U.S. Hotel Sector Hosts Promising Results

According to STR, the U.S. hotel industry saw occupancy increase 1.4% to 56.4% during the week of 28 January to 3 February, while ADR rose 2.2% to $122.35 and RevPAR increased 3.6% to $69.05.  STR is a source for industry data benchmarking, analytics and marketplace insights. www.str.com 

The U.S. hotel industry reported positive year-over-year results in the three key performance metrics during the week of 28 January through 3 February 2018, according to data from STR.  In comparison with the week of 29 January through 4 February 2017, the industry recorded the following:

  • Occupancy: +1.4% to 56.4%
  • Average daily rate (ADR): +2.2% to US$122.35
  • Revenue per available room (RevPAR): +3.6% to US$69.05
  • Super Bowl LII host, Minneapolis/St. Paul, Minnesota-Wisconsin, reported the largest increase among Top 25 Markets in each of the three key performance metrics: occupancy (+38.3% to 72.5%), ADR (+129.1% to US$241.98) and RevPAR (+216.9% to US$175.51).

Seattle, Washington, posted the only other double-digit lift in ADR (+15.7% to US$152.30), which resulted in the second-highest jump in RevPAR (+20.1% to US$104.17).

Two markets matched for the second-highest rise in occupancy: Philadelphia, Pennsylvania-New Jersey (+8.8% to 57.4%), and Chicago, Illinois (+8.8% to 49.9%).

Affected by comparisons with its Super Bowl host week last year, Houston, Texas, reported the steepest decline in RevPAR (-45.1% to US$73.24), primarily because of the largest decrease in ADR (-42.7% to US$109.76). Occupancy in the market fell 4.1% to 66.7%.

Nashville, Tennessee, experienced the largest drop in occupancy (-4.9% to 61.9%).

San Diego, California, reported the second-largest decreases in all three key performance metrics: occupancy (-4.7% to 70.6%), ADR (-4.8% to US$145.75) and RevPAR (-9.3% to US$102.85).

 

“Good” Inflation: Rising rates and falling stocks

Over the past week, the Dow fell by 4%, more than halving its ytd gains through Friday 1/19 (all time high).   Bonds continued the decline started in mid-December, bringing losses during the current ‘bond rout’ to -5.7% year to date.  That is a one week decline in the Dow of 4% and a four-week decline in long-bond prices of 5.7%.  Balanced investors have seen stocks gain and bonds lose, putting most investors (moderately conservative to moderately aggressive) at a mild gain or loss so far this year.  Generally, diversification across asset classes reduces volatility when bonds go up, stocks generally are weaker and vice versa.    When the classes move together differentiation across risk profiles diminishes.  Stocks remain in a strong uptrend and given the substantial gains over the past few months, equity centric investors should be able to take this in stride (or they shouldn’t be equity-centric) as 4% is a small blip in a strong multi-quarter uptrend awash in investor optimism, all-time low cash levels, all-time high exposure to stocks and financial assets and expectations of higher wages, earnings and GDP growth.   In this light, a rebound, or ‘buy the dip’ would not be surprising.  The new feature though is that volatility has returned.

The ‘bond rout spilling into equities’ explaination has to do with relative attractiveness.  If rates keep rising, bond prices are hurt, while becoming more attractive (due to higher yields) to equity investors, putting pressure on equity prices.  At some point, earning safe interest attracts enough investors from stocks to weaken stock prices.  The S&P 500 dividend yield is now 1.8%, similar to what can be found offered on 18 month CD.

Rate have climbed due to rising inflation expectations.  Inflation is expected to, finally, exceed the 2% goal set by the Federal Reserve ‘in the coming months’.  Current thinking is that a tight labor market is pushing AHE (average hourly earnings, +2.9% Jan ’18 vs Jan ’17), combined with more take home pay (via tax reform), will result in more spending from consumers and investment from business.  This will take time but markets have already priced it all in.  Just like the stock market has priced in exceptional earnings growth to match its exceptional valuations.  The chart below shows us that we’ve been in a tightening labor market for years without being able to hold above 2.0% inflation but briefly.

infl vs unemplmnt

Given the new feedback loop between stocks and bonds, perhaps we shouldn’t be so excited about inflation, even if its ‘good’.  On the bright side, the past few years has seen 3.25% as a top in 30yr bond yields and perhaps a decline in rates near term may help both bond holders and stock investors alike.

Observations and Outlook January 2018

Investors have not been as fully invested in the stock market since 2000.  Does this mean anything?

