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Worried about the end of easing? The effects of QE3 haven't even been felt yet

Real estate investors should be thinking about moving to actively managed assets

Nov 4, 2014 @ 12:01 am

By Jacob Frydman

I expect that the Federal Reserve will commence raising interest rates shortly and once the Fed does so, I expect that we'll see interest rates rise quickly. It is always dangerous to predict when the Fed will take action, and especially with respect to interest rates, and I generally prefer not to make specific predictions.

But if I were forced to look deeply into my crystal ball, I would likely target the end of the first quarter of 2015 as the point when we will commence seeing interest rates rise. Of course I could be wrong, especially if the Fed perceives continued weakness in the economy or if we see some events which lead to instability in the stock markets.

With respect to when the effects of the third round of quantitative easing, known as QE3 (launched in September 2012) will fade from the economy, I would rather suggest that the effects have yet to be felt on the economy. That is to say that by virtue of the Fed's "bond buying" at the rate of $85 billion per month for an extended period of time or, stated differently, the Fed's printing $85 billion a month for the past several years, we have seen a significant rise in the money supply.

(Related: Nobody mourns death of QE as demand for Treasuries proves insatiable)

And it isn't just QE3. The Fed (and other central banks) have been 'printing' money in recent years under various code-names, including quantitative easing (QE 1, 2, & 3), LTRO, SMP, TWIST, TARP and TALF, in order to bring unemployment down and speed up the economy.

At the beginning of the Great Recession, the Fed held between $700 billion and $800 billion of Treasury notes on its balance sheet. In November 2008, the Fed bought $600 billion in mortgage-backed securities. By June 2010 it held $2.1 trillion of bank debt, mortgage-backed securities and Treasury notes supported by QE1 by printing $30 billion per month.

QE2 commenced in November 2010, with the Fed “buying” $600 billion of Treasury securities by the end of the second quarter of 2011. QE3 started in September 2012, when the Fed began “buying” (read: “printing”) $40 billion per month, which was increased to $85 billion monthly in December 2012. Through this process the Fed increased its balance sheet to $4.5 trillion, or a $3.8 trillion increase.

Since the Fed began printing money in 2008, we have seen a 38.3% pace of rising year-to-year growth in the money supply. This is unprecedented and the Fed's QE activity puts the monetary base in uncharted territory, both in terms of historical level and year-to-year growth.

The impact of that additional money supply should impact the economy by generating inflation. And we have not yet begun to see the inflationary impact which I anticipate. Given the velocity of the Fed's printing of money on the increase in the money supply, I expect that we will begin to see the inflationary impact once the Fed raises its 0% cap on federal funds rate, which is the rate at which banks can borrow nightly at the Fed funds window.

In effect, the 0% cap on Fed funds rates has created a synthetic cap on inflation, and when that disappears, along with rising interest rates (which is the price paid to rent money), which undoubtedly will increase, we will see corresponding increases in inflation and capitalization rates.

Both inflation and capitalization rates are the two kissing cousins of interest rates, and we can expect both to rise as inflation rises. Of course the negative externality of rising capitalization rates is a decrease in valuations of real assets which have no rent increases. This could create a deleterious impact on portfolios of real estate assets which are primarily comprised of single tenant leases with no rent increases.

This is because if these assets were purchased at a lower rate than they will be sold at, and since the net operating income remains flat, these assets will lose value, and by extension the investors in these assets will take a hit to their equity investments.

As a result, investors should be thinking about shifting their investments from non-rent increasing triple net leased assets into actively managed real estate assets with inflation protected leases and where there is an opportunity to enhance value by repositioning, remarketing or redeveloping those assets.

Many of today's nontraded REITs are saddled with significant triple net leases that do not have any rent increases. In fact, it has been reported that at least 77% of the underlying portfolios of open nontraded REITs are comprised of such leases. To the extent that those REITs are required to dispose of their assets within a definitive timeline, if they must sell those assets at a higher rate than they were purchased at, investors will take a hit.

Jacob Frydman is CEO and chairman of United Realty.

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