The Markets

The first quarter of 2019 was very profitable for stock investors around the globe. After falling sharply during the last months of 2018, stocks had their best quarterly gain in nearly 10 years because central banks around the world reversed course and abandoned their well-publicized efforts to instill discipline into government borrowing and spending trends.  The Federal Reserve went out of its way to assure markets that it would stop raising interest rates, thereby capitulating to proponents of larger government involvement in the developed world’s economies. Investor relief was palpable and anxiety surrounding trade talks between the U.S. and China, slowing growth in Europe and the ramifications of Britain and potentially Italy spinning out of the orbit of the European Union receded into the background.

The U.S stock market led the world again with technology companies leading all sectors, much like the last several years. The technology index gained 16.8% in the first quarter while industrial companies rose 11.8%. The broad-based index of all U.S large companies went up 13.6%. Overseas, stocks gained 10.1%. For the first time since 2014, all 11 Standard & Poor’s 500 industrial sectors ended higher for the first quarter of 2019.  The energy sector and real estate sectors both attracted a huge volume of investor interest as they each rallied around 16.5%. European stocks gained around 11.6% while China’s stock market rebounded sharply after a dismal 2018, and produced a whopping 22% return from January through the end of March.

Interest rates on 10-year U.S. Treasury bonds have declined 10% so far in 2019, and they are down almost 25% since last fall which is an incredibly large move. One would think that bond prices would have gone up a lot more than they did, but there is tremendous anxiety about the future of economic growth in Europe, China, and Japan and the effect of a global slowdown on America.  Due to declining interest rates, the U.S.  government bond market had a total return of 3.3% during the first quarter while the total U.S. bond markets were up 2.5% and a composite of all international bonds gained 2.8%. Long-term U.S. corporate bonds had the greatest increase, rising 8%, which shows they have an almost one-to-one inverse correlation to the interest rates. High-yield or junk corporate bonds continue to come to market at a torrid pace and some market pundits point to the U.S. high-yield or junk bond market as the place most likely to unravel during the next market panic.

The biggest winners in the commodities markets during Q1 were gasoline and hogs! Oil prices had their best 1st quarter start since 2002, rising 32%. Oil-producing nations overseas are trying to coordinate a decrease in production so that the price of oil does not sink much below $70 a barrel. The Saudi Arabian national oil company recently released its financial statements for the first time, showing itself to be the world’s most profitable enterprise. The political climate has affected the output of nations such as Iran and Venezuela and taking both of these countries supplies of oil offline has had a palpable effect on prices. Gold increased a mere 1% during the first quarter while silver continued its long-term decline, down 2.5%. U.S. farmers, hard-hit by the U.S. tit for tat trade sanctions policies, saw the value of their output decline and so have planted the smallest number of acres than at any point in the last hundred years in the hopes that prices will be driven up later in 2019.  The worst performing commodity in 2019 has been natural gas where prices are collapsing in most industrialized nations. Output from the U.S. continues to flood the market and even more new liquefied natural gas (LNG) export facilities are coming online soon to boost U.S. exports of energy.

The Economy

The U.S. continues to have one of the strongest economies in the developed world and government reports state that domestic inflation rates have remained low.  This has helped justify the Federal Reserve’s reversal of its interest rate policy. The White House is pushing the Fed to actually cut interest rates as a “precautionary effort” to head off the next recession.

In the real economy, the gross domestic output of the U.S., the broad indicator of goods and services produced across the economy, rose at a meager 2% annualized rate in the final quarter of 2018.  It showed a slightly worse result during the first quarter of this year, around 1.4%. Corporate profits in the U.S. are declining as the average company earnings is expected to go down 4% compared to a year ago. Technology companies in particular are expected to report profit contractions so investors are looking towards industrial and energy shares to power the market higher during the rest of 2019.

American consumers sharply pulled back on holiday spending in December of last year and January’s patterns were not much better. Prices for consumer goods across the U.S. economy have started to fall, and since the U.S. economy is driven by households’ outlays, the lack of growth in consumer spending is a major concern to some market experts. As a result, we may have seen 2019’s entire stock market gains achieved in the first two months of this year!

