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December, 2024
Entering a New Era
The election is behind us, but uncertainty isn’t taking a holiday break. No, uncertainty is too pessimistic a word. At this point, 2025 appears to be somewhere between “interesting” and “exciting” for real estate investors.
Let’s take a look at key trends and dynamics to watch heading into 2025.
Regime Change
With the changing of the guard in Washington comes a fresh set of variables for real estate investors to consider. The incoming administration’s agenda suggests a more business-friendly approach to development and construction, with an emphasis on supply-side solutions to our persistent housing affordability crisis. While the specifics remain fuzzy, the broad strokes are becoming clearer: tax incentives, reduced red tape, and a general tilt toward stimulating new construction.
The National Association of Home Builders seems optimistic – their confidence index jumped notably post-election. But here’s the rub: treasury yields surged too, pushing 30-year mortgage rates back up to 6.79%. It’s a reminder that real estate capital markets are a constant battle of double-edged swords.
The Housing Puzzle Continues
Speaking of interesting, the housing market remains a study in contradictions. We’re still facing a stark reality: homes are historically expensive and increasingly out of reach for many Americans. The supply-demand imbalance that’s defined the market for years shows no signs of quick resolution, even with policy changes on the horizon.
For multifamily investors, this creates an intriguing dynamic. While new tax incentives and looser regulations might make development more attractive on paper, elevated construction costs and stubborn capital costs could keep the supply pipeline constrained.
413,809 apartment units were delivered this year through September,¹ on pace to well surpass the record delivery of 2021. This pace of development is still a function of COVID-era dynamics: this year’s deliveries began at a moment when renters’ pockets were stuffed with government cash, interest rates were still on the floor, and the Fed was actively participating in injecting liquidity into capital markets. Accordingly, the national vacancy rate has hit 8.7%, up from 4.7% in 2019. Still, rents increased 2% year-on-year in the third quarter, below recent averages but still positive. And the supply picture is rapidly changing: Capital Economics forecasts that multifamily starts and completions will decline by 45% in 2026 and 2027. Capital Economics also expects a 60 basis point decline in vacancy rate by the end of 2026, and annualized rent growth to reach 3% by 2027.
The bottom line? The fundamental investment thesis for multifamily remains robust: high household formation, expensive single-family homes, and limited supply should continue driving rents higher.
Beyond Residential
The incoming administration’s agenda could reshape other real estate sectors in interesting ways. Tax cuts – which seem likely given the unified government – could broadly benefit business activity, potentially lifting demand for retail, hospitality, and certain office spaces. Tech hubs in lower-cost metros like Phoenix, Austin, Nashville, and Atlanta might see particularly interesting opportunities emerge, especially if promised regulatory changes spark increased venture capital deployment.
But it’s not all smooth sailing. The administration’s stance on international trade could create winners and losers in the industrial sector. Properties configured for foreign trade might face headwinds, while those serving domestic manufacturing could benefit from an emphasis on onshoring. Still, fundamentals and macro trends also support the industrial thesis in the years ahead:
- Institutional investor allocations to industrial have increased from 14% in 2017 to 35% in 2023 (now the highest share of the “core four” CRE sectors).
- While the nationwide industrial vacancy rate has ticked up to 5.7% (due to a similar set of supply factors as multifamily), the vacancy rate remains below the long-term average of 6.7%.
- A generally business-friendly climate (including lower corporate taxes and deregulation) could spur investment, requiring industrial and warehouse space, across a wide range of industries.
The Global Picture
Zooming out, several global trends continue to shape real estate markets:
- Geopolitical tensions keep adding spice to an already complex market
- Inflation, while moderating, isn’t going quietly into the night
- The tech sector’s AI revolution promises both disruption and opportunity
- A broader shift toward economic nationalism is reshaping supply chains and space needs
It’s also worth casting a cautious glance at liquid markets. The new administration has signaled unwavering support for artificial intelligence-based technology, continuing to drive the top-heaviness of the S&P 500. Cryptocurrency values are hovering at or near all-time highs, as the administration promises deregulation and friendliness to the industry.
This increasing concentration of market gains within a narrow set of stocks poses significant diversification challenges. A downturn in the tech or crypto sectors, for instance, could have disproportionate ripple effects, given the weighting of these assets in major indices. What happens if prominent voices in these industries fall out of favor with the new administration (to put it politely)?
Given some uncertainty around the legislative agenda elsewhere, non-tech sectors won’t necessarily offer solid diversification in the years ahead for investors looking to reduce cross-asset correlation. Illiquid alternatives, like real estate, could be worth a look.
Portfolio Strategy in Uncertain Times
Our recent analysis of investor behavior reveals some interesting patterns. Younger investors tend to embrace more growth-oriented opportunities, while those with more market cycles under their belt often maintain more balanced allocations. It’s worth noting that in times like these, diversification isn’t just a buzzword – it’s a survival strategy.
The good news? Real estate continues to offer that rare combination of offense and defense that portfolios need in “interesting” times. Real estate’s versatility remains one of its most attractive features. If the ‘wisdom of the crowd’ is to be believed, the new administration should create tailwinds for real estate. But the specific sectors and geographies that will benefit most remain a bit of a mystery. Diversifying across these parameters, as well as positions in the capital stack, may be a wise strategy before these dynamics fully take shape.
Looking Ahead
As we head into 2025, several key questions loom:
- How quickly will the new administration’s policies impact real estate markets?
- Will inflation force the Fed to keep rates higher for longer?
- Can regional markets maintain their momentum as migration patterns evolve?
The fundamentals remain strong, but the path forward requires careful navigation. As always, we’re here to help you chart your course.
¹ Source: Cushman & Wakefield
October, 2024
Another positive jobs report, another inflation reading, another step closer to softly landing the plane. The September jobs report was the strongest in six months, with the unemployment rate falling to 4.1%.
And yet, this is not an anxiety-free economic moment. “While the global decline in inflation is a major milestone, downside risks are rising and now dominate the outlook,” Pierre-Olivier Gourinchas, the International Monetary Fund’s chief economist, wrote in a recent report. After reaching its highest peak in six months, the consumer sentiment index fell slightly in October amid frustrations over lingering inflation. (Though, nevertheless, consumers keep spending.) Americans are jittery about the election. It’s beyond the scope of this newsletter to opine on politics. Still, it’s clear that the election result may significantly impact international trade, labor force composition, regulation (particularly of tech giants) or even monetary policy. Concentration of stock market gains at the top — to the ‘Magnificent Seven’ tech companies — has reached stratospheric levels.
All to say that the fundamentals remain strong, but the asset allocation roadmap is a bit fuzzy. On top of over-reliance on just a few big tech stocks, a few other factors point to potential stock market volatility ahead:
- Elevated P/E ratios
- Geopolitical turmoil (see below)
- A looming election, which may drive up the VIX even more than usual this cycle
The good news: private-market real estate, now as ever, offers a set of potential benefits during moments of volatility. And, following a thrilling WNBA finals, the NBA season just kicked off (bear with us).
As wall-street-guy-turned-personal-finance-blogger Financial Samurai has said, real estate is a “[preferred] asset class to build wealth because it is a tangible asset that is both offensive and defensive… on the defensive side, real estate tends to outperform in a downturn because people seek the basics of food, clothing, and shelter… on the offensive side, real estate benefits in a robust economy due to rising rents and rising property values.”¹ In honor of the start of the NBA season, let’s extend the metaphor: real estate is like the versatile wing every team needs — the player that won’t let you down in transition, that raises your floor on defense, and that can provide stable scoring, even when the shot isn’t falling for the rest of the team.
Checking in on Residential
Multifamily is considered a particularly “defensive” real estate asset class. This is the basketball player who can keep getting to the line and giving you scoring even when his own shot isn’t falling; even if valuations fall or stagnate, cash flow from a tangible, irreplaceable asset tends to hold steady. The macro, long-run case for multifamily has only grown stronger over the past few weeks. Since the Fed dropped its benchmark rate by 50 bps, average 30-year mortgages rates have dropped some, but not as much as realtors might have hoped. In fact, mortgage rates increased in each of the first three weeks of October.
Meanwhile, construction starts on new single-family homes has picked up slightly, but multifamily starts dropped to a four-month low in September, with the total number of residential building permits (reflecting future construction) falling by 2.9% on an annualized basis. What does this mean? That overall residential supply remains suppressed relative to demand, especially as single-family homes aren’t getting any more plentiful or affordable. This occurs at a time when future rate cuts are highly likely, setting the stage for growth in multifamily valuations. In other words, multifamily may be a great combo of offense/defense, a “both ways player” for investors’ portfolios.
