Life is ten percent what happens to you and ninety percent how you respond to it.”

–    Lou Holtz

“Reality trades at lower multiples.”

–    Peter Atwater

There is an old joke about economists that seems remarkably apropos these days given the market, financial, and economic data the most recent quarter provided. The crux of the joke is that we should (please forgive the visual) remove every economist’s left hand so that they cannot say, “but, on the other hand,” when trying to explain data, behaviors, or how economies are supposed to work. Mediocre as the joke might be, it is timely. After all, for every positive data point observed during the third quarter, it seemed that a contradictory one was never too far behind. Maybe my handy Waze app failed me, not noticing the “signpost up ahead,” and mistakenly directed me into 2023’s version of the Twilight Zone. Or maybe there are just too many economists around with fully functional left hands.

Is the U.S. consumer tapped out or not? According to several articles I read (including some nifty data and charts included in those news sources), U.S. consumers have just about exhausted all their built-up, pandemic-related savings. Well, September’s retail sales increased 0.7%, more than double expectations and Americans continue to spend. Housing prices? Those must have tanked of late in the face of substantially higher interest and mortgage rates. Nope. Housing prices nationally were up during the quarter. Same with stock prices, right? Negative. Markets have dipped of late, but the S&P 500 and NASDAQ remain solidly green this year, despite modest declines in September. Banks must be falling like dominoes as their cost of funds skyrocket, lending activity dries up, and loans, especially on office properties, sour like the Dodger’s pitching staff. Nope, not yet. So, let’s dig into some of the data…

Treasury yields have ballooned since July, rising from 3.86% at the start of the quarter to 4.59% at quarter-end (and a whisper away from 5.0% at last glance), a tremendous rise, nearly 20% in relative terms, while inflation mostly steadied. Residential single-family mortgage rates followed a similar path, with 30-year rates rising from 6.7% to over 7.5% (and over 7.90% today).

However, stock indices mostly yawned in response, with the S&P 500 and NASDAQ both down only about two percent during the quarter, a far more modest decline than one might have expected in the face of these higher rates, the specter of additional rate hikes this year and next, Fitch’s downgrade of the U.S.’s credit rating in August, another looming government shutdown, and expectations that corporate earnings are expected to decline a collective 5.2% during the third quarter, all perhaps foretelling an economic slowdown, if not a recession.

Meanwhile, oil prices increased like there is no recession in sight, up about 30% during the quarter, while gold prices, the traditional inflation and uncertainty hedge, declined. Oh, and real growth in GDP? After increasing 2.4% in the second quarter, the International Monetary Fund just raised its U.S. growth projection for this year by 0.3%, to 2.1% earlier this month, as compared to its forecast in July. That’s right. They raised guidance, and here’s what’s head- turning. This revised growth estimate is larger than what they had projected for U.S. growth back in 2019, before the pandemic. Meanwhile, the Federal Reserve Bank of Atlanta predicts

that real third quarter GDP growth was…5.4%, a real outlier, and more than double second quarter GDP. Really? Well, here you go…

And home prices? They must have dropped precipitously with mortgage rates reaching levels not seen in over 20 years. Nope. Home prices rose a seasonally adjusted 2.0 percent during the quarter. That isn’t to say that every residential housing market witnessed higher home prices, but we can’t be all that surprised that home prices in Phoenix, Austin, Boise, or Seattle have fallen modestly this year, given how sharply prices in those markets rose over the past several years. But there ain’t all that much red on this particular map.

Single-family transaction volumes are another story, however, as they have fallen off a cliff, so to speak, as both buyers and sellers mostly sit on the sidelines in a state of housing “couch lock.” Mortgage applications hit a 28-year low during the quarter and firms like Rocket Mortgage and their peers appear grounded.

Indeed, from nearly every vantage point, I see economic warning signs flashing and am concerned that we are in for a harder landing than many anticipate, but the markets don’t seem to agree with me, as they remain fairly resilient, if not complacent. And this was before recent unrest in the Middle East and the ongoing political circus in our nation’s capital. While Barnum & Bailey’s may have closed shop a number of years ago, they have apparently set up tent in Washington, an appropriate venue for the House to elect a new Speaker. I fully expect Bozo to appear on a Speaker ballot soon enough.

So, let’s take a more detailed peek at these and other seemingly contradictory data points to try and get a better sense of where the economy and markets have been and where they might be headed.

Contradiction One: “The Consumer is Tapped Out”

According to recent data, U.S. households have now expended virtually all of the savings they accumulated during the pandemic. According to the San Francisco Fed, U.S. household savings declined from $2.1 trillion (trillion with a “t”) in 2021 to about $190 billion at the end of June or roughly $100 billion each month, which would imply that household savings are now entirely depleted. That is, the consumer is tapped out and ready to capitulate. Here are a few of those nifty graphs I referred to earlier:

However, as mentioned above, September retail sales were up 0.7% year-over-year, more than double expectations, as Americans continue to spend. And spend. And spend. On restaurants. On travel, leisure, and gaming. On Ozempic. On experiences like U2 at the Sphere or Taylor Swift anywhere. What was Cyndi Lauper’s hit song from way back when? Wasn’t it, “Americans just wanna have fun?” Yes, they certainly do.

How can that be? Where is the consumer finding its mojo? Consumer debt? Home equity lines of credit? Higher wages? Second jobs? Cash and coins hidden behind sofa cushions? In a word, “yes,” though I am not sure how much spare change can be found in or under your typical Lazy Boy.

Higher household debt offers one clue. Specifically, credit card balances increased $45 billion during the second quarter (latest available data), to $1.03 trillion, a record, having increased significantly since the end of the pandemic. Auto loan balances have also increased significantly.

The average interest rate on a new car loan just hit a record 7.2%, while the average interest rate on a used car loan is now 11.0%. The average new car payment in the U.S. is now $750 and the average new mortgage payment is $2,850. This means that an average American who wants a new car and home is paying $3,600 each month ($43,200 a year), or over 60% of median household income. Necessities have apparently become luxuries. However, even with these increased debt levels, the relationship between household debt and disposable income looks far different today than it did immediately preceding the Great Financial Crisis and well below long- term averages, although it has increased since this relationship hit an all-time low in Q1 of 2021.

Higher wages likely offer another explanation. Average hourly wages were up 4.2% in September (year-over-year) exceeding inflation (3.7%), continuing recent trends and reversing decades of stagnation. Recent strikes of the Writers Guild, Kaiser Permanente, and UPS have resulted in materially higher wages for union members, as they flex their collective muscles in a surprisingly tight employment market. According to one data source, some 457,000 workers have participated in 315 strikes so far in 2023 involving over 360,000 workers, including the

ongoing United Auto Workers strike. Maybe UCLA faculty members are next, so stay tuned. Live better, work union, I say!

Separately, I read that commuters save $51 for every day that they are able to work remotely, so perhaps the post-pandemic hybrid work model is also providing some marginal spending oomph. Maybe those sub-3.0%, 30-year residential mortgage rates (and sub-2.0% rates for 15- year mortgages) from 2021 and the lower mortgage payments that result, are also providing some marginal spending cash for those lucky mortgage lottery winners. Maybe it’s all those Uber and Lyft drivers working multiple jobs (see below).

In any case, whether the consumer can continue to power the economy forward in the face of depleted savings, higher borrowing costs on everything from credit cards to auto loans, the restarting of student loan payments after a two-year hiatus, and so much uncertainty here and everywhere, remains to be seen. So far, the answer seems to be “yes.” Regarding those student loan repayments, they are set to resume in October for the first time since 2020. In fact, a total of 45 million people in the U.S. have student loans, with about $1.6 trillion of student loans outstanding. Assuming an average monthly student loan payment of $200, roughly $9 billion in potential consumer spending will be curtailed. While not insignificant, I don’t think that these additional obligations will sink the consumer overall.

Or maybe I am just wrong, and the secret does indeed lie behind the sofa cushions.

Finally, here is one other trend not getting much attention. Consumer sentiment, while still low from a historical perspective, was surging upward at one of the fastest clips in modern history through July, but has declined every month since, according to the University of Michigan.

While well above last June’s all-time low, consumer sentiment is well off from pre-pandemic levels. But maybe it is just one of those anomalies that even if consumers aren’t feeling so hot, they will escape to restaurants, a Rams Game, or the Sphere to try and cheer up.

Contradiction Two: “The job market in in surprisingly excellent shape”

In September, the economy added 386,000 jobs, more than double estimates, while the unemployment rate remained steady at 3.8%, more than “full employment.” The high-level figures are solid.

And every state is benefitting, even California, where the unemployment rate is a reasonably healthy 4.5%, despite rumors and media reports that everyone is “fleeing” the state.

And job openings? As of the end of August (most recent available government data), there were

9.6 million job openings, an increase of 690,000 over the prior month, and according to the Bureau of Labor Statistics, these openings cross numerous sectors: professional and business services (+509,000), finance and insurance (+96,000), state and local government education (+76,000), nondurable goods manufacturing (+59,000), and federal government (+31,000).

And what about wages? As mentioned above, workers have experienced real wage gains for five straight months, following more than two years of negative real wage growth.

How do I square this rosy employment data with headlines like this, which just appeared on CNBC’s home page last week: “Big Banks are Quietly Cutting Thousands of Employees, and More Layoffs are Coming”? How do firms reduce headcounts “quietly?” They whisper as they escort folks out the door? Well, apparently the five largest U.S. banks have “quietly” cut a combined 20,000 positions this year and more cuts are forthcoming. And anecdotally, I keep hearing about how tough the job market is for many white-collar professionals, from aspiring lawyers to real estate brokers/agents, to mortgage bankers. And some data bears this out, as full-time employment has actually declined since June, down nearly 700,000 jobs.

Huh? This sort of data would normally imply we are in a recession. However, what’s peculiar, if not enlightening, is that the number of folks holding two full-time jobs has increased to an all- time high of 447,000. Perhaps that is where the contradiction lies.

The last few times this occurred during the last 25 years were in 2001, 2008, and 2020. Meanwhile, part-time employment increased by nearly 1.2 million jobs last month. What the heck is going on? Are folks taking on multiple jobs (e.g., driving Uber, delivering for DoorDash, trading crypto) to combat inflation and more easily afford those U2 tickets? Double-dipping while they work from home in their Vuori outfits, unbeknownst to their multiple employers? I’m not sure.

In any event, I suspect that the job market is not quite as strong as headlines and even overall employment figures would have us believe. Perhaps the next quarter or two of job data will provide clearer clues.

Contradiction Three: “Real Estate Prices, Equity Markets, and the Economy Generally Fare Poorly as Interest Rates Rise”

Perhaps one picture tells a thousand words, depicting the performance of the NASDAQ index since 2021 versus 10-year U.S. Treasury yields. What’s peculiar is that the two move in almost perfect correlation until the start of 2023 when they begin to diverge…and widely. How can that be? It can’t all be due to artificial intelligence and investor hype, or…? After all, third quarter earnings are expected to be the “worst in years,” down 5.2%, as a result of higher interest rates and energy prices, at least according to “professional economists,” Wall Street analysts, and market pundits.

Regardless, something has to give, it seems to me. The NASDAQ was down some 5.8% in September and is down about 2.5% this month, so perhaps some cracks are starting to emerge.

But the markets remain broadly higher this year, despite the higher rates, with the S&P 500 and NASDAQ up 12.5% and 27.2% this year, respectively, at last glance. If you would have told me that the 10-year Treasury yield would be up from 3.88% to over 4.90% during the year, and the equity markets would be up double-digits, I would ask you what alternative universe you had been living in or what cannabis dispensaries you frequent. Yet here we are.

However, much like the jobs data is somewhat misleading, there is more that meets the eye when we peek under the equity market hood. The 10 largest companies in the S&P 500 now comprise over a third of the index, with an average price-earnings ratio of 50. This is the highest percentage of concentration since 2001, during the dot-com era. Even at the 2008 market peak, before the failures of Bear Stearns and Lehman Brothers, the 10 largest companies relative contribution to the S&P 500, peaked at about 26%.

And those home prices? How can we reconcile those higher prices in the face of such higher mortgage rates? It seems inherently contradictory that home sales would fall to their lowest

rates in over a decade, dropping month after month, while prices…rise. The culprit? There simply is not enough supply, barely over three month’s worth, well below historical norms and near historical records.

Anyone who purchased a home in or before 2022 is not likely to sell unless they have to, as they likely have mortgages they are now wedded to, certainly those paying less than 3.0%, proverbial mortgage handcuffs (my least favorite type). And if they were to sell, they would be hit by a double-whammy: substantially higher prices and substantially higher mortgage rates. These homeowners are more likely to move and yet hang onto their homes as rental properties.

Others, principally the Baby Boomers, have so much equity in their homes that they ain’t selling out of the unattractive prospect of sizable capital gains taxes. Meantime, builders can’t build enough housing (both single- and/or multifamily) for reasons we have explored many times before: lack of buildable lots, labor issues, the cost of capital, restrictive zoning, neighborhood outcry, or a lack of adequate transportation and infrastructure.

The net result is that the median monthly house payment sits at record levels no matter what state you examine. The math isn’t all that complicated. The monthly payment on a $500K home, with a 30-year mortgage and 20% down, is over $2,800 a month. And that assumes you have

$100K in liquid assets to meet downpayment requirements.

Hawaii became the first state in history with a required median monthly house payment exceeding $5K each month, while California’s median house payment of some $4,800 per month represents 64% of median household income, also a record. In turn housing affordability (shock, shock) just hit another all-time low. Adjusting for inflation, U.S. home prices have increased approximately 118% since 1965, while median household income has increased by just 15%, more than a 7x difference. 90% of major U.S. metros are characterized by price-to-income ratios above the maximum recommended ratio of 2.6. Only six of the 50 most populated U.S. metros have price-to-income ratios of 2.6 or lower: Pittsburgh, Cleveland, Oklahoma City, St.

Louis, Birmingham, and Cincinnati. And as luck would have it, Los Angeles is the least affordable city in the U.S., with the median home costing 9.8 times median income, with San Fransisco a close second, at 9.1x. The bottom line is that Americans need, on average, $114,000 of household income to afford a typical home. That’s tough.

As home prices have risen in the face of dramatically higher mortgage rates and multifamily rents have actually declined modestly (see below) during the same timeframe, housing affordability has reached another auspicious milestone, a record low.

Meanwhile, foreign buying of U.S. homes fell for a sixth straight year, sinking to the lowest level on record. International buyers purchased 84,600 U.S. homes in the year ended in March, down 14% from the prior year, according to the National Association of Realtors (NAR). The dollar volume of homes purchased by these buyers fell 9.6% to $53.3 billion, also a record low since NAR began collecting the data in 2011. Similarly, investors have purchased a third fewer homes this year than last year.

In response to declining transaction volumes and significant affordability headwinds, Zillow announced during the quarter that they will begin offering mortgages with just 1% down, while other lenders are now offering 40-year mortgages. I’m not convinced this is wise or will prove materially impactful. After all, unless sellers want to sell and/or builders are able to build, home sales will remain mired in the muck. In any case, didn’t we learn any lessons from the Great Financial Crisis, that offering more aggressive loans and loan terms to strapped borrowers is not generally a grandmaster-worthy chess move?

Meantime, shouldn’t multifamily housing benefit from all the single-family residential headwinds? Yes, of course, and it generally is, though rental growth has moderated, and vacancy rates have risen slightly in the face of increased deliveries in markets like Phoenix, Boise, Austin, and Atlanta. Overall rents declined modestly in September, about 1.2% year-over-year.

However, some historical perspective is in order. After an unprecedented increase in rents during the pandemic (up some 20%), we shouldn’t be surprised that they have moderated slightly since last year’s peak, and rents should remain in a fairly narrow range until the middle of next year, I suspect, when I believe demand will again catch up to supply, and rents will begin to increase yet again, although at a more normal rate (three to five percent annually).

It is the same with vacancies, so while they have risen since the second quarter of last year, they are still just a tad over 5% nationally and have recently begun to level off, as new supply gets absorbed. The key is that multifamily starts have declined precipitously during recent months, which comes as no surprise in the higher-rate, liquidity (both debt and equity) constrained market. Many of the cranes crowding skylines from Phoenix to Denver and Dallas will soon come down and are likely to stay down for a long time. Apartment building starts fell to a seasonally adjusted annual rate of 334,000 units in August, a 41% decline from the pace seen the same month a year prior, according to the Census Bureau. An annual decline of this magnitude has happened only once since the subprime housing crisis.

Obviously, it is a tale of individual markets and just like with single-family home prices, those markets that experienced the largest rental increases over the past several years, from Austin to Phoenix to Atlanta, are returning some of those outsized gains. Meanwhile markets that were generally left behind, those in the Midwest (e.g., Cincinnati, Chicago, Indianapolis), are now experiencing rental growth, albeit at fairly modest rates. In one interesting comparison, someone pointed out that with average San Francisco rent of about $3,500 per month versus rent in Las Vegas of only $1,500 a month, you could possibly commute to work via Southwest Airlines each day between Vegas and the Bay Area and still come out ahead. Of course, just think of what all the salty snacks would do to your blood pressure, let alone going through airline security each day, with or without TSA Pre-check or Clear.

Finally, are apartment cap rates peaking and prices/values therefore, bottoming? There’s a growing view among multifamily investors that cap rate expansion is nearing that point, though I wouldn’t yet call it a consensus view. After cap rates expanded 60 basis points between the second quarter of last year and the first quarter of 2023, they rose just 10 basis points to 5.2% in the second quarter of this year and the early buzz is they will likely inch up only modestly more in the second half of 2023 as deal flow picks up a bit. But given the relative dearth of transactions, it is hard to say where cap rates actually stand at present.

Finally, I want to revisit one last topic regarding the multifamily market which I discussed briefly in last quarter’s memo and in recent presentations: exploding insurance costs that keep hitting new highs, and in some cases, insurance coverage is not even available as more and more insurers pull out of certain markets (e.g., California, Florida) and reduce coverages or coverage limits, and/or increase compliance requirements everywhere. Natural disasters, inflation and a shrinking reinsurance market have pushed insurance premiums to record levels. That leaves many landlords in a bind and buffered by yet another headwind.

While building values and rental income are generally down across all asset types and geographies, uncontrollable expenses like insurance rates on commercial properties keep rising, having risen 7.6% annually on average since 2017 and by double-digits this year. Those increases can result in hundreds of thousands of dollars or more in additional annual costs, depending on location and size of the property, steep enough to wipe away an entire year of cash flows.

Contradiction Four: “Banks Are Going to Fall Like Dominoes Given Skyrocketing Cost of Funds, Increasing Unrecognized Losses on Investments, Declining Lending Activity Drops, and Mounting Credit Losses”

Following the failures of Signature Bank, Silicon Valley Bank, and First Republic earlier this year, predictions that any number of regional banks (if not one of the money center banks) would follow became commonplace. And yet, based on recent earnings reports from Goldman Sachs, B of A, Chase, Citibank, Wells Fargo, and Morgan Stanley, things do not appear as dire as they might seem. Most banks that have reported third quarter results have beaten forecasts.

Granted, expectations and forecasts have been markedly tempered, but thus far, none of the banks that have reported third quarter results seems in any immediate danger. Perhaps the shoes are yet to drop, but so far, so good. Or maybe not “good,” but “not so bad.”

For example, in its third quarter earnings release, Morgan Stanley indicated that it has set aside

$134 million for credit losses due to “deteriorating conditions in the commercial real estate sector.” B of A reported that its non-performing loan portfolio (those with past due payments of 90 days or more), increased to nearly $5 billion in the third quarter, up from about $4.3 billion at the end of June. Those figures sound ominous. However, everything is relative, and from a broader historical perspective, delinquency rates pale in comparison to what we witnessed leading up to the Great Financial Crisis.

Same with net interest margin, the difference between interest earned on loans and that paid out to depositors. They certainly don’t reveal any material concerns…at least for the time being.

There is no question that the foundational premises for the perspective that additional bank failures are coming are not inaccurate. Banks costs of funds are much higher this year, as depositors move money from traditional savings and checking accounts paying official interest rates formally known as “jack squat”) into higher-yielding money market accounts and certificates of deposits. Lenders have significantly cut loan originations and tightened lending

standards (e.g., raising minimum levels of acceptable credit scores), with loan originations down over 50% this year, across all property types. But let’s face it. It isn’t just banks toughening up standards that is reducing new loan originations but collapsing demand.

Obviously, concerns remain. Over $1.3 trillion of commercial real estate debt comes due between 2023 and 2025, about a trillion of which matures between now and the end of next year. How much of that debt is impaired or potentially troubled? Data is not easy to come by, but some estimates are that about 40% of these loans or more are potentially “troubled.” And that was before the most recent spike in rates, which certainly will not alleviate whatever distress exists.

So, if banks curtail lending, where will liquidity and debt capital come from? According to a recent survey, senior loan officers indicate that conditions for loans to businesses and consumers will only get tougher, while loan demand declines in the wake of a less favorable business climate. In fact, the Mortgage Bankers Association predicts commercial-property lending will have fallen 38% by the end of this year, as compared with 2022. Some worry that once-reliable sources of credit will be unwilling to return to their previous levels of lending, leaving property owners high and dry.

Meanwhile, U.S. companies have $600 billion in corporate debt set to mature this year, a total that will grow to more than $1 trillion a year from 2025 until 2028. Some companies will be unable to replace such debt and will need to meaningfully restructure, either within or outside bankruptcy court, while others merely face substantially higher borrowing costs.

Other data supports this perspective, as there have been 459 corporate bankruptcy filings so far this year through August, nearly double that of last year. 57 companies filed for bankruptcy in August versus 30 in August of 2022. However, when comparing the 2022 data to other years following the Great Financial Crisis, nothing appears out of the ordinary. Or again, are we just waiting for more shoes to drop?

And just as banks are facing the dual headwinds of higher costs of funds and declining loan demand, U.S. regulators, responding to the bank failures earlier this year, announced sweeping rule changes and increased (Tier I) capital requirements in July for all banks with more than

$100 billion in assets. These changes, perhaps well intentioned, will only constrain bank lending activities and market liquidity further, at a time when the markets and borrowers, actual and prospective, will likely need more of it.

Contradiction Number 5: “Higher Inflation is Really Pressuring Treasury Yields”

The Consumer Price Index rose 3.7% in September, matching August figures, while the cost of shelter (rent or equivalent and utilities), which comprises the single largest component of consumer prices (about a third), rose 7.2% from a year ago and represented the largest component of September’s inflation figures.

But keep in mind three things. One, inflation exceeded 9% barely over a year ago, so while inflation remains well above the Fed’s two percent target, significant headway has been made. Two, the cost of shelter, again, the single largest component of consumer prices, has a well- documented lag effect (as long as 12 months) and these costs and their impact on reported inflation are likely to decline in coming months, given declines in asking multifamily rents discussed above. In fact, excluding the cost of shelter, consumer prices were up just 2% year- over-year last month. And finally, excluding volatile food and energy prices, consumer prices have actually declined for six straight months.

Therefore, it isn’t just inflation that has pressured Treasury Yields, which increased 20% during the quarter. So, what else is causing such a dramatic rise in interest rates, if it isn’t just inflation? The answers lie in several data points and graphs, the first two depicting the Treasury holdings of China, Saudi Arabia, and Japan, three of the largest (if not, the largest) owners of our national debt. In short, they have collectively lightened their Treasury holdings by hundreds of billions this year.

Meantime, the Fed itself, the largest owner of our Treasury Bonds, has lightened its Balance Sheet and Treasury holdings by about $800 billion since last year. You will recall that the Fed mostly acquired them during years of their Quantitative Easing endeavors, principally during the pandemic when they bloated their Balance Sheet by about $6 trillion.

So, why are China, Japan, and Saudi Arabia dumping Treasuries? It is likely a combination of factors. China has a myriad of well documented fiscal challenges and has been dipping into their reserves (i.e., selling Treasuries) to prop up their struggling economy. Japan has had to prop up the Yen in the face of a rapidly increasing U.S. dollar. And Saudi Arabia? Their motivations are

less clear, especially in a market of increasing oil prices. Color me a conspiracy theorist, but I suspect it may have something to do with their desire to pressure the Democratic administration in an election year. This perspective is consistent with their cuts in oil production, pressuring oil prices and requiring the Biden Administration to dip into our strategic reserves to offset higher oil and gas prices.

Finally, let’s not forget ballooning federal deficits, requiring more and more borrowing (and debt service) every passing second. With barely two months left to 2023, the fiscal budget deficit has already more than eclipsed the massive 2022 shortfall. The fiscal 2023 federal deficit will likely be about $2 trillion compared to $1.375 trillion last year, as tax revenues have declined and our national debt has ballooned to $33 trillion, “movin’ on up” faster than when the Jeffersons relocated “to the east side.”

One would think that these trends are simply not sustainable, and I agree. Something has to give as future spending, especially entitlements, is only expected to grow as the Baby Boomers retire and there are not enough young workers around to pick up the slack. The only question is how this plays out…and about that, I am not so sure. Folks have predicted a day of reckoning for so long and yet, those warning calls have not yet materialized in any recognizable way. Maybe it will merely be this way until the end of time, when our galaxy collides with our neighbor, Andromeda, and quadrillions of debt outstanding at that time will simply evaporate.

While Congress Remains in a State of Limbo, as the House Seeks a New Speaker, Local and State Politicians are Picking Up the Slack…as Usual

As usual, I monitor the machinations of government and public policy since they inevitably impact housing markets. In fact, in a single day in July, two articles hammered this premise home. One article addressed yet another effort here in California to place statewide expansion of tenant protections on the ballot, namely a proposition to repeal the Costa-Hawkins Rental Housing Act, which would effectively expand rent control throughout the State. The second involved the City of Maywood here in Los Angeles County, where renters comprise nearly three quarters of residents. Maywood issued a 60-day “rent freeze” in July, which was then extended through the end of September. In a world of climate change and global warming, rent “freezes” are bucking the trend. Coincidentally, on that same July day, the Wall Street Journal ran an article, “High Housing Costs, Evictions Push Homelessness to a Record Increase.”

Meantime, other cities are doing what they do, all trying to rein in higher housing costs, the increasing lack of affordability, and rising homelessness. From Pasadena (Measure H, allowing rents to be increase only once a year and no more than 75% of inflation), to Cudahy (rents can only be increased by inflation or 3%, whichever is less, once a year, and with a 30-day notice), to Bell Gardens (lower of 4% or 50% of inflation, once per year), voters will have some important decisions to make and given basic mathematics, that there are more tenants who vote than landlords who vote, I will go out on a limb and predict that all will pass.

On the other side of the country, New York passed tough new short-term rental regulations in September, which would place restrictions on apartment owners or tenants to lease out units via Airbnb or the equivalent. City Councils in Dallas, Philadelphia, and New Orleans are mulling their own versions of such restrictions.

And, Before we Say Our Goodbyes to Another Quarter and Another Excessively Verbose Quarterly Memo, Let’s Take a Quick Look at Other Goings-On This Past Quarter

  • While the Office Market Continues to Struggle Mightily and the Industrial Warehouse Market Softens, Local Neighborhood Strip Centers are Performing Surprisingly Well: According to a recent article in the Wall Street Journal, the “hottest” real estate play these days are local neighborhood strip centers, you know the ones with a donut shop, family-owned grocery store, and ju-jitsu studio. Such centers, owned mostly by certain public REITS like KIMCO, Realty Regency Centers, and Federal Realty, are over 95% occupied at present. Perhaps the increased success of these assets is a result of changing work habits (more at-home or hybrid jobs) or excessive traffic. However, I am not convinced as all three of the just-named REITs are down this year, significantly underperforming market indexes.

Meanwhile, the office market continues to gasp for air, and I could provide numerous examples and macro-level data to hammer home the known reality. Perhaps just a couple quick anecdotes will suffice. One, WeWork warned in early August that it might have to file for bankruptcy. Once worth some $47 billion, the company’s equity is now nearly worthless. Keep in mind that they still lease at least 20 million square feet in hundreds of locations in the U.S. and Canada.

In another anecdote, a real estate private equity firm run by one of Hong Kong’s wealthiest families sold an office campus on the San Francisco waterfront to Blackstone, the country’s largest private landlord, back in 2018, the height of the tech boom, for

$245 million. Now that same firm, Gaw Capital, wants to buy the property back, but at about one-third of its pre-pandemic value, about $90 million. Keep in mind that the outstanding balance of the mortgage encumbering the property approximates $150 million. Ouch.

Finally, the industrial warehouse market, one of the darlings in recent years, has seen some expected softening, in terms of leasing activity, rental rates, and occupancy. The national vacancy rate rose to 4.1% in the second quarter (most recent data), up from 3% last year. However, the national industrial market continues to perform well, despite softer regional figures here in California, for example. The onshoring of key supply chains and increased manufacturing activity in the Southeast are providing tailwinds to the overall market.

  • Homelessness and Record-Level Wealth Inequality Continue to Provide Challenges: If a single picture captures a thousand words, it might be this particular data set, which summarizes wealth inequality by country, and it won’t surprise you to learn who leads the pack, so to speak. Wealth inequality in the U.S. has never been higher with the chasm between the haves, the have-less and the have-nots, continuing to widen.

From another perspective, the delta between CEO compensation and that of a typical worker has never been wider. In the most recent data, from 2021, CEOs made nearly 400 times an average or typical worker. Yowza! My recommendation is that if you are ever offered a CEO job, take it.

In any event, this relationship is nothing short of eye-popping and cannot be healthy, likely leading to increased homelessness, economic and political divisiveness, and other unfavorable demographic changes.

  • ·         The U.S. Dollar is On a Roll: A couple of quarters ago, I wrote about how concerns surrounding the future of the U.S. dollar as the principal fiat currency were overblown and that for any number of reasons, the dollar was and is not at risk of losing its global status to the Yuan, Rupee, Bitcoin, or Susscoin despite understandable concerns. While the amount of U.S. dollars in foreign exchange reserves has declined since the end of 2000, the dollar has strongly rallied this year, in the face of increased global uncertainty and higher U.S. interest rates.
  • China is in a World of Hurt: When I visited China back in 2017, it seemed like the country could do no wrong, at least economically, and had an extraordinary future, likely to become the global GDP leader within a few decades. My, how things have changed, and in just five or six short years. China’s population declined last year for the first time in 80 years. Two of their largest real estate companies, Evergrande and Country Garden, have imploded, and more are likely to follow. Those Chinese under 25 years of age are unemployed in staggering numbers, with a related unemployment rate of at least 25%. We can’t be sure, since China simply stopped publishing unemployment figures, as though that would help. And while we worry about inflation, China has experienced deflation in 2023, though such deflationary pressures have recently eased.

This is not something to necessarily celebrate, as China lightens its ownership of our Treasuries, as discussed above, and their challenges only add to global uncertainty.

In the face of so much uncertainty – economic, financial, political, and geopolitical – forecasts are no easy matter and recent horrific events in the Middle East, which should be universally condemned, only add to market risks

At the beginning of 2023, nearly 60% of surveyed economists predicted that the U.S. would enter a recession during the next year. Then, as data came in, those dual-handed economists did what they do so well. They changed their forecasts, because while some data pointed to a slowdown, if not a recession, “on the other hand…”

Will Jerome Powell and the Fed be able to engineer that proverbial “soft landing,” to thread that needle I thought was virtually impossible? Thus far, the answer seems “yes,” or it seems possible. Recent GDP, employment, and earnings data suggests that any recession is still aways away. Granted, consumers and investors are a fickle bunch, so things can change quickly.

History tells us that when economies soften and the Fed has to provide stimulus, they do so in fairly dramatic fashion. That is, if one examines expectations regarding interest rates, captured by the Fed Funds forward curve, it looks smooth, with rates declining in a fairly linear fashion between 2024 and 2025.

However, history looks quite different. That is, when the Fed cuts rates, they usually do so quickly and dramatically in response to a more sudden and significant downturn.

Meantime, there is seemingly no consensus among market pundits and economists, while there are plenty of warning signals. I started this memo with the yield curve, which remains inverted,

with short-term interest rates exceeding longer-term ones. This phenomenon has predicted something like 12 of the last five recessions, according to market observers and comedians. That is, it can and often is, a false negative. Similarly, if one compares the spreads between 10-year and three-month Treasuries, you get an ominous picture like this, which is scary, and definitely worthy of the Halloween season:

Maybe that’s real takeaway. There is no consensus about nearly anything and everything, and conflicting and contradictory data is not hard to find. These markets offer the economic equivalent of the Chinese game, Go.

Finally, while I generally avoid any sort of political discussions in these quarterly memos, other than commenting on policies that impact real estate, I feel compelled to comment briefly about recent events in the Middle East. My heart goes out to all impacted, including some of my family members. However, as a long-time faculty member at UCLA, I am profoundly disheartened by the antisemitism we have witnessed not just at UCLA, but on campuses throughout the U.S. (and beyond). I have also been troubled by the obvious equivocating by university leaders, who have mostly been unwilling to unambiguously condemn acts of terrorism and inhumanity, seemingly unable to articulate and reconcile competing thoughts simultaneously out of some inexplicable fear of upsetting or offending others.

Let me be clear. It should never be hard or controversial to call out and condemn inhumanity and terror, exactly what Hamas has done. We should collectively agree that murdering, assaulting, and kidnapping civilians is unacceptable, full stop. At the same time, it is not unreasonable to question what sort of response from Israel is appropriate when so many other civilians (Palestinians) will be impacted. What does a “proportionate” response mean? What might be the consequences of an Israeli response, in the short-, intermediate-, and long-term? Will more hatred and terrorism be fomented?

I don’t know the answers to such complex ethical questions, but too many university presidents (and others) have issued namby-pamby responses, trying to placate everyone through careful wordsmithing, but instead, offend many, including yours truly. The bottom line is that empathy should be an unwavering moral compass and principled leadership should not be a theoretical construct.

As always, I want to express my gratitude and thanks to each of you: our investors, supporters, employees, partners, vendors, or just those of you who somehow are here just to read my verbose quarterly memos. Thank you. I know these are trying times and there will be continued challenges in the markets and certain assets in our portfolio, unavoidable realities of this particular market and market cycle. Rest assured we will give all we have to navigate them.

We continue to evaluate potential acquisition opportunities when they cross our desks, though deal flow remains anemic. We continue to raise capital for the three-asset portfolio in the Inland Empire (IE3), which has exceeded projections since we acquired it. I hope you might take a look before we end the fundraise at the end of the year. We will continue to pursue attractive acquisition opportunities, though they are certainly not easy to find (bid-ask spreads between potential buyers and sellers remain wide), and transaction volume has declined substantially, consistent with data I provided earlier.

Please feel free to reach out to me or a member of our investor relations team (Tania Mirchandani, myself, or Christopher Serna, who just joined our firm) about any questions you might have about your investments or the IE3 opportunity. Aimee DeFord recently transitioned to a different role within our property management firm, Clarion Management, and I want to express my appreciation for her exceptional efforts these past couple of years.