While interest rates have fallen in the market, the Fed is likely going to take no further action as it waits to see what happens in Europe and  China. International trade is at risk of falling off sharply due to the failure so far of talks to end U.S.-China and U.S.- European Union tariff wars.  A slowdown in the U.S. economy has long been expected and the Fed wants to be able to lower interest rates in a quick response to global economic events.  I remain unconvinced that they will have this option.  This is not a problem while global growth rates are sluggish, especially in places like Germany and Italy.

Germany will experience a change in leadership over the next few years as Angela Merkel steps down. The Italian government, run by ideologically driven groups, has proposed that the gold bullion reserves held by the Bank of Italy be reclaimed by “the people,” which would make for interesting times. France and England each have their own challenging economic issues to face and they are likely going to be  hamstrung by domestic politics that will crowd out any real potential growth in their economies for some time. Compared to Europe, the U.S. looks downright boring but attractive. Trump’s 2017 tax cut bill has lowered government tax revenues, but  government expenditures continue to rise.  This results in an untenable increase in the federal deficits.

The U.S. economy has been buoyed by these recent events that convinced the Fed to lower interest rate expectations.  There has been a pickup of a new home formation (by Millennials) which in turn has helped the production and consumption of durable consumer goods. Mortgage applications are up 9% in the first quarter. As noted above, U.S. corporate profits are declining and so are their employment ranks. As U.S.  companies continue to acquire their competitors, instead of creating new jobs, many thousands of jobs in the corporate sector are going away. U.S. companies are getting larger and more dominant in their markets, which gives employees and consumers less leverage in negotiating for either wage increases or price decreases.  With U.S. unemployment at historically low levels, wage growth should be stronger than it is and, unfortunately, most of the benefit of the continued bull market in stocks is going to a small segment of the population.

Asset Allocation

By Kyle Burns

From 2012 through the end of 2017, the U.S. stock market experienced a six-year period of declining volatility and, for the 14-month period leading up to January 2018, it never declined more than 4%. This was unprecedented as the stock market soared to new heights. Then, on February 5th, 2018 volatility returned with a fury, with the Dow dropping 4.1%. It was the largest stock market decline since August 2011. The decline made many investors nervous and they looked to retreat from the stock market.

Some investors and large institutions, looking to capitalize on the volatility, used the declines as buying opportunities. The constant buying as the market declined created rapid bounce backs and the market quickly recovered. The ups and downs of the market created an emotional rollercoaster for many investors, and there was a feeling of relief each time the market recovered. After several months of volatility from February through June 2018, the market settled back into a steady climb.

Investors welcomed the lower volatility and recovery in the market and, as their fears waned, they looked to add dollars back into their stock portfolios. However, the recovery was short lived, and in the final quarter of 2018 the US stock market declined 15.8%. Investors that bought back into the market saw their investments decline rapidly and they again looked to escape the market by selling stocks they had only recently purchased. Through the first quarter of 2019, these same investors have seen a near full recovery of the market from the decline at the end of 2018. The S&P 500 was up 13.6% through the first quarter and investors that sold are now kicking themselves for missing out on yet another turnaround. This brings us to the importance of strategy and asset allocation.

It is impossible to time the market. There are times when the market may present us with mispricing or we find value in a stock at a specific point in time. This is different than market timing. Market timing is when an investor looks to shift between asset classes or go in and out of the market in short term increments to squeeze out returns. Market timing requires a constant shifting of strategy and it has been proven many times that market timing is a losing proposition. When investors allow their emotions to dictate their strategic position, it can become a form of market timing. Investors buy when they feel confident and sell when they are nervous. In our experience, this often leads to worse results than just sitting tight.

When we talk with an investor about strategy, we work to find an asset allocation that fits their risk profile, and gives them comfort and relief from some of the anxiety they may experience when watching the ups and downs of the market. Finding comfort in a strategy often leads to better results because then market timing doesn’t come into play. By reducing investors’ anxiety over their investments, they will experience better returns and less stress.

