SUMMARY

What is the Fed and what does it do? In this episode, Steven is joined once again with Mark Gallinaro to talk about the federal funds rate and how the Fed is impacting the different treasuries that the US government offers.  Join us to learn how we are making decisions now with the information we have to be able to make smart investment choices.  

 

Key Takeaways

  1. By making interest rates lower, the Fed is being accommodative and promoting growth.
  2. What it means to the market when the Fed starts to raise interest rates, and start clearing things off of their balance sheet
  3. Discover how the Fed impacts the real estate market and the commercial debt markets
  4. The markets don’t know exactly what direction things are gonna go – there’s uncertainty, which is creating volatility, and fear in the market.
  5.  You have to identify those opportunities – have a conservative approach, have discipline, and have a strong understanding of your own personal investment strategy. 
  6. You make the most amount of money when things go from terrible to just bad. And you have the potential to lose the most amount of money when things go from great to just good. 
  7. Learn what great sponsors are doing during times of economic change like this.

 

Resources Mentioned

Interested in connecting with other like-minded individuals? Then join our VonFinch Private Capital Network.  Learn more at http://www.vonfinch.com/invest.

Episode Transcription

Steven Pesavento 00:05
This is the Investor Mindset podcast and I'm Steven Pesavento. For as long as I can remember, I've been obsessed with understanding how we can think better, how we can be better, and how we can do better. And each episode we explore lessons on motivation and mindset for the most successful real estate investors and entrepreneurs in the nation.

Steven Pesavento 00:31
Welcome back to the investor mindset podcast. I'm your host, Steven Pesavento, and each week we share mindset tips and real estate investing strategies to help you take your business and your investment portfolio to the next level. Today, I'm joined by our chief investment officer Mark Gallinaro how're you doing today, Mark?

Mark Gallinaro 00:48
Great, Steven, happy to be here.

Steven Pesavento 00:50
So we're gonna be diving into a topic today that is on everyone's mind. And I think it's very timely, we're gonna be talking about the Fed, what the Fed does and what the impact that the feds decisions have on the real estate market. And so with that said, I want to mark that today is June 21. And that many things change very, very quickly in the world today. So the conversation that we're going to have in relation to anything about the economy is time stamped today and could change at any time, we're going to continue to put out more information to share updates with each and every owner view about what that means for us what our analysis is on what's happening. But with that said, let's absolutely dive in to the conversation about the Fed. And I have to also advise that none of this that we talked about today is financial advice. And these are simply our views and opinions. So, you know, there's a lot of uncertainty in the media. This is why it's really critical to trust in the right experts, and to listen to the people who actually have a good solid understanding true practitioners in the field. So let's start out with a quick, easy definition. Before we dive into a much more complex conversation. What is the Fed, what does the Fed do?

Mark Gallinaro 02:18
So the Fed is the body that controls the monetary policy within our country. Now, Put very simply, as the Fed likes to describe it, they have a dual mandate. Part one of that mandate is to minimize unemployment. Part two is price stability, the way in which they do that is multiple, very detailed levers that they can pull. But essentially, they create policy that either is more accommodative to the economy, therefore, encouraging the economy to grow, or more restrictive to the economy, trying to bring in the reins a little bit. And a lot of times, you'll hear that accommodative policy called dovish, and the restrictive policy called hawkish. So those have been some pretty popular terms in the headlines. And I think it's important kind of for everyone to have a baseline understanding of what we're talking about. So the

Steven Pesavento 03:13
Fed is here for two reasons to control or influence employment, reducing unemployment, etc. And to control inflation or deflation. When you say price stability, that's what you're really referring to.

Mark Gallinaro 03:29
Yes. And obviously, the inflation part of that is what everybody is talking about right now. In addition to inflation, price stability really also means stability within financial markets, which is kind of another thing that they won't come out and say that they control but they are always keeping an eye on it.

Steven Pesavento 03:49
So from a simple perspective, why does the Feds decisions or hinting at a potential decision makes such a huge impact in the financial markets?

Mark Gallinaro 04:01
So really, the Fed right now when they're talking about the federal funds rate, it's implement, it's impacting the entire yield curve. And what I mean by the yield curve is the different treasuries that the US government offers two year Treasury 10 year Treasury 30 year and all of those different treasuries, impact debt markets, and they impact valuation on assets. The Treasury is considered to be kind of a risk free investment, because it is backed by the US government. If you give your money to the government, you expect your money back with the return that they promised. All risk assets. That's real estate. That's the public equities that can be crypto, all of these things are impacted by what's called a risk premium. So the amount of incremental return you would expect to get given the The amount of risk that you're taking over investing in the US government. So as the Fed is making some of these decisions, those decisions are really impacting all financial assets right now.