Notes from the Guys with all the Data
The Fed has released its October ‘Beige Book Report’ (as the name implies, good night table reading if you need a sleep aid). Here are a few major takeaways, kept brief to keep you from nodding off:
As you may recall, EquityMultiple maintains a proprietary evaluation model for CRE markets across sectors. These are examples of region and sector-specific factors that may be incorporated. Stay tuned for an updated version soon.
Return of the Quest for Yield?
We may also be headed for a new “quest for yield” period, with “safe” assets not really bringing home the kind of returns that investors seek, over a long time horizon, to counterweight more aggressive portions of their portfolio. This was more or less the environment between the GFC and the runup of interest rates. We may be entering a prolonged period of similar real yields from relatively safe, broadly available investments.
Alpine Notes are worth a look for any investor seeking alternatives to money market accounts and t-bills. With Alpine, EquityMultiple is committed to bringing investors a flexible cash management tool, and an attractive return versus other short-term investments.
¹ Buy This, Not That, Sam Dogen. Pages 153-154.
² Note that our current industrial investment in St. Cloud, FL was not impacted by the hurricane.
September, 2024
The Fed cut rates by 50 bps on Wednesday, bringing rates down from the highest point in 23 years, following the most aggressive tightening of monetary policy in roughly forty years. This was anticipated, but the size (a half a point rather than 25 bps) comes as welcome news.
Let’s be a little less dry: this is friggin’ huge.
Rates are an enormous factor for real estate investing, as we have discussed at length. In short, rates impact values. Rates go up, values go down; rates go down, values go up. Correlation does not imply causation, but CRE values and the Fed’s benchmark rate are tightly coupled. The most obvious ingredient in this soup is debt cost as a direct factor in the P&L of any real estate investment. When the Fed lowers its key rate, it puts downward pressure on the prevailing rates banks and other lenders offer to real estate operators. This reduces monthly cost for real estate operators (debt service) makes deals more profitable (all else being equal) and puts upward pressure on demand in real estate capital markets, hence boosting values.
Another simple dynamic in play: when rates return to something within the normal range, more deals happen. Buyers are more optimistic, and sellers are no longer “holding on” for brighter days.
Movements in the benchmark Fed rate impacts real estate markets in other ways that may be more unique to the moment. A brief rundown:
Impact on Consumers
A lower rate environment can benefit consumers in various ways. Let’s talk about some current nuances.
Following the supply-side inflation in the car market, plus rapidly rising rates on car loans and outsized inflation in car insurance, cars have become much more expensive. Overall vehicle debt in the United States has increased by 85% over the past 10 years. Overall household debt has been steadily creeping up. While a drop in the Fed’s key rate won’t provide debt relief instantly, it will trickle through all major types of household debt. If not directly, consumers may benefit from more refinance and debt consolidation options as rates drop.
This could be important for real estate markets. Debt relief reliably improves consumer confidence, which in turn could improve prospects for retail (including mixed use spaces and physical space for “non-essential” goods and services like restaurants, spas, or boutique goods). Less obviously, improving household balance sheets, if only marginally, should help with rent. While inflation overall has come down, shelter inflation continues to outpace overall inflation by a wide margin.
Increasing housing costs means increased rent, which is good for multifamily investors, right? Sort of… but not forever. The pace of shelter inflation so far this cycle does drive home the point that multifamily, as an asset class, can “capture inflation.” However, there’s clearly an upper limit. When households are stretched thin elsewhere, unchecked shelter inflation ultimately leads to delinquencies, vacancy risk, lower rates of household formation, and trouble for the multifamily sector. A drop in interest rates may help to support renters, in turn mitigating risk for operators. Over time, a drop in rates should inject liquidity into capital markets and help to calibrate supply and demand for multifamily at a time when the supply pipeline is thinning considerably.
Impact on Businesses
Generally rate cuts are good for business and good for the stock market. Lower borrowing costs factor into discounting of future cash flows, and hence investors view stocks more favorably. That said, this isn’t true across the board, or with every cycle of rate cuts. Corporate performance and stock performance depend on various other macroeconomic and sector-specific factors, and it remains to be seen how much anticipated rate cuts have already been priced in.
Rate cuts figure to drive strong tailwinds in areas that depend on significant investment. Namely:
- Manufacturing, logistics, and other cap ex-heavy sectors.
- Ecommerce, where inventory management, logistics, and consumer confidence all come into play.
Hence, industrial may be a CRE sector to watch carefully. Rate cuts could drive significant physical investment and leasing activity for warehouses, logistics facilities, and other industrial assets.
What Does This Mean for EquityMultiple Investments?
Again, dropping rates are generally good news for real estate, so long as those rate cuts are not a response to a clear and present recession threat (as of now, we can still remain hopeful for a “soft landing.”) In some cases, this may create favorable refinancing scenarios for our sponsors.
This moment could signal opportunity for forward-looking investors as well, across several different categories of investment:
- Alpine Notes: get ‘em while you can — Higher rates (as noted) are a drag on consumers and the economy in various ways. Higher rates do mean higher rates for CDs and money market accounts, however. Rates of return investors can earn on cash holdings respond fairly quickly and directly to changes in the Fed’s key rate. EquityMultiple Alpine Notes offer a spread above typical CD rates. While the rates we offer on Alpine Notes are not directly influenced by the Fed’s rate moves, Alpine Note rates will eventually mirror the overall rate environment. Hence, now may be the time to lock in current Alpine Note rates, particularly for 9 month notes.
- Ascent Income Fund and debt products — we remain confident that real estate private credit offers a compelling risk-adjusted return thesis in almost any rate environment. However, the rates that private lenders can command is now likely at the high point of the current cycle, and today’s rate cut may signal that we are at the high water mark. Investments made in the Fund before capital markets recalibrate may benefit from a higher blended rate.
- “Buy and hold” strategies — rates go up, values go down. Rates go down, values go up. Again, correlation does not imply causation and it’s more complicated than this, but the relationship tends to hold. A period of dropping rates should benefit any current asset operator and investment strategy. However, a climate of gradually dropping rates may particularly advantage core and core-plus investors. This is because relatively little else needs to change to engineer healthy returns. The cap rate expansion during this period of rising rates means that simply by maintaining (or marginally improving) rent rolls at core or core-plus properties, within established markets, operators can benefit from asset appreciation. And, because core and core-plus properties tend to be in more established markets and sub-markets, exiting the asset at a favorable moment may be easier, with more buyers entering the market in a favorable rate environment in established markets.
We’ll repeat a couple of things that we’ve said (many) times before.
- While rate cuts are a welcome development for real estate markets, none of us can predict the future. As a wise man once said, diversification is the only free lunch in finance.
- The specific types of CRE investment listed above are a great place to start. But given that we can’t predict how fast, or how much, rates will come down (or how the rate environment will impact the broader economy) diversifying across various types of real estate, and at different moments, may serve investors best.
August, 2024
The plateau didn’t stretch on beyond the horizon. That’s probably not a cliff in front of us, but it may be a gradually sloping hill. Just as interest rates seemed to have leveled off, ushering in a “higher for longer” rate environment, global equities markets had their worst day in recent memory. In the U.S., the VIX (a measure of market uncertainty) reached its highest level since early in the pandemic.
As we’ve discussed before, overreliance on large tech stocks and high price/earnings ratios in the U.S. are contributing to volatility. Monetary policy watchers anxiously await forthcoming payroll, inflation, and consumer sentiment readings. The next few weeks could be very interesting for
That said, there’s no particular reason to believe that we’re headed for a recession. New jobless claims have come down, and consumer activity is moderating, not dropping off a cliff.
Newmark, a leading real estate capital markets research outfit, puts the odds of a “soft landing” at 55%, their highest probability near-term scenario. In this case inflation returns to target, and growth returns to long term averages. Fed normalizes monetary policy.”
When it comes to your real estate portfolio, there are reasons to act, and there’s plenty of reason to stay the course.
Get ’em While You Can
We’re talking, of course, about investments supported by a higher rate environment. It now seems likely that rates will come down more rapidly and more significantly than we recently thought.This is the inverse of locking in a favorable mortgage rate.
Real estate remains potentially a great bet. But lower benchmark rates can quickly filter through real estate capital markets and negatively impact rates that private lenders can command. EquityMultiple’s Ascent Income Fund, for example, may be close to a near-term high water mark in terms of loan profiles and return potential. We may soon be exiting a particularly attractive phase. (That said we expect risk-adjusted return for Ascent to remain attractive, and real estate debt has proven to be a consistent driver of attractive risk-adjusted return in recent history.)