Maybe.  It is a reflection of investor expectations though.  One can infer this by assuming investors own what they think will go up in price and therefore is investors are very long, then they expect prices to rise.  The American Association of Individual Investors (AAII) recorded the highest level of optimism in 7 years, since December 2010.  The historical average is 38.5%.   In an article from AAII, dated January 4, 2018 they review how markets performed after unusually high bullish and usually low bearish sentiment readings.

From AAII:    “There have only been 46 weeks with a similar or higher bullish sentiment reading recorded during the more than 30-year history of our survey. The S&P 500 index has a median six-month return of 0.5% following those previous readings, up slightly more times than it has been down.   Historically, the S&P 500 has realized below-average and below-median returns over the six- and 12-month periods following unusually high bullish sentiment readings and unusually low bearish sentiment readings. The magnitude of underperformance has been greater when optimism is unusually high than when pessimism has been unusually low.”

This does not necessarily mean that our current market will decline rapidly.  Actually, AAII finds that while returns are below-median, they are positive.  Positive as in ‘above zero’.   Sentiment drives markets and when sentiment gets too extreme, either in bullish for stocks or bearishness for bonds or any other financial asset, returns going forward are likely to disappoint.  If everyone has bought (or sold) who is left to drive prices up (or down)?   What we need to recognize is that investors become optimistic after  large advances in the stock market, and pessimistic after declines.  UM-Probability-of-Stock-Mkt-Rise-Oct-2017-1024x705_thumb1

Again, this chart above does not mean we are about to enter a bear market.  It only shows the markets progress at points of extreme optimism.  We can see in 2013 into 2015 rising expectations and a rising market as well as from 2003 to 2007.   Now that we can visualize the mood of the market, lets review some other metrics from 2017 and what is in store for 2018.

2017 was interesting in several areas.  It was the first time in history the S&P500 had a ‘perfect year’ where every month showed gains in stock prices.  We are also in record territory for the longest length of time without a 5% pullback, almost 2 years.   Historically, 5% drawdowns have occurred on average 3-4 times each year.  In addition to price records, there are several valuation metrics at or near all-time records.    The ‘Buffet Indicator’ (market capitalization to GDP) just hit 1.4, a level not seen since Q4 1999.  “Highest ever” records are exceeded well into mature bull markets, not the early stages.  Stock markets generally spend most of the time trying to recover to previous highs and far less of the time exceeding them.    Momentum and priced-to-perfection expectations regarding tax policy are driving investors to be all-in this market, as reflected by Investors Intelligence Advisors’ (IIA) and American Assoc. of Individual Investors (AAII) stock allocation and sentiment surveys each at 18 and 40-year extremes.  Combined with the Rydex Assets Bull/Bear Ratio, at its all-time extreme bullish reading, it’s difficult to argue who else there is to come into the market and buy at these levels.

However, bullish extremes and extreme valuations can persist.  Their current levels do likely indicate that we are well into a mature bull market.   The bull was mature in 1998 too and went on to get even more extreme.  This is the case many perma-bulls trot out, that since were not as extreme as 1999, there is plenty of room to run, and ‘dont worry’.

The US Dollar and Quantitative Tightening

The current ‘conundrum’ is why is the US dollar so weak?  We have a Fed that is raising interest rates growth likely to exceed 3% in the fourth quarter.  Usually a rising currency would accompany these conditions.    The dollar declined throughout 2017.  This was a tailwind for assets outside the U.S. whose value in dollar terms increases as the dollar declines vs foreign currencies.   If the dollar begins to move back up this will be a headwind for ex-US assets and for sales/profits to large companies in the S&P 500 who do almost half their business outside the U.S.

In addition, central banks have given notice that, while the Fed ended QE in late 2015, other central banks are beginning to end their programs with the European Central Bank reducing its bond purchases from 60 billion euros per month to the current 30 billion, and down to 0 in September 2018.   The Bank of Japan (and the Japanese Pension Fund) have declared they are reducing their purchase of stocks, bonds, and ETFs.  Only China hasn’t formally announced and end to market interventions.   Most pundits are pointing to the bond market as the area that will be most affected.  Possibly, but to claim that bonds will get hurt and stocks will be fine is ignoring how global equities have performed hand-in-glove with banks’ liquidity injections over the past 10 years.  Both stocks and bonds will likely be affected.

Yield Curve Inversion (or not)

I102YTYS_IEFFRND_I30YTR_chart

The chart above shows in red the persistent decline in 30-year treasury rates.  This week Bill Gross called the bottom (in rates, the top in prices).  This may be premature as one can see dips and climbs over the past few years, all of which have been accompanied by calls of the end of the 35 year bond bull market.

