“I am so f___ tired of living in unprecedented times.”
- Random person on my Twitter feed
“Youth isn’t wasted on the young. Wisdom is wasted on the old.”
- Raymond Reddington, Blacklist
“Hard times create strong men (people), strong men (people) create good times, good times create weak men (people), and weak men (people) create hard times.”
- C. Michael Hopf
Before getting to the nitty gritty of what was a fairly painful quarter, I would appreciate your momentary indulgence while you join me for a quick dip into one of my very favorite destinations, the “hot tub” time machine. While any time machine would work perfectly well, I have always been partial to the hot-tub variety since the release of that mostly forgettable film series back in 2010. Just to get you in the mood and/or refresh your memories, I will provide a visual cue:
In any event, I would like you to imagine that this unique time machine has transported us back to the fall of 2008, mid-September to be precise. Try to remember where you were, how you felt, and what your views on the economy, markets and investments might have been at the time. For some of you, it won’t take much imagination because you were truly “there,” perhaps living in New York and working for a money-center or other bank, perhaps Lehman Brothers itself, as the world was seemingly on the verge of collapse. For others, we will remember it like a bad dream, like those of us who thought seeing Hot Tub Time Machine 2 was a good idea. And some will barely remember it at all, those of you who were fortunate to have still been in school at the time, and whom I envy just a tad.
Anyhow, Lehman, the 164-year old investment firm with some $700 billion in assets (and more, if you include those pesky off-balance sheet items) literally filed bankruptcy at midnight on September 15th of that year (after Bear Stearns had collapsed in March), setting in motion a global domino effect and crisis: numerous bank and financial firm failures (e.g., Wachovia, Washington Mutual, Merrill Lynch, Countrywide, CIT, IndyMac), the bankruptcies of firms from General Motors to Chrysler to Circuit City to Linen n ’Things, to the sovereign bankruptcy of Iceland, to the bailout of insurance giant AIG. Firms, households, and governments failed or were on the brink of doing so. It is hard to fathom that between October 2007 and March 2009, the S&P 500 fell nearly 60%, 37% in 2008 alone.
Now fast forward to today and how most, if not all, of us feel as we glance at stock prices most days, watch or read the news, peruse our third quarter brokerage statements, and/or consider how this unprecedented rise in interest rates has impacted our broader investment portfolios, including interests in real estate. Now I know a lot of you, predicting where I am headed next, are going to reply with something to the effect of “sure, I remember, and I know. But that’s history. This time is different.”
Ah, the old “this time is different.” Of course, every market crisis is different and I have been through more than a few of them: the stock market crash in October 1987, when the equity markets dropped over 20% in a single day; the global financial crisis and failure of Long Term Capital Management in 1998; the dot-com bubble burst and roughly 80% drop in the NASDAQ between the spring of 2000 and fall of 2001; the Great Financial Crisis (2008-2009); and most recently, the drop in markets at the start of the COVID pandemic when the market dropped roughly 26% in a single month (March 2020).
And so here we are. Knee-deep in what seems to be another crisis, or at least a significant bear market, with its own unique underpinnings: global inflation, an unprecedented increase in interest rates, and widespread geopolitical unrest. Yet the results are essentially the same. Markets are sharply lower, especially equities and fixed income securities. Investors are increasingly nervous, even seasoned asset managers. Commercial real estate prices, especially Class B and C office and retail assets, have declined significantly, with rapidly increasing vacancy rates.
Even multifamily values, which have generally shined in recent years, have declined at least 5 to 10%, if just because the sharp rise in interest rates cannot be offset by lagging increases in rents. Home prices are starting to soften, especially in markets like Boise, Austin, and Phoenix, cities which have experienced the greatest price rises in recent years. The U.S. Dollar has soared, reaching near parity with both the Euro and British Pound. And as though the bad news in the third quarter wasn’t enough, the Dodgers were eliminated shortly thereafter in the first-round of the playoffs, forcing me to watch the Padres face the Astros. Ughh.
The unprecedented interest rate hikes have resulted in nearly $8 trillion in losses in fixed income and equity markets, while investors in 10-year Treasury bonds have lost over 18% year-to-date (through October 15th), the worst performance on record. Several pictures set forth some of the sobering specifics and grim realities about this downturn:
And yet, in every previous crisis or significant downturn, markets and asset prices ultimately recovered, and then some, and I have every confidence that history will repeat itself. However, lacking true psychic powers, I can only state with unwavering confidence that the timing for such a recovery in asset values is uncertain. Academic research, if not common sense, tells us that even the most sophisticated and informed investors cannot time market peaks or troughs. I have repeatedly said that investors are fickle creatures and sentiments change quickly, sometimes shifting imperceptibly and quickly from the depths of pessimism to something very different, like how the coldest and loneliest craps table on any given night in Vegas can become rowdy and euphoric in mere moments and a handful of rolls.
