Guest Post: Real Estate Bulls Need To Check Themselves Before They Wreck Themselves
Kevin Clark @Cribdilla: Why the inveterate bulls should, as Ice Cube said, check themselves before they wreck themselves.
One of my favorite follows on Twitter is Kevin Clark @Cribdilla. He isn’t afraid to throw out a contrarian take in the echo chamber that RETwit can sometimes be.
He is a CRE broker in New York City at Realty Advisors Group, a proptech founder, and an adjunct professor of real estate economics & market analysis & negotiation at New York University. He’s not just some schmo like me firing off Twitter hot takes.
He is also passionate about juvenile diabetes as one of his daughter’s was diagnosed with type 1 diabetes (T1D) in 2020. He has a fundraising page running through December 31. He has raised $9,862 of his $10,000 goal.
I will match any donation made, up to $500 in total. I know we won’t fall short as all my readers are incredibly wealthy from all my free information lol.
Kevin recently put out a 37(!) Tweet thread on his take on the current real estate market and where he thinks it is going. (Spoiler alert: Not up forever.) It’s a great read for anyone who is insanely bullish at the moment in order to better understand risk exposure.
I have transcribed his tweet thread into an article below. Enjoy!
Why Inveterate Bulls Should, As Ice Cube Said, Check Themselves Before They Wreck Themselves
As someone who makes most of their money on the transaction side of the business, I love buyers. They are the risk takers. The visionaries.
And importantly, I believe there are good investment opportunities in every market. And there are many well capitalized folks making big bets right now who will be very successful in the current market.
However, as someone who made it through the Global Financial Crisis (GFC) as a real estate pro, I know market crashes aren’t good for anyone. So here is my extended take on the current real estate market, how we got here and where we are likely heading.
Current State Of The Real Estate Market
Real estate cycles average 8 years. The current cycle started in 2008. Even with a slow start due to GFC, the current cycle is going on 14 years, making it one of the longest real estate bull runs in history.
All assets classes are subject to cycles due to over investment, corrections and underinvestment. The reason this happens in real estate varies, but cycles typically end due to externalities - things that are happening outside of the market - rather than froth in the market itself.
So understanding how those externalities could affect real estate is a key to understanding risk exposure.
How We Got Here
Typically, New York City leads the broader real estate market by ~18 months. With favorable interest rates and stable market growth, NYC’s rents peaked in 2018-19 and the market topped in 2019. By 2020, the market was slowly correcting and the wider real estate markets were continuing to appreciate as expected.
In 2019 the economy had recovered. Unemployment rate was 3.5% - the Fed’s dual mandate of *stable prices and maximum sustainable unemployment* was achieved and contractionary policies were in the works. The Effective Fed Funds Rate (EFFR) hit 2.41% in July 2019 and in March 2020 it was 1.59%.
For comparison, from April 2020 to December 2021, the EFFR averaged approximately 0.08% (that is not a typo). So, the July 2019 EFFR was roughly 30X higher than it has *averaged* over the last 21 months. (More on this below.)
We’re Not Bond Traders, So Why Should We Care About Interest Rates?
Well, if you’re not massively repositioning the real estate, the “going in” cap rate determines both the purchase and subsequent sale of the asset and is most influenced by the cost of debt in the broader economy.
Cheap, abundant debt incentivizes over investment, thereby pushing up asset prices and lowering in place returns significantly. This was already happening in 2019-20 and aggressive COVID monetary policies pushed it into overdrive.
March 2020 COVID hits and a 100 year black swan event created externalities that were overwhelmingly *beneficial* to real estate in ways that are impossible to ignore. Never before have we seen fiscal and monetary policies work in concert at this scale to give money directly to the population in the form of $trillions of direct stimulus payments.
At the same time, the Fed dropped the EFFR to 0.0/0.25%, initiated aggressive open market operations to compress interest rates, widened the discount window and lowered Reserve Requirements to 0. Overnight the economy was awash in cheap capital seeking diminishing returns.
And this was on top of a prolonged period of cheap capital during the GFC. If that wasn’t enough, extended national eviction moratoriums slowed natural vacancy churn, pushing up rents due to increasingly constrained availability.
Fed payments, PPP loans, and shutdowns bolstered household savings and COVID ravaged supply chains, delayed or postponed large ticket consumer good purchases (cars, computers, cameras), pushing savings rates to historical highs.
Work from home and furloughs shifted populations away from city cores causing demand spikes and gap ups in asking rents in new-located markets. The 2nd component of real estate cap rate is expectation of rent growth.
Historically, rent growth comes from submarket job growth and the resulting population growth. In this case, rents spiked due to COVID driven population relocation.
“Who Cares Why?”
Well the reason rents are spiking is an important consideration in its sustainability from an NOI standpoint.
*Why* things are happening is often more important than what is actually happening.
The fact that forced remote work has allowed significant relocation does not mean these are long term trends or particularly sustainable. It also doesn’t mean they’re not. Just understand you are betting on this outcome by making long term real estate investments.
With the economy awash in cheap capital, high savings, booming equity/property markets and collapsing supply chains, inflation begins to rear its bulbous head. Investors attribute rent growth to inflation magic and justify investment at lower cap rates because #inflation.
Market rent spikes seem to justify further real estate bullishness especially when underwriting above market rent growth well into the future even when this has rarely, if ever, happened in the past without an outlier event (think GIs returning from WWII.)
And if this wasn’t enough, ongoing supply chain disruptions caused construction price spikes, further justifying “replacement cost” fallacy investments.
Finally - institutions flooded into tertiary markets and non-institutional assets, further compressing cap rates. The presence of institutional capital paradoxically acted as a bullish signal to non-institutional investors - becoming a dangerous positive feedback loop.
All of these were COVID outcomes and decidedly not investor prescience.
So Where Do We Go From Here?
Inflation has kicked in and the Fed’s dual mandate requires them to address these price spikes. The Fed’s primary lever to combat inflation is trying to increase interest rates to disincentivize investment. And that process was announced last week.
The Fed will accelerate the taper schedule - which means the Fed will buy fewer bonds in open market operations putting upward pressure on interest rates followed by at least 3 interest rate increases in 2022. All but guaranteeing cap expansion throughout 2022.
And while bullish real estate calls speak of “massive pent up demand” pushing rents ever higher, the demographic facts run counter to this prediction.
2010 - 2020 population growth slowed significantly from previous decades and, more importantly, there was a decline in population in the important under 18 age group.
Additionally, high asset prices have led to over building. The 4 quadrant model explains this pretty thoroughly - high asset prices lead to high development leading to over building where supply exceeds demand and rents fall.
This process takes years - and is hard to see in real time - but we are 14 years into this cycle and pipeline deliveries are happening and accelerating.
With investment success we tend to oversubscribe self-serving or simplified reasons for why things have happened when the reality is much more complex. We also tend to buy into our own BS.
The reality is COVID rewarded real estate investors in ways that were completely unforeseeable in January 2020. Two years into this black swan event has emboldened investors to believe their hype and will likely lead to a deep property market correction.
Not GFC level, but certainly rivaling some of the bigger property market busts. I have no idea when this will happen, but it will happen eventually. In the meantime, I will continue to sell assets at record breaking prices.
Viva la mercado alcista.