The Perfect Storm?

What makes financial markets so perennially interesting is that they never quite evolve as you think they should. In real estate, for example, you almost couldn’t imagine a worse macro set-up. Interest rates are up over 500%, banks are failing, housing is at peak unaffordability, and people aren’t really returning to offices. Yet, we haven’t seen all that much damage, especially when you consider what happened during the Great Financial Crisis a decade ago.

The macro meteorological report is calling for the perfect storm but right now all we’re seeing is some light rain and some ominous clouds in the horizon.

To understand just what the heck is going-on here, we have to rewind the clock a bit to the days before COVID. As 2019 came to a close, we were at the tail end of an incredible decade for real estate. After suffering a 40% decline in the GFC, values had gone nowhere but up and far surpassed the pre-GFC peak. There was hardly an asset in the world with a Cap Rate over 5%. This was a function of both improving fundamentals and a result of Central Bank policy.

With interest rates pinned to the floor, there was almost nowhere to go to find yield. In real estate, there was a brief period where you could still get some decent yield but that was gone by 2015 or 2016. Most investors don’t understand the extent to which this chase-for-yield phenomenon transformed the real estate industry. What was once a game primarily about yields and cash-flow morphed into one about financially engineering opportunistic returns using low-cost debt, pro-inflationary strategies (i.e. doing whatever you needed to do to raise rents), and flipping. In other words, real estate had evolved into a fully financialized game.

Then COVID hit and for a brief second, when the lockdowns started and governments around the country started passing anti-eviction and other pro-tenant emergency measures, it looked like the industry was in for some serious trouble. But, crazy enough, the exact opposite happened and instead of a bear market, we essentially got a blow-off top in real estate. Multifamily rents and house prices went crazy. Industrial properties boomed. Investor sentiment was so strong that even the office market, where you didn’t have to be a genius to see the trainwreck coming as a result of work-from-home, didn’t struggle as much as you’d expect.

A few years into the COVID crisis, real estate values kept making higher highs (and cap rates lower lows). And the speculative fever of era, which was manifesting most notably in places like crypto and venture capital, had made its way into real estate as well. This was particularly true in multifamily, where a whole bunch of relatively inexperienced players, mostly syndicators, came into the market and bid up properties even further.

Just when it looked like things couldn’t get any crazier, inflation started to rear its ugly head, ultimately forcing the Fed to raise rates from 0% to over 5% in a very short amount of time. It wasn’t long before the wheels started to come off. Here’s the thing, a 5.5% Fed Funds is existential to the financial returns of any deal put together in the last decade with either floating rate or maturing debt. It’s a matter of simple arithmetic:

As you can see, a 500bp increase in borrowing cost turns a healthy cash-flowing property upside down pretty quickly, even at conservative leverage levels. With math like this, it’s shocking that we aren’t in a full-blown crisis.

So, what gives?

Outside of some ugly office transactions, all we have seen so far is basically a massive volume recession. Real Estate investors are just doing nothing or as little as possible in the hopes that the high-interest rate storm will just pass.

The only people getting hurt are those that are forced to transact. If you have a loan coming due or you are an investor (mostly likely, a syndicator) who needs fresh equity to plug the hole created by your floating rate debt, this is already a scary time. But most investors are just in wait-and-see mode.

I think there are 3 reasons we haven’t seen panic yet:

1. There’s still a bunch of liquidity out there.

You’d think with multiple bank failures that the debt world would be in nuclear winter already but the banks seemed to have learned something important from the GFC—i.e. it’s far better to work with borrowers then to panic and foreclose. I know, anecdotally at least, that the banks have been much easier to work with this time around and far more willing to offer extensions and waivers on various loan covenant terms.

At the same time, real estate funds are sitting on a record $205.5B in dry powder.

Property owners and investors aren’t stupid. Not only do they know this money is out there, they know that the people in control of it are financially incentivized to put it to work. I was in a room full of big real estate CEO’s the other day and they all reported the same thing: that their capital partners were eager to deploy. I’m sure it has nothing to do with their compensation structure and year end bonuses. Anyway, take that for what it’s worth.

2. The economy is doing pretty well.

Outside of the office market, which is suffering from its own unique structural challenges, this goldilocks economy has been good for real estate. Consumers are still buying stuff, going on trips, and using massive amounts of data capacity. With the AI-boom, the corporations are in the mix as well. Meanwhile, the job market is holding up so people keep paying rent. Literally, in every major category besides office—think data centers, industrial/warehouse, multifamily, hospitality, and even retail—fundamentals are pretty good. And some categories, like student housing and manufacturing, are even booming. Who knows how long this will last but right now things look ok.

3. Structural inflationary pressure in real estate might be enough to overcome the shock of a higher rate regime.

This is probably the most important and least understood phenomenon of this whole confusing picture. The core problem, besides people not returning to office, is that borrowing costs moved up too far, too fast. But much of the story of the Great Interest Rate Shock of 2022 remains yet unwritten and there’s a chance this resolves differently than in past cycles. In the scenario where we get sticky inflation, for example, there’s a chance that rents end-up rising fast enough to outweigh the damage caused by increased borrowing costs. Is this really that hard to imagine?

For better or worse, capitalism has evolved around the world in way where it is essentially structurally pro-inflationary for real estate. This has to do with mass urbanization, the regulatory regime for development, zoning politics and corruption, and our legacy of Central Bank activism. Taken together, it’s a story of ever-growing demand coupled with multiple points of market failure in an already slow-moving supply function. Even in the good times, it’s just really hard to build and today, high rates and inflation uncertainty are making things even worse. Development pipelines either already have ground to a halt (e.g. office) or are about to (e.g. multifamily), setting the stage for another nasty bout of real estate inflation in the next bull phase.

These days there’s a lot of chatter about inflation expectations and how important they are. Well, let me tell you: the largest, most persistent inflation expectation in our system is in real estate. Remember back when “house prices were never going to come down.” Well, people still believe that and it’s not just a housing thing. It’s an idea that pervades the entire real estate industry. By the way, there are two other structurally embedded, nasty inflation expectations in our system—1. That the price of college is going to go up and up and 2. That the price of health care insurance and services will do so as well—but that’s a story for another day.

Over the last 40 years, real estate investors have been trained by the market to not only pursue inflation (i.e. by engaging in strategies involving raising rents whenever possible) but also to expect it. This expectation is the point that gets missed but it’s such a strong force that it’s become a kind of embedded feature of our system. Why sell in a bad market when you know that if you can just wait things out the market will reward you with higher rents and valuations? This is why we’re seeing such a big mismatch between buyers and sellers in this market.

The truth is that many smart investors, aware of / believing in this phenomenon, have structured their deals for this exact scenario—i.e. by using conservatively leveraged fixed rate loans—and many others are just holding on for dear life. And because development pipelines are shrinking, those who can hold-on will eventually be doubly rewarded.

So, where do things go from here?

As investors, we’re always looking for a kind of emotional and intellectual clarity—that feeling of not only knowing what to do but also having a sense of confidence about it. Of course, it never quite feels that way in the moment, for uncertainty is the only constant to the great art of investing that we all love.

Though it may feel like we are in the midst of (or about to enter) the perfect storm for real estate, this is actually a time for nuanced thinking. To be sure, there are massive headwinds out there like dramatically increased borrowing costs, the potential for sticky inflation, and the ever-present danger of an actual recession. But there are also interesting structural dynamics within the real estate industry, like broken supply functions and embedded inflation expectations, that suggest that things might not be as bad as they seem.

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