Best,

Eric Sussman

Managing Partner

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“If the road is easy, you’re likely going the wrong way.”
Terry Goodkind
“In a crisis, don’t hide behind anything or anybody. They’re going to find you anyway.”
Bear Bryant

In recent years, universities across the country have been wrestling with student requests for what are known as “trigger warnings,” explicit alerts that the material they may read, see, or hear as part of a course curriculum might upset them or cause excessive or unwarranted stress. Thus far, after nearly 30 years at UCLA, I have yet to provide any such warnings in my accounting and real estate courses and I do not anticipate doing so in the future. For better or worse, prospective students will just have to prepare themselves in other ways for the discomfort they will inevitably feel when I subject them to discussions about housing policy, a dreaded cold call, and/or a less than fashionable shirt from Jos. A. Bank or Kirkland (as though one exists).

However, as I delve into the second quarter real estate and financial markets and some views about what might lay ahead, please be warned that my opinions, observations, and perspectives may induce nausea, abdominal pain, and/or constipation, essentially the same potential side effects one might experience from taking Ozempic or watching the Mets this season. Here is the upshot. During the first quarter of 2023, longer-term interest rates declined from the end of 2022, providing optimism that the Fed’s unprecedented and aggressive efforts to combat inflation had been successful and that they would return to more accommodative policies in 2024, if not earlier. Such would be beyond welcome to commercial real estate participants.


Unfortunately, this optimism was dashed during the second quarter, as inflation – especially the cost of food, housing, energy, and Taylor Swift tickets – remained stubbornly persistent, and interest rates reversed course, which in large part led to the mid-quarter failure of First Republic Bank (May 1st), the second largest in U.S. history ($229 billion in nominal assets) and a growing number of foreclosures, principally in the office market. In turn, the MOVE index, which measures interest rate volatility, has spiked.

In fact, between June 30th and July 7th, the yield on 10-year U.S. Treasury bonds increased from 3.81% to 4.06%, only to reverse course and decline to 3.83% one week later, on July 14th. Rates on 30-year mortgages increased from 6.32% at the end of the first quarter to 6.81% at the end of the second, and by the end of last week neared 7.0% (6.96%). Two-year Treasury yields ended the second quarter at 4.88%, up from 4.06% at the end of March. And at last glance? 5.04%. Such sharp increases in rates not only reduce the values of bonds and commercial real estate, at least on paper and perhaps temporarily, but add to investor and lender uncertainty.

This reversal and increased volatility in interest rates foretell challenges for the commercial real estate industry and its participants, from lenders to principals and sponsors to other service providers (e.g., mortgage bankers/brokers, escrow/title officers, property/asset managers). In short, the next couple of years will likely be a slog, as owners and sponsors work through the stresses caused by higher costs of capital, tightening liquidity, and increased uncertainty. Of course, we have already witnessed significant dislocation in the office and retail sectors, with a large number of foreclosures and failures experienced from coast to coast…and sometimes in-between. According to a new report from MCSI Real Assets, some $64 billion of commercial real estate is now distressed, while more than $150 billion is “potentially troubled.”

Moreover, previously “hot” segments of the commercial real estate space – multifamily (including student and senior housing), industrial, and data centers – while having far better underlying fundamentals, are not immune and increased delinquencies, notices of default, and foreclosures in these sectors are inevitable. In many cases, the problem is not and will not be the real estate itself – rents, occupancy rates, and/or pre-debt cash flow – but merely untenable capital structures and excessive leverage in a higher rate environment. In fact, while the Clear Capital portfolio continues to mostly track forecasts and operating cash flow projections, it is the debt, especially that which is floating rate (even hedged), which is proving challenging, especially for legacy assets. On paper, nearly all commercial real estate values are probably down anywhere from 15 to 30%, merely from increases in interest rates. While perhaps temporary, these unrealized losses are not without consequence.

In fact, earlier this year, Veritas, San Francisco’s largest landlord, defaulted on a huge loan (at least $448 million) encumbering nearly 2,500 apartment units in ninety-five different buildings throughout the city. The largest mortgage loan (non-performing) being shopped secures a 75-building portfolio consisting of 2,149 rent-controlled units and forty-five commercial spaces, mostly ground-floor retail. The locations are generally good, and we are talking about San Francisco, though the city has been plagued by homelessness, a softening technology market, and a flight of retail and white-collar office workers, as has been widely publicized.
While foreclosure activity during the first half of 2023 pales in comparison to that experienced in the Great Financial Crisis, foreclosure activity has picked up in recent months and I sense we are still in the early stages of this cycle, which will likely have a long(er) trough. These realities should present potentially attractive investment opportunities and we are excited about our recent acquisition of the “IE3,” a portfolio of three assets in the Inland Empire. However, with less liquidity, higher cost of capital, and more conservative underwriting, closing on even appealing opportunities won’t be a slam dunk. Fear and uncertainty are unwelcome bedfellows to acquisition endeavors.

And inflation data itself? Both consumer and producer prices have moderated, with inflation declining for eleven straight months. The Consumer Price Index was up 3.0% in June (4.8%, excluding food and energy costs), year-over-year, versus a whopping 9.1% a year ago. The U.S. now has the lowest inflation rate among developed nations, despite the political rhetoric.

And producer prices? The June Producer Price Index was down 0.8% between May and June, and 5.4% from June 2022 to June 2023. Producer prices have declined even faster than consumer inflation, so inflationary pressures are definitely easing. However, the Fed’s two percent inflation target still seems aways away.


Regardless of moderating inflation, June witnessed the world’s major central banks delivering the largest number of monthly interest rate hikes year-to-date, surprising investors and signaling the possibility (if not probability) of more tightening ahead as policy makers grapple with inflationary pressures. Seven of the nine largest central banks hiked rates last month, while two opted for no change (including the U.S.). Both Norway and the Bank of England increased rates by a larger-than-expected fifty basis points, while Canada and Australia also resumed their rate hiking ways. Sweden, Switzerland, and the European Central Bank also tightened, taking the collective tally of rate hikes to 225 basis points last month. May witnessed six rate hikes. Across the entire G10 (group of eleven industrialized nations), there have been twenty-eight rate hikes this year, totaling 950 basis points, and since Norway started raising rates in September of 2021, major central banks have increased rates by a combined…3,765 basis points. Yowza.

The increase in rates and the specter of persistently higher inflation are probably the biggest news stories of the quarter, narrowly beating out the discovery of a small bag of cocaine in the White House (wasn’t mine, I swear), the departure of Pat Sajak as host of Wheel of Fortune, the tragic Titanic submarine implosion, a failed coup (or whatever the heck that was) in Russia, and the predictable (if not unnecessarily politicized) conclusion of debt ceiling negotiations closer to home.
Regardless, conflicting data appears around every corner, making economic, financial, and market predictions about as difficult as interpreting Mona Lisa’s beguiling smile or anticipating the winner of an Elon Musk-Mark Zuckerberg cage match. Analyst estimates of global GDP are wide, twice the range of predictions made in previous years, and the word “uncertainty” appears more than sixty times in the most recent International Monetary Fund’s Global Economic Outlook. One day the Dallas Fed Chief, Lorie Logan, says that interest rates should rise further, and then, on the very next day, Fed Chief Jerome Powell says something far less hawkish. These conflicting narratives remind me of that memorable scene from 1982’s Fast Times at Ridgemont High, when Sean Penn (or rather, his character, Jeff Spicoli) responds to a friend after totaling this friend’s brother’s new Camaro and the friend’s subsequent admonition…’My brother is going to _hit! He’s going to kill us!’ to which Spicoli replies, ‘Make up your mind, dude! Is he going to _hit or is he going to kill us?’

Let’s start with the job market, since the Fed is tracking this data closely in setting interest rate policy. In short, it remains surprisingly robust, rekindling fears of persistent inflation and higher interest rates. In June 372,000 new jobs (non-farm) were added versus the 268,000 expected. Wages increased 5.1%, year-over-year. Despite the odds, the U.S. labor market continues to add jobs and even companies in the crosshairs of rising interest rates are holding onto or adding workers. Builders, architects and engineers, real-estate agents, vehicle manufacturers and other businesses typically sensitive to higher borrowing costs have actually increased employment levels this year, though I sense this may reverse in the coming months.

These job gains, along with much larger increases in industries still trying to claw back workers lost during the pandemic, have added up to almost 1.6 million new jobs in the first five months of 2023, outpacing forecasts. Meanwhile, other firms continue to reduce headcounts. Although merely an anecdotal (and unsubstantiated) data point, I heard a rumor that a surprisingly large number of MBAs from UCLA Anderson did not have job offers at graduation time last month as traditional recruiters in tech (largest hirers in recent years), finance, consulting, and real estate have pared back hiring needs. Other firms have pushed back start dates. On a somewhat related note, I recently read that the jobless rate among Chinese 16- to 24-year-olds rose to a whopping 21.3%, compared to 7.5% here in the U.S. Yowza, again.

Meantime, the so-called, but appropriately monikered “Misery Index,” computed by adding the previous 12-month change in the Consumer Price Index percent change and the unemployment rate, has been trending downward, to a recent 6.57% in June. The last time the Misery Index was this low was before Covid, in September 2019. So, would someone please tell me why I don’t feel better…or at least less miserable?

How about the equity markets? Well, the S&P 500 is up 17.4% this year, with the tech-heavy NASDAQ gaining a whopping 34.9% thus far, its best first half in 40 years. If you compare the equity markets between 2009-2010 and 2022-2023, they look eerily similar, with a significant downturn followed by a reversal the following year.

However, when we peek under the equity market hood, there is more (or less) than meets the eye. In fact, when I recently read a headline that the S&P 500 and NASDAQ had reached their highest levels since last August and that the price rise was almost enough to represent a “bull market” (generally defined as a 20% rise in the S&P 500), I did a double take. Bull market? Really? This has to be the least fun and exciting bull market I have ever experienced.
And no wonder. This “bull market” has really been powered by a small number of mega-cap tech stocks: Apple, up 38% this year. Nvidia, up 165%. Tesla, 128.5%. Meta (Facebook), 151.5%. In fact, just twenty stocks, including the likes of Apple, Microsoft, Amazon, Nvidia, Alphabet (Google), Meta, Berkshire Hathaway, Tesla, and United Health, represent over 90% of S&P 500 returns through May, despite comprising less than 30% of the Index. In fact, on Friday of last week, Nvidia’s stock price moved up and down so substantially in a single day that the implied value of the intraday swing (change in market value) was larger than the market capitalization of four hundred other companies in the S&P 500. That’s just nuts. Another “yowza” seems warranted.

Meantime, corporate defaults rose last month, with forty-one in the U.S. so far this year, more than double the same period last year, according to Moody’s. Heavy debt loads, high interest rates, and uncertain economic conditions are beginning to take their toll. The number of bankruptcy filings in the U.S. this year has also sharply risen to levels not seen since 2010. Through June, there were 324 bankruptcy filings, not far behind 2022’s total of 374, according to S&P. The list of failures includes Silicon Valley Bank and Bed Bath & Beyond, of course, but others like regional sports network owner, Diamond Sports, and the information technology firm, Avaya.

And how about the residential real estate markets, both single- and multifamily? How are they holding up in these challenging markets?
In a word, “resiliently,” with single-family prices up 2.0% nationally for the year ended April, representing 135 straight months of higher prices. That is not a typo. While individual markets may be struggling (e.g., Bay Area, Denver, Phoenix, Los Angeles), the overall market remains in decent shape and prices firm. Perplexed, the New York Times recently posed a rhetorical question in an article captioned, ‘What is Happening in the Housing Market?’ trying to explain how housing prices have not dropped despite the extraordinary increase in interest rates.

The answers are fairly simple. Record-low supply tops the list, as inventory hovers near 40-year lows. Baby boomers, with their trillions of equity in homes, ain’t selling. Folks who own or bought homes in recent years, with mortgage rates of 3.0% or less, ain’t selling. And builders can only build so many homes, with constraints on everything from buildable lots, available labor, raw materials, along with (of course) higher construction and borrowing costs, at least for smaller, privately-owned builders who cannot easily access the capital markets.

While more than 23,000 Alternative Dwelling Unit (ADU) or “Granny Flat” permits were issued in California last year (versus 5,000 in 2017), following the elimination of R-1 zoning in the state, the overall impact represents that proverbial drop in the bucket. The fact is that newly built homes represent about a third of all homes for sale in March, about double historical norms.

Some buyers, perhaps recognizing that waiting for a significant price drop in home prices is indeed akin to “waiting for Godot,” have decided not to wait any longer. Institutional and foreign buyers are also reliable sources of demand, albeit at reduced levels from previous years. In fact, while prices are firm, sales volumes are down sharply, as are mortgage applications.

Meanwhile, homebuilders have been one of the hottest sectors in the equity markets thus far in 2023, defying all expectations and all the economic headwinds and higher rates. For example, KB Home is up over 24% this year and over 79% in the past 12 months, something I would never have predicted. Another “yowza” seems more than apropos. The entire homebuilding sector is up nearly 33% in 2023, more than double the return of the S&P 500. Yeah, those homebuilder stocks sure are boring. #sarcasm

Ironically, the apartment market has not fared quite as well in recent months, as rent growth has stalled. The average of six national rental-price measures from rental-listing and property data companies indicates that asking rents for new leases rose just under 2% over the 12 months ending in May. One of the rent measures, courtesy of Redfin, indicates that rents for both apartments and single-family rental homes, actually declined 0.6% in May, year-over-year. A decline in asking rent over a 12-month period had only happened one other time since the Great Financial Crisis, when the rental market briefly declined in 2020 because of Covid-19, ending a decade-long streak of rent growth. However, while data providers agree on the direction of multifamily rents, they do not necessarily agree on the precise figures themselves.

There are a couple of silver linings. One, absorption for multifamily units (excess of unit leasing activity above new supply) and demand are picking up. Two, affordability challenges continue to benefit apartments over single-family residences, making the renting decision more compelling. According to Realtor.com, the median home price in the U.S. was $445,000 in June, versus $441,000 in May. Combined with mortgage rates of around 7%, the monthly “cost to buy” is at least 40% higher than to rent.

According to a number of articles I have recently read, higher income individuals and families are choosing to rent, perhaps also preferring the extensive amenities and flexibility provided by high-end multifamily units. Renters in the highest income range (household income over $150K per year) grew by over 80% between 2015 and 2020 (most recent data available), according to RentCafe.

Finally, the markets with the greatest net absorption during the first half of 2023 include Houston, Phoenix, Dallas/Fort Worth, Chicago, and Charlotte.

There is one other material issue impacting the residential housing markets, both single- and multifamily units, the escalating cost of property and casualty insurance…if you can even get it. You have probably read stories about how State Farm and Allstate are no longer writing new policies in California and Florida, as they grapple with increased claims from wildfires, hurricanes, and other weather/climate related issues. As you may know, Phoenix just recorded its nineteenth straight day of 110+ degree weather, a record, and July 2023 has thus far been the hottest month in history, at least since we have been measuring such things.

So, I suppose it cannot come as any significant surprise that the third quarter of 2022 marked the 20th consecutive quarter of increased premiums for commercial property/casualty, according to the latest report from the Council of Insurance Agents and Brokers. The average premium increase was up 20.4% in the first quarter of this year, again not a typo. To say insurers exiting certain markets and/or mercilessly increasing premiums are not impacting the residential housing market would be a profound understatement.

Perhaps a picture tells a thousand words…or a multitude of billion dollar claims.

How are mortgage lenders and debt providers behaving in these volatile and uncertain markets?
Even if a broader banking crisis and global credit crunch were averted following the collapse of Silicon Valley Bank, Signature Bank, First Republic, and Credit Suisse, prospective borrowers continue to be squeezed, not just from higher rates, but from stricter underwriting, higher spreads, and ultimately reduced proceeds. It is no surprise that multifamily lending volumes have tanked, reducing available liquidity, just when this source of capital is needed most.

Keep in mind that there is approximately $20 trillion of commercial property in the U.S. (e.g., office, rental housing, industrial warehouses, and retail space) and all have been impacted by macroeconomic and geopolitical events. These assets are encumbered by some $4.5 trillion of collective mortgage debt, broken down as follows:

Meantime, the number of FDIC-regulated banks has declined precipitously (over 70%) since 1984.

Thus, it is no surprise that the fastest-growing lending segment is “private credit,” or alternative lenders often referred to as “shadow banks.” Since the start of 2008, private credit has grown almost sixfold, to $1.5 trillion, according to the IMF—bigger than the high-yield bond or leveraged-loan markets. At $4.4 trillion, these three markets collectively exceed the value of all commercial and industrial loans provided by traditional banks, at $2.7 trillion. How these shadow banks and debt funds will respond to distress remains to be seen. My sense is that they have different objectives than traditional lenders, but whether that means they will be more or less flexible and willing to “extend and pretend” remains to be seen.

Finally, when are various commercial real estate loans coming due? The vast majority of loans come due between 2023 and 2025.

And consumers? Since they drive so much of the U.S. economy, how are they holding up?
Consumer spending is also sending mixed signals. On the one hand, core personal spending remains positive, though monthly changes in spending have been declining. That is, it seems that the consumer is finally losing steam, at least from the looks of the data.

This is confirmed by the most recent data out of Las Vegas, where gaming revenues, one of the most discretionary of all expenditures, declined in both April (3.4%) and May (1.7%), the most recent data available, as compared with the same period last year. Perhaps softening consumer spending is not surprsing, as the cash savings accumulated during Covid, including the impact of government largesse (read: PPP loans) and lower residential mortgage payments (all those homeowners who refinanced in 2020 and 2021), have mostly run their course. Cash reserves are dwindling, with median account balances at their lowest levels in nearly three years, dropping some 41% from their April 2021 peak, according to JP Morgan.

In addition, with higher interest rates on everything from new car loans to credit card debt to mortgages, consumers are feeling an incremental pinch.

On the other hand, having been on more than my fair share of planes in recent weeks, it seems that the consumer is not quite dead yet. Most flights are fairly full and I have to take extra steps to ensure that I don’t end up in that dreaded middle seat (yeah, flying coach is what it is). Data confirms my anecdotal observations, as North American air carrier’s traffic climbed 31% in May 2023 versus May 2022, while the load factor (% of occupied seats) rose 5.1% to 85.1%, the highest in the world. Globally, air traffic is now at 96.1% of May 2019 (B.C., Before Covid) levels, according to the International Air Transportation Association.
What have our wonderful politicians been up to policy wise in Q2, especially with such important local, state, and national elections teed up next year?
•Biden Administration’s New Mortgage Fees: Effective May 1st, new fees made their debut on already lengthy closing statements, as homebuyers with “strong credit” are being charged with higher fees by Fannie Mae and Freddie Mac, to subsidize borrowers with lesser credit. For example, a borrower with a FICO score of 700 and a 20% down payment previously would have paid an upfront fee of 1.25% of the loan amount, say $3,750 on a$300,000 mortgage. Now that fee has been increased to 1.375%. Generally speaking, lesser qualified borrowers will still pay higher fees, but the relative difference is lower. Presumably the objective is to make homeownership more affordable for lower-income borrowers, but I loathe these particular sorts of redistribution efforts, because I have always believed that the obsession with that “American Dream” of homeownership and specifically, that three-bedroom, two-bathroom, three garage home (gotta have room for the boat or Harley), is misguided.

•California Lawsuit Against Elk Grove: In early May, the State filed a lawsuit against the city of Elk Grove, in Sacramento County (near the state capitol), for denying a proposed66-unit affordable housing project. Meanwhile, the State exercised its political influence in getting San Francisco to approve three projects that had been subject to public opposition, including one 450-unit tower. Meanwhile, the State owns 7.6 million acres of property, including something like 58 million square feet of office space, much of which is under-utilized, if used at all. However, the sheer number of California’s 2023 Housing Related

Legislative endeavors are so voluminous that I can’t nearly summarize them all here. However, if you are so inclined, you can follow this link for a complete list and graphical summary, which looks like some of Picasso’s finest work. I just recommend that you fasten your seat belt and grab a glass of your favorite alcoholic beverage before doing so:
https://www.dropbox.com/s/6cnpm11spdoqc2x/CA-housing-bills-20230611.pdf?dl=0

•Montana Legislation Limiting Local Governments from Implementing Rent Restrictions: On the other hand, in May, Montana became the 33rd state to pass legislation limiting local governments from trying to implement rent restrictions, coming on the heels of similar legislation passed in Florida at the end of March and Ohio last June. Of course, other states, from California (of course), Maine, Maryland, Minnesota, New Jersey, and New York are behaving quite differently. According to the National Apartment Association, there are eighty-three state bills out there that would regulate rents. But bills do not legislation make, so we shall see, but I have warned of this inevitability for years. Politicians will do tenant bidding, so long as there are more tenants than landlords who vote.
And finally, what else has been going on in this wacky world that may impact commercial real estate?

•Commercial (office and retail) property woes continue, surprising nobody: Changes in work and shopping habits continue to wreak havoc on related property markets. UBS estimates that around 50,000 retail stores will close in the U.S. in the next five years. Bed, Bath, and Beyond will shutter about five hundred locations in total. The value of malls is down 19% in the past year and 44% since 2016. And the office horror story is well known, with values down 25% or more across the board, with occupied space per worker down 12%from 2015. Regarding specific submarkets, Chicago saw a jump in office sublease availability jump 7.7 million square feet in the first quarter, which pales in comparison to San Francisco’s 8.9 million square feet, a 140.5 percent increase since 2020. The Los Angeles office vacancy rate reached 22.5%, a historic high, while the vacancy rate increased to 17.1percent, up from 16.9% at the end of 2022. The percentage of Washington D.C.’s office market that is available for lease jumped to 21.7%.


•Student Loan forgiveness: In mid-2020, during the throes of the Covid pandemic, the federal government suspended required payments on nearly $1 trillion of student loans. The moratorium was meant to last six months (or roughly the length of a Kardashian marriage),but like so many government policies, it lasted far longer than intended. The moratorium was extended eight times, of course, which is comical. Don’t get me wrong. I fully understand the argument that the government has a history of forgiving debt (e.g., PPP loans) and bailing out corporations, the old “what’s good for the goose is good for the gander” argument, though I don’t necessarily subscribe to it.

In any event, student loan payments recommence in September, at long last, which will curbsome consumer spending, at least on the margin. In addition, the Supreme Court recentlyruled that President Biden did not have the unilateral authority to forgive some $400 billionin student loans without congressional approval. In response, the Administration announcedthat it will forgive $39 billion of such loans under a different, income-driven proposal, whichwill more likely pass muster and judicial review. We shall see. The important takeaway isthat many consumers will be required to service debts with funds they were previously ableto spend on other goods and/or services…including rent (presumably).

•Deficits and Debt Ceiling Negotiations: I am not sure if you have ever seen the billboard-sized display on Sixth Avenue between 42nd and 43rd Streets in midtown Manhattan, which provides a running total of our nation’s gross outstanding debt and each American family’s share of it. I am also not sure it quite compares with Lady Liberty, the Empire State Building, or Grand Central Station in terms of tourist attractions, but you certainly can’t miss it if you happen to stumble upon it. Anyhow, when this unusual “clock” made its debut in 1989, our debt approximated $3 trillion. Here is a more recent picture, sobering as it might be. You will note that the clock still begins with a “3,” but there are more digits after that:

I mention this in the context of both the recently completed debt ceiling negotiations, which can charitably be labeled a “_hitshow,” as the agreement to raise the ceiling by $4 trillion merely allows us to borrow enough to pay existing obligations and fund government operations for the next two years. So, let’s dispel some misconceptions right off of the bat. One, the negotiations and accompanying agreed-to spending cuts do virtually nothing to balance the budget. Sure, it will cut spending by some $1.5 trillion over the next decade, but the agreement doesn’t lay a hand on areas of real spending: Social Security, Medicare, and defense, three outflows that collectively represent nearly 80% of our annual federal budget. And there’s the rub.

While I appreciate the political sensitivity to making cuts (or significant changes) to these programs, I don’t see any way that we can’t, at least without substantially raising taxes. We spend six times more per senior than per child, trading off social security benefits and education, but let’s be clear. That tradeoff simply isn’t sustainable as the costs of entitlements increase, our population ages (I have written a lot about that in prior letters, our so-called “baby bust”), we have fewer younger workers, and the government collects far less taxes. Tax collections have predictably fallen, following the passage of the 2017 Tax Cuts Job Act (TCJA). At some point, our politicians on both sides of the aisle are going to have to face the music, sacrificing politics for national fiscal security.

Figures from the Congressional Budget Office, which coincidentally don’t anticipate recessions, crises, or understated required infrastructure investments (think conversion of auto industry to electric), tell just a part of the story. In any event, I find the graph below to be just a tad frightening, perhaps even more than most driver’s license and high school yearbook photos.

Something has to give, as the gap between revenues and outlays widens over time, mainly because of rising interest costs and growth in Medicare and Social Security spending, resulting in ever-widening budget deficits. After World Wars I and II, we repaid debt by raising taxes and cutting expenditures. Compare that to today’s mindset, which seems completely different, and both parties to blame, of course. Even before Covid, in an economy characterized by record high stock prices, strong housing and commercial real estate markets, and low unemployment and inflation, we still ran a deficit, in part due to the TCJA. In any event, if the federal government does ultimately decide to face the music, raise taxes, and reduce spending, the impact should be materially deflationary, all else equal.


•Artificial Intelligence (AI) and real estate: Unless you have been living under that proverbial rock (and if you have, I sure hope it isn’t in Phoenix), 2023 might be labeled “The Year When AI Became Mainstream,” with the release (or at least popularization) of ChatGPT. At this point, it is hard to say how AI will impact commercial real estate, but you can bet your bottom dollar (or your favorite cryptocurrency) that it will be impactful in the following areas:
-Location, location, location: AI companies and related jobs and infrastructure investment will cluster around established tech markets, universities, and innovation centers.

-Increased demand for certain types of assets: AI research and development will require more and perhaps distinct types of data centers, energy grids and related infrastructure.
-New asset and product types: The AI transition will spur the development of new types of commercial properties, or at a minimum, significant investment in existing product types (e.g., office, industrial) just to make them AI-compliant. Think about the last time you saw an individual staffing a parking kiosk. Smart cameras and related security systems will replace uniformed officers. Or consider how hotel lobbies will change as the need for in-person interactions (e.g., check-in, check-out, concierge services) changes.
-New/Changed underwriting processes: AI-will substantially automate underwriting and the understanding and analysis of markets and individual properties. Individual acquisition personnel will still be needed, if just to exercise judgment and interpret data, but I suspect investors and sponsors will require less human engagement in the underwriting process.
-Design and space function: AI will allow engineers, architects, and other related professionals to more efficiently and quickly design and customize spaces and settings.

In my career, I cannot recall a market with so much conflicting data, adding to investor uncertainty and making predictions no easy task. However, while challenges lay ahead, crises and down cycles inevitably provide opportunities.

If one were to watch the news (or media outlets that hold themselves out as such), pay attention to certain polling, or read your weather app, you might think the sky is falling, the planet melting, and a recession around the corner. In fact, according to a recent Wall Street Journal poll, a large majority (78%) of individuals polled “do not feel confident” that their children will be better off than they were, the highest percentage since the survey began in 1990.
With all the negativity emanating from everyone from politicians to media outlets to my mother-in-law, such pessimism is understanding. Interest rates remain high and volatile, and while recent inflation data looks promising, it is too early to declare victory. Consumers will be more stretched and challenged in coming months, as cash reserves dwindle, student loan repayments resume, and the cost of consumer debt remains high. The disruptive potential of AI and negative psychological influence of social media only add to the understandable angst. And commercial real estate investors, capital providers, and all other industry participants are going to be busy working through a longer trough of this particular downcycle. There is no escaping this reality.
However, from GDP figures to employment levels to real wages to corporate profits and equity markets, it appears that a recession is not in the cards, at least for the time being. However, that could change quickly if the Fed continues to wield the interest rate sledgehammer, causing additional disruption to investors, lenders, and capital markets, generally. But let’s be clear. Our economy has done and is doing pretty darn well, all things considered, especially relative to the rest of the world, despite news and rhetoric to the contrary.

In 1990, the U.S. accounted for a quarter of total global output, essentially the same percentage today, even in the rising power and influence of China and India. We represent nearly 60% of the collective GDP of the G7, the most of all other developed nations. Our economic productivity is much higher than that of Europe or Japan. American companies own more than 20% of patents registered abroad, more than China and Germany combined.

Regardless, and as I stated in unequivocal terms last quarter, we are more than cognizant of the challenges that lie ahead and are acting accordingly in all aspects of the business. As I mentioned earlier, our portfolio is mostly tracking to budget and plan, at least on operations. Debt service, including reserves for interest rate caps, on our floating-rate debt is a different story, and we continue to pursue options to convert this debt to fixed rate via cash-in refinancings. Ironically, while higher interest rates cause debt service pain, we benefit from higher rates inasmuch as the cost of renting becomes far more favorable vis a vis buying.
Meanwhile, we do not intend on ignoring potentially attractive acquisition opportunities when they present themselves, though they are certainly not easy to find (bid-ask spreads between potential buyers and sellers remain wide), and transaction volume has declined substantially, consistent with the loan data I provided earlier. According to CoStar, multifamily sales volume fell 74% in the first quarter of the year, the largest year-over-year drop since the first quarter of 2009, at or near the trough during the Great Financial Crisis. We were pleased to acquire the attractive three asset, Inland Empire based portfolio here in Southern California in an off-market transaction and are still soliciting investor capital for that particular transaction, so I hope you might take a look at that opportunity.

Finally, thank you for supporting the firm and its endeavors, even in these challenging times. Rest assured we take our role as a fiduciary seriously and will continue to do our best navigating these tricky times and markets, providing our views, perspectives, and relevant market and property-specific information in a timely and transparent fashion, which I hope is part our corporate DNA. Please feel free to reach out to me or a member of our investor relations team (Aimee DeFord and Tania Mirchandani) should you have any questions, concerns, or other needs regarding either your existing investments or opportunities we are pursuing.
Best,

Eric Sussman
Managing Partner

“There is nothing more deceptive than an obvious fact.”
-Sir Arthur Conan Doyle
“Value-add multifamily real estate is a canvas of potential waiting to be transformed into a masterpiece of profit and social impact.”
Fictional quote created by ChatGPT
“Uncertainty is the only certainty there is, and knowing how to live with insecurity is the only security.”
-John Allen Paulos

I have often said that the only constant in life and markets is change and my, oh my, did the first quarter of 2023 live up to that adage, trite as it might be. In what seemed to be the blink of an eye, we had the beginning and apparent passing of a banking crisis, the introduction and seemingly widespread use of ChatGPT, an eerily effective artificial intelligence tool, and the historic indictment of a former president. To put it in college basketball terms, we experienced several March Madness moments during the most recent quarter. These whiplash-like news events echo that famous quote from one of the characters in Ernest Hemingway’s, “The Sun Also Rises,” who responds when asked about his financial woes and how he went bankrupt: “Two ways. Gradually, and then suddenly.”

Since there are lots of newsworthy tidbits to cover, perhaps I should just get on with it and summarize the highlights, or lowlights, from the quarter.

• In a matter of days in mid-March, Silicon Valley Bank went down the proverbial tubes following a bank run (or perhaps more aptly described as a “mouse click stampede”), representing the second largest bank failure in U.S. history and the largest since the Great Financial Crisis. Two days later, Signature Bank, not wanting to miss out on the fun, was also forced to close its doors. A combination of poor risk management (mismatching of asset and liability duration, excessive investment in shorter-term Treasuries and/or long-term fixed rate loans) and related unrealized losses, technological change, anachronistic FDIC insurance and financial accounting rules, and underlying bank fundamentals (e.g., high leverage, thin margins, asset illiquidity) not only sealed their fates, but revealed fundamental risks across the entire banking industry, especially among smaller, less diversified regional and community banks (e.g., First Republic, Zion’s, Pacific West).

2 | P a g e
Not surprisingly, bank stocks were crushed during the quarter, with the KBW Nasdaq Bank Stock Index down nearly 35% year-to-date. The impact of these recent events will reverberate during the remainder of 2023 and 2024 through decreased bank profitability (if not additional failures), reduced lending activity, and increasing withdrawals of deposits, all increasing the risk of recession and overall systemic risk.

Across the pond, Credit Suisse, the global investment bank and financial services firm, was purchased by UBS in a bailout transaction brokered by the Swiss government. Bank runs and related contagion are indeed a thing. Fortunately, quick Fed intervention and the collective efforts of other banks to prop up competitors apparently saved the day here at home, at least for the time being.

Specifically, a group of 11 financial institutions, including B of A, Well Fargo, Citigroup, and JP Morgan agreed to deposit a total $30 billion in First Republic to demonstrate confidence in the banking system and First Republic, specifically. I cannot recall ever witnessing anything comparable. Sure, Warren Buffett and Berkshire Hathaway lent $10 billion to Goldman Sachs and General Electric during the Great Financial Crisis, but that was quite a different story. In any event, bank stocks seemed to substantially stabilize during the last half of March. Given the recent positive earnings announcements from JP Morgan and Citibank, it may end up being a “tale of two types of banks” or the financial equivalent of Beauty and the Beast, where large, diversified, money center banks end up benefitting from the market turbulence at the expense of smaller community and regional institutions.

• The Federal Reserve, in the wake of the crisis, short-lived as it might have been, was compelled to rethink its sledgehammer interest-rate strategy and better balance potentially competing objectives of reining in inflation while minimizing strain on and risk of failure of member banks. The Fed agreed to backstop all deposits at both Silicon Valley and Signature Bank and “only” increased the Federal Funds Rate by 0.25% last month, instead of the 0.50% increase that had previously been anticipated. While the Fed has indicated that one more rate increase is likely this year, no one should be counting them chickens before they hatch. As I have said many times, Fed Chair Powell is trying to thread one very challenging needle.

Meanwhile, this aggressive, if not wholly responsible and reasonable Fed response, comes at a cost, of course. The Federal Reserve’s largesse and unprecedented money-printing and quantitative easing endeavors in recent years, which bloated its balance sheet from some $5 trillion (yes, trillion, with a “t”) before the pandemic began, to nearly $9 trillion last April, has been materially responsible for the inflationary pressures we have experienced over the past 18 months or so. Through subsequent monetary tightening efforts, the Fed had successfully shrunk its balance sheet to $8.3 trillion by the beginning of March. And then came the banking shenanigans, the Fed’s response, and in a mere two weeks, some two-thirds of the Fed’s tightening endeavors had been undone. The best laid plans of mice and the Fed, I suppose.

So, where does the Fed go from here? It is hard to say, of course, but there seems to be a disconnect between what the Fed is telegraphing as opposed to what the market is anticipating.

