later with what is that, two, four, six, six rate hikes between them. How is the actual borrowing rate if I’m going to go get a commercial mortgage, how has that changed with this series of six different rate hikes over the last three years in the federal funds rate?
David Pascale – Good question. LIBOR has gone up accordingly. For many years LIBOR was at virtually 0% OR 0.25% And so a typical LIBOR loan is anywhere from 1% to five or six percent above LIBOR. LIBOR borrowers have seen about 1.75% increase in LIBOR during that time, but interestingly spreads have compressed a little.
Adam Hooper – Right.
David Pascale – To alleviate that. Fixed-rate borrowers, things have been very steady interestingly enough. From maybe December, from 2012 to 2015, we saw some loans, fixed-rate loans both Fannie Mae, Freddie Mac, 10 year CMBS, 10-year life company, while that being done while the Treasury was in the I’ll call it 180 to 220 range. Some loans were being done in the high threes, 3.75 to 3.8 or the low fours. Right now rates are in the high fours or the low fives, so there’s been about I would say, a one to one and a half percent increased in fixed-rate loans overall since then and so rates are still very attractive. In my career I have seen fixed-rate lending as high as 750 to eight and a half percent in the 90s and borrowers were happy to get those loans because cap rates were higher etc.
Adam Hooper – I think what I was trying to get to which I think you got there was, the spread is basically what’s insulating the current borrowing rates, right? I mean we were in an environment for a long time where the federal funds rate was basically zero. It was a quarter percent right?
David Pascale – Right.
Adam Hooper – So the spread between where that’s gone up, 2% in the last couple of years, with not a commensurate increase in the actual end-user borrower rate. So where is that spread going? Is it just that the lenders are willing to accept a lower return on their capital or what is causing that spread to basically insulate the end borrower from those rate increases? And will that continue?
David Pascale – Well, about floating rates, there’s been increased competition. There is a massive amount of money in the unregulated debt fund market right now, and there’s so much competition for transactions and loan volume from them that they’ve been willing to cut spreads. And the way they make money is they have a tranche of equity, that is investor money from hedge funds, pension funds etc, giant family offices, and then they borrow money on a bank line over LIBOR and at a very low rate as low as LIBOR plus 100 to 200. They lend money out at LIBOR plus 200 to 400 to 500, and so the equity in the fund then can get a return of anywhere from eight, nine, 10 or 11%. And that equity has been willing to take maybe a little bit of lower return which results in lower rates for borrowers. Banks have been, the money center banks especially have been aggressive for low-leverage loans for good sponsors, and they’ve been lending in the high 100 into the 200s for good transactions. And then there is also a securitized market for floating rate loans called the collateralized loan obligation market, which is like a floating rate CMBS for summary purposes. That market has been very active lately because interestingly enough, as rates go up, there are more buyers for LIBOR-based securities because they can protect themselves against rate increases. Because the CMBS bond buyer is buying a fixed-rate, ten-year security, and what they’re always worried about is that their security rate at some point the Treasury rate, corresponding Treasury rate goes above the their security
David Pascale – and they’re…
Adam Hooper – Right.
David Pascale – kind of upside down because they’re in a higher risk instrument with a lower yield than a Treasury. Conversely, as the Fed raises rates, the CLO market has been frankly on fire lately with tons of buyers and so that has then compressed spreads. So ironically, the raising of the index has resulted in a higher demand for floating rate instruments.
Adam Hooper – Which again and on the other side of that as a borrower’s perspective, in an inflationary environment where you think interest rates are going up, having that ten-year fixed rate is far more attractive than floating rates. So that’s just interesting how those are kind of opposed but working together in some sense almost again, further tighten that spread and keep it from running away necessarily in the end-of-day borrowing rate.
David Pascale – Right. And that comes to the business plans. Floating rate loans are for construction or renovation of properties and fixed-rate loans are for stabilized properties. So floating rate borrowers are racing to finish their business plan before fixed rates go up anymore, so they’re watching both rates. And then there’s an exception where there’s some borrowers that just put a floating rate loan on a stabilized property so they can stay quote unquote, “nimble” and be able to sell without a hefty prepayment that comes along with a fixed rate. So a lot of the floating versus fixed is dependent on the business plan.
Adam Hooper – Now let’s take kind of a step back to some more of a macro picture and what are some of the main factors that influence the federal funds rate and then also I guess after that we can talk kind of general health of the economy and maybe get a crystal ball out and see where we think that might be going to.