Truth be told, it is not all bad news. Companies are continuing to hire, despite the slowing economy, with the unemployment rate presently sitting at 3.5%, after the economy added 263,000 jobs in September. Consumers are still spending, with the Commerce Department recently announcing that household spending rose by 0.4% in August, after dropping 0.2% in July. Core personal consumption, after stripping out volatile food and energy expenditures, increased 4.9% year over year in August.
While I expect spending to slow, retail sales and consumer spending have not fallen off the cliff as one might have expected given inflation - especially higher food and energy prices - and the market downturn. In fact, just last week the CEO of Bank of America said that their internal data suggests that the U.S. consumer is “healthy” and that customers “continue to spend freely, using their credit cards and other payment methods for 10% more transaction volume in September and the first half of October than a year earlier.” Other data supplied by Mastercard seems consistent with his perspective. And let’s be clear. It seems to me that consumer spending is contributing to the inflation we are witnessing, as much as supply chain kinks or excessive money supply.
So, how long do I think this downturn will last? What is my best bet as to the timing for an economic recovery? If I had Aladdin’s lamp in my hot little hands, one of the wishes I would make would be that I had the ability to see the future. My next wish would be that I could change it, if desired. My final wish would be that I also had a hot tub time machine. I think a hot tub time machine/Aladdin lamp combination would make quite the holiday gift, along with that Jewish space laser I have heard about. Unfortunately, while I continue to search for such a lamp, I have thus far been unsuccessful, though there were a few listings for “Aladdin’s Lamps” on eBay and Etsy. I remain skeptical, however, since they are all “pre-owned” with the potential wish-granting powers likely exhausted. The prices for such lamps also seem suspiciously low.
Anyhow, in many presentations I gave between 2011 and 2015, I would ask audiences a sort of rhetorical, but important, question: how long after March 0f 2009, when markets bottomed, did they begin feeling better, more optimistic, and start investing again? 2010? 2011? When did the memories of the Great Financial Crisis fade into the investment past? The answers to these questions likely provide clues as to the question posed above as to how long the downturn will last, since investor psychology plays such a significant role in financial markets and investing.
Historical data tells us a lot. While the S&P 500 dropped 37% in 2008, it was up over 26% in 2009 and over 15% in 2010, virtually recapturing all losses, and by the end of the 2012, that 37% loss had turned into a nearly 10% gain. Since 1990, the NASDAQ has experienced annual increases and decreases in value of over 30%, 11 and five times, respectively. In eight different years since 1990, the NASDAQ has increased over 40%, but only in 2000 did the NASDAQ decline that much. The conclusion? Trying to time markets is a fool’s errand. Bear markets last an average of 13 months and the S&P 500 slipped into an official bear market on June 13th of this year, while the NASDAQ entered bear market territory in April.
Does this mean that the market will turn during the latter half of 2023? Well, I only wish I could be that prescient, of course, but I would not be shocked if such a reversal came to pass. After all, there is still a heck of a lot of cash and capital sitting on the sidelines. I have provided this graph several times in previous updates, setting forth M2 money supply or the total value of currency held by the public, including demand deposits. While it has ticked down slightly in recent months, as bank depositors pulled about $270 billion from accounts in recent months, about $22 trillion remains on the sideline, very near an all-time high. Some of this capital, along with the $30 billion in equity that Blackstone just raised in its tenth fund and other “dry powder,” will most certainly find its way back to the markets in due course.
This is not to sugarcoat or ignore the significant uncertainties and challenges that lay ahead: inflation everywhere one looks; the Russia-Ukraine conflict and impact it has had on energy prices and the economies of Europe and the U.K., the latter which will have its third different prime minister in a matter of months; China and its significant economic challenges; the strong dollar (up nearly 20% this year, the biggest rise in 40 years) and the havoc it is wreaking on international markets, especially economically developing nations; the upcoming markdowns in private market asset values in everything from real estate to venture capital to private equity; and, of course, how central banks might respond with whatever tools they have in their toolboxes and whether those tools, including increases in interest rates, prove effective.
In part, one of the issues that is likely to determine how deep and how long this (or any) bear market lasts is systemic leverage. That is, with excessive debt and leverage, the risks that a market downturn persists and/or deepens increase. The process is depressingly intuitive. Asset prices decline, driving values below debt levels, margin calls are made (or foreclosures commenced), assets are sold under duress, and asset values are driven down further, and the process repeats.
