Jason Hartman hosts Venture Alliance member Mike Zlotnik. They discuss cap rates and the current interest rate environment. Mike discusses what cap rates are and how they are affected by interest rates. He illustrates why that after years of artificially low rates, we are finally seeing some rise in rates.
I started researching on real estate investing about three or four years ago, two years ago, I was lucky enough to stumble upon the podcast when I was doing a search. I listened to you for probably three or four months, but I was hooked after the first episode, just everything from the real estate information, politics, the philosophy, the economics, and after about three or four months, I decided, you know, I’m gonna put my information in and see what Platinum comes back with. So I plugged my information in on the website. Oliver contacted me a couple of days later. And by the way, he has been a tremendous resource for me, just pointing me in the right direction, especially as somebody with no prior experience to real estate investing, but he definitely pointed me in the right direction, helped to educate me and help to show me different sources of information where I can better myself as a real estate investor.
Jason Hartman 0:54
We are now on Alexa. So if you have an Alexa device, you can get more Real Estate update on Alexa as part of your daily flash briefing, so be sure to check it out in the Alexa store and add the skill for Jason Hartman’s Real Estate Minute. Welcome to the creating wealth show with Jason Hartman you’re about to learn a new slant on investing some exciting techniques and fresh new approaches to the world’s most historically proven asset class that will enable you to create more wealth and freedom than you ever thought possible. Jason is a genuine self made multi millionaire who’s actually been there and done it. He’s a successful investor, lender, developer and entrepreneur who’s owned properties in 11 states had hundreds of tenants and been involved in thousands of real estate transactions. This program will help you follow in Jason’s footsteps on the road to your financial independence day. You really can do it on now. here’s your host, Jason Hartman with the complete solution for real estate investors. Hey, welcome, welcome, welcome. This is your host Jason Hartman episode number 1071 1071. Thank you so much for joining me today. And greetings from Tampa, Florida again. Now I have not moved since the last episode. But I tell you this digital nomad life. It’s kind of fun, adventurous, but it’s a little bit of a hassle. It’s getting a little old. I must admit, sometimes. I don’t know. Depends what day you asked me some days. I absolutely love it. I am making more connections and seeing more friends. You know, it feels like I’m on a political tour or something like I’m touring the country. I had to get a big one of those big political buses and, you know, paint my name on the side and say, Hey, Jason Hartman for reason and sanity. Maybe my big campaign promise will be that I will And a few of these really annoying things like noise. noise is the scourge of modern society. What is that noise? Well, you know the chief among them leaf blowers. Yes. And leaf blowers. We will outlaw leaf blowers will outlaw secondhand smoke. We will outlaw people who play their music too loud. Well, unless it’s really good music like the music I would choose. Will outlaw all these annoyances? You know? I tell you air conditioning abuse. That’s one air conditioning abuse. Yes. You know, everybody’s worried about the environment. Well, why don’t you put the air conditioning at a reasonable temperature? You know, you don’t need to chill us. We’re not at the Ice Hotel here in Sweden. Like we were in the venture Alliance trip where you’re abusing us with air conditioning. Okay, now for that no for that. No, I’m not running for office because I’m not crazy. Anyway. Today we are going to talk about the seeds that are being sown for the market downturn. It is coming. I tell you, as I am, yes, yes. Oh, and I have to tell you something, I have to tell you something. I bought a house. Yeah, a house in which to live not another rental property. I own so many darn rental properties. But it looks like our client and partner in one of those properties, the big apartment complex we own. We also got a mobile home park together. He wants to sell now I don’t really want to sell. I would like to just hold but he’s kind of antsy to sell the property. And I might just agree to it. But I am going to need to come out of that 1031 exchange, this real estate investing thing. It’s awesome. It’s the most historically proven asset class. In the entire world, but I must admit, it’s a bit of a trap. Why? Because you got such great tax benefits that if you don’t keep exchanging or keep the property, you’re gonna pay some capital gain. And who wants to pay taxes? Certainly not me. It’s one of my least favorite things to pay for. I just wrote another big check to the IRS yesterday. Yeah.
