When I write an Altus Insight, I try to have a theme that runs throughout, tying in the relevant questions and data, and sometimes coming to a conclusion. This month? Nothing. No theme. There is a lot going on, nearly all of it out of our control, but no common thread tying it all together has come to the forefront of my consciousness.
The first slide for our quarterly Investor call last week was “It is Broken”. Thankfully we weren’t talking about our portfolio, but rather the US investment real estate market at large. The real estate market being broken is as good of a place to start as any.
If the world of investment real estate really ends up as impacted as we believe it will be (and as recent events/activity portends), it will be the most obvious and expected recession in the real estate markets in memory. If interest rates are the largest single impact to cash flow (they are), and cash flow leads to market pricing (it does, through many different cause and effect channels), then it is impossible that the changes in interest rates we have experienced over the past 18 months won’t have a substantial impact. The impact is far greater than just affecting real estate of course, but with some real estate segments having experienced tulip mania mode (value add multifamily) going into the interest rate spike, the first place to see the impacts of the rate hikes is where there was/is the most exposure. And that is real estate.
Everyone knows the office real estate story. COVID opened up the world of working from home, certain demographics loved it, office space demand plummeted, and boom, there is crisis in office. As it turns out, office is (or rather, was) the preferred real estate investment vehicle for institutional real estate investors, with the market size in dollar value dwarfing some of the other real estate segments. Losses in apartments are huge and growing, but that is first and foremost a fundamental performance issue. A sharp reduction in demand with roughly no change in supply. Add in the huge increase in interest rates, and office owners are in trouble. Of the $79.7 Billion of current distress (a lot!), 41% of it is office. (Side note: As was the case with the “retail is dead” crowd from several years ago, the office story is far more nuanced, and some office types are still performing well. Meanwhile, retail is at historically high occupancy levels)
But the story in hotels may be worse. Fourteen percent of all hotel loans are in distress. 14%!!! On top of that, 30% of hotel loans mature in 2024. Even if we assume all those loans were ten-year terms, the refinance rate would still increase roughly 50%, with most loans of shorter fixed periods having a far larger rate impact. If these loans amortized over that ten-year period, maybe they will be okay, because assuming a 30-year amortization schedule for both loans, the payment would only increase 18%. Hopefully over ten years operating income would have increased enough to cover the increase in debt payments. However, hospitality fundamentals are terrible right now. While not true in absolute, many hotel types are struggling badly under skyrocketing costs with flat to falling ADR (average daily rate: a combination of occupancy and room rate), with an emphasis on flat room rates. There are various theories as to the cause of the stagnation, but certainly the reduction in business travel and the proliferation of VRBOs are both playing a part.
Without question, the real estate market is broken.
It goes further. Probably without needing to be said, Washington is broken. The leading two candidates are both already older than median life expectancy, and wouldn’t finish their term for another five years. To put that in perspective, that is 2 and 1.4 standard deviations above the median. One has shown signs of serious cognitive decline while the other only says things are true by mistake. This second candidate also has shown complete disregard for the laws of the country, including the highly important sanctity of our elections. This is the best we can do? Meanwhile, one party created history when they kicked out the speaker of house, compounded by weeks of leaderless languishing. The other party, and NOT the same party of the election denier candidate, is led in Congress by…a full-blown election denier. Both parties have largely been taken hostage by the extremes within their parties, leading to more infighting than doing any actual…you know…governing.
The government’s financial picture isn’t much better. There was bragging from the Administration about the largest deficit decline in history (from their own record high deficit of course) and now there is lots of crowing about the strength of the economy. And make no bones about it, the Q3 GDP number was hot. But we also just finished up a fiscal year that had the largest non-COVID deficit ever. Yes, ever. That includes war time and recessions. If we are in such a great economy, why in the world do we need this deficit spending? The easy answer is the deficit is what is funding the economy. In three years in office, in supposed good economic times (i.e. highest tax receipts), we have had the largest deficit ever, and the largest non-COVID era deficit.
Of course, deficits aren’t new. A recent report released by Bank of America pointed out that since the 1980s total government debt has grown from 31% of GDP to 120%. Their analysis indicates that the increase in borrowing resulted in a massive increase in personal wealth, with 2/3rds of that transfer ($129 Trillion – with a T) ending up on the balance sheets of Baby Boomers and older citizens. All at the expense of the future generations that have to deal with the slower growth tied to higher debt, and the eventual repayment, or reduction in services, of that debt.
The deficit funding isn’t just providing the current society with economic gains at the cost of future generations/taxpayers, it is also working in complete odds with what the Federal Reserve is trying to do. It’s old news that the Fed is aggressively (historically) raising interest rates to try and control inflation. The hope is the higher interest rates will dampen borrowing. But if the reduction in borrowing (or at least the growth of borrowing) is backfilled by government largesse, then the impact desired from increasing the rates is severely muted, the collateral damage not-withstanding.
Part of this may be because of the way inflation is measured. I say “may” because I haven’t figured out a way to validate this premise. And in presenting this premise I acknowledge that measuring inflation is a hugely imperfect science in trying to accumulate each citizen’s individual inflation situation into a nationwide number. But I do know that the lower income demographics are feeling the impacts of inflation and the increase in interest rates far more severely than the higher income demographics. Average residential rents across the country are now 40% of income, which is higher than we allow at most of our properties (let alone have it be the average). Gas and food aren’t included in core inflation numbers, but gas and food are a huge percentage of the lower earner’s monthly spend. Medical? Let’s not even go there. Since 2019, and for the first time in memory, real incomes in the US have fallen – 5% over the last 4 years. This means for the first time in generations, the average (median) family’s quality of life is worse now than it was 4 years ago. And yet, headline numbers report strong economic growth. So the premise is this: if the way inflation is being measured is understating inflation (and there are people that think it is), then with real economic growth being measured as nominal economic growth minus inflation, and if inflation is higher than measured, then true economic growth is lower than reported.
If this is true, and depending to what order of magnitude, then we could be closer to a recession than we think. The inverted yield curve would agree, as would the index of economic indicators, which has weakened every month for 16 straight months. This is the third longest streak in history, with the other two being such severe contractions they got “Great” in their name. The Great Recession and the Great Depression.
But also, if inflation is running hotter than reported, it means the Federal Reserve is farther from being able to get it under control, so more rate hikes may be coming, which in turn will cause additional collateral damage.
The Swedish National Bank (the oldest national bank in the world) needs a government bailout because of their bond losses. The Federal Reserve has lost $111 Billion (and rising daily), and total bond losses world-wide are estimated at $107 Trillion (a massively large number).
Ukraine and Russia.
Israel and Hamas.
China and the Philippines (and India, the US, Japan, etc.)
Are we having fun yet?
Maybe I have a theme for this Insight after all. “It is Broken” seems pretty befitting.
But be of good cheer. The last time things broke, it was the Great Financial Crisis (GFC)/Great Recession. It wasn’t easy, but those that were able to overcome their fears and analyze opportunity with a clear mind benefited from incredible wealth creation. Maybe next month, pending no new major events that should be discussed, the Insight will share my own GFC experience and some of the lessons learned.
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 fjinks@altusequity.com.