Steven Pesavento 05:11
So the federal the Fed has the ability to control the federal funds rate as well, which is influencing how cheaply it is for banks to move money between one another and be loaned money from the Fed. And so by pulling on these different levers, it is leading to different changes in the economy. And why does it end up leading to such a big change when the Fed, for example, makes interest rates much lower?

Mark Gallinaro 05:39
Well, by making interest rates lower, the Fed is being accommodative or dovish, and it's promoting growth, because low interest rates mean it's attractive to borrow, it's attractive to invest. And with everything that went on during COVID, and especially in March of 2020, with such a concern for what was going to happen to the economy, the Fed threw everything, including the kitchen sink at the economy to try to support it. So you had the significant rate cuts, you had an increase in the money supply, all of that to try to stimulate the economy, because of the level of uncertainty that we had at that point in time, there was real concern that the entire economy could come crashing down.

Steven Pesavento 06:26
So cheaper money means businesses and individuals can borrow that money in businesses can invest in infrastructure, and, you know, assets, and they can invest in people, and hiring and overall growth. And so we've seen a lot of growth happen, we've seen asset prices go up as a result of this cheap money. And we've seen that for quite some time, definitely during the pandemic, but we're also seeing fairly low interest rates for the last decade as well. What does that signal to the markets, when the Fed starts pulling some of those levers, essentially saying they're going to a raise interest rates, and be start clearing things off of their balance sheet?

Mark Gallinaro 07:12
What it signals to the economy is that we're going to be entering a period of slower growth. And taking a step back to Stevens Point. The question may be like, Why is the Fed doing it? And the reason is because of inflation, right now, inflation is being driven for multiple factors. But one of the biggest thing is a increase in demand for products and services, but a decrease in supply. And you have a lot of reasons for that decrease in supply. So what the Fed is trying to do right now is actually rein in the economy a little bit. They've actually we've seen too much growth, too much appreciation. So the Fed is using its levers to undo some of the things that they did in 2020, but to your point, have been doing for a pretty long period of time going back to the great financial crisis.

Steven Pesavento 08:06
And so what does that mean for the real estate market? What's the impact of this?

Mark Gallinaro 08:11
So when you talk about the real estate market, first looking at the residential market, we're starting to see a scenario where mortgage rates have gone up drastically, in a very short period of time, the debt market, especially as it relates to residential mortgages is massive. And the amount of volatility that we're seeing right now is almost unprecedented. So obviously, as it's more expensive for people to borrow, the same priced house is costing significantly more for borrowers. So in theory, and what the Fed is trying to do is actually bring in that housing prices by raising interest rates and having mortgages go up. Part of the problem, though, is the country is still short, a lot of housing, you have a lot of different numbers that come out. It could be as much as 4 million homes that the country is short, chances are that numbers may be more in the two to 3 million range. And that's just because we went through a period of time post financial crisis, where homebuilders are not building as much because housing was a lot of the problem previously. So that's it from the residential side.

Steven Pesavento 09:21
So on that just one of the thing about it is that people often say, Hey, are we heading into a bubble in the residential market? And the likelihood is, we don't know. But the likelihood is probably not because of this lack of supply. But also when you look at a chart and charts are really important, because we're able to see what's happening over time, we will look at CPI, which is essentially inflation versus housing prices. They've typically been right in line for nearly all of history. And right now they're right, matching up directly along that same line. The big problem means that wages have not necessarily caught up to inflation, which is causing some of that feeling like, oh, well, things are really much more expensive than they used to be, because people maybe aren't making as much money. But what's happening on the other side of the the other side of the coin,

Mark Gallinaro 10:17
as it relates to commercial, so commercial right now, the biggest impact that you're seeing, as far as the movement in interest rates is actually what it's doing to the commercial debt markets. The commercial debt markets, again, a massive industry, it's very efficient, you have a lot of commercial lenders within the space. And when went through this period of low interest rates, the low interest rates that you could borrow, were supporting the low interest rates that you were seeing on the cap rate side, now we have a period of time where the debt markets are moving. And again, because of the volatility, something that's less common in the debt markets, we're at a period of time where a lot of lenders are kind of unsure on their pricing. And with the amount of time that it takes a commercial project to close, you're seeing movements in the debt markets that are significantly impacting borrowers ability to get the financing that they thought they could have received. This will have some impact on cap rates, obviously, as we talked about counting that risk premium, but for the time being, in my opinion, the biggest impact is really occurring in the commercial debt markets.