Jason Hartman 5:27
Yeah. Anyway, yeah, I bought a house for myself though. Now. I decided to buy the house. You know me, I really believe in renting high end properties for oneself, and then buying lots of low price rental properties that you rent to other people. But here’s what I did. I did the same thing. All of you do. Yes. I’m just human just like everybody else. I made my decision emotionally. And then I proceeded immediately to rash Eyes it with logic. Yes. Now this wasn’t that emotional of the decision. And the leap in logic to rationalize it was pretty minor. Okay, so it was pretty minor. Yes, this property costs way more than a rental property, but it didn’t cost that much. It wasn’t that bad. And guess what i think i think if I decide to rent it at some point, it would probably rent for point 652 point seven RV ratio. And you know, that ain’t that bad. It ain’t that bad. Do you like my grammar? Eight? Yeah, well, sometimes eight is just you know that slang kind of sounds good. I know. It’s not a proper word, just like ours. And that our isn’t the proper word either. Okay, so yeah, that’s what I did.
Jason Hartman 6:54
And my house is under construction. So I will be able to move hopefully into my beautiful new home in about 35 days, right after our Hawaii trip Well, a little bit after our Hawaii trip. So anyway, join us in Hawaii. For the awesome two trips we have planned. We’re putting the final touches on them now for our profits in Paradise and our venture Alliance trip. And they’re going to be phenomenal, phenomenal, phenomenal. By the way, we decided against the I think we decided against now it’s not totally formal, we decided against the luau in favor of something better for Saturday evening. So if you are attending look forward to more than that. By the way, a few of you who have asked me about the time for the event, Saturday morning, we start at 9am. Sunday morning, we start at 9am. Both days will go to about 6pm both days, maybe Sunday, we’ll kind of wrap it up at about 5pm. So join us for that Jason Hartman calm For more on Hawaii event and then of course the venture Alliance event immediately following in Hawaii, just a short little $70 plane flight away. And that’s going to be awesome. My first time in Hawaii. Yes, I’ve been to 81 countries, but I’ve never been to Hawaii. So I can’t wait to go there. Can’t wait to go. The pictures look spectacular. We were choosing the restaurants for adventure lion sinners. Oh my gosh, because restaurants look phenomenal. The views, the sunsets, that spectacular VISTAs are just going to be awesome. So anyway, back to today’s guest now. I have to apologize in advance. I know the sound quality isn’t that great of this intro even. But the sound quality for the guest is not awesome, either. It’s okay. It’s passable. But it’s not up to more high standards. Bear with us on that. I mean, it’s not bad. It’s just a little bit less than than it should be. We’re talking with our venture Alliance member, Mike, who is going to talk about cap rate compression a lot. And generally what is happening to the marketplace with rising interest rates. So it’s an important topic. Let’s just get over to our guest and let’s dive into the show. We’re going to get a little wonky here for you today. We don’t always do that sometimes we get a little wonky. Sometimes we talk more practical matters. Sometimes we talk about the future of the economy. You know what we do here? You’ve been listening for 1071 episodes. Of course, you know what we do? A lot of variety, a lot of variety. Anyway, without further ado, let’s get to our guest today and talk about the changes in the market. And some of them a little bit ominous. I wouldn’t worry too much, but we are definitely seeing signs of a shift in the marketplace. What that means for us, not much. It doesn’t mean much for us at all, because we followed commandment number five and we bought properties that made sense the day we bought them. So these changes in the market, they really just mean for us more inflation in increased rents. By the way, a huge inflection point has occurred in the national debt picture in terms of debt service costs, being about the same as productivity cost and how that fills the tax coffers the government. And when that inflection point happens, and we always knew this day would come and it is basically upon us. That means that the government has no choice, no choice but to simply inflate. And if you’re a follower of mine, and hopefully you are you believe in my teachings about inflation induced debt destruction and you are going to get so darn rich. Following my philosophy, yay. Okay. Without further ado, let’s get to our guest today. Here we go. And our venture Alliance member mike.
Jason Hartman 11:20
I’m Jason Hartman and I’d like to invite you to our very first two day conference in beautiful Hawaii. Many of our attendees are making a vacation out of this event, you will learn the most innovative strategies for real estate investing available today. We have helped thousands of people invest in properties around the us and we can help you do it too. So I hope you’ll join us and happy investing.