David Pascale – Okay. The Fed has a mandate that they feel is their I would say their reason for being or their purpose. It’s a very core concept. And that mandate is based on two things; unemployment and inflation. And they want to have an economy at full employment, with manageable inflation. So for years the targets were a 4% unemployment rate which several economists think that when you’re at 96% employment in the reports, that you’re basically at full employment. Because that last four percent are transient jobs and people that don’t want to work or for whatever reason, a built in inefficiency in the system where you’re never at 100%. So 4% employment is considered, is a target and 2% inflation is their maximum inflation target. So the Fed often said that they would raise rates when they were at what we called four and two. And inflation has been very stubbornly low, even in an era of unprecedented low rates which in the pre-crisis era would have been unthinkable. If you had put a 0% rate on in 1975, 1995, I mean you probably would have seen inflation gallop up to seven, eight, nine percent. And that is part of the new normal in the post-crisis world where we had ultra low rates and ultra low inflation. Inflation is now just hitting approximately 2%, we’re starting to see signs of commodities and prices starting to move up, but it has remained stubbornly low and with the Fed watches because a lot of people think of inflation as being CPI, Consumer Price Index, it is actually, they watch something called
David Pascale – PCE, Personal Consumption Expenditures. Which is a different basket of goods and what the Fed feels is more accurate for a typical American family or home unit and that has just started to hit 2%. And another part of the feds mandate which is interesting is kind of a well-being mandate and that is wage inflation. Where the average American is seeing their wages increase. That has also been stubbornly low and if we do see a tick up in wage inflation, you’ll see the Fed act more quickly because interestingly the Fed you know keeps rates low hoping the American worker will see a benefit.
Tyler Stewart – Why has inflation been so stubborn?
David Pascale – There’s several theories about it. In the aftermath of the Great Recession, companies don’t really have a lot of less pricing power also it could be what we call the Amazon effect. It’s not like the old days where you got the newspaper out and compared prices, people have very sophisticated tools on their phone and computers to compare prices for anything from bread and milk to refrigerators and cars. Companies are aware of this and they don’t have the pricing power they had in the maybe what they might call the good old days of the 70s and 80s, where people just didn’t know what prices were in another state or even the adjoining city. So that is a big part of it. Oil and other commodities have stayed pretty low because again, there’s so much more efficiencies in buying so a lot of it has to do in my opinion with technology. It is one of the great economic questions of our time, is how a 0% money rate for 10 years basically, resulted in 1% inflation. It would have been unthinkable before the crisis and it’s something that the Fed is literally along with all of us trying to understand daily and monthly.
Adam Hooper – Some of these things we’ve talked about here, the employment, unemployment, inflation PCI, this Personal Consumption Expenditures, what are some of the other indicators or benchmarks or stats do you look at when you’re trying to consider the overall health of the economy? How do we look on some of those maybe indices that people can be looking out for as this continues, what should we be keeping an eye on?
David Pascale – I mean obviously we look at GDP, Gross Domestic Product which is always comes out and then it’s adjusted. In the again, the good old days we used to see GDPs of four to six percent, the GDP in recent years has been stubbornly low again maybe one to three percent. Again, that could be just the fact that the economy is different this time, it doesn’t have, there’s not a lot of increases in production or in activity, it’s very flat-lined right now. Also watch the Producers Price Index, which is the cost of goods before it gets to the consumer. And a lot of people are watching in the wake of the tax cuts is is there going to be investment in, is like, is what is the industrial capacity in the big goods like claims and factories, and how much investment is going on by companies on a large scale. It’s another one of the things that I really personally, think that America and the world should be doing is investing in our country. That comes down to things like infrastructure, etc. because I often think that the United States it’s like a piece of real estate. I mean, you have an office building, if you don’t put money into it and you have deferred maintenance it’s not going to be worth as much and you know a lot of economic activity is based in investing in your assets.
Adam Hooper – You could tell some of the road crews here in Portland, they could listen to you on that.
David Pascale – Yeah.
Adam Hooper – Do you have a couple resources or anything that you subscribe to that would be helpful for listeners to get some that information and we can link that in the show notes?
David Pascale – Yes and it’s the usual suspects out there, I mean it’s Bloomberg, I would say the big four, Bloomberg, CNBC, Market Watch, and another thing called Business Bloomberg, which I also subscribe to. Full disclosure, I’m not shilling for any these companies, this is the websites I go to, I have no relationship with them. Then there’s some more esoteric things like I like a site called seekingalpha,
Adam Hooper – Mhmm.
David Pascale – Some of these they kind of quantitative sites but basically and I love, there’s a Market Watch page that has all the reports, daily reports coming on, what the market expects and how they come in. And that’s what really drives our economy is it’s the expectation of what the reports going to say and when the report comes out, how much it differs from the market expectation, and that’s what obviously drive short-term moves. And I would also say that there’s a, to go on our website which I do have an affiliation which is gspartners.com, when you want to see rates and spreads and things like that.
