It’s been hard to miss the recent news about the outbreak of the coronavirus COVID-19, and even harder to miss the ripple effects the outbreak has had for the international economy. In the past week alone, concern about the virus sent financial markets plummeting to their worst performance since the 2008 global financial crisis, with losses amounting to almost $6 trillion, according to a recent Reuters article. The US stock market has also been heavily impacted, with all three major indexes reporting losses. As of Friday afternoon, the Dow Jones was down 13% for the year, the S&P 500 was down 10.6%, and the Nasdaq had lost 6.8%. Depending on coronavirus news over the weekend, by Monday we may see a strong recovery in these indices, further declines, or even more likely, both.
First conceived soon after the Great Recession of 2008-10, we designed Groundfloor as a tool that can help investors weather times like these. In addition to sharing the thoughts below, we’re also soliciting your perspectives via a new survey.
Macroeconomic Considerations
Drastic market fluctuations stoke fears of a global recession as stock market investors struggle to adjust to the hits their portfolios are taking. Over the past week, demand for bonds has skyrocketed, with the yield on the 10-year US Treasury bond hitting a record low of 1.243% on Thursday, according to Forbes (bond yields decrease as their prices increase in response to demand). Now more than ever, the impact of such uncertain economic times underscores the importance of having a portfolio that is diversified into alternative asset classes. While public stock and bond markets tend to react swiftly to negative events like the current coronavirus outbreak or the trade war with China last year, many alternative asset classes exhibit much less volatility during uncertain times. This is especially true for real estate.
As an asset class, real estate has long been considered to be less reactive to market conditions than the stock market. Current reports about the possible effect of the coronavirus outbreak on the real estate industry are largely in line with that view. Real estate won’t be immune to the effects of an economic slowdown, however. In commercial real estate, for example, buyers and tenants can be expected to bid asset prices down as occupancy and activity responds to reduced expectations for earnings and access to capital. A rise in unemployment, reduction in household wealth, or slowdown in income growth could likewise impact multifamily and single family residential real estate markets.
Stocks and Bonds vs. Notes
Market volatility has a way of focusing investors’ attention. Investors who weathered them consider events like the Dot Com Crash (2000-2001) and the Great Recession (2008-2010) as valuable learning experiences. The most valuable learning is about our tolerance for different types and levels of risk -- especially how we handle, manage, and ultimately profit from it. For example, are you the kind of investor who can maintain your strategy (buying, holding or selling) through ups and downs? Do you feel confident knowing whether that’s the right thing to do, and whether it’s the right “time?”
Research studies show that investors are notoriously bad at knowing when to buy and sell, also known as trying to “time the market” -- especially during volatile periods. This is one reason financial advisors or your friendly neighborhood finance professor will commonly recommend that you invest consistently over a long period of time in a series of low-cost index funds designed to replicate the performance of public stock and bond markets. That is generally regarded as good advice. But what should you do with the part of your savings or portfolio that you might need in the medium or short term? What if you have a large windfall that you want to put to work now?
Equity ownership (stocks) is by its nature a more volatile type of investment than debt (bonds and notes). This is because debt holders (for example, the bank) are due their principal and interest before equity owners (for example, a homeowner) can receive their returns. The repayment of debt is an obligation, while a return on equity depends on what is left over. Debt is more reliable, especially over shorter periods of time.
But not all debt investments are the same, however. There are three main factors for the debt investor to understand in differentiating among them: (i) the term to maturity, (ii) the form of underlying security to repay the debt, and (iii) the tradability of the instrument. There are exceptions, but holding other factors constant, shorter terms usually mean more stability (and, less yield). Some debt is backed by a government promise (for example, Treasury Bills or CDs) or by an asset (for example, Mortgage Backed Securities), while other debt is backed by cash flow (for example, Corporate Bonds). Finally, investors should realize that the price and value of debt that is traded on the public market can swing wildly -- as is happening right now.
The Virtue of Investing In Private, Residential Real Estate Debt
Groundfloor opens the opportunity for everyone to participate in the market for private real estate notes. Before we came along, participating in this alternative asset class previously required making large minimum investments, concentrating investment in a limited number of loans and/or qualifying as an accredited investor. Since our “Limited Recourse Obligation” (LRO) offering is qualified by the U.S. Securities & Exchange Commission, it offers investors the benefits of public market regulatory disclosures without the pricing risk and volatility.
When you buy a large number of $10 LRO series on Groundfloor, on average you can invest with an expectation of the general time frame when most of those series will repay, and the rate of interest they will return. This is a virtue of LROs being a debt investment. It is also a short-term, private note rather than a publicly traded bond. That means the theoretical “value” of your $10 investment is likely to remain very stable throughout the time you own it. Regardless, your borrower owes the full amount of your investment, plus interest. See the explanations above (“Stocks and Bonds vs. Notes”) to understand why this is the case.
In addition to the virtues of being a private note investment, Groundfloor is also not a fund. Here’s why that matters in times like these: Your liquidity (returns of invested capital) are not controlled by us, but by the performance of the LRO series you choose. That means you’re free to reinvest or withdraw funds upon repayment of each investment you make, as you choose. For a contrast, ask a REIT or read the fine print about their “redemption policy.”
Conclusion: Select and Control Your Risk
As mentioned at the beginning of this post, residential real estate is not immune to market risk. No investment asset class is (except, arguably, government-backed or government-issued debt). The intelligent investor, therefore, must understand, select, and control the risks they take.
If residential real estate is ultimately impacted by this current market turbulence, equity investors will feel the pinch first as asset values decline. While equity investors could take a significant hit swinging from past returns as high as 15-20% to realizing deep losses, private market real estate debt investors should also plan ahead for the prospect of returns that may be as much as 100-300 basis points lower. With Groundfloor, that could mean realizing average net annualized returns of 7-9% instead of 10-12%* (see Note below).
Debt and equity investors alike also must prepare for the potential of a longer time horizon to realize their returns. Depending on many factors unique to particular market conditions and each investment, investors can expect durations to extend out from six months to several years longer than originally expected.
Taking these risks into account, in summary, we continue to believe that investors holding private market loans backed by residential real estate at low leverage have a competitive advantage in weathering the COVID-19 storm and potential for continued repricing of public and private market assets. We are monitoring market developments very closely and considering a variety of adjustments to our underwriting models and asset management interventions to ensure our investors continue to be well positioned throughout the ups and downs. We would be pleased to address any questions or perspectives you’d like to share in the comments below, via our new survey, by writing to support@groundfloor.us, or by emailing me and Nick directly at founders@groundfloor.us.
On behalf of all of us at Groundfloor, thank you for continuing to place your trust in us and supporting our mission with your investments.
* Note: Estimated returns are for illustrative purposes only. Any illustration of average annual returns on Groundfloor assumes a well-diversified portfolio of LRO series. Our historical loss ratios have ranged from 0.1% to 0.7%. An additional loss of 1.0% to 2.0% as illustrated above would represent a 3-10X increase in loss ratio, inclusive of costs of recovery. Groundfloor does not provide investment advice or project future investor returns. Historical results do not guarantee future results. As with any investment, Groundfloor offerings carry significant risk as described in our offering circulars and other filings with the U.S. Securities & Exchange Commission. Investors must make their own assessment of risk and determine their own expectations for future returns.
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