EquityMultiple’s Alpine Note rates do not move directly with treasury yields, but will track with the prevailing treasury yields over time, as EquityMultiple seeks to offer a meaningful spread to investors. T-bill rates move much more rapidly, as they are highly sensitive to market factors. Yields on the 10 year treasury have already fallen by around 100 bps from the prior highs in this phase of the market cycle. Alpine Note rates remain elevated (the current 6-month note features a rate 93 basis points higher than the first series of Alpine Note). Now could be the moment to lock in these favorable rates.
Uncertainty in Residential Markets: Certainly Not Bad for Multifamily
Mortgage rates are already coming down, falling from near 8% to 6.47%, the lowest rates since early last year. While a boost to housing affordability is welcome news, it won’t necessarily mean lower rents at multifamily properties. An inverse relationship between rates and home prices is perceptible, but statistically weak. (After all, we just saw housing prices continue to climb alongside interest rates.)
The bottom line is that there just aren’t enough houses for everyone who wants one. Market-rate housing is already underbuilt across large swaths of the U.S., and new housing starts fell by over 25% percent from the second quarter of 2022, before rates started rising, disincentivizing builders. While inflation has cooled generally, inflation in average rents has proved stubborn, remaining at levels above what economists had expected.
All to say that the future demand dynamics for single-family homes, and the near-term prospects for multifamily rent growth, both remain a little uncertain. Odd are, though, that with an overall undersupply of market rate housing, a thinning single-family supply pipeline, and a thinning multifamily supply pipeline, the broad thesis for multifamily should remain strong.
It’s worth noting that disparities may be emerging among local multifamily markets. Migratory patterns of the pandemic (and even before) as well as supply factors like zoning and height restrictions, may be creating a more varied opportunity set for multifamily investors. Coastal metros that were hit hard early in the pandemic may be coming full cycle. As Green Street notes in a recent multifamily sector update, “Early-3Q leasing trends and a heavier Sun Belt supply pipeline suggest coastal top-line outperformance is likely to continue in the near term.”
Local demand factors come into play as well. As economic conditions moderate, diversifying or established local labor markets are at a premium for multifamily investors. These factors are carefully considered in EquityMultiple’s proprietary market rating framework, which lends extra scrutiny to local multifamily market conditions. Recall also that, should job growth weaken further, multifamily may be relatively well positioned. Again, from Green Street: “In a tougher economic climate, sectors catering to less discretionary demand sources such as SFR and apartments should prove a relative winner”
Again, no reason to be overly pessimistic about macroeconomic conditions. But, as we enter what could be an interesting period for markets, diversifying across a range of multifamily markets may be a solid bet.
July, 2024
Taking on Current (Potential) CRE Myths
These are uncertain times—we get it. A period of steadily rising interest rates has left many investors leery of CRE. That said, a few major (more negative) narratives in the space do not really hold water. This is good news for you, discerning investor. It may mean other investors are unduly fearful, and this could bring unique opportunities your way.
Let’s dive in.
Office Is an Existential Threat…to More Than Just Office
Is distress in the office sector a threat to CRE in general, and potentially to the entire financial system? We’ve received this question more than once from anxious investors, and no one can blame them for asking.
The raft of gruesome headlines from, say, late 2022 to early 2024 seemed to indicate two things about how the press understands and talks about commercial real estate. Number one: it bleeds, it reads (same as it’s ever been). Number two: the papers seem to think CRE = office; or at least think that people think CRE = office. Green Street data shows that office is now just 7.1% of CRE holdings in the U.S. It accounts for just 3% of the market cap of listed REITs. And a Morgan Stanley analysis of 30 banks of various sizes indicated average office exposure, as a percentage of total assets, at just 2.7%.
Small and regional banks are also quick to point out that their typical loan is on a mid-sized building (the grocery-anchored retail centers, small office buildings, dentists offices, and so forth that make up the backbone of a community). Banks with under $15 billion in assets, of which there are many, are not the lenders messing with the huge, half-vacant office buildings that capture headlines.
Multifamily Is the Next Domino to Fall!
In parts of the country, rents are indeed starting to fall. There’s now fear among some industry watchers that multifamily is overbuilt, and that the music is slowing for this key sector. With elevated interest rates, some worry that challenges to rent rolls plus growing debt service cost will create alarming distress for lenders with a high degree of multifamily loans on their books.
Let’s take a look at both factors.
Is Multifamily Overbuilt?
Short answer: no. America is still short 7-10 million market-rate dwelling units. The multifamily pipeline is dwindling. Writ large, residential in the U.S. is still vastly underbuilt. With homeownership historically expensive, this creates broad and durable upward demand pressure for multifamily.
Yes, luxury apartment buildings are overbuilt in many markets. Certain Sunbelt markets that caught fire during the pandemic and generally have loose building regulations may be overbuilt. But, to borrow from Tolstoy, all multifamily markets in supply/demand equilibrium are in equilibrium in the same way; all multifamily markets that are out of equilibrium are out of equilibrium in their own unique way, creating idiosyncratic opportunities for investors. Everyone needs a place to live, and this is a big country, full of metro areas with their own unique demographic trends and housing supply challenges.
You can read more about the mechanics of specific multifamily markets, and where we see opportunity, in our recent Second Half ‘24 Whitepaper.
Is Multifamily a More General Concern for Lenders, and Hence for the Broader System?
For the reasons explored above, probably not. Some lenders who were loose on their underwriting and overexposed in very specific markets could be justifiably concerned about multifamily, but the case for multifamily remains generally strong, and rent levels are unlikely to decline relative to debt service costs for long.
That said, higher interest rates do challenge multifamily lenders, including small and regional banks, who may be tightening lending standards amid greater scrutiny (see above). Who stands to gain? Probably not Fannie and Freddie, as the article implies.
“If regional banks and large investment banks decide they’re not going to be making multifamily loans, then Fannie and Freddie will simply get more of the business,” said Lonnie Hendry, the chief product officer for Trepp, a commercial real estate data firm. “It’s a fail-safe that the other asset classes simply do not have.” This is not quite right. Fannie and Freddie do not issue loans; they buy and securitize existing loans. This may include HUD or FHA loans that are guaranteed by the federal government. Could Fannie and Freddie provide a lifeline to certain lenders and multifamily asset operators (borrowers) who otherwise may be facing distress? Sure, but the charters of these organizations preclude activity on loans over a certain dollar amount. In other words, in a credit crunch and amid dwindling DSCR figures, Fannie and Freddie aren’t going to do very much for the world of multifamily finance.
So, who could get more of the business? Private lenders. Alternative sources of capital, such as EquityMultiple’s Ascent Income Fund, may be critical for operators, both for refinancing and completing the capital stack for new projects.
Remember: Real Assets for Shaky Times
These days, predicting any kind of downturn would be a “cry wolf” move. The U.S. economy bucked fears of a recession throughout 2023 and well into 2024. The latest quarterly macro figures just came in higher than expected. The stock market remains at or near historic highs. Hopefully things will look more or less the same for the time being—we naturally approach the long-term 2% inflation target, and the Fed accordingly eases down rates.
But it’s worth considering whether those are, in fact, storm clouds on the horizon. While inflation has come down, it remains “sticky.” The IMF has forecasted down GDP growth in the U.S. as labor markets and consumer spending cool. Meanwhile, the stock market is tranquil on the surface, but elevated P/E ratios, an uncertain policy environment in the U.S., and geopolitical tension all could spell volatility for public equities.
It isn’t easy to shake up an asset allocation strategy, much less explore a new asset class, in uncertain times. Still, there are a couple of persistent reasons why private-market real estate can be worth considering at such a moment.
Real Estate Tends to Outperform During Inflationary Periods
This is part and parcel of the underlying appeal of real estate. It behaves differently from other asset classes, in that returns are driven by demand in the real economy. Factors such as a supply/demand imbalance in the housing market, as noted above. This means real estate, of the right type and in the right places, can potentially be a source of income and total return even as other asset classes and economic indicators show poor performance.
An Alliance Bernstein analysis for the years 1970-1991 had U.S. real estate as the strongest risk-adjusted return driver during stagflationary periods.
A KKR study during inflationary periods showed private real estate, along with infrastructure, far outperforming U.S. public equities.
Give Yourself a Few More Bites at the Apple by Diversifying
As with multifamily markets, each combo of CRE sector and metro area in the U.S. brings different dynamics and a different opportunity set. The stock market may or may not continue on its current trajectory through this year’s election cycle and into 2025. But you can be sure that the majority of individual investors will be betting on it, and mostly, therefore, on a handful of tech stocks. Private-market real estate, across a wide range of sectors and markets, offers opportunity for idiosyncratic return potential.
As always, don’t hesitate to give us a shout at ir@equitymultiple.com.
