The Private Equity Real Estate Podcast – Show 21
Summary
On this week’s episode, we talk about how commercial real estate hedges against inflation. To discuss this topic we have David Pascale. He is the Senior Vice President at George Smith Partners and has directly overseen the placement of nearly $4 billion in capital into commercial real estate and he’s worked extensively on retail, multi-family, hotel, office, and mixed use transactions.
And our guest this week wrote an article on this very subject on forbes.com. He’s the Senior Vice President at George Smith Partners. He has directly overseen the placement of nearly $4 billion in capital into commercial real estate and he’s worked extensively on retail, multi-family, hotel, office, and mixed use transactions. He is David Pascale. David, thank you so much for being on the show today.
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Eric Murphy:
You’re listening to the Private Equity Real Estate Podcast brought to you by First National Realty Partners, where investors learn from private equity experts and insiders. We share our own real-world experiences so you know exactly what it takes to be highly successful at investing in passive commercial real estate opportunities.
Eric Murphy:
Hello, and welcome to the Private Equity Real Estate Podcast which is brought to you by First National Realty Partners. I’m your host Eric Murphy, and on this program we like to sit down with experts in commercial real estate and talk about different subjects across the commercial real estate landscape. And on this week’s episode we’re going to talk about how commercial real estate hedges against inflation.
Eric Murphy:
And our guest this week wrote an article on this very subject on forbes.com. He’s the Senior Vice President at George Smith Partners. He has directly overseen the placement of nearly $4 billion in capital into commercial real estate and he’s worked extensively on retail, multi-family, hotel, office, and mixed use transactions. He is David Pascale. David, thank you so much for being on the show today.
David Pascale:
Hey, thank you for having me, I’m excited to be here.
Eric Murphy:
Great. Before we jump into the topic of the program today, David, let’s find out a little bit about you. Could you tell us about your background and how you got started in commercial real estate?
David Pascale:
I got started here at George Smith Partners in Los Angeles arranging debt financing. I started in 1995 and I actually started here to create a lender database and it was an auspicious start because I was able then to interview lenders extensively all over the country for years, meeting with them and really understanding their lending programs and capital markets tendencies. And then in about 2000 I started arranging loans on a team here and also writing about capital markets trends.
Eric Murphy:
Okay, great. Well, today we’re talking about how commercial real estate hedges against inflation. And let’s start from the beginning for our listeners who may not know what is inflation and what are some of the factors that cause it?
David Pascale:
Inflation is literally just increase in prices of various goods and services. When you look at CPI, the Consumer Price Index, which is a common inflation metric that people look at, it is the famous basket of goods and services that an average household will buy each month, food, energy, clothing, transportation, travel, et cetera, rent or mortgage payments. The index measures the increase or decrease in those prices and it’s a real pocketbook issue because if your wages don’t go up accordingly and inflation is out there on in the consumer world it can obviously negatively affect households, so it is a major issue.
Eric Murphy:
Why is inflation an important concept to understand and consider when investing?
David Pascale:
Well, one reason inflation is important is because deflation is so scary for the economy. And so what you see the central banks doing lately is in an era of low inflation they are very wary of what’s called a deflationary spiral, which is when prices go down and then consumers stop buying items because they believe the price will be lower next month or the month after that, and then prices keep getting cut because demand pulls back and it is very difficult for an economy to get out of a deflationary spiral. So that is a big fear amongst the central banks coming out of the financial crisis to today in this era of low inflation. When inflation gets below 1% that’s a danger sign because in a deflationary spiral economic activity slows dramatically, wages go down, et cetera, and this really can become a situation where “there’s no bottom.”
David Pascale:
And so inflation of about 2% is the Federal Reserve’s target inflation rate. That is the generally accepted amount of what I’d call healthy inflation because inflation is also a sign that the economy is growing, the people are able to pay more for goods and services. But of course too much inflation and runaway inflation like you saw in Weimar, Germany, for example in the 1920s is also very dangerous, and it’s happened in some emerging market economies in Africa and South America in the modern era where literally prices go up daily and inflation gets out of hand. So that’s another spiral central bankers are always trying to avoid.
Eric Murphy:
Yeah, I think some people hear the word inflation and they immediately think it’s bad. So you’re saying that inflation can actually be a good thing for the economy?
David Pascale:
Yeah, a moderate amount of inflation is healthy for the economy because it usually augers a market that is in balance. Meaning, when the fed targets a 2% inflation rate they’re also targeting a 3%, three to 5% unemployment rate. So a little bit of inflation during a period of nearly full employment when there’s just a little more demand and supply for goods is considered optimum for long-term steady growth.