After all, the spread between short- (three-month) and long-term (10-year) Treasuries has never been wider, resulting in the most inverted yield curve in history.

Seen another way, longer-term Treasury rates on two- and ten-year maturities have not changed all that much since the beginning of the year and are actually modestly lower, but rates on the shorter end of the curve have risen. Such a steep inversion would almost certainly foretell a significant economic slowdown, if not recession, but the equity and labor markets (see below) do not seem convinced.

• M2 money supply, in turn, witnessed its largest decline in history during the quarter, as depositors pulled funds from banks in record numbers, preferring risk-free (read: principal-protected) Treasuries and non-bank money market funds versus potentially at-risk bank deposits. It is my strong view that the Fed needs to revisit the anachronistic FDIC-insured limits, which were last changed following the Great Financial Crisis. There is no way that depositors can adequately assess the financial risk of banks in which their deposits are held. That would be asking too much of even this CPA and accounting professor, let alone other depositors, and arguments about moral hazards do not seem very compelling to me, at least when it comes to depositors. Employees, management, Board members, and capital providers (debt holders and stock owners) should individually and collectively bear the risks of bank failures, in my view, not depositors.

In any case, let’s be clear. The entire banking system remains at risk and subject to whimsical shifts in depositor confidence and psychology, especially given the wide spread between yields on short-term debt securities (think two-year Treasuries) and the Fed Funds rate, both of which approximate 5.0%, and rates banks are willing to pay on many demand deposits, something between jack and squat, keeping in mind that significant balances of these demand deposits are likely uninsured under current rules.

Finally, record levels of commercial mortgages come due this year and next, about $500 billion each year, much of which is held by those smaller regional and community banks, those with less than $250 billion in assets. It remains to be seen how many of those loans are repaid, extended, or ultimately defaulted on, given the significantly higher cost of capital, declines in commercial real estate values, and weakening fundamentals. Maturing commercial real estate loans will provide a worthy adversary to bank balance sheets, especially in the event of increasing delinquencies and/or defaults.

• Housing prices remain firm, though one can argue that it is a tale of different housing markets and different time periods. In all 12 of the major housing markets west of Texas (Austin), home prices declined in January, year-over-year. However, prices actually rose in all markets to the east. Perhaps, it is partly a question of what goes up, must come down (or at least revert to the mean), but the disparity more likely reflects the relative difference in job markets within these geographic locations. Specifically, most of the job losses announced since last year have been in the tech sector, so markets with disproportionate exposure to these industries (e.g., San Francisco, Seattle, Los Angeles) have been hardest hit.

However, just as in so much other economic data, year-over-year figures often mask nearer-term trends. Since last summer, home prices across the country have dropped for seven straight months (through January). From June’s peak, national housing prices have declined about 5.3%, but are down much more in San Francisco and Seattle, 14.8% and 17.2%, respectively.

Moreover, all housing pricing data may be a tad skewed because of the sharp drop in transaction volume. Through February, overall home sales are down 22.6% year-over-year, 14.5% from January, and have declined for 12 straight months, whether considering overall or seasonally adjusted data. Higher mortgage rates and declines in consumer (read: homebuyer) confidence are to blame. At last glance, 30-year fixed rate mortgages nationally averaged 6.27%, according to Freddie Mac. While well off the 7.08% rate hit last year, rates are obviously more than double those witnessed in 2021.

In the U.S., the widespread use of long-term, fixed rate mortgages provides a certain buffer to downside risk, as borrowers are able to better able to meet mortgage obligations and are not forced to sell their homes as a result of short-term financial or economic distress. In fact, anyone who acquired or refinanced a home in 2020 or 2021 is now the fortunate owner of “mortgage handcuffs,” (insert joke here), likely unable or reluctant to sell and/or relocate because any subsequent home they might purchase would require substantially mortgage payments (over 25%). The widespread use of fixed-rate mortgages also explains why housing markets in Sweden, Canada, and Australia, where floating-rate mortgages on single-family homes are far more common, have been hit much harder than here in the U.S.

• Meanwhile, data surrounding multifamily markets is decidedly mixed. According to Redfin, asking rents for apartment units fell in every metropolitan area in the U.S. over the last eight months, reflecting not only normal seasonal slowdowns (August through February are traditionally slow leasing periods), but broader indigestion as several markets which saw significant construction activity must “absorb” new units coming to market. Developers of these new projects are engaged in aggressive lease-up efforts, offering generous move-in specials and rent concessions.

According to Redfin, median rent nationally fell 0.4% in March, year-over-year, the first annual decline since March 2020, the start of the pandemic. Rents nationally are down 3.5% since August, with the largest declines in Austin (11%) and Chicago (more than 9%). Other cities with rent declines of 3% or less include Phoenix, Las Vegas, New Orleans, Houston, and Atlanta. However, rents still remain far higher than before the pandemic, up 20 to 35% in many, if not most, markets. And perhaps more importantly, rents in March appear to have rebounded, at least compared to February, up 0.5%, according to Apartment List. Again, year-over-year data can really mask more recent, and arguably, more probative data points.

However, while directionally consistent with Redfin, Apartment List’s provides slightly different data regarding specific markets, rental growth (or declines) in said markets, over differing time periods. Anecdotally, those markets with greater exposure to technology and other white-collar jobs (e.g., San Francisco, San Jose, New York, Boston, Los Angeles) and those that experienced the greatest rental growth since the pandemic began (e.g., Austin, Atlanta, Phoenix) are generally those that are experiencing the most modest rental growth, or even experiencing rental declines, at least in recent months.

Meanwhile, national vacancy rates ticked up to 6.6%, their highest level since the summer of 2020, again reflecting uninspiring economic growth, higher inflation, and new supply.

Regardless of shorter-term trends or blips, the “affordability gap,” the difference between mortgage costs and effective apartment rents has never been wider, and homeownership remains decidedly out of reach for most, even two-income, white collar- households. But rising interest rates, higher home prices and decreasing inventory aren’t the only things making it difficult to buy a home these days. Last year, nearly a third of U.S. homes were purchased with cash, according to Redfin, likely foreign and/or institutional buyers. That’s an eight percent increase from 2021, continuing a trend that started during the pandemic, and representing levels not seen since 2014, when the housing market was on the rebound following the Great Financial Crisis. The rise of all-cash purchases comes at a time when the average home buyer is increasingly likely to be white, wealthy, and older, with the proportion of first-time buyers at its lowest in more than 40 years.

However, higher capital costs and uncertainty surrounding the economy and supply will continue to weigh on apartment valuations and transaction volumes. All property owners, especially those with floating-rate mortgages, are grappling with surges in short-term rates and the increasing costs associated with hedging exposure to such rates (interest rate caps), as yields on both SOFR (Secured Overnight Financing Rate) and 3-month Treasuries have spiked to their highest levels on record, or at least since the period preceding the Great Financial Crisis.

The three-month Treasury Bill yield rose to 5.08% this month (5.06% at last glance), its highest level since March 2007. Keep in mind that the yield on short-term Treasuries was 0.70% a year ago, and a measly 0.02% two years ago. Ouch.

Thus, it is no surprise that some apartment owners are struggling. In early April, a large apartment project in Houston, consisting of 3,200 units, was taken back by its lender in early April. Veritas, a San Francisco based PW firm defaulted on a $450 million loan backed by rent-controlled apartments, and Blackstone is currently negotiating with its lenders on portfolio of apartment buildings in NYC.

Meanwhile, the multifamily market continues to grapple with increasing supply in several markets. However, while there are about one million multifamily units under construction nationally, one should be cynical when reading headlines claiming that multifamily construction is at its highest level in 50 years, as proclaimed in a recent article published by MHN, Multi-Housing News, since such a claim is inherently misleading or at least incomplete.

For one thing, there are far more multifamily units in the U.S. today than in 1970, so on a relative basis, the increase in absolute construction activity is about a third of what it was in the early 1970’s. Those construction starts in the 1970’s tended to be smaller projects, 20 units or fewer, which were approved and built far more quickly than today. For those of you from Southern California, think about the apartment buildings you routinely see in submarkets like Hollywood, Brentwood, and/or Koreatown. The larger projects which dominate construction starts today take longer to build and bring to market. Finally, the U.S. population has grown significantly since the early 1970’s. For example, there are nearly double the number of adults aged between 25 and 54 today, and those prospective renters or homebuyers reside in different markets than they did back then, reflecting population and demographic shifts, away from both coasts and into markets in the Southwest and Sunbelt, for example.

Now, don’t misunderstand me, as there are a lot of apartments under construction, which along with those higher capital costs and operating expenses (e.g., insurance, labor), are impacting fundamentals and will continue to do so through at least the end of this year, especially in certain markets. However, demand will eventually catch up with supply and with the cost of single-family homes being essentially out of reach for so many, apartments will benefit at least on a relative basis. While the road will be challenging for both developers of new product and operators and owners of existing stock, I believe that the market will stabilize by the end of the first quarter of 2024.

Finally, in what has to be the single most exciting headline in the multifamily space was the news that a local Southern California developer is planning a mixed-use project with apartment units atop a Costco. Imagine, renting an apartment above Costco. You wouldn’t need an on-site gym. Walking the aisles of Costco and lifting cases of drinks and water bottles would provide all the exercise one might need. You could live off of free food samples. If ever one might find heaven on earth, I believe this particular development, if it comes to fruition, would nearly qualify.

• The commercial real estate market, especially the office sector, saw significant weakness and a large number of foreclosures during the quarter, principally in gateway cities: New York, Los Angeles, Boston, and San Francisco. Few landlords can withstand the double whammy of significant increases in interest rates and weakening fundamentals, which will create additional stresses on operators and lenders in coming quarters. As discussed in greater detail below, to say that the fundamentals in the office sector are not pretty would be a profound understatement. While being a multifamily owner/operator/developer is challenging these days, these challenges pale by comparison to those landlords or operators in the office sector.

This quarter my inbox was flooded with one anecdote or headline after another, each highlighting woes in the office market. Here is just a sample, and trust me, this is (sadly), just a sample:

  • “Pac Mutual Building in Downtown LA hits the market at half its previous price”
  • “Google Parent Alphabet to spend $500M cutting office space this quarter.”
  • “California Government to Trim 132 Office Leases”
  • “Distress in Office Market Spreads to High-End Buildings”
  • “Blackstone unloads two 13-story buildings in Southern California at a big discount”
  • “Brookfield defaults on two Los Angeles office towers”
  • “Pimco-Owned Office Landlord Defaults on $1.7 Billion Mortgage”

From Los Angeles to New York to Boston to San Diego to Washington D.C. to nearly everywhere in-between, the office market is in a depression and heavily distressed, experiencing rapidly declining rents, increasing vacancies, and comatose-like transaction volume. Shockingly, there are still a fairly large number of new projects coming to market, nearly 124 million square feet across the country, projects that had already been approved, financed, and begun before the turmoil started, so the beatings will continue for some time.

Billions of square feet of office will probably be obsolete by 2030, reflecting significant overbuilding and a greater shift to hybrid work. Sure, some projects will be repositioned, converted to other uses (e.g., healthcare, medtech, housing), but I remain dubious as to whether obsolete office buildings can be practically converted, and in most cases, I suspect buildings will remain vacant for years, ultimately razed and rebuilt for other uses. Impediments from zoning, architectural/design limitations, lack and cost of available financing for such projects, will simply be too great to overcome.

And retail real estate? It is not faring that much better, though the end of the Covid pandemic is certainly a positive for the sector. During the quarter, I read that Simon Property Group, the largest retail landlord in the country, defaulted on a $295 million loan on a 1.2 million square foot shopping center in Orange County, California, and poor Brookfield, repeating its experience on certain office assets, defaulted on a nearly $80 million shopping center loan in Washington state. There is no question that this will be the most challenging commercial real estate cycle since the 1970’s and I see no proverbial light at the end of the tunnel.

• The Consumer Price Index increased a modest 0.1% in March from the previous month, or 5.0% year-over-year, representing the ninth consecutive decline in year-over-year inflation figures and the lowest inflation levels seen since May 2021. Core inflation (excluding volatile food and energy prices) increased 5.6% year-over-year, driven in large part by continued increases in shelter (housing) costs, which increased 8.2% year-over-year.

With apologies for the size of this next chart, it provides a more granular and insightful breakdown of the yearly inflation change. However, one should exercise caution in drawing conclusions from year-over-year figures because they can obviously mask shorter-term trends that are perhaps more likely to persist going forward. For example, while egg prices rose an astounding 36% between March 2022 and March 2023, they fell 7% in February and another 11% in March. Thank goodness! One can only eat so much oatmeal, Cheerios, and avocado toast, even in California.

Meanwhile, March 2023 producer prices increased “only” 2.75% over the last year, the smallest increase since January 2021. By comparison, producer prices increased 11.7% in March of 2022 (versus the prior year), so costs have been declining, at least among domestic producers.

Where inflation goes from here is obviously a big question mark. On the one hand, decreases in housing/shelter costs and in lending activity, coupled with broad demographic and population changes are broadly deflationary. In addition, the continued trend towards automation and yes, AI, should prove deflationary with related changes in labor markets, as evidenced by this interesting graph. Firms require far less workers to generate substantial revenue than in the past.

Finally, the consumer seems to be losing some steam, perhaps having finally expended their PPP funds, unemployment benefits, and Covid-related savings when spending dropped like a stone. U.S. retail sales increased only 1.5% in March over the last year, the lowest growth rate since May 2020 and well below the historical average of 4.8%. After adjusting for inflation, the story is worse. Real retail sales fell 3.3% over the last year, the 7th consecutive year-over-year decline.

However, data surrounding certain discretionary spending appears contradictory. On the one hand, although I have not been to Las Vegas in recent months in order to obtain data supporting the Sussman Spa Bookings Index (SSBI™), my favorite measure of discretionary spending, I couldn’t help but note that Nevada casinos won nearly $1.24 billion in February, a new record for the month. On the other hand, Darden Restaurants, in a recent earnings call, indicated that households making less than $50K annually were eating less frequently at its Olive Garden and Cheddar’s restaurants according to data, echoing similar comments made by Walmart. Now I realize many reading this memo are not frequent consumers of endless bread sticks at Olive Garden (shame on you), but the anecdotes are consistent with overall trends in retail sales. Recent headlines, especially woes in the banking industry, have understandably weighed on consumer confidence.

In perhaps the scariest data point, “professional economists” (as opposed to the unprofessional or amateur ones) recently surveyed by the Wall Street Journal, project that inflation will slow to 3.1% by end of 2023. My cynicism about such polls is well documented, but if you need any evidence as to how difficult predictions are, not a single one of the economics professionals accurately predicted where interest rates would be at the end of 2022 and not a single number one seed made it to the Final Four in this year’s March Madness. Of course, had my beloved Bruins hoopsters did not sustain the injuries that they experienced and received a number one seed, I am confident we would be hanging up another banner in Westwood. Oh, well. As Andy Dufresne said in the Shawshank Redemption, “Hope is a good thing, maybe the best of things.” I have always liked that quote.

• The job market, while softening, still appears robust, providing a recessionary buffer. The March job report was solid, with an increase of 236,000 new jobs (non-farm) added, slightly exceeding expectations. The unemployment rate fell to 3.5%. Year-over-year average hourly wages increased 4.2%, slightly below the 5.0% inflation rate.

With Baby Boomers (those born after WWII) retiring, we are witnessing labor shortages that many have previously warned about. How do we find more nurses, teachers, bus drivers, and those willing to work in the construction trade (e.g., carpenters, plumbers, electricians)? Who will rebuild the bridges and roads in desperate need of repair, especially when we are already at or near full employment and our immigration policy remains a political football? The share of the U.S. population between 24 and 54 who are employed reached an all-time record in March, approaching 81%, so there is not a heck of a lot of additional labor supply to be found here.

But is not all peaches and cream in the labor markets as layoffs also continue to accelerate, especially in tech, banking, and real estate. Thus far, many laid off workers have been able to find other work, but I am not sure that will remain the case. The running total of layoffs for 2023 based on full months to date is 168,243, according to Layoffs.fyi. Tech layoffs to date this year currently exceed the total number of tech layoffs in 2022, according to their data.

How will AI impact labor markets now and looking forward? This is, perhaps, the most significant uncertainty surrounding employment over the coming years and remains to be seen, of course, but in the meantime, I am relieved that both business school faculty members and managers of financial services firms are not likely to be replaced, at least for a little while.

So, why are so many Americans sour on the economy when labor markets remain reasonably robust, and the stock market continues to hold its own?

I recently came across some data, released by a conservative think tank (please forgive me, liberal friends), American Compass, and an index it created and labeled, the “Cost of Thriving Index” (COTI) Essentially the index begins with a simple foundational premise, that households must prioritize five sets of goods: food, housing, health care, transportation, and higher education, a sort of modern-day take on Maslow’s hierarchy of needs.
The COTI strives to measure how the median American family is doing in terms of its ability to afford these goods, by looking at the cost of these five items back in 1985 versus today, comparing them with the median wage someone 25 and older and working full-time would earn, and finally, how many weeks it would take for that wage earner to pay for them. The data and conclusions are sobering, but informative, with two pictures communicating a thousand words.

Here’s the upshot. In 1985, it took about 40 weeks of work per year to pay for these things, giving families room to enjoy other consumer goods and luxuries. And today? It takes more than 62 weeks to afford these same costs. You don’t need to be an expert in the Gregorian calendar to realize the issue. The bottom line is that the median American family simply cannot afford what one would consider life’s necessities on a single middle-class paycheck.


For years, I have written about wealth inequality, the differential between the “haves” and “have-nots” Those with assets – principally, equities, bonds, and real estate – have become richer and richer, creating a wider disparity between themselves and the middle class. So, perhaps the declines in stock prices (since the beginning of 2022), fixed income securities, and more recently, commercial real estate values, along with the substantial job losses in technology, banking, and real estate represent a sort of “richsession” as several publications have described it, a sort of rebalancing, if you will. Blue collar jobs in trades, services, hospitality, and leisure continue to thrive, unions are gaining more traction, and government relief programs, including eviction moratoriums and expansion of rent control (see below), have expanded significantly in recent years, consistent with the thesis.

Either because of, or in spite of, political divisions and broad economic forces (read: wealth inequality), local, state, and our D.C.-based politicians seem eager to promulgate one housing related policy after another, generally benefitting renters at the expense of landlords or property owners
I have predicted for years that the most fundamental premise that “there are more tenants than landlords who vote” and housing has become increasingly unaffordable would result in increased expansion of rent control and inclusionary zoning, along with greater rights afforded tenants facing evictions. According to the National Low-Income Housing Coalition, 32 states and 73 municipalities have passed new tenant protections, just since January of 2021.

• National “Renters Bill of Rights”: Almost right on cue, President Biden rolled out a proposed ‘Renters Bill of Rights’ in January as a potential push for federal rent control. Not surprisingly, these efforts have been spurred by the Progressive wing of the Democratic caucus, though it remains to be seen whether the push will result in actual legislation or formal policy change. I suspect it is mostly window dressing and no substantive new national policy measures are forthcoming. After all, for certain types of FHA financing, restrictions are already placed on landlords, generally requiring that units be rented only to tenants satisfying certain income tests. And states are, for better or worse, promulgating their own regulations. For example, the Wisconsin and Economic Development Authority and Pennsylvania Housing Finance Agency agreed to cap annual rental increases to 5% per year for federal- or state-subsidized affordable housing.

• End of Covid-related eviction moratoriums…or not: One week before they were set to expire, the Los Angeles County Board of Supervisors extended by two months its tenant protections against eviction for those impacted by COVID-19, while also approving the establishment of a $45 million relief fund for small landlords who have been unable to collect rent from some tenants. At this point, the last phase of Los Angeles’ rent eviction moratorium will end in June 2023. Imagine that. The end of June, months after President declared the national Covid emergency over, and months after every other state had already lifted its eviction restrictions. Understandably, the extension was met with anger from property owners, while The Apartment Association of Greater L.A. (AAGLA) filed a lawsuit against the city to overturn and stop enforcement of the new ordinances that make it more difficult to remove tenants as well as penalize landlords for raising rent.

One ordinance in question stipulates that at least one month’s rent be past due before initiating eviction proceedings. The other forces landlords to pay relocation fees if rent is raised by at least 10 percent or by five percentage points over the rate of inflation, whichever is lower, and results in a tenant’s displacement. That includes paying three times the fair market rent of the unit plus $1,411 in moving costs. Call me a cynic, but I don’t think AAGLA will get much traction in the Los Angeles Superior or local District Courts.

• New York rent regulations upheld by federal appeals court: In New York, rent regulations and restrictions were upheld by federal appeals court, supporting decades old policy impacting about one million apartments. In short, the Second Circuit Court of Appeals rejected a challenge by landlords to state law passed in 2019, which made it much more difficult for landlords to free up apartments to achieve “market” rent. As other courts have found, the Second Circuit determined that rent regulations are not an intrusion on property rights or an unconstitutional taking and that legislatures have broad authority to regulate land use without running aground of the Fifth Amendments bar on physical takings. The Court reasoned that landlords are not restricted from receiving market rents “in perpetuity.” In my view, the Courts consistent justification of restrictive rent policies under land-use guidelines is misleading and another example where judicial ends justify economic means. But I call B.S. on this perspective, since it is not the “land use,” which is at issue, but rather the income stream that is derived from that same use. But realizing that judges allow desired outcomes to influence judicial reasoning and rulings is about as shocking as it was to learn that George Santos wasn’t Jewish or an astronaut.

• Rent-related proposals in Colorado, Massachusetts, and Maryland: As indicated above, several states have proposed legislation to protect tenants or ostensibly increase the affordable housing stock. In Colorado, a bill was recently introduced which would give local governments a right of first refusal to purchase multifamily properties before private parties so long as they commit to rent out units for affordable housing. In another measure, which has passed the State House of Representatives, statewide rent control preemptions would be revoked, allowing local communities to establish their own rent-related policies. In Boston, the City Council passed the mayor’s proposal to cap rent at six percent plus the increase in the Consumer Price Index, up to a maximum of 10 percent. However, state lawmakers still need to strike down statewide rent control preemption. Finally, in Maryland, two major counties appear poised to pass rent controls. In Prince George’s County, which surrounds the eastern half of Washington, D.C., county officials just pushed through a measure temporarily capping annual rent increases at three percent. In neighboring Montgomery County, lawmakers are considering two proposals that would cap rent increases at either three or eight percent. Have your popcorn ready.

• Los Angeles’ Measure ULA Tax: The ULA Tax is a new real property transfer tax that was recently approved by voters in Los Angeles. The tax went into effect on April 1st and will be levied in addition to existing city and county documentary transfer taxes. The ULA Tax will be 4% on all real property sales (commercial and residential, whether single- or multifamily) priced between $5 million and $10 million, and 5.5% on real property sales priced or valued at $10 million or greater. You do the math. It’s an extraordinary and very significant tax, which will very consequently impact the industry, reducing property values, transaction volumes, and ultimately, the economics and construction of new housing.

In addition, it’s inherently absurd, as it ignores the amount of equity one might have in a home, as it is based solely on the sales price. Therefore, someone selling a $4.5 million piece of property pays no tax, even if the property has no debt, while someone selling a $5 million asset with a $4.5 million mortgage pays the full tax. Finally, while the revenue raised by the new tax is intended to be used to fund affordable housing and tenant assistance programs, I assume it will make nary a dent on homelessness or housing affordability.

And, as always, there are always other interesting economic, financial, and real estate related tidbits that grab my attention

• Rumors of the U.S. dollars demise are greatly exaggerated. Every now and then, a story or three emerges about how this country or that one seeks to diversify away from the U.S. dollar, kicking off frenzied concerns about the inevitable end of dollar dominance. Naturally, these stories provide fertile ground for gold bulls, cryptocurrency promoters, and perhaps just your regular run-of-the-mill grifters to stoke fear about the dollar’s imminent (or just ultimate) death and the potentially catastrophic economic consequences that may follow. Lately, and not surprisingly, perhaps, given the political climate and ability to stoke fear via social media, there have been more than a few such headlines:

Doomsayers offer numerous reasons for the dollar’s inevitable demise, from China’s increasing local and global influence, America’s stagnant economic growth, chronic fiscal deficits, irresponsible monetary expansion and growing debt burden, trade disputes, etc., to challenges posed by potentially disruptive technologies like central bank digital and cryptocurrencies. However, it is my strong view that such rumors are just that, rumors, and that the dollar remains incontrovertibly dominant in global trade and finance, now and looking forward, if not a bit less dominant than before, perhaps Lebron James in the twilight years of his career.

Specifically, while the dollar’s share of central banks’ $12 trillion foreign exchange reserves has declined since 1999, it is still almost twice that of the euro, yen, pound, and yuan combined and the same as it was a decade ago. Its nearest competitor, the euro, accounts for barely 20% of central bank reserves (compared to the dollar’s 58%), followed by the Japanese yen and Chinese yuan at 5% and 3%, respectively.

Moreover, China also employes strict capital controls and foreign investment quotas, as well as a complex system that manages onshore trading and influences offshore yuan activity, so until and unless such controls and heavy-handed management end, I cannot see the yuan replacing the U.S. Dollar anytime soon.

• While the exodus from big cities slowed in 2022, the U.S. population is expected to decline shortly after 2040 if current trends hold: In recent years, I have written extensively about demographic changes and how they might impact real estate markets looking forward. Broadly speaking there have been a few significant shifts in U.S. demographics.
One, folks are getting married later, if at all, and having fewer children. That is a persistent trend throughout the developed world, largely deflationary, and arguably irreversible no matter what incentives might be provided. Let’s face it, feeding, housing, clothing, and educating kids has gotten too darn expensive, especially in populated cities. And without a significant shift in immigration policy, projections indicate that the U.S. population will begin to decline in about 20 years, just like Japan, and more recently, China.

The second was a significant move back to urban cores beginning about 10 to 15 years ago, following decades of “white flight.” However, this trend reversed course again as a result of Covid, when people relocated to less dense suburbs and/or were able to work remotely and moved, if just temporarily. The third has been the relocation of households from the coasts to less expensive inland markets, resulting in the Californication (or NewYorkification) of several cities, from Phoenix to Atlanta, from Reno to Nashville, from Boise to Miami. In fact, California saw some 700,000 residents, net, leave the state following Covid, a figure matched only by New York, which experienced similar population outflows.

However, recent data suggests that the migratory outflows from the largest metro areas following the pandemic have abated, if not reversed course. However, New York, San Francisco, Los Angeles, Chicago, and Washington D.C. are still experiencing population declines, though they were far more modest in 2022 versus the 2020 to 2021 timeframe. But with greater remote work options and the obvious externalities of living in urban cores suburbs and exurbs should continue to witness greater relative growth than urban cores. In metro Atlanta, for example, Fulton County, representing the urban core, grew 1.1% last year, while four peripheral counties—Dawson, Jasper, Lamar and Walton—grew at least three times as fast.

In conclusion, the first quarter of 2023 seemed to be the real-world embodiment of this year’s Oscar winner for best picture, Everything Everywhere All at Once, creating additional market and economic uncertainty
Making sense of economic and financial data and forecasting short-term trends is difficult in the most stable of markets, let alone volatile and uncertain markets like those we are experiencing today. The quasi-bank crisis we just witnessed in March merely adds to all the other uncertainties and unknowns we face, from inflation, the related Fed response in terms of the Fed Funds and Quantitative Tightening (or Easing, I suppose), Russia/Ukraine, China/Taiwan, the political environment, and even the impact of ChatGPT and artificial intelligence on just about everything. Perhaps in coming quarters, I will merely ask ChatGPT to write these memos for me. That sure would be a time-saver.

Meanwhile, we are fully aware of the challenges that lie ahead, and we are prepared to address them. For the existing portfolio, that means maximizing occupancy, managing expenses, carefully evaluating capital investment projects, and refinancing debt when possible, especially certain floating-rate debt we have on several of our more recent projects. We know that eliminating distributions, even for just a short while is painful, especially for me and the firm’s principals, given the significant capital we have invested in each and every one of the firm’s projects. But in uncertain times, conservative fiscal management must take precedence. And I remain convinced that the long-term outlook for the multifamily remains bright.

On the other hand, while markets remain challenging, attractive acquisition opportunities await, and we have been fortunate to find several. One is Aspire Seneca, in Victorville, California, a market we know well as we already own two assets in the submarket, including one right across the street. We have also acquired several other assets from this particular seller over the years. The projected returns are higher than we have seen in sometime, and we are still raising capital for that transaction. The other, an attractive three-asset portfolio in the Inland Empire, will be acquired using 1031 funds from two assets we successfully monetized (Aspire Midtown and Aspire Glendale).


With that, the entire Clear Capital team and I pass along our very best wishes to you and yours. We thank you for your continued engagement and support of our firm and its endeavors. And, as always, I want to express a special round of thanks to the Clear Capital Team, who continue to go above and beyond for our clients, colleagues, and partners, especially in challenging times.
Best,

Eric Sussman
Managing Partner


“Microeconomics concerns things that economists are specifically wrong about, while macroeconomics concerns things economists are wrong about generally.”
-P.J. O’Rourke
“Bull markets are a hell of a lot more fun.”
-Anonymous Managing Director, Merrill Lynch

According to Wikipedia, where I learn everything worth knowing (sorry ESPN, Twitter, and Truth Social), I have recently come to understand that New Year’s resolutions originated over 4,000 years ago in ancient Babylon during a 12-day festival known as Akitu. The tradition was subsequently adopted by the Roman Empire and then by knights in the Middle Ages, who would renew their vows to chivalry at the start of any year. Meantime, I know many of you are intimately familiar with Rosh Hashanah, signifying the Jewish New Year, which in on-brand messaging, marks the holiday with ten days of repentance, culminating with Yom Kippur, a day of fasting and prayers of atonement for past year’s transgressions.


Therefore, I wish to start the inaugural 2023 quarterly newsletter with more than just a perfunctory “Happy New Year” and expression of well wishes for 2023 (which I want to pass along, of course), but with a sincere mea culpa for getting the 2022 inflation and interest rate story so wrong. While I expected inflation and interest rates to increase under less accommodative Federal policies and that wages and rents would roughly keep pace, providing a reasonably inflationary hedge, I certainly did not expect the Fed Funds rate to rocket from 0.00 to 0.25% at the start of 2022 to 4.25-4.50% by the end of the year, following an unprecedented seven rate hikes in a single year.


As a result, there was and is simply no way that wages, rents, and ultimately, the operating cash flows for virtually any asset (e.g., equities, fixed income, and residential/commercial real estate) could keep up with such a sudden increase in the cost of debt, especially since we (and others) so often use variable-rate debt in concert with value-add strategies. Even though that debt is hedged via interest- rate caps, rates moved up so sharply and quickly that we are now paying the maximum hedged interest rate on virtually all of our floating-rate debt. The pain is not inconsequential.

One silverlining is that lenders are requiring us to set aside funds each month to purchase replacement rate caps if we continue to hold the current loan subsequent to expiration of the rate cap. We are looking to utilize more fixed rate agency or bank financing while maintaining exit flexibility in future offerings.


Perhaps there is safety or comfort in numbers, as every single economist surveyed by the Wall Street Journal at the end of 2022 got it wrong, but such sentiments represent mixed emotions at best.
According to “professional” economists (an oxymoron if one ever existed) surveyed in late 2021, the average forecast for yields on 10-year Treasuries at the end of 2022 was 2.04%, with the largest outlier being 2.90%. Oops. 10-year Treasury yields actually finished the year at 3.78%, after peaking at 4.34% in October.

Meanwhile, the yield curve was substantially inverted at year end, with rates on two-year Treasuries exceeding that of ten-year securities by 60 basis points. Imagine that. Those supposedly “in the know” predicted that 10-year Treasury yields would end 2022 at 2.04%, while yields on two-year bonds ended the year at 4.38%. There is no other way to say it than that is one heck of a whiff. If there is a silver lining to the inversion, the market clearly expects inflation to subside, though it may be on the back of a recession.

The last time prognosticators got it this wrong, Buster Douglas was a 42-1 underdog against Mike Tyson, the Soviets were merely slight favorites to beat a terribly overmatched U.S. men’s hockey team in the 1980 Olympics, the “Red Wave” in the midterm elections was expected to materially change the political landscape, and TCU had a fighting chance in this year’s college football championship game. As I have opined many times, prognosticating is one tricky endeavor. I suppose I should not be too harsh on myself. At least I didn’t put Elizabeth Holmes, Sam Bankman-Fried, Barry Minkow, or Ken Lay on the cover of a national publication or anything, believing they were the next Steve Jobs or Warren Buffett, or that Enron was the best company to work for. Yikes.

And the culprit for the unprecedented interest rate moves? Well, it’s simply this graph, setting forth monthly inflation rates (CPI-U) in the U.S. between the start of 2020 and the end of 2022. The good news is that inflation appears to have peaked and inflation rates have started to drop, declining each month since the middle of last year. What happens to this graph is quite likely the single most impactful unknown as we look forward to the financial and real estate markets in 2023 and beyond. Despite my misgivings, I will provide my inflation outlook in short order and will do so, knowing full well I might end up yet again with a face full of eggs. And given the recent price of eggs, that would be costly.

In response to inflationary pressures and the Fed’s aggressive responses, 30-year fixed rate, single- family mortgage rates more than doubled last year, from 3.05% at the end of 2021, to 6.42% at the end of 2022. Keep in mind that mortgage rates were even higher just a few months ago, reaching a peak of 7.2% in October, so as inflation has dropped since the summer, so have mortgage rates.
Needless to say, rates on multifamily and other commercial real estate debt moved up similarly, as have spreads, the margin over underlying indices that lenders use to “price” loans and the cost of debt. Higher rates and higher spreads are one of those double-whammies and, though I am not entirely sure what a whammy is, I know that even a single one is not good.

The result? Ugliness wherever one looks, as stocks recorded their fourth lowest annual return in half a century, with the S&P 500 down nearly 20% and the tech-heavy Nasdaq down by nearly a third.
For the first time in 150 years, both U.S. stocks and long-terms bonds were down more than 10%. During the fourth quarter stocks seemed to be stabilizing in October and November…and then came December. The S&P 500 and NASDAQ were down nearly 6% and 9% alone in December, after positive returns in the prior two months to start the fourth quarter. So much for a Santa rally.
Apparently, Rudolph and team went on strike, or his nose ran out of batteries.

To nobody’s surprise, the stocks that have taken the most significant body blows are the previous highflyers, the ones which rarely, if ever, reported profits or generated positive cash flows, and whose entire business models remain suspect (e.g., Peloton, Roku, Affirm, Carvana, Coinbase, Spotify, Zoom). Indeed, the ones that Jim Cramer touted bigly with a routine “booyah,” when the cost of capital was near zero and investors seemed convinced that these firms would be long-term disruptors. Can I get another “oops”?