Once a stock strategy is developed and adhered to, investors can further protect themselves through diversification within their selected strategy.  The market will always be unpredictable, and utilizing a strategy that emphasizes diversification leads to better results in the long term. The best asset class to own in 2018 was cash, however, it was also the worst asset class to own in 2017. It is highly unlikely that an advisor or investor would be able to choose the best performing asset class each year. By creating a portfolio that holds a broad range of both public and private market investments, investors greatly improve the likelihood of having consistent returns over the long-term.

Investment strategy

Given the dependence of the public stock and bond market on the largesse of central banks, we have been strong proponents of diversifying into private investments, particularly those backed by real estate. Many of our readers participate in some of these projects which run from small, direct loans to entrepreneurs seeking to acquire commercial real estate all the way to larger renovation and new construction projects targeted to the burgeoning population of Millennials entering their 30s and Baby Boomers entering or already in some form of retirement. The geographic location of our private projects has clustered around New York and Western North Carolina because it is in these two locales that we have teams of local persons who are knowledgeable and active in hands-on real estate deals. The demographics of those two are positive as well and, while each project has its own level of complexity and risk, I thought it would benefit our general readership to hear about some of the new projects we are undertaking with the local sponsors.

Below, you’ll find short summaries of two general kinds of investment vehicles.  Both are oriented towards the specific kind of private, real estate backed projects we have grown to specialize in due to their high degree of collateral value and our relative importance in the investments, which assure us a seat when major management decisions need to be made. The projects described below are available only to accredited investors, i.e., those individuals with net worth, excluding their personal residence, of over $1 million. It is interesting to note that the Securities Exchange Commission is considering changing that restriction for direct clients of registered investment advisory firms like the Rikoon Group. This would do away with the $1 million threshold for net worth or reduce it substantially, so long as the advisory firm conducts the proper due diligence on each project.

There are also samples of three individual generic projects noted as Opportunity Zone Funds that are especially suited for those persons who have realized or unrealized capital gains. In the last commentary, we generally explained opportunity zones. If you have an interest in learning more, please contact our office and we will send you further information on this portion of the 2017 Tax Act. In addition, we are happy to analyze your portfolio to see if these make sense for you to consider for future investment, whether or not capital gains are part of your personal tax picture. If, after reading the below synopsis, you have questions, please feel free to reach out by email or telephone and we will try to explain more fully the circumstances under which these investment opportunities can be pursued.

Income vehicle

The Income Fund has a national scope in terms of project location, a wide range of loan maturity dates, and is able take large investment positions in both direct and indirect loans. The Income Fund has been established to provide commercial real estate and other business loans to individuals, small businesses, and investment vehicles nationwide. Loans made by the Income Fund will provide access to capital for borrowers who are looking for alternatives to traditional bank loans due to the regulatory constraints on bank lending and to borrowers needing funds more promptly than commercial banks can provide.

Borrowers will be considered for their demonstrated track record of past financial success as well as making a positive contribution to the local community. When making loans or providing credit, the Income Fund may do so with the participation of other pooled funds, provided that the borrowers meet the same criteria as those considered for direct loans.

Representative Projects:

  • $1.6MM, 2-year loan for construction of 3 sets of luxury townhomes with priority on all assets as collateral and 35% loan to value, estimated 9% investor return.
  • $1.6MM, 2-year loan for land acquisition for a mixed-use development with first and only lien on collateral, estimated 10% investor return.
  • First mortgage loan to owners/operators of proposed continuing care facility with an estimated 9% investor return.
  • $1.5MM-4MM construction loan for mixed-use commercial/residential live/work project in mid-sized US city with an estimated 9% investor return.
  • $1MM construction loan for comprehensive residential development with estimated 9% investor return.
  • Commercial bridge lending fund focused on originating and servicing short-term commercial real estate loans secured by first lien positions on the underlying real estate as collateral, targeted 8.5% investor return.

Growth vehicle

The Growth Fund is an equity-based fund that complements the credit-based fund described above. The Growth Fund has been established to provide investors with the opportunity to participate in the ownership of a wide variety of commercial real estate business ventures. Most of these projects will be operated by individuals who are the Fund’s direct partners, be they individuals, small/medium size businesses as well as utilizing other pooled investment vehicles. Partners must be able to demonstrate a track record of past financial success as well as making a positive contribution to the local community. In addition, the Fund may invest in other direct private investment companies whose  portfolios meet the same criteria.