Adam Hooper – You know you said well you’re not shilling for those others, we will give you a chance to shill for the FINfacts and your perspective.
David Pascale – I will shill for FINfacts, yes.
Adam Hooper – This is all really good stuff but I think a lot of our listeners are trying to figure out what does this mean for them, right? As a potential investor into commercial real estate, how does the health of our economy, how does this stubborn inflation, how does this more robust employment number, what does that mean for me as an investor looking at commercial real estate? What does that mean for rates going forward and how can they kind of… What are the takeaways from where we’re at and some of the stuff that we’ve been talking about today as an investor in this asset class?
David Pascale – Well what I would say is, if inflation is coming back and I recently wrote a column for Forbes on real estate as an inflation hedge and real estate traditionally in the era of what I call regular inflation, call it Post-World War 2 up to 05 or 06, was an inflation hedge for many reasons. One is there was some tax benefits with depreciation, etc. but the thought was that as prices went up, lease terms would go up excuse me, rental rates would go up, whether it’s apartments, whether it’s a retail center, an industrial or a hotel, with hotel rates. So it was your income should rise as your expenses and your income both rose with inflation, your net income would then match the rate of inflation assuming what we call a secular level of inflation across all markets. So real estate it is an inflation hedge and going forward, I still think commercial real estate is an attractive investment because it allows you to go at all levels of the risk spectrum. From apartments which are considered the lowest risk because housing is the first dollar out from any consumer to grocery incurred retail etc, industrials very strong in the internet age for obvious reasons, because that’s where the supply chain is concentrated. And going forward, a lot of investing is I would say deal-specific, market-specific, different parts of the country are growing at different levels. I think that there has been a continuing kind of wealth gap in America, where it’s not as what I would call hegemonoius like where everyone was in a big group and some people were slightly richer than others,
David Pascale – there’s the very rich, the working poor. So a lot of in investors are betting on kind of the working-class like the 99 cent stores, the discount stores, the daily needs in certain markets and then maybe the very top 1%, the ultra luxurious kind of high-street retail for example. So there’s a lot of trends to watch as America changes and you want to buy real estate that is going to be fungible five years from now. And so it’s really kind of looking into the future and watching especially in the case of retail right now, what’s going to continue to be a viable piece of real estate.
Adam Hooper – And I guess to that, you touched on housing as being typically first dollar out. Are there different segments of the market, different asset classes that you think are going to be better suited to provide that hedge against inflation or you said if it’s a secular thing across all different segments of the market, it should be I guess more even amongst the different product types?
David Pascale – I think that in an inflationary environment I do like apartments. Also housing prices continue to go up, the more out of reach housing gets for a lot of Americans the more apartments become necessary. And I would also say that a lot of it is driven by the growth in certain parts of the country. I think there’s a lot of Sun Belt, the south, the southwest and the Northwest’s that are really booming and growing right now so again location, location, location is very important. And I really am watching population inflows and outflows. I mean there’s some amazing numbers in Texas. Personally I go to Texas every month, my son lives there, and I mean the number of people moving into Houston, Dallas, San Antonio and Austin on a daily or weekly basis is astounding, so I think a lot of it is watching where the population is going.
Adam Hooper – Well and a great thing about apartments too is you got much shorter lease terms so you can ratchet those rents up with inflation a lot easier than if you have a 10 year office or industrial lease as well, right? So I think that provides a little more flexibility. Assuming…
David Pascale – Right.
Adam Hooper – We’re banking on going into a more inflation in our environment.
David Pascale – Exactly, exactly.
Adam Hooper – So again, crystal ball time. Heading in the last quarter here of 2018 maybe we’ll get a couple more rate hikes as we turn the corner to 2019, what are some of the things that are on your mind the investors might be looking out for or maybe some warning signs or indicators that people can kind of keep their eyes open for as we start looking for 2019 here.
David Pascale – First of all on the Fed, the recent Jackson Hole symposium which is always highly watched, chairman Powell gave a speech that a lot of investors interpreted. He said gradual rate hikes and made very case for very situational rate hikes and a lot of investors interpreted that as him taking a December rate hike off the table, I personally think it’s still on the table. That is after a quote unquote “guaranteed” rate hike next month in September to which would be the third one of the year. I still think December is on and you might see two or three or maybe four next year, so that’s being closely watched. Another thing that’s being very closely watched by the markets, is trade agreements or trade disagreements, tariffs and the like, the US/Mexico breakthrough this week. Some people are just calling it a new name for NAFTA but just the fact that it’s not a trade war and that it seems Canada may join also is very reassuring for the U.S. because those, a lot of people don’t realize that Canada is our biggest trading partner and Mexico is a massive trading partner. The big kahuna in this world is watching the U.S.-China trade talks which haven’t been going well, there was some speculation that there would be a big breakthrough timed for the November elections possibly, coincidentally or not. And those talks don’t seem to be going well but the chance of a full-blown trade war between the US and China, that fear is now receding a little bit hopefully, so trade talks is something we’re watching.