Eric Murphy:
And why is it so important to have a hedge investment that can fight inflation?
David Pascale:
Well, because if inflation does rise and you started investing at the beginning of the cycle, you want to have an asset, it is not going to lose value in relation to the inflation rate. For example, if you take $1000 and you just put it in an envelope and put it in your drawer, inflation is occurring, that $1000 in the next year may only be able to you what you could have bought for $950 the year before. And so that means that the $1000 in your drawer is losing value because the value of money is not intrinsic, it is based on the goods and services or assets you’re able to purchase with that money.
Eric Murphy:
One of the reasons that I wanted to have you on today is that I mentioned you wrote an article on Forbes. It really outlined some of the reasons that commercial real estate is a good hedge investment. Can you go over some of the aspects that make commercial real estate such an appealing investment option during times of inflation?
David Pascale:
One of the main aspects of commercial real estate is it’s based on the collection of rents, whether you own a retail shopping center or warehouse or a hotel which is based on room rates, or a apartment complex which is based on people paying their rent, those rents rise in an inflationary environment. That means that the companies that are renting your space are charging more for their products, you’re charging them more for rent, and so in a equilibrium situation your rents should be going up commensurate with the inflation rate so your income is going up.
David Pascale:
And if you have a fixed rate loan on the commercial real estate property that you own, most borrowers usually go for a 10-year fixed rate loan, that is the standard real estate financing instrument of about anywhere from 60 to 70% loan to the value. So it’s a big part of the capital stack and that rate is fixed at the beginning of the loan period. If inflation occurs during that loan period, during those 10 years, your monthly interest payments are fixed for 10 years and if your income’s going up, then your income is rising commensurate with the inflation rate so you are hedged against the inflation. And if you then sell the property, those higher rents should then translate to more income and a better price when you sell it, so the value of the property also should be going up in lockstep with the inflation rate.
Eric Murphy:
David, what is the exact reason that real estate generally appreciates with inflation?
David Pascale:
Yes. The rental increases that I talked about before are often tied to CPI. There’s CPI provisions in most leases. And so every three years or five years, or sometimes even every year, rental income will rise exactly commensurate with the CPI usually for that district, whatever state you’re in. For example, Southern California CPI or L.A. in Orange County for where I am. So you’re hedged right there, your costs are going up and your rent increases are rising commensurate. The higher rents that are based on CPI should then translate into a higher value if you’re selling the property. After you purchased it you purchased it based on the old, lower rents, you’re selling it based on the higher rents so you should then also get an appreciation based on inflation on your sale.
David Pascale:
And that assumes that cap rates are steady and the cap rates are the factor by which the income and the purchase price relate to each other, and it’s basically a multiplier of the income that equals the purchase price. So assuming cap rates are steady which in a steady period of growth they should be depending on the market, your cap rates should be steady and therefore your property appreciates in value commensurate with inflation.
Eric Murphy:
And you had mentioned higher maintenance costs can be associated. What are some other risks that investors should be aware of in regards to getting involved with commercial real estate during inflation?
David Pascale:
Well, I mean, it’s all your costs. It could be insurance if there’s a lot of disasters. For example, sometimes insurance rates go up after if you’re in a hurricane area or it’s an tornado area insurance is a big factor in real estate expenses. Taxes are usually expected to go up pretty close to inflation. The state governments and the assessors are usually very cognizant of keeping tax increases based on value and or something close to the inflation rate.
David Pascale:
The other risks that are outside of inflation are an inability to rent. There’s some market dislocation where there’s vacancy goes up, but that’s usually tied to an economic recession, either a local one or a national one. And in times of inflation usually the economy is not in recession, so that again helps make the case for commercial real estate being an inflation edge. Because in tough times you’re not going to be seeing a lot of inflation and that’s the times when you may have vacancy go up and then when inflation comes back, usually it’s a growth period and you’re able to fill up the property easier and then your rents are then rising commensurate with the inflation rate.
Eric Murphy:
Yeah. And speaking of taxes, are there particular tax benefits that one might get if they’re using commercial real estate as a hedge investment?
David Pascale:
Yes. I mean the classic inflation tax benefits can be summed up and two major ones are one, depreciation, and that is you’re able to depreciate the property on what’s called a straight line basis during your ownership, which means that you are able to deduct a portion of your taxable income. You’re able to make a deduction against that based on the property depreciating even though you’re not actually losing any money. And the depreciation schedule, the way the tax code is written is actually independent of whether the property is actually gaining in value because depreciation is a concept that properties erode over time, they’re shiny and new at the beginning and then they erode and then they’re functionally obsolete, that is the philosophy behind depreciation.