The Growth Fund intends on maintaining a focus on the return of Investor capital, regardless of market conditions, with a primary objective of capital appreciation. At least 55% of the fund’s projects will be done on a direct basis, through directly acquiring or financing properties (or portions thereof). Indirect projects provide Investors with the benefit of additional diversification across geographic regions, industrial sectors and project sizes, as the Fund will invest in the equity or provide other forms of financing to other sponsors’ commercial real estate projects nationwide. The generation of a moderate level of current income may occur as a result of the Fund’s normal operations through  rental or other income.  The Manager expects that much of the fund’s income will be sheltered by depreciation or other forms of tax credits.

Representative Projects:

  • Commercial development partner with retail, healthcare, and industrial projects in multiple asset classes nationwide that are developed, pre-leased, and then sold with a long-term lease within 24 months of original acquisition.
  • Purchase and renovation of commercial, residential, and vacation rental spaces in three buildings located in a mid-sized city.
  • Acquisition through bankruptcy auction of building in major metropolitan area to be developed into fully furnished co-living apartments with affordable housing allocations.
  • Acquisition and entitlement of a 53-acre raw land parcel in a prime location in the Southeast sold to residential developer for substantial investor return.
  • Acquisition of two boutique hotels in the Northeast with combined nightly occupancy of over 95%.
  • Acquisition through foreclosure action of six-unit retail building in mid Atlantic state that has undergone substantial capital improvements and is now fully leased and appreciating with positive net cash flow.

Opportunity Zone Funds

Project ‘1’ is a new construction development consisting of up to 64 efficiently designed one and two bedroom/studio rental units.  The project seeks to provide outstanding returns to investors and fill a market niche for reasonably priced live/work choices in southern Appalachia. The 64 units will, after the 18-24-month construction phase, be used as long-term rentals. The Manager anticipates this will be the plan until the ten (10) year anniversary of the Close of the Offering passes so as to be eligible to be a Qualified Opportunity Zone Fund.  In this way, Investors should receive several special capital gains treatment benefits  afforded under the Tax Cuts and Jobs Act of 2017 (“New Tax Act”).

The Manager hopes the Project will serve as a model for other moderately priced aesthetic  and eco-friendly environments designed specifically for singles and couples of all ages. It also should attract entrepreneurs as well as outdoor enthusiasts due to its proximity to a river, bike path system and Greenway.  The project involves developing the property in conformity with the recent rezoning to a high-density residential designation that allows for live-work units. It is contemplated that some of the residents of this neighborhood complex may not use cars because of the easy access to downtown and the popular use of bicycles in this locale.  This will allow the project to rent the garage/studio spaces for  premium prices on an as needed basis. The Project will be oriented towards single people and couples, especially those with a vocation or avocation that is enhanced by access to “studio” space.

As with other opportunity zone projects, this project will result in an extensive upgrade to the quality of the housing stock in the area. The contractor plans to use highly efficient construction building techniques along with an innovative landscape architectural layout.  Preliminary plans call for up to sixteen (16) buildings each consisting of four (4) living units.  The one bedroom will measure five hundred and sixty (560) square feet with a full living room.  Two bedroom units will be approximately 700 square feet.  The rooms will be factory-built off site and ready to install upon delivery.  The use of modular component bedroom/living room layouts should allow the project to be completed at a reasonable price and in a shorter time period than traditional construction methods.  The target total cost per square foot of building the residential units is estimated to be $150 per square foot, all in.  A typical one-bedroom rental unit of 560 square feet is projected to rent at a market rate of $1000 per month plus utilities.

The project is intended to qualify for Qualified Opportunity Fund tax benefits which may include the deferral, until December 31, 2026, of realized capital gains on assets sold no more than six months before Investor’s contribution of capital to the Project. The deferral of capital gains until the end of 2026 is supposed to be augmented by a 15% reduction of capital gains rate at that future date.

Project ‘2’ is a new construction development consisting of approximately 20 efficiently designed commercial rental units. The project seeks to provide solid returns to investors and fill a market niche for small commercial rental units for entrepreneurs, business owners and artists in this Southeastern city.

