Catch the full episode: https://www.wealthformula.com/podcast/312-should-real-estate-investors-be-worried-about-inflation/
Buck: Welcome back to the show, everyone. Today my guest on Wealth Formula podcast is Christopher Volk. Christopher has an unparalleled perspective on what it takes to create a successful enterprise that over 30 years of experience leading three successful publicly traded companies, spent even more time providing capital to thousands of businesses throughout the United States with a significant experience in real estate, which is, of course, of major interest to us. He’s also the author of The Value Equation, a business guide to creating wealth for entrepreneurs and investors. Christopher, welcome to Wealth Formula podcast
Christopher: Buck It’s an honor to be here. And thanks for letting me banter with you for a few minutes.
Buck: For sure. We would love to get your take. We live in interesting times, right, Christopher? I think today, in fact, I’m curious on your taking this, particularly because of your background in real estate. But I think we had some inflation numbers come out today, and it was about eight and a half percent year over year. When you think about real estate, how do you look at inflation through the lens of real estate, whether that’s I know you were doing some commercial leaseback type things and that kind of thing. But certainly I’m guessing you have a pretty good idea or thought on how inflation affects real estate as a whole?
Christopher: Yes, there are a lot of debates on how inflation affects real estate as a whole. I think over time the evidence is pretty clear that real estate tends to rise with inflation. For one thing, it just costs more to replace. That being said, the rental incomes don’t exactly move up with lockstep with inflation. So on a current income basis, it doesn’t necessarily follow that inflation is going to be met by rent increases. We look at the companies I’ve run. There’s a relationship, a very loose relationship between cap rates, yields on real estate and inflation. And it works something like this, that for every point in the ten year treasury that goes up, the cap rates go up by half a point. So just for the sake of argument, if you’re levered 50%, so you’re putting down 50% equity and you’re levered 50%, then that sort of means that your absolute cash flow rate of return stays unchanged in an inflationary type environment. So it’s not really going up, but it stays unchanged. You’re getting a decent absolute rate of return, and then what you’re doing is you’re taking what we try to do in real estate, you can’t really match fund leases. So what we try to do is match fund cash flows and make it so that your free cash flow is able to pay down your debt. And then if you’re borrowing any more debt, you’re using that debt to buy real estate at higher cap rates. And so that’s how we would sort of manage inflationary risk. And just to give you an idea of how it’s worked for us over a long period of time, the first public company that I ran, we took public in 94, sold it in 2001 to GE. During that seven year stretch, the ten year treasury averaged around 650. Our rate of return for investors was 1220. So in a business format, you’re making treasury times too. So that’s pretty good. The second company we started in 2003, and we sold it in 2000. And the 710 year treasury was 450. We did 19. So that’s even better. The third company is still public, so hopefully it stays public for a long time. But during the time that I ran it, the ten year treasury was probably two or in change, and the rate of return was over 13. So what does that say to you? I guess it says to me in a way that when ten year Treasuries are high, you can still generate really nice rates of return. It’s just harder to do it.
Buck: Yeah. You know, one of the things that when you’re talking made me think of the different kinds of real estate certainly makes a difference. When you’re in an inflationary environment like this, having one of the advantages certainly our group has had is that we do primarily multifamily real estate, which allows us to raise rents more rapidly on a yearly basis, whereas if you’re doing triplenet where you’re doing longer term leases, you may not have written that contract thinking that there would be eight and a half percent inflation year over year.
Christopher: Right. Well, I mean, of course, the multifamily space has been pretty good for several years, even before the inflation started ticking up the way it has, and a lot of that has been due to supply and demand. One of my observations about the economy overall has been that while we’ve had no inflation to speak up over the last number of years, we have had a lot of asset inflation. So having low interest rates has caused real estate and other hard assets to really soar in value. And as Warren Buffett likes to say, higher interest rates act like gravity on the stock market and other types of investments. And I think that probably includes real estate assets as well. So I think that higher rates will probably impose a certain amount of discipline which will help those people who are in the market and really understand what they’re doing and try to take some of the froth out. I think that certainly for the former public, the company I used to run, I think it’ll be good for them.
Buck: Right. So, of course, again, having a fairly Biden administration against just predicted higher than they were. Right about this higher than expected inflation. When you think about the real estate sort of drilling down in your experience, what do you think some of the best places would be, at least from the perspective of hedging inflation within real estate or what kind of I should say.