Regardless, the reality is that there was no place to hide in 2022, including real estate. The FTSE NAREIT Index, an index of publicly traded real estate investment trusts, was down roughly 23% in 2022. The best performing segment of publicly traded REITs was hospitality/lodging, down “only” 15.3%. Keep in mind that hotels can change rental rates daily in response to inflationary pressures

and travel significantly rebounded last year. Meanwhile, residential REIT prices were down 31.3% in 2022 and according to Green Street Advisors, commercial property prices overall (public and private markets) fell 13%.

More granular results were fairly predictable. Existing home sales tumbled, down over 35% through November (year over year), while home prices themselves were down only modestly, about 5% on average, across various swaths of the country and different price points. This was one prediction I got mostly right, that higher interest rates would significantly reduce transaction volumes, but pent-up demand, persistent undersupply, elevated money supply and liquidity, the relative health of banks, the availability of mortgage capital, and continued (albeit lower) institutional investor interest in the space, would prevent what would be the worst sequel in history, the Great Financial Crisis, Part II (barely beating out Caddyshack II and Jaws: The Revenge).
Here is the data (through November) in all its…splendor:

And the multifamily market? Was it able to buck the trend?
In a word, “no.” While multifamily assets should and generally do perform better in inflationary environments than other real estate assets encumbered with longer-term leases and stickier short- term cash flows, residential rents (like all rents) simply could not keep pace with the Federal Reserve’s gravity-defying interest rate moves. And to make matters more challenging, recession fears, general economic and political uncertainty, and the additional supply of units to several markets, have resulted in a recent softening of rents in most markets, a reversal of trends witnessed in recent years.

While I believe these challenges and headwinds are transitory and will provide some very favorable buying opportunities, they will create operational and financial challenges in the interim, as bear markets inevitably do. That is, the longer-term fundamentals supporting multifamily investments remain squarely intact (e.g., affordability, supply of single-family homes, demographics). However, if asset managers and private equity firms are prudent and conservative, they will likely reduce distributions, manage controllable expenses more carefully, and postpone capital projects with uncertain ROIs until inflation abates, markets stabilize, and visibility becomes less uncertain, likely during the latter part of 2023. We are certainly doing so and I was hardly surprised when Blackstone recently announced that it would “curb” investor withdrawals from its behemoth $69 billion REIT.

A few pictures communicate a thousand words with regards to the multifamily markets. While national rents increased 3.8% in 2022, the annual figure masks a more sobering reality that rents actually declined in each of the last four months of the year. For example, rents in December 2022 were down 0.8% nationally. The reality is that 2021’s overall multifamily rental growth of 17.6% was simply remarkable and unsustainable and so it is not shocking that rental growth in the 40 largest markets has softened during the past year.

For example, in Palm Beach, rental growth declined from 30.4% in 2021 to 1.7% in 2022, still positive, but barely so. Phoenix and Las Vegas, markets that witnessed 20%+ rental growth in 2021, saw rents decline year-over-year. And 2022’s Oscar winner for “greatest year-over-year rental growth?” Indianapolis, at 7.4%, followed by a number of other Midwestern markets, including hotspots Cincinnati, St. Louis, and Columbus. Last year’s top 10 list for rental growth was over- represented by cities in the Midwest, after the Southwest and Sunbelt were overrepresented in prior years. Is it “what goes up, must come down” or “what does not go up as much as others, must eventually catch up?”

In short, the fourth quarter was a challenging one for multifamily investors and asset managers, on top of an otherwise challenging year of inflation and higher capital costs, as limited absorption (net units rented) and new demand ran headfirst into the reality of nearly 100,000 new units delivered to the market nationally, increasing the national vacancy rate from 5.7% at the end of the third quarter to 5.9% at the end of 2022. And I am not even counting the housing that Elon Musk created when he converted some of Twitter’s offices into temporary bedrooms, causing some to quip that Musk is the first person to add housing to the Bay Area in years.

In short, 2022 was already likely to be challenging, if just by comparison to 2021, before Russia – in what has to be considered an extraordinary and historic strategic blunder – invaded Ukraine and China decided it would be better off shutting down its economy to stymy Covid rather than treat its population with western vaccines. Throw in a spoonful of financial fraud (FTX/Alameda Research) and a pinch of domestic political chaos (heck, I was willing to become Speaker of the House last week) to a gallon of inflation and Federal Reserve tightening, and you have a Michelin-starred recipe for a bear market and significant declines in asset values. 2022 was truly the flip side of 2021, where almost any investment strategy worked, and all asset classes saw healthy returns. Markets can indeed be and are fickle things.
So, what’s the broad economic outlook for 2023? Will market values recover? Inflation and the Fed? Recession or…?


One might think that being once bitten, I would be twice or perhaps three times shy in making predictions for 2023, but old habits die hard, I suppose. Maybe I am just like that proverbial broken watch, right twice a day. I am also an optimist by nature, believing that market downturns inevitably create opportunity for longer-term, patient investors, perhaps because they do.


To cut to the chase, I expect 2023 to be a year when the markets find their footing and, during the second half of the year, recapture all of 2022’s losses, perhaps a recurrence of what happened in 2009 following 2008’s significant market declines. Inflation will continue to retreat as the economy softens and the impact of higher interest rates and capital costs take their toll. The markets will respond favorably to lower inflation prints and the end of the Fed battering ram. Residential and commercial real estate rents will decline across nearly all markets during the first third or half of the year, before recovering, repeating what we witnessed during and subsequent to the Great Financial Crisis and other downturns over the past couple of decades.

While a 2023 recession seems a real possibility, I am not convinced that one is unequivocally in the cards. For one thing, according to a recent survey of public company CEOs, over 90% felt that there would be a recession this year. I am not nearly convinced that CEOs are more accurate at forecasting than professional economists, though one would expect that they would have better information and insights as to current demand and backlog. The contrarian in me tells me that when there is that sort of consensus, something else is likely to happen. Secondly, global GDP was up 1.3% through the third quarter of 2022, and while these numbers are nothing to crow about, they are not horrible given all the headwinds the world economy has faced and they do show growth, albeit modest.


In addition, while layoffs have accelerated of late, unemployment remains low and the job market fairly robust, even in the face of higher inflation and a broader economic slowdown. While tech firms are laying off increasing numbers of staff, Main Street is acting as a job sponge and is still facing challenges attracting and retaining talent. Job losses at Amazon, Twitter, Meta, Microsoft, and Salesforce have thus far been offset by employment gains in leisure/hospitality, healthcare, and other service industries. In December, employers added 223,000 jobs, above the 200,000 estimates, though these results represent the smallest job gains in two years. Average hourly earnings were up 4.6% year over year, down from March’s peak of 5.6%, and below more inflationary expectations (5%). The wage gains were the most modest since mid-2021.

Some articles have announced the tech layoffs with attention-grabbing headlines, as though these headcount reductions represent the “end” of an era in Big Tech, as the Washington Post crowed in mid-November, with a tagline that the layoffs are “stoking memories of the dot-com crash 20 years ago.” Please. Nothing like a dash of journalistic hyperbole to accompany your morning latte. Sure, Amazon, Meta, Microsoft, Netflix, Alphabet, Twitter, and Apple are trimming some fat, but they aren’t going anywhere and future technological breakthroughs in everything from virtual reality to artificial intelligence to health care will prove significant future job creators.

Meantime, consumer confidence has rebounded off its summer lows, as have the equity and bond markets. In fact, the S&P 500 and NASDAQ are up 4.2 and 5.9%, respectively, during just the first two weeks of 2023. And in one last data point, the staff tending the front desk of the spa at the ARIA casino in Las Vegas told me they were swamped and completely booked when I asked just a few weeks ago during a visit and was on my way to the gym. Thus, consumers are clearly still spending on discretionary items, at least when it comes to shiatsu and aromatherapy, according to the SSBI (Sussman Spa Bookings Index™).

However, we should keep in mind that residential and commercial real estate comprises some 20% of U.S. GDP. Housing’s combined contribution generally averages between 15 and 18% of our economy and includes construction of new single-family homes (including manufactured ones) and multifamily projects, residential remodels, and brokerage commissions. Perhaps it is as simple as one of my UCLA Anderson colleagues, Ed Leamer, wrote in a 2007 paper, “the housing cycle is the business cycle.” Meanwhile, according to another study I recently read, commercial real estate (think office, retail, industrial) contributes another five percent to our GDP each year.

In short, one does not need to be a psychic, economist (professional or merely rank amateur), market pundit or guru to recognize that sharp declines in residential and real estate transactions and declines in new housing starts and permits issued will translate to significant economic drags in 2023 and perhaps beyond. In addition, in my last quarterly update, I predicted that declines in the housing market – purchases and sales and housing starts – would present considerable headwinds to companies whose results are closely tied to the housing cycle. The recent rumor that Bed, Bath, & Beyond will be shortly filing for bankruptcy could be Exhibit A in this regard. I expect other firms to follow or significantly underperform (e.g., Wayfair, Williams Sonoma). This simple chart speaks volumes, indicating that housing starts are expected to decline sharply in 2023, regardless of who is doing the forecasting.

The worst of inflation appears behind us (can I get a “hallelujah”?), but the question remains as to where it might find its equilibrium, and will that equilibrium approach the Fed’s two percent target? At this point, I see more deflationary pressures in the U.S. economy, though energy and food prices are challenging to predict. Between significant declines in nearly all asset values (e.g., equities, bonds, real estate), the recent retreat in crude oil prices (back below $80 a gallon from over $100 this past summer), December’s historic 15% decline in used car prices, and the overall 0.1% decline in December’s CPI-U from November, evidence of deflation is not hard to find.

In early December Kroger’s CEO indicated that food inflation was “easing” and in fact, food prices declined modestly in December, down 1.9%, according to the FAO Food Price Index, while overall food prices were up 10.4% last year. Of course, one might not believe the data based on the price of eggs, where not just the sunny side is up. Egg prices were up 60% in 2022 and over 11% in December alone. Finally, in perhaps the most probative data point surrounding inflation, I recently read Sam’s Club recent earthshaking announcement that it has cut the price of its in-house hot dog and soda combo to $1.38 from $1.50, undercutting Costco! Of course, the last thing I need is additional motivation to consume more hot dogs.
Money supply and bank lending activity also provide compelling deflationary evidence
Over the past few quarters, I have mentioned that tremendous sideline liquidity – some $22 trillion in M2 money supply – provided a significant downside buffer to sustainable market declines and support for my contention that once markets stabilize and fears of recession abate (or a mild recession ends), that liquidity will find its way into the markets, driving prices back to previous levels. However, in recent months, there has been a modest decrease in money supply, consistent with deflationary pressures.

In addition, U.S. banks have tightened underwriting standards for business loans, consistent with what we are witnessing in multifamily real estate lender underwriting. Stingier loan underwriting is deflationary, at least on the margin.

The unprecedented run we experienced in housing prices and rents between 2010 and the end of 2021 is clearly taking a pause. The days of multiple offers, many waiving contingencies, offering significant non-refundable deposits, and/or others accompanied by pictures of families and cute pets, are likely over, at least for this cycle. As mentioned, single-family home prices are generally down about 5% nationally, and according to a recent article I read, about 8% of homes bought in 2022 are under water. Certain markets, principally those that defied gravity in recent years (e.g., Boise, Phoenix, Atlanta, Austin) and witnessed prices of single-family homes rise nearly 60% or more between 2012 and 2019, are down more sharply.

For example, according to Redfin, housing prices in Austin and Boise declined by over 3% and 2% in December alone, respectively, and homes were taking over two months to sell, twice as long as last year. In another example, the median home price in Sacramento, where Clear Capital owns two assets, the median single-family home increased 40% in value between March of 2020 and the end of June 2020, reaching a median of $560K. More recently, the median home price has dropped to about $510K, a modest (10%) retracing.

How long the housing slump lasts remains to be seen, but I anticipate that rents will decline modestly over the next year and then begin to rise again, recapturing previous highs, similar to what we witnessed during and subsequent to the Great Financial Crisis. Keep in mind that a new study released by National Multifamily Housing Council and National Apartment Association indicated that we need to build 4.3 million new apartment units by 2035, just to meet demand.

However, the data is conflicting. On the one hand, graphs like those below seem to indicate that housing prices may be poised for further declines, if just because they appear at significant odds with historical norms, whether comparing them to interest rate levels (first graph) or other factors including population growth (second). Both graphs are sourced from Robert Shiller, of Yale and Case-Shiller fame.

However, as discussed in previous memos, this time may, in fact, be different, as a result of everything from Covid and pent-up demand, a lack of single-family supply, institutional involvement in the single-family market, and excess liquidity. Moreover, three other important data points provide support for the contention that significant declines in housing prices are not in our future.
One, banks have exercised far greater underwriting discipline in recent years, such that more than half of borrowers have credit scores of over 760. Two, the collective amount of equity homeowners own in their homes exceeds $30 trillion, a record high, and a very different reality than what we witnessed during and following the Great Financial Crisis. Finally, as discussed in the last quarterly memo, banks are in decent financial shape and not excessively levered generally, with excessive exposure to the single-family market.

In short, I expect the housing market, both single- and multifamily, to be fairly soft in the first half of 2023, but to rebound towards the latter half of the year and into 2024, as inflation subsides, interest rates decline, the Fed ends its money-tightening endeavors, and the equity markets stabilize. In the meantime, macro-level themes persist. Single-family homes will remain out of affordable reach for many or even most, driving them to rent, perhaps indefinitely.


Consistent with that premise, I recently read an article in the Wall Street Journal about non-profits getting into the housing game, acquiring single-family homes for cash, and then re-selling them to families at cost, a sort of “activist home flipper.” The particular non-profit and market featured in the article were in Milwaukee, where home prices are far more affordable than countless other markets. But these efforts reveal just how widespread and systemic the housing affordability issue happens to be. However, while these efforts may merely reflect that old adage that “desperate times call for desperate measures,” I cannot fathom that they will be broadly impactful.

Meantime, I am keeping my eye on several other housing-related trends and data points
• Homebuyers are moving farther away: In an interesting statistic recently released by the National Association of Realtors, buyers who bought homes during the year ending June 2022 moved a median of 50 miles from where they owned their prior home, the greatest distance on record, literally quadrupling historical behavior, and reflecting an increasing trend over the last five years. Remote work and lower housing prices are compelling relocations and growth in tertiary and quaternary markets, exurbs, and rural markets, trends we have discussed at length previously. The shift explains the explosive growth in markets like Idaho and California’s Central Valley, from Riverside County to North Port, Florida, to Indianapolis. I am reminded of Southwest Airline’s catchy advertising tagline, “You are now free to move around the country.”

Home sales to investors slid 30% in 2022: In the third quarter of 2022, institutions bought approximately 66,000 houses in the 40 markets tracked by Redfin in Q3, down over 30% from the same period in 2021. Even institutional investors have been reining in their horns a bit in the face of all the economic, political, and market uncertainty. But let’s be clear. They have proven that owning single-family homes as rental units is an investable and scalable asset class for institutions, and I expect they will continue to scoop up homes, new and existing, going forward, competing with traditional homebuyers.

Millennials are much less likely to own their homes: In a data point surprising nobody, millennials are far more likely to be renters or living at home (sorry, parents), and I believe that this trend will persist for the foreseeable future, presenting additional long-term tailwinds to Clear Capital’s multifamily strategy, despite nearer-term challenges.

Uncle Sam will start backstopping mortgages of more than $1 million in “high- cost” markets beginning this year: In November, the Federal Housing Finance Agency announced that it will begin to back single-family residential mortgages up to $1 million in certain “high cost” parts of the country, allowing prospective homeowners to secure larger loans with lower rates. In most areas of the U.S., the new limit for “conforming” loans backed by Fannie Mae or Freddie Mac, will be $647,200 for single-family homes, an increase of nearly $100K from the previous limit of $548,250. I don’t think the change will be significantly impactful, but it is a worthwhile data point impacting the housing market.

Foreign housing markets, however, are facing even greater pricing pressures, with several markets (e.g., Canada, New Zealand, Australia) experiencing double-digit price declines: Last week I was giving a presentation to a group of corporate real estate folks from Taco Bell, when someone from the audience asked for my views about Canadian real estate markets. I confessed that while I don’t follow them very closely, I had seen some data surrounding single-family homes that made me uneasy. Specifically, several of these foreign markets are far more levered, with far higher levels of household debt. Australia, Canada, and Sweden, in particular, appear at far greater risk than the U.S. or Ireland, for example.

Finally, there are always a few other economic, political, or market headlines or news items that have grabbed my attention and are noteworthy
• Politicians mostly seem to have taken the fourth quarter off: In a welcome break, politicians and other policy makers were rather quiet during the fourth quarter of 2022, perhaps focusing on midterm elections, holiday shopping, and the third season of Emily in Paris. I did read one relevant article, however, which discussed how tax policies surrounding vacant land are creating an unnecessary impediment to the construction of new housing. Specifically, in certain areas (e.g., New York City), tax levies on high-rise housing projects are often higher than on vacant lots. The article focused on one six-acre site next to the United Nations on the upper east side, which is valued at over $100 million and is zoned for 1,500 apartment units but has sat empty for 15 years because taxes on the parcel are minimal. While I am dubious that property or other local taxes could present such a significant impediment to a potentially successful housing project, I have repeatedly spoken and written about how policy makers should focus on economic carrots and incentives to promote housing development and increased unit density.

• The office market is a dumpster fire: Many tech companies that drove demand for office space here and elsewhere as they expanded are now canceling leases and flooding businesses with office space as they downsize. Recently Meta, Lyft, Salesforce, and Twitter have been shedding millions of square feet in the Bay Area (Silicon Valley and San Francisco), New York, and Austin as they reduce headcount and shrink their office footprints. Amazon.com stopped construction in July on new office buildings. About 212 million square feet of sublease space is on the market, a record since CoStar began tracking such data in 2005. The national occupancy rate, about 12.5%, its highest level since 2011, will be heading higher in 2023 as net new absorption will be decidedly negative. I anticipate a large number of office foreclosures this year and next, and I would steer clear of the segment as I fail to see any upside catalysts.

• Mergers and acquisition volume, stock, and bond offerings, as well as angel and venture activity are at their lowest levels in a decade: As the equity and debt markets swoon, Wall Street and their brethren are taking a proverbial breather. IPOs, debt issuances, and venture capital deal volume will likely be taking an extended vacation in 2022, at least until interest rates and markets stabilize. This trend is not only deflationary but will impact virtually all real estate markets and asset classes.

• Over the next thirty years, baby boomers will be transferring tremendous wealth (and real estate) to Generations X and Y: Over the next several decades, Generation X (born between 1965 and 1979/1980), which includes this author, and Generation Y (born 1984 to 1994-1996) are poised to inherit over $28 trillion from baby boomers, those born between the end of WWII and 1964. I can almost hear the long-gone John Houseman echoing a slight twist on that distinguishable catchphrase he popularized in Smith Barney commercials back in the 1980’s: “I make the money the old-fashioned way. I inherit it” (for you, youngins, Smith Barney “earned it.”). The impact of this wealth transfer will be significant, but uncertain. I assume many homes that have not been sold in decades will hit the market as beneficiaries monetize assets, those that they ironically may not be able to afford or even want to own and live in.

• And lastly, a couple of updates on demographic data and population shifts: During the last quarter, a few articles and data points crossed my desk regarding demographics and population, merely confirming trends we have noted and discussed for some time. One, U.S. population growth remains sluggish, increasing just 0.4% for the year ended June 30, 2022, somewhat better than the 0.1% increase during Covid. Eighteen states lost population, led by New York (-0.9%), Illinois (-0.8%), and California (-0.3%). Population gainers included Florida (1.9%), Idaho (0.8%), South Carolina (1.7%), and Texas (1.6%).

Without immigration reform, the U.S. is destined to experience less economic growth, as I see it. Perhaps it is the lack of immigration policy that results in so many more illegal crossings and border challenges, along with the profound politicization of the issue.

On a related note, China just announced that its population declined last year, falling for the first time in 60 years, reflecting record-low births, consistent with global trends, especially in developed nations. The implications (e.g., economic stagnation, labor supply) are profound and whether China (and others) can reverse the trend remains a significant question mark. I am skeptical and believe that these broad demographic trends (e.g., delayed marriage, declining birthrates) will persist, reducing global growth and inflationary pressures, longer-term.

In conclusion, while 2022 was an entirely forgetful year when it comes to virtually almost anything economic and financial, making predictions for 2023 a bit challenging. However, if history is any barometer, savvy and patient investors will take advantage of the declines in asset values.
I think this 2012 cartoon from the New Yorker captures the challenges, uncertainties, and conflicting data found in today’s markets as well as any:

However, while downturns and bear markets test wills, abilities, and balance sheets, they inevitably separate wheat from chaff, acting as a sort of survival of the fittest. The Clear Capital team is going to be managing all assets in the current portfolio with even greater focus and prudence, while hoping to take advantage of any dislocation and distress through strategic acquisitions to add to our portfolio. Some of these decisions will create short-term pain (e.g., reduced/suspended distributions, cash-in refinances), but will be necessary to work through a higher-rate, higher-inflation, more uncertain economic environment.
Before ending yet another lengthy quarterly memo, I would like to leave you with a bit of perspective, if not a tad of optimism. While recently trolling folks on Twitter (probably Elon Musk himself), I stumbled upon a letter that Mark Twain wrote to Walt Whitman on the occasion of Whitman’s 70th birthday. In that letter, a true literary time capsule, Twain took the opportunity to identify several inventions that had taken place during Whitman’s 70 years, all in a tone of profound wonderment: the steam press, steamship, steel ships, railroad, cotton gin, telegraph, phonograph, photogravure (crude photography), electrotype, gaslight, electric light, sewing machine, and surgical anesthesia.


Twain subsequently mentions some of the momentous events that had occurred in that same time period: removal of the French Monarchy, the U.S. Civil War, and the end of slavery. I suppose the point is never to underestimate human ingenuity and progress, and to be profoundly cynical when journalists proclaim the “end of Big Tech” because of an industry slowdown and layoffs. If two pictures can hammer home the point, I give you two, a mere 66 years apart, in 1903 and 1969, respectively:

And finally, in what has become an annual tradition in our fourth quarter letter, I would like to leave my final words to Calvin & Hobbes, arguably the greatest philosophers from the last century, and their perspective as to how important it is that we look forward to 2023, closing the curtain on a very challenging 2022.

Before I sign off, I want to invite you my virtual “office hours” on January 24th at 12 PM PST, where I will be chatting about the markets and other economic/political/business news via LinkedIn Live (https://lnkd.in/gKz6T2qJ). We will also be hosting our 2022 Review|2023 Outlook webinar on February 7th at 12pm PST (click here to register), so mark your calendars for both events! And, last, but most certainly not least, I would like to express my sincere appreciation and thanks to you, our investors, supporters, and friends, as well as the entire Clear Capital and Clarion Management teams for their extraordinary efforts over a challenging fourth quarter and year. I remain grateful and fortunate to work alongside each of you.
Best,
Eric Sussman

“I am so f___ tired of living in unprecedented times.”

  • Random person on my Twitter feed

“Youth isn’t wasted on the young. Wisdom is wasted on the old.” 

  • Raymond Reddington, Blacklist

“Hard times create strong men (people), strong men (people) create good times, good times create weak men (people), and weak men (people) create hard times.”

  • C. Michael Hopf

Before getting to the nitty gritty of what was a fairly painful quarter, I would appreciate your momentary indulgence while you join me for a quick dip into one of my very favorite destinations, the “hot tub” time machine. While any time machine would work perfectly well, I have always been partial to the hot-tub variety since the release of that mostly forgettable film series back in 2010. Just to get you in the mood and/or refresh your memories, I will provide a visual cue:

In any event, I would like you to imagine that this unique time machine has transported us back to the fall of 2008, mid-September to be precise. Try to remember where you were, how you felt, and what your views on the economy, markets and investments might have been at the time. For some of you, it won’t take much imagination because you were truly “there,” perhaps living in New York and working for a money-center or other bank, perhaps Lehman Brothers itself, as the world was seemingly on the verge of collapse. For others, we will remember it like a bad dream, like those of us who thought seeing Hot Tub Time Machine 2 was a good idea. And some will barely remember it at all, those of you who were fortunate to have still been in school at the time, and whom I envy just a tad.

Anyhow, Lehman, the 164-year old investment firm with some $700 billion in assets (and more, if you include those pesky off-balance sheet items) literally filed bankruptcy at midnight on September 15th of that year (after Bear Stearns had collapsed in March), setting in motion a global domino effect and crisis: numerous bank and financial firm failures (e.g., Wachovia, Washington Mutual, Merrill Lynch, Countrywide, CIT, IndyMac), the bankruptcies of firms from General Motors to Chrysler to Circuit City to Linen n ’Things, to the sovereign bankruptcy of Iceland, to the bailout of insurance giant AIG. Firms, households, and governments failed or were on the brink of doing so. It is hard to fathom that between October 2007 and March 2009, the S&P 500 fell nearly 60%, 37% in 2008 alone.

Now fast forward to today and how most, if not all, of us feel as we glance at stock prices most days, watch or read the news, peruse our third quarter brokerage statements, and/or consider how this unprecedented rise in interest rates has impacted our broader investment portfolios, including interests in real estate. Now I know a lot of you, predicting where I am headed next, are going to reply with something to the effect of “sure, I remember, and I know. But that’s history. This time is different.”

Ah, the old “this time is different.” Of course, every market crisis is different and I have been through more than a few of them: the stock market crash in October 1987, when the equity markets dropped over 20% in a single day; the global financial crisis and failure of Long Term Capital Management in 1998; the dot-com bubble burst and roughly 80% drop in the NASDAQ between the spring of 2000 and fall of 2001; the Great Financial Crisis (2008-2009); and most recently, the drop in markets at the start of the COVID pandemic when the market dropped roughly 26% in a single month (March 2020).

And so here we are. Knee-deep in what seems to be another crisis, or at least a significant bear market, with its own unique underpinnings: global inflation, an unprecedented increase in interest rates, and widespread geopolitical unrest. Yet the results are essentially the same. Markets are sharply lower, especially equities and fixed income securities. Investors are increasingly nervous, even seasoned asset managers. Commercial real estate prices, especially Class B and C office and retail assets, have declined significantly, with rapidly increasing vacancy rates.

Even multifamily values, which have generally shined in recent years, have declined at least 5 to 10%, if just because the sharp rise in interest rates cannot be offset by lagging increases in rents. Home prices are starting to soften, especially in markets like Boise, Austin, and Phoenix, cities which have experienced the greatest price rises in recent years. The U.S. Dollar has soared, reaching near parity with both the Euro and British Pound. And as though the bad news in the third quarter wasn’t enough, the Dodgers were eliminated shortly thereafter in the first-round of the playoffs, forcing me to watch the Padres face the Astros. Ughh.

The unprecedented interest rate hikes have resulted in nearly $8 trillion in losses in fixed income and equity markets, while investors in 10-year Treasury bonds have lost over 18% year-to-date (through October 15th), the worst performance on record. Several pictures set forth some of the sobering specifics and grim realities about this downturn:

And yet, in every previous crisis or significant downturn, markets and asset prices ultimately recovered, and then some, and I have every confidence that history will repeat itself. However, lacking true psychic powers, I can only state with unwavering confidence that the timing for such a recovery in asset values is uncertain. Academic research, if not common sense, tells us that even the most sophisticated and informed investors cannot time market peaks or troughs. I have repeatedly said that investors are fickle creatures and sentiments change quickly, sometimes shifting imperceptibly and quickly from the depths of pessimism to something very different, like how the coldest and loneliest craps table on any given night in Vegas can become rowdy and euphoric in mere moments and a handful of rolls.

Truth be told, it is not all bad news. Companies are continuing to hire, despite the slowing economy, with the unemployment rate presently sitting at 3.5%, after the economy added 263,000 jobs in September. Consumers are still spending, with the Commerce Department recently announcing that household spending rose by 0.4% in August, after dropping 0.2% in July. Core personal consumption, after stripping out volatile food and energy expenditures, increased 4.9% year over year in August.

While I expect spending to slow, retail sales and consumer spending have not fallen off the cliff as one might have expected given inflation – especially higher food and energy prices – and the market downturn. In fact, just last week the CEO of Bank of America said that their internal data suggests that the U.S. consumer is “healthy” and that customers “continue to spend freely, using their credit cards and other payment methods for 10% more transaction volume in September and the first half of October than a year earlier.” Other data supplied by Mastercard seems consistent with his perspective. And let’s be clear. It seems to me that consumer spending is contributing to the inflation we are witnessing, as much as supply chain kinks or excessive money supply.

So, how long do I think this downturn will last? What is my best bet as to the timing for an economic recovery? If I had Aladdin’s lamp in my hot little hands, one of the wishes I would make would be that I had the ability to see the future. My next wish would be that I could change it, if desired. My final wish would be that I also had a hot tub time machine. I think a hot tub time machine/Aladdin lamp combination would make quite the holiday gift, along with that Jewish space laser I have heard about. Unfortunately, while I continue to search for such a lamp, I have thus far been unsuccessful, though there were a few listings for “Aladdin’s Lamps” on eBay and Etsy. I remain skeptical, however, since they are all “pre-owned” with the potential wish-granting powers likely exhausted. The prices for such lamps also seem suspiciously low.

Anyhow, in many presentations I gave between 2011 and 2015, I would ask audiences a sort of rhetorical, but important, question: how long after March 0f 2009, when markets bottomed, did they begin feeling better, more optimistic, and start investing again? 2010? 2011? When did the memories of the Great Financial Crisis fade into the investment past? The answers to these questions likely provide clues as to the question posed above as to how long the downturn will last, since investor psychology plays such a significant role in financial markets and investing.

Historical data tells us a lot. While the S&P 500 dropped 37% in 2008, it was up over 26% in 2009 and over 15% in 2010, virtually recapturing all losses, and by the end of the 2012, that 37% loss had turned into a nearly 10% gain. Since 1990, the NASDAQ has experienced annual increases and decreases in value of over 30%, 11 and five times, respectively. In eight different years since 1990, the NASDAQ has increased over 40%, but only in 2000 did the NASDAQ decline that much. The conclusion? Trying to time markets is a fool’s errand. Bear markets last an average of 13 months and the S&P 500 slipped into an official bear market on June 13th of this year, while the NASDAQ entered bear market territory in April.

Does this mean that the market will turn during the latter half of 2023? Well, I only wish I could be that prescient, of course, but I would not be shocked if such a reversal came to pass. After all, there is still a heck of a lot of cash and capital sitting on the sidelines. I have provided this graph several times in previous updates, setting forth M2 money supply or the total value of currency held by the public, including demand deposits. While it has ticked down slightly in recent months, as bank depositors pulled about $270 billion from accounts in recent months, about $22 trillion remains on the sideline, very near an all-time high. Some of this capital, along with the $30 billion in equity that Blackstone just raised in its tenth fund and other “dry powder,” will most certainly find its way back to the markets in due course.

This is not to sugarcoat or ignore the significant uncertainties and challenges that lay ahead: inflation everywhere one looks; the Russia-Ukraine conflict and impact it has had on energy prices and the economies of Europe and the U.K., the latter which will have its third different prime minister in a matter of months; China and its significant economic challenges; the strong dollar (up nearly 20% this year, the biggest rise in 40 years) and the havoc it is wreaking on international markets, especially economically developing nations; the upcoming markdowns in private market asset values in everything from real estate to venture capital to private equity; and, of course, how central banks might respond with whatever tools they have in their toolboxes and whether those tools, including increases in interest rates, prove effective.

In part, one of the issues that is likely to determine how deep and how long this (or any) bear market lasts is systemic leverage. That is, with excessive debt and leverage, the risks that a market downturn persists and/or deepens increase. The process is depressingly intuitive. Asset prices decline, driving values below debt levels, margin calls are made (or foreclosures commenced), assets are sold under duress, and asset values are driven down further, and the process repeats.

So, how much leverage and debt are out there? How much systemic risk exists?

If one looks only at U.S. money-center banks (e.g., Wells Fargo, Citibank, Bank of America), their balance sheets appear adequately capitalized. In fact, according to the most recent “stress tests” conducted by the Federal Reserve, “capital levels remained above required minimums.” Fitch, one of the large credit rating agencies concluded that “U.S. bank capital levels remain robust” and they expect the banks’ earning capacity and capital balances to be “more than sufficient.” However, certain foreign-based banks (e.g., Credit Suisse, Deutsche Bank, UBS) are more leveraged and at risk. Moreover, in recent years, the “shadow banking” industry – think unregulated debt funds providing capital to asset managers in private equity, real estate, and venture capital – has ballooned.

These firms (e.g., Blackstone, Centerbridge, Cerberus) typically provide short-term and variable-rate debt financing to real estate asset managers like Clear Capital or corporate private equity firms to fund acquisitions and repositioning strategies, and it is virtually impossible to know how much of this debt is out there, as they are largely unregulated. It is certainly hundreds of billions, and this segment of the capital markets has grown substantially in recent years. It is this debt which is most likely to create distress as the debt issued by these funds tends to be variable and shorter-term in nature.

How these funds respond to leveraged borrowers and asset distress remains to be seen. Much depends on whether the Federal Reserve is successful in tamping down inflation and interest rates, the hedging strategies employed by particular borrowers, and the financial strength and experience of borrowers. We shall see. Let’s just say that I am glad that Clear Capital and its principals have extensive experience in these markets, solid capital reserves, and a focus on the multifamily market where fundamentals remain strong (see below). Having said that, we, too, have a significant amount of floating-rate debt across our portfolio and even though it is hedged, the relevant rates and borrowing costs have increased considerably in recent months.

My sense is that less experienced borrowers, “zombie companies” (those with negative free cash flows and business models that may not be sustainable), and private equity firms with less of a track record and less capital are at the greatest risk in the current market environment, assuming interest rates remain high or continue to increase. While I believe workout specialists and bankruptcy attorneys will be busy bees in the next 12 to 18 months, I don’t see the sort of systemic risk here in the U.S. that existed back in 2008 to 2009. That is, this downturn is not a banking crisis. I also predict that most lenders will work with borrowers when practical, knowing that forcing borrowers into bankruptcy and/or taking back assets often leads to suboptimal outcomes.

How have residential real estate values fared so far in 2022 given the economic dislocation? What is happening on the rent and occupancy front? Have the fundamentals changed and what is the outlook for the sector?

In the multifamily market, we are witnessing a period of “price discovery,” as sellers remain in a state of nostalgia, if not denial, failing to appreciate that asset values have declined (perhaps temporarily) by at least five percent and likely more, while buyers are hoping to pick up prices on the cheap, hoping to take advantage of price dislocations and distress. Each is off on their timing. The math, yet again, is simple, if not sobering. Interest rates have risen so much and so quickly, immediately increasing borrowing costs, while rental growth lags.