So, how much leverage and debt are out there? How much systemic risk exists?
If one looks only at U.S. money-center banks (e.g., Wells Fargo, Citibank, Bank of America), their balance sheets appear adequately capitalized. In fact, according to the most recent “stress tests” conducted by the Federal Reserve, “capital levels remained above required minimums.” Fitch, one of the large credit rating agencies concluded that “U.S. bank capital levels remain robust” and they expect the banks’ earning capacity and capital balances to be “more than sufficient.” However, certain foreign-based banks (e.g., Credit Suisse, Deutsche Bank, UBS) are more leveraged and at risk. Moreover, in recent years, the “shadow banking” industry – think unregulated debt funds providing capital to asset managers in private equity, real estate, and venture capital - has ballooned.
These firms (e.g., Blackstone, Centerbridge, Cerberus) typically provide short-term and variable-rate debt financing to real estate asset managers like Clear Capital or corporate private equity firms to fund acquisitions and repositioning strategies, and it is virtually impossible to know how much of this debt is out there, as they are largely unregulated. It is certainly hundreds of billions, and this segment of the capital markets has grown substantially in recent years. It is this debt which is most likely to create distress as the debt issued by these funds tends to be variable and shorter-term in nature.
How these funds respond to leveraged borrowers and asset distress remains to be seen. Much depends on whether the Federal Reserve is successful in tamping down inflation and interest rates, the hedging strategies employed by particular borrowers, and the financial strength and experience of borrowers. We shall see. Let’s just say that I am glad that Clear Capital and its principals have extensive experience in these markets, solid capital reserves, and a focus on the multifamily market where fundamentals remain strong (see below). Having said that, we, too, have a significant amount of floating-rate debt across our portfolio and even though it is hedged, the relevant rates and borrowing costs have increased considerably in recent months.
My sense is that less experienced borrowers, “zombie companies” (those with negative free cash flows and business models that may not be sustainable), and private equity firms with less of a track record and less capital are at the greatest risk in the current market environment, assuming interest rates remain high or continue to increase. While I believe workout specialists and bankruptcy attorneys will be busy bees in the next 12 to 18 months, I don’t see the sort of systemic risk here in the U.S. that existed back in 2008 to 2009. That is, this downturn is not a banking crisis. I also predict that most lenders will work with borrowers when practical, knowing that forcing borrowers into bankruptcy and/or taking back assets often leads to suboptimal outcomes.
How have residential real estate values fared so far in 2022 given the economic dislocation? What is happening on the rent and occupancy front? Have the fundamentals changed and what is the outlook for the sector?
In the multifamily market, we are witnessing a period of “price discovery,” as sellers remain in a state of nostalgia, if not denial, failing to appreciate that asset values have declined (perhaps temporarily) by at least five percent and likely more, while buyers are hoping to pick up prices on the cheap, hoping to take advantage of price dislocations and distress. Each is off on their timing. The math, yet again, is simple, if not sobering. Interest rates have risen so much and so quickly, immediately increasing borrowing costs, while rental growth lags.
Hopefully, interest rates will moderate in response to the Fed’s discount rate sledgehammer (they raised rates 0.75% at the end of July and Fed rhetoric foretells rate increases to come), while rents will continue to grow, perhaps less rapidly than they have in recent years. However, not even 9% year-over-year rental increases, as we saw in September, can compensate for the new, if even transient, yield-curve and interest rate reality. At last glance, the 10-year Treasury yield approximates 4.25%, up some 42 basis points (0.42%) since the end of the third quarter. That is a remarkable move, following other remarkable moves. I can relate to what that anonymous tweeter that I quoted at the start of this letter feels. In any event, the short-run impact of these interest rate moves on asset cash flows and values are not inconsequential, and patience and prudent asset management have become even more paramount.
And 30-year fixed rate mortgage rates? They have mimicked the move in U.S. Treasuries, with record-setting increases.
Not surprisingly, in the face of economic uncertainty, substantial declines in equity values, and a drop in consumer confidence (which hit an all-time low in June, according to the University of Michigan), rents declined in September, the first monthly drop since December 2020. Specifically, they declined 2.50% between August and September, according to Redfin. Of course, they are still up 23% since August 2020 and should rebound given that the underlying demand and supply fundamentals for multifamily assets remain squarely intact, and we have seen this play before, in previous crises or downturns. Rents decline through downturns but then recover strongly. I anticipate this history will repeat itself, at least in time. However, I think it is also safe to say that the double-digit rent increases we have witnessed in recent years have gone south for the winter, and likely beyond, so to speak.