Jason Hartman 11:53
It’s my pleasure to welcome Mike Zlotnik. He is one of our venture Alliance mastermind members. I have known Mike for several Yours and he does quite a lot in the hard money lending space. He runs a couple of different funds in that world as well. And he has a very analytical mind. He’s a math pro really has some interesting ideas on what these increased interest rates mean, to investments, cap rates, and a whole host of other things in the economy. Mike, welcome. How are you? Hey, Jason, how are you? Thank you for having me. Appreciate it. Good. It’s good to have you back on your returning guests. So we see interest rates rising, that is having an effect or it’s going to have a significant effect on the market. Ultimately, the Fed has been very transparent about the fact that it will continue to increase rates maybe up to five more times in the next year. So this is pretty significant. This is maybe the most transparent Federal Reserve, certainly of my adult life. You’d probably agree with me on that. But what does it all mean? to investors into investments.
Mike Zlotnik 13:03
So let me move forward, move a couple of slides forward, this presentation for educational purposes only. So that’s my first disclaimer. So interest rates this this chart covers 30 plus years of interest rates, Federal Reserve target rate. And we are certainly in the period of a mama low interest rates. You can see after the crash of 2008, we’ve been essentially near zero for almost eight years. And I believe that Fed has made a significant error by not raising interest rates earlier. So they woke up towards the end of 2015, early 2016. And they started to increase interest rates, and they’re increasing them at a pretty rapid pace, in my opinion, the impact so
Jason Hartman 13:44
so you’re saying they were behind the eight ball, they were behind the clock is your thesis now that they’ve moved too quickly that they because they waited so long, that now they’re overreacting? Exactly.
Mike Zlotnik 13:57
What they have done is they can rates so low that the economy start heating up and it overheated unemployment and they have dual mandate, as you know, fight inflation into keep the employment full. They missed the the curveball or what would they bowl mean, on the inflation big time and the inflation is actually reasonable. But the employment is the problem right now. The employment is full, we are facing lowers historic interest rates. The man went on the moon.
Jason Hartman 14:28
Yeah, yeah. Yes. So what’s interesting about what you say there is that that’s a problem
Mike Zlotnik 14:34
as a problem, because that has to raise rates and raise it fast. They need to fight that.
Jason Hartman 14:38
Right. Right, basically. So this is this is the issue of the Phillips Curve, right, that relationship between employment and interest rates and, and you know, GDP and everything else, right. But it’s really employment and inflation is the the most core aspect of this discussion, I guess. So yeah. Okay, go ahead with what you’re saying.
Mike Zlotnik 15:00
So, the Fed is raising rates, as you mentioned, they have stated they will do five more increases one more in 20 1830, more in 2019. And one in 2020. This is the current projections, they might wind up actually doing even worse, doing more increases of employment continues to be where it is right now or continues to improve. So the consequence of that is that the rates are rising fast. And my point is, this whole presentation, the rising interest rates, they cause grief on everything out there, including stock market, commercial real estate, some residential real estate, the cost of financing goes up. Look at this stock market literally today. It’s having a fit stock market is not collapsing, but it’s having a pretty bad day. And it’s been having a bad day for quite a number of sessions recently, since a Fed increased rates by just a quarter. It’s the expectation of the cleaners increases, the current economy is heavily overweight. leverage with cheap debt corporations who align with cheap debt to deliver great results and great profits. And it’s going to come to an end. And it’s going to come to an end very, very fast. The other problem that will happen is corporate debt. And some of the real estate notes will come to maturity in 2019 2020. And that paper needs to be refinanced and the rates are now a couple hundred basis points higher than what they were a few years ago. That’s a lower problem. It’s going to put all
Jason Hartman 16:28
kinds of we’ve certainly been spoiled by artificially low interest rates for far too long, and I couldn’t agree with you more this is causing or has caused significant financial repression, where savers can’t earn any decent interest rates on their savings. You know, they’ve done the right thing all their life, and they’re forced into risky investments that they shouldn’t be investing in usually older people. Of course, because of this financial repression, the interest rates are too low. And so now you’re getting this position. where they’ve got to overreact. And this is the problem, Mike, you know, the feedback loop takes so much time to work its way through the system. And this is another argument against why we shouldn’t have a managed economy, why we shouldn’t have a Federal Reserve, we shouldn’t have central planning, because they can’t get the feedback as fast as the market can get the feedback. It’s like, the feedback happens. Maybe they do something today, you start to see it in six months, you start to see it more in a year, and you’re always looking in the rearview mirror. And then they got to have a meeting and talk about it. And there’s all these political interests. Nothing’s aligned. And it’s, yeah, it’s something else. It really is
Mike Zlotnik 17:42
so true. You’re letting bureaucrats and politicians make the decisions when it comes to the economy. And I’m in agreement with you 100% know, what has happened is that the governing body and we know what Federal Reserve, it’s not necessarily acting in the interest of the public sector in the interest of the Bank cartel was founded many years ago. So they may still have good intent. The problem is they don’t react in a timely manner. And again, it’s regulation and sort of manipulation by a bunch of folks with data, markets could do a whole lot better. So my point here is that the velocity of the increases are the problem. It’s not the fact that the interest rates are rising, how fast they’re rising.