What is more interesting is that in the past 3 recessions, the yield curve as seen through the 10-2 Year Treasury Yield Spread declines, through the zero level (aka inversion, 10yr bonds paying less than 2 year notes) before a recession.   Our current level of .5% is not far from zero.   Most people are waiting to see it invert before saying a recession in on the way, often adding it will be a year beyond that point.    If one looks very closely at the chart we can see said spread actually increase after bottoming out, just prior to a recession starting (which wont be officially recognized until 6-8 months along).   While there are different factors influencing the 2yr and the 10yr rates, a spread widening might be a more important development than continued compression.

Finally, what does all this mean for an investor.   In short, we must all recognize that a 24 month span without a 5% decline is extremely unusual, as there are often 3-4 in a given year.   Also that when investors are most optimistic, returns often lag with the more extreme readings leading to more significant changes.  Mature bull markets eventually end and investors with a longer term horizon need to have a strategy not only for growing their investments, but also protecting the gains one already has.

We all know how to deal with a bull market, but few people have a strategy on how to deal with a bear market.

Adam Waszkowski, CFA

What are Alternative Investments?

  • Real Estate: Tenancy-in-Common, LLC,  LLC Unit or Partnership Interests in Real Property investments, such as hotels, storage, retail and other real estate types.
  • Arbitrage: Simultaneously buying and selling related securities, sometimes in different markets, to exploit mis-priced relationships.
  • Hedging: Investing to offset the risk of price declines using methods such as buying or short selling.
  • Trend-following: Identifying price patterns with profit potential and implementing similar long/short positioning

IMPORTANT RISKS
Alternative investments do not guarantee a profit or protect against a loss.  Sophisticated techniques can magnify a gain or loss, for more information consult your financial adviser, prospectus or private placement memorandum.

What is the “JOBS ACT”?

Typically, when a company raises capital, it has to register its securities (basically the shares/interests that they are offering for sale).  Registration is expensive and takes a long time.  Most companies look for an exemption from registration. The most common exemption used by companies for this purpose is the private placement exemption, which basically meant the companies couldn’t publicly solicit or advertise.

The “Jumpstart Our Business Startups Act”, or the “JOBS Act” changed that.  The JOBS Act allows companies to publicly solicit for funds and advertise while still conducting a private offering.  However, it comes with a major catch.  The only investors allowed to invest must be “accredited investors”, and the company raising money has to verify that their investors are truly accredited investors.

A simple questionnaire is no longer sufficient – instead, companies must take further “reasonable steps” to prove their investors are accredited investors.  Failure to comply is a violation of federal laws and may subject the company to enforcement action and the obligation to return money raised.  That’s obviously bad for companies, but it’s also bad for investors who don’t know if the companies they invested in will suddenly have to return a portion of its capital to other disgruntled investors.

What is an “Accredited Investor”?

An “accredited investor” is a type of investor. Generally, sales of securities must be registered with the SEC unless an exemption is found. Some of the exemptions require sales to be made to accredited investors. Our application lists out the various categories of accredited investor.

The Securities and Exchange Commission also has a helpful page on accredited investors here: https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-bulletin-accredited-investors

For more information, please contact Paul McIntyre at pmcintyre@namcoa.com

Tax Cuts and Jobs Act May Help Investors

While investments in commercial real estate came away with some clear advantages relative to other industries and investment types, the law also generally takes away some tax benefits and deductions previously available to high-income individuals, and in most cases increases the tax burden on persons residing in states with high state and city taxes (since the deductions for those local taxes is now limited).  So investors will need to evaluate the law’s overall effect from the point of view of their individual tax situation.

Commercial Real Estate is a Clear Winner

In general, the law will have corporations, partnerships, and family-owned firms seeing tax cuts across the board.  In those areas where the law otherwise eliminates special breaks or imposes tighter standards, commercial real estate almost inevitably gets a pass.

As noted in a recent NY Times article, most businesses will be subjected to new limits on deductions for interest payments, but not real estate. Most industries will lose the ability to defer taxes on the exchange of similar kinds of property, but not real estate. Domestic manufacturers and pharmaceutical companies will lose some industry-specific breaks in exchange for lower tax rates, but the real estate industry will benefit from an even more generous depreciation timetable, allowing owners to shelter more income. And in a break from previous practice, REIT income qualifies for a lower tax rate, the kind of special treatment traditionally reserved for long-term capital gains and certain qualified dividends.