Hopefully, interest rates will moderate in response to the Fed’s discount rate sledgehammer (they raised rates 0.75% at the end of July and Fed rhetoric foretells rate increases to come), while rents will continue to grow, perhaps less rapidly than they have in recent years. However, not even 9% year-over-year rental increases, as we saw in September, can compensate for the new, if even transient, yield-curve and interest rate reality. At last glance, the 10-year Treasury yield approximates 4.25%, up some 42 basis points (0.42%) since the end of the third quarter. That is a remarkable move, following other remarkable moves. I can relate to what that anonymous tweeter that I quoted at the start of this letter feels. In any event, the short-run impact of these interest rate moves on asset cash flows and values are not inconsequential, and patience and prudent asset management have become even more paramount.

And 30-year fixed rate mortgage rates? They have mimicked the move in U.S. Treasuries, with record-setting increases.

Not surprisingly, in the face of economic uncertainty, substantial declines in equity values, and a drop in consumer confidence (which hit an all-time low in June, according to the University of Michigan), rents declined in September, the first monthly drop since December 2020. Specifically, they declined 2.50% between August and September, according to Redfin. Of course, they are still up 23% since August 2020 and should rebound given that the underlying demand and supply fundamentals for multifamily assets remain squarely intact, and we have seen this play before, in previous crises or downturns. Rents decline through downturns but then recover strongly. I anticipate this history will repeat itself, at least in time. However, I think it is also safe to say that the double-digit rent increases we have witnessed in recent years have gone south for the winter, and likely beyond, so to speak.

One of the drivers of multifamily demand has been the decline in “home affordability,” which sits at the lowest levels since 1989. It may be mixed emotions, but such affordability challenges present substantial tailwinds for the multifamily market. I see nothing that will derail this trend, which I see as long-term and structural. Most future housing needs will be satisfied by higher-density, multifamily units. The “American Dream” of homeownership will likely become a compromise of sorts, perhaps the less fulfilling dream of living in a well-appointed, Class A apartment, in a project with all the fixings: pool, clubhouse, gym, dog park, business center, laundry services, etc.

I suppose it can come as no surprise that according to the WSJ/Realtor.com Emerging Markets Index, released this summer, Elkhard-Goshen, Indiana is the top “emerging housing market,” based on “solid economic fundamentals, in-demand amenities and lifestyle options, along with a critical dose of affordable homes.”  Elkhard-Goshen was followed by Burlington, North Carolina, Johnson City, Tennessee, Fort Wayne, Indiana, and Billings, Montana in the rankings. I can honestly say that I have never considered investing in these particular markets and would have difficulty identifying any of them on a map.

Maybe that is the very point. The best housing markets in the future won’t be found on our coasts, downtowns (Central Business Districts), or in the heart of cities that have been such attractive destinations for new residents over the past decade (e.g., Atlanta, Nashville, Charlotte, Phoenix, Boise, Austin, and Dallas). These are trends that have accelerated since COVID made its unwelcome appearance and remote work became a viable option for many professionals and households. It is all about where that proverbial “puck is going” and not “where it’s been.”

One other challenge contributing to the lack of single-family affordability relates to a rhetorical question recently posed in an article from the New York Times: “Whatever Happened to the Starter Home?” In the 1990’s, a typical “starter home,” a three-bedroom, two-bath home, was 2,000 to 2,200 square feet and cost about $100K. Today? That same home would be 2,300 to 2,600 square feet and cost five times as much. Some of these changes and the higher prices that follow have been caused by increased land and construction costs, minimum lot sizes required under local zoning rules, and increased infrastructure requirements (e.g., green spaces, community resources).

Another byproduct of the drop in housing affordability and perhaps a partial explanation of the increasing size of single-family homes is the growing trend towards multigenerational households living under one roof. Such a phenomena is routine elsewhere, but historically has not been the case in the U.S. Well, just as “necessity is the mother of invention,” high housing costs are compelling many generations of the same family to cohabitate. Seeing Charlie Bucket, his mother, Hellen, Grampa Joe, Grandma Josephine, Grandpa Ubeck, and Grandma Georgina all crammed into a small house in Charlie and the Chocolate Factory always seemed a bit strange to me, even as kid mostly interested in the darn chocolate. But that may soon be more of a norm.

This prediction is supported by a couple of recent studies, the first out of Harvard and sponsored by the U.S. Census Bureau, which concluded that Millennials don’t stray too far from where they grew up. The study found that by age 26, more than two-thirds of young adults in the U.S. lived in the same area where they grew up, 80% lived within 100 miles, and 90% within 500 miles. Migration distances were shorter for people of color and those of financial means (read: wealthy). The reluctance of Millennials to move far away is backed up by other studies showing declines in mobility. Of greater interest, I think, was a second study, based on a Pew Research Center Survey, which showed that a quarter of U.S. adults aged 25 to 34 resided in a multigenerational household in 2021, up from just 9% in 1971.

In any event, as a result of the higher mortgage rates and declining consumer confidence (and to nobody’s surprise), single-family home sales have fallen for eight straight months. And let’s face it. Any homebuyer who was lucky enough to secure a 3-ish%, 30-year fixed rate loan (or even lower rates on 15-year mortgages) during 2020 or 2021 is not going anywhere, as they are restrained by these mortgage handcuffs. They cannot afford a higher-priced replacement house, with 30-year mortgage rates approaching 7%. In addition, I recently read that Blackstone and its single-family rental business had ceased home purchases in 38 cities, including Boise, Fresno, and Memphis. Other institutional homebuyers – Invitation Homes, American Homes 4 Rent, and KKR’s My Community Homes – are among the institutional landlords that have also slowed home purchases. As a result, existing-home sales dropped 0.4% in August from July and nearly 20%, year-over-year.

It really is a question of geography, however. While existing-home sales declined in every region of the country, certain markets, specifically those that saw the greatest growth and appreciation in recent years, have seen the sharpest drops in transaction volume, cities like Boise, Austin, Phoenix, and Atlanta.

As a sidenote, this seems like an appropriate place to add that I expect upcoming sales figures from the likes of Bed, Bath, & Beyond to Home Depot to Lowes to my beloved Costco to suffer from these declining home sales. Fewer home sales translate to fewer furniture purchases and fewer trips to building supply stores and other retailers that generate significant sales from new homeowners. Consistent with this thesis, Restoration Hardware recently indicated that it expects net revenue to drop between 15 and 18% this quarter. In addition, U.S. mortgage lenders, especially those that are non-regulated and not required to maintain certain minimum levels of capital reserves, are feeling the pain. First Guaranty Mortgage, majority owned by PIMCO, the large investment management firm, recently filed for bankruptcy, and I suspect they are the first of many mortgage lenders which will fail.

However, in the face of declining sales volumes, home prices overall have remained reasonably firm, at least in most markets, as I have predicted. It is simply a story of inadequate supply and pent-up demand. In August, the median home price for existing-home sales across the U.S. increased 7.7% year-over-year, though they declined 0.7% month-over-month. I believe home prices overall will decline five to 10% nationally, with certain markets, the likes of Boise, Phoenix, and Austin, falling further. It is a question of gravity to some extent (“what goes up…”) and the thesis is supported by recent data out of Boise.

Regardless of what the demand for housing may be looking forward, the real story remains on the supply side

Over the years, I have repeatedly pointed out that the increasing cost and difficulty in adding to our housing stock, both single- and multifamily, essentially guarantees that real rents would increase over time, a story that has played out, certainly for better and worse. That continues to be the case. Everything from the lack of buildable lots, increased building costs, a shortage of labor and contractors, restrictive neighborhood CC&Rs (covenants, conditions, and restrictions) and good old NIMBYism remain a persistent and consistent theme. And now we throw higher borrowing costs into the mix. The net result is that it becomes harder and harder for potential construction projects to pencil. While housing starts unexpectedly increased 12.2% in August from July, housing permits issued, foretells future construction, declined 10%.

Affordable housing projects, those dedicated to tenants whose incomes fall below certain thresholds, are becoming increasingly hard to finance, as they become squeezed not just by the higher construction and borrowing costs, but by the inability to receive market rents, an economic vice of sorts. Without substantial subsidies and/or other financial support (e.g., tax credits), these sorts of projects are not viable, sadly dead on arrival.

Meanwhile, a recent study published by the National Multifamily Housing Council and the National Apartment Association found that 4.3 million more apartment units will be needed by 2035 to meet anticipated demand. Developing needed units at affordable rents will be no easy task. One particular anecdote from this past quarter highlights the challenge. You may have read the story about how Marc Andreesen, the founder of Netscape and a well-known (and very well-heeled) venture capitalist and his wife, actively protested the construction of a whopping 58 apartment units in their tony “enclave” of Atherton, California, a hop, step, and jump from the Stanford campus, where the average home sold for nearly $8 million in 2020 and where more affordable housing is desperately needed to house the folks that educate their kids, serve them food and drink in local (mostly upscale) dining establishments, or just bag their groceries.

As part of their protest, the Andreesens and other of life’s lottery winners submitted letters to City Counsel expressing concern about not just “traffic, tree removal, light and noise pollution, and school resources,” but “massive decreases in home values.” The obvious hypocrisy becomes even more evident when one considers that Mr. Andreesen recently agreed to invest $350 million in Flow, a new start-up led by WeWork founder, Adam Neumann, whose strategy is to address the country’s “affordable housing problem.” In a related story out of Woodside, an Atherton-adjacent community, the Woodside government announced that it was designating the city as a “sanctuary for mountain lions” in order to avoid a new law requiring that a certain amount of housing be added to their community. California’s attorney general sent a letter to the city (certified, I am sure), accusing Woodside of “deliberately attempting to shut off the supply of new housing opportunities.” Only after the Department of Fish and Wildlife advised officials that the proposal was illegal, that it could not designate the entire city as a mountain lion habitat, did the city relent. You can’t make this stuff up.

In another thought-provoking and relevant article, the Wall Street Journal argued that the U.S. is “running short of land for housing.” Perhaps we can file this story under the old adage from Will Rogers, that we should all “buy land” since “they ain’t making more of it.” While any flight over the middle of the country would seem to confirm that we have plenty of empty land, much of it is not buildable, lacks any infrastructure, has no meaningful source of water (worsened by climate change), and is expensive, having nearly doubled in price over the past 15 years. Much of the land is owned by the Bureau of Land Management and is not available for sale or development.

And inflation? What is driving it? Supply chain issues? Excess liquidity and money supply? Robust consumer spending?

I don’t think it would be too controversial to argue that inflation remains the most significant uncertainty the markets face and thus far, the data continues to be sobering. September consumer prices increased 8.2% year-over-year, and even if we were to exclude volatile food and energy prices, inflation clocked in at 6.6%. The culprits continue to be a little bit of this and a whole lot of that, but let’s not kid ourselves. Supply chain challenges and excess money supply may be contributors, but we should not and cannot understate the impact of the consumer, who continues to spend.

The net result is increasing costs of anything and everything, from housing to food to energy to insurance to booze to airfare to hotel rooms. And it doesn’t matter whether you are staying at the Four Seasons or if Tom Bodette is leaving the light on for you. Wages, while on the rise, are playing catch-up, unless you are a lobbyist or free agent in professional sports.

You may recall that in previous memos I discussed how the very modest inflation we have witnessed over the last 20 years might be the byproduct of certain exogenous realities: the “three A’s” (Amazon, automation, and artificial intelligence) and the outsourcing of manufacturing and certain services (e.g., call centers) to lowest-cost markets (e.g., Southeast Asia, China, India), Fed policy, and even the pandemic. However, one has to wonder if some of these trends, along with an aging demographic, are reversing, creating inflationary pressures.

Here is the thinking. Over the past decade, increasing asset values (principally stock prices and real estate) compelled the departure of those 55 and over (read: asset rich) from the workforce and allowed for their early retirement (kudos to Tom Selleck and those reverse mortgages). According to the U.S. Census Bureau, around two million workers are “missing” from the U.S. labor force, after accounting for slower population growth and the aging of the population. The result is a decline in the supply of available labor. Meanwhile, these sprightly retirees consume, and according to research, consume even more than they did before. While they might purchase fewer capital goods (e.g., homes, autos), they increase spending on everything from travel and leisure to healthcare, thereby increasing inflation, net-net. In addition, with fewer available workers, wages rise and create the potential for a wage spiral. The dual Fed mandate of “full employment” and “price stability” become incompatible. Such a thesis seems plausible and may mean that inflation will not prove transient no matter how much the Fed increases interest rates.

However, declining asset values may reverse this trend. With the S&P 500 and NASDAQ down 23.2% and 32.3% year to date respectively, at last glance, some deflation is quite transparent. Softening rents and housing prices are also clearly deflationary. Moreover, inflation is expected to ease if the inverted yield curve or investor surveys are to be believed. On the other hand, it would be naïve to assume that inflation will approach the Fed’s two percent target anytime soon.

The labor market, at or near full employment, continues to shine, though layoffs loom

As mentioned above, the national unemployment rate sits at 3.5%, matching July’s 29 month low and better than the expected 3.7%, according to those economic pundits. Thus far we have experienced a job-creating slowdown, the flip side of the more often witnessed “jobless recovery.”

However, with many firms recently announcing job cuts – U.S. employers announced nearly 30,000 job cuts last month, a 46% increase from August – I sense that the labor market is beginning to experience a sort of bifurcation, where employment levels decline and job cuts accelerate, while the economy softens, and wages rise. Hearing that the IRS plans to add nearly 90,000 new agents by 2031 is truly the definition of mixed emotions (replacing the more traditional definition, seeing your mother-in-law drive off the cliff in your new Mercedes).

Traditionally, the Phillips Curve (named after the economist A.W. Phillips) predicts that inflation and employment have a stable and inverse relationship. Simply put, economic growth creates more jobs, higher employment, and inflation. However, the “stagflation” experienced in the 1970’s, where both inflation and unemployment levels were high called the theory into question, and it remains to be seen whether 2023 will represent the unwelcome sequel to the late ‘70’s. If recent job openings data prove probative, such may be the base. In August, the number of job openings in the U.S. dropped to 10.1 million, the lowest level since June 2021, and down from a record of 11.9 million in March.

Meanwhile, even with wages increasing five percent in September, real wages, after inflation, declined 2.5% from the prior year, and 0.1% month-over-month. As I have mentioned many times before, higher wages will allow households to pay more rent, so it is generally something we welcome, provided it does not create excessive inflationary pressures and higher interest rates, those good old mixed emotions yet again.

After a springtime lull, policy makers had active summers as they continue to try their darndest – albeit unsuccessfully – to address the issue of affordable housing

In just the last month, two articles really caught my eye, one in the Economist, (“More Cities are Passing Rent Control Laws. Is That Wise?”) and another, from the New York Times (“Rent Revolution is Coming”), confirming trends I have seen coming for some time. It is all so predictable, and contrary to common belief, it isn’t a blue or red state thing. In fact, the Times’ article focused on Kansas City, Missouri, where a recent city council meeting was repeatedly interrupted by chants from protestors in attendance: “The rent is too damn high! The rent is too damn high!” With a modest population of 500,000 and a median home price well below that of countless other locales, one would not usually think of Kansas City as some sort of hotbed for a renter uprising.

Yet, even in the reddest of states, unhappy constituents are seeking help from politicians, who are eager to place and pander for votes. This unhappiness extends across the economic and political spectrum. On one end are renters who aspire to purchase a home but have had their dreams dashed by high mortgage rates and high home prices. On the other are low(er)-income tenants, who make up the bulk of the 11 million households across the country which spend at least half of their income on rent. And in between? A hollowed-out middle class steadily finding themselves stuck in the proverbial middle, unable to qualify for rental assistance (or sympathy) and finding a greater share of their incomes going to rent.

Thus, it should come as no surprise that rent control has found its way to Florida, a state which banned the practice in the late 1970’s. In August, officials in Orange County, Florida, located in the center of the state and home to Orlando, placed a rent control measure on November’s ballot, which would limit rent increases to the consumer price index. They also approved a measure requiring landlords to give 60-days of notice before any rent increase of more than 5 percent can be implemented.  In June, lawmakers in South Portland, Maine voted to limit annual rent increases to 10%.

From Pomona, California to Kingston, New York, to a local community near you, additional rent restrictions and controls are a-comin.’  In Nevada, the North Las Vegas City Clerk rejected a petition to include a rent control measure on the November ballot citing “insufficient valid signatures.” The petition, initiated by the Culinary Workers’ Union Local 226, failed to reach the 15% threshold of voters who had voted in the previous city election, according to Rodgers. The union is seeking a review of the ruling.

In Maryland, The Montgomery County Council held a public meeting this week which included discussion of a proposed measure that would place a 4.4 percent cap on rent increases. Several organizations and property owners spoke out against the bill at the hearing. I can only imagine when residents in Idaho, Utah, and Montana sporting Make America Great Again hats, waving American flags, and shouting from the rooftops about the dangers of socialism begin lobbying local politicians to “just do something” about the higher rents in Boise, Salt Lake City, and Billings. It seems that everyone becomes a socialist when money earmarked to them is at issue. Or when the rent is “too damn high.”

Finally, back to good ol’ California, which passed statewide rent control in 2019, recently passed Senate Bill 6, which allows residential construction on commercially zoned properties without the lengthy and costly rezoning requirements. Thus, in theory, vacant stores could be converted to housing. However, the law is no panacea. While it might streamline approvals and ultimately allow for the development of more housing, it fails to address the other significant impediments to new supply, discussed above (e.g., soaring costs and higher interest rates, a lack of labor, environmental reviews). Finally, Los Angeles’ City Council voted to finally allows landlords to evict tenants whose rents are in arrears, but not until next February. That’s right, next February. As Tom Petty said, and said well, “the waiting is the hardest part.”

And, of course, I would be remiss if I failed to include some other tidbits I found interesting and which impact real estate markets, values, and/or transactions

  • The U.S. population is getting older and poorer, and Gen-Zs are in no rush to walk down the aisle: one of the biggest concerns that I have and have repeatedly expressed is that the U.S. is mimicking Japan in terms of demographic trends. Between 1955 and 1990, Japan’s GDP grew at an impressive 12% per year. However, since then Japan has grown anemically, 0.6% per year, principally resulting from not just an aging populace, but a declining one. With Gen-Zers taking their sweet time to not only marry and procreate, despite ABC greenlighting and airing more episodes of The Bachelor and Bachelorette than ever, our fertility rates are declining rapidly, and we are headed down a similar path. The inability of Democrats and Republicans to get their you know what together and pass meaningful immigration reforms and policy isn’t helping.

Meanwhile, the Gini Coefficient or “wealth inequality index” is at its widest, 0.494. Nearly 38 million Americans, or nearly 12% of our entire population, are considered poor, a 10% increase over 2019, before COVID.

  • The commercial real estate market is showing some cracks: for the first time since the start of the pandemic, commercial real estate asset values (e.g., office, retail, and industrial) are beginning to soften.

The office market is significantly oversupplied. The trend towards reducing the amount of office space a tenant rents per full-time employee had begun to fall about ten years ago, as “creative,” or more open-air, office plans became popular. Throw in technological advances and a dose of COVID and remote work, and you have a near crisis on your hands. The physical vacancy rate for office space in Los Angeles is 20%, but brokers will tell you that the economic vacancy is more like 30%.

In fact, I just read that L.A. office tenants have put some 9.6 million square feet of sublease space on the market, up from 9 million square feet at the end of the second quarter and 8.2 million square feet at this time last year. But according to brokers, takers are few and far between. Meanwhile, in the Big Apple, KPMG just announced that it is reducing its N.Y. office space by 30%. I really would not want to own any Class B or Class C office space, just about anywhere. The fundamentals are not pretty.

And the industrial market? It, along with multifamily and self-storage markets, has been the hottest sector in commercial real estate in recent years, driven by growth in on-line retail (Amazon itself has been a voracious consumer of industrial space in the past decade), last-mile delivery, the legalization of cannabis, and the onshoring of production of certain goods driven by pandemic demand. While national vacancy rates are still very low, they have recently risen to 3.2% from 3.0%. However, the market is beginning to show some modest cracks, as Amazon has mothballed several projects and many retailers are dealing with bloated inventories.

  • After decades of tremendous economic growth, the Chinese property market is imploding and overall economy slowing significantly, leaving it with some difficult policy choices: I was last in China in 2017 to teach one of UCLA Anderson’s “global immersion courses” during which one speaker after another fawned over China’s long-term vision and extraordinary commitment to growth, innovation, and capital investment. This hyperfocus on capital investment generated extraordinary wealth, transformed the country and countryside, increased borrowing, but increased wealth inequality. Now, with the global economic slowdown and post-COVID realities, China’s investment-centric strategy has left it with some unenviable choices. While investment typically comprises a quarter of global GDP, China has invested 40 to 50% of their annual GDP into infrastructure (including property development) and investment. If you think U.S. Fed Chair, Jerome Powell, has a tough job trying to steer our economy to a “soft landing,” China’s job is far more challenging.

Look no further than their property market, where the government had to clamp down on developers who had taken on way too much debt in the name of growth. In fact, the Chinese property market is likely the single largest asset class in the world.

So, what next? Unlike Magnus Carlsen, the Chess Grandmaster, Chairman Xi can’t just walk away from the game. Perhaps the country shifts from private real estate growth to public infrastructure (e.g., bridges, roads, Silk Road), but this sort of investment is not necessarily productive. All I know is that a significant slowdown and tough choices await, while consumer confidence plunges.

With the risk of stagflation seeming more and more of a possibility, real estate fund managers and sponsors will need to manage assets even more carefully, focusing on occupancy versus rent growth, managing expenses and expenditures carefully, and conserving capital

You don’t have to look very far to read, see, or hear bad news these days and perhaps it is darkest before dawn. UCLA’s extremely disappointing showing on the gridiron yesterday would seem to support that notion. Regardless, it never ceases to amaze me how quickly investor sentiment shifts, and when this particular market bottoms, it will only have been evident in the rearview mirror. While the next 12 to 18 months is going to be very bumpy, I am sure that long-term investors, exercising patience, will be rewarded. I also sense that the downturn will present opportunities, as they inevitably do.

The Clear Capital team, like all sponsors, will have its hands full, especially with assets we own with floating-rate debt. As I mentioned in a short memo I recently wrote, while we generally hedge this debt with interest rate caps, such caps expire two to three years following acquisition. As a result, we will carefully balance occupancy rates with rent increases, emphasizing the former over the latter. And while I hate to reduce investor distributions (remember that the Clear Capital principals and affiliates are generally the largest investors in our projects), I believe it is crucial that we (and all sponsors acting responsibly) increase cash reserves and manage all cash outflows as conservatively as possible in such broad market uncertainty. Frankly, it is in the tough markets when sponsors earn their keep and wheat is separated from chaff.

In that regard, we had a busy quarter, refinancing Aspire of the High Desert, returning over 80% of investor capital, while selling two assets, Iris Gardens and Aspire Glendale, on which investor returns are anticipated to exceed 32.3% and 36.4%, respectively. We acquired one asset, Aspire Columbia Ridge in Portland, Oregon, with our joint venture partner and for which we are presently raising capital (for up to half of their investment). We like the asset and the real estate, and should you be interested, please let us know.

As November and the holiday season are almost here, the Clear Capital team and I want to pass along our very best wishes to you and your families for a healthy and celebratory holiday season. I would also like encourage all of you to get out there and vote, provided you are able to so. While I generally avoid political discussions in these memos, or try to stay reasonably agnostic in my writings, we cannot and must not take our democracy (or indeed, our Republic) for granted. This picture says it all, as electoral and liberal democracies are seemingly out of favor these days and that worries me. Certain trends pose existential threats, even more than higher interest rates and inflation.

As always, thank you for your continued support of me and our entire team. Feel free to reach out to with any questions, comments, or concerns that you might have.

Best,

Eric Sussman

Managing Partner

“A cynic is a man who knows the price of everything, but the value of nothing; a sentimentalist
is a man who sees an absurd value in everything, but doesn’t know the market price of a single
thing.”

-Oscar Wilde

“Too many people spend money they haven’t earned to buy things they don’t want
to impress people they don’t like.”

-Will Rogers

“I love bringing that sparkle, the rainbow, and the sun to everything I do.”

-Paris Hilton

Some of you long-time readers of Clear Capital’s quarterly memos will recognize that
there are three quotes at the top of this letter as opposed to the typical two. Well, with
inflation being so widespread and of significant concern, especially following last
week’s report that the June Consumer Price Index reached another multi-decade high,
increasing 9.1% year-over-year, I decided, in sympathy, to inflate by 50% the number of
quotes with which I begin this quarter’s newsletter.


Besides, with so much tough news coming out of this quarter – from higher inflation to
significant increases in interest and mortgage rates, swooning equity and bond markets,
the specter of recession, the ongoing war in Ukraine, ever-growing gun violence,
shortages of baby formula, the (predictable) crash in the cryptocurrency markets,
sobering revelations from the January 6th Commission, controversial Supreme Court
rulings, to yet another rapidly spreading Covid subvariant – it hasn’t been a quarter
worth remembering or celebrating.


So why not start this memo with an uplifting, if not incomparably vapid quote from
Paris Hilton in an attempt to bring a “little sparkle, rainbow and sun” to an otherwise
forgettable quarter and an equally droll quarterly newsletter? Well, before I douse you
with too much sparkle and rainbow, here is a look at last week’s sobering inflation data:

And as though the inflation story could not get any worse, I am still reeling from the
very recent announcement that Costco is raising some of their food court prices, with
the price of a chicken bake and a standalone soda being increased by $1.00 and $0.10,
respectively. The severity of the blow was tempered, however, by the welcome news
that they are not increasing the prices of either the hot dog/soda combination or the
price of their rotisserie chicken. Phew. If and when that happens, my faith in capitalism,
my Executive Costco membership, and view of life itself may collapse entirely.


So, it is for posterity and nostalgia’s sake (and a touch of sparkle and rainbow), that I
provide these important photos, to remind us of the way things used to be, them “good
ol’ days” and just how perverse inflation can be:

So, just how bad is inflation? Well, even family-owned Arizona Iced Tea, which had
stubbornly held onto its $0.99 price per can, announced this past week that it is
increasing the price of each can to $1.99, still less than its competitors, but one heck of
an increase. And how about the strongly rent-controlled City of Santa Monica,
affectionately and occasionally referred to by locals as the “People’s Republic of Santa
Monica,” approving the highest rent increase in 40 years, allowing landlords to hike
rents by six percent this year?


The two graphs below also confirm what many of us already know. Inflation has really
impacted travel costs, and we are not just talking about a gallon of gas.

Well, the Fed has not stood by idly, and following May’s inflation data (an 8.6% yearover-
year rise), Fed Chair Jerome Powell took a page out of Paul Volcker’s 1981 Federal
Reserve playbook, “How to Quell Inflation Regardless of the Consequences” and, along
with his colleagues, raised interest rates by 0.75%, the largest such increase since 1994.
Canada increased its discount rate by 100 bps (1%) last week, and most expect the U.S.
to follow suit with a similar increase later this month.


Keep in mind that Chairman Volcker faced far more daunting, double-digit inflation
when he was appointed Fed Chair in 1979. Inflation was rising at over one percent each
month and home mortgages averaged 11.2% at the time. The Fed Funds rate was just
under 11%, and by June of 1981, after a series of aggressive moves to quell inflation, the
Fed Funds rate exceeded…wait for it….19%. Imagine that. 19%.

The response to the Fed’s recent actions has been predictable: a significant upward shift
in the yield curve, especially on the short (up to two years) end. Yields on two-year
Treasuries, which stood at 0.78% at the beginning of 2022, are now yielding 3.13%, a
more than fourfold increase.


And ten-year yields? They have increased to nearly 3.0% (2.93% at last glance), up from
1.63% at the end of 2021. Yes, you are reading the data correctly. Yields on two-year
Treasuries are currently yielding 20 bps (0.2%) more than those on ten-year bonds, at
least as of the end of last week.


Oh, one last thing, though I am not sure it will make you feel any better. Despite all the
rhetoric and misplaced blame, inflation is a global phenomenon. Inflation in the EU has
been tracking slightly higher than that in the U.S. and many countries are experiencing
double-digit inflation.

What does this mean when short-term interest rates are higher than longer-term ones?
Is a recession imminent?


Inverted yield curves often precede a recession, and while the jury is still out on
whether we will experience a recession (two consecutive quarters of a drop in GDP),
investors and the markets are clearly expecting the U.S. economy to slow, to slow
dramatically, and for inflation and longer-term interest rates to subside as a result.

This conclusion is consistent with the following data, which indicate that while
investors expect short-term interest rates to continue to increase into 2023, they
anticipate that inflation will drop to near 3% within five years:

These predictions are not without some economic foundation. Since reaching an all-time
high last month, the average price for a gallon of gas in the U.S. is now about $4.50,
down from $4.84, while the prices for other commodities have declined significantly in
recent months. For example, copper prices just hit a two-year low and saw their largest
quarterly decline in over a decade. As the economy slows, recession or not, and short term
interest rates drop, future inflation rates should be tempered.

However, it will likely be some time before inflation approaches the Federal Reserve’s
two percent target, and while longer-term inflation may subside, one must wonder just
how much of the low inflation, low interest rate environment we have experienced for
the past several decades was simply a product of favorable demographics (i.e., slowing
population growth, reduced fertility rates), increased savings, globalization and the
shifts in production and outsourcing to places like India and China, automation,
Amazon, and aggressive fiscal policy.


And mortgage rates? What has been happening to real estate borrowing costs, and
what has been the impact?


To nobody’s surprise, these too have spiked, though thankfully they have come down
from recent highs. It is hard to imagine that 30-year, fixed mortgage rates averaged less
than 3.0% in 2021 (2.96%, to be precise) and now exceed more than 5.5%, nearly
doubling in six months, and up nearly one percent since the end of the first quarter.

As a result, borrowing costs have increased significantly. The difference between a 30-
year fixed rate mortgage at 3% versus one at 6% translates to six figures or more in
additional (nominal) loan payments over time, depending on the price of the home and
size of the mortgage, of course:

Again, to nobody’s surprise, mortgage applications for both new home purchases and
refinancings have plunged this year and the red-hot housing market has cooled, with
nationwide inventory of homes for sale up about 10% in recent weeks. Overall, in over
80% of the nation’s 400 largest housing markets, inventory levels have risen during the
past six weeks, although they remain below pre-pandemic levels.

Finally, prospective homebuyers or those who have contracted with developers to
purchase new homes have been canceling those transactions in increasing numbers, but
these figures are not really alarming as cancellation rates are still less than what was
experienced at the start of the Covid-19 pandemic.

And housing prices? Have they dropped significantly in this environment of
substantially higher mortgage rates?
Well, this is where things get interesting and important. For the past several years,
prospective homebuyers have been fighting MMA-style for homes, like they were
chasing Beanie Babies, Cabbage Patch Dolls, or some other faddish holiday gift, rushing
into crowded Walmarts during Black Friday sales events. Buyers would send
compelling personalized letters and pictures of their families to accompany their offers,
believing that emotional connections might make the difference and compel a
homeowner to sell their home to them. Meanwhile, along with emotional pleas, these
potential home purchasers would foolishly agree to waive inspections and loan
contingencies, while accelerating closing dates, all caught up in the emotional frenzy.


However, while mortgage costs have increased and inventory levels risen (up almost
19% in June 2022 versus June of last year), home prices have not declined, at least not
broadly. That is, while demand has ebbed, supply increased, and prices in some
markets have softened, there was so much pent-up demand and liquidity awaiting
investment, such that these demand drivers coupled with an overall lack of supply and
persistent underbuilding, prices on closed transactions continue to rise overall. I don’t
believe this trend to be sustainable and prices will inevitably decline, at least in some
markets, especially those at the very high-end (e.g., San Jose, Seattle) or where prices
rose the most in recent years (e.g., Boise, Fresno).

However, I expect home prices overall to drop only modestly, perhaps five to 10
percent, and in some markets, prices may not fall at all. Liquidity on the sidelines
remains high (M2 money supply stood at about $21.75 trillion at the end of May),
institutions are likely to continue their purchases of homes to rent (institutions
accounting for 20% of all home purchases in the last quarter of 2021), household
finances and debt levels remain in decent shape, banks remain adequately capitalized
and, having learned their lessons from the Great Financial Crisis, have significantly
tightened up their borrower underwriting (average FICO scores for homebuyers and
borrowers are about 50 points higher than what preceded the financial crisis).


Perhaps prospective sellers will merely see fewer offers, fewer family photos and
handwritten emotional pleas, and may simply receive more customary purchase offers,
you know, the kind which include due diligence provisions, contingency periods, and
closing dates. Frankly, I would be far more worried about the single-family housing
markets if I were Canadian, British, or French. In those markets, prices have risen far
above disposable income levels:

And multifamily rents and occupancies? How have apartments fared in this higher
interest and mortgage rate environment?


Well, in two words, “very well,” and being that I am big on pictures telling 1,000 words
(actually 1,500 now, due to inflation), here are three telling graphs:

Meanwhile, occupancy rates nationally remain above 95%, consistent across asset quality and
location:

Through June, rents rose 14 to 15% nationally year-over-year, with the median listed
rent for an available apartment rising above $2,000 a month for the first time. Rents are
up more than 20% in several Florida markets (e.g., Orlando, Miami, and Tampa) and
over 15% in many markets (e.g., Austin, Phoenix, Nashville). Across the Clear Capital
portfolio, rents are up more than 10%, and higher in certain markets and in certain
assets. The only residential asset in the country with substantially declining rents is the
Arconia in New York City, due to the high number of violent crimes and unsolved
murders that continue to happen there (shameless plug for “Murders in the Building”
for you fans and Hulu subscribers).


While bidding wars have been a staple of hot single-family markets, these contests are
becoming more commonplace in the rental market. Real-estate agents from New York
to Chicago to Atlanta say they see more people than ever making offers above asking to
lease homes and apartments that they will never own. An increasing number of whitecollar
professionals—some of whom recently sold homes—are reluctant to buy or buy
again because of record-high home prices, those higher mortgage rates, and limited
supply of homes for sale. They are renting instead, helping to drive a frenzy for leased
properties of all kinds, and helping fuel the higher rent trend.


Look, the math is simple. If more folks – whether blue-collar or white, whether single or
married, whether childless or not – enter already hot markets where home prices and
mortgage rates remain high and where the supply of new homes for them to rent or buy
doesn’t substantially increase, rents really have nowhere to go, but up. It’s a simple
process. Mortgage rates go up, the ability for homebuyers to purchase homes decreases
(much higher down payments required along with higher ongoing servicing costs), and
there are more renters in the market who will remain renters for longer periods of time. In the face of static or modestly increasing supply, rents increase.

