The Guru Is In
Inflation For Fun and Profit
By David A. Smith
5 min read
Part 2, How to Adjust Now
Inflation being here in force regardless of our desires, last month’s Part 1 demonstrated that, when it comes to operations, your actions depend on what you think about the economic future. By contrast, because every financial transaction (both equity and debt) is a purchase and sale of expected future money for actual cash today, in underwriting your actions must depend on what other people think about the economic future.
Everyone wants beefy reserves. When volatility is low and money is chasing deals, competitive pressure and the mutual optimism of crowds steadily planes down required collateralized reserves. The instant inflation takes off, the asset managers, whose cautions were overridden in the hothouse, do stress-test analysis on the portfolio, compare it with the remaining fund-level balance and blanch.
‘Triage’ becomes the unmentionable omnipresent concept. Presentation of portfolio stress-test scenarios triggers muttered senior leadership conclaves with dog-whistle phrases, like ‘finite resources’ and ‘corporate sustainability.’ Each property or developer relationship that the fund determines it must support implicitly rejects supporting others less in favor. These decisions are unpleasant to make, often based on self-interested considerations, and seldom communicated to the unfunded until the cupboard is bare.
The debt markets’ time horizons shorten. Inflation blurs investors’ sight and shrinks their confidence. Not only do interest rates rise, the yield curve also does too (longer fixed debt greater spreads). So does the less-documented risk curve (spreads above safe rates, such as like-term Treasuries). Rising spread costs of hedging future interest-rate risk gives developers a Hobson’s choice: Pay ‘too much’ to fix the interest rate or try raising equity atop modernized long-term low-floaters, fund the interest-rate hedge in higher collateralized reserves and wind up with similar ultimate economics.
Tax-exempt bonds rise in usage. If both inflation and interest rates rise, the relative appeal of tax-exempt bond transactions will also rise. Not only do wider risk spreads raise all rates, widening gaps in taxable and tax-exempt rates make it more likely that sponsors will pursue volume cap, not just for the four percent credits, but also for their debt service advantages.
New pricing weakens. Even as the cost (spread) of a long-term fixed-rate loan rises, Low Income Housing Tax Credit equity prices come under pressure. With nine and four percent credits locked by (twice amended) statute, both rising interest rates and rising yield expectations for other equities put downward pressure on LIHTC pricing.
Fortunately, financial institutions’ unceasing appetite for positive Community Reinvestment Act investments, coupled with rising emphasis on racial equity and Environmental, Social and Governance investments, means that LIHTC equity will always have price support. Yet pricing will slip, especially for weaker sponsors, softer markets with less rental advantage and places with less social-justice sizzle. Though this will not be a rerun of 2008, where for a few landlocked states there was no LIHTC equity at any ready-money bid price, post-award prices sliding into retreat will force many stretched transactions into re-underwriting.
Projected operating expenses and replacement reserve deposits become bones of contention. As a credulous lad in 1978, I compiled a comparative table of every new syndication’s per-apartment projected operating expenses and discovered that actuals from previous properties by the same developers were one and a half times as much. Though the developers’ stated reasons were scarcely credible, the light dawned when I capitalized out the difference and quantified the resulting financing gap from using actual comparable results.
Growth assumptions take on much greater significance. In a happier time of low inflation, two/three percent growth rates needed neither reflection nor discussion. Now growth assumptions matter. Even after using the tortuously scrutinized and negotiated operating expenses, more and more underwriting pro-formas will show several years of operating deficits. Despite adding cushions of higher reserves and sponsor deficit guarantees, and screening out weaker developers, lenders and investors will need to persuade themselves to believe that no matter how deep the early-year deficits, the property will pop up smiling – once the (temporary, they’re temporary, right?) inflation shocks tamp down.
Glitz is trimmed. Things once seen as QAP-winning essentials are rethought into options. The balance tilts away from up-front QAP-additive gewgaws now in favor of minimizing downstream deficits, risks or enduring unfunded mandates. Minimum payback periods to justify green and sustainable technology likewise shorten.
Safety valves are discreetly adjusted. More attention is paid to relief-from-deeper affordability in the (surely hypothetical) scenario of a property whipsawed by fast-rising costs against affordability-oriented statutory or contractual rent affordability caps, for instance if Section 8 rents do not keep up with credit caps, or below-60 percent-Area Median Income contractually agreed credit caps become financially infeasible.
QAP advocacy alliances fluidly reform. What we agreed to agree upon when everybody got a share might be rapidly unagreed-upon, and what two of us formerly disagreed upon we might mutually discover we can now embrace. Political alliances, even inside the same entity, such as a Housing Finance Agency, invisibly shift.
Inflation puts everyone’s head on a swivel. Inflation destabilizes everyone relative to everyone else, and because the belief in inflation is a self-fulfilling mania of crowds, the disorientation of perceptions rapidly becomes meta. Everyone seeks to persuade everyone else to adopt a view of inflation that works from the persuader’s perspective.
Readers, skate with your head up, and always look confident and well capitalized, because in inflationary turbulence, he who looks weak, is weak.