Jason Hartman 18:27
Okay, so, so talk to us about what this does to a real estate deal. And the thing that drives me crazy, Mike, and you know, it’s an ongoing thing I’ve said this for 15 years easily is that nobody really segments the marketplace, they don’t talk about the marketplace. You know, they talk about the real estate market as though 400 markets in this huge country are all the same, right? They don’t segment into linear cyclical and hybrid markets. You know, they talk about quote unquote, housing, and you know, what price range houses You know what market there’s so many things. But we have to make some sweeping generalizations here, which we’re going to do, and even talk about it from the commercial real estate standpoint to something that we’ve talked about many times over the years, which is cap rate compression or yield compression, right?
Mike Zlotnik 19:17
Yeah. So cap rates are used in commercial real estate. They can also be used in residential real estate, simply computed as net operating income divided by the current price or market value. That’s just the definition. I’m going to skip the example I’m going to assume the audience knows how to compute a cap rate. Again, it’s an income divided by the cost of a given asset, many applicate applications, all types of commercial deals and investment. Real estate is a good use case. So now let’s talk a little bit about the inverse relationship between cap rates and the prices. I wanted to cover this point. So if cap rates get worse, essentially the cap rates increase and the cap rates will increase. Inevitably, with rising interest rates. We’ll talk about this in a minute, but as capital Rates get higher, the prices get lower. That’s as simple as that there’s an inverse relationship. As cap rates go down, the prices go up. And the reverse happens. As cap rates go up, the prices go down. So this is just for clarification how this works mathematically. Now, let’s chat about what happens with interest rates and cap rates. Now, the relationship is not strictly mathematical because it varies by type of asset. It varies by the amount of leverage. It varies on many factors. But they move in tandem. When the interest rates go up. cap rates generally will go up to what degree in depends, it’s very possible that the global economy
Jason Hartman 20:40
Did you say cap rates will go up or down,
Mike Zlotnik 20:44
interest rates go up, cap rates go up,
Jason Hartman 20:48
cap rates go up? Why? Because prices,
Mike Zlotnik 20:51
two reasons. One is cost of financing goes up. So let’s say you’re buying a property with a cap rate of six and you’re getting into rate at four and a half that spread between the cap rate and the interest rates you’re paying on a mortgage is your positive leverage between the income and the debt service rate,
Jason Hartman 21:11
right? That’s your
Mike Zlotnik 21:12
debt service coverage ratio banks require. In other words, you got to have more income than the mortgage payments.
