"Current Thoughts on the Capital Markets," Michael Becker
Current Thoughts on the Capital Markets
Written by Michael Becker as of March 27, 2023
Hi, Michael Becker Here...
This past Wednesday (March 22, 2023) concluded the most recent Federal Open Markets Committee ("FOMC") meeting followed by the press conference from the Federal Reserve Chairman Jay Powell. At this meeting, the FOMC raised the federal funds target rate another 0.25% up to a range of 4.75-5%. This action has a direct correlation to 30-day Average SOFR, which most adjustable interest rates are set off. As I write this article, 30-day Average SOFR is at 4.59%, which is up from 0.10% exactly one year ago in March 2022 just before the first rate hike of this tightening cycle. To say this is a dramatic rise would be a major understatement.
That same evening, I attended an event hosted by my good friends Paul Peebles and James Eng at Old Capital Lending where JP Conklin, the President of Pensford (a firm that facilitates interest rate hedging strategies by primary selling Interest Rate Swaps and Caps) presented his thoughts and reaction. As many of you are aware, the FMOC meeting immediately followed a very volatile week for the banking sector with the failure of Silicon Valley Bank and Signature Bank. I wanted to share my thoughts on the market while plagiarizing some of JP's slides in the process.
For those of you who might not be aware, at SPI Advisory we have a mixed bag of loans with both floating and fixed interest rates on our various multifamily communities totaling approximately $1 Billion. The majority of our floating-rate debt is protected by an interest rate cap with varying expiration dates; however, we have some loans that are uncapped. As you can imagine, I follow the capital markets pretty closely week in and week out as the current state of the market throughout the past year has been pretty impactful to our day-to-day business. However, before you read my thoughts and predictions on where we sit today and what the rest of the year will hold, it’s important to keep in mind that I am by no means an expert economist – I am a state school graduate and an ex-banker who borrows a bunch of money on Multifamily projects in Texas. As such, I reserve the right to be mistaken and/or just flat-out wrong. With that being said, here’s where I think we are and what’s likely to come next.
As I mentioned above, over the past year the FOMC has essentially taken short-term interest rates from 0% to 5%, thereby increasing borrowing costs along the way in their attempt to fight inflation. With the recent turmoil in the Regional Banking sector, this has consequently led to banks freezing up and restricting their lending standards virtually overnight. As a result, loans available for small-to-mid-sized businesses to fund operations, and more specifically for businesses like mine to fund commercial real estate projects, have radically reduced. Considering that nearly 70% of all commercial real estate projects are financed by a regional bank, this will have a significant impact on our sector. However, we in the Multifamily industry are very fortunate to have both the Agencies (Fannie Mae/Freddie Mac) and HUD to provide considerable amounts of liquidity to our space. I would argue that the impact of this seismic shift in lending standards should be relatively muted for Multifamily when compared to the other CRE asset classes like Office, Retail, and Hospitality.
One notable exception where Multifamily might be impacted is in the ground-up, new development segment, which happens to be largely financed by regional banks. Relentless interest rate pressures and liquidity issues in regional banking sector have made it extremely difficult to finance the construction of new Multifamily projects. The vast majority of new projects that aren’t already under construction by and large likely aren’t going to happen for a long time. Once the current pipeline gets completed and leases up over the next 18 to 24 months, there will be substantially less supply behind it. With this in mind, I fully expect there to be a major hole in new multifamily supply in 2025 and 2026 until regional banks return to lending on new construction.
With the rise in interest rates and tightening in bank lending, we’re starting to see layoffs occur. Much like JP, I feel that the official rhetoric of the Fed and parroted by the financial media about the historically tight job market is largely overstated. For example, until the summer of 2022, I had never heard of the "JOLTS" index. If you’ve watched CNBC anytime in the past 9 months, this index is somehow one of the most important leading indicators quoted to support the thesis that the job market is historically strong. The JOLTS index effectively measures how many open job postings there are, of which there are currently 11 million.
In contrast to the JOLTS report, private sources such as Zip Recruiter and LinkedIn have announced that hiring has been down dramatically in recent months. Moreover, in Q1 2023, there have been major layoff announcements for large tech companies like Meta and Amazon, to name a few. A lot of those laid-off employees will get 6-8 weeks of notice followed by 6-8 weeks of severance. That means that those layoffs won’t show up on the unemployment rolls for 3-4 months after the loss of a job happens, further underscoring a discrepancy with the JOLTS index.
In addition, history tells us that there’s generally a significant lag between the Fed’s first hike and an increase in job losses with the average lag being approximately 1.7 years following the first hike. Considering that the current hiking cycle began in March of 2022 just one year ago, there’s considerable evidence to surmise that the Fed’s optimistic perspective on the job market is premature.
