Our Perspective on the Current Economic Environment
Given the increased volatility in financial markets since the beginning of the year and increasing concerns regarding global and US economic growth, we thought this would be a good time to share our perspective on these economic developments and remind investors about our business model, which utilizes several layers of protection designed to safeguard investor capital under adverse financial conditions.
What we know for sure is that global financial markets have been very volatile during the month of January, and there are many smart people offering differing perspectives about what this all means for economic growth and the prices of both real and financial assets. Analyzing this data and evaluating these arguments is part of the macro economic analysis Iron Bridge performs on an ongoing basis. However, we will not outline our base-case economic scenario here or make an argument for why our scenario is the highest probability outcome. We know from experience that investment strategies that are dependent on specific economic events can be perilous, and we have witnessed many well-known investment managers lose money because either they made the wrong economic bet or the timing of their bet was wrong.
Our Top Defense Attributes
Recognizing this risk, we designed the Iron Bridge business model to be defensive and to perform well in most economic environments. It’s important to point out that these defensive features of our business model are separate from the “higher rate of investment return per unit of risk” that we believe exists in the private lending industry. For more on that subject, please see our recent post Why Private Lending Offers Asymmetrical Investment Returns.
While there can be no assurance that investors in the Company will not lose all of their investment, we believe that the Company’s business model has certain defensive attributes that may allow the Company to perform relatively well in adverse economic environments. The following is a list of defensive business model attributes that we believe have allowed the Company to perform relatively well between 2009 and 2016. There can be no assurance that these attributes would provide the same or any level of protection in the future.
The Company does not rely on increases or decreases in real estate prices.
The Company’s investment returns are primarily derived from the interest payments and fees paid by the Company’s Portfolio Borrowers who have generally demonstrated an ability to find profitable projects in various economic environments. We believe this is one of the reasons Iron Bridge profitability and investor returns have remained stable through depreciating, flat and appreciating real estate markets since 2009.
The Company generally makes short term loans of less than 12 months that enable both Iron Bridge and its Portfolio Borrowers to adapt quickly to changing economic conditions.
For example, if real estate prices soften and resale activity slows down, some of our Portfolio Borrowers may break even or lose money on current Projects because their estimated resale prices may prove to have been too optimistic. However, because these are short-term Projects with defined exit strategies, our Portfolio Borrowers are often able to adapt quickly by buying the next Project at a lower price to account for changing market conditions.
Changes in interest rates do not require the Company to re-price its Portfolio Loans, minimizing interest rate risk.
The Company has the intent and ability to hold its Portfolio Loans to maturity. Therefore, Portfolio Loans are stated at their outstanding unpaid principal balance with interest thereon being accrued as earned. Changes in interest rates do not require the Company to re-price its Portfolio Loans. However, changes in interest rates can create reinvestment risk related to changes in the rate of return available on new Portfolio Loans made by the Company.
The Company’s Portfolio Borrowers are more price setters than price takers.
Because our Portfolio Borrowers’ Projects are short-term, and their profits come primarily from the value created in the Project, we believe our Portfolio Borrowers are more sensitive to completing and selling their Projects quickly than they are to the current level of real estate prices. For example, between 2009 and 2012, when real estate prices were in decline, many of the Company’s Portfolio Borrowers were buying properties from foreclosure auctions at very low prices, rehabbing the houses, and then listing the houses for sale at prices that were often lower than competing listings, resulting in quick sales.
The Company’s loan portfolio is secured by residential real estate, which we believe to be a more defensive asset class relative to other sectors of the economy.
Real estate is a well-known inflation hedge, but what’s more important is that, in our view, the Federal Reserve and other policymakers are likely to prioritize the health of the residential real estate market over other sectors of the US economy. The simple reason is that consumption is approximately 70% of US gross domestic product and housing is the largest single investment for most consumers. Accordingly, we believe that policymakers will be unlikely to allow the residential real estate market to suffer for an extended period without taking action. The same cannot be said for other sectors of the economy, such as the oil and gas industry which has experienced a massive decline in energy prices since mid-2014 that has led to significant capital spending reductions and industry layoffs. However, from an economic perspective the benefits of lower energy prices transmitted through increased consumer spending generally appear to outweigh the negative effects of oil industry contraction.
The Company’s business model generates strong and stable monthly recurring revenues, which means the Company is well positioned to cover interest payments.
For the year ended December 31, 2015, the Company generated revenues of $10.3 million and combined interest expense of $3.7 million related to its private debt and Bank Borrowings. Revenues were 2.8 times the amount needed to cover this combined interest expense, with average portfolio leverage of 65% during 2015. We believe that this level of interest coverage provides a significant layer of portfolio protection that should help safeguard investor capital during an adverse economic event.
Investor capital is further protected by the value of the underlying real estate collateral.
As of December 31, 2015, an estimated $91 million in real estate collateral secured the $60 million loan portfolio. The value of the real estate collateral was approximately 2.2 times the amount necessary to pay off our private debt and Bank Borrowings combined ($42,179,273), and 1.5 times the amount needed to pay off our entire capital stack – equity capital, private debt and Bank Borrowings combined ($59,545,862). We believe that this level of real estate asset coverage provides another important layer of portfolio protection that should help safeguard investor capital during an adverse economic event.
Therefore, whether you believe that (1) the economy slips into a mild recession, and the December Fed rate hike was a one and done, or (2) the economy continues to muddle through, with sub-trend growth rates but stable unemployment and moderate inflation, limiting the Fed to just one or two rate hikes this year, or (3); economic activity reaccelerates, such that the Fed must raise interest rates by 100 basis points or more in 2016, Iron Bridge is prepared and well positioned to continue delivering superior risk adjusted returns, while preserving investor capital.