After the 12-18-month construction period, the units will be used as long-term commercial rentals. The Manager anticipates holding the project as a long-term investment, at least until the ten (10) year anniversary of the Close of the Offering passes so as to be eligible for classification as a Qualified Opportunity Zone Fund The Manager hopes the Project will serve as a model for other high quality unique commercial rental projects that serve local business owners and artists.

The  project consists of approximately 1 acre of gently sloping property on the edge of a residential neighborhood and a former industrial area.  Surrounding structures include modest single family and multi-family houses and apartments that are within walking distance to a large Target Super Center and multiscreen movie theatre.  In addition, there are many local businesses in the immediate vicinity including health and fitness studios, retail, and a new brewery.

Preliminary plans call for up to twenty (20)  units spread out between either two or three buildings.  Each rental unit will have an approximately 600-800 square feet commercial bay with a glass panel garage door and high-quality windows in the front and rear walls.  The goal is to provide ample natural light and open spaces for tenants to conduct their business.  Tenants will be able to choose from a menu of upgrades and components such as mezzanine levels, interior walls, and bathroom with showers to promote bicycle commuting and daily exercise.  Some of the units may offer private outdoor spaces and there will be the ability to connect multiple units for tenants desiring larger spaces.  The development team is considering both site built and factory built methods for this project.

The site will include ample parking and outdoor amenities, both private and public spaces, for tenants to connect with fellow tenants or find a quiet outside area. The sponsors hope to create a park-like environment, as one goal is to create a unique and satisfying work environment for  tenants.  The target total cost per square foot of building the residential units is estimated to be $150 per square foot, all in.  A typical rental unit of 700 square feet is projected to rent at a market rate of $1,000 per month plus utilities.

Project ‘3’  will acquire and substantially improve residential parcels in Opportunity Zones located throughout the Southeast  This will involve  the renovation of existing structures and or the construction of new homes on  parcels located in neighborhoods  that still have some room to fill up (ergo the term “infill”). The QOZB seeks to yield a solid rate of return over a ten-year holding period through the rental of single-family homes which are chosen at specific urban sites that have a high appreciation potential.  It is expected that Investors and Management will enjoy significant tax advantages for participating in this project located in an approved Opportunity Zone (“OZ”).  It will target neighborhoods with charming “character” homes that have  convenient access to amenities desired by Millennials and Baby Boomers. Infill development parcels will be assessed for their potential to generate rent, taking into account access to city sewer/water, road frontage, ability to build additional residences on the property, and suitability for  renovation of existing structures.

Existing home renovation and construction of new structures will be designed to maximize their rental potential during the first 10 years of the Project.  It is also a high priority to provide ways to economically maximize the sales value at the end of the 10-year period by making updates at minimal cost to highly desired features such as flooring, countertops, and bathrooms. The Manager plans to have a small reserve fund so that the QOZB has ready access to capital needed to preserve the desirability of each property before selling.

All aspects of the Project  will be designed to be consistent with the existing neighborhood character while providing more than normal modern features which are highly desired by residents. Some of the homes will feature the traditional Craftsman look, others may echo the mid-century style of certain neighborhoods.  New construction will have a more modern look and feeling, such as 9’ ceilings, and slanted roofs to offer more light. Most residences will have a smaller auxiliary dwelling unit (“ADU”) which means a small mother-in-law apartment, live-in garage or studio that will feature highly efficient “tiny” living with an easy flow to them for everyday use.

Staff updates

Rob Rikoon:  In February, I traveled for the first time to Amsterdam and then went on to Berlin. It was a short visit, three days in each place, but very inspiring. Amsterdam is best traversed via bicycle so my friend from junior high school and I rented bikes. We stayed in youth hostels to get the full flavor, or should I say aroma, of the experience! We toured the major art museums and bicycled out of town one windy afternoon, almost all the way to the North Sea! Berlin had a major impact on me, most notably the various memorials to the murdered minority populations of Europe, so, as a result, I plan to pursue, as my next art project, a series of monumental steel and concrete sculptures portraying the ongoing drama of human conflict and resolution, which is so palpable in the Eurozone.