Jason Hartman 21:19
But the problem is, it takes time for that that equation to equalize. Right? You don’t get equilibrium right away. At first you have interest rates go up, and cap rates are the same. Because the prices haven’t fallen or the noi, the net operating income hasn’t increased. Right now these things do all come together. And they’re like these equilibrium points in the market. But it takes some time for that to happen,
Mike Zlotnik 21:44
right? That’s exactly correct. So initially, what happens is fed starts rising rates, the rates go up fast, and when they go up fast, the cost of financing goes up, adjust very, very quickly. And anytime a maturing loan has to come for refinancing. That’ll Already happens if there is a sale of a property, the cap rate, theoretically is still the good old rate. But when they compute their service coverage ratio, that’s going to get worse. In the long run with inflation, the revenues and the net operating income will go up and will keep up and that will sustain the prices in the long run. But in the short run, that balance is out of whack. In other words, the short term impacts of interest rate increases, that felt much faster than the adjustment of the cap rates. And the cap rates, by the way, have not been getting worse, even though the interest rates have been increasing. Right. And now this is one that
Jason Hartman 22:38
was my point of asking you that question before it. Yes, yeah,
Mike Zlotnik 22:41
that’s what I’m saying. That’s a great point. The cap rates have been stubborn, they have not increased. What I am saying is, well, every time interest rates go up, there’s more and more pressure on cap rates to go up as well. Over time, they will move in the same direction, and they’ll move there sooner or later. So this is This historic chart or what what has happened since 2001, until end of 2016, directionally the interest rates have been dropping the cap rates have been not necessarily moving in exactly in tandem, but directionally, they’ve moved them in the same direction. The market doesn’t move perfectly. It goes up and down as supply demand of the money is inflow of capital from China, running into the United States looking for assets that could cause the cap rates to come down. Who knows? I mean, there’s a lot of money from outside of the United States that’s looking for safety of the US markets. Those things influence obviously prices, but overall, the substitution effect obviously, savers get more when their money in the bank instead of making investments in deals to generate less cash flow, and then the cost of financing the debt service coverage ratio itself is what’s causing pressure on the cap rates. So look at this. This is an example of what higher interest rates do to cash flow capital. anessa prices. So this is an example of talking about an asset that is worth $10 million, with seven and a half million dollar mortgage, and a two and a half million dollar equity. Make long story short, let’s look at the gross revenues of a million dollars a year with expenses of $250,000 in net operating income of $750,000. So in the scenario of interest rates being 6%, just just for the sake of this discussion, the cap rate is seven and a half percent, the interest rate is six, there’s a pretty decent, positive leverage. And the cash on cash return in this case to investors is about a point 4%. So that’s a decent scenario, but that that is based on 6% interest rates as interest rates go up. Now, if you look at the same sort of scenario, when the interest rate goes up to 7%. And again, this doesn’t happen overnight, but a couple of quarterly increases my guess there. What will happen is if investors want the same level of cash on cash return around 8.4%. They will be now demanding the cap rate no longer seven and a half, but more like 8.1%. And what would it do to the price, what it will do to the price is is effectively, they will be willing to pay only 9,270,000 instead of 10 million. So the price that they’re willing to pay drops 7.3% because the cost of financing is higher. And if they need to maintain the cash on cash return, the only way it can happen is either net operating income has to go up, but that takes time. And certain times there are factors that the investor can’t control. They can control how fast the rent roll will go up. They can’t control a number of other things the expenses can go up. But all other things being equal for the sake of the argument right now with saying the properties run to the best of the management ability today. So the noi in the property is still 750,000 Now’s a year. But if the interest rates have gone up to 7%, the investors will no longer pay $10 million, they’ll pay 9.2 will change.
Jason Hartman 26:08
This problem is multifaceted. Obviously what happens in these cycles is you see the seller and the buyer, but the seller is using the past comps saying that you know, this property down the street sold at a seven cap, then that means I should get a seven cap rate and they’re saying that to the buyer, and they’re trying to come to an agreement, but since the capital structure has changed, and then the fact that these interest rates are higher, you know, the buyer is not going to be willing to pay that. But again, this is a very slow process of the way this works its way through the system. And that’s why real estate is so much less volatile than stocks because it’s slow to trade. It has fairly high transactional friction. And I look at this as a benefit. I think this is a good thing. Most people say well, the stock market People say, Oh, it’s a bad thing. You know, I love stocks, I can treat it with a click of a mouse and very little cost. But that liquidity creates volatility. As I always say, when there’s less liquidity, there’s less volatility. Contrary to what some people believe some people might argue with me on that, but they’re wrong. And I’m right.
Mike Zlotnik 27:20
Mike Zlotnik 27:22
it’s hard to ever prove you wrong.
Jason Hartman 27:25
I know. I’m pretty good at debating.
Mike Zlotnik 27:28
You always right?