Christopher: Wow. Well, I mean, I am a big fan of multifamily and you’re in multifamily, but making broad assessments would be hard for me. I would say that I’m in a net lease space where I view higher interest rates to be a net positive for the people that are established players out there. There’s been a certain amount of cap rate compression that’s been out there with lower rates, and I think that the cap rate compression will start to abate a little bit, and I think that would be good for that space. Oftentimes the real estate markets and certainly the public real estate markets behave, they’re concerned about fear of interest rates more than the actual interest rates themselves. So, for example, if the ten year treasury would stay at three and a half and it would just stay there for a long period of time. A lot of real estate investment trusts perform just brilliantly as long as people are just afraid of the volatility of rates and that causes the markets to depress. And it can also cause some disconnections to the real estate market.
Buck: I know one of your expertise is in sort of just determining equations or factors or metrics in terms of trying to figure out ways to evaluate opportunities. When you look right now, what factors and metrics should investors examine to determine inflationary impacts on real estate or any other investment at this point?
Christopher: Well, different companies have different sensitivities to real estate to inflation rather, for example, if you have a company that’s an asset heavy company that’s got super high levels of inventory receivables, they’re going to have to just pay more for that stuff, even whether it’s real or inflationary. If sales grow by inflationary numbers, then inventory grows by inflationary numbers. So it is receivable. So basically, companies get caught in cash crap. And one of the advantages of real estate is that real estate doesn’t have a high level inventory. There’s not a lot of working capital in real estate. So relative to companies that have to have that kind of investment, it’s a positive thing. And given that it just depends on the type of real estate, some real estate tends to be much more labor intensive and some real estate far less labor intensive. I’m just a big believer personally, in just diversifying. And I tend to concur with people that think that the inflation won’t stay. But this is not your garden variety inflation that we’re going through right today. It’s 1970. I graduated from College at 79, so I graduated in the middle of a huge recession and prime hit 21%. And we had Stagflation and we had the Arab oil embargo that drove a lot of this stuff much higher for the US and for the rest of the world. Here you have truly global inflation. It’s not just the US problem. It’s every country that has been impacted by this. And the Pandemic has definitely contributed a lot to it. And of course, global situation with the confrontation in Europe is also affecting this and affecting the price of oil, which is affecting the price of everything and gas. And I expect over time this will pass. But in the meantime, you have to put some discipline on it, raise some interest rates. And that’s actually, I think, a positive thing for everybody. And of course, the economy is pretty strong right now, so I think it can withstand some of that.
Buck: Yeah. And along that lines, I guess a lot of people think that in raising interest rates, some sort of recession is fairly inevitable. And funny, in the last 20 years or so, it seems like recession has turned into like a metaphor of zombie apocalypse. Right. But it doesn’t necessarily have to be that way. In other words, if you have a recession. How much should real estate investors fear that or is it just, hey, we’re slowing down a little bit, but it doesn’t mean it’s the end of the world. We just need to ride this out. And what’s your take on that? Because I know, especially those of us who have really been active participants in the economy for the last two decades, we have probably a little bit of a warped sense of business cycles and how it really affects things.
Christopher: Right. Well, I tend to be a long term thinker on this stuff and think that stuff is going to be resilient over time. You serve dollar cost average in your business and what you do. So you’re buying you were in real estate several years ago and hopefully you’ll be in real estate several years from now and you’ll be buying and selling at different prices. And overall, the goal is to generate really nice, attractive, risk adjusted rates of return for yourself and your investors. And I’ve behaved likewise in the companies we have. When you’re committed to a strategy, you just do it and you execute it. And I’ve done it through a variety of economies. What’s interesting today is if you think about where we’ve been and where we came from, to have had a 21% crime rate in 19, the world couldn’t withstand that today. At that time, the ten year treasury was worth 10%. And so the average tenure, by the way, if you go back a long way around four and a half, I think at four and a half, you’re talking even issues because it’s going to affect just the regular home market. People are concerned today that fixed rate mortgages now are over 5%. So we’re not going to see I don’t think it’s just anywhere close to what we saw in the last huge inflation spike that we had in the early 80s, because I think that the world economy, let alone the US economy, would have a hard time trying to grapple with that, which gives the way the thought that you could have some inflation but still lower interest rates than you think. Right. Normally, a lot of us were brought up raising thinking that inflation interest rates are going to rise with lockstep, but they may not rise with lockstep as much as we would have been taught, because to raise interest rates to where we were in the early 80s would be pretty draconian.