Kyle Burns: My family and I were very thankful for the snow filled winter we experienced in Santa Fe this year. My kids participated in Ski Santa Fe’s White Tornados program where they enjoyed ski lessons every Saturday. This helped their skills improve, and taking them up the mountain also granted me some extra days of skiing. After two years of hard work, my wife Tabitha is graduating from nurse practitioner school this May. After graduation, she is hoping to work in a family clinic. I am looking forward to longer days with extra sunlight giving me more time for outdoor activities and playing sports with the boys.

Contessa Archuleta: With spring on its way, I am looking forward to seeing all the growth that is expected from the moisture we received this winter.  We haven’t seen this much snow fall in Santa Fe since I was child, and are very fortunate to experience all four seasons here.  I am excited about planting flowers in the yard and starting an herb garden with my daughter. It will also be nice to spend more time outdoors, which is where my family and I are most fulfilled.

Keren James: This winter has been a season of change and transition. My son moved to a new school at the beginning of January. He is thriving academically, and slowly making new friends. We celebrated his 11th birthday in New York City in April with family and yes, more dim sum.  I continue to learn and grow in my role here at the Rikoon Group, and enjoyed the time spent in NY that allowed me to visit the 72nd St. investment property. Though I have been exceedingly grateful for the moisture and snow we have seen, I eagerly await spring and hope for low winds and sufficient rain to see us into summer.

Anthony Penner: In February, my wife and I shared our 10 Year Wedding Anniversary. We celebrated the decade milestone by taking a week-long vacation in Fort Lauderdale, FL to visit my brother-in-law, followed by a short trip to the Bahamas for some relaxation time on the beach. After experiencing some much-needed warm weather there, we now look ahead to Spring in New Mexico to start enjoying some more backyard living with family and friends. Our daughter is also excited to start getting outside again as she currently is learning to ride a bike and we are all hoping to plant a garden this year.

Patrick Gendron: After a nice wet winter full of snowboarding and rallying in the snow with my Subaru, I am looking forward to the warmer weather and additional light for evening activities.  I have started to get out and take pictures again and am preparing my mountain bike for the time when the trails finally dry out.  Presiding over the board of ARTsmart, we had a successful auction dinner fundraiser in March and now are planning for our annual Edible Art Tour in June.  At my family’s intentional community in Southern NM, we had a very successful Equinox Meeting. It was nice to visit with my parents and soak in the hot springs under the stars.  I am now looking forward to getting my garden and yard ready for Spring and have a lot of projects around the house that need work.

Jeff Sand: With the warming weather, we have been able to make some progress on our casita and garage construction projects. The basic structures are completed: the roofs, walls, windows and doors. Next, we will focus on putting stucco on the exteriors and finishing the interior of the casita. We are planning to do some traveling and visit my step-son in Russia in May or June. It will be an exciting trip and our first visit there.

Gayle Johnson: I am so looking forward to spring and summer, aren’t you? My summer plans include water skiing, the Santa Fe Opera, family birthdays, and hopefully travel to a new destination as I have 4 continents to go and 14 more states to visit. More importantly, my 4-year-old granddaughter scored a goal at her first soccer game.  Her 16-month-old sister can’t wait to follow in her big sister’s footsteps.  So, what’s happening in the investment world?  Bitcoin, block chain, Brexit, inverted yield curve, IPOs, marijuana stocks, tax law cuts, volatility, and the Wall. Just add a train and an old dog, and we’ve got a Country Western song on our hands! Did you know that every day in the U.S. 10,000 people turn 65, or the largest hotel company in the U.S. (Airbnb) doesn’t own a single room? The largest global taxi operator, Uber, doesn’t own a single car, and Socrates thought the world was flat. The times, they are changing!

Upcoming Teas

Please join us for our quarterly gathering at 2218 Old Arroyo Chamiso in Santa Fe to discuss economic and market related events on Wednesday, June 26th from 3:30 to 5 p.m. (MT). The call-in” tea” will occur on Thursday, June 27th from 3:30 to 4:30 p.m. (MT). The call-in number is 719.234.7872, code: 470070#.