Source: Eisner Amper —
For the last fifteen years, multifamily and commercial real estate investors surfed a rising wave of increasing property valuations buoyed by abundant and cheap capital. But in 2022 the ebb currents gained the upper hand and liquidity washed away. The culprit? The return to higher interest rates powered by the Fed’s wrestling match with inflation. There was no moment when the music stopped for CRE investing, as there was in 2007 when spreads on AAA CMBS bonds suddenly blew out by 1500 basis points. Instead, since the spring of last year there has been a gradual return to the old-world reality of market-based interest rates. While interest rates today are not that high historically speaking, the doubling of rates in a year has wreaked havoc on owners of multifamily and commercial properties across markets and property types. The on-going volatility is so consequential and long-lasting that the motto for the industry may have to be changed to “location, location, the Fed.”
If it comes as any consolation, the current threat to property values and yields was not the industry’s doing but rather the result of shifts in the economy and the capital markets. Supply and demand are relatively in balance and most property sectors have been generating generous returns for their investors. But as rental growth slows from the almost absurd rates seen in the last few years, and inflation pushes up wages and other operating costs, property cash flows are likely to be squeezed. In combination with a higher cost of capital, that means falling asset values. Some reports are saying we are not in a downturn but a return to normal conditions. That’s wrong and right. We are returning to historically normal conditions in terms of higher rates and improved wage inflation, but this new reality will cause values to fall and, having been through quite a few, I call that a downturn in the cycle.
The transition from a policy-induced boom market to a market-based real estate investment environment will be rough for a lot of owners. Even if the Fed backs down later this year or in 2024, higher interest rates are here to stay. The biggest deterrent to capital flows is uncertainty, and not knowing where rates will land will keep liquidity on the sidelines and prolong the process of price discovery. The search for clarity won’t be solved in a few months, it will take time for sellers to capitulate to new pricing and for lenders to believe in the new valuations. We may not understand the full extent of sector distress until we move through hundreds of billions of dollars of loan maturities in the next several years. But real estate companies and banks are healthy, property fundamentals remain relatively strong, and, like so many times before, the industry will adjust to the new market conditions and capital will flow once more.
The Context – Demand Drivers and Economic Volatility
Several key ingredients are needed for the real estate market to thrive: population growth, high employment and good wages, and people willing to spend money on goods, services, and leisure.
Demographics: Where did all the people go? The long-term health of any economy requires population growth. In fact, many countries around the world face the prospects of shrinking populations and the economic woes that follow. In the United States, we are around break-even with the population growing very slowly in recent years, around 0.5% growth in 2022. Americans are not having children at the rates needed to organically grow the population, and immigration has slowed dramatically over the last few years due to both policy changes and the pandemic.
A lot was written during the pandemic about population migration around the country that is fueling growth in some markets at the expense of others. These migration patterns have been ongoing for decades but certainly accelerated recently, helping markets in the Sun Belt and western and mountain states. But a key driver of these moves is a lower cost of living, and the influx of people in some markets has altered that calculus, particularly housing costs. Metropolitan areas with the greatest in-migration have gotten so expensive that they are no longer affordable to many families. In addition to spectacular rent growth, Phoenix, Atlanta, and Miami had the highest inflation rates of the metro areas, according to Yardi Matrix. While these communities remain attractive, we expect migration patterns to shift in the next few years and investors will need to monitor these trends in local demand. Demand is already rising in midwestern and northeastern cities (see more on the multifamily sector below). The winner for in-migration and rent growth in 2022 was not Austin but Indianapolis.
Another area to highlight demographically is the aging of America’s Baby Boomers. According to the Pew Research Center, about 10,000 Boomers have been turning 65 each day since 2010, and their average age is now about 66. Over the next few years all 70+ million Boomers will be of retirement age, and some will be in their 80s. The group is already draining the labor force and will be consuming less while requiring more health care services. This is a demographic dynamic of unprecedented proportions for the real estate industry that will bring extraordinary opportunities for those who respond to changing demand for new products and designs accommodating the changing needs of this aging generation.
Employment: Real estate’s greatest tailwind A strong job market is the single most important driver of real estate demand and despite all the economic turmoil the employment remains on fire. The economy gained a whopping 4.5 million jobs in 2022, pushing down the unemployment rate to 3.5% at the end of the year. In January an additional 517,000 jobs were added, almost three times the market’s estimate, bringing down unemployment to 3.4%. The ratio of open positions to unemployed workers has risen to 1.9x. Technology companies may be laying off tens of thousands, but small businesses remain desperate for talent. A recent Barron’s survey indicated that 93% of business owners seeking to hire in December had few or no qualifying applicants. The shortage of workers has been caused by many factors including the lack of immigration, the on-going and increasing rate of Boomer retirements, and a surprising number of Gen Z staying out of the work force, particularly less educated younger men. Making matters worse is the lack of mobility of the American workforce due to high housing costs and mortgage rates – many people won’t give up their current low mortgage rate and move to a new job opportunity when mortgage rates have doubled.
Consumption: The economy’s fuel American consumers are still spending, just a little bit less. They have jobs with higher salaries and about half of the pandemic stimulus checks are still in their bank accounts. Credit card balances, at $930 billion at the end of the third quarter of 2022, have returned to their pre-pandemic high after falling $150 billion during the lockdown. No doubt inflation has taken a bite out of the spending budget, especially due to volatile gas prices and groceries rising at an astonishing 11%. Inflation, the threat of a recession, and job cuts in the headlines are understandably making people nervous. The University of Michigan Consumer Sentiment Index is down to 59 from 96 just before the pandemic. And a McKinsey study indicated a significant drop in the American optimism for the economy last year that cut across income, gender, and age groups. Nonetheless, spending dropped by a mere 0.1% and 0.2% in November and December, respectively. A continued willingness to spend is critical for economic growth (it accounts for about 70% of GDP) and the health of retail, restaurant, and hospitality sectors of real estate (see more on the retail sector below).
Inflation: The root problem Now that the topic of inflation has been broached, what began as a pandemic-induced trend seems to want to hang around, despite all efforts of the Fed. And the main ongoing driver is wage gains (about 4.8% in 2022), which of course is good news for American workers but not so great for policy makers. Other long-term inflation drivers include de-coupling from China and de-globalization generally, growth in spending power and demand from major emerging economies such as India, the continuing uncertainty over global fuel costs due to geopolitical turmoil, and the reduction in the Fed’s balance sheet. But it does appear the worst may be over, with inflation rates rapidly dropping in the last six months of 2022. The Personal Consumption Expense (PCE) index (the Fed’s reported favorite measure of inflation) rose just 0.1% in November and December 2022, resulting in a year-over-year inflation rate of 5% in December (4.4% excluding food and energy). Annualizing the December month-over-month rate yields a PCE measured inflation of just 1.2%.
