February 19, 2013
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Kyle Bass, the founder of Hayman Capital, foresaw the collapse of the sub-prime mortgage bond market in 2008 and the foreign sovereign debt crisis in Greece, and he now predicts that Japan will be the next to fall. Bass’ latest warning is about looming Inflation – and he advises how to protect against it.
On February 1 at the Tiger 21 conference in Palm Beach, Florida, Bass was interviewed by CNBC’s Gary Kaminsky. Kaminsky began by pointing out that the Dow Jones Industrial Average has reached 14,000 for the first time since 2007 and asked pointedly, “Does this make sense to you, and is the stock market the place you have to be?”
Bass replied, “Look, if the monetary base is going to continue to grow at the rate it is growing and the Fed is going to hold rates where they are today, we've lost the correlation between stocks and bonds. And the fed is buying $85 billion a month, about as much as our fiscal deficit. I think stocks continue to go higher.”
Bass elaborated on what sounded like good news for equities. “I think you kind of lose sight of what's important, in my opinion, if you are so focused on nominal pricing and equities when the monetary base is growing as fast as it is,” he said. “The analogy I drew inside was simply: One of the best-performing equity markets in the last decades has been Zimbabwe. But your entire equity portfolio now buys you three eggs? You have to really focus on the insidious nature of what inflation is and how real returns might be negative in both equities and bonds.”
Kaminsky quickly asked the key question: “How do you protect yourself from the inflation ahead?”
“I think to protect yourself, you need to own productive assets,” Bass said. “You need to own anything — like an apartment complex or an oil well or a global business — that is a productive business that sells things in various different currencies. And if you really want to protect yourself, you put long-term fixed-rate debt on these businesses. Just don't put too much debt on these businesses. Own some sort of asset that generates cash flow, and finance it with these low interest rates Bernanke is giving us, fixed.”
Before we dive in, I must admit I know very little about the ownership of oil wells, and I can’t define what Bass means by a global, productive, multi-currency business.
But I will focus on the third asset class he mentioned and the one I know best – real estate.
Breaking down real estate
When Bass recommended buying apartment complexes that generate cash flow using low leverage and financing them with low interest rates, he was referring to buy-and-hold core real estate.
A full 93% of pension funds and other institutions invest in real-estate private-equity funds. These funds can generally be categorized into one of four buckets: core, core plus, value-add and opportunistic. I will provide a brief description of each to demonstrate that Bass was talking about core.
- Core: High-quality real estate assets, leveraged between 0% – 30%, with a stable tenant base and conservative, income-focused return targets.
- Core Plus: Leverage up to 50%, with substantial share of expected total return to be derived from income.
- Value Added: More aggressive active asset management often employs more leverage and involves buying property, improving it and selling for a gain.
- Opportunistic: Includes investing in emerging markets, development projects, distressed assets and nonperforming loans.
Core real estate performance in inflation
First, let’s look back at the times when where inflation was greater than 4% in the last 35 years. To evaluate how core real estate fared in these times, we will look at the NCREIF Open End Diversified Core Fund Index (NFI-ODCE). The NFI-ODCE reports on both a historical and current basis the results of 30 open-end commingled real-estate private-equity funds pursuing a core investment strategy.
Inflation vs. Core Real Estate Private Equity
As you can see, there were nine years in the past 35 when inflation was over 4%, and a four-year period between 1978-1981 when inflation stayed above 8.9%. In every year except 1990, core real-estate private-equity funds outperformed the rate of inflation.
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