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And it Begins…

March 2023 Insight

I have not seen this number of quality investment opportunities in the world of real estate since 2014, maybe even 2010.  Not in absolute terms, but certainly from a risk adjusted return basis. Sure, in the past 9 (or 13) years there have been many good, or even great, opportunities. But they were opportunities that we had to search for. The difference between now (and the years immediately following the Great Recession) and the last ten years (approximately) is that instead of having to search for opportunities, it is a matter of picking which opportunities we like best, then trying to figure out how to fund them. There is always a tension in our business between having enough strong opportunities or having enough money for the opportunities at hand. For years the harder part has been finding opportunities in which we truly believed. This is no longer the case. Now, and suddenly, the number of opportunities far exceeds the available capital needed to pursue all the projects.

I wouldn’t have said this a month ago, and maybe not even two weeks ago, but the situation has changed, and quickly. The opportunities look nothing like they did a decade ago. At least not yet. So far, the most lucrative opportunities are in debt that provides high-quality risk/return profiles as some traditional lenders are desperately searching for liquidity, or holding on tightly to the liquidity they already have. And the structure of these opportunities is more complicated than a decade ago when jumping into the game was as simple as buying a house or an apartment complex. The debt markets are more opaque, and the structure of the investment vehicle(s) is more important in terms of locking in risk mitigation and maximizing returns.

Altus has been expecting distress in the real estate (and tangential) markets for several months and has written about it on multiple occasions (here, here, and here). But it was always with some level of insecurity in our convictions. While I can’t speak for the rest of the Altus team, the strength of my conviction has increased dramatically. While this unfortunately will mean a lot of pain for market participants, it appears more and more likely that investors who position themselves correctly will have another Great Recession type opportunity to capture outsized returns over the coming few years. Okay, maybe not THAT good of opportunity, but certainly a huge increase in risk adjusted returns versus the last seven or eight years (on a market wide basis).

My conviction has been strengthened because of the spike in opportunities we are seeing, and more specifically, tied to two different March occurrences.

Everyone is familiar with the first occurance: the collapse of Silicon Valley Bank (SVB) and Signature Bank (in New York). While I believe the collapse on its own is a bit of a canary in the coal mine, it is the events thereafter that I believe will roil the markets in the coming months/years.

The Federal Reserve said it was going to keep raising interest rates until something broke. And with as much cheap money that has been slushing around the system for the past couple years, there was no question investments were being poorly allocated. Then, if you raise rates at a historical pace and scope, guess what? The Fed got what it wanted, something did in fact break.

When the bailout was first announced on the Sunday after the Friday bank run, my first reaction was favorable. The administration didn’t call it a bailout of course, and in fact went out of their way to say it WASN’T a bailout. That is completely false. Further, the Treasury Department’s handling of the fallout is taking a bad situation (something broke!) and turning it into a coming Main Street disaster (my opinion). Consider:

  1. SVB was specifically categorized as NOT a threat to the stability of the financial system. That determination was made by the Treasury Department itself. Because of that determination it had lower liquidity requirements than if it would have been considered “Too Big to Fail”. However, despite repeatedly saying there would be no bailout for uninsured depositors in the first two days of the meltdown, the Treasury then called the failure a systematic risk and decided to insure all depositors. What good is regulation and structure if it is thrown out the window upon any change to a situation? Why have, and advertise, a depository insurance program if it doesn’t mean anything?
  2. And what were the non-insured depositors at the bank thinking anyway. Roku had over $400 million deposited at that one single bank. Do they not have an internal treasury function? Are they so profitable that it wasn’t worth their time to buy short-dated treasuries with a large chunk of those funds (we are talking about millions in lost income here)?
  3. There have been calls, including from the President himself, to claw back executive compensation from the executive team at SVB. While I am not sure how I feel about this (I tend to lean towards being in favor since the depositor insurance is a taxpayer expense), I can’t figure out why no one in the mainstream media hasn’t called out the Federal Reserve regulators for their part in this failure. Quoting from the March 15th Wall Street Journal (hat tip to John Mauldin’s “Thoughts from the Frontline”):

“In its February 2022 Stress Test Scenarios, the Fed’s “severely adverse scenario” asked banks to assess their riskiness over a three-year horizon in a hypothetical world in which the three-month Treasury rate stays near zero while the 10-year Treasury yield declines to 0.75% during the first quarter of 2022 and doesn’t change in the subsequent two quarters. Even in December 2021, however, the Federal Open Market Committee’s Summary of Economic Projections was showing the Fed likely targeting interest rates double those of 2022 in 2023, far higher than what it used for bank stress tests.

