We Haven’t Seen Anything Yet

Are we living in a post-low interest rate world? Or has this just been a painful little interregnum? Of course, it’s really hard to tell but I’m starting to think the risk of higher rates for longer is real. When the world’s most powerful and influential banker—aka JP Morgan CEO Jamie Dimon—starts talking about 8% Fed Funds, we should at least consider the possibility, right?

Whatever the case, the longer this goes, the bigger the chance of a financial or economic accident. And this is the last thing the world needs, especially the democratic West. Imagine what kind of stress our democratic process would be under in a world of mass unemployment and falling asset prices. Our narcissistic society is ill-prepared for conditions that demand collective sacrifice, that’s for sure. And that’s precisely what we’ll need if we find ourselves in another crisis. 

Anyway, I know I complained a lot recently about how frustrating of a market this has been but the truth is we haven’t seen anything yet. Consider the real estate world for a second:

Distress levels are up but they are nowhere near where they could be! Things could get a lot worse and they just might if this last mile of inflation doesn’t dissipate. Fed Chair Jay Powell seems fully committed to the 2% target and determined to get there no matter the consequence to the economy.  

For what it’s worth, I have a lot of respect for Powell for this stance, especially given how politically unpopular it may become. I don’t see President Biden fighting Powell too much on this but if Trump wins again, I expect a full-on crisis when he tries to fire Powell before his term is up in 2026. To make a long story, short it’s unclear whether the President has the legal authority to fire a Fed Chair. It’s a position that is supposed to be independent but I have a feeling that in a world where high rates are causing real damage to the economy and the market, politicians will start clamoring for Powell to change the target. Is there any real difference between 2% and 3% inflation? What’s so special about 2% anyway? 

The problem here is inflation or, perhaps better said: how we measure inflation. We have a bunch of different ways to measure inflation and these days, at least, they aren’t all saying the same thing. None of them are measuring the actual true rate of inflation, of course, but that is a story for another day. 

To illustrate the point, let’s consider something we know a little bit about: shelter inflation

This is an area where I’m convinced our measures are all wrong, so much so, that the degree of mismeasurement may be forcing the Fed into a big policy mistake. The CPI’s version of the shelter inflation calculation is coming in way too hot—5.8% is a long, long way from that 2% target—and it makes up such a big percentage of the weighting (1/3^rd of the total!) that it’s messing-up the whole measure. 

Look, it’s not like people don’t know that the CPI methodology—the goofy survey-based Owner’s Equivalent Rent—isn’t great. Why we haven’t changed it is beyond me, especially since we have a ton of other measures out there—like the Apartment List National Rent Index in the chart above—that obviously work better and make more sense in how they are constructed. Indeed, people in the know have become so fed up with the inane CPI methodology that they’ve resorted to making their own measures, like the popular Truflation Index

Interestingly, Truflation is estimating that inflation is a full 1% below where the CPI is and the shelter measure is 2% below. 

I think this is much more reflective of reality than the Owner’s Equivalent Rent Calculation, that’s for sure. That being said, I think both Truflation and the Apartment List number are probably still overstating shelter inflation. As I mentioned on Forward Guidance recently, I think the big cities are seeing outright deflation in rents at very substantial levels, at least for new leases. The aggregate data doesn’t seem to be picking up the whole concessions phenomenon. Essentially, what’s happening across the country is that property owners, especially of new construction properties, are struggling so much to get leases that they are offering big upfront incentives in the form of free months of rent. We’re seeing everything from 1-4 months, which is the functional equivalent of price declines in the range of 8%-33%!

This is a long way of saying that just as it was possible for the Fed to make a huge policy mistake on the way up—remember the whole “inflation is transitory” thing—it’s possible for them to make a mistake in the other direction. It feels like this could be happening today.

For those of us in interest rate sensitive industries, like real estate, we know firsthand just how consequential a Fed mistake might be. But this goes beyond just business and investing, for this could leave ordinary American households with just as much pain if not more. This is especially true for the most economically vulnerable among us.  

An unnecessary bout of higher for longer rates is particularly problematic for the housing industry, which is both strategically and systemically important for the future of American democracy. Housing is a key industry, both on account of its strategic significance in defining societal conditions but also its raw economic weight (approx. 20% of GDP). It’s hard to think of a more important industry really.

While housing has always been an important source of wealth for Americans, in recent years it’s become even more so:  

Note: this is what you get when you throw a decade of zero interest rates at a systemically important industry where local political capture, corruption, and ineptitude have existentially impaired the capitalist supply function. But are the good days over? Was this last run-up that we saw during the COVID era the final run higher, one last gift to the Boomers? It certainly seems that way. 

Anyway, what happens if this trend reverses? What will that mean for the millions of American households who count their house as their main source of wealth? 

Higher for longer cannot be good news for housing values. As a reminder, the existing home sales market is already fundamentally broken. With mortgage rates at 7.5%, basically everyone with a mortgage is locked in place.

This is problematic for many reasons but particularly so because it restricts economic mobility. When you cannot take that new job or jump at the opportunity of your dreams because you feel stuck in place financially by your low mortgage rate, that’s a problem. 

Thus far, the new home market has held up pretty well and provided some relief for a stagnating industry but only in those few places around the country where homebuilders are actually building. Plus, homebuilders have only been able to keep things going mainly by using rate buydowns, predicated ultimately on the belief that rates will be lower. If consumers start to believe that these high rates are here to stay, buydowns will become less effective as an incentive. Watch out below if this comes to pass!

As if there wasn’t enough uncertainty out there, we’re also in the early phase of what appears to be a massive surge in immigration:

Legal or otherwise, no one really understands the implications of this surge. To assume it’s not going to be consequential would be foolhardy. 

It could have massive implications for real estate.  Remember, we are in the middle of a housing affordability crisis and are short something like 5M units. On a good year, we produce maybe 1.5M new housing units. Just where are these 3.8M people going to live? What happens if 3.8M more people come in this year? Where are they going to live? The numbers here are so huge you can see a bullish case for housing and multifamily almost regardless of the macro situation.

This population surge has to be inflationary as well—either from the simple math (more people chasing the same goods and services) or as a result of the likely fiscal implications of this situation (more deficit spending). Look, we’re already seeing immigrant-related spending in big cities across the country and we’ll likely see more, probably no matter who wins the Presidency. 

I say all this to say: it’s probably time to prepare ourselves for a future where inflation remains a problem, rates stay higher, and the housing market stays broken. I know…this is no rosy outlook but, remember, there are opportunities in every kind of market. The task now is to find them.

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