June, 2024
Let’s talk about office building conversions. Much has been made of the concept, but mostly wrapped in words of caution.
The distress in the office sector goes on, and the housing affordability crunch goes on (and on). The longer these factors persist, the closer office building conversations are to penciling for those operators who have the vision and knowhow to pull it off. Three moments in a recent New York Times article about the state of play are illuminating:
The Cost — “Many in the real estate business see converting office buildings into apartments as a way to deal with the need for more housing in cities and the decreased demand for office space. But conversions are costly, and not all buildings are easy to retrofit.”
No doubt. But the reasons why are a lot more stubborn than the reasons why not (the second two factors). It doesn’t seem like the demand for traditional office space is coming back, at least not to requisite levels for these assets to be economically viable as is.
Despite the bucolic fantasies of the early pandemic, the U.S. population is still urbanizing rapidly and market-rate housing is woefully undersupplied. Meanwhile, conversions are expensive and complicated, but where there’s a will, there’s a way. Tax incentives and HVAC technology gains could help. (Local governments have an incentive to make this work, because less activity in urban cores means less tax revenue.) Creative floor plans and amenities could tip the scales, like built-in virtual reality stations, rooftop common areas, and interior terrariums.
- The investment picture — “You could see wealthy people buying empty office buildings,” … “But they can afford to take the long view where an investment fund can’t.”
- Yes, and certain funds or traditional lenders may have balance sheet requirements that preclude this type of investment. Holding on to an aging office building for any period of time could precipitously ding the NAV of a public fund even if the basis and return potential are attractive. More nimble operators and sources of capital may be first-movers on this concept, and face less competition.
- The financing picture — “Some of these buildings, I just don’t know what happens,” Mr. Kaplan said. “It’s not feasible to convert all these ‘meh’ office buildings into residential. It’s still too expensive in a lot of cases.”
- In a lot of cases, yes. But there is a tipping point. The more loans come to maturity, the longer interest rates stay elevated, the more distress may force asset owners to liquidate at a price tag that may move the needle for forward-looking investors.
What About Those Actual Buildings?
The built environment is a big deal when it comes to climate change. Heating and cooling of buildings accounts for about 15% of global greenhouse emissions. The birth and life of big buildings can’t be ignored either.
Typical lifecycle analyses of high rise buildings show that 65-85% of emissions for a given building are generated in the “cradle to gate” phase — the extraction, transport, and manufacture of building materials. A non-negligible percentage is also attributed to the destruction of obsolete structures. Converting and rehabbing an existing structure mitigates both. Preserving an existing structure keeps carbon sequestered, rather than releasing it back into the atmosphere.
What’s more, in carbon emissions, as in investing, time matters. Just like the time value of money is part and parcel of considering IRR (a time-weighted return), the time value of carbon emissions is critical. A ton of emissions saved now is significantly more valuable than a ton saved over decades. Hence, higher efficiency insulation and HVAC systems are important, but giving an old building new life may carry a far greater time-weighted benefit.
Don’t Forget About Multifamily Value-Add
Repurposing aging buildings is not just about office conversions, of course. Given how under-built America is in terms of quality market-rate housing, it is just one piece of the puzzle. Converting Class B and Class C multifamily assets is another critical piece. The “higher for longer” interest rate environment presents real challenges. Rehabbing and repositioning of aging multifamily assets is all the more critical as the new supply pipeline thins.
Turning old multifamily into higher-quality product, and leasing to higher occupancy rates, is one key way to mitigate the undersupply of quality housing. This is particularly true if operators can add density to rehabbed assets. And, again, improving the buildings that already exist is the far, far better option from an emissions standpoint.
“Most of the positive climate effect we can have for the next few decades will come from renovating, with a deep energy upgrade, the buildings we already have so that the world’s cities do not act like the cooling fins on a motorcycle engine.”
— Build Beyond Zero, Bruce King & Chris Magwood
This is part of the story of an upcoming EquityMultiple debt investment opportunity. in the Atlanta area. EquityMultiple will be providing a loan for up to 65% of the total project costs, including renovation of 82 units (the sponsor has already renovated 138 units). Value-add improvements include HVAC maintenance and replacement; roof repair; and installation of various amenities, including a playground and BBQ area.
In sum, the sponsor seeks to increase occupancy and quality at a high-density, affordable housing asset that will not compete with new construction. Meanwhile, EquityMultiple inventors can expect a healthy low-teens fixed rate of return while participating in the renovation of an aging asset, helping to add quality affordable housing in a market that sorely needs it.
May, 2024
Another month, another news cycle dominated by inflation and interest rates. For better and worse, not much has happened. Inflation continues to prove sticky (which, in retrospect, feels very obvious). While the Fed, as anticipated, did not cut rates, it has signaled a low probability of more rate hikes anytime soon. “Right now, the probability of rate hikes is very low,” remarked a Fed governor earlier this week.
Yes indeed: “higher for longer” has replaced “soft landing” as your financial markets phrase of the year. For a refresher on how present market conditions can favor alternative assets, here’s recent EquityMultiple perspective from CFA Institute.
You might think this is bad news for real estate investors. It isn’t, or at least not entirely. Though higher rate increase cost of capital — bad in a vacuum — higher, but stabilized, rates could offer the following benefits:
- Debt and preferred equity positions can command higher rates for longer, potentially benefiting EquityMultiple’s Ascent Income Fund, for example.
- The fact that rates have largely stabilized (there’s little chance that they’ll move much in either direction for some time) means that investors can more confidently pencil out pro formas and buyers and sellers can more easily get together on pricing. More transaction volume likely would mean more choice for individual passive investors.
- Higher rates for longer (especially if this is clearly telegraphed by the Fed) means that asset operators who are already feeling distress, or have loans coming due, may be forced to liquidate, creating opportunities for operators who are holding dry powder.
On that last point, this may be a key moment for middle-market real estate opportunities (where EquityMultiple generally plays). This is because underwriting timelines or balance sheet exigencies may keep institutional players on the sidelines for a bit longer.
But what do the institutional players say about the state of CRE markets these days? Here’s JPM on the state of markets. Some key points:
- Luxury apartment vacancy rate was nearly 200 basis points higher than class B and C. Meanwhile, especially with the nuances of persistent inflation, workforce housing is a critical need across markets.
- Smaller, smarter retail is the next phase of the retail sector. Office vacancies are at an all-time high, but “desirable office properties in the most active locations will likely outperform.” In other words, we may be at an inflection point for the two sectors hit hardest by the pandemic years.
- Lower rates mean lower returns on liquidity. Higher rates mean higher returns on liquidity. Managing liquidity to take advantage of opportunities as they arise is key.
Re: liquidity, this advice is as applicable to individual investors as it is to institutional investors. This is the point of Alpine Notes, which recently crossed the $200M threshold in invested capital. Investors have the ability to roll over into a real estate investment as soon as 30 days after allocating to a Note, giving investors the opportunity to tap into attractive rates while staying liquid for opportunities as they emerge in a fluid market.
April, 2024
Prognosticating future macroeconomic trends is more likely to make you look dumb than make you a fortune. Most “serious” economists predicted a recession by the end of 2023. Most serious economists (the ones still willing to venture a guess) have declared victory for the “soft landing.” When the sun sets on 2024, the soft landing crowd may not look too smart either. Only time will tell.
Still, there are a number of sectoral trends that even the most mealy-mouthed market pundit wouldn’t doubt. Some interrelated things:
AI is a thing. You may think that a vast reimagining of the economy is still a ways off. You may think that tighter capital markets will stymie growth of the industry. You may even think that AI will hasten the demise of our species. Those questions aside, AI will keep charging ahead. This means more processing power will be needed (potentially at an exponential rate).
What corners of the CRE market benefit? Data centers, and various property types in tech hubs big and small.
Ecommerce: still a thing. like Zoom meetings, buying stuff online feels like the way it’s always been. What’s amazing is that online shopping accounts for only about 25% of total shopping. Despite a torrid pace of growth since the onset of the COVID-19 pandemic, ecommerce still has plenty of room to run.
What corners of the CRE market benefit? Industrial, especially warehouse space that can accommodate high-volume shipping and benefits from access to dense population areas.
Ecommerce growth is only one reason EquityMultiple is currently bullish on the industrial sector.
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There aren’t enough houses and no one can buy them. With mortgage rates creeping up over 7% again, and confusion about the upshot of the recent NAR class action suit, prospective homeowners are back to playing the waiting game. “The costs of buying a home are also outpacing the increases in rent, making it relatively cheaper to rent.” Meanwhile, cities across the country are trying to figure out how to build more market rate or affordable housing, and it’s tough sledding.