Jason Hartman 27:29
Yeah. No, I’m not always right. Hey, listen, I’ll tell you something I’ve been infamously wrong about and that is interest rates, what we’re talking about now. I mean, years ago, I was predicting we’d have much higher rates all along the way. And we should have I mean, you know, I’m sure you’ll agree that we should have logically speaking rates should have been higher. They were artificially low. But we live in a world where the Federal Reserve and the Treasury, they can defy gravity. It doesn’t have to make sense. It’s covered And central bank Fiat
Mike Zlotnik 28:01
school socialism. Yeah, well, I run away from
Jason Hartman 28:04
socialism. But yes, I know,
Mike Zlotnik 28:06
this is a subsidy, this is a government manipulation, right, the private sector coming in and providing cheap interest rates to the public. That’s what they’ve done for years.
Jason Hartman 28:15
Yeah. And low interest rates are not necessarily good. That’s another contrarian thinking, right, Mike? Like, you know, rates should be where they need to be based on the supply and demand of money in the marketplace. Okay, they shouldn’t be artificially suppressed. Because on one side, you think, well, Hey, I got a bunch of cheap debt, that’s good. But on the other side, you can’t earn a return on your money safely, you know, and they cause inflation and have lots of ripple effects throughout the economy.
Mike Zlotnik 28:45
That’s right. So I’m going to continue here when I said the old was right, I amended a little bit sarcastically I’m not trying to pick you up, but from time to time, you don’t always get it right.
Jason Hartman 28:54
Yeah, no, I didn’t get the interest rate thing right many years ago, and I freely admit, I was fabulously wrong. About interest rates,
Mike Zlotnik 29:02
you couldn’t predict what the government’s going to do. So that’s one thing that’s really difficult to do. But again, let’s go back to the key subject here. So the key subject is the directional in this example, as interest rates go up by 1% per year, the cap rate adjusts by roughly point 6%. And then the price of an ESA drops by 7.3%. And then you look all the way to the right on the last column of a table, very school out by 2%. Much worse picture happens. In this particular example, the cap rates goes up twice point six or 1.2%, and the price of anessa drops to 8.6 million from 10 million. directionally This is inevitable, it may not happen in the same proportion. And as you said, it may take time for the market to absorb the interest rate increases, right? It’s not liquid and it’s not fast, but the market forces will do that to assets over time. Competing So the whole point of this discussion was when people invest today, they have to prepare for high interest rates and for higher cap rates in these projects. I’ve seen a lot of these offering memorandums, a lot of gurus out there doing syndications. And they put this deals forward on the table today. And then they offering great returns on paper. But the reality is that our assumptions are wrong on the back end. So these assets are not going to be worth what they think they’re going to be worth on the back end. Right. So this particular slide, all it says is if you’ve got into a project at a good price, and you have built in equity, just focus on the cash flow, because the appreciation on the back end may or may not happen, depending on what happens with interest rates. That’s the key point here. So as even a strong project today, if you have underwritten it aggressively and interest rates will go up the back end value of the asset may not be the same as you you hope to achieve initially.
Jason Hartman 30:53
Well, Mike, this is the beauty of residential real estate investments versus commercial real estate Investments, you can get those highly desirable three decade long fixed rate loans at still artificially low interest rates on commercial properties, you typically will get a shorter run, you’ll get a five year fixed, and then it’ll become adjustable rate, maybe seven years, maybe even 10. But rarely do you see that 30 year fixed rate loan on a commercial property. And you definitely don’t get as much leverage as you do on a residential property. So the residential investment market, I like it the best for that reason. And it would be an interesting thought experiment. You know, do you think interest rates are I mean, I doubt you think interest rates are at the market rate yet, but like, what is the market rate? Will we ever really know the market interest rates because we have so much manipulation and distortion in the market?