David Pascale:
So even though your property has rising rents and you’re keeping it up and maintaining it well, and maybe the area’s getting better, still when you go to file your taxes you are taking depreciation losses against the property and it’s purely a paper loss, it’s only for tax purposes. And so that is a major benefit to owning real estate as far as taxes. The other benefit is the 1031 exchange laws, which allow you to sell a property for a gain and then not pay taxes on that gain. You are able to defer the taxes if in a certain amount period of time you purchase what’s called a like property, another property for about the same debt to equity ratio, you then are able to roll those gains into the new property without paying any taxes.
David Pascale:
Now, that is not a tax break, it is just the deferral of taxes but in the minds of a real estate investor they’re able to kick the can onto another day, hold that property and let it appreciate and not have to pay taxes on those gains. So the depreciation and the ability to defer taxes through the exchange are two major tax benefits that are pretty unique to commercial real estate.
Eric Murphy:
You’re listening to the Private Equity Real Estate Podcast which is brought to you by First National Realty Partners. And today our guest is Senior Vice President at George Smith Partners, David Pascale, and today we are talking about how commercial real estate hedges against inflation. Now, David, when it comes to inflation, if an investor is weighing options between say investing in commercial real estate or stocks and bonds, what are some factors that you think they should consider?
David Pascale:
During a time of high inflation I would say that buying bonds is usually not the best investment during an inflation period because bonds are a fixed income investment where your return is set exactly the same every year for usually, it’s 10 years, most bonds are 10 years, it could be 20 years, 30 years. And the value of that cashflow auto mine is going to go down over the years as inflation eats into it because every year the cash flow you receive from that bond is going to be able to do by you less and less goods and services. So bonds are traditionally a good investment in periods of low inflation.
David Pascale:
And with stocks, you are basically taking the risk that the stock that you’re buying will appreciate faster than the rate of inflation. Now, if it’s a consumer stock, something maybe like Walmart or retail stocks, they should be making higher profits during times when inflation when they are charging more. But again, then they have issues with their expenses and it’s hard for a typical investor to really be able to gauge that.
David Pascale:
And so again, commercial real estate shines here because it’s an asset where the balance sheet is very apparent to you because it’s not a giant balance sheet of a multinational company and it’s a balance sheet of a simple property in a place that you know, hopefully, in a market that you understand and you’re able to make sure when you buy it that the rents are maybe tied to CPI or that your tenants will be able to pay more rent in the times of inflation. And then along with the tax benefits I described earlier, which by the way you do not get in stocks and bonds. And so commercial real estate is a more scalable investment for someone concerned about inflation because you can literally see income go up, value go up, et cetera.
Eric Murphy:
And if someone wants to go that route and invest in commercial real estate, what are the ways they can do that?
David Pascale:
There’s many different ways. There is buying your own property, whether you start out with a duplex or a fourplex and end up leaping forward from that into buying small apartment buildings or midsize apartment buildings or buying a retail center, industrial warehouse, et cetera. Or you can invest with partners and find partners or go into some partnerships that are arranged by investment bankers like myself, et cetera. And you can invest with the group, and of course, when you’re investing with a group there and you’re buying individual properties you want to trust the people making the decisions and you can do your research there.
David Pascale:
Or you can really be a passive investor and buy REIT stocks, and REIT stocks are solid investments. If someone really wants to and feels that commercial real estate values are increasing, these REITs by their charter by law have to pay 90% of their profits directly back to the shareholders.,They’re not allowed to churn big expenses. And then there’s a new new-ish way to invest, which is crowdfunding. And it’s whereby a sponsor identifies a property in a business plan and it is put onto a crowdfunding site where investors have already subscribed. They’re able to read about it and learn about the property and they attend an online seminar and do their own due diligence and invest that way. And you’re investing then side-by-side with people all over the country that you’ve never met, it’s a very efficient way to put things together.
David Pascale:
And then there’s the old-fashioned syndications which go back to at least the ’60s. And that is where, it’s called friends and families, sometimes it’s called country club money. It’s as a group… Someone comes out and identifies a property as sponsor and purchases it or sets up a business plan on an existing property and puts out a PPM, a private placement memorandum to accredited investors. And this is a little different from crowdfunding. It’s people that they know through networks, often CPAs, attorneys, investment groups, put those together, put those PPMs together and people invest together in that.
David Pascale:
I think the main difference between the types of investments is are you actively investing or are you passively investing? Now, actively investing being a sponsor means that you’re making decisions on leasing and financing and you are working the asset. And those sponsors usually get a preferred return, or what’s called a promote above the other investors, it’s called their sweat. Every year they’re working the property and spending a lot of time and they take a lot of risks because that’s what they’re spending their time on. Whereby the passive investors get a good return, hopefully, and they’re working their other career, whether it’s being an attorney or an actor or whatever they’re doing. And meanwhile, while they sleep and work they’re making money on properties and making passive income. It’s about picking the right sponsors, the right markets, and the right product types.