What corners of the CRE market benefit? Multifamily, but especially non-luxury and value-add multifamily in locations that are not overly burdened with zoning and building regulations, such as a handful of Florida and Texas markets.
Is It Time to Buy the Bottom?
Buy the bottom; buy the dip; buy when there’s blood in the streets, even if it’s your own; be greedy when others are fearful. Easier said than done, right? If it were so simple, we’d all be Warren Buffett, and hence there would be no Warren Buffett. Doesn’t mean we shouldn’t try.
Is right now the “bottom” in real estate markets? As always, we won’t know til the dust has settled. But there are signs. Institutional players are on the move. In total, CRE values have fallen 21% since the first interest rate hikes two years ago. This could be the moment, or at least the period, when the best bets are made.
- Rates will come down… at some point, to some extent. This may mean tentativeness on the part of investors and would-be buyers — from that same WSJ article, “many investors still aren’t ready to jump back into the market again.” This tentativeness, almost by definition, means opportunity for those who are ready to jump back in.
- Blackstone may be moving aggressively, but not all institutional asset managers are. Pension funds have stepped back, and generally many bigger investors are tethered to return hurdles that keep them on the sidelines, especially with uncertain capital markets. This may particularly point to opportunities in CRE middle markets.
- The supply pipeline is thinning out. This holds true across a number of sectors but is especially intriguing for multifamily. Per Mill Creek Residential, purpose-built rental apartment starts (new supply) should slow from nearly 500,000 units started in 2022 to an average of 220,000 in 2025 and ‘26. That’s an over 50% drop at a time when job growth and new housing starts are still robust. Paired with the general lack of housing affordability and inventory in the U.S., this starts to look like the moment to strike for multifamily investors.
But where, and which types of CRE are the right bets now? Again, this only becomes fully clear in retrospect, and the right current bet for you will depend on your risk tolerance. That said, we do know that a “higher for longer” interest rate environment, combined with record CRE loan maturities coming due, favors real estate private credit. EquityMultiple’s Ascent Income Fund makes this opportunity real for individual investors.
In this context, it’s worth recalling that the U.S. is a big, dynamic country with lots of individual real estate markets. When it comes to private-market real estate investing, that’s part of the fun and part of the opportunity. Just look at this range of headlines on CRE markets, just from one publication on the same day. (“Move Theaters Saved by Weird Real Estate” may be the best example of how varied, and pleasantly unexpected, real estate investment opportunities in the U.S. can be.)
Ultimately, you give yourself the best shot of “buying the bottom” with a range of bets across the capital stack, across markets, and across property types. If you ever want to talk it through, don’t hesitate to reach out to ir@equitymultiple.com
March, 2024
At various points in our history we have commented on market trends in less than unequivocal terms. Or speculated about future market dynamics with hedgy word choice. This is partly because this is the nature of writing down any opinions in a heavily regulated industry. It’s also partly because this is the one thing we know for certain: in markets, as in life, there are no absolute truths.
Patterns emerge and persist, but the future will never look 100% like the past. If you read this newsletter regularly, you also wouldn’t be wrong to point out that we often view market dynamics through the lens of benefits to private-market real estate investing. This is partly, of course, because we are a real estate investment firm that sells real estate investments. It’s also because we believe it to be true: no matter the state of interest rates, unemployment, GDP growth, trade balances, stock market performance, or any other indicator, we believe some form of private-market real estate investment is timely.
We hold that this omnipresence of private CRE opportunity comes from various factors, not limited to but including:
- Private-market real estate investment gets investors closer to alpha. In other words, returns less correlated with the dynamics of the overall financial system. Another way of saying this: returns as a function of skilled management and asset selection. No matter the market, there are skilled operators out there with local knowledge and the wherewithal to execute a specific business plan. EquityMultiple’s job is to find those operators and redeploy the opportunity for alpha to individual investors.
- Potentially recession-resistant strategies. A number of CRE sectors are driven by demand factors that are less correlated, or even inversely correlated, with general market sentiment. Just to name a few: Class B and Class C multifamily, student housing, self-storage, or assisted living facilities.
- The full spectrum of private-market real estate investments, across the capital stack, offers many strategies for different moments in the cycle. For example, as discussed, a “higher for longer” environment favors debt / real estate private credit.
- Illiquidity. Private-market real estate assets are exchanged in inefficient, often opaque markets. Illiquid assets are “heterogeneous,” i.e. are not directly interchangeable like, say, a share of a stock. In these inefficient markets, pricing is also more subjective and mutable. Put simply: private markets offer the opportunity to hopefully “beat the market,” whereas a large body of research suggests that no one (or at least very few people) beat public market indices in the long run. As stated in seminal research on the topic, “excess returns are fair game” in private markets.
So with all that in mind, what’s new in markets? Not that much. The jobs picture still looks good (though unemployment inched up a tad). Inflation is still a thing (especially when you drill into the numbers). And the stock market is humming along. Is this a good environment for private-market real estate investing? Why, yes — we believe it is.
Let’s dive deeper:
Private real estate credit still looks real good
We’re on a high and dry plateau. Again, unemployment remains low and inflation (though cooling) remains present. This points squarely to the “higher for longer” scenario for rates. Meanwhile, many traditional lenders remain sidelined in a year that should see a rebound in transaction volume. “Low transaction volumes masked the scarcity of capital in 2023, but the credit gap is likely to become more noticeable as transaction volumes pick up this year. We expect alternate providers of capital to have a significant opportunity to lend on high-quality, well-located real estate at attractive yields and terms.”
Private-market real estate investments may outperform during down markets
The “soft landing” scenario does still seem viable. However, some now fret over the possibility of inflation hitting working class households particularly hard (see figures above) triggering a recession. Certain sectors of real estate hold a strong counter-cyclical thesis. Multifamily, in particular, may show resiliency in recessionary and even stagflationary markets. Ken McElroy sets the table well in a recent discussion of his portfolio and typical renter mindset. “We are severely undersupplied as a nation” (when it comes to rental housing stock). Though late 2023 saw a surge in new deliveries, the supply pipeline is expected to thin for the foreseeable future. Two notable differences between equity investments in a multifamily asset versus, say, public equities: the asset potentially captures inflation better and more directly; and many multifamily investments will produce cash flow, even during relatively lean times.
Looking at years that the U.S. economy was in recession between 1980 and 2019, private-market real estate investing outperformed the S&P 500 both in terms of average annual return (1.35% vs. -1.1%) and on a risk-adjusted basis (standard deviation of returns for S&P returns in these years was 56% higher).
Stability in shaky times
The stock market has had a nice year so far. As the Economist puts it, looking ahead to the rest of 2024: “equities could underwhelm in many ways.” The theory goes that a) price/earnings ratios are historically high and b) the recent run-up in corporate profits was driven largely by things that can’t happen again: large corporate tax cuts and free money. As Blackstone put it recently, “the last time P/E multiples were at this level, the [S&P 500] provided only a 7% annualized return over the next 10 years.” Using the NCREIF Open Fund Index as a proxy, private-market real estate compares very favorably with S&P performance for the years 2000-2023 (including ‘23, when private real estate took a hit).
- Volatility, proxied by standard deviation of annual returns, was 55% higher for the S&P than for private real estate
- Risk adjusted returns, measured by avg. annual return divided by volatility, was 89% higher for private real estate than for the S&P 500.
Multifamily stands out. No matter what may happen with hybrid work, AI, P/E ratios, data centers, international trade flows, and on and on… people still need a place to live. And, as Mr. McElroy points out, the U.S. has not built enough places for people to live.
But we shouldn’t content ourselves with one asset class or strategy right now. We may be in for stormy seas this year. Many things of consequence will happen in the next nine months as a result of monetary policy, elections, geopolitical tensions, and technological developments. Look at the bright side: in the broad range of private-market real estate opportunities, there are a lot of places to put your chips right now. And in private-market real estate investing, the house doesn’t always win.
February, 2024
We talked last time about how the “vibecession” may be receding. This momentum continues, with the coiner of the term now declaring a “vibespansion.” People are feeling better about things (and we hope you are feeling good too). What do the vibes mean for your portfolio?
We’ve spoken in several recent Multiples about what history portends in this moment: the stock market may not end up being as vibey as we might hope through all of 2024.
Looking at historical data around other burgeoning “vibespansions,” the stock market could be in store for a rather bland period. Per MarketWatch, “The median S&P 500 SPX change when consumer sentiment picks up to this degree is a rise of 3.4% over 6 months and a gain of 7.6% over 12 — so below the average S&P annual gain of 9.9%. Put a different way, by the time Main Street has noticed the economy has improved, Wall Street has already made its money.”