Mike Zlotnik 31:52
Well, that’s a really good question, Jason. I don’t know because we don’t have a legitimate market here. So what we have is we ever heavily manipulated Market by a Federal Reserve also in the residential housing and some multifamily, this the GSO, Fannie Mae, Freddie Mac, FHA, USDA, VA, all these loans have artificially low rates, they act as a subsidy. So what would be a real market? If those organizations who are out of business, it will certainly be higher? I don’t know how much high it’s harder to determine. I almost can’t speculate on what the rates would be. If we didn’t have manipulation by the various parts of the government, the race artificially low. The point is this, we will continue to live in this environment. We’re not going anywhere, anywhere fast. The Fed has to exist unless this government needs to print money. And we live in the age of no gold standard. So the Fed is absolutely a part of a system and it’s there for good and I’ll continue to manipulate interest rates, what I think will happen and you’ve heard me before, as much as interest rates should be higher. They will go up somewhat for a brief period of time, a few years. I believe in the grand conspiracy theory, for sure you’ve heard of this grand conspiracy theory? There’s many theories. Yeah, but the theory is that the United States government just can’t afford high interest rates, right, the debt service on national debt, and overtime unfunded liabilities. So they’ll manipulate rates back down to quantitative easing, will still have inflation, but will have low interest rates as strange as it sounds, because your government just can’t afford to pay high interest rates on its debt
Jason Hartman 33:32
in the long run. Mm hmm. Yeah, well, it’s pretty cool in a way, I guess, to have the world’s biggest debtor of the US control the global interest rates to the largest extent of any party out there. So I guess that means we will never have them as high as they should be in a free market.
Mike Zlotnik 33:55
All major economies trying to manipulate they all want to devalue their currency. They all I mean, I think it’s your term inflation used it that destruction term. So now, though I’m in agreement, but one point I wanted to convey. So here’s a question, is it possible that the asset prices will not fall, even with rising interest rates? And the answer is we’ve had this discussion of loving interest rate increases typically means rent increases. But that takes a while to kick in. So yes, it’s possible that the rents have to go up and as the rents go out, net operating income goes up, and that adjusts for higher interest rates, right.
Jason Hartman 34:33
The one thing that does happen, though, is when you get higher interest rates, and yes, rents slowly work themselves up, right, and rents go up along with interest rates, those are correlating indicators. But what happens is that the supply contracts, because there are fewer investors buying investment properties in higher rate environments because it’s harder for them to make the numbers work, because it takes a while to get back to that equilibrium point. And this is why you could argue, you know, this is really just the business cycle, right, that Austrian School business cycle concept, because we’re not talking about inventories here, like we talked about in the rest of the business cycle. We’re talking about all we are talking about inventories housing inventory, but we’re talking about, you know, strike prices, because investors won’t make decisions when things don’t make sense. You know, they’re always going to look for the best alternative for their capital. And so the supply of rental housing will constrict, because not as many investors are buying or developing rental housing inventory, but also also you have the situation where current renters cannot afford to buy and move out of the renter pool because they can’t afford the higher interest rates. So they’re stuck in the renter pool. So demand actually increases Or at least is sustained. Well, inventory contracts. It’s a whole interesting thing. There’s one more component though on the homeowner side, okay, there are homeowners out there with these terrific very low artificially low interest rate mortgages. And even if they want to move if their family is expanding or they want to move to another area, they won’t make that move because they can’t give up their cheap mortgage. because they can’t afford the next one, right? Yeah, exactly. like living in like you live in New York. It’s like living in a rent controlled apartment. That rent controlled apartment is such a good deal that even if I want to move if I need to move because families expanded, I’m not going to give it up easily, right? I’m gonna make an artificial decision to stay in that rent controlled apartment and a cheap mortgage is like a rent controlled apartment in a way.
Mike Zlotnik 36:49
That’s exactly correct. I am in 100% agreement with you that the long term interest rate the assets that you have leveraged with fixed rate debt and that rate is low. That’s a phenomenal asset. It’s a liability on your balance sheet. But the fact the rate is low is sort of a, it’s sort of an asset. So I would agree with you that people don’t move away from great mortgages unless they absolutely have to.
Jason Hartman 37:13
mortgages are a terrific asset. Absolutely. That’s a big.