Steven Pesavento 11:30
So the cost of that debt is going up, essentially. And there's a lot of uncertainty about how much it's going to go up, which is the real challenge that we're experiencing. On the commercial side. Is that what you're saying?

Mark Gallinaro 11:42
That's exactly what I'm saying. So markets like certainty, whether that's, you know, the equity market, the debt market, they'd like to know what's going to happen, and then everybody can price for it. If we have a pretty good idea of what's going to occur, then everybody can associate the level of risk and figure out the correct pricing for something. Right now we're in a situation where the Fed has, for lack of better term contradicted some of the things that they've said previously. And in the most recent Fed meeting, the June meeting, when Powell came out with 75 basis point raise. In some ways, he contradicted what he said previously, in the May meeting where the expectation was 50 basis points right now. So when you have these events that occur, that just add more questions versus providing clarity that causes the volatility.

Steven Pesavento 12:31
So the markets don't know exactly what direction things are gonna go. So there's uncertainty, which is what's really creating that volatility, and it's creating the fear that's in the market.

Mark Gallinaro 12:42
Yes, there's fear is running rampant in the market. Right now, there's a lot of different investor and consumer sentiment readings that you can look at, that are either at or even below some levels that we saw in March of 2020. And I don't have to remind you guys, but think back to March of 2020, and how much uncertainty there was about what shutting down a global economy and global supply chain looked like. And as we sit here today, there are some readings that measure that same level of fear in the market.

Steven Pesavento 13:18
So there's a lot of fear in the market. And, you know, we're experiencing volatility in the debt market. We're experiencing volatility in the consumer sentiment about where the economy is going and what's happening. And that impacts throughout all businesses. What impact does that have on our investment philosophy? And how are we making decisions now with the information we have to be able to make smart investment choices?

Mark Gallinaro 13:51
So I think it's really important to kind of take a step back and invest investing, it feels like there are really only two emotions, there's greed and fear. And that tends to drive most investment decisions. And Stephen and I talk about that we cannot let that be the deciding factor. So we need to take a step back, look at everything that's going on. In my personal opinion, we don't have the amount of uncertainty that we did in March of 2020. As I look out to kind of the future of the economy, the future of certain markets, the future of commercial real estate, I still remain bullish on commercial real estate as an asset class. And I think you need to kind of see through some of these short term noise, short term fear, uncertainty, doubt that is honestly being pummeled that all of us through a 24 hour news cycle through push notifications on our phone, and really look at it as kind of the big picture of commercial real estate being a strong asset to invest in.

Steven Pesavento 14:52
What does that mean?

Mark Gallinaro 14:55
So you have to look at really where the fundamentals are in Real Estate and you talk about things Location, location, location, you talk about markets, and I mean kind of cities and neighborhoods within cities that have actually benefited from some of the things that have gone on in the past few years. And for us, as real estate investors, we have to identify those opportunities, and also structure our deals in such a way where we're protecting our downside, but also looking at this period of time as an opportunity. When you look back at the great financial crisis, when you look back at.com bubble, as terrible of a time as those were for people, it also provided a lot of opportunities for individuals. So again, this Where is where having a conservative approach, having discipline, having a strong understanding of your own personal investment strategy. This is the time where you should be starting to implement some of those things.

Steven Pesavento 15:56
So what I'm hearing is that you're saying, don't stay in the state of fear. You have to look at it understand, well, what is the information telling me? What is the opportunity that the information is now creating for us because you can create great returns in any type of market. But the key is, you have to know what market you're in which the volatility ends up creating a little bit of uncertainty there. So how does an investor make those decisions about when to be investing versus when not to be investing?

