In April, we exited our most recent deal, which generated returns above our most optimistic projections. Our successful timing was largely due to our adherence to a decision-making process based on market fundamentals. As financial markets continue to adjust on macro and micro levels, we are excited to share our current investment thesis. In the first half of 2023, we are confident we will see investment opportunities that generate above average risk-adjusted returns as markets continue to react to an ongoing set of changes in real estate fundamentals.
High real estate prices from cheap debt, high rent growth, government stimulus
During the pandemic, the Federal Reserve became focused on the downside risk of a major recession due to Covid. As a result, they reduced interest rates to historic lows and pumped trillions of dollars into the U.S. economy. At the same time, rental rates across the U.S. rose faster than expected. In response, multifamily buyers paid unprecedented prices based on below average mortgage rates, high leverage, and optimistic rent projections. Accordingly, capitalization (“cap”) rates compressed to historic lows. While defined as the ratio of net operating income (“NOI”) to a property’s value, a cap rate can also be thought of as the sum of the risk-free rate of return (e.g., treasury yields) and a premium for risk (i.e., reward needed to take on an investment). The result was “pricing to perfection” – rising optimism about future rents and low cost of debt. It is important to note that the benchmark 10-year treasury yield hit a historic low in 2020.
Deflated prices from quantitative tightening, reduced rent projections
As a result of both supply-chain challenges associated with Covid and generous stimulus spending, the economy was poorly positioned to handle the rebound as we moved out of quarantine. Surprising many, inflation quickly hit a 40-year high. The Federal Reserve’s concern about avoiding a major recession from Covid quickly changed to a deep fear about high and persistent inflation. Since then, it has aggressively raised the federal funds rate multiple times and began unwinding its balance sheet. By design, these moves put significant upward pressure on borrowing costs. The 10-year Treasury went from under 0.32% in early 2020 to over 4.2% this month. As the risk-free rate rises, investors demand higher cap rates for properties, which pushes prices down. This scenario is happening today. Values are further impacted by evidence that many rent growth projections were too optimistic. The reality is renters’ have a limited ability to absorb rent escalations in the face of a looming recession. Additionally, with reduced migration into secondary and tertiary markets, demand for units has ebbed.
Forced sales from aggressive financing
Many properties purchased during the recent pandemic were financed with short-term, high-leverage, floating-rate debt. Therefore, a disproportionate number of maturing loans will be very difficult to refinance without borrowers investing additional equity. Without contributing new capital to refinance these assets, owners will be forced to sell because refinancing at the current lower values are unlikely. Lenders of floating rate debt require many owners to repurchase rate caps, which put a ceiling on a loan’s interest rate. This practice is common. However, because of the rapid rise in interest rates, the cost of rate caps has increased significantly (with some borrowers facing costs exceeding 10 times initial estimates). These borrowers are in a precarious position. They need to infuse unplanned capital into their deals or become “forced sellers.”
Demand vacuum
Finally, retail investor syndications and larger institutional investors bought many of the transactions in recent years. These syndicators typically buy value-add properties, hoping for a rapid “pop” in value and short hold period. They now are increasingly faced with selling just to have investors break even. Institutional investors, who generally purchase larger, core/core-plus properties, are highly sensitive to risk (real or imagined). They are currently sitting by the sidelines until the perception of uncertainty dissipates. Moreover, many institutional investors are reducing their real estate portfolios to reset their investment weights; with stocks and bond values falling, they have found that they have too much invested in real estate. The rebalancing will yield another headwind in the short term. Should both large purchasing groups remain by the wayside, there should be decreased demand for quality assets in the near term, equating to opportunity.
Fortune favors the patient
For the above reasons, and more, we are confident that it is fundamentally sound to, as Warren Buffet says, “be greedy when others are fearful.” We firmly believe a window of significant opportunity is opening to purchase high-quality residential real estate at discounted prices. As markets restabilize and cost of capital eventually decreases, asset values will once again rise on pace with normalized inflation and interest rates. When we identify the right opportunity in the coming months, we will not hesitate to act. As we have successfully done in the past, we faithfully adhere to investment decisions based on fundamentals. Without any legacy assets impacting our balance sheet or monopolizing our attention, we are uniquely positioned to be nimble and opportunistic.