Dear Coffee Readers,
As predicted in the last edition of Coffee, inflation in April was the lowest in two years. May inflation was lower still and the Producer Price Index (PPI) was reported down for eleven consecutive months.
In that same edition, I noted that “surging” rent was the driving factor in the Consumer Price Index (CPI). The very next evening, I joined several other apartment owners in a suite at an Atlanta Braves game hosted by a lender. The CPI report was the topic of conversation. “Did you see that rents are surging?” I quipped rhetorically. The very idea seemed preposterous to all of us because we have real-time data that rents had plateaued. The absurdity of the report led us to play act searching for that “surging” rent growth under cabinets, seats, and even in the trash. None of us could find surging rent growth anywhere, let alone in our portfolios.
To add to the confusion, on June 12th there were back-to-back stories in the Wall Street Journal. The first announced May’s CPI, which included “surging” rents driving the inflation rate since rent comprises 30 percent of the index. But the very next story by Will Parker was headlined: “New lease rents are poised to fall on an annual basis for only the second time since the 2008 financial crisis”. How could both be true?
The rents for the CPI are determined using a telephone survey the same way the Fed did it back in 1950. They call people on their home phones! How credible can the data be when many of us don’t have home phones or rarely answer them if we do? Moreover, the Fed does not consider net effective rents (rents after concessions), and the survey data is compiled over six months, making the published rents inaccurate and woefully outdated. Rents were ending their upward cycle over six months ago. By using out-of-date data, CPI may be correct. However, rents today have normalized. And with the largest number of new units being delivered in fifteen years, rents could be under continued pressure. So, Will Parker is also right. Surely the Fed knows that rents stopped “surging” in October of 2022? Once we compare October 2023 rents to the same month last year, CPI inflation will ebb. But because the reporting is just that antiquated and slow it may not catch up to the data until April next year.
Given that inflation is coming down, housing costs are stable, and the credit crunch is about to clamp down on business activity, what’s with the Fed? They continue to loudly threaten additional rate increases. Will they – really? And what effect will Fed policy have on our economy and more specifically, on real estate?
Find that easy chair, pour a brew over some ice, and let’s discuss the Fed, with an emphasis on the future of real estate, particularly multifamily.
We Hold These Truths…
I previously noted that, below the surface of those reports the Fed watches, our economy is under strain. Announced job layoffs are considerable and recent claims for unemployment insurance are up. Banks have literally shut off their faucets. They are not lending. Companies that roared to life early after the global economic shutdown, are struggling now, while others late to restart are growing into normalcy. One such example is the hotel industry. It was decimated early in the pandemic, but it is now rapidly recovering. Some are calling this process a “rolling recession.” I tend to agree.
The truth is the Fed doesn’t understand what we are experiencing. Few of us do. There is no precedent for it. With the Fed Funds now 100 basis points higher than reported inflation, a dynamic inverted yield curve, the money supply contracting, withdrawal of government stimulus, and supply chain issues normalizing, inflation will right itself. In my view, to realize a 5-point reduction in inflation in nine months is considerable. The largest Fed rate increases happened in Q4 after inflation already began its retreat and the government’s Covid stimulus was terminated. The Fed’s preferred inflation gauge fell to 3.8 percent in May, the best in 25 months despite rents being noted as surging when they are anything but.
Anticipation…
Yet the Fed is using tougher, more hawkish language, the more dovish its actions. I am concerned that we are having a Heinz Ketchup moment. I remember those commercials back in my childhood when ketchup only came in glass bottles. As you opened the cap of a new bottle and turned it upside down, the ketchup didn’t seem to move. Hence the Heinz TV commercial ditty “Anticipation. It’s making me wait.” I vividly recall hitting the bottom of the ketchup bottle once, twice, three times. Yet the ketchup was taking its sweet time to dress my hamburger. Frustrated at the red condiment’s lethargy, I hit the bottle harder and harder. Finally, I hit that bottle one too many times, and wham, the ketchup spilled out everywhere. What a tasty mess.
That’s what I fear about these ten months of consecutive Fed rate increases. The Fed is hitting the back of the inflation jar. On the surface, inflation is coming down the bottle very slowly. But, if the Fed hits the inflation bottle with rate increases one too many times, we could have a mess on our hands, and the economic spillover, like that ketchup, cannot be easily cleaned up.