There’s another way that not-so-distant economic history may prove instructive: productivity. In most academically accepted models of GDP growth, productivity is one of the key, if not most important, variables. As Nobel Laureate Paul Krugman has said, “Productivity isn’t everything, but in the long run it is almost everything.” And how do we drive productivity growth? Technological innovation. However, the last 20 years have been rife with innovation (think smartphones, internet of things, robotics, and now AI) yet labor productivity growth has yet to materialize in any major way.
Let’s go back to the early 90’s. Economists coined the term “productivity paradox” to describe their consternation: computers had been around for decades but hadn’t created a productivity boom… yet. As Robert Solow, godfather of macroeconomic growth models, said in 1987, “You can see the computer age everywhere but in the productivity statistics.” We all know what happened next: the internet happened, Microsoft Office products became omnipresent, and an era of robust economic growth followed. The S&P 500 returned an average annual rate of 26.3% over the back half of the ‘90s.
Are we in a similar place now? This kind of optimism goes beyond the “soft landing.” A productivity boom would mean that the economy, already nearing full employment, would be able to crank on without inflation concerns. In other words, it’d blow the top off the Phillips Curve (the theoretical relationship between unemployment and price levels) that hems in classical Fed strategy.
Here are a couple of major reasons to be optimistic about a coming “productivity boom,” and what it could mean for real estate investors:
Artificial Intelligence… It’s a Thing
The naysayers — those who insist we’re in a new ‘productivity paradox’ — note that it took decades for past major innovations, like computers, electricity, and the combustion engine, to drive meaningful economic growth. Others note that the benefits of AI (unlike computers generally) are likely to confer benefits mostly on the tech sector. Don’t be so sure. AI has something that no major prior innovation has: the potential to improve itself. Hence, productivity growth from AI may look more like an upward parabola than a straight line or stepwise function. By that same token: yes, it will benefit the tech sector first… but beyond that, who knows.
Hybrid Work
There is no consensus on how “hybrid work” impacts productivity. That’s partly because the data is weird, and partly because employers and employees are doing it a billion different ways and no one has truly figured it out yet. There does appear to be consensus, though, that hybrid work is here to stay and that neither full-time remote or full-time in office is optimal for anyone in the long run. Therefore, you just need one thing in order to believe that hybrid work will yield massive productivity benefits: a little faith. We’re so early in the process that best practices have not emerged. As we all settle in, it’s quite possible that employers and employees will find an equilibrium where hybrid work generates cost savings, more focused collaboration, and more sustained headspace for transformative productivity. While we can debate the statistics, maybe the more important consideration is simple, albeit squishier: hybrid work makes employees happier. Even the most mirthless economist can get on board: studies show that even when carrying out mundane tasks, happy workers are more productive.
How Does This Impact Real Estate Investors?
Productivity growth is good for the economy, and generally what’s good for the economy is also good for real estate markets. That said, there’s one general reason tech-driven productivity growth could benefit real estate investors: it could mean growth that’s rate-hike free. In theory, paychecks and profits could grow sustainably without inflation becoming a fixture. Broad-based growth without rate hikes is the holy grail for real estate.
That aside, AI and hybrid work are, to use the most tired terminology, “paradigm shifts.” Hybrid work could bring the types of real estate investment opportunities we talked about throughout the pandemic, except hybrid workers and workplaces would no longer be a temporary bandaid. AI could revolutionize any number of sectors. True, the most immediate advances may be in software and clerical work, but in short order AI may spur changes in the built environment that could both optimize real estate investing and call for new real estate investment, e.g. autonomous vehicle infrastructure or adaptive, high-efficiency HVAC systems.
Some other CRE sectors, or new strategies, that may be ushered in my AI and hybrid work:
- Amentized multifamily and build-to-rent (BTR)
- Conversion of obsolete warehouses and retail to data centers
- Office conversions to support density housing shortfalls
In the near term, don’t sleep on the student housing and data center asset classes. We’re gonna need more servers and more nerds!
Checking in on Cross-Asset Correlations
We’ve explored at length the relationship between asset classes, the imperative to “de-correlate,” and the potential power of private-market real estate to help decorrelate from a traditional 60/40 portfolio. Where do we stand now?
Looking at the last couple decades of data, including the pandemic and the beginnings of the current higher-rate, higher-inflation environment, private real estate stands out.
- Private real estate equity bears a significant negative correlation with large and small cap stocks in positive market environments.
- Private real estate debt bears almost no correlation with stocks in any environment
- In any environment, private real estate equity bears significantly less correlation with stocks than do REITs.
So, if you’re a believer in the “vibespansion,” private real estate equity may be an extra strong potential diversifier. Whether we go north or south, and to what extent rates stay “higher for longer,” a blend of private real estate equity and debt may serve investors well. This isn’t a matter of adding one or two assets. This should be a long-term strategy of creating a diversified private real estate portfolio across property types, expected maturities, positions in the capital stack, and strategies. (A strategy EquityMultiple facilitates via low minimums and diverse offerings.) As discussed above, we don’t know exactly how the future demands on the built environment will take shape, and where those opportunities will be most concentrated. But we do know that the winds of change are blowing.
What will the rest of 2024 hold for markets? Even AI doesn’t know. No matter how transformative AI will be, and regardless of how the next phase of the cycle plays out, it’s probably a good idea to grab onto something tangible.
January, 2024
Is the vibecession over? Consumer sentiment is a big deal in the U.S. In dry economic terms, the U.S. has a relatively low savings rate among developed economies, and consumption accounts for a high share of GDP (around two thirds of the economy). In more vibey terms, the economy runs (quite well, for the most part) on the aggregate momentum of millions of people believing tomorrow will be better than today (and therefore, you know, buying stuff). The vibes haven’t been so good lately. Despite those dry economic figures, such as unemployment, looking better-than-expected through most of 2023, Americans were not feeling the vibes.
This may be changing, with consumer sentiment leaping 13% in the first half of January from December. There’s a bit of a self-fulfilling prophecy at work here: consumers may feel that inflation is under control and a recession is less likely. Hence, inflation is more likely under control and a recession is less likely. Analysts with Allianz Insurance concluded that 25% of the dip in inflation can be attributed to “anchored inflation expectations, or the belief that the Fed would not let inflation spiral out of control,” above the 20% attributed to the actual effects of tighter monetary policy.
Do the sunny vibes portend a strong, stable 2024 for public markets? Not necessarily. In our last Monthly Multiple, we reviewed reporting that suggests the “soft landing” scenario may already be priced into markets. Historical data suggests current price-earnings levels set the table for only moderate forward growth. The stock market remains top-heavy and highly dependent on the “magnificent 7” tech stocks. At the end of 2023, the P/E ratio of the top 10 stocks in the S&P 500 was 26.9X, carrying 86% of the total return of the index for the year.
We’re also entering a year of elections across the globe, not least in the U.S., while geopolitical tensions and armed conflicts loom large, and fears of a weakening dollar are emerging. While the economic picture in the U.S. may be rosy, global uncertainty creates further potential for volatility at home.
Returning to the self-fulfilling-prophecy thing: when the vibes start to heat up, a lot of dry powder potentially comes off the sidelines from the long tail of retail investor savings. If you believe that stocks are fairly priced, or maybe a little expensive, the vibes may keep pushing in that same direction, dampening return potential and/or increasing the probability of a correction.
Let’s summarize:
- In critical ways, things look pretty good for the U.S. economy. What’s more, Americans are starting to feel pretty good about things.
- While this sounds good for the stock market in theory, the reality may be more drab if everyone feels this way.
- Given overweighting to mega-cap tech stocks and global factors, there may be more potential for public market volatility than the good vibes suggest.
What Can Multi Do For You?
Meanwhile, the vibes feel pretty good around multifamily. As Dr. Peter Linneman remarked during a recent webcast, Multfamily benefits from a 3.5M shortfall of single-family housing — ”multifamily’s best friend is the face that single-family is underbuilt.” While 2024 carries the promise of lower mortgage rates, 2023 was the worst year since 1995 for home sales. Meanwhile, attitudes toward renting and homeownership have changed. The percentage of Americans opting to rent rather than buy continues to surge upward, especially among higher income demographics.
If it feels like we talk about the broad thesis for multifamily all the time, it’s because we feel it’s relevant all the time. Irrespective of whether we truly see a soft landing in 2024, or how interest rates and inflation play out over the next several years, the fundamental case for multifamily remains valid:
- People always need a place to live.
- There is simply not enough supply of places to live in most markets in the U.S.
- Multifamily potentially offers a steady blend of income and appreciation through cycles, including (and especially) during inflationary periods.
How About Reducing Unforced Errors?