“A reasonable observer would expect FOMC’s policy objectives to have been embedded in the 2023 Stress Test Scenarios. But by February 2023 [!!!!], the Fed still hadn’t changed its regulations to match its monetary policy. While FOMC’s December 2022 projections show its policy rate reaching 5.1% by the end of 2023, the February 2023 severely adverse scenario was almost identical to that used in February 2022: The three-month Treasury rate falls to near zero by the third quarter of 2023, while the 10-year Treasury yield falls to around 0.5% by the second quarter, then gradually rises to 1.5% later in the scenario.”

Think about that for a second. The exact same organization that had raised the overnight rates to 4.75% (and now 5%), and was telling anyone that would listen that they were going to raise them further (they did), was simultaneously forcing banks to stress test at historically low AND FALLING rates. That is insanity.

  1. Treasury Secretary Yellen can’t figure out what she thinks. One day saying all banks will be backstopped, and then shortly thereafter saying only systematically important banks will be bailed out. Whaaaattttt? How is this good for anyone, anywhere? By explicitly telling the market that small banks will not be backstopped beyond the current FDIC insurance levels, they are telling people (and more importantly businesses) that they need to move money from small banks to big banks or risk losing their cash. Lots and lots (and lots) of small businesses have to hold more than $250,000 in cash to run their operations. Losing those non-insured funds would be a death knoll to many small companies. So, they move their money. Much of it is going to the big banks. A significant part is going into non-bank liquidity like treasuries, money markets, or secured private funds (plug for the AE HGF Liquidity Fund!). The government should not be picking winners and losers. It did it with the bailouts of banks and automakers in 2009, the Trump administration did it by giving incentives and tax benefits to hand-picked companies, and now the Biden administration is saying they will only support the largest banks in the country? Our country is built, and runs, on the backs of the “little” businesses, entrepreneurs, and workforce.
  2. Non systematically important banks do the vast majority of lending by transaction volume in the country (i.e. 80% of commercial loans in 2022). This is more obvious than it may first appear. While the Big Four banks do a huge amount of loan volume (in dollars), there are only four of them. There are 4,232 non-Big Four banks. The smaller banks don’t have to do a lot of loans each to add up to substantially more loans funded than the Big Four. The Big Four, along with other money center banks, mostly fund big businesses and institutional real estate. The smaller banks fund Main Street. I realize this is a generalization, but in sum it is a pretty accurate one.

Let’s now tie the last couple paragraphs together. The smaller banks are losing deposits. Putting aside that this may create a fight for their very existence, it certainly means they will be forced reduce their new loan volume.  With the vast majority of Main Street lending coming from the smaller banks, and thus the vast majority of total loan volume, loan volume will be (and already is) severely impacted. The money supply calculation is based on only two inputs, one of which is the velocity of money. Lending, and especially within the fractional banking system, is the gear that keeps money velocity turning. Take it away (or in this case severely restrict it) and the money supply is going to contract, and I think substantially. This is by definition deflationary, or, if prices continue to rise regardless, stagflationary.

Another interesting dynamic here is that these smaller lenders already have millions (or billions) of debt on their balance sheets. While many of those loans are adjustable (and unlike the treasury portfolios owned by SVB, First Republic and some others – are great to own in an interest rate increase environment), a large percentage of the loans are fixed over 3, 5, or 7 years, with nearly all of them held in portfolio. Those loans will reach expiration and will need to be paid off. This usually happens through refinance. In the Great Recession, at least after the initial few months, banks were allowed (and encouraged) to extend and pretend until valuations recovered. SVB showed us that we aren’t (yet) in a credit risk situation. We are dealing with interest rate risk. With deposits already dropping, banks need liquidity. Loan payoffs provide liquidity. They can’t (again, speaking in generalities) extend at rates lower than the current market. They simply don’t have the liquidity to do so. Borrowers with expiring interest rate caps or upcoming balloon payments are in much bigger trouble if their lenders are also under financial distress. One of our analysts extraordinaire created a model to calculate the NOI growth required for a property to qualify for refinance under normal DSCR requirements. The results are sobering. Money borrowed at 3% with 65% leverage (not at all unheard of, and if anything, much lower leverage than many borrowers used) requires NOI growth of 16% PER YEAR for three years to achieve a 1.30 debt coverage at a 6% interest rate. How many properties are able to achieve such performance?