Eric Murphy:
Well, before I let you go, David, I see a lot of pundits making predictions on what might happen with all the stimulus money coming into the economy. In your opinion, what do you think the outlook is going to be post-coronavirus? Do you think we’re headed for a higher than normal inflation rate?
David Pascale:
It’s interesting you say the word normal, because one of my favorite commentators is the ex-head of PIMCO and he’s now at Allianz, his name is Mohamed El-Erian. And he coined the term coming out of the financial crisis, the new normal, and the new normal started in, call it 2009, 2010, 2011, where there was massive stimulus by the central banks around the world to inject liquidity into the system. So lots of dollars and euros flooding the market, which you think would be inflationary and it turned out to be non-inflationary and interest rates remained at literally zero or 1% for years.
David Pascale:
I’m talking from 2010 to 2015, there was no movement in rates and literally no inflation. And that new normal was based on some factors like companies find it harder to raise prices because people have so much access now to price comparisons with computers and cell phones and wages also stagnated, so it was a two-edged sword. And this period of ultra-low rates and low inflation was really unprecedented in modern economic history, which the old theory was low interest rates would automatically create an increase in the money supply and the more dollars that are out there, and I’m just using dollars because we’re in America, but whatever currency you’re working and your country has. The more dollars there are out there, the higher prices would be because there’s a limited number of goods and services and when you inject more dollars into the system you would think that those goods and services will then have increased pricing.
David Pascale:
That did not occur and there are several explanations for it. A lot of it has to do with technology, a lot of it has to do with the loss of labor union power to increase wages, the ability of companies to outsource labor and lower their labor costs. And it’s not the old world of the ’40s, ’50s, and ’60s, where someone would work for a company for 30 or 40 years and get a salary increase every year and prices went up every year. We’re in a totally different economy where employment has become almost transactional and those transactions have proven to be non-inflationary. So, we’ve come out of this long period of ultra-low inflation.
David Pascale:
And the question for 2021, and then you asked the exact right question, is, are we finally going to see inflation? And I think possibly so. I’m always watching oil prices as an inflation gauge and even though renewable energy is on its way oil is still the workhorse of the economy worldwide for energy. And oil prices reached a negative point during the pandemic, if you’ll recall they were $10 a barrel. So oil just last week went above $50 a barrel and there is a lot of speculation that with the United States stimulus and the record deficits and further stimulus in the Biden administration, and all the pent-up demand amongst consumers for traveling, going to hotels, and going out to eat, all the pent-up demand that is built up during the pandemic.
David Pascale:
And by the way, there’s some statistics out there that show that U.S. consumers have saved an extra trillion dollars during 2020 of money that they did not spend because they’ve been on pandemic shutdowns and stay-at-home laws, et cetera, that there is going to be as the vaccinations rollout and freedom of movement returns, and people return to traveling and in-person shopping and going to movies and concerts, that we might finally see inflation start to uptick.
David Pascale:
And we also saw the 10-year treasury which was at 0.9 a couple of weeks ago is now 1.15, so it’s gone up about 25 bips in a matter of weeks since the Georgia runoff election when it became apparent that the new Biden administration will have a Democratic Senate and Congress, and so the ability to pass more stimulus. There’s also some speculation that the Biden administration probably won’t try to do anything with taxes this year so that will further increase the deficit and we may finally see a level of inflation that we have not seen since the 2000s. There is a lot of speculation that 2021 is the year in the words of Muhammad El-Erian, the old normal might return.
Eric Murphy:
Great. David, if someone wants to get in touch with you how did they do so?
David Pascale:
They can find me at George Smith Partners. Our website is wwwgspartners.com. My name is David Pascale, My phone number is (310) 867-2976. And you can find my email and my profile online at George Smith Partners.
Eric Murphy:
Fantastic. David Pascale, Senior Vice President at George Smith Partners, thanks so much for being on the show today.
David Pascale:
Oh, thank you for having me.
Eric Murphy:
My thanks again to our guest, David Pascale, And thank you for listening to the Private Equity Real Estate Podcast brought to you by First National Realty Partners. if you’d like to find out more about our sponsor you can visit them at fnrpusa.com or you can contact someone and email them at info@fnrpusa.com. I’m your host, Eric Murphy. If you haven’t already please subscribe, rate and review the podcast. It’s a big help to us and we will definitely appreciate it. I’ll talk to you next week.
