Strategy note

My latest community service announcement: Protecting gains and rolling up the capital structure

A new strategy note from Chief Market Strategist Troy Gayeski

Troy A. Gayeski
October 4, 2022 | 5 minute read

As you are probably aware by now, we continue to be less than constructive on markets for multiple reasons that we have articulated in past strategy notes (see here and here). Unfortunately, if you are overweight equities and bonds, our outlook has not changed over the past fortnight. Fortunately, if you have embraced alternative strategies like senior secured commercial real estate debt or ’40 Act (Investment Company Act of 1940) daily liquid multi-strategy funds, you may be potentially experiencing more consistent return streams, lower volatility and less downside risk. The time for alts is now!

I’m going to skip another rundown of the reasons I have had a dim outlook for markets since the beginning of this year and more recently, the economy. Instead, I will do my best to offer another community service announcement for the investment community and our clients: It is high time to roll up the capital structure in real estate or harvest gains in equity real estate investments and diversify that risk.

  1. After a long post-global financial crisis (GFC) bull market and recent meteoric appreciation over the last two-and-a-half years, the real estate market is starting to come under pressure:
    • The residential housing market has already rolled over as affordability has collapsed back to the pre-GFC housing bubble lows of 2006, inventory/sales ratios have soared and buyers have rationally dropped bid prices.
    • Commercial real estate is starting to show incipient signs of price declines driven by similar factors: higher borrowing costs, higher cap rates and lower transaction volumes.
  2. Fortunately, both residential and commercial real estate markets do not have vast overhangs of excess supply driven by excess building and construction.
  3. Luckily, both markets continued to engage in rational, thoughtful underwriting including low loan-to-values.
  4. Further, both markets have ample equity to absorb price declines without leading to losses to lenders in the event of sustained price declines.
  5. However, it is more than likely both markets will experience price declines over the next several years. You can think of it as a mini-galactic mean reversion or galactic mean reversion, Part II.
  6. Thus, it’s now a potentially golden opportunity to harvest gains in real estate equity investments, roll up the capital structure to senior secured private asset-backed loans (and I humbly suggest not next week, not next month, not 2037, but you might want to consider soon).
  7. Another approach that makes sense is to harvest gains in real estate investments and allocate that capital to low beta and no duration liquid multi-strategy ’40 Act funds.

Fight inertia by embracing the urgency to improve investment outcomes!

Late last year, I began to articulate the challenging outlook for 60/40 and why I believed it was toast. Those who did happen to take action and allocated to certain alternatives may now be smiling (or at least not as much of a grimace). If you have yet to overpower inertia and take action, I urge you do to so now particularly as it looks like another bear market rally has just begun. Additionally, and to be crystal clear, I also urge you to roll up the capital structure in real estate investments or at least diversify that risk!

Lastly, in times like these, let us all remember the Hippocratic oath of investing: First, do no harm. Downside protection is still paramount and will be for quite some time. And second, don’t be a hero. Buying dips in bear markets ends in tears (averaging down into oblivion). Instead, we urge you to embrace alternatives because the time for alts is now!

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Troy A. Gayeski, CFA

Chief Market Strategist

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