  1. Don’t call it contagion, but shortly after the collapse of SVB and Signature Bank, Credit Suisse Bank came under pressure and was purchased by UBS in a Swiss government arranged bailout that occurred without any shareholder or debtor approval. Their country, their prerogative, but Switzerland is a western economy, and as such would claim to have strong property rights protections. Not unsimilar to the US government bailout of GMC in the Great Recession, the Swiss government wiped out AT1 bonds and left common shareholders in place. Legally that is not the way it is supposed to work, and I am sure there will be plenty of lawsuits that arise out of this. But that isn’t the big deal here. The big deal is that debt got wiped out while equity remained. Not to get too much into the weeds, but funding for bank lending/investments comes from two sources: deposits, or cash held by the bank. That cash comes from equity investment or bonds sold to investors (generally not the same type of bonds purchased as investments by SVB). Deposits can be loaned out at 1:1 ratio while bank cash can be leveraged substantially higher (call it 8:1). Why would a bond buyer buy a bank bond if they have no protection against discretionary government action? And without buyers for bank bonds, bank’s availability to tier 1 capital will be greatly impacted. Which then in turn diminishes the bank’s ability to lend. And we are back to the same deflationary issue of contracting loan portfolios that I mentioned above.
  2. Not yet highlighted in this analysis is the reality that increased lending capacity at the big banks and decreased lending capacity at the small banks means more money (relatively speaking) for the “rich” companies and investors, and less money for the general economy (and those not as rich). Recessions are supposed to erode wealth, thereby diminishing the rich/poor gap. If it plays out as I have outlined, the opposite will occur.

Financial crises generally don’t unfold quickly. Lehman blew up 6 months after Bear Stearns. We are in the early innings here. Those that can obtain financing and have access to capital are going to win, and win big. And there are going to be lots of losers on the other side of those transactions.

And then there is the second March occurrence…

Syndication is a legal term used to describe a certain way of raising capital for investment into private ventures. I attended a conference this month where I found out it was also a cult industry. I ended up at the conference a little bit by coincidence because attendance was included with another event I attended. I had no idea that such an industry existed, and no idea of the scale of dollars that had been raised from individual small investors. I don’t want to disparage anyone that attended. There are some strong operators and incredible business minds within this cult industry. But they are the exception and not the rule. Most of the attendees, and I would take it further to say “participants”, in this business strategy have almost no real estate experience, very little business experience, and have never invested in anything other than a market on rocket fuel such as we witnessed in the apartment world the last couple years (the heat of which may have been caused by the very same participants). Over the three-day event I never heard the words “intrinsic value” once. I never heard the term “risk adjusted return”. And the three sessions that were least attended were on Financing and the Interest Rate Environment, How to go from a deal maker to a CEO, and How to Successfully Scale an Investment Business. Sessions that were well attended were mostly confined to marketing and promotion, especially related to social media. If there was a cryptomania type version of real estate investment, this was it.

Nearly all the participants used short-term floating rate debt, though often with a couple years of rate caps. A lender for a buyer of one of the properties we sold last year had a booth at the event. She shared with me that their business had placed $450 million of loans in 2022. A whopping 84% was adjustable, short-term debt through debt funds. Most of the remainder was also short-term but was through local/regional banks. And close to 100% of it was for value-added apartment investment purchases with no intent for long-term ownership. Earlier I laid out the NOI growth needed to get a property to qualify for refinance. If I change the purchase leverage to 80%, the annual (and compounding) NOI growth needed goes to almost 30%. Folks, this just isn’t something that happens on a consistent basis. Rather, it is something that rarely, rarely happens period. Especially with apartment market rents having largely flatlined and operating expenses skyrocketing.  This lender is only one player in the space. That is a lot of debt that will almost certainly be blowing up over the next couple years, and with it happening to inexperienced operators with a ridiculous amount of investors in each deal, it could very well get ugly. Unless you are a buyer, in which case… opportunity galore!

Bank runs, falling liquidity, bank tightening, inexperienced participants… Buckle up, this is going to be fun. Okay, maybe not fun for everyone, but at least interesting.

Happy Investing.

About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at