On January 20, 2016, the country is sending a businessman to Washington in one of the riskiest bets in history. Donald Trump appears to be intent on running the country like a business enterprise. But Trump is not just a business man. He is a real estate developer, an important distinction, as it impacts how he will think about revitalizing an economy that has struggled to maintain significant growth.
Trump promises to cut both corporate and individual taxes while investing up to $1 trillion on the country's infrastructure. By simultaneously decreasing the country's revenue and increasing its expenses, Trump would be making a huge bet that the resulting growth will be substantial enough to outpace the buildup of debt, potential inflation and recession that could be the outcome if his plan fails.
Not surprisingly, this bet is reminiscent of a real estate development, of which our President-elect is very familiar - use debt to invest in a property in the hope that the improved asset will generate enough cash flow to ultimately reward the investment.
Trump's real estate background provides him with the outline for how to fix the economy:
- Spend money on the asset using debt
- Make improvements that, when completed, will generate more income (in this case, infrastructure to improve commerce)
- These new improvements will lead to more business, which will generate more cash flow (in this case economic growth)
- The hope is that increased cash flow will outpace the growing debt
This is how every value-added real estate project is done – take on debt and spend money in hopes that the project provides enough cash flow to pay the debt and become more valuable.
When it works, it can be very profitable. When it does not work, the project could end up in Chapter 11, like Trump's New Jersey casinos.
Only this time the bet is on the country, not a building. Depending on the outcome of Trump's bet, the economy could finally break free of its lethargy or find itself in a deep recession.
This dichotomy is reflected in the markets today. We are seeing the stock market reach record highs on hopes of lower taxes, less regulation and big government spending, while the bond market (usually the smarter market) is seeing increased interest rates, a reflection of the risk in Trump's strategy.
So how should investors allocate capital in the real estate market on the verge of a Trump administration?
- Go slow: We all need to be careful to see if the reality will match the hype. Thus in the early days, we are staying with major markets, more cash flow, more preferred equity structures, less interest rate dependent investments.
- Stay short term: Look at shorter duration investments so as not to be tied up long-term in a quickly changing market.
- Less interest rate sensitive investments: Avoid investments that are pure interest rate plays as well as investments that rely on low cap rates and/or low refinancing rates in order to be profitable.
- Keep some dry powder: Leave the "lower interest rates for longer" attitude and adopt a "prepare for change" attitude. There will certainly be disruptions and dislocations along the way that will provide for some great investments.
From experience, we have learned that change brings opportunities; however, change typically does not telegraph its arrival. In 2017, we have the rare knowledge that it is on its way. Now is the time to think about how to find the upcoming opportunities.