Such benefits do not necessarily extend to owners of residential real estate, however.  Residential realtors, for example, are among the biggest losers under the tax code overhaul, since decades-old perks that were designed to encourage home ownership will be wiped out. And by almost doubling the standard deductions for individual and joint tax filers, the legislation blunts the advantage of the mortgage interest deduction, which is often a key factor in home-buying decisions, particularly in pricey markets. The legislation also caps the deduction for state and local taxes at $10,000, a blow to homeowners in high-tax states.

20% Deduction for Pass-Through Income Benefits Real Estate Investors

The change that might most directly affect investors and sponsoring real estate companies is the 20% deduction in income received through pass-through entities like partnerships or limited liability companies.

Pass-through income is business income that is not subject to corporate or entity tax, but is rather taxed at the level of the ultimate business owner(s), at their individual rates.

Nearly 40 million taxpayers claimed pass-through income on their individual tax returns.

The 20% deduction differs from the House’s original proposal to simply lower the applicable tax rate on pass-through income.  Under the final law, 20% of pass-through income can be deducted, but the rest will be subject to tax at the regular rates, up to a new top rate of 37% (down from 39.6% under current law).  The bill includes some limits on who can take the deduction (medical, legal, and consulting practices won’t be eligible), and also limits the deduction further for people who make more than $157,500 (or $315,000 for married couples).

For those facing a limit on the 20% deduction, the deductible amount is capped at 50% of the wages paid by the business or 25% of wages paid plus 2.5% of the value of the business’s “qualified property,” whichever is greater. Qualified property is tangible, depreciable property that pass-through businesses use to produce income – a qualifier that, again, benefits real estate investors.

Shortened Depreciation Periods

Property investors may also benefit from the shortened depreciation schedules for buildings. Both residential and non-residential properties have had their depreciation schedules reduced to 25 years, from 27.5 years and 39 years, respectively.

The change is significant for residential property, but even more important for commercial real estate. The shortened depreciation schedules will allow investors to more quickly realize the tax benefits on property purchases and related capital expenditures.

Expanded Expense Treatment for Certain Costs

Some commercial real estate, especially non-residential, may benefit from the new law’s expanded treatment of deductions of the cost of certain types of property as expenses, rather than capitalizing such expenses into the cost of the property. The new provision includes certain depreciable tangible personal property “used predominantly to furnish lodging or in connection with furnishing lodging.” It’s as yet unclear whether this provision will be limited to the hotel sector or might be interpreted to extend to other properties.  The expanded definition covers a range of improvements to non-residential real property, including roofs, HVAC systems, fire protection and alarm systems, and security systems.  The provision should benefit many value-add commercial real estate projects.

Limitations on Sponsor Business Interest Deductions Are Also Avoided

The law generally limits the deduction for business interest expenses.  Because property loans make up a significant portion of a real estate project’s overall capitalization, such restrictions could have been very problematic for real estate companies.

Under the law, the ability of most businesses to deduct interest expense will be limited to deductions that are not greater than 30% of their earnings before interest and taxes (EBIT). But that limit will not apply to commercial real estate.

Limited Changes to Carried Interest Taxation

Real estate developers make much of their money from taking a “promote” interest in their projects – a portion of the profits beyond those otherwise attributable to their invested capital – which is treated similarly under the tax code as “carried interest,” a similar compensation mechanism used by hedge fund and private equity managers. This compensation has typically been taxed at a lower rate than ordinary income, and some observers (including, earlier, President Trump) had called for the elimination of that disparity.

The favorable tax treatment of carried interest generally survived in the new tax law, but now longer holding periods are required to take advantage of the lower rates.  Currently, to get taxed at the long-term capital gains rate, a fund must hold an investment for one year. The new law extends that to three years.

The effect of this change may be limited, since real estate sponsors tend to hold properties for several years anyway.  Sponsors involved with projects having a relatively short-term renovation and exit strategy, though, may look at slightly extending their investment hold periods in order to continue taking advantage of the lower tax rates on their “promote” interest.

REITs to be Taxed at Lower Rates

Real estate investment trusts (REITs) pay no separate business tax, instead passing through nearly all of their taxable income to their shareholders, who then pay tax when they file individual returns. Under the new tax law, the top income-tax rate of 39.6% on dividends received from REITs will drop to 29.6%.

That reduction may help to keep REITs on the same playing field as pass-through vehicles, which will enjoy the 20% deduction discussed above. The lower tax rates may also REITs’ appeal relative to other yield-oriented investments, particularly for those owning REITs in a taxable account.