Buck: I was just thinking when you said that the way you brought up to think certain ways you could say probably the same thing generally for asset markets right now. Right. I mean, you went through covet and you would think that you would think that everything was just fine. When you look at the stock market and you look at real estate prices and all that sort of thing, what is your take on this? I guess asset market is almost looking like Teflon not reacting to recessions. I guess and just expecting monetary policy, fiscal policy to come in and build them out. I think there’s almost an expectation of that. So you don’t really see markets moving in line with any sort of real economic data?
Christopher: Well, I think that the market hasn’t gotten accustomed to the notion that the inflation is really a long term phenomenon. You’re in the real estate markets a lot. So real estate markets are always working with a rear view mirror when properties start to decline. The guy who’s appraising the asset that you’re trying to buy is appraising it based upon six month old comparables will show the asset being high when the markets going back up the same appraisers, appraising the asset prices that are super low. And what I found was that and you can see this in the bond market when we were selling bonds at Store Capital or the company that I ran up till last year, when we were issuing bonds, when the ten year treasury was hitting one and a half, a lot of times the bond spreads would gap out a lot because the bond investors are thinking, oh, no, this one and a half isn’t really real. We’re not going to have these low rates for a long time. And then, of course, we did have the low rates for a long time. And then the Bods spread started really coming in to sort of more traditional levels because people were comfortable that low rates were going to be around for a while. I think that with inflation today, there’s enough noise from economists saying that this should be transient, that people are not really thinking that this is a long term event and they’re not pricing it into everything they do.
Buck: Yeah. Let’s pivot a little bit, talk a little bit about your book. It’s called The Value Equation, a business guide to creating wealth for entrepreneurs and investors. Why did you write it?
Christopher: Well, I’m writing articles on this subject for a very long time. And then when I was leading Store Capital, we actually did a video series on how businesses create wealth and how people get rich. And one of my observations is there are a lot of really wonderful books on how to get rich. But one of the things that’s really notable is that the richest people in the world tended to make their money in business. So you look at the Forbes 400 without exception, every person in that list made their money from business or perhaps inherited money from somebody who did. The question is, how do businesses create the wealth? Right. Because if you could decipher how businesses create wealth, then you’re cracking the code for how the richest people got that way. And there’s no books on how businesses create wealth. I went to business school for four years at night and graduated without really understanding how businesses created wealth. It’s not really well taught today, but it’s insanely important. The Value Equation works off of the centerpiece of the book is an equation. It’s a six variable equation that I devised in 1999, and it’s used to help run some of the companies that I’ve guided. And it can really sort of simplify how you look at businesses and really just drill them down into six essential variables. That middle school math. Anybody can understand it. It’s not that complicated. It takes away the mysteries of accounting, just focuses on finance, because finance is a universal language and it’s like music, whereas accounting is not a universal language. And so the idea is to sort of help people understand what it takes to create a company that creates a wealth out of thin air and therefore gives them a better chance to be able to build a substantial net worth.
Buck: When you talk about the six variables, what do you think some of the more important variables are? Can you give us a sort of a taste of what those variables are and how you look at them?