One of the drivers of multifamily demand has been the decline in “home affordability,” which sits at the lowest levels since 1989. It may be mixed emotions, but such affordability challenges present substantial tailwinds for the multifamily market. I see nothing that will derail this trend, which I see as long-term and structural. Most future housing needs will be satisfied by higher-density, multifamily units. The “American Dream” of homeownership will likely become a compromise of sorts, perhaps the less fulfilling dream of living in a well-appointed, Class A apartment, in a project with all the fixings: pool, clubhouse, gym, dog park, business center, laundry services, etc.
I suppose it can come as no surprise that according to the WSJ/Realtor.com Emerging Markets Index, released this summer, Elkhard-Goshen, Indiana is the top “emerging housing market,” based on “solid economic fundamentals, in-demand amenities and lifestyle options, along with a critical dose of affordable homes.” Elkhard-Goshen was followed by Burlington, North Carolina, Johnson City, Tennessee, Fort Wayne, Indiana, and Billings, Montana in the rankings. I can honestly say that I have never considered investing in these particular markets and would have difficulty identifying any of them on a map.
Maybe that is the very point. The best housing markets in the future won’t be found on our coasts, downtowns (Central Business Districts), or in the heart of cities that have been such attractive destinations for new residents over the past decade (e.g., Atlanta, Nashville, Charlotte, Phoenix, Boise, Austin, and Dallas). These are trends that have accelerated since COVID made its unwelcome appearance and remote work became a viable option for many professionals and households. It is all about where that proverbial “puck is going” and not “where it’s been.”
One other challenge contributing to the lack of single-family affordability relates to a rhetorical question recently posed in an article from the New York Times: “Whatever Happened to the Starter Home?” In the 1990’s, a typical “starter home,” a three-bedroom, two-bath home, was 2,000 to 2,200 square feet and cost about $100K. Today? That same home would be 2,300 to 2,600 square feet and cost five times as much. Some of these changes and the higher prices that follow have been caused by increased land and construction costs, minimum lot sizes required under local zoning rules, and increased infrastructure requirements (e.g., green spaces, community resources).
Another byproduct of the drop in housing affordability and perhaps a partial explanation of the increasing size of single-family homes is the growing trend towards multigenerational households living under one roof. Such a phenomena is routine elsewhere, but historically has not been the case in the U.S. Well, just as “necessity is the mother of invention,” high housing costs are compelling many generations of the same family to cohabitate. Seeing Charlie Bucket, his mother, Hellen, Grampa Joe, Grandma Josephine, Grandpa Ubeck, and Grandma Georgina all crammed into a small house in Charlie and the Chocolate Factory always seemed a bit strange to me, even as kid mostly interested in the darn chocolate. But that may soon be more of a norm.
This prediction is supported by a couple of recent studies, the first out of Harvard and sponsored by the U.S. Census Bureau, which concluded that Millennials don’t stray too far from where they grew up. The study found that by age 26, more than two-thirds of young adults in the U.S. lived in the same area where they grew up, 80% lived within 100 miles, and 90% within 500 miles. Migration distances were shorter for people of color and those of financial means (read: wealthy). The reluctance of Millennials to move far away is backed up by other studies showing declines in mobility. Of greater interest, I think, was a second study, based on a Pew Research Center Survey, which showed that a quarter of U.S. adults aged 25 to 34 resided in a multigenerational household in 2021, up from just 9% in 1971.
In any event, as a result of the higher mortgage rates and declining consumer confidence (and to nobody’s surprise), single-family home sales have fallen for eight straight months. And let’s face it. Any homebuyer who was lucky enough to secure a 3-ish%, 30-year fixed rate loan (or even lower rates on 15-year mortgages) during 2020 or 2021 is not going anywhere, as they are restrained by these mortgage handcuffs. They cannot afford a higher-priced replacement house, with 30-year mortgage rates approaching 7%. In addition, I recently read that Blackstone and its single-family rental business had ceased home purchases in 38 cities, including Boise, Fresno, and Memphis. Other institutional homebuyers – Invitation Homes, American Homes 4 Rent, and KKR’s My Community Homes – are among the institutional landlords that have also slowed home purchases. As a result, existing-home sales dropped 0.4% in August from July and nearly 20%, year-over-year.
It really is a question of geography, however. While existing-home sales declined in every region of the country, certain markets, specifically those that saw the greatest growth and appreciation in recent years, have seen the sharpest drops in transaction volume, cities like Boise, Austin, Phoenix, and Atlanta.