Mark Gallinaro 16:35
So that decision, I heard a really great quote on that recently. And the quote was, you make the most amount of money when things go from terrible to just bad. And you have the potential to lose the most amount of money when things go from great to just good. So really, the kind of sign that was given on when things went from great to just good, was back in November, during one of Fed Powles Fed Chairman Powell was press conferences, where he had gone through this period of talking about inflation being transitory that they were going to continue to be accommodative. And then all of a sudden, in November, you saw a little bit of a pivot, and people call it the Powell pivot. And that's where he kind of started talking a little differently about inflation talking differently about the accommodative policy. And that was a period of time, we're actually in hindsight, and it's easy to look back. In hindsight, that's when things should have started to come a little bit more risk off. As we sit here today, things have been pretty terrible for, you know, three to six months now, there has been significant wealth destruction in the public equity market in the crypto market. And we kind of have to look at it now and make a best guess at where we are kind of in this period of uncertainty. And identifying the point in time in which kind of things go from terrible, to just bad, because that's when we start to get kind of that next upswing. We're always going to be in a cycle, there's always going to be another recession coming. But at the same time, that means that there's also going to be another cycle of growth companies as well.

Steven Pesavento 18:20
Yeah, it's really interesting, because when you look at the data, you can see that anytime during the last 10 years, if you are not invested in assets at the right time, you have not got the huge bumps that came whether that's in the equities market, or the real estate market. So when you're sitting on the sidelines, 100% of the time, it's difficult to know when to get in the game. And it's really hard to know exactly where you're at in the cycle, day to day, you can look back, as we can look back now and say, Hey, here's the impact of how things have gone over the last six to eight months, what has actually follow it on after multiple other press conferences that have, you know, given us more information, but at the core, when you're in this state of fear, and you realize that everybody else is in a state of fear, that is actually the greatest opportunity for creating great income and great returns. And that's when the best investors actually start prospecting for opportunities. That's when they start looking for opportunities that maybe have a little bit more growth potential or when they're make you start making investment decisions that try to reduce your risk, but still give you a decent return. And so I think what I'm taking away from our conversation here today, and many conversations with other smart people, is that the wealthiest investors are not pulling everything out and just sitting back, they're actually getting more aggressive right now is they're starting to see a little bit of a shift and that's why it's it's a phenomenal time to make sure that one you're spending time really getting to know who you're investing with how the deals that they currently are operating or doing. And most importantly, what is their strategy to head into the new kind of economic cycle that we're in. Because a lot of sponsors who are operating over the last three to five years, potentially even the last decade, they've had the tail winds of growth behind them. And so many of those people have been able to create great returns. And, you know, I think everybody who has created returns in the last 10 years can give a little bit of kudos to that cycle that we've been in. But this is where the rubber really hits the road. It's extremely important to know who you're investing with where those dollars are going. And are people actually being conservative? What actions are they taking, I know, personally, I've gone through, I've lost money in real estate, when 2020 happened, I went as liquid as I could, in order to take, take advantage of some of the opportunities that I saw available. The Fed ended up pumping in trillions of dollars. And so those opportunities did not come to fruition. But my personal philosophy and I know marks much more conservative than I am. My personal philosophy is to protect the downside at all costs. So I was willing to take 20% less of a return in order to make sure that I didn't have any kind of losses. And so that's the mindset that we're carrying forward as we're heading into this new economy. And with that mindset, when things do start getting better, as they eventually will, we'll actually be able to gain all of that benefit from being conservative by being able to come up over top of our performance.

Mark Gallinaro 21:45
Yeah, it's absolutely correct. And I kind of think of a warren buffett quote, with everything you just said, when he talks about when there's blood on the streets, time to invest, and I believe his most recent quarter, you talk about great investors, his most recent quarter was one of the most active that Berkshire Hathaway has been in recent memory. So to Stevens Point, you know, it's tough to kind of always watch from the sideline, and then expect to figure out that perfect entry point to jump in, you need to continue to stay active in the market, you need to really understand what's going on, and find opportunities to find good investment opportunities and appropriate level of return for the risk that you're taking. Because it's not good over the long term to kind of pull out completely. And then you could find a situation like we had during 2010, where there was such a large run up, and a lot of people missed out on that, because of the fear that they carried from the great financial crisis. Well, it's

Steven Pesavento 22:45
nearly impossible to pull out of the markets completely and still have a good pulse about what's actually happening. You just can't, you just can't be not invested, and still have a good idea of where growth is happening. If we were completely out of the markets, we wouldn't know that, that brokers are calling us asking for offers, we wouldn't know that there was a shift in the debt market, and that some of the terms have changed some of them that are actually we're going to use to our advantage in the type of opportunities that we're placing, because we can go and find other people who need what we're able to offer and therefore create a disproportionate return versus the amount of risk we're taking by going out and finding those opportunities. So what else would you add to the conversation about what really great sponsors are doing during times of economic change like this, so that investors can keep an eye out? And kind of have that alert up? Oh, that's somebody who's doing XYZ? That's exactly the kind of thing I should be looking for?