As Dr. Linneman remarked, many investors may now be making “type 2 errors” when it comes to multifamily: “I don’t invest when I should have.” A good way to avoid type 2 errors? (And reduce the magnitude of potential type 1 errors, by the way)… pursue a more diversified asset allocation.
While bigger public market swings have become commonplace over the past couple decades, allocation to alternatives has steadily grown. Per WealthManagement: “Institutions and asset managers are doubling down on investing beyond public markets, and the total size of private markets has gone from just a few hundred billion dollars in 2000 to $13 trillion today.”
Recent analysis supports the notion that a more diversified portfolio is the surest path to good vibes:
- J.P. Morgan concluded adding a 25% allocation to alternative assets can bolster 60/40 returns by 60 basis points—an 8.5% improvement to the 60/40 portfolio’s projected 7% return.
- Similarly, KKR found that 40/30/30 outperformed 60/40 across all timeframes studied.
- We’ve done our own research on the matter, featured in the CFA Institute’s Enterprising Investor.
For more on our investment thesis for the year ahead, please have a look at our 2024 Market Outlook.
December, 2023
“Soft landing” has transitioned from the mythical to the expected. Should we bet on it? Maybe, maybe not. “Even if it works out,” mused James Mackintosh in the Wall Street Journal, “the market gains to be had from betting on something happening that pretty much everyone agrees will happen aren’t likely to be large.” Though the Fed’s more dovish posture at the December FOMC committee may feel like rain in the desert, markets have already priced in the happy path, and then some, according to the article.
So if you bet on the soft landing, you will probably realize soft returns… if the soft landing happens. If not, the 60/40 portfolio’s prospects in 2024 may look a lot like 2022: volatile and, with the possibility of a stagflationary climate, potentially getting little relief in terms of bonds’ classic hedging capacity.
What’s to be done? JP Morgan has an idea. “…In a world in transition there are many ways to build up from the 60/40 starting point. For instance, simply adding a 25% alts allocation to the 60/40 boosts forecasts 60bps and improves the Sharpe ratio by 12%.” JPM’s 2024 outlook continues, on a less optimistic note, “investors will still need to pay attention to the corrosive nature of inflation on real returns as well as the implications for portfolio construction. Simply put, inflation is the enemy of both stock and bond returns.”
Note that JPM’s analysis covers the period from 1989 through Q1 of this year, underscoring that an “alts infusion” is no fly-by-night strategy, but may generate superior risk-adjusted returns through different business cycles. EquityMultiple’s researchers wrote on this topic in a recent CFA Institute article.
In other words, whether or not 2024 is truly the year of the “soft landing,” diversifying to alternatives — particularly an inflation-hedged alternative like private real estate — may be key to achieving better-than-soft real returns, as JPM has suggested.
Looking ahead to 2024, EquityMultiple’s diversified opportunity set offers several potential solutions for investors looking to sail above the “soft landing paradox” and pursue better risk-adjusted returns than the 60/40 portfolio may offer. To summarize:
- As returns to cash diminish (in response to slackening monetary policy), the Alpine Note may offer increasingly attractive spreads versus money market accounts (the 9 month note currently offers a 7.4% APY to investors)
- While rates may not stay at current levels through 2024, CRE debt interest rates are likely to remain elevated above early-2022 levels for some time. Along with tighter credit from traditional lenders, the case for private real estate credit may remain strong for some time, offering an alternative or supplement to bond allocations.
- A halt to interest rate hikes — and potential slashing of rates on the horizon — bodes well for real estate private equity. With a plateauing of rates, transaction volume may finally thaw out while a steady reduction in rates (barring a significant downturn) would allow operators to potentially harvest attractive returns, even over a relatively short timeframe.
Research heads at major CRE firms have voiced optimism: “we expect to see some interest rate reductions which will be beneficial to the real estate markets… Once we see that transition, that will be a really good sign for commercial real estate investment … this could be a much better cycle for returns than people are anticipating. Two reasons: because people have gone through such an abrupt adjustment over the last 12 months, people are more hesitant to put their hand back in the oven and get burned, but also, looking at the last couple of business cycles, there’s more leeway for the Fed to cut than before the pandemic… [a period of rate cuts] puts wind in the sails of investors and increases the probability that we could get some good outcomes over the next two years.”
In summary: in the interest of avoiding soft returns in 2024 (and beyond) you may want to consider hard assets.
November, 2023
Regarding interest rates — the financial press seems mired in a misconception. The narrative now seems to go “interest rates went up, real estate values went down, REAL ESTATE: BAD.”
Let’s consider the “glass half full” perspective.
On the one hand, rising interest rates increase cost of capital, potentially reduce cash flows, and create stress for operators. Not ideal for (some) individual operators who already own assets and are ill-positioned to hang onto them. (This also creates opportunity in the form of private lending and distressed asset opportunities.)
On the other hand, the typical narrative misses something very fundamental: asset valuation does not equal performance. Yes, interest rates have an inverse relationship on real estate values. But the glass-half-full side of this story shouldn’t be ignored: when rates go down, values go up. This means investors today can potentially get in at a better cost basis, and have better future return prospects because interest rates now have the potential to drop. In more jargony terms, we now have potential for cap rate compression whereas two years ago there was hardly any.
Looking Ahead Towards 2024
While real estate may be getting short shrift, other narratives around market forces are rosier. The correlational flip that sunk the 60/40 portfolio in 2022 has eased. Inflation is not such a big deal anymore. The stock market is on the upswing and the “soft landing” scenario looks increasingly likely. These are welcome trends, should they remain intact for the next phase of the cycle.
However, there’s some reason to cast a sideways glance at each:
Stock/bond correlation and the 60/40 portfolio:
With recent gains in the stock market, it’s easy to forget that 2022 was the worst year for the 60/40 portfolio construct since at least 1937. Seven companies are responsible for 72% of the growth of the S&P 500 this year, while the other 493 stocks are up only 7%. And most of the gains of those seven stocks have been buoyed by enthusiasm for AI. While the potential of AI is truly groundbreaking, the pace and breadth of innovation are a matter of speculation, and arguably the highest-profile business leader in the space was just sacked by his board under mysterious circumstances. Not quite a recipe for stock market stability.
Also, the stock/bond decorrelation effect doesn’t seem to have come back. While the CPI has trended downward, rolling 24-month stock/bond correlations have hovered around 60%, considerably higher than pre-2022 (when this correlation was negative in some periods). In other words, if the stock market dips, bonds may not be there to break the fall. Private real estate debt, on the other hand, potentially provides a less correlated, income-focused alternative.
Recent analysis from KKR shows (again) that allocating meaningfully to private-market alternatives can boost risk-adjusted portfolio returns vs. a traditional 60/40 construct. While the analysis suggests this is the case across market cycles, the spread is most acute during higher inflation periods. As the recent Blackstone study put it, perhaps the “set it and forget it” days are over and “simply owning the market won’t get it done anymore.” Private-market alternatives, and the potential alpha thereof, may be a key piece of the puzzle moving forward.
What Inflation?
Recent CPI numbers are encouraging, but it’s not a done deal. There’s reason to believe sticky inflation may stick around for some time. For one thing, consumer expectations of forward inflation have remained persistently high. Inflation is partly a reflection of our collective psychology; it tends to be a self-fulfilling prophecy. Should inflation stick around, private real estate (where operators can “capture” inflation in the form of rents) may hold appeal.
Have We Landed the Soft Landing?
Maybe, maybe not. In many ways, the effects of higher rates have not made their way to the core drivers of economic growth. Job numbers and consumer confidence remain high. However, we may be starting to see some cracks form. In six prior recessions dating back to the late 1960’s, the lag from peak interest rate to recession was, on average, 10 months. This means that if rates have peaked, or will peak in early 2024, we still may be a ways out from the onset of a recession. Should a recession come to pass, our thesis remains that private commercial real estate can offer a uniquely favorable investment thesis, particularly sectors that offer a counter-cyclical strategy (such as Class B multifamily, student housing, and self-storage) and those that are supported by durable sectoral trends (such as data centers, last-mile industrial, and medical office buildings).
Far be it from us to be economic doom-sayers. We aren’t alone, however. Recent modeling by the NY Fed (using the yield curve as the main forward predictor) put the probability of recession by mid-2024 at about 70%.
This fork in the road forms the basis of our current asset selection focus.
- In the positive (soft landing) scenario, we enter into a “higher for longer” interest rate environment, which prolongs the opportunity in private real estate debt and credit. (Our Ascent Income Fund was established to provide investors access to this once-in-a-cycle opportunity.) Meanwhile, longer dated equity investments may offer the opportunity for cap rate compression.