As a sidenote, this seems like an appropriate place to add that I expect upcoming sales figures from the likes of Bed, Bath, & Beyond to Home Depot to Lowes to my beloved Costco to suffer from these declining home sales. Fewer home sales translate to fewer furniture purchases and fewer trips to building supply stores and other retailers that generate significant sales from new homeowners. Consistent with this thesis, Restoration Hardware recently indicated that it expects net revenue to drop between 15 and 18% this quarter. In addition, U.S. mortgage lenders, especially those that are non-regulated and not required to maintain certain minimum levels of capital reserves, are feeling the pain. First Guaranty Mortgage, majority owned by PIMCO, the large investment management firm, recently filed for bankruptcy, and I suspect they are the first of many mortgage lenders which will fail.
However, in the face of declining sales volumes, home prices overall have remained reasonably firm, at least in most markets, as I have predicted. It is simply a story of inadequate supply and pent-up demand. In August, the median home price for existing-home sales across the U.S. increased 7.7% year-over-year, though they declined 0.7% month-over-month. I believe home prices overall will decline five to 10% nationally, with certain markets, the likes of Boise, Phoenix, and Austin, falling further. It is a question of gravity to some extent (“what goes up…”) and the thesis is supported by recent data out of Boise.
Regardless of what the demand for housing may be looking forward, the real story remains on the supply side
Over the years, I have repeatedly pointed out that the increasing cost and difficulty in adding to our housing stock, both single- and multifamily, essentially guarantees that real rents would increase over time, a story that has played out, certainly for better and worse. That continues to be the case. Everything from the lack of buildable lots, increased building costs, a shortage of labor and contractors, restrictive neighborhood CC&Rs (covenants, conditions, and restrictions) and good old NIMBYism remain a persistent and consistent theme. And now we throw higher borrowing costs into the mix. The net result is that it becomes harder and harder for potential construction projects to pencil. While housing starts unexpectedly increased 12.2% in August from July, housing permits issued, foretells future construction, declined 10%.
Affordable housing projects, those dedicated to tenants whose incomes fall below certain thresholds, are becoming increasingly hard to finance, as they become squeezed not just by the higher construction and borrowing costs, but by the inability to receive market rents, an economic vice of sorts. Without substantial subsidies and/or other financial support (e.g., tax credits), these sorts of projects are not viable, sadly dead on arrival.
Meanwhile, a recent study published by the National Multifamily Housing Council and the National Apartment Association found that 4.3 million more apartment units will be needed by 2035 to meet anticipated demand. Developing needed units at affordable rents will be no easy task. One particular anecdote from this past quarter highlights the challenge. You may have read the story about how Marc Andreesen, the founder of Netscape and a well-known (and very well-heeled) venture capitalist and his wife, actively protested the construction of a whopping 58 apartment units in their tony “enclave” of Atherton, California, a hop, step, and jump from the Stanford campus, where the average home sold for nearly $8 million in 2020 and where more affordable housing is desperately needed to house the folks that educate their kids, serve them food and drink in local (mostly upscale) dining establishments, or just bag their groceries.
As part of their protest, the Andreesens and other of life’s lottery winners submitted letters to City Counsel expressing concern about not just “traffic, tree removal, light and noise pollution, and school resources,” but “massive decreases in home values.” The obvious hypocrisy becomes even more evident when one considers that Mr. Andreesen recently agreed to invest $350 million in Flow, a new start-up led by WeWork founder, Adam Neumann, whose strategy is to address the country’s “affordable housing problem.” In a related story out of Woodside, an Atherton-adjacent community, the Woodside government announced that it was designating the city as a “sanctuary for mountain lions” in order to avoid a new law requiring that a certain amount of housing be added to their community. California’s attorney general sent a letter to the city (certified, I am sure), accusing Woodside of “deliberately attempting to shut off the supply of new housing opportunities.” Only after the Department of Fish and Wildlife advised officials that the proposal was illegal, that it could not designate the entire city as a mountain lion habitat, did the city relent. You can’t make this stuff up.
In another thought-provoking and relevant article, the Wall Street Journal argued that the U.S. is “running short of land for housing.” Perhaps we can file this story under the old adage from Will Rogers, that we should all “buy land” since “they ain’t making more of it.” While any flight over the middle of the country would seem to confirm that we have plenty of empty land, much of it is not buildable, lacks any infrastructure, has no meaningful source of water (worsened by climate change), and is expensive, having nearly doubled in price over the past 15 years. Much of the land is owned by the Bureau of Land Management and is not available for sale or development.
And inflation? What is driving it? Supply chain issues? Excess liquidity and money supply? Robust consumer spending?