Mark Gallinaro 23:51
Yes, I think great sponsors are finding opportunities in areas where there is going to be some tailwind to it. So just as an example, you know, finding markets where the local governments have contributed significantly to the potential economic growth that's going to occur. Like I said, there have been a lot of trends that came out of 2020 that I think are going to continue. And there's a lot of money being invested to attract employers to attract talent. So sponsors who identify these macro trends that then have an impact on the micro markets. I think that's key. In addition to that, really having the discipline and the conservative approach to just weather this period of uncertainty and kind of the the storm we're currently in. And, you know, having a business plan that works and can weather the storm in order to kind of get through to the next side of it.

Steven Pesavento 24:50
Yeah, and what's really important within that business plan is reserves. Too many businesses run so lean, that they're able to squeezed out a couple more percentage points of profit for investors during good times. But those are the same investors that will get cleaned up on in any kind of economic change where they can no longer afford to cover the expenses of running that property during times that maybe aren't quite as rosy on a lot of folks, I've looked at a lot of deals that we passed on. And we see the pro formas of what people are putting those out on. And we're seeing the growth that's being projected 12 months ago, six months ago, two months ago, and it just doesn't really line up. And so those are great opportunities for us as operators and sponsors to keep an eye on because we already know the project, we already know the product. And we know that during times of change, there's gonna be an opportunity for us to be able to scoop that property up for our investors and create a better return. But it's really critical that cash reserves are being kept at the project level. So that during any kind of change, we're not seeing that impact. Our ability to pay debt or pay investors are doing the things that are necessary. What would you add to that?

Mark Gallinaro 26:12
Yeah, I think that's a great point. And when you're talking about the rent growth, that's that has occurred. That's not going to repeat itself for many factors. But keeping an eye on those opportunities, and knowing that, there could be a chance for us to come in and either acquire the asset or structure a investment, where we put ourselves in a better position. Again, this is why you always have to have a pulse on the market, you need to stay involved, you need to be getting those phone calls of what's going on. And, you know, there's gonna be a ton of opportunity that's going to be presented from this period.

Steven Pesavento 26:53
Yeah. So I think the thing to summarize our conversation on is, the Fed is here to influence the markets, their job, their mandate is to keep prices stable, and to keep employment in a healthy position. And they do that by making different decisions and hinting at different decisions, that they have the ability to go out and move the markets in those directions. And the media loves to feast on that fear. People will pay so much more attention to something when there's fear when there's the potential of loss, and they'll end up freezing up. And it's important to understand that that's a natural response. It's not something to feel bad about. Even us as professionals, we still fall into places of fear. During the pandemic, there was moments, either days or weeks where I was very uncertain, and very fearful about what was happening. But the important thing is to then connect with other people who know more than you about what's happening, who've been through this before, and can advise you to go down the right path. So at the end of the day, you have to make decisions that you're going to feel comfortable standing by. But with that said, it's really important to not get frozen in fear. If you're going to get frozen for a day or a week or a month. So be it. But catch yourself in that moment. And ask yourself, Where is the opportunity today? Who can I trust for this information? And who can I invest with that are going to make decisions where your best interest my bedsure best interests are coming to mind and that we're able to thrive during times of economic uncertainty, instead of kind of staying still and being in that place of fear. So thank you so much for listening. Great to have you on again, Mark, and I look forward to seeing you guys on the next episode. If you're invested in living in a state of prosperity and be able to move forward during any kind of craziness that's happening in the market today, head over to vonfinch.com/invest. We're putting out updates on what's going on in the market and our view on that so that you can follow along and make some decisions to grow your family's wealth, even while everyone else is hiding under their desks. So we'll see you next time.

Steven Pesavento 29:27
Thank you for listening to the Investor Mindset podcast. If you liked what you heard, make sure to rate review, subscribe and share with a friend. Head over to the InvestorMindset.com to join the insider Club, where we share tools and strategies from the top investors and entrepreneurs and how to take it to the next level.

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Steven Pesavento

The Investor Mindset Podcast & President VonFinch Capital

Steven Pesavento has always been obsessed with understanding how we can think better, how we can be better and how we can do better. He is an active real estate investor who curates Commercial Real Estate Investments for clients.

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