David Pascale – And of course the US and Europe recently came up with a major agreement. So that was something that could produce a lot of headwinds to the economy’s trade. We’re watching the midterm elections and political tumult in Washington. Some economists think that gridlock is the best thing because things just keep puttering along. I personally think that I would like to see out of Washington, a major infrastructure bill, I think it would help real estate and all other aspects of life in America. I think a lot of the highway system we built in the 50s and 60s needs an upgrade with new trucks and everything like that, so we’re watching for that. And we’re also watching for what I call Black Swan events which often are the unexpected events that can derail growth like for example the Turkish currency crisis. There was fear that that would have contagion and it seems like some countries like Qatar and Germany are stepping in and providing bailouts, so that situation seems to be resolved for now. What always derails the economy or what often derails the economy is a Black Swan, unexpected event, whether it could be an Italian bank failure etc. Going into next year is significant because the recovery started maybe in March 2009, that was the low point of the stocks and so as we get into the ten-year anniversary are we in the late innings or are we in the middle innings of the recovery, we just wonder how much more legs this has. We’re going to see the may be tailing effects of the tax cuts, the recent tax cuts, turned out to be
David Pascale – a big boon to corporations as we know. Now, are corporations investing that money or are they just doing stock buybacks? Stock buybacks will be a short-lived spike, real investment in the economy, new equipment, payroll bonuses for the working man and women are what was hoped for and we’ll see how that turns out.
Adam Hooper – Well that’s plenty to look out for. That’s a good synopsis. I mean overall are you optimistic? Are you cautiously optimistic? Are you slightly pessimistic? Where would you say your overall sentiment as we turn the corner to nineteen?
David Pascale – I’m cautiously optimistic, I’m a little bit worried about the deficit. I would also you know think that bankers around the world and investors would like to see some discipline on our deficit because the supply demand of Treasuries could create a problem. Too many Treasuries out there and not enough buyers could see interest rates spiking very dramatically, no one wants to see that. So I am cautiously optimistic because the recovery seems to be in low in inflation and steady. But we’re watching things like China’s economy, China’s property market and there’s been a little bit of a slowdown lately and what kind of shocks that can have you know for the world as China’s economy changes, it’s something to watch.
Adam Hooper – Okay, but we’ll take cautious optimism, I think that’s a pretty reflective look on a lot of folks that we talked to as well. So we’ll see as we round out this year and get in 2019 as you said, we reach a ten-year mark in the recovery, where’s it going to go? We’ll be along for the ride for sure. Well David, I think that’s a great point to wrap up. Why don’t you take a second, tell us a little bit about how listeners might be able to get signed up for FINfacts or Pascale’s Perspective which again I said I’ve been a longtime subscriber to and would highly recommend everybody listening to this does go get signed up for it.
David Pascale – Oh, thank you for the opportunity to discuss that. To subscribe to our weekly newsletter, which is called FINfacts and FINfacts, my column appears at the bottom but the main thrust of FINfacts is it provides information on the transactions we are closing. A lot of detail; rate, term etc. And sponsors and owners of real estate can look at these terms and possibly know that they can get those terms for a similar property that they have. My column is included in FINfacts and it is at www.gspartners.com, P-A-R-T-N-E-R-S,.com. It’s very easy on the home page to see all the interest rates and to subscribe to FINfacts, it’s very, very easy.
Adam Hooper – Perfect, and we’ll put a link in the show notes here so everybody can get to that.
David Pascale – Oh thank you.
Adam Hooper – Yeah, absolutely. Again, we’re thrilled to have you on today, I think this is a ton of really, really good information and I’m sure our listeners will love it and hopefully we can have you back sometime next year and get an update and see where we’re at on all these different issues we talked about today.
David Pascale – Okay, perfect. Alright, thank you for having me.
Adam Hooper – Likewise, and listeners as always, if you have any questions or comments, please send us a note to firstname.lastname@example.org and with that, we’ll catch you in the next one.
Tyler Stewart – Hey listeners, if you enjoyed this episode, be sure to enroll on a free six week course on the fundamentals of commercial real estate investing. Head to realcrowduniversity.com, to enroll for free today. In RealCrowd University, real estate experts will teach you the important fundamentals like to start with risk approach, how to evaluate real estate sponsors, what to look for in the legal documents and much more. Head to realcrowduniversity.com to enroll for free today. Hope to see there.
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