I don’t think it would be too controversial to argue that inflation remains the most significant uncertainty the markets face and thus far, the data continues to be sobering. September consumer prices increased 8.2% year-over-year, and even if we were to exclude volatile food and energy prices, inflation clocked in at 6.6%. The culprits continue to be a little bit of this and a whole lot of that, but let’s not kid ourselves. Supply chain challenges and excess money supply may be contributors, but we should not and cannot understate the impact of the consumer, who continues to spend.
The net result is increasing costs of anything and everything, from housing to food to energy to insurance to booze to airfare to hotel rooms. And it doesn’t matter whether you are staying at the Four Seasons or if Tom Bodette is leaving the light on for you. Wages, while on the rise, are playing catch-up, unless you are a lobbyist or free agent in professional sports.
You may recall that in previous memos I discussed how the very modest inflation we have witnessed over the last 20 years might be the byproduct of certain exogenous realities: the “three A’s” (Amazon, automation, and artificial intelligence) and the outsourcing of manufacturing and certain services (e.g., call centers) to lowest-cost markets (e.g., Southeast Asia, China, India), Fed policy, and even the pandemic. However, one has to wonder if some of these trends, along with an aging demographic, are reversing, creating inflationary pressures.
Here is the thinking. Over the past decade, increasing asset values (principally stock prices and real estate) compelled the departure of those 55 and over (read: asset rich) from the workforce and allowed for their early retirement (kudos to Tom Selleck and those reverse mortgages). According to the U.S. Census Bureau, around two million workers are “missing” from the U.S. labor force, after accounting for slower population growth and the aging of the population. The result is a decline in the supply of available labor. Meanwhile, these sprightly retirees consume, and according to research, consume even more than they did before. While they might purchase fewer capital goods (e.g., homes, autos), they increase spending on everything from travel and leisure to healthcare, thereby increasing inflation, net-net. In addition, with fewer available workers, wages rise and create the potential for a wage spiral. The dual Fed mandate of “full employment” and “price stability” become incompatible. Such a thesis seems plausible and may mean that inflation will not prove transient no matter how much the Fed increases interest rates.
However, declining asset values may reverse this trend. With the S&P 500 and NASDAQ down 23.2% and 32.3% year to date respectively, at last glance, some deflation is quite transparent. Softening rents and housing prices are also clearly deflationary. Moreover, inflation is expected to ease if the inverted yield curve or investor surveys are to be believed. On the other hand, it would be naïve to assume that inflation will approach the Fed’s two percent target anytime soon.
The labor market, at or near full employment, continues to shine, though layoffs loom
As mentioned above, the national unemployment rate sits at 3.5%, matching July’s 29 month low and better than the expected 3.7%, according to those economic pundits. Thus far we have experienced a job-creating slowdown, the flip side of the more often witnessed “jobless recovery.”
However, with many firms recently announcing job cuts – U.S. employers announced nearly 30,000 job cuts last month, a 46% increase from August – I sense that the labor market is beginning to experience a sort of bifurcation, where employment levels decline and job cuts accelerate, while the economy softens, and wages rise. Hearing that the IRS plans to add nearly 90,000 new agents by 2031 is truly the definition of mixed emotions (replacing the more traditional definition, seeing your mother-in-law drive off the cliff in your new Mercedes).
Traditionally, the Phillips Curve (named after the economist A.W. Phillips) predicts that inflation and employment have a stable and inverse relationship. Simply put, economic growth creates more jobs, higher employment, and inflation. However, the “stagflation” experienced in the 1970’s, where both inflation and unemployment levels were high called the theory into question, and it remains to be seen whether 2023 will represent the unwelcome sequel to the late ‘70’s. If recent job openings data prove probative, such may be the base. In August, the number of job openings in the U.S. dropped to 10.1 million, the lowest level since June 2021, and down from a record of 11.9 million in March.
Meanwhile, even with wages increasing five percent in September, real wages, after inflation, declined 2.5% from the prior year, and 0.1% month-over-month. As I have mentioned many times before, higher wages will allow households to pay more rent, so it is generally something we welcome, provided it does not create excessive inflationary pressures and higher interest rates, those good old mixed emotions yet again.
After a springtime lull, policy makers had active summers as they continue to try their darndest – albeit unsuccessfully – to address the issue of affordable housing
In just the last month, two articles really caught my eye, one in the Economist, (“More Cities are Passing Rent Control Laws. Is That Wise?”) and another, from the New York Times (“Rent Revolution is Coming”), confirming trends I have seen coming for some time. It is all so predictable, and contrary to common belief, it isn’t a blue or red state thing. In fact, the Times’ article focused on Kansas City, Missouri, where a recent city council meeting was repeatedly interrupted by chants from protestors in attendance: “The rent is too damn high! The rent is too damn high!” With a modest population of 500,000 and a median home price well below that of countless other locales, one would not usually think of Kansas City as some sort of hotbed for a renter uprising.