On the inflation front, it’s my opinion that the method in which the widely observed, official Consumer Price Index ("CPI") is measured is backward-looking and overweighs rental inflation. I won’t go off on a tangential rant about how BS the "Owners Equivalent Rent" survey that's incorporated into the calculation of CPI is; instead, I’ll just say that it’s unequivocally backward-looking. As an owner of thousands of multifamily units, I can attest that there’s been a significant cooling of rents in the last 8-9 months following an abnormally high rent growth percentage in the teens to twenties in much of 2021 and the first half of 2022. Today, in my company’s portfolio, we’re seeing just slightly above normal growth in the 4-5% range on average (we typically underwrite to 3% rent growth).
Additionally, with the supply chain issues that occurred over the past few years largely resolving themselves, I think the official inflation gauge as measured by the CPI is about to drop dramatically. There’s very little I can think of that is more disinflationary than banks not lending money. Furthermore, the market’s forward-looking inflation expectations are already down significantly. I personally think the Fed has largely won the fight on inflation, and it’s only the backward-looking nature of inflation reporting metrics that gave them the cover to hike 0.25% at the most recent meeting.
With impending job losses, it seems like a looming recession is nearly guaranteed in 2023. All this crazy talk by financial pundits about a "'No Landing' Scenario" is going to look silly in no time. I strongly believe that Jay Powell and the other FOMC members know this, and they’re just talking tough about hiking rates to maintain credibility and fight inflation with rhetoric, because the backward-looking CPI still gives them the excuse to do so. I believe that, in their mind, this recent hike will give them more room to cut rates further and soon in order to fight off a recession.
My prediction at this point in time is that the 0.25% rate hike in March 2023 is the last one that we’ll see from the Fed for this cycle. I foresee that the long-awaited "Fed Pause" will be crystalized at the next FOMC meeting on May 3rd. Once the Fed stops hiking rates, they’re “on the clock” to start cutting. If I’m wrong, I can’t imagine they get more than one more 0.25% hike out in May, tops. Over the past four cycles, the average time between the last hike and the first cut has been 8.7 months.
Historically, at the time of the last hike, markets overestimate the forward path of the Fed Funds rate. So, when the forward curves demonstrate that rates are going to stay elevated for a year or two, history would tell us the opposite.
Interest Rate Cap costs fall materially within months after the last hike.
An important note on Freddie Mac floaters: Freddie Mac requires their borrowers to impound monthly escrows based on 125% of the current cost of a 2-year interest rate cap (however you are only required to purchase a 1-year cap extension when the existing cap expires). They then adjust those monthly impound amounts every 6 months. What has been acutely painful the past year for Freddie floating-rate borrowers (of which we have many loans) is the rise in interest rates and market volatility. The cost of rate caps has risen dramatically which in many cases has caused the rate cap monthly impounds to increase 15-20X on average, or more in some cases.
The same trend is true when it comes to the 10-year Treasury: markets historically underestimate how much it will fall following the last hike.
WHAT DOES THIS ALL MEAN? . . .Reading the market with history as my guide, and if Wednesday was the last hike of this cycle, Fed Funds have peaked. It is now just a matter of time before we get some significant relief on our current floating-rate loans. The relief will come both in the form of monthly interest expenses dropping as well as the price of the replacement rate caps declining, the latter of which we must purchase several in Q4 2023 on many of our properties. If I am right, most of the money we have been diverting the past several months to hold in escrow to ensure we had sufficient funds to repurchase the rate caps upon expiration should not be needed. This is not to say we won’t have to address potential issues within our tenant base in the face of potentially elevated unemployment… However, this will be a huge pressure release for my company, SPI Advisory, as well as many other multifamily owners.
Furthermore, with the regional banks pulling back credit availability dramatically that will lead to a hole in new multifamily supply in 2025 and 2026. Due to the limited new supply, I predict that those two years will be among the highest for rent growth I will see in my lifetime. I am very optimistic that 2025 and 2026 will produce phenomenal returns for SPI Advisory and our investors. We will do our best to position ourselves ahead of time to take advantage of this upcoming opportunity.
It's volatile out there and current inflation readings are still elevated (even though I personally think they’ll be coming down quite quickly) so there’s likely some more choppiness to come. However, I do feel it’s likely that Fed Funds -- and by extension SOFR -- has peaked and we are more likely to get relief on that front before the end of the year. Again, I reserve the right to be wrong, but that is how I view the world today.
Cheers,