Whether the Fed raises rates another 50 bps this summer or not, the stresses in real estate are already very real. We have all seen the massive reckoning in the office space sector. Thirty percent of all office loans are coming due in the next year. Office owners won’t be able to refinance their maturing debt. We are seeing some of the most prominent institutions like Brookfield and Blackstone simply walking away from their office loans and handing back the keys to their lenders. Query what those lenders will do with them or what all these defaulted loans will do to the banks. Office defaults have dampened an already skittish real estate debt market including those who lend in other asset classes like multifamily. Hotel debt is already hard to come by. Hotel distress started much earlier in the pandemic and RADCO was able to take advantage of that opportunity. But let’s turn our attention now to multifamily to determine where it currently sits in the neck of the ketchup bottle by looking at a few recent anecdotes.
Reflections & Projections…
I asked our analysts to examine the properties we sold in 2021. Of the first five we reviewed, one has already foreclosed, another is in default on its loan, and a third is on the lender’s watch list. The other two used floating rate debt, one without a cap, and the other with an interest rate cap that expires next month. In short, all are under pressure or in distress. Meanwhile, in early June, I received a notification from one of the largest US banks that our loan officer was “temporarily transferred,” along with others, to its “Asset Resolution Group.” This means the bank is allocating its lending resources to work out underperforming and defaulted loans. The last time I saw such a move was in 2009.
The plain fact is that with interest rate hedges expiring, loans maturing, and rents barely growing, there will be a day of reckoning for thinly capitalized multifamily assets, especially for those purchased at a 2021 basis. It feels like it’s right around the corner. It may be a long corner, as lenders employ ‘extend and pretend’ strategies or borrowers resort to legal defenses. We do intend to buy value-add deals when the opportunities present themselves to the marketplace. But they may take time to work through the system. And, due to the risks involved, the cap rate spread over Class A deals needs to be much wider to justify the risk of investing again in this asset class. Right now, there are more buyers than sellers for this product, and a scarcity premium has priced these assets beyond my comfort zone. I believe rents ran too high to be sustainable in the workforce housing space. Working families will have trouble affording the current rent premiums, let alone additional increases now that stimulus cash is rapidly being exhausted.
Patience & Persistence…
But there is an opportunity coming soon that I do find compelling on a risk-adjusted basis. We can buy newer, high-quality assets in great locations below replacement cost, and at cap rates we have not seen in many years. There are several reasons for this shift in strategy. For one, new properties cannot easily refinance out of their construction loans. Second, institutional equity is itching to sell sooner because they need cash to cover their losses elsewhere or their redemptions. Third, most institutional equity, that typically buys these newer, well-located core deals, has moved to the sidelines. With the low-leverage debt available today, most buyers cannot raise the sizeable equity slug required to buy these larger deals. This paves the way for a company like RADCO that can raise institutional-sized equity to acquire higher quality deals. Fourth, the risk-adjusted returns are unusual for high-quality assets. Fifth, new apartment starts are nearly impossible due to higher construction costs and a lack of liquidity in the debt markets. When the current new supply is absorbed, there may be an opportunity for additional rent growth as tenants in these better properties are more qualified to pay them. Sixth, if we need to, we can pivot to hold these assets longer without worrying about the need for substantial capital improvements because the product is newer and will not suffer from obsolescence. And finally, I firmly believe that when institutional equity returns to buying multifamily, which it will, core multifamily assets will be their priority. Hence, we can see the exit for our acquisitions.
In the last four years, RADCO has only purchased three apartment communities. To give our recent discipline context, in the four years before that, we acquired about forty of them. We did not sit idly by these past four years even though we sold much of our multifamily portfolio. Besides pivoting to a once-in-a-decade opportunity to buy mid-market hotels, we invested heavily in our multifamily infrastructure to prepare for this next cycle. It is an exciting time for a company that prides itself on entering markets early in new cycles with the experience of turning around underperforming properties. RADCO is preparing the groundwork to form a fund to exploit the opportunity to acquire what would otherwise be institutional quality multifamily assets. This is a once-in-a-cycle opportunity to buy properties ordinarily dominated by institutions. It may be a short window and we need to take advantage of it.
Distressed real estate is our specialty. Whether the Fed raises rates again or not, if we have a recession soon, or if we somehow softly land our economy, the damage to much of the real estate industry has already happened, even if not obvious in the statistics being published today. Only new capital, combined with better execution capabilities can, to use our lender’s term, find “asset resolution” for these properties. RADCO is culturally and physically positioned for just such a market.
So, in addition to coffee, grab popcorn and a slushy (vodka optional), and let’s watch this new cycle story play out together.
I will end this edition on a high note by going off script. I would like to introduce my new and very first grandson, William Paul Hurd, born June 27, 2023. What a way to celebrate our nation’s birthday. For those of us who are concerned about the current state of things, holding William Paul in my arms offers me inspiration that our nation has a bright future. Happy birthday America!
Best Regards,
Norman