Yet, even in the reddest of states, unhappy constituents are seeking help from politicians, who are eager to place and pander for votes. This unhappiness extends across the economic and political spectrum. On one end are renters who aspire to purchase a home but have had their dreams dashed by high mortgage rates and high home prices. On the other are low(er)-income tenants, who make up the bulk of the 11 million households across the country which spend at least half of their income on rent. And in between? A hollowed-out middle class steadily finding themselves stuck in the proverbial middle, unable to qualify for rental assistance (or sympathy) and finding a greater share of their incomes going to rent.
Thus, it should come as no surprise that rent control has found its way to Florida, a state which banned the practice in the late 1970’s. In August, officials in Orange County, Florida, located in the center of the state and home to Orlando, placed a rent control measure on November’s ballot, which would limit rent increases to the consumer price index. They also approved a measure requiring landlords to give 60-days of notice before any rent increase of more than 5 percent can be implemented. In June, lawmakers in South Portland, Maine voted to limit annual rent increases to 10%.
From Pomona, California to Kingston, New York, to a local community near you, additional rent restrictions and controls are a-comin.’ In Nevada, the North Las Vegas City Clerk rejected a petition to include a rent control measure on the November ballot citing “insufficient valid signatures.” The petition, initiated by the Culinary Workers’ Union Local 226, failed to reach the 15% threshold of voters who had voted in the previous city election, according to Rodgers. The union is seeking a review of the ruling.
In Maryland, The Montgomery County Council held a public meeting this week which included discussion of a proposed measure that would place a 4.4 percent cap on rent increases. Several organizations and property owners spoke out against the bill at the hearing. I can only imagine when residents in Idaho, Utah, and Montana sporting Make America Great Again hats, waving American flags, and shouting from the rooftops about the dangers of socialism begin lobbying local politicians to “just do something” about the higher rents in Boise, Salt Lake City, and Billings. It seems that everyone becomes a socialist when money earmarked to them is at issue. Or when the rent is “too damn high.”
Finally, back to good ol’ California, which passed statewide rent control in 2019, recently passed Senate Bill 6, which allows residential construction on commercially zoned properties without the lengthy and costly rezoning requirements. Thus, in theory, vacant stores could be converted to housing. However, the law is no panacea. While it might streamline approvals and ultimately allow for the development of more housing, it fails to address the other significant impediments to new supply, discussed above (e.g., soaring costs and higher interest rates, a lack of labor, environmental reviews). Finally, Los Angeles’ City Council voted to finally allows landlords to evict tenants whose rents are in arrears, but not until next February. That’s right, next February. As Tom Petty said, and said well, “the waiting is the hardest part.”
And, of course, I would be remiss if I failed to include some other tidbits I found interesting and which impact real estate markets, values, and/or transactions
- The U.S. population is getting older and poorer, and Gen-Zs are in no rush to walk down the aisle: one of the biggest concerns that I have and have repeatedly expressed is that the U.S. is mimicking Japan in terms of demographic trends. Between 1955 and 1990, Japan’s GDP grew at an impressive 12% per year. However, since then Japan has grown anemically, 0.6% per year, principally resulting from not just an aging populace, but a declining one. With Gen-Zers taking their sweet time to not only marry and procreate, despite ABC greenlighting and airing more episodes of The Bachelor and Bachelorette than ever, our fertility rates are declining rapidly, and we are headed down a similar path. The inability of Democrats and Republicans to get their you know what together and pass meaningful immigration reforms and policy isn’t helping.
Meanwhile, the Gini Coefficient or “wealth inequality index” is at its widest, 0.494. Nearly 38 million Americans, or nearly 12% of our entire population, are considered poor, a 10% increase over 2019, before COVID.
- The commercial real estate market is showing some cracks: for the first time since the start of the pandemic, commercial real estate asset values (e.g., office, retail, and industrial) are beginning to soften.
The office market is significantly oversupplied. The trend towards reducing the amount of office space a tenant rents per full-time employee had begun to fall about ten years ago, as “creative,” or more open-air, office plans became popular. Throw in technological advances and a dose of COVID and remote work, and you have a near crisis on your hands. The physical vacancy rate for office space in Los Angeles is 20%, but brokers will tell you that the economic vacancy is more like 30%.