Mike Zlotnik 37:17
I agree. Everything you said is good. Absolutely good. Let me continue to. So the whole lifecycle of this supposed to do this is supposed to be inflation, right? Ultimately wise fed raising rates? Well, because they expect inflation to be higher, the 10 year Treasury moving up. Why? Because 10 year Treasury is reflecting expectation of inflation. So inflation, if the patient goes up, hopefully the real inflation will go up. And typically inflation means higher growth rounds, high in a lie that enables a higher debt service and better cash flows. And overall, that’s what forces sort of appreciation based based on the income approach. Obviously, residential properties don’t just trade an income, they trade also On market forces on competitive properties in the price, but the investment math in commercial or investment, real estate is very similar. From the math perspective. My question is, maybe interest rates are good for the real estate. And in the long run, yes, I would agree that the interest rates are generally pretty good. Real estate is a great hedge against inflation. So if interest rates are reflecting inflation, then real estate holdings over time should work as a hedge. But the problem is that the quickly raising interest rates could cause a debt crisis. So it’s not again the increases themselves, but it’s the velocity of increases the cause problems. And I mentioned this a little earlier in this discussion, but if there’s a rate reset on variable rate mortgages are fixed for five years and then they reset or there are assets that need to be purchased or sold. That’s where the rate reset could cause all kinds of grief, requiring additional capital contributions in a building Buddy finance and whatnot. So of course, debt crisis and real estate, not the only sector, the whole economy is over leveraged. By the way, one of the reasons why stock market is reacting very nervously right now to rising interest rates is because the corporate balance sheet, they have a little over leveraged with cheap financing. moment that that rolls over much higher cost of financing, much worse earnings. So what we’re seeing in the stock market right now, is a fear that the earnings are peaking temporarily, or in the long run, they’ll go up again when the inflation catches up. But for now, that’s the problem is that the P is at the peak level. And that’s why the stock market is right now is in a nervous breakdown. Again, I mentioned this and the major risk is the the fact that the Fed is raising rates too fast. It’ll slow down many, many sectors of the economy. As I mentioned, refinancing costs will go up, and they can cause just major major crisis on the refinancing. And this also may cause psychological issue for the moment. Corporations earnings go down. What a corporation’s do they cut spending, they have responsibility to investors. So a significant part of this is consumer centered the fact that consumers are spending money for the moment corporations start cutting jobs. The whole thing made me go into vicious recession cycle faster than you think. Right? How to prepare for rising interest rates. Well, number one refinance today, lock in long term fixed rates today, they’re still good on a long term basis. So if you can do this, do this. The other point that I’m making is reduced leverage, especially if you have variable rates don’t get over leveraged. If you can get 75% loan to cost mortgage maybe should do 70 or even 65. Put a little bit more cash in it’ll create safe, it’ll reduce your leverage, you may not feel you’re getting a greater return on equity if the prices were climbing up, but we What if there’s a recession? My point is having lower leverage will help you during a recession. And now we’re not looking at a great appreciation period of time, we’re looking at a potential with some level of correction and recession. The other point to keep in mind is a times it’s good to have partners. So instead of taking on more debt, maybe take taking a partner of somebody in shipping some capital and reduce borrowing. The next point is cash is the king increase cash reserves as much as you can. First of all the cash in the bank today starts earning interest. That’s the good news. That’s what that’s what Jason you said the savers are making return on their money. So having cash having some some interest on cash, Mel’s second?
Jason Hartman 41:40
Well, I would say a little bit of cash, but not too much because cash is money losing deal, you know, after taxes and inflation. Yeah, I agree. I agree. So what I’m saying is, do you want enough cash to get yourself through the storm you need reserves? It should be called reserves, not cash.
Mike Zlotnik 41:57
Look at my flight. What does it say? It says increase cash reserves I did not say go to 50% in cash fairly 5% in cash go to 10% that’s all I’m saying,
Jason Hartman 42:06
okay, little money or cash, maybe for the downturn got it.
Mike Zlotnik 42:10
Exactly. And when the market corrects and opportunities come to the table having cash is always handy to take advantage of as opportunities. diversify. So, that That goes without saying as much as you can keep diversifying between different markets that have assets location, and as you mentioned, various parts of the country will behave very differently. So coastal markets can go up and down like a yo yo, while steady markets will do much better. From that perspective. diversification is a great place to focus on cash flow, just focus on good solid cash flow generating assets and fixed long term interest rates. Good stuff, Mike,
Jason Hartman 42:47
thank you for joining us, appreciate it. give out your website.
Mike Zlotnik 42:49
The easy way to remember is Big Mike fund.com. So this is the this is my podcast, big mic fund COMM And I did grab a site called Big microphone dot com as well. But the primary website is chemical funding that comes from the word temporary investments, key EMP or temple funding calm. And I appreciate you having me on the podcast. Mike, thanks for joining us. Good to talk to you. Go to talk to you, Jason. Thank you.
Jason Hartman 43:20
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