How Different Investments Perform in an Inflationary Environment

Wally Smith:
When we look at interest rates, we can’t stop today without talking about interest rates and how things have changed. I know you were author back in November of an article that was, I think in real estate assets, one of the trade magazines. He was talking about the 60, 40 portfolio being broken and 60, 40, 60 stocks, 40 bonds, interest rates killed the bonds.

Jeff Hertz:
Everything went down.

Wally Smith:
Everything went down. So people are then looking around, I need some non-correlated assets. And so that’s something that we see in the investment advisory side of our sister company. People are looking around for what do we have, if it’s not 60, 40, what are we going to do? What’s non-correlated? That’s really where we get into the alternative investments. So let’s say that you just give an example, four years ago you bought into a multifamily and they had projected maybe 2% a year growth on rents, and now they’re seeing inflation where rents are going up 10%, 12%, 15%. In a master lease environment the structure of that is going to flow through.

Jeff Hertz:
And it goes back to, again, the quality of the sponsor. If they underwrote the property at levels that were not appropriate and not sustainable, then that DST is going to miss the mark. So you also want to be careful of saying, boy, this operator thinks that they’re going to raise rents 10% per year. That’s just not realistic on a long term basis, and you can’t count for that being the case. To your point, on the opposite end of the spectrum, you see DSTs that were underwritten, I think conservatively and hopefully appropriately, that have outperformed those numbers and are able to actually pass on greater cashflow to the investors. But that’s not true of all real estate assets.
If you have a 25 year lease with either flat rents or maybe one to 2% contractual increases, it becomes much more like a bond. And that type of real estate maybe doesn’t perform as well in an inflationary environment. That’s why sometimes it’s good to diversify. Maybe a client has some longer term net lease assets that are going to be stable and hopefully good times and bad will continue to generate cash flow and then potentially some shorter term assets like a multifamily or a self-storage, that are going to hopefully have a little more horsepower during inflationary times.

Wally Smith:
Well when we sit with a client and we’re trying to figure out what to put in their portfolio, my father used to joke that one of the first things they teach you in medical school is how to say it depends. Who of us haven’t heard that when we ask the doctor about a specific answer? But the same with real estate, which DST would be best? Well, it depends. Are you solving for, maybe you have so much income from other, the last thing you need is more taxable income, then maybe you go into a highly leveraged position instead. Let’s say that yield is the most important thing or you don’t have kids, okay, you don’t have any heirs that you want. It really does come down to what’s important to each client.

Jeff Hertz:
Again, to your point, I had a situation a number of years ago where the client decided not to go into a DST. They bought their own single tenant net lease asset, and their attitude was, it’s a 20 year lease, I don’t care what happens at the end of 20 years, I’m going to clip that coupon for the next 20 years, and if I walk away from this property 20 years from now, from a risk standpoint, they felt they were better off. Other investors take the exact opposite approach, which is, hey, if I’m not growing in my real estate value, then I’m losing ground because of inflation.

Wally Smith:
DSTs if you just plan to hold it and let the next generation deal with it, then it is more of a bond like. And again, the strength of the sponsor or the queues, the quality of the sponsor, quality of the property, quality of the income is what’s going to be important there.