In fact, I just read that L.A. office tenants have put some 9.6 million square feet of sublease space on the market, up from 9 million square feet at the end of the second quarter and 8.2 million square feet at this time last year. But according to brokers, takers are few and far between. Meanwhile, in the Big Apple, KPMG just announced that it is reducing its N.Y. office space by 30%. I really would not want to own any Class B or Class C office space, just about anywhere. The fundamentals are not pretty.
And the industrial market? It, along with multifamily and self-storage markets, has been the hottest sector in commercial real estate in recent years, driven by growth in on-line retail (Amazon itself has been a voracious consumer of industrial space in the past decade), last-mile delivery, the legalization of cannabis, and the onshoring of production of certain goods driven by pandemic demand. While national vacancy rates are still very low, they have recently risen to 3.2% from 3.0%. However, the market is beginning to show some modest cracks, as Amazon has mothballed several projects and many retailers are dealing with bloated inventories.
- After decades of tremendous economic growth, the Chinese property market is imploding and overall economy slowing significantly, leaving it with some difficult policy choices: I was last in China in 2017 to teach one of UCLA Anderson’s “global immersion courses” during which one speaker after another fawned over China’s long-term vision and extraordinary commitment to growth, innovation, and capital investment. This hyperfocus on capital investment generated extraordinary wealth, transformed the country and countryside, increased borrowing, but increased wealth inequality. Now, with the global economic slowdown and post-COVID realities, China’s investment-centric strategy has left it with some unenviable choices. While investment typically comprises a quarter of global GDP, China has invested 40 to 50% of their annual GDP into infrastructure (including property development) and investment. If you think U.S. Fed Chair, Jerome Powell, has a tough job trying to steer our economy to a “soft landing,” China’s job is far more challenging.
Look no further than their property market, where the government had to clamp down on developers who had taken on way too much debt in the name of growth. In fact, the Chinese property market is likely the single largest asset class in the world.
So, what next? Unlike Magnus Carlsen, the Chess Grandmaster, Chairman Xi can’t just walk away from the game. Perhaps the country shifts from private real estate growth to public infrastructure (e.g., bridges, roads, Silk Road), but this sort of investment is not necessarily productive. All I know is that a significant slowdown and tough choices await, while consumer confidence plunges.
With the risk of stagflation seeming more and more of a possibility, real estate fund managers and sponsors will need to manage assets even more carefully, focusing on occupancy versus rent growth, managing expenses and expenditures carefully, and conserving capital
You don’t have to look very far to read, see, or hear bad news these days and perhaps it is darkest before dawn. UCLA’s extremely disappointing showing on the gridiron yesterday would seem to support that notion. Regardless, it never ceases to amaze me how quickly investor sentiment shifts, and when this particular market bottoms, it will only have been evident in the rearview mirror. While the next 12 to 18 months is going to be very bumpy, I am sure that long-term investors, exercising patience, will be rewarded. I also sense that the downturn will present opportunities, as they inevitably do.
The Clear Capital team, like all sponsors, will have its hands full, especially with assets we own with floating-rate debt. As I mentioned in a short memo I recently wrote, while we generally hedge this debt with interest rate caps, such caps expire two to three years following acquisition. As a result, we will carefully balance occupancy rates with rent increases, emphasizing the former over the latter. And while I hate to reduce investor distributions (remember that the Clear Capital principals and affiliates are generally the largest investors in our projects), I believe it is crucial that we (and all sponsors acting responsibly) increase cash reserves and manage all cash outflows as conservatively as possible in such broad market uncertainty. Frankly, it is in the tough markets when sponsors earn their keep and wheat is separated from chaff.
In that regard, we had a busy quarter, refinancing Aspire of the High Desert, returning over 80% of investor capital, while selling two assets, Iris Gardens and Aspire Glendale, on which investor returns are anticipated to exceed 32.3% and 36.4%, respectively. We acquired one asset, Aspire Columbia Ridge in Portland, Oregon, with our joint venture partner and for which we are presently raising capital (for up to half of their investment). We like the asset and the real estate, and should you be interested, please let us know.
As November and the holiday season are almost here, the Clear Capital team and I want to pass along our very best wishes to you and your families for a healthy and celebratory holiday season. I would also like encourage all of you to get out there and vote, provided you are able to so. While I generally avoid political discussions in these memos, or try to stay reasonably agnostic in my writings, we cannot and must not take our democracy (or indeed, our Republic) for granted. This picture says it all, as electoral and liberal democracies are seemingly out of favor these days and that worries me. Certain trends pose existential threats, even more than higher interest rates and inflation.
As always, thank you for your continued support of me and our entire team. Feel free to reach out to with any questions, comments, or concerns that you might have.
Best,
Eric Sussman
Managing Partner