- In the negative scenario, allocation to potentially counter-cyclical and non-cyclical sectors, particularly multifamily (which bears the strongest risk-adjusted returns in NCREIF Property Index data since inception).
EquityMultiple’s three pillars — Keep, Earn, and Grow — were devised to support investors in uncertain times. No matter what the future holds, you can easily allocate to tailored diversification options across cash management, debt (fixed-income), and private equity real estate.
Oh and by the way, we’re offering up to 1% boost on new investments made between now and November 30th, 2023¹ as a token of our appreciation during the holidays. Happy Investing!
October, 2023
Entering the fourth quarter of a turbulent year, we see plenty of uncertainty in capital markets and a yield curve that’s been inverted for most of the past year. The prognostications on the economy and real estate markets are mixed. What do the smartest people in the room have to say?
In the modestly titled “Most Insightful Hour in CRE,” Professor Peter Linneman notes the various, but fairly obvious, reasons that interest rates don’t actually impact the real economy, at least not quickly. Most of the economy is not rate-sensitive. Take healthcare, for example, which represents 18% of the economy. Demand for healthcare services doesn’t move (i.e. is highly inelastic); healthcare providers respond in kind, regardless of rates. The majority of businesses,like the majority of homeowners, are not operating on short-term credit. Higher rates may eventually impact hiring, but certainly haven’t yet. Not coincidentally, Dr. Linneman disagreed with 60% of surveyed economists at the beginning of the year by predicting that no recession would come to pass in 2023.
Looking ahead, Dr. Linneman takes a definitionally bullish view of real estate’s long-term prospects: “As we sit here today, I’d place my bet on the private markets … we’ve had good Presidents and bad Presidents, good Congresses and bad Congresses, high taxes and low taxes, the one [consistent] thing is we always grow. Real estate is a long-term asset, and I’m going to bet on that growth.”
In his most recent memo, the mighty Howard Marks of Oaktree Capital takes a “duh” look back at the past forty years of the investing climate, when interest rates fell by 2,000 basis points. Most investors are too young to remember the period before, and we’ve all been on a “moving walkway at the airport,” oblivious to the constant tailwind of falling or bargain basement interest rates. Marks then poses the question Will leverage add as much to returns if interest rates don’t decline over time or if the cost of borrowing isn’t much below the expected rate of return on the assets purchased? It hardly needs a reply. Of course not, at least not broadly. “In the new environment, earning exceptional returns will likely once again require skill in making bargain purchases and, in control strategies, adding value to the assets owned.”
In real estate markets, and in terms of what EquityMultiple brings to investors, there are three main implications of this sea change in capital markets:
Headwinds become tailwinds for real estate debt
Marks provides the following parable: five years ago, an investor went to the bank for a loan, and the banker said, “We’ll give you $800 million at 5%.” Now the loan has to be refinanced, and the banker says, “We’ll give you $500 million at 8%.” That means the investor’s cost of capital is up, his net return on the investment is down (or negative), and he has a $300 million hole to fill. That hole, and the generally less borrower-favorable market for debt capital, means opportunity for alternative real estate lenders. The picture for a non-bank CRE lenders looks completely different than it did two years ago. The market dictates higher returns (rates) for loans at better overall leverage, with high quality borrowers looking farther afield for sources of debt capital.
As noted by Dr. Linneman, interest rates increases have not blunted economic growth much, and demand drivers remain strong in many pockets of real estate (consider, for example, the general undersupply of market-rate multifamily units in the U.S.) Deals will still pencil, but private debt and credit can now capture a larger share of returns. As Marks succinctly states,
“thanks to the changes over the last year and a half, investors today can get equity-like returns from investments in credit…. And, importantly, these are contractual returns.”
-Howard Marks, Oaktree Capital
Quality over quantity in equity positions
Marks also puts forth the “boiling frog” analogy. Over the longest bull run in U.S. history following the GFC, investors became more and more conditioned to a cornucopia of assets projecting juicy returns. In part this has been a welcome development, and a factor of more than lax monetary policy; tech-powered and alternative investing platforms allowed individuals to tap into institutional-type asset allocation strategies and find more channels for potential alpha. Investors’ collective frog brain may have lost sight of the fact that, in normal times, 30%+ IRRs are rare, alpha in the form of skilled management is hard to find, and a diversified approach is the only way to expect healthy overall returns from equity positions. (To quote the late great Dr. Harry Markowitz , “diversification is the only free lunch in finance.”)
At EquityMultiple we’ve always taken a quality over quantity approach when it comes to asset selection. In a capital markets environment likely to remain fluid for some time, diversifying temporally, across assets, and across operators is more important than ever. In addition to rolling out a market evaluation framework, EquityMultiple’s Investments Team will also be putting more muscle into evaluating sponsor partners and finding those most equipped to deliver alpha in a more challenging environment.
Time to get real with return expectations
It’s important to take stock of where we’ve been and where we’re going. The era of easy money was unusually kind to equity, and we can’t expect the same availability of levered returns in the coming years. Still, it’s important to remember that private debt and credit, while timely, do not offer appreciation. And, if inflation proves stubborn, nominal returns from debt positions and elevated bond yields may not carry a portfolio alone. With cap rates on the rise, a blend of real estate investing strategies — from core to distressed opportunities — could help form the basis of a winning asset allocation. In any case, a longer view and “full cap stack diversification” are in order.
September, 2023
Short-Circuiting the Doom Loop
The financial news cycle now seems almost as obsessed with the “real estate doom loop” as with the “soft landing.” To be sure, office vacancies and banking turmoil are no laughing matter. That said, news of the real estate sector’s death may be greatly exaggerated. Or at least over-generalized. Is there a potential vicious cycle in play for certain lenders, borrowers, assets, and central business districts? Yes. Is the entire CRE sector doomed? No. Has opportunity for real estate investment dried up? Again, no.
As we have noted previously, the contours of this CRE credit crunch uniquely create opportunity for alternative sources of debt capital (such as EquityMultiple and our investors)
From a recent WSJ article:
Besides banks, lenders such as private debt funds, mortgage REITs and bond investors can also provide funding—but many of them are financed by banks and can’t get loans. “We are seeing a serious credit crunch developing,” said Ran Eliasaf, managing partner of Northwind Group, a private real-estate lender.
Further, the ‘doom loop’ refers mostly to larger office assets and central business districts. As Kathleen McCarthy of Blackstone notes, you can’t paint commercial real estate with a broad brush. Numerous sectors (not named “office”) now benefit from demand tailwinds and, comparing this moment with 2006, at the doorstep of the Financial Crisis, leverage is 48% lower and supply 28% lower now.
REIT values seem to be responding positively to the expectation of more stable capital markets. Yet, as McCarrthy points out, real estate investors cannot “wait for the all clear signal” — diversifying sectorally, geographically, and temporally may serve investors best as we seek to capitalize on dislocation.
The “Next Austin”
Knowledge industry employers are increasingly looking to decentralize work locations, and the dispersion of knowledge workers continues apace. In this big country, ‘digital nomads’ are steadily flocking to a wide array of secondary and tertiary markets. And these secondary and tertiary markets are jockeying to be “the next Austin.”
Jennifer Davidson, a Brooklyn transplant, moved to Salt Lake City in October 2020 after a visit to a friend here showed her how much she valued the outdoors. “It is really hard to have a bad day when you can drive 20 minutes and be in the mountains,” she said …. Amen to that.
The tail end of the ‘era of free money’ — roughly from 2019 to 2022 — was at times characterized by highly compressed cap rates in certain premier markets and a fair amount of risk elsewhere. In the next few years, following the current wave of cap rate expansion, we may see opportunities for cap rate compression again and diverse demand drivers spur opportunity as “knowledge work” (and the breweries, coffee shops, and boutique hotels that go with it) continues to spread across a broader set of metros.
Meanwhile, some gateway metros seem to have finally woken up about their respective affordable housing crises, snapping into action to stimulate office building conversions. Broadly, multifamily is poised for a strong opportunity set in the near term due to a number of interlocking factors:
- America’s strange, stubbornly tight single-family home market (pushing more would-be buyers into the rental market)
- Persistently low unemployment and income growth in lower tiers of the earning spectrum
- Persistently high rates of new household formation
- A supply pipeline that is robust in the near term, but weakens by 2025 in terms of delivery of new units. (And is, regardless, insufficient to meet the shortfall of affordable housing — 7.3 million units nationwide as of 2021)
Weather it’s New York, Austin, or any number of metros trying to “be the next Austin,” demand will generally exceed supply across multifamily property classes. Real estate investors and developers should have plenty of opportunity for creative approaches — from rehabbing to office conversions to leveraging new local tax incentives.