Yet, even as rents have risen, the cost of owning has increased even more such that gap
between the costs of owning and renting has widened:

In many cities, home prices have increased so much that the time it takes to “break even” on a
home purchase (due to the higher upfront and ongoing mortgage costs) has widened, making
renting more attractive. For example, in Phoenix, where Clear Capital owns six assets, it now
takes over three years to break even on a median-price home purchase, up from about 2.5
years it took before the pandemic.

While builders were completing units at an unusually rapid rate in early 2022 (349,000
units per-year), about 1.2 times the pre-pandemic pace, according to the Joint Center for
Housing Studies at Harvard, the number of occupied apartments was rising more than
twice as quickly. For now, the housing market is bifurcating, with the market for
purchased homes slowing even as the rental market remains hot. Already, new home
construction has dropped sharply as borrowing costs climb, declining 14.4 percent in
May to the lowest rate in more than a year. Early data suggest that apartment
construction is also being impacted.


The caption from a recent WSJ article (late June) – “Worker Shortage Stymies
Construction” – highlighted one of the issues impeding the addition of new supply to
the constrained market. With unemployment already low (see additional discussion
below), homebuilders and contractors cannot identify and hire enough help, a challenge
exacerbated by the demand for labor tied to $600 billion in transportation-specific
funding earmarked in the $1.2 trillion bipartisan infrastructure bill passed last
November.

So, short-term residential housing data in this inflationary environment looks
favorable, but what are the prospects longer-term?


Because short-term trends can deceive, the question as to how investments in real estate
perform longer-term in the face of high inflation is an important one and was the
primary focus of our most recent monthly newsletter Clear Insights. Without repeating
all that was discussed there, I will simply provide a few data points and graphs that
were included in the newsletter in case you missed it.


The first demonstrates that single-family homes have provided positive real returns
(above inflation) since 1990.

Meanwhile, during 1978 to 1981, a period some refer to as the “Great Inflation,” private
real estate exhibited the highest correlation to headline inflation of all major asset
classes. Private real estate also had the most favorable risk-adjusted return profile
during this period, as illustrated below.

Private Real Estate vs. Major Asset Class Classes
During the “Great Inflation”
(March 1978 – September 1981)1

Finally, a paper published in November 2011, “Inflation and Real Estate Investments,”
written by Brad Case, Senior Vice President of NAREIT, and Susan Wachter, Professor

at Wharton, evaluated how publicly traded Real Estate Investment Trusts (REITs), the
most transparent of real estate investments, and came to a similar conclusion. In 1979,
when the consumer price index averaged 13.5%, total REIT returns 24.4%. During 1978
to 1980, when inflation averaged 11.6%, REITS’ total returns were 23.1%, and from 1974
to 1981, when the CPI averaged 9.3% per year, REITs returned 16.3% on average.


In theory, multifamily investments ought to perform well in an inflationary, high
interest-rate environment because of their shorter-term lease structures and higher
demand versus single-family homes, the latter of which become substantially less
affordable, as set forth above. In addition, in the face of greater uncertainty and risk,
prospective homebuyers prefer to sit on the sidelines and wait. After all, homebuying
activity may represent the single best barometer of consumer confidence, given it is
such a substantial and generally illiquid investment. And consumers are not exactly
brimming with confidence these days, which cannot come as any real surprise.

Even with the decline in confidence, consumers can carry on spending for a while, as
households across developed countries are still sitting on roughly $4 trillion of savings,
about 8% of GDP, mostly due to savings and government largesse during the
pandemic. To be clear it is not just the well-heeled who have increased their savings. I
read an interesting statistic recently that bank accounts of lower-income families were
65% higher than end of 2021 vs. 2019. Cynics will rightly point out that this statistic is
deceiving given the low absolute level of savings in this lower-income demographic, a reasonable criticism, but the broader point remains. Households are in better financial
shape than they were before the pandemic, all else equal.


Finally, with average hourly earnings for private-sector jobs increasing about five
percent in 2022 (the highest increase in years), these higher wages, while below inflation
and inadequate to shrink the mortgage cost-rental gap, will still allow for greater rental
payments. Moreover, I anticipate that even higher wages are forthcoming as employers
seek to fill open positions.

Meanwhile, there are a couple other issues and data points regarding housing
worth discussing
• “The Great Reshuffling” (not to be confused with the “Great Resignation”):
According to a new working paper from the National Bureau of Economic
Research, written by researchers from the Federal Reserve Bank of San Francisco
and the University of California, San Diego, home prices grew by nearly 24%
during the pandemic (December 2019 through November of last year), and the
study found that remote work accounted for 15.1% (or 60% on a relative basis) of
that growth. Cities like Austin, Boise, Phoenix, and San Diego saw some of the
biggest home prices increases in the country as a result.

According to the study, these remote-work friendly cities share three principal
features: i) A predominant industry that allows for remote work. Tech jobs, for
example, can often be performed remotely because they mostly involve work on
computers, of course; ii) Lower population density, where there is more space
and more affordable housing than in the biggest cities in the country. Because of
the high living costs in Manhattan, for example, having extra space for a home
office comes at a significant premium, even if it is economically doable. Lowerdensity
areas are more attractive for remote work; and iii) A warmer climate or
appealing lifestyle. I know this is a real shocker, but folks working remotely
would rather hear ocean waves, singing birds, and croaking toads (Jim Croce,
anyone?) than horns honking, trucks beeping, and sirens wailing.

• Increased amounts of home equity: According to the Federal Reserve,
Americans have more equity tied up in their homes than ever, nearly $28 trillion,
up over $4.5 trillion during just the first quarter of 2022. The hot housing markets
are largely responsible, of course, along with the high concentration and longterm
ownership of single-family homes by Baby Boomers who are reluctant or
unwilling to sell.
What is interesting is that a significant chunk of that increased equity has been
monetized through cash-out refinancings or HELOCs (home equity lines of
credit). There is no question that this additional liquidity found its way into the
markets and compelled increased economic activity. This source of economic
lighter fluid will all but dry up this year.

One bright spot is the job market, which remains surprisingly robust
Last week, the Bureau of Labor and Statistics indicated that non-farm payrolls increased
372,000 in June, well above the 268,000 estimate, maintaining the unemployment rate at
3.6%. Meanwhile, there are still over 11 million job openings, and anecdotally, many
businesses are having difficulty attracting and retaining help. Thus, although we may
experience a recession later this year or next, an economic downturn may not result in
significant job losses, net-net. While job losses may accelerate in some industries with
softening growth (e.g., tech, retail), other industries may very well see continued job
growth (e.g., travel and hospitality, construction).

There were a couple of academic research papers that recently caught my eye, each
focusing on different issues involving labor and housing. The first was “Low-Income
Workers, Residential Location, and the Changing Commute in the United States;” and
the second, “Moving to Density: Half a Century of Housing Costs and Wage Premia.”
Imagine you are a janitor, an important but lower-level employee. Would you be better
off economically if you lived and worked in Huntsville, Alabama, or New York City?


What about if you are an MBA-trained investment banker or an attorney? How far
would (or should) such a worker commute to get to their job? How does the cost of
housing impact answers to these questions? Have workers stopped moving to the
highest-density, highest-productivity places in the country because of a decline in the
urban wage premium, or because the rent is too high? These two papers tackled these
sorts of questions, made interesting observations, and asked thought-provoking policy
questions.


Typically, lower-income workers lived closer to their work and had shorter commutes,
often working and residing in high-density urban cores. These non-college workers

earned “urban wage premiums,” benefitting from the proximity between their
residences and places of employment. Higher wage earners generally live in the
suburbs and make longer commutes to work, on average, but also benefitted from an
“urban wage premium” because employers would pay premia for employee skills. This
all seems intuitive.


However, the authors found that a growing number of lower-income workers have
relocated to the suburbs in search of more affordable housing, which increases
commute times. In some cases, work had indeed shifted from the urban cores to the
burbs, but more often than not, the cost of housing was a key factor in the relocation. In
short, the “urban wage premium” for unskilled labor is now an “urban wage penalty”
because housing costs are too high. This shift creates real challenges, especially for
businesses in urban cores that rely heavily on unskilled labor. How are such businesses
going to attract and retain needed workers, especially if reliable and efficient public
transportation isn’t available? Are employers going to need to provide and/or or
subsidize the cost of transportation to employees? Should the government subsidize
these efforts?

Looking forward, the lack of affordable housing and spotty public transportation in
many communities is going to create significant challenges to businesses in certain
urban cores that rely on unskilled labor, with such challenges only exacerbated by the
pandemic.

Perhaps one of the related issues is the disparity between average worker pay and
management. In another article I recently read, I was not at all surprised to learn that
even with the recent increase in worker wages, which are up about six percent this past
year, it would take 186 years for the average worker at a publicly traded company to
match what a typical CEO earns. 186 years, about how long it has been since my
beloved Bruins appeared in a meaningful Bowl game.
In 2021, the typical compensation for the CEO of an S&P 500 company was up more
than 17%, to a median of $14.5 million. Obviously, some executive compensation
packages are eye-popping. The CEO of Expedia Group took down a cool $296.2 million
last year, while Jamie Dimon of JP Morgan Chase earned a mere $84.4 million. In
comparison, the median Walmart Associate made $25,335 last year. I suppose it is no
wonder that workers are making increased efforts to unionize, with employees of
Amazon and Starbucks garnering the most attention in recent years.


While the second quarter was reasonably quiet in terms of new housing regulations,
that would change significantly if John Oliver had his way,
Some of you may have seen the John Oliver segment from late June where he focused
on rising rents and housing affordability and argued that housing should be a federally
funded right and rent control broadly expanded. Landlords were essentially portrayed
as greedy capitalists raising rents mercilessly at the expense of the working class. You
can check it out here, if you are so inclined:


https://www.bing.com/videos/search?q=john+oliver+rent+control+you+tube&docid=608052449075874575
&mid=FF11ADDEF511F1CDADEBFF11ADDEF511F1CDADEB&view=detail&FORM=VIRE

Now, as much as I like a lot of John Oliver’s schtick and enjoy thoughtful comedy and
commentary as much as anyone, I was profoundly disappointed at how superficial,
incomplete, and fundamentally flawed his analysis and conclusions were. I realize that
Mr. Oliver hosts a comedy show, and as a comedian, he might not have all his facts
right or understand all the nuances on a topic he covers. But he barely touched upon
issues surrounding the supply of housing, excessive regulation, byzantine building
codes, and public opposition to almost any proposed project, especially those with high
density. It is what an experienced litigator feels when watching an episode of “Law and
Order.”


In one obvious error, Oliver rails on new construction, complaining that it is only
directed to high-end, white-collar renters, and that this new supply does not help the
working class and their need for housing. On the macro-point, of course he is right. We

need more darn housing and more affordable housing. But his analysis is flatly
incorrect and way too shallow. All else equal, more housing supply means more
available housing and lower overall rents, period. Additional supply of higher-end
units will allow some white-collar renters to relocate from their Class B units, making
them available to more cash-strapped renters.


He fails to mention that affordable housing projects require government largesse, which
is not only limited, but comes at a price. Complying with all the rules and regulations
tied to whatever government largesse is received (i.e., need to use unionized labor,
comply with stricter environmental regulations) substantially increases the cost to
construct affordable housing projects. More than half a dozen affordable projects here in
California are costing more than $1 million per unit, three times what it costs to build a
market-based unit.


In another glaring oversight, he was wrong on rent stabilization, claiming that it only
exists in California and Oregon. He failed to mention New York and its two types of
programs: rent control and rent stabilization. He failed to mention that some form of
rent control exists in other jurisdictions, from Boston to Minneapolis to Washington
D.C. Finally, he claimed that many landlords refuse to accept Section 8 vouchers, which
is true, but misleading. In California, for example, a landlord may not discriminate
against a prospective Section 8 tenant and may not reject them out of hand. If a unit is
available and a Section 8 tenant comes along and otherwise qualifies as a renter, the
landlord has to rent to that Section 8 tenant.

Finally, this quarter’s winner for least effective public policy decision to address
housing affordability goes to a regular nominee for the award, the Los Angeles City
Council, which voted 12-0 to purchase and municipalize a 124-unit property just north
of downtown and Chinatown to prevent the current landlord from increasing rents to
market. On the one hand, I applaud the landlord for creating enough of an uproar to
compel the City to purchase the property from him at its fair value. On the other, I am
none too thrilled that taxpayer funds (to which I am a contributor) are being used in
such an ineffective way, one that will make absolutely no meaningful inroads to the
housing affordability challenges the City faces.


Before we put another quarterly memo to bed, I should mention a few other events
impacting financial markets and the economy

• Cryptocurrencies and other speculative investments (e.g., Meme stocks,
SPACS) have their comeuppance. This quarter saw the implosion of the

cryptocurrency market, with the total capitalization of Bitcoin and its siblings
losing almost $2 trillion (over 60%) in value, and frankly, as much as I hate for
anyone to lose money, if not their life savings, it has been long overdue. As I
discussed in one of my Focus on Facts podcast episodes last year (still available
on Spotify and Apple!), “Bitcoin: Currency of the Future or Just Another
Bubble?,” I could never discern a compelling need for cryptocurrencies, at least
for non-illicit transactions and honest transactors. Deregulated markets coupled
with human propensity for greed are a toxic cocktail. Other speculative
investments (read: meme stocks, SPACs) took it on the chin in the second
quarter.

Several crypto exchanges, dealers, asset managers, and lenders ironically now
occupy crypts, having filed Chapter 11 during just the past couple of months –

Voyager Digital, Three Arrows, Celsius – while a number of “stablecoins” (can
you say “oxymoron”?) proved anything but (e.g., Terra/Luna). With more crypto
firms becoming insolvent and filing for bankruptcy, it is now clear that many
customers (gamblers?) will face massive losses, and another generation will have
learned a painful lesson and the difference between investing and speculating,
and how silly graphics like this, which seem polished, are nothing more than
graphical artistry and a paragon of “form over substance.”

• Strength in the U.S. Dollar: Perhaps not completely untethered (pun intended)
from the collapse in the cryptocurrency market, the dollar is up by over 7%
during the last twelve months, versus a broad basket of currencies, and is now
trading at par (1:1) with the Euro for the first time in 20 years. Slowing economic
growth, exacerbated by an energy crisis brought on by the conflict in Ukraine
and high inflation (the EU’s inflation rate is close to our own), has seriously
impaired the value of the Euro. This is good news for those of you intending to
travel to Europe this year but not so great news for global economic stability and
financial markets generally.

Finally, history tells us that markets cannot be timed, with peaks and troughs known
only in hindsight. Therefore, most investors should simply stay the course, effectively
managing leverage and focusing on investing in assets that should do well in
inflationary environments.


It is hard to sugarcoat the news and challenges that the second quarter brought, making
it no easy task to watch or read the headlines: higher inflation and mortgage rates,
declining stock markets, geopolitical conflicts, increasing threat of recession, gun
violence, another virulent variant of Covid, the crash in crypto and other speculative
assets, sobering revelations from the January 6th Commission, food shortages globally
and a baby formula shortage closer to home. At this point, newscasts should start their
broadcasts with health warnings like those for pharmaceutical products: “This news
report may cause gastrointestinal distress, increases in blood pressure, and difficulty
with breathing.”


However, as I mentioned in our last quarterly memo, markets and investor sentiment
are fickle things, and it is a fool’s errand to chase what’s hot and sell what’s cold in an
effort to time peaks and troughs in asset values. If pictures tell 1,000 (I mean, 1,500, due
to inflation) words in this regard, these have to do the trick:

I want you to imagine that you are back in 2009, and reliving the Great Recession, when
equity prices fell nearly 40%. What was your mindset then? How eager were you to
make new investments at that time? Were any of us predicting that the market would
bounce back the following year? Well, it did, and the next decade was incredibly
favorable for stock prices. How long after the Great Financial Crisis ended were you
making investments without even giving any thought to what had happened not much
earlier? 2011? 2012? Most likely it was after the markets had already recaptured much of
their losses.


Fast forward to today, when the S&P 500 and NASDAQ are down approximately 19%
and 27%, respectively, during just the first half of 2022. I imagine many of us are
nervous, hoarding cash, and awaiting markets and asset prices to stabilize before
jumping back in. Well, if history is any indicator, by the time that happens, you will
either be late to the party or will have missed it entirely. Obviously, I cannot predict
that equity markets will bounce back during the second half of the year or in 2023, but I
sure wouldn’t bet against it. Rainbow, sparkle, and sunshine are always around the
proverbial corner. Just ask Paris Hilton if you don’t believe me.

Meanwhile, Clear Capital continues to execute, maximizing returns on its existing
portfolio, and pursuing acquisitions we find attractive, including Aspire West Phoenix,
an 180-unit project built in 1977, with attractive fundamentals and projected returns.
Details about the offering can be found here:


https://investors.clearcapllc.com/portal/offering/8fedb2db-5fc7-47ff-a598-c881f6e80537.
We will close our fundraising for this asset in less than two weeks, so let us know if you
might be interested or want to learn more. We anticipate refinancing and/or selling a
handful of assets before the end of the year, so stay tuned for additional news on that
front.
And lastly, because I do want to end a droll quarter and lengthy newsletter with some
Paris Hilton inspired positivity, I will turn to my go-to therapy in tough times and
favorite life advisors and philosophers, Calvin & Hobbes, who never disappoint.

With that, the entire Clear Capital team and I pass along our very best wishes to you
and yours, and hope you make the most of your remaining summers, just like Calvin
and his stuffed tiger companion.


We thank you for your continued engagement and support of our firm and its
endeavors, including our latest opportunity, Aspire West Phoenix. And, as always, I
want to express a special round of thanks to the Clear Capital Team, who continue to go
above and beyond for our clients, colleagues, and partners.

Best,
Eric Sussman
Managing Partner

“Change is the law of life. Those who look only to the past or the present are certain to miss the future.”

-John F. Kennedy

“Education is the most powerful weapon we can use to change the world.”

– Nelson Mandela

As I practiced my karaoke skills last week while listening to Sirius’ radio’s ‘70’s on 7’ and badly butchering Blood, Sweat, & Tears’ hit song, “Spinning Wheel” (“what goooes up, muuust come down, spinning wheel got to go round”), before moving on to Bloomberg Radio, where I was met with headlines like “record oil prices,” “highest inflation in 50 years,” “fears of recession and stagflation,” “a new Cold War,” and “waning stock indices,” I wondered whether I had become trapped in a Twilight Zone episode where my satellite radio had somehow transported me back in time.

But then news about Elon Musk’s offer to buy Twitter, China’s temporary closure of Shanghai in an effort to stymy the spread of Covid, and reference to California cannabis taxes and the resulting black market snapped me out of my daydream, reminding me that I was still firmly ensconced in 2022 and simply experiencing that old Twain adage that “history doesn’t repeat itself, but merely rhymes.”
So, with my brief imagined trip back to the 1970’s complete, let’s cut to the brass tacks from the first quarter of 2022, one I am glad to see relegated to the history books. Despite good news about the job market and an economy that saw half a million jobs added in March, a drop in the unemployment rate to 3.6%, the confirmation of the first Black female Justice to the U.S. Supreme Court, and my parents turning 90 and 84, respectively, there were more than a handful of sobering headlines during the quarter.

During the Academy Awards a few short weeks ago and the slap heard ‘round the world, you may have missed one auspicious award category, “Worst News of the Quarter,” the nominees for which were as follows…:
• Russia’s unprovoked invasion of Ukraine, an obvious tragedy and travesty that history will remember as such
• The decline in U.S. equity prices, ushering in the worst quarter for stocks in two years, with the S&P 500, Dow Jones Industrial Average, and NASDAQ down 4.6, 4.9, 9.1%, respectively (and in a newsflash, the S&P is down 8.42% and the NASDAQ 15.67%, as of (a less than) Good Friday)

• The highest inflation seen in a generation (40 or 50 years, but who’s counting?) and the higher interest and mortgage rates it has engendered, along with Dollar Tree substantively becoming “$1.25 Tree”
• Record-high (nominal) gas prices (which seem to have had no effect on traffic)
• Persistent supply chain woes, exacerbated by sanctions on Russia, the shutdown of Shanghai as China experiences the limits of its “no Covid” policy, and Texas’ Governor Abbott slowing down all traffic crossing the Texas-Mexican border to address supposed “security concerns,” and last, but not least,
• The release of yet another variant of Covid, an unwelcome Omicron sibling

In the “honorable mention” category for “worst news of the quarter,” I would include my beloved Bruins’ loss in the NCAA Tournament to North Carolina, the ending of this season’s Bachelor that left two women in loving suspense at the final rose ceremony, and headlines about some rabid fox on the loose on Capitol Hill that ended up biting at least one member of Congress. I realize many may think the latter story might make you wonder why it had to be only one member of Congress, but I will leave that debate for another day.
Without picking an Oscar winner (loser?), three pictures about the equity markets, inflation, and interest/mortgage rates, respectively, tell a thousand sobering words about the most recent quarter, and a tad beyond:

Now, the trillion-dollar question is what’s next? With so many macroeconomic challenges, are we inevitably headed into a recession? On the one hand, if I were to refer to my Easy-Bake Oven™ recession recipe, it might read something like this:

  1. One quart of higher interest rates
  2. Three cups of Federal Reserve tightening and balance sheet “reductions”
  3. Two tablespoons of broad consumer-based inflation
  4. A teaspoon of higher oil and commodity costs
  5. A pinch of geopolitical tension
  6. A dash of bubble-like trading action in speculative assets

Over the past 75 years, every time inflation has exceeded four percent and unemployment has gone below five percent, the U.S. economy has experienced a recession within two years. Today the U.S. inflation rate (CPI-U) exceeds eight percent and unemployment sits at 3.6%. Add in the boom in commodity prices, the Fed’s decision to increase interest rates and shrink its balance sheet, the war in Ukraine, and the flattened yield curve (note the very modest difference between yields on two- and 10-year Treasuries) and you would think a recession has to be in the cards. And that perspective is certainly not without merit.

On the other hand (economic pundits must always have that second hand, if not a third), extraordinary liquidity (M2 money supply of some $22 trillion), near record lows of household debt service payments as a percentage of disposable personal income, and near record highs of real median household income (see graphs below), all combined with pent-up post-Covid demand, create plenty of economic tailwinds. The data is conflicting and confounding to say the least.

Meanwhile, anecdotally I have witnessed increases in traffic of late: on LA’s freeways (higher gas prices be damned), in LAX and Atlanta airports (Delta was offering $700 to seven passengers on an overbooked flight I recently took), and at the shopping destinations I frequent (yes, Costco, of course). In addition, geopolitical tensions, from Taiwan to Hong Kong, to Ukraine to Latin America, while creating a material drag on global GDP, will create additional capital flows to the U.S. as investors seek safe(r) havens in which to place their capital. Recent trends in the value of the U.S. dollar speak directly to this reality.

And remember that the likes of Blackstone and Trammel Crow, which just closed a new fund (Crow Holdings Development Opportunities Fund I, L.P.), along with their private equity compatriots, have raised significant capital (read: billions) in recent months that they will need to deploy. To wit, in February, Blackstone acquired Preferred Apartment Communities, Inc. in a $5.8 billion deal. Preferred owns about 12,000 units in the southeast, as well as a smattering of other commercial assets. I am sure Blackstone will continue its shopping spree like it’s Black Friday given its sizable war chest.

In short, a Vegas bookie would have his or her hands full trying to handicap the odds that a recession is on its way in the next year or two. At this point, I find myself in the “no recession” camp, but that perspective may change after first quarter earnings season is over or if Will Smith slaps me to my senses. For my money, the biggest question marks remain inflation and how consumers and investors react to the persistently higher prices they are likely to experience, from grocery stores to the gas pumps to cars; what the Fed does and how it tries to thread the inflation-recessionary needle; and, finally, what happens with all that capital sitting on the sidelines.
I continue to hoard popcorn as I evaluate all the data. And for the record, popcorn prices at Disneyworld are up from $12 to $13 a bucket this year….and I blame Russia, the Fed, and the late Orville Redenbacher. And what about real estate? Will higher interest rates necessarily mark the end of the hot housing market?

To say that the residential real estate market has been hot would be an understatement. I can almost hear that annoying voice from the 1980’s Crazy Eddie commercials shouting, “These Prices are Insane!” as rents and housing prices continued their upward marches in the first quarter. Through the first three months of the year, 2022’s national multifamily rent growth is outpacing 2021, according to at least one source (Zumper’s National Rent Report). According to Zumper, the national median rent for one-bedroom apartments reached an all-time high of $1,400, representing a 2.5 percent increase for the year so far, ahead of the 1.9 percent growth experienced at this time last year, while year-over-year increases reached double-digits in market after market. Markets like Miami, Austin, and Phoenix continue to lead the rental growth pack, but even markets like Detroit saw double-digit rent increases during the past year. Just two of the fifty most-populous metro areas saw rents fall from a year earlier. Rents declined three percent and two percent in Milwaukee and Kansas City, respectively. Again, a picture tells the story, in all its rainbowed glory:

And single-family homes? It, too, is the “same old song,” as the Four Tops once sang (that would be ‘60’s on 6’ on your Sirius/XM dials for you satellite radio subscribers), with prices up sharply thus far in 2022, and year-over-year. The median sales price for a home here in Los Angeles rose by 11.2%, from $850,000 in February 2021 to $945,000 in February 2022. Nationally, the median listing price was 12.9% higher in February compared to last year.

Meanwhile, the supply of homes for sales remains tight, with homes available for sale in Los Angeles and nationally down 41.3% and 24.5%, respectively, year-over-year (through February). It is no wonder that negotiations between prospective homebuyers and sellers are looking more like MMA bouts than normal negotiations. In any case, the multifamily market remains a significant beneficiary of these single-family trends and realities.

So, what now? Not surprisingly, the typical narrative is that higher mortgage rates will temper the housing market, and there is no question that they will to some degree, as some first-time or more cash-constrained homebuyers become shut out of the market. However, several factors make the housing market more robust and resistant to broad-based declines than in prior cycles. One, consumer and household balance sheets are in terrific shape, beneficiaries of everything from reduced spending and borrowing to governmental largesse during the pandemic. Take another look at the two charts above from the Federal Reserve laying out levels of household debt to personal income and real household income.
Two, there simply ain’t enough single-family homes to go around, with a lack of supply and persistent underbuilding following the 2007-2009 financial crisis, something I have written about repeatedly.

And finally, the influx of investors that have entered the single-family market, discussed at length in previous memos, present a newer source of housing demand. While investor activity may have slowed more recently as the likes of Zillow have left the market, investors are still active participants in the market. Data recently released from the National Rental Home Council and John Burns Real Estate Consulting shows that build-for-rent homes accounted for 26% of properties added to the portfolios of single-family rental home providers in the fourth quarter of last year, up from just 3% in Q3 2019. Of course, homes built specifically for rent reduces the already constrained supply of homes available for sale.

In fact, I recently read a Bloomberg article which introduced me to a single-family residential rental company I had never heard of previously, Pretium Partners, LLC, and its affiliate, Progress Residential, which raised $2.5 billion in 2019 and was the party that bought the homes that Zillow had to sell last year. Anyhow, it added 35,000 homes to its portfolio in 2021 alone and now owns about 75,000 homes. 75,000! And here I thought Clear Capital’s 5,000-unit multifamily portfolio was really something.
I realize some of you may read some of this and have a visceral response that all this institutional activity in our single-family housing markets is a big negative, increasing housing prices for families, changing the fabric of neighborhoods, and/or reducing opportunities to save for retirement through homeownership and related equity, and I can appreciate that perspective. On the other hand, many others will simply believe this is how capitalism and free markets work, and that allowing individuals and families to rent homes increases the pool of potential single-family occupants. I will stay out of the fray for now but would merely note that other wealthy countries like Denmark and Germany have lower rates of homeownership than the U.S., but far more robust social safety nets and pension benefits. In any event, the issue is as much economic as it is political, I suspect.

Finally, bank balance sheets are in far better shape than in the past, certainly less risky than in the period preceding the financial crisis when lenders were giving out mortgages like Butterfingers on Halloween. Some will point out, not incorrectly, that the “shadow banking system,” which includes financial institutions that are not regulated, has expanded significantly over time, making the overall system riskier than it may seem, but the overall systemic mortgage risks appear far more manageable than they were in 2007.

There may be one graph that looks a tad scary, one from Yale’s Robert Schiller (of Case-Schiller fame). The two lines I routinely think about are the correlation between real home prices and population. Common sense would tell us that the two should have reasonably high correlations, and over time, they do. However, the last time the disparity between the two was so significant was the period preceding the financial crisis.

Again, what to make of it all? Is this time different? Overall, I believe the answer is “yes,” that those waiting for housing prices to drop will be disappointed, as I have said repeatedly in recent years. That is not to say that higher interest rates will not dampen demand at the margin because they will, and they must.
But with housing supply constrained, ample liquidity wherever one looks, the significant presence of institutional players in housing markets, and interest rates still relatively low by historical standards, I expect housing prices to remain high and rents to increase, extending trends over the past decade. Those increases will just moderate from recent trends.
With the major quarterly punchlines addressed, let’s take a more granular look at inflation and interest rates, since both dominate recent economic news and so profoundly impact financial assets and real estate markets
If you had just awoken from a six-month nap and glanced at a graph of U.S. Treasury rates, you would probably do a double-take. Maybe a triple-, as you took a large swig of whatever caffeinated drink you might have chosen after such a long slumber. In just the last six months, yields on 10-year Treasuries have more than doubled, from 1.40% to a recent 2.91%, an astonishing rise. As a result, the fixed income markets have been decimated, with bond prices suffering their worst drawdown on record. 30-year fixed mortgage rates have spiked to 5%, as detailed above, their highest levels in 12 years.

The culprits? Inflation, of course, as higher prices prove anything but transitory, and that over-the-top toner use by the Fed as it printed money like it was going out of style. Meanwhile, everything from Russian sanctions to the temporary shutdown of Shanghai to a slowdown in shipping across the Texas-Mexico border to a looming strike of more than 22,000 union dockworkers employed at 29 ports along the West Coast when their existing contract expires at the end of the June do not bode well for future inflation reports. The challenge is that higher prices are everywhere, from durable goods to travel to housing to food to energy prices. Heck, I won’t even tell you what I just paid for a standard coach ticket to Atlanta.
Just take a peek at what has happened to certain commodity prices, with wheat and corn prices up over 60% since the end of 2020. You can count on Wheat Thins getting thinner, Frosted Mini-Wheats getting “Minier,” and Corn Flakes becoming Corn Crumbs in coming months.

How will investors respond to persistent inflation, something so many investors have never experienced before? It is impossible to say with certainty, but equity and bond markets are likely to have a rough going this year and next, while real assets (yes, real estate) ought to fare much better. I would be very wary of investing in anything that resembles “fixed income” for the time being. In March alone, the Consumer and Producer Price Indices rose 1.2% and 1.0%, respectively, and 8.5% and 9.2%, year-over-year. Ouch.

And oil prices? It seems like only yesterday (end of 2020) when many Wall Street analysts, commentators, and fund managers (Exhibit A: Jim Cramer and Cathie Wood, if they count) were predicting that oil prices were down for the count and would never recover, after they had dropped over 30% that year. Oops. I remember a fellow UCLA faculty member in the Public Policy Department, who had studied the oil markets for his entire career, telling me that nobody can predict the price of oil, not even OPEC. He appears to be correct, as this graph clearly communicates.

So, what is the Federal Reserve to do, while it fights a two-front war and the risks of persistent inflation and looming recession? Jerome Powell, the Fed Chair, may have the toughest job in America, right after Oscar host, coal miner, and ICU nurse (business school faculty member and real estate private equity managers are close runners-up). How much to raise rates? When? The Fed has indicated it expects to raise rates at least six more times this year, though many analysts are predicting seven to eight more increases, which would increase the Fed Funds rate from its current 0.50% to 2.0 to 2.25%. We shall see.

Meanwhile, the Fed has started its new Nutrisystem diet as it plans to shed $95 billion each month from its bloated $9 trillionish balance sheet, selling various securities it acquired in recent years as it implemented stimulus efforts and handed out money left, right, and center, which bloated its already hefty balance sheet by some 40% in just two years.

Higher interest rates continue to be in the cards, with the only question being how high do they go? These are such unprecedented times, it is simply hard to say, since so much depends on future inflation trends, and the to-be-determined Fed and investor response. What we are also seeing is not just higher rates, but higher spreads, the premium above Treasury rates that lenders are charging borrowers. In periods of uncertainty, lenders raise these spreads, which is hardly surprising.

Obviously, Clear Capital has not been immune to these trends, and we have been significantly whipsawed by higher rates. Because our value-add strategy dictates that we obtain variable-rate, “bridge” financing until we complete our planned improvements and replace the bridge financing with permanent debt, we have suffered the double-whammy of both higher rates and widening spreads. While we routinely acquire interest rate caps to hedge against interest rate increases, caps provide only partial protection against rate rises.
From the most recent inflation data, there may be a reason to be marginally optimistic that inflation will subside. Though the overall CPI-U increased by 8.5% in March of 2022 from the prior year, core inflation, which excludes more volatile food and energy prices was up “only” 6.5%, or 0.3% for the month. I suppose it is a question of perspective, but 6.5% is still far higher inflation that we have experienced in decades. I imagine that most Fed meetings are fairly dull affairs, but I think this year’s meetings may just be a little interesting than most. A tad.

Fortunately, multifamily investments ought to provide a reasonably good hedge against higher inflation, as rents rise to offset higher operating and capital costs
Perhaps the most common question I am asked these days is how multifamily investments will fare in an environment of higher inflation. Of course, it essentially boils down to four variables: rents, operating costs, cap rates, and financing costs, and

whether rents will (more than) keep pace with higher operating expenses (and capital improvement costs), and whether cap rates expand along with higher financing costs.
Overall, while I think the multifamily sector will continue to be a relative bright spot, investors will need to temper their expectations on future returns, continuing a trend that has persisted over time. While rents will continue to rise, so will operating expenses, albeit more slowly, if just because certain operating expenses are fixed or relatively so and should not change linearly with rents. Meantime, higher borrowing costs are inescapable, of course. Our cost of debt has increased nearly 200 bps (two percent) in what seems like the blink of an eye.
According to Redfin, multifamily rents rose 15% in February, year-over-year, while mortgage payments spiked by spiked by 31 percent. Both figures are the highest since Redfin began tracking this in 2019. The hottest markets generally remain those in the southeast and southwest, from Miami to Tampa to Orlando to Austin to Vegas to Phoenix to Portland, all of which saw rental increases of more than 23% over the past year, 8.5% inflation be damned.

The biggest uncertainty is what happens to cap rates, which have steadily declined over the past decade. Common sense (which is often neither common or sensible) tells us that cap rates would have to move higher in the face of higher interest rates and resulting negative leverage, but there is still so much darn liquidity out there chasing investment opportunities and it is not exactly a secret that real assets should benefit from higher inflation. In the fourth quarter of last year, national cap rates reached a low of 4.7%, down 30 bps from the prior year.