Christopher: Sure. Well, the six I’ll list the six quickly for you and then tell you the most important ones. But the six variables are going to be sales, which is pretty simple. Business investment, not so simple. It’s basically the amount of money that you’re putting into a business that has to be funded with debt and lease capital. Basically, I refer to that as OPM and equity. So capital desiring a return. So you have sales, business investment, operating profit margin. And again, you got to deal with this on a cash basis. You’re backing out a lot of non cash depreciation amortization. If you’re looking at public companies, you’re backing out stock based compensation, things like that, and then you have the percentage of your company that’s funded with OPM. So you’re dealing with the capital stack. So how much money are you using from OPM? What’s the cost of that OPM? The fifth variable. And then the final variable is the maintenance capex, the amount you have to put in to the company every single year to kind of keep it up, maintain your multifamily housing. How much do you have to sort of reinvest into your facilities every year? And some of these variables are not really you’ve got to really understand what goes into the variables because there’s just more to it than just that. So, for example, on maintenance capex, you’re running a restaurant. You have to replace French fryers every year. That kind of stuff. But then maybe every five years you do a remodel because you got to do a facelift. It’s a consumer facing business. Same thing that happened in real estate. And sometimes I hear people saying, well, it’s a non recurring expense or something like that. No, it’s not recurring. This happens. It’s part of the whole deal. So you have to smooth this stuff out. Now, this is not something that would affect you and real estate. But for example, if you’re looking at operating businesses that are consumer facing. It’s really not uncommon for people to close down locations from time to time. Walmart has closed down a boatload of Sam’s clubs. They’ve closed down smaller Walmart, they’ve closed down neighborhood stores. And so you might even include those kinds of losses that occur that you incur in that kind of activity into maintenance capex numbers. It’s part of the ongoing capex as part of what you’re doing. Same thing if you’re buying a company, if you’re in the business of buying lots of companies, invariably people lose money on some of the companies they buy when they pursue an M and a strategy. So that’s the six variables. But the big three are going to be sales and business investment and operating profit margin. And that’s where most entrepreneurs focus most of their time. I would tell you that you can make money on the capital stack decisions. Capital stack decisions are super important, and then the mainstream capex can come and bite you as well. So the book will spend time talking about that. And the goal is and by the way, when you string these variables together, what you’re getting is what’s called a current pre tax return on equity, you know what you’re getting today? You’re an investor. It could be an apartment complex, it could be Walmart, it could be anything. What are you getting today currently? And you’re using that as a foundation for deciding what businesses are worth, how much value is created. And so the book just walks you from that basic formula into everything from business valuation to capital stock decisions. And it’s done pretty simply. So it gives you an idea about wealth creation and wealth creation being I want to make a company worth more than the cost to create. Most businesses in America or in the world don’t rise to that level. Most companies, when the people that started them sell them, they can’t really recover much more than what they put into them. They just don’t rise to that level. The people on the Force 400, of course, blew that number away a long time ago. And most really successful people have been able to create companies for more than they be able to create companies that are worth more than they cost to create, because that’s when you’re sort of really manufacturing money from thin air, and only business can do that.
Buck: I’m just curious in terms of our conversation before about where we are in the economy. Is it a good time right now to invest? Is it a good time to start a business? Is there any sense in trying to time out a market when you’re doing something new or making acquisitions?
Christopher: Well, there are cycles in every sector and times to get in and out of sectors. I was talking to a real estate developer about the value equation, and the real estate developer commented to me that, well, when you’re looking at real estate, the timing of how you get in the market when you get in the market really does matter. Whereas, let’s say if you’re a property management company or you’re a servicer, then the timing is less important, right? You’re not sitting there making your money on a flip. So I tend to be an optimist about this stuff and think there are always times for people to get into business. And I think there’s more money out there. In the United States today, there are 10,000 some odd private equity firms and venture capital firms. Today when I started my career, there were zero. So there’s more money out there than there are for people to invest in. And if people have really good ideas and they have good leadership teams and they have a decent business model, business model being the key, and they think they can generate a return that’s higher than expectations, which means that you can generate a company. You create a company that’s worth more than it cost to build. If you think you can do that, then you have a chance to raise money to start a business. And that’s what makes America exceptional. I mean, that’s why this country has about a third of the world’s net worth. And we’ve been leading economy since 1871, and we’re about one and a half times. The second biggest economy today is because of a free enterprise system that works. What’s next for you, Christopher? I know you wrote this book. You’ve had multiple companies and exits. Are you working on anything new? Well, right today the book is the main thing. And after I get the book out, which will be out in May, and you can reorder it on Amazon and elsewhere. But right now the book is the thing. And then after we get into the second half of the year, I’m going to think about what I want to do when I grow up. Meanwhile, I’m teaching a class at Cornell University and guest lectures from time to time and keep my hands busy.
Buck: We certainly appreciate your thoughts and spending your time with us today. The book once again is The Value Equation, a business guide to creating wealth for entrepreneurs and investors. And I’m sure you can get that at every major place that you buy books. Is there going to be an Audible book here, too, Christopher?
Christopher: I don’t know that yet, but I would love to be able to create one.
Buck: Fantastic. Well, thanks again for joining us, Chris. Would love to have you back again in the near future.
Christopher: Okay. Well, Buck it is a pleasure. I enjoyed getting to meet you, and I’ve enjoyed reading your reader. Thank you.
Buck: We’ll be right back.