No Changes to 1031 Like-Kind Exchange Tax Deferrals for Real Estate

Investors that re-invest the sales proceeds from investment properties into replacement investment properties have long benefitted from the tax deferrals on gains that qualify for “like-kind” exchanges under Section 1031 of the tax code.  While the bill eliminates such tax deferrals for personal property, it leaves the tax provision unchanged for real estate investments.

Alternative Minimum Tax Remains in Place

Originally a subject of repeal in the House version of proposed tax changes, the final law preserves the alternative minimum tax but implements increased exemptions and phase-out amounts until the end of 2025.

Individual Mortgage Deductions Will Be Capped

The tax law is not as kind to the residential real estate market, since it would reduce or eliminate some of the benefits of homeownership that Americans have come to expect.  Homeowners in areas with hefty property valuations and high property taxes will be most affected, but real estate agents, home builders, and housing industry groups also worry that the effects will be felt by a wide swath of homeowner borrowers.  This is because the tax bill could make existing homeowners less willing to move up to bigger homes, which in turn might make it harder for renters to enter the housing market.  Recent home ownership figures indicate that ownership rates are already near some of the lowest figures seen in the last few decades.

The tax bill will reduce the maximum available interest deduction available on owner-occupied mortgage debt from a $1 million cap to just $750,000. More expensive areas along the coasts will likely feel the pinch; the move will likely serve to raise the overall cost of buying a home in those areas, and perhaps discourage existing homeowners in those regions from moving.

The tax bill will also cap the deductibility of state, local, and property taxes at $10,000, another provision that could weigh on the construction and resale of more expensive homes in high-tax states like California and New York.

The potential advantage to commercial real estate investors, however, is that such changes may continue or accelerate the shift from home owners to renters.  If this is the case, then the commercial property sector that focuses on rental units may well benefit.

Jury is Still Out on the Plan’s Macroeconomic Effects

The anticipated cut in the corporate rate to 21 percent from 35 percent and other business perks are lifting the stock market to new heights; “animal spirits” have been revived. Over time, however, because of the deficit restrictions imposed on the majority-vote rules by which the tax law passed in Congress, most of the broad-based tax cuts for individuals will likely disappear.  The few of the richest Americans will continue to benefit, but most people who earn less than $100,000 will see their taxes later rise over time.  These increases could slow the economy’s primary engine – consumer spending.

Neither NAMCOA nor any of its affiliates, advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice, either express or implied.  Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.

Money for Nothing: from QE to QT

During the crisis, central banks lowered interest rates dramatically during the stock market crash.  The Fed Funds Rate went from 5.25% July 2007 to 3.0% March 2008 (when Bear Stearns failed, most people remember Lehman, which failed in September).   That summer Freddie Mac and Fannie Mae failed and the FFR was lowered to 2% and then 1% in September and finally 0% was the official rate in December 2008.  All the while financial asset prices kept falling and the economy was hemorrhaging.  Soon after hitting 0% as the cost of money to the banking system, the Federal Reserve started Quantitative Easing, where the Federal Reserve would buy mortgage backed securities (as well as other tax-payer insured instruments) to provide ‘liquidity’ to the markets.   The stated goal was to increase the prices of assets (stocks, real estate, bonds) so that the “wealth effect” would spur people to spend money rather than save it.  Given the anemic pace of economic expansion, the primary effect QE has had has been to push up stock prices well beyond normal valuations.

While the US has ceased QE, raised interest rates off the 0% mark, and laid out a plan to shrink its balance sheet (taking liquidity away from the market); the European and Japanese central banks continue to buy assets. The Europeans buy corporate bonds and the Japanese buy everything including equities.  The ECB has expressed a desire to cease its purchases (stopping new liquidity into the market) starting in 2018, but have not committed to a schedule.  The chart above combines all the central bank’s asset purchases and projections into 2019 overlaid with global equities.  On the chart below, notice how the EM (emerging markets withdrew liquidity late 2015 to 2017—emerging market stock indices (EEM) fell 39% from Sept 2014 through Jan 2016).  Additionally we can observe the effect central bank purchases have had on interest rate spreads, giving investors the most meager additional interest for taking on additional risk.

The chart shows the Fed’s net reductions in liquidity and the Swiss, Japanese and Europeans declining levels of new liquidity to the marketplace.   Given that adding liquidity boosted asset prices, as additional liquidity slows and possibly reverses, it is not unreasonable to assume markets will become much more volatile as we approach that time.  We will likely see the effects of Quantitative Tightening (QT) beginning in, and throughout 2018.  One way to counteract this, would be for private investors to save/invest rather than spend this difference (approx. $1.2 trillion), but a reduction in consumer spending would bring its own problems.

central bank purchases 2019