In a nutshell, I am optimistic that the multifamily, self-storage, and hospitality sectors should fare best in an inflationary environment, but future returns in all sectors will be lower than in recent years, and that investors of all sorts ought to temper expectations looking forward.
One economic bright spot remains the strong labor market, though attracting and retaining talent remain challenges
Despite the sobering headlines, the job market remains robust. Total nonfarm payroll employment rose by 431,000 in March and the unemployment rate declined to 3.6%, not too far away from the 50-year low of 3.5% we saw before the pandemic. Notable job gains were made in leisure and hospitality, professional and business services, retail trade, and manufacturing. Meantime, job openings remain at a record high, some 11.3 million at the end of February, while new jobless claims reached a 54-year low. In one sign of how desperate employers are to attract workers, Walmart is offering starting annual salaries of $110K for new truck drivers.

Finally, there were a couple of other interesting labor-related tidbits I happened to stumble upon that I thought were interesting. A recent article from the Economist argued that the pool of potential workers in the U.S. may be far smaller than previously thought because of the surge in asset values, which have increased household wealth, allowing many to work from home in some self-employed capacity or to leave the workforce (read: hang out poolside with mai-tai in hand) entirely. Data on “labor participation” seems consistent with this argument:

The other was the theory that many previous blue-collar workers – those working in construction, mining, and transportation – have transitioned to white collar positions, taking “office jobs,” as employers offer better pay, working conditions, and relax certain standards for employment, including the requirement that employees have a college degree. I suppose working for folks like Michael Scott, the fictional Regional Manager of Dunder Mifflin on “The Office” may look more appealing than driving for Walmart, no disrespect intended. The reality is that college enrollments dropped by one million during the pandemic, and as college gets more and more expensive, providing skills that might not translate to today’s workplaces, relaxing certain job prerequisites makes sense to me.
After a quiet end to 2021, politicians have been busy, busy bees in the first quarter, not just in California but throughout the country, as they deal with housing affordability and homelessness
Politicians continue to reach into their policy bags of tricks as they try, ineffectively, of course, to combat higher housing prices and rents. More broad use of rent controls and extensions of eviction moratoriums are mostly on the menu, while zoning restrictions are relaxed as well. The problem is that these policy changes either don’t work or are simply band-aids in nature, appealing to constituents, but offering little, if any, real relief. And, to be clear, these policy endeavors are not just limited to the “Blue States,” as these issues confront constituents just about everywhere.

• Senate Bill 9, “California Housing Opportunity and More Efficiency Act,” (whoever came up with this name should get an award), which I have mentioned previously, went into effect at the start of 2022, allows up to four units to be built on any particular lot previously zoned “R-1” and single-family units. The Wall Street Journal could not have been more effusive about the Bill, with one op-ed author estimating that around 2.5 million single-family homes could be converted to duplexes. However, the author is naïve, failing to recognize and appreciate the numerous impediments to additional construction, from the availability of contractors and subs, higher material costs, the permitting process, the higher cost of and access to debt or other capital that might be used to construct these additional units.

• Assembly Bill 2179: A week before California’s eviction moratorium was scheduled to expire, the Legislature announced and the governor signed into law a proposal to extend Covid-19 protections for tenants by an additional three months, to July, so that the state can “finish sending out rent relief payments.” California politicians have kicked this can down the road for so long, they are almost reaching the Oregon border.

• Regents of the University of California v. S.C. (Save Berkeley’s Neighborhoods): In 2019, a local neighborhood group, “Save Berkeley’s Neighborhoods,” sued the University to compel it to redo an environmental impact report regarding the impact on increased enrollment levels on everything from housing prices to traffic, and that the report that had previously been submitted violated California’s Environmental Quality Act. Between 2010 and 2020, attendance at UC Berkeley jumped up from around 36,000 students to over 42,000 students and now exceeds 45,000. In a ruling that surprised no one, at least not yours truly, the California Supreme Court ruled in favor of the Defendants and that the University must freeze enrollments for failing to provide enough housing for students around campus.


• Rent Control Bills in Numerous Jurisdictions: A recent Globe Street headline read, “Rent Control a Top Priority for Local Lawmakers,” the scariest publication title since “The Amityville Horror” (dating myself again). From Boston to Montclair (New Jersey), to mobile-home communities in Colorado, to several metros in Florida, proposed rent controls are on the menu. In those places with previously enacted rent controls, proposals to establish more restrictive caps on rent adjustments are in the works. In St Paul, Minnesota, for example, voters will decide whether to limit annual rent increases to 3%, regardless of inflation. Such a proposal, if passed, would constitute some of the more restrictive rent controls to be found in the country.

Frankly, there are others in the works, but in the interest of brevity (#sarcasm), I will leave discussion of other public policy brilliance to future quarterly updates, since I think you get the point.
And finally, before we put another quarterly chronicle to bed there are a few other economic, financial, or real estate related tidbits from the first quarter I found noteworthy


• Commercial real estate continues to shine: Despite facing many of the same headwinds as the multifamily markets, and others, from the increase in remote work and Amazon.com, commercial real estate values, from office buildings to shopping centers to industrial buildings to hotels, continue to appreciate. Obviously, excess liquidity remains a tailwind, as does the perception that real estate provides a reasonable inflationary hedge. According to Real Capital Analytics, commercial properties saw record sales last year, reaching $809 billion, nearly double 2020’s total and the previous record of $600 billion record in 2019, preceding the pandemic.

• Recent data confirms recent trends in demographic shifts and fertility rates: Data published by the U.S. Census Bureau at the end of March indicated that California saw a net loss of 262,000 residents for the year ended June 2021, with the lion’s share of the losses coming from Los Angeles County (159,621 people, about 1% of the total population). The second largest countywide loss was experienced in New York, which declined by about 111,000 residents (6.9%), followed by San Francisco (54,000 residents or 6.7%). Obviously, the Covid-19 pandemic was impactful, but the data underscores how California’s housing crisis and other demographic forces are reshaping some of the country’s largest cities.

Meantime, the following graph is a bit sobering as one thinks about long-term global economic growth. The bottom line is that global population growth is expected to continue to decline over time, with drops in economically developed nations being the most pronounced. Perhaps U.S. politicians should spend less time talking to media microphones and more time promulgating meaningful tax and immigration policy to stem this negative trend.

• Employers are beginning to mandate that employees return to work: In early March, Apple CEO, Tim Cook, told employees that they needed to return to the office full-time on April 11th. And if traffic on Los Angeles freeways is any indicator, most companies are asking employees to leave their home offices and Lululemon pants behind and return to the workplace. You may recall that I wrote sometime ago that I could not imagine firms hiring the best and brightest so that they could work separately and remotely from home, not with collaboration being so crucial. Perhaps employers recognize the importance of the ”Allen Curve,” named after the author of a 1970’s study, which indicated that communication between office workers declined exponentially with the distance between their desks.
Concluding Thoughts
As I look at the bottom of the MS Word version of this memo and realize that I am on page 24, I really hope that the second quarter will be less newsworthy. More than a few of you have noted that these memos continue to grow in length, and I can only tell you that it’s not my fault. There is just so much material economic data to digest and think about, and it is important that I/we do so.

Markets are fickle creatures and investor sentiments move on a dime (ok, a quarter or more given inflation), especially in this technological age. Just think about Phoenix for a moment. Fifteen years ago, during the Great Recession, Phoenix real estate prices tanked, and single-family foreclosures dotted every block. Prospective homebuyers in that market were able to shoot fish in a barrel, as they say. The median home price was something like $218,000. Fast forward to 2019, preceding the pandemic, and prices had increased, but modestly, to $285,000 (about 31%, or 2.5% annually). And today? The median price is $435,000 (a nearly 53% increase) and moving higher each week.

Perhaps the picture below from October 2020 says it all. Jim Cramer, one of my favorite television entertainers (comedians?), was waxing effusively about “The Magnificent Seven,” stocks in which “investors don’t care what they do. They just want to own the names.” Well, if you have some spare time on your hands, you might want to check out the charts for Netflix, Roku, Peloton, Square, Paypal, and Zoom, to see just how “magnificently” those stocks have done since then. Tesla is the only name yet to implode, so tread carefully.

In closing, the beginning of 2022 has begun as I anticipated, with some significant headwinds and challenges (e.g., inflation, less accommodative Fed), and that was before Vladimir Putin decided to add his name to the sadly long list of despicable autocrats and warmongers. Investors will need to place capital thoughtfully during the first half of 2022, focusing on investments that can withstand if not perform well in excessively inflationary environments and paying close attention to data as it emerges.

Finally, and as always, we remain so appreciative of those of you who continue to support our firm and its endeavors. I am so grateful that that list is as lengthy as it is. And to those of you who somehow got through all 25+ pages of this missive, I owe you a very special round of thanks!

Best,


Eric Sussman

“The best time to buy real estate is five years ago.”

– Anonymous

“A pessimist sees difficulty in every opportunity; an optimist sees the opportunity in every difficulty.”

-Winston Churchill

As a stickler when it comes to protocol, please allow me – on behalf of the entire Clear Capital team – to comply with the Style Guide for Fourth Quarter Investor Newsletters, by passing along our best wishes for the coming year. I hope that the holiday season was a joyous one for you and your families.  Last year was a record-breaking one for the firm and our entire team remains profoundly grateful for your support. 

With introductory pleasantries aside and 2021 behind us, our attention turns to 2022 and what it might bring in terms of the economy, financial markets, and multifamily investment opportunities. In short, I believe this year will be challenging, with lingering uncertainties surrounding COVID (I, like many others, am recently recovered from a breakthrough case, despite my three jabs), higher interest rates and inflation, moderating economic growth, geopolitical question marks (e.g., China, Russia), and the midterm elections later this fall. I suppose one could categorize the 2022 uncertainties as either the five C’s (COVID, costs, consumers, China, and Congress), or perhaps the four C’s and two I’s (COVID, consumers, China, Congress, inflation, and interest rates).   

Financial markets face measurable headwinds, if just because recent performance has been so strong. Home sales volume and prices hit 15-year highs last year, up 8.5% and 16.9%, respectively. The S&P 500 was up a whopping 27%. Oil prices were up 56.4% and most other commodities (aluminum, nickel, zinc) were up more than 20%. Heck, even Bitcoin was up nearly 60%. In the face of higher interest rates, the Bloomberg Barclay’s Corporate Bond Index was only down a modest 1.2%, despite much higher 10-year Treasury yields.

One of the other macro-level concerns is whether the air that has been recently let out of the riskier, if not, speculative asset balloon, will prove contagious. The NASDAQ has already “corrected” nearly 12.0% this year. The ARK Innovation Fund (ARKK), which holds a basket of what I would consider the riskiest of the riskiest equities, and Bitcoin are both down about 25%. SPACs (Special Purpose Acquisition Companies) as a group are down over 15% year to date. Netflix, Peloton, Robinhood, and fill-in-the-blank with your favorite highflying meme stock, are trading at 52-week lows, with Peloton and Robinhood trading below their initial public offering prices. One quote from Saturday’s Wall Street Journal seemed especially apropos, if not a tad scary: “SPACs seemed, briefly, like a way to earn easy money. Now, the hype is giving way to reality.”

“Easy money?” Phrases like that, along with Jim Cramer shouting “Booyah” on CNBC’s “Mad Money” (not to be confused with another CNBC favorite, “Fast Money”), as he provides a painstakingly detailed and thorough 30-second analysis on some fast-growing, gravity-defying stock, give me the heebie jeebies…whatever those are (I believe they are closely related to the “willies”).

Meanwhile 10-year treasury yields have increased from 1.51% to 1.75% and 30-year mortgage rates from around 3.1%, to 3.5%. All in about three weeks. The financial market captain has illuminated the “Fasten Seat Belt” sign, and suggests you stay seated for the remainder of the flight.

That is not to say that the increased volatility and uncertainty will not present investment opportunities, a perspective Sir Churchill would endorse (see quote above), as they always do. But I am not so naïve as not to recognize and appreciate certain realities. That is, in part, what is required of us, as fiduciaries and stewards of capital. However, so much about this coming year depends on how markets respond to the Fed’s less accommodative monetary policies and whether Omicron marks the end of the pandemic or just another Greek letter in the worst fraternity ever.

Over the last decade, growth-related investments have significantly outperformed value-oriented ones, but I sense the tide may finally be turning.  According to Morningstar, value-based funds outperformed growth funds in 2021 for the first time since 2016, and it has been a rough decade for value-oriented investors. Businesses with more predictable and stable cash flows ought to be relative outperformers in markets such as these, and over time, you know, the kind of investments where making money isn’t “easy” or a “Booyah” doesn’t quite capture the fundamental analysis required to assess an opportunity. Perhaps this simple picture comparing recent relative performance of Berkshire Hathaway to ARKK is telling. Value investing may finally be having its day…or year…or…

While I know this will shock nary a single reader as I have a habit of beating the same proverbial drum, but I would include multifamily residential properties in the mix of stable, cash-flow producing assets that ought to perform relatively well in these volatile markets. While I don’t anticipate multifamily or other commercial real estate prices (i.e., industrial warehouses) to repeat the stellar performances they have experienced in recent years, assets with reasonably stable and predictable cash flows, combined with modest leverage, should be a valuable combination in markets such as these. Regardless, careful underwriting, asset selection, and market analysis will be especially important.

While this final picture paints quite a compelling picture and describes what has happened with multifamily pricing and cap rates over the last decade plus, I don’t anticipate the slope of either average prices paid per apartment unit or average cap rates to continue so linearly looking forward. It may not be that returns always revert to their long-term averages, but rather that trees don’t grow to the sky (and the corollary, roots don’t grow to the center of the earth).

However, if one remarkable tailwind remains, it is all the dry powder out there. The Blackstone Property Fund, a non-traded Real Estate Investment Trust, surpassed $50 billion in assets last month and has been raising $2 billion per month from retail investors since the middle of 2020. $2 billion a month! Not sure that kind of inflow qualifies as “easy money,” but it is certainly a lot of capital to deploy. Meantime, M2 money supply (cash, checking and savings accounts, money market funds, time deposits), all earning negative real returns (after inflation), approximated $21.5 trillion at the end of 2021, another all-time high, and a decent chunk of those funds will likely end up being invested in riskier assets at some point. The only question is when and where these assets go.

In conclusion, I could really use a Ouija Board and some tea leaves to forecast 2022 with so much depending on what is challenging to predict or know: the pandemic and what happens post-Omicron, politics, the impact of changing Fed policy, inflation, interest and mortgage rates, and the employment picture. As an information junkie, it should be a very interesting year, and I will do my best to try and make sense of it all and hope you will stay tuned alongside me and the rest of the Clear Capital team as we endeavor to do so.

While the fundamentals for multifamily residential assets remain strong, we cannot ignore the impact that higher interest rates, slower economic growth, challenging collections, protective tenant policies, the changing employment market, and other uncertainties may have on rents and values

As alluded to above, I am often (and very appropriately) accused of repeating the same theme and beating the same drum every quarter, the “Gospel of Multifamily Investing.”™  I won’t plead the Fifth, but willingly admit guilt. For the last 20 years and more, I have preached that the future of housing in the U.S. is higher-density, multifamily housing, and that housing affordability would lead to increased relative demand for apartments, domestic migration (Manifest Destiny, in reverse, so to speak, as elaborated upon below), and multiple generations living under a single roof. These trends have come to pass, and I cannot see any reason as to why these macro-level realities will change any time soon, if ever.

However, to simply purchase assets indiscriminately, ignoring cycles, macroeconomic data, and geographic particulars (distinctions between various markets and submarkets), is not something we are ever going to do.  The key is to recognize, appreciate, and evaluate the data, exercising even greater care and attention to detail while underwriting any potential investment opportunity. Obviously, we are not always right, but I believe our long-term track record speaks for itself.

Let’s start with some data from 2021 and the first part of 2022, which essentially tell the broad multifamily story. Rents and net absorption of units (net units rented) increased sharply during the year.  Vacancies declined. In all markets. While the first graph is certainly eye-popping, the second may be more telling. Rents increased in every month of 2021 except December, when they declined ever so slightly. But the trend between the end of summer and year-end was telling, as rental growth moderated substantially during the latter half of the year. That is no surprise and was bound to happen, but is probative when thinking about 2022, when I expect rental growth to return to more normal levels, like those experienced prior to the pandemic.  

To witness this sort of rental growth and a decline in the overall vacancy rate is quite remarkable, reflecting the economic and employment recovery, sharply higher single-family home prices, and moderating construction starts and units brought to market due to supply chain disruptions and a shortage of construction workers.

But it isn’t all peaches and cream, and higher rents, occupancies, and unit absorption can be deceiving, because all neglect to capture whether landlords are actually collecting the higher rents or whether tenants are moving and relocating as one would expect in a “normal” market. This is where the impact of the pandemic is clearly seen and skews the data. Collecting scheduled rents and evicting delinquent tenants remain challenges, even as eviction moratoriums burn off. In most jurisdictions, the courts are unable to process the backlog of unlawful detainer actions.

So, it is this sort of MMA battle between competing forces, as I so often describe. Demand is trickier to forecast because it depends on so many unknowns: changes in GDP and employment (which in turn are driven by everything from COVID to the future of remote work), the equity markets, interest rates, consumer sentiment, and household formation. There is no question that higher interest rates and elevated single-family home prices will increase demand for apartment units, all else equal. Otherwise, more precise demand forecasts are challenging.

Supply is a bit easier to forecast, if just because the amount of land available for development is essentially fixed and new housing units in the pipeline, whether single- or multifamily, can be quantified, at least to some degree. From my perspective, this has been and will continue to be the housing rub. We cannot construct enough units to catch up and keep up, and I cannot foresee that changing anytime soon, even with recent increases in multifamily starts.  Besides, new units coming to market are virtually all “Class A,” focused on the higher end of the market, as opposed to workforce housing, the sort of assets that Clear Capital seeks to acquire.

In summary, multifamily fundamentals remain solid and should benefit from an improving economy, labor market, higher interest rates (reducing housing affordability), and excess liquidity on the sidelines. But rental growth nationally this year will likely be quite modest, more like what occurred before the pandemic and during the latter half of 2021, while cap rates remain flat or even expand modestly.

So, what housing markets look best for 2022 and beyond?  Where are potential apartment renters headed?

Location, location, location. Some may believe this platitude is the real estate equivalent of “Booyah,” but I don’t think so. It may be overly trite and simplistic, but we can all agree that there is a lot of truth to it. Not surprisingly, we spend a lot of time thinking about which markets in which we want to pursue opportunities, and then, in those markets we find attractive, the specific submarkets on which to focus. Consider our projects in Colorado Springs or Lakewood, both outside of Denver, or those in Gresham, Oregon City, or Eugene, Oregon, all essentially exurbs of Portland.

As we have discussed at length in previous quarterly updates, the U.S. population, like a fidgety child on a long car ride, has never sat still. For those of you are willing to head back to high school history for a moment (don’t worry, just a moment), we may remember being taught “Manifest Destiny,” the 19th century doctrine or belief that the expansion of the U.S. throughout the American continents was inevitable and justified.  Perhaps not politically correct today, but the phrase “Go West, young man,” concerning our expansion westward, relates to Manifest Destiny.

Following World War II, as automobiles and highways became omnipresent, and so westward and southbound we went. To the suburbs we moved. To warmer locales, we flocked. My father did exactly that, moving from New York City (yes, the East Bronx for those of you interested in such things), to New Orleans for medical school, and then to Southern California for the opportunities it presented (thanks, Dad), including the opportunity to meet attractive and intelligent co-eds attending UCLA (thanks, Mom).

Fast forward to today, when we seem to have Manifest Destiny in reverse, at least in part. People are leaving the coasts, its high cost of housing, higher taxes, and crime, and heading to lower-cost states in the South, Southwest, Southeast, and parts of the Northwest. Data is a bit hard to come by, but according to the Federal Reserve Bank of Cleveland, about 1.1 million people moved from high-cost metro and coastal areas to either mid-size cities or rural areas since the start of the pandemic.

 Texas, Arizona, Florida, Colorado, Montana, Oregon, and North Carolina all gained population according to the most recent census, while California and New York have lost residents. Not surprisingly, these population trends inform projections for rental growth in 2022 and beyond.

It is no surprise that the Sunbelt will likely see the greatest population growth in 2022, perhaps 250,000 new households. However, I am less sanguine about all these rosy rental growth forecasts, due to the uncertainties I have already discussed. As many of you know, we sold most of our Texas portfolio late last year because we were unable to achieve the sort of rental growth that we had predicted, in part because supply was able to mostly keep up with demand. In any event, many of the same locales that have been popular destinations in recent years from Phoenix to Vegas to Tampa to Atlanta to Sacramento will continue to be popular according to Freddie Mac. On a more macro-level, growth in the U.S. population continues to decline, a trend I have discussed for some time now, continually confirmed by new data.

This reality will have longer-term growth implications to be sure, perhaps another reason I don’t think Elon Musk has to worry too, too much about the need to colonize Mars, although I imagine numerous value-add investment opportunities await us there and elsewhere.

And single-family home prices in 2021?  Wowza! But 2022 will likely look a whole lot different…

2021 was simply a remarkable year for the single-family residential market, with every single state realizing higher home prices. Just imagine that home prices in Arizona, Florida, and Idaho, rose 28.6%, 25.8%, and 25.5% in one year, respectively. “Wowza” really is the right word. One almost feels sorry for poor Alaska, which only experienced a 7.5% rise in home prices. The single-family market benefitted from an almost perfect storm of price drivers: record-low interest rates, increased household savings during the pandemic, a rising stock market, remote work, millennials entering homebuying years, institutional buyers loaded with capital, and reduced inventory and new supply.

However, these sorts of increases are not sustainable, and in the face of higher inflation and mortgage rates, slowing economic growth, the lingering pandemic, and broad uncertainty – economic and political –home prices are likely to remain flat this year, best I can foresee.

One impetus for higher home prices in 2021 was Wall Street and all the institutional i-buyers (e.g., Zillow, OpenDoor, and OfferPad) which were scooping up homes left, right, and center before they began to suffer some serious acquisition-related indigestion. Mark one in the “I got it right” column, as I have consistenly expressed pessimism about their strategies, basing purchase prices and home values on mathematical algorithms, while they forewent due diligence and purchased homes willy-nilly, for all cash and with quick closes.  As though buying a home is like buying bubblegum at Walgreen’s. Even if their mathematical models were accurate, I could not detect a sustainable, scalable business model, especially in an economic downturn. It is equally likely that their models were a bit of GIGO, “garbage in, garbage out.”

Exhibit A for this colossal mess is Zillow, which announced a complete exit from the home-flipping business and is now offloading some 7,000 houses for $2.8 billion, on which it is expected to take a meaningful bath. Keep in mind that about 5.6 million single-family homes are sold in an entire year in the U.S. (plus about 700,000 condominiums). Whether their selling activity will depress prices in certain markets remains to be seen, but can we be surprised that they appear to have bought the most homes in Phoenix?  From what I understand, a New York based investment firm has agreed to buy 2,000 of the homes from Zillow, so perhaps it depends on what this firm decides to do with them. 

And sure enough, Zillow is not alone, as their competition is also starting to sell. Economics 100 tell us that this increased supply will negatively impact pricing, at least on the margin. 

Meanwhile, more favorable longer-term trends in the single-family market persist, including a lack of buildable lots. Back in 2004 to 2005, homebuilders collectively generated new home sales of about one million units. And today?  About 800,000. Will Rogers quote about “buying land because they are not making any more of it” was prescient.  In a recent survey, about three-quarters of developers described the number of buildable lots in their markets as “low” or “very low”. 

Meantime, supply chain and labor woes have provided and will continue to provide some downside buffers to single-family home prices. The cost to build a home is up about 20% over the past year, and most developments are at least two months behind schedule. I am sure more than a few of you have been experienced the supply chain challenges first-hand, perhaps a delay in the delivery of a washer and dryer or some other home appliance. We have. How long it takes for supply chains to return to normal is anyone’s guess, but given my penchant for cynicism, I am betting it will take more time than less.

In other single-family housing news, I recently read that Fannie Mae is going to increase the size of home mortgages that it is willing to back, to nearly seven figures, reflecting the obvious, that its previous ceilings were impractical in the face of higher home prices.  As of now, the maximum loan limit is $647,200, so whether they follow through remains to be seen. Given that some 60% of single-family homes purchased in the U.S. are financed through Fannie, the change would be impactful.

Regardless, I believe home prices will be mostly flat this year or will trade in a modest range (up or down a couple of percent). I certainly don’t see a repeat of 2021, but on the other hand, I don’t see any impending collapse. The banks have been more prudent in their lending standards, supply remains low, and even with their recent rise, mortgage rates relatively low by historical standards.

Location, location, location?  More like inflation, inflation, inflation….

Unless, you have been living under a rock (if you have, I hope it is not in the Sunbelt as it would get awfully toasty under there), rising prices and inflation have been on every consumer, investor, and policy maker’s mind of late, as we have recently witnessed inflation rates not seen for some 40 years. Consumer prices rose 7.0% in December, as compared to the prior year, even higher than November’s 6.8% rise, and levels not seen since 1982.  One picture tells 1,000 words, and it’s not pretty:

Here’s the thing. After a year of brushing off these higher prices as “transitory,” it is proving anything but, and can we really be shocked? The Fed has printed money for over a decade like they would never run out of toner. Does anyone think that the bubbles we have witnessed in speculative assets (see November Clear Insights newsletter) and higher assets generally (including, yes, real estate prices) have strictly been based on fundamentals?  Sure, those have been highly influential, too, but let’s not pretend that the accommodative Fed has not played its part.

Here are another couple of interesting pictures which tell the inflation story, and in ways that I found unique and interesting. The first summarizes – across various categories (i.e., housing, food, gasoline, new cars, wages) – just how many years it has been since inflation rates were as high as what we have recently witnessed. Let’s just say that it has been…a while.

The second presents similar data, in a different way, but with the same conclusion.  Prices, wages, raw material prices, etc. are all experiencing well above normal price or rate increases.  

Perhaps the Fed mandate to promote maximum employment, stable prices, and moderate long-term interest rates is asking too much, as Jerome Powell and his predecessors are not Houdinis, and 2022 is most certainly not 1982, when the Fed Funds rate was 14.2% (that is not a typo), and “Quantitative Easing” (significant asset buying) was not in the lexicon. Today we have this unique situation where the Fed Funds rate is something like 0.08% and the Consumer Price Index over 7.0%, resulting in an inflation-adjusted, effective Fed Funds Rate of negative 6.96%, something never seen previously. 

So, what is the Fed to do? Somewhere in the back of my mind, I am now hearing the Naked Eyes song from 1983 (no coincidence, perhaps), “Promises, Promises,” because just last week, the Fed announced that they will “tighten monetary policy” at a much faster pace than thought a month ago. Median forecasts are for the Fed to raise interest rates three times in 2022, starting in March, to 0.75-1.00% by year end, up from the two hikes forecast in December. We shall see.

What is interesting is that when the Fed made its last announcement and plans for two rate hikes in 2022, the markets essentially yawned. But not this time. If I have one other concern is if inflation, like everything else these days, becomes “politicized,” and blame for higher prices is placed on “greedy” corporations or “rigged” markets, instead of other obvious factors, like supply chain disruptions, pent-up demand, and the Fed’s money-printing ways.  We should all be very wary of those calling for “price controls” as a policy response, because we must remember our economic history, like President Nixon’s predictably ill-fated efforts to freeze wages and prices back in the early 1970’s. 

Because all this inflation talk can be fear-invoking and sobering, I would like to put one positive spin on the data, relating it back to what we do for a living. Thankfully, real estate has historically proven to be a good inflation hedge, something I wrote at length about in the August edition of our Clear Insights newsletter.  Perhaps not surprisingly, those classes of real estate assets in which landlords are able to adjust rental rates more quickly in response to inflationary pressures do well. Historical data indicates that multifamily and industrial assets fare best in these environments, perhaps explaining, in part, their outsized performance in recent years.

In any event, higher inflation rates and a less accommodative Fed will act as significant headwinds to financial markets this year, and while multifamily investments will benefit from higher mortgage rates, making homes less affordable, these higher rates will impact asset underwriting and both purchase and projected exit cap rates.

While the employment picture has certainly brightened, folks are quitting their jobs in record numbers and who can blame them? 

In one week, I read several articles which really captured what is happening in the job market.  One was “The Great Resignation,” describing the record number of people, especially the young, leaving in their jobs due to everything from low wages, poor treatment, COVID, and new professional or personal opportunitites (e.g., education, cryptocurrency/NFT trading).  As of year end, there were some 12 million job openings (including several openings at Clear Capital), as compared to about 7.5 million unemployed. In 2021, some 4.4 million left the workforce.

Another article that crossed my desk (or desktop) was “Companies Plan Hefty Raises for Workers.” While labor strikes at John Deere and Kelloggs were settled in November, the settlement terms spoke volumes. The Illinois manufacturer’s United Auto Workers voted in favor a new six-year agreement that included an $8,500 signing bonus and a ten percent wage increase, along with enhanced retirement and performance benefits. And then in following weeks, I read about strikes involving the Seattle Carpenter’s union, certain Denver-area grocery store workers, and some 17,000 BNSF Railroad employees. From Wall Street to Main Street, from London to Berlin to Los Angeles, wages are headed higher.

In the face of increases in food, energy, and housing prices, it is a necessity, and from my view, about time. I have long written about expanding wealth inequality and its perverse consequences. The graph below tells the story, and how we need to return to something more balanced when it comes to household wealth.

On the public policy front, there are just a couple newsworthy items from the fourth quarter

Somehow, some way, politicians here and everywhere provide fodder for these quarterly diatribes, usually suggesting, proposing, or implementing harebrained or shortsighted salves to address longer-term systemic issues. Here are a couple from the fourth quarter that fit the description:

  • For all units subject to rent control (about 650,000 units, three quarters of housing stock), the city of Los Angeles decided to freeze residential rents until 2023. Yes, you read that right. No rent increases until 2023, decided upon at the end of 2021. How can this be sound economic policy, let alone Constitutional? Perhaps it was this story juxtaposed against another that broke on the same day that really got my goat, where a local anti-growth group is seeking to block a separate proposed housing plan by the city, which would allow for greater housing density and potentially add 500,000 units to the rental stock. What developer in their right mind would want to develop units in a city which is incessantly trying to rein in higher rents through price controls?
  • From Los Angeles to the White House, from New Zealand to Ireland, politicians are mulling or implementing restrictions on who can purchase a home or adding taxes and fees to address housing affordability. Los Angeles City Council is supposedly considering a proposal that would not allow entities (e.g., corporations, limited liability companies) to purchase single-family homes, a completely impractical, if not unconstitutional policy. During the fourth quarter, New Zealand passed legislation eliminating certain tax breaks for property owners and investors and Ireland implemented a 10% tax on bulk buying of homes, which represent less than two percent of transactions.

None of these policies will meaningfully impact housing prices or rents. In this prediction, I feel pretty darn confident.

And despite this memo’s length, I will end with just a couple quick tidbits from the quarter that I found interesting or noteworthy

  • By admission, I am always a late adopter when it comes to technology, and while I have an iPhone, I won’t tell you which model I own other than it is a few iterations behind. Anyhow, during the quarter, I read that Ukraine (of all places), may allow for Non-Fungible Tokens (NFTs) to signal proof ownership for certain financial assets or transactions, including the exchange of real property deeds, bypassing traditional intermediaries. I have always found title insurance and the entire recording process for deeds and real estate ownership to be inefficient, cumbersome, and excessively costly. I don’t know whether technology and real estate will finally meet, as they have been reluctant bedfellows. We shall see.
  • In response to supply chain bottlenecks, CEOs are rethinking their global production playbooks, which could result in greater onshoring of manufacturing and distribution activities. If such comes to pass, the industrial market will receive another shot in the arm. Industrial rental rates have already doubled in the last 24 months.

In closing, I can’t say I am altogether unhappy to see 2021 in the rearview mirror, though the way 2022 has started, I am already longing for the good old days…all the way back to December. While I am a perpetual optimist, I am not one to simply don rose-colored glasses because my VSP insurance covers their cost. 2022 will likely present challenges, if just because higher inflation, a less accommodative Fed, the lingering pandemic, and the midterm elections increase uncertainty and present tailwinds. And let’s be candid. Financial and real estate markets have performed so well for so long, more modest expectations and returns ought to be in the cards regarldess.

What this means for Clear Capital is simple. We will have to be especially mindful and critical when underwriting potential acquisitions, stress-testing key assumptions and what-if scenarios. We will likely monetize certain assets in certain markets, where we have realized projected returns and see limited upside, perhaps entering new markets as we remember hockey great Wayne Gretzky’s simple message, that success is figuring out where the puck is going and not where it has been.

Finally, and as always, thank you.  Thank you to our investors, partners, vendors, employees, friends, and the entire Clear Capital and Clarion Management teams for their support and extraordinary efforts during a challenging year. I remain grateful and feel very fortunate to work alongside such a talented and dedicated group of individuals.

Best,

Eric Sussman

“It’s no wonder that truth is stranger than fiction. Fiction has to make sense.”
– Mark Twain

“You see, but you don’t observe. The distrinction is clear.”
– Sherlock Holmes (Arthur Conan Doyle)

As a kid, I devoured mystery and detective books, and might even have been considered a Hardy Boys groupie. I read every new release in the series almost as soon as a new one came out.  In any event, no crime was too complicated or any mystery unsolvable for Frank, Joe, and the Hardy Boys’ high school chums, and they were coincidentally fortunate that their fictional hometown of Bayport, New York was so riddled with shady characters and crime syndicates.  Perhaps if Bayport were a real place, Clear Capital might consider investing there as a contrarian, value-add play.

Fast forward to today, as I wade through and try to make sense of a barrage of complex, if not seemingly contradictory, third quarter economic data, I sure could use the Hardy Boys, Nancy Drew, Encyclopedia Brown, Sherlock Holmes, and their hangers-on to help answer the numerous questions and solve the mysteries that surround today’s markets and the economy:

  • Is this recent bout of inflation we have experienced transitory or something longer lasting?
  • Are we going to experience a repeat of the 1970’s “stagflation,” reliving the worst of two worlds, economic stagnation and higher prices? 
  • When will all the missing workers return to the workforce?  At what cost? 
  • How much higher can asset values, including real estate prices, go?
  • When will the Fed taper its bond-buying activities and/or increase interest rates?
  • When will the bottlenecks surrounding supply chains clear?
  • Will Evergrande and other Chinese developers go kaput, with the impact felt in our markets?
  • Are we finally getting towards the end of the COVID-19 tunnel? What will the post-COVID workplace look like longer-term in terms of remote work?
  • Will politicians at all levels actually and meaningfully legislate, and what impact might new laws and regulations have?
  • Will there be a second season of Squid Game? 

These are some weighty questions worthy of discussion, and though I recognize the limits of my psychic abilities, I will weigh in on each, with apologies in advance that I don’t have the Hardy Boys et al to lend an analytical hand or four.

Regardless of how these economic question marks and mysteries are solved and resolved, I remain confident that housing prices and rents – whether single- or multifamily assets – will be heading higher in coming months and years, with non-coastal markets continuing to outperform

I suppose it is a question of perspective of whether this prediction is a positive or negative. 

For Clear Capital, investors, and others that own financial assets, including residential real estate, this prediction would certainly be welcome and positive.  On the other hand, for those seeking to purchase their first homes and/or those concerned about housing affordability and homelessness (all of us, I imagine), this reality would also have certain perverse outcomes. It is truly a two-sided coin.

The third quarter was a very positive one for landlords and owners of residential assets, characterized by significantly higher housing prices and rents.  Once again, several pictures tell the story, whether one is analyzing single- or multifamily markets.  Prices and rents increased and increased sharply.

Nationally, home sales surged in September, with existing home sales up 7% (versus August), amidst already record-high prices, which were up another 1.4% from the prior month, and over 19% year-over-year.  Here in Southern California, prices were up 1.3% in September, with the median sales price reaching $688,500, up 12.9% from the prior year.

In 182 of the 183 residential markets tracked by the National Association of Realtors, prices were higher year-over-year.  In Austin, nearly 2,700 homes have sold for $100,000 or more above asking prices thus far in 2021.  And in another telling anecdote, a Bay Area broker commented that she was not at all surprised that a home listed for $850,000 received six offers above its asking price, ultimately selling for seven figures, but that she was surprised that she received one offer below the asking price.  I cannot recall ever hearing an agent being surprised at receiving an offer below its listing price.

And who is doing all of this buying?  Well, in certain markets, it is institutions, the Zillows, OpenDoors, Blackstones, and Invitation Homes of the world, and amazingly enough, more institutions are entering the fray (e.g., Flyhomes, Ribbon, Home-Light). Literally two days after I put the finishing touches on my last quarterly memo, I read an article about Tricon Residential, Inc., a Toronto-based company which already owns and rents about 25,000 homes, which announced that it is partnering with a Texas pension fund to acquire another $5 billion of U.S. houses to convert them to rentals. That is not a typo. $5 billion, which will theoretically allow for the purchase of 18,000 more homes, plus or minus. Institutions have already bought between 15 and 20% of all single-family homes sold thus far in 2021.

I cannot fathom how these business models or trends are sustainable. In fact, Zillow just announced last week that it was suspending its homebuying activities after buying 3,800 homes in the second quarter, resulting in a little single-family indigestion.  Keep in mind that Zillow had announced plans earlier this year to acquire 5,000 single-family homes each month by 2024. Oops. Now I just hope that Zillow is willing to share their residential Pepto-Bismol with Tricon and others.  Certain institutional investors, so-called “i-buyers” are buying homes sight-unseen, based strictly on mathematical algorithms (think “Zestimates” from Zillow).

The tremendous imbalance between demand and supply for housing, exacerbated by the impact of institutional homebuying, unparalleled liquidity, low rates, higher construction costs (e.g., labor and materials), anti-growth sentiment, and political shortsightedness will likely ensure that even higher home prices are in our futures.

Another interesting tidbit that caught my eye was that the top-performing single-family residential markets in recent years have been those with longer commutes to job centers (read: urban cores), according to the Brookings Institution.  For the two years ended May 2021, home prices in neighborhoods with 70-minute commutes rose over 30%, strongly outpacing the 9.2% price gain and 2.5% price decline for markets 20 minutes and 10 minutes from job centers, respectively. The growth in such markets has led to those “exurbs,” areas that have seen significant net migration.  Keep in mind that these trends pre-date COVID, which only accelerated them.

These exurb-type markets are really the ones worth watching, as they attract companies and employees alike, all seeking lower-cost locales.  Take South Carolina’s Berkeley County, about 30 miles northeast of Charleston, which saw its population grow nearly 30% over the past decade, and local officials predict that the county’s population of 230,000 will grow to at least 350,000 in the next 20 years.  While we have looked at investment opportunities in Berkeley County, Clear Capital’s investment strategy is absolutely informed by such data points, as we invest in exurbs closer to home.

And multifamily markets?  Asking and effective rents hit record highs, with asking and effective rents nationally increasing 7.5% and 7.9% nationally, according to Moody’s Analytics REIS, the highest quarterly growth experienced, at least since the firm began to track such data in 1999.  Net absorption in the third quarter exceeded the first two quarters of 2021 combined, with third quarter demand representing record highs, resulting in the vacancy rate for the top 79 metros tracked by REIS dropping 60 basis points, to 4.7%.  Household incomes for new renters reached a new high, at more than $70K/year.  Data from Yardi Matrix provides additional color on the broader data:

Meanwhile, rent collections post-COVID continue to lag, as the National Multifamily Housing Council found that 78.4% of apartment households made a full or partial rent payment through the first week of October, a one percent decline from the same period in 2020.  Los Angeles landlords are owed at least $3 billion in back rent, according to a report co-authored by researchers at UCLA and USC.  Across our portfolio, we are still owed significant sums in back rent, and we continue to await payments from the various rental assistance programs. For example, here in California, the State has disbursed less than 20 percent of the $1.4 billion in rental assistance aid that was given to the State by the Federal government, at least at last look. 

Finally, as eviction moratoriums are lifted, what will the impact be?  Will there be a tidal wave of defaults, foreclosures, and evictions?  Some 2.8 million households, comprising nearly 7.5 million individuals, are behind in their rent. However, my sense is that a combination of financial aid, rental assistance, and lender/landlord forbearances will stymy any significant increase in foreclosures or evictions, but time will tell.

There is one final topic I thought I would mention briefly before I move onto other subjects. During a recent UCLA Anderson event, I was asked by a former student as to how climate change might impact real estate values looking forward.  It is not something I have completely ignored, as I did check predictions about future sea levels when I purchased an income property for my own portfolio down in the Pacific Beach area of San Diego a few years ago. 

However, his question made me think more broadly about not just rising sea levels, but about fire risks, and its potential impact on future development and insurance costs, the latter of which is something I have discussed previously.  Sure enough, just a few days later, an article appeared in the WSJ about a proposed housing development in Colorado Springs, where we own some assets and are buying others.  In this case, a proposed development, a 420-unit project, “2424 Garden of the Gods,” was shelved because of concerns surrounding wildfire evacuations in the area.  Similarly, in August, a California appeals court blocked a planned expansion of a resort near Lake Tahoe after agreeing with concerns raised by environmentalists about fire evacuation risks. 

Therefore, his question was not only timely, but important.  Rising sea levels, in addition to increased levels of drought and associated fire risks, will meaningfully impact real estate. On the one hand, insurance costs are going to continue their upwards march, and in some cases, may be impossible to procure.  I bet more than a few of you have received “Notices of Non-Renewal” from your insurance carriers because your property poses “excessive” fire risk.  I have. On the other hand, anti-development activists will have another tool in their arsenal, as they argue, in some cases with justification, that certain projects should not be approved because of wildfire risks.  Ironically, the decision to mothball the Colorado Springs project may be good news for us, at least marginally, because caps on supply translate to higher rents, all else equal, and we will own three assets in that market by year end.

Higher inflation will persist, at least when it comes to wages, commodities, housing costs, and asset values 

As I wrote in one of my recent, more condensed (yes, thankfully), monthly memos, I have always marveled at how Costco has been able to sell a mammoth-sized hot dog and bottomless soda for $1.50, and $4.99 for an entire ready-to-eat roasted chicken, year after year after year. During my last visit a mere three weeks ago, I was profoundly relieved to see that those prices still have not changed.  Yet, everywhere else one looks, and I mean virtually everywhere, prices are higher, if not much higher, than they were in the not-too-distant past. 

Inflation, as measured by the Bureau of Labor and Statistics, increased 5.2% in August (versus the prior year), excluding food and energy, the third time in the last four months that increases in the consumer price index have exceeded five percent, well above the Fed’s two percent target.

While the Fed has indicated that annual inflation will return to two percent by 2022, that seems like a pipe dream, at least according to investors, who are predicting that the consumer price index will rise by an annual average of 2.64% over the next decade, based on recent pricing in the TIPS (Treasury Inflation-Protected Securities) market:

Meanwhile, there is simply too much liquidity on the sidelines for asset prices not to go higher: $20 trillion in M2 money supply and nearly $7 trillion in cash and investments on corporate balance sheets, mostly earning negative real returns. Much of that capital will eventually find its way into the economy and markets, driving real estate and equity markets higher. The impact of the unprecedented largesse of the Federal Reserve, perhaps borne out of economic and COVID necessity, will prove long-lasting, or at least for the next several years, as I see things. Two pictures tell a thousand words.

In fact, it can come as no surprise that Google recently announced it was purchasing a Manhattan office building for $2.1 billion, while in 2020, Amazon acquired the nearby former Lord & Taylor department store for nearly $1 billion and Facebook purchased REI’s office campus in Bellevue, Washington for $368 million. Expect more of the same looking forward.  

Meanwhile, wages are heading higher, and materially so. Recent labor strikes experienced at John Deere and Kellogg’s are only the beginning, and the principal way to move workers off the sidelines and back into the workforce, is higher wages. In this new reality, Walmart recently increased its minimum wage to $15 across the entire company, and check out this Bank of America advertisement, which appeared in last week’s Los Angeles Times:

Although perhaps not a universally held view, I have long argued that wages need to be higher, and while I might be biased because higher wages will likely translate to higher residential rents, I believe that the widening gap between the haves and have-nots is economically and socially destabilizing. Since 2010, U.S. home prices have increased by a whopping 153.3%, compared to far more modest wage gains of only 14.2%, essentially matching annual inflation rates (about 1.25% per annum). The chasm between the haves and the have-nots has never been wider. Again, a couple pictures provide meaningful perspective.

Obviously, the biggest concern is that we enter some sort of perverse time machine and head back to the 1970’s, when inflation averaged 6.8% per year. Disco, bell bottom jeans, Studio 54, and hour-long gas lines (my mother’s Dodge Dart, the affectionately nicknamed Red Bomber was a real guzzler) were bad enough, but a return to 1970’s-like inflation would be deleterious, to say the least.

Food prices globally are up 30% this year, and oil prices recently surpassed $80 a barrel, a price last seen seven years ago, almost to the day. And this chart is, perhaps most frightening, apropos of the Halloween season, where slowing growth and inflation become unwanted bedfellows.

While the three A’s (Amazon, automation, and artificial intelligence), low fertility rates, and other demographic shifts provide deflationary counterforces, and all that money supply should keep interest rates low (or lower than they otherwise would be), the excessive liquidity, upward pressure on wages, coupled with supply chain disruptions and pent-up demand, will provide more than worthy inflationary competitors.  It’s truly an MMA battle of competing tailwinds and headwinds, and my money is on asset inflation, net-net.

However, if the bond markets are to be believed, the high inflation we have experienced in recent months will, in fact, prove temporal, and I, too, cannot foresee a return to the 1970’s, if just because unions lack the power that they had back then, automation is increasing, and policymakers have thankfully learned a thing or three in the last 50 years. That is not to say that the Fed’s two percent target will not be breached, given the factors we have discussed (e.g., excess liquidity, supply chain challenges) as the TIPS market is already predicting somewhat higher inflation, but even if that 2.64% annual inflation comes to pass over the next decade, it should not be worrisome. Stay tuned.

The Fed is walking a very precarious tightrope, as it tries to thread an economic needle  

Taper and raise interest rates too quickly, and the Fed risks pushing the economy into recession and economic stagnation.  Continue their $120 billion a month bond-buying spree and a near-zero interest rate policies, and they risk adding more fuel to the inflation fire, if not asset bubbles, something we are already witnessing in several corners of the markets. Exhibit A might be this past weekend’s headline from the WSJ: “Trump SPAC Swept Up in GameStop-like Frenzy.” Buying frenzies in everything from cryptocurrencies (yes, Bitcoin has raced to record highs recently) to certain SPACS (check out “DWAC,” the stock symbol for the new Trump social media SPAC) to single-family-homes makes me inherently uneasy.  And as I have discussed at length previously, the Fed’s Balance Sheet has already experienced unprecedented expansion in recent years.

My sense is that the Fed is going to maintain the status quo for now, until there is clearer economic direction. As I mentioned, the bond markets don’t seem spooked by the specter of higher inflation or interest rates, and rates remain low, even with 10-year Treasury yields now trading at about 1.60% (versus 0.97% at the end of 2020).

In recent Congressional testimony, Fed Chair, Jerome Powell agreed that “we are seeing upward pressure on prices, particularly due to supply bottlenecks in some sectors,” and stated that “these effects have been larger and longer-lasting than anticipated, but they will abate, and as they do, inflation is expected to drop back toward our longer-run two-percent goal.” His subsequent commentary was fairly generic, as he ambiguously stated that the Fed will respond to “market shifts,” whatever that means. We will just need to stay tuned, and we will.

Supply chain bottlenecks, resulting in dozens of ships anchored off our coasts awaiting delivery of goods and empty store shelves, will clear in time, but how long that takes is unclear

It is not merely a shortage of truckers, labor shortages generally, or new environmental regulations causing our supply chain bottlenecks, though they are certainly significant contributing factors.  Frankly, COVID-19 and the economic dislocations it caused revealed longstanding risks and vulnerabilities of interconnected and geographically concentrated global supply chains. While the bottleneck should clear in the coming months, policy makers and businesspeople alike will need to rethink supply chains and how they procure goods and services to prevent future disruptions. The primary beneficiary in the real estate market will be industrial assets, which will benefit from the onshoring of previously outsourced goods. 

Because the real estate sector accounts for such a significant part of China’s economy (20 to 25% of GDP, versus 15 to 18% here in the U.S.), China cannot afford widespread failures in the sector for fear of the resulting fallout

While Evergrande and its compatriots (e.g., Sinic Holdings and R&F Properties) are clearly over-leveraged ($2.8 trillion in debt, collectively), the Chinese government will likely bail them out in some way, shape, or form, having learned the lessons from Lehman Brothers’ collapse and the subsequent financial crisis.  Perhaps we should think of the real estate tightrope China must deal with as analogous to the challenging balancing act our Fed must perform. I just don’t see China allowing a wave of developer defaults, and in fact, late last week, Evergrande made some outstanding and past-due interest payments.

But that is not to say it will be easy or painless. In fact, just last week, China disclosed that its third quarter growth in GDP was 4.9%, which hardly sounds unhealthy, but it compares quite unfavorably to 2020’s third quarter growth of 7.9% and higher analyst forecasts.  With countless construction projects now being halted, China’s GDP data may be even more sobering in coming quarters.  However, I don’t anticipate that China’s real estate challenges will spread to our shores in any meaningful way.    

Remote work, or some sort of hybrid-work model, will persist, allowing some workers to live remotely indefinitely, with long-lasting impact on secondary and tertiary real estate markets and their suburbs

Just before the second quarter ended, Price Waterhouse announced that none of its 40,000 workers need return to the office, adding to the dozens of others companies that have made similar announcements (e.g., Adobe, Capital One, Coinbase, Dropbox), at least for a portion of their employees.  As a result, the demographic shift we have seen over the last decade, with significant numbers of households relocating from urban cores to suburban secondary, tertiary, and quaternary markets will persist.

In fact, I recently learned a new word, “Exurb,” referring to suburbs of suburbs, which have experienced significant growth in recent quarters, in part due to the trend of relocating workers. Areas outside of Denver, Salt Lake City, Phoenix, Charlotte, or Nashville represent these new and growing exurbs.  The shift to remote work will provide additional tailwinds to these markets, and Clear Capital’s strategy and acquisitions of assets in these markets is no accident.

Political paralysis will persist, minimizing the likelihood that meaningful legislative changes to public policy, spending, or taxes that might impact real estate markets are significantly reduced

A question I am frequently asked is what is likely to happen to tax rules surrounding 1031 transactions, in which gains realized from the sale of investment property can be deferred, so long as the sales proceeds are reinvested in another investment property (or properties) in a timely manner. You may recall that President Biden has on more than one occasion indicated that this provision of the tax code ought to go the way of the dodo bird.  Well, I think we should rest easy. While the current version of Biden’s tax reform bill does cap 1031 transactions at $500,000, I see little, if any, chance that the legislation will be passed. 

After all, the Administration is still focusing on the stalled $3.5 trillion infrastructure legislation, which has now been reduced to less than $2 trillion, and any vote on that legislation still seems out of view.  The parties themselves can’t seem to agree on much, with political infighting providing meaningful legislative impediments, with numerous old-timers being “eliminated” in quasi-Squid Game style, as they decide not to run for reelection or lose primary battles.  On a more local level, politicians will continue to address housing affordability and homelessness with their typical incompetence and myopia. 

During the quarter, California Governor Gavin Newsom, having survived the recall effort, signed into law Senate Bills 9 and 10, which eliminates R-1 zoning, and allows for up to four units to be built on lots previously restricted to single-family dwellings. While perhaps a step in the right direction, the impact will prove marginal, likely adding less than half a million new rental units.  The new law does nothing to address other impediments to new construction, from higher building costs, labor shortages, and the need for local officials to approve projects more expeditiously.  For example, when Los Angeles passed an ordinance allowing detached garages to be converted to dwellings (Additional Dwelling Units or “ADUs”), the ordinance required that the city approve qualifying projects within 30 days.  Well, approvals are now taking more than six months. Color me shocked.

Finally, there are two other public policy related tidbits I thought I would mention, one from across the pond, in Berlin, which you may recall enacted the most restrictive rent control policies I have ever encountered and described previously.  Well, in late September Berlin’s voters decided to expropriate apartments from any landlord which owns more than 3,000 units in the city, a move akin to eminent domain.  The referendum is not legally binding, so the next move belongs to city officials, which would need to acquire the properties from these landlords, requiring some 40 billion euros. Where it would find this sort of funding is beyond my knowledge.  Perhaps it should just issue its own cryptocurrency and purchase the assets with a new “Berliner Coin.”  Sarcasm aside, I don’t believe that the city will expropriate anything meaningful, but it speaks to just how deep divisions are between landlords and tenants in certain housing constrained markets, and radical maneuvers being considered to address them.

Lastly, I came across a story in the Los Angeles Times a couple of week ago, describing how a local judge struck down a previously approved 1,119 residential housing project in San Diego County (Otay Ranch), which would have included commercial stores, a new school, and a fire station. The project was consistent with zoning regulations, had been approved by the County Board of Supervisors, and was supported by local fire officials. However, the development was opposed by the Sierra Club and a group of other environmental groups, who raised concerns that the project did not do enough to address affordability issues, wildfire risks, greenhouse gases, and the potential impact on the endangered “Quino checkerspot butterfly.”  Without commenting on the case specifics, the story reflects why housing supply cannot possibly keep up with demand…and won’t, in California, or just about anywhere else.

Where have all the workers gone and when will they return to participate in the labor force?

While the overall unemployment rate dropped in September, to 4.8%, some ten percent below where it was in April 2020, when some 23 million people were unemployed immediately following the COVID outbreak, we are experiencing near record-low rates of labor participation during an economic recovery. Is this going to be the latest installment in the Hardy Boys series, “The Mystery of the Missing Worker?” Well, according to the Department of Labor, there were nearly 11 million job openings at the end of July (seasonally adjusted), or 1.3 jobs for every person considered unemployed, records for both metrics, so perhaps the Hardy Boys could indeed have a meaningful mystery on their hands. 

Is it really all about unemployment benefits, as some would have us believe?  No. While certainly impactful, the labor shortage is multifactorial, as I have discussed previously, and we should all avoid simple singular narratives trying to explain complex topics like the labor shortage. Sure, enhanced federal and other unemployment benefits and government-sponsored assistance programs were impactful, but the causes are numerous, from a lack of childcare, lingering concerns over the virus, a reduced worker base in urban cores, increased automation, inadequate wages, and/or retiring Baby Boomers (and others, perhaps). Some may simply be fighting employee mask mandates or trading various cryptocurrencies.

In fact, the labor force shrunk in September, for the first time since May, indicating that lots of folks seem content with sitting on the sidelines. Despite record job openings, employers only added 194,000 jobs in September, below expectations for the second consecutive month. In August, the economy added just 235,000 jobs, less than a third of the 720,000 that was anticipated.

Finally, real estate developers are on the front lines of the labor shortage. In a recent poll conducted by the National Multifamily Housing Council, 50% of respondents said they had been impacted by the lack of available labor. Thus, contractors and real estate developers are being hit with multiple whammies, a shortage of labor and materials, along with higher prices for both.    

And, as always, here are a few other tidbits I found newsworthy from the third quarter

  • The 2020 Census data is out.  Initial details from the 2020 Census were released in August, revealing a few noteworthy data points.  One is our increasing diversity, as our non-Hispanic, white population declined 2.6% over the last decade, while the country’s total population grew only 7.4% during the decade, the second slowest on record, second only to the 1930’s, the period of the Great Depression.  Meantime, the under-18 population decreased, by 1.4%. I find our slowing and aging population growth to be concerning, as it will translate to slower economic growth and deflation.  We do not want to repeat the mistakes of our Japanese friends, who have suffered with the consequences of unfavorable demographics – slow population growth and an aging populace – for decades. 
  • The corporate diaspora continues.  Over the last few years, I have written extensively about population moves away from the coasts. Frankly, this reality has driven much of Clear Capital’s acquisition strategy, as we pursue opportunities in the Southwest, Northwest, and Mountain West regions of the country.  However, the population shift is both a cause and effect of corporate migration, which has also been occurring, as large, multinational companies relocate from the coasts to less expensive locales.  In mid-August, AECOM, the large infrastructure, construction management, and engineering firm with deep and long-standing roots in Southern California announced that it is relocating its headquarters to Dallas.  About three weeks ago, Tesla officially announced that its new headquarters will be in Austin, a move from Fremont, in Northern California.  These two companies are now part of a fraternity that includes Hilton, Northrop Grumman, Occidental Petroleum, Nestle, Toyota, CBRE, and hundreds of other companies who have relocated over the last decade or so.
  • Household debt continues to soar. U.S. household debt soared to nearly $15 trillion in the second quarter, increasing by $313 billion (2.1%), the largest nominal jump since 2007.  Mortgage balances – the largest component of household debt – rose by $282 billion, while auto loans, credit card balances, and student loans increased by $33 billion, $17 billion, and $14 billion, respectively. Mortgage originations (including refinancing of existing mortgages) reached $1.2 trillion, surpassing volumes in the preceding three quarters combined. The data is likely skewed by COVID and pent-up demand, but low rates, an improving economy, higher asset prices, and all that liquidity are impacting household borrowing and leverage.  While I do not see excesses or the sort of reckless lender behavior witnessed before the last financial crisis, I am watching the data carefully. We all should.

In closing, it has been a newsworthy quarter, such that the Summer Olympics and Afghanistan withdrawal debacle seem eons away, like distant memories.  Many challenging questions remain, and I don’t think even a consortium of Sherlock Holmes, the Hardy Boys, and the Psychic Friends Network can provide definitive answers as to what lies ahead. Regardless, I remain convinced that higher asset prices, longer-lasting inflation, higher wages, and anemic economic growth will characterize the remainder of this year and next, while politicians continue to spend more time talking to news outlets and any microphone in front of them than legislating in any meaningful way.  Let’s hope I am wrong in a few of my predictions.

As always, I would like to express my sincere appreciation and thanks to you, our investors, supporters, and friends as well as the entire Clear Capital and Clarion Management teams for their extraordinary efforts over a challenging period. I remain grateful and feel very fortunate to work alongside such a talented and dedicated group of individuals.

With that being said, I would be terribly remiss if I did not end this missive by acknowledging the loss of one of our own, Clear Capital’s very first employee, Dan Lukes, Director of Asset Management, who passed away from COVID last month. Dan’s contributions to the firm were immeasurable, and he will be profoundly missed, personally and professionally. Our sincere and heartfelt condolences go out to his colleagues, friends, and family members. May his memory be a blessing.

Best,

Eric Sussman

“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.”
– Sam Ewing

“Money can’t buy you happiness, but it does bring you a more pleasant form of misery.”
– Spike Milligan

As I watched Richard Branson, the eccentric billionaire and founder of the Virgin Group, rocket to the edge of space last weekend, I felt profoundly mixed emotions. On the one hand, I marveled at the achievement that the first suborbital passenger flight to space represents, and human ingenuity, generally. Although I have absolutely zero interest in traveling to Mars (just getting to the office in Los Angeles traffic or fighting for a parking space at Costco are exciting enough) or starting an interplanetary real estate fund (not yet, but stay tuned!), the launch was thrilling to witness. Perhaps the flight was not quite as dramatic or significant as Apollo 11’s historic moon landing, but it certainly represents a significant milestone.

At the same time, however, Mr. Branson’s flight reminded me of the significant challenges we face back here on planet earth, and whether the billions being spent on these space-seeking endeavors by Branson and his billionaire brethren, Elon Musk and Jeff Bezos, could help address problems we face closer to home: increasing wealth inequality, a lack of affordable housing and homelessness, the private sector’s encroachment on and need to assume what were previously public sector responsibilities, the challenges businesses are facing to fill job openings, concerns about inflation, the lingering impact of the pandemic including a recent resurgence in cases and hospitalizations, and record heat waves and drought in some parts of the world and record flooding in others. And to think I did not even mention the toxic political environment, the tragic collapse of the Surfside condominium complex, or Brittany Spears’ conservatorship troubles.

I suppose it is a question of perspective as some of these realities present opportunities for Clear Capital and investors generally, who benefit from higher real estate values, rents, and stock prices, fueled in part by the impact these challenges create: a material undersupply of housing (both single- and multifamily), persistently low interest rates, and record levels of liquidity and household wealth. While we continue to face challenges with regards to rental collections, the lingering effects of the pandemic (past due rents across our self-managed assets exceed $4 million), and the uneven economic recovery, operating metrics (e.g., economic occupancies, rental rates) across our portfolio have improved substantially in recent months.

Thus, despite so many broad social, political, and economic challenges, the underlying fundamentals and outlook for Clear Capital and housing markets is very positive. As a result, we remain optimistic as we look out to the remainder of 2021 and beyond. Perhaps not surprisingly, we have been very busy of late, having acquired the following four assets (461 units) since my last update:

  • Urban Park (Aspire Midtown), 104 units, Phoenix, Arizona
  • Mountain View (Aspire West Valley), 96 units, West Valley City, Utah
  • The Preserve (Aspire Oregon City), 135 units, Oregon City, Oregon
  • Landing Point (Aspire Salt Lake City), 126 units, Salt Lake City, Utah

We anticipate presenting you with additional offerings shortly and hope one or more might interest you. I imagine we will also entertain offers to sell some assets, especially those where we have implemented our value-add strategy, captured higher rents, and can take advantage of favorable market conditions. With all this being said, highlights and relevant tidbits from the second quarter are as follows:

  • Housing prices continue to skyrocket, while apartment rents have mostly recovered from pandemic-related declines (and then some), at least in most markets.

Perhaps the most common question I am asked is: “Are we in another real estate bubble?” The short answer is “no,” though it is easy to think so given recent headlines and countless tales about “all-cash, non-contingent offers above asking prices” for single-family homes in markets from Boise (ID) to Bethlehem (PA), to Tulsa (OK) to any Rust Belt City near you. Some buyers are acquiring homes, sight unseen, relying solely on video tours.

Anywhere one looks, data points confirm that we are in a strong bull market when it comes to housing prices. According to Zillow, the price of a single-family home in the U.S. increased approximately 15% during the past year (through June), with the median price nationally rising 24%, to over $370,000.

However, as much as significantly higher single-family home prices bring back memories of the period preceding the Great Recession, this time is indeed different, at least as I see it. Bank balance sheets are in far better shape, lending standards have not been materially relaxed, and average credit scores of borrowers are higher. Historically low interest rates, record levels of liquidity, anachronistic zoning regulations, institutional buyers (according to the WSJ, 20% of homebuyers are investors, including Blackstone, which reentered the single-family rental business after previously exiting it), a lack of buildable lots, higher commodity prices, and pent-up demand provide substantial market tailwinds.

And as sobering as it might be, many of these drivers of higher housing prices will persist indefinitely, such that lower single-family home prices are not likely anytime soon, as I have discussed in detail in prior newsletters and my podcast (“Focus on Facts”) several months ago. Meanwhile, a sampling of recent headlines captures the market sentiment surrounding home prices, and I could have cited dozens and dozens more, from nearly any news outlet or newspaper:
“The Housing Market is on Fire,” Bloomberg Business Week (June 14)

“Real Estate Frenzy Hits Small Towns,” Wall St. Journal (May 20)
“The East Bay Real Estate Market is So Hot, Housing are Selling for More than $1M over Asking Price,” SFGATE (May 5)
“Austin housing market sets new record as median home price hits $575,000,” Culture Map Austin (July 16)
“Long Island Home Prices Hit Record High Due to Insatiable Demand,” Newsday (July 15)

As if demand were not already strong enough, the Federal Housing Administration (FHA) recently announced that it is changing how it factors in student debt when assessing a prospective homebuyers’ creditworthiness and eligibility to qualify for FHA assistance. Clearly the change is intended to allow more borrowers to qualify for loans backed by the FHA, namely that superhero duo, Fannie Mae and Freddie Mac. The change will result in lower debt-to-income ratios for prospective borrowers with student loans, increasing the eligibility of certain prospective homebuyers for FHA-based loans. Perhaps increased competition from large debt funds and life insurance companies for some of FHA’s customers are compelling the change. Regardless, the competition and tremendous liquidity are compressing spreads, reducing borrowing rates, and increasing demand just as one would predict, although I am not sure the market needs any more demand drivers.

However, even if demand were to soften due to an economic downturn or increases in interest rates, neither of which I foresee, a systemic and persistent shortfall in supply remains the real culprit, as I have described previously, and I cannot foresee how that reality will reverse course anytime soon. The current supply of homes for sale represents less than 2.5 months of inventory versus 3.6 months one typically sees at historic cycle peaks. In many “hot” markets in the Southeast and Southwest, less than one month’s inventory is currently available. Earlier this month, Bank of America estimated that only 65,000 “starter homes” were completed in 2020, less than a fifth of what is typically built.

Sure enough, a new National Association of Realtors study reported that construction of new housing during the past 20 years fell 5.5 million units short of longer-term needs, requiring a “once-in-a-generation response.” Unfortunately, however emphatic their urging, it will go unheeded, but not because of a failure to acknowledge or recognize the problem. Political paralysis and the complete inability of competing factions to compromise and appreciate the most basic of principles, pitched back in the 18th century by the British philosopher, Jeremy Bentham, that the true measure of any “right” policy is that which provides the “greatest good to the greatest number” remain the culprits.

I even read that the U.S. is short of homebuilders themselves, which may, in part, also help explain the chronic undersupply of new housing. In 2007, the Census Bureau indicated that there were over 32,000 “spec” builders in the U.S. And today? Less than half that figure. There has certainly been some consolidation in the industry, while large, publicly traded homebuilders (e.g., D.R. Horton, Lennar, PulteGroup) have significant, if not insurmountable, scale and cost advantages over local or regional players.

Meanwhile, rents have continued to recover from their pandemic swoon. Nationally, apartment rents increased 2.3% in June and are up 9.2% for the year. In 38 of the largest 50 metros, rents hit new peaks during the quarter. One pattern arising during the pandemic perpetuated, as suburbs led in rental growth. Among the markets that witnessed rent increases of more than 15% during the quarter include Riverside (CA), Memphis (TN), Tampa (FL), Phoenix (AZ) and Sacramento (CA). Even rents for single-family homes were up sharply during the quarter, up over 5% year-over year.

Moreover, the number of occupied apartments in the largest 150 metros increased by nearly 220,000 units in the quarter, the largest quarterly increase since the early 1990’s when such data was first tracked. Here, markets in the Sunbelt and previously hard-hit urban coastal markets led the way. However, national figures mask significant regional variations, as many markets, mainly coastal, continue to see rents well below pre-pandemic levels. For example, rents in San Francisco and New York City remain nearly 15% lower than those witnessed in March 2020, though they have rebounded sharply, up 17%, since the start of the year.

Perhaps the biggest challenge remains collections, or differences between physical and economic occupancies. However, while tenants continue to struggle to pay rent on time, before the end of the first week of any given month, they are mostly paying and meeting obligations.

  • Secondary, tertiary, and quaternary single- and multifamily markets continue to outpace coastal competition.

You may recall that I mentioned that the “hottest” single-family real estate market during the first quarter of 2021 was Fresno, California, according to the Wall Street Journal. However, I may need to offer a mea culpa because I subsequently read articles elsewhere that claimed the hottest market might have been either C’ouer D’Alene (ID); Glendale, (AZ); or, Kendallville, (IN), depending on the news source.

Perhaps we are merely splitting hairs and getting lost in the trees, while missing the forest, that the market leaders – whether Fresno, C’ouer D’Alene, or Glendale – are an unlikely bunch of tertiary markets, not nearly primary or coastal. Even Harry Potter and his wizardry would find affordable housing in Hogwarts hard to find. I am not sure Clear Capital will be pursuing opportunities in any of these markets, especially Hogwarts, though the graph below indicates that perhaps we should, if the multifamily fundamentals and price changes in these same markets are like those impacting single-family home prices.

Perhaps a different view, data from Allentown (PA), where they may have “closed all the factories down,” according to Billy Joel, indicates that even that particular market has not experienced tempered housing demand, at least recently.

The story is precisely the same in the multifamily market, as alluded to above and discussed in previous quarterly memos, and precisely why Clear Capital continues to pursue opportunities in markets like Colorado Springs, Salt Lake City, and Phoenix. Pictures do indeed tell a thousand words.

  • While concerns about inflation remain widespread and the topic of countless news articles, the bond market is telling us such worries are overblown.

It is truly remarkable how the focus of reporters can change on a dime (or perhaps a quarter these days?). For years, I saw few articles that raised the specter of higher inflation, even as the Federal Reserve was printing money at record rates and asset prices continued to grow. And now? Nary a day goes by without one economist or another raising the prospect of systemically higher inflation.

It is really no wonder, as just last week the Labor Department reported that the Consumer Price Index rose 0.9% in June, the largest monthly increase since June 2008, and increased 5.4% over the last twelve months. Core inflation, which strips out volatile food and energy prices, rose 4.5%, the largest increase in that measure since September 1991. Everywhere one looks, whether it is your local Chevron, Home Depot, or Chipotle, higher prices are on the menu (the menus at Chevron and Home Depot might be worth avoiding).

And if companies are not increasing prices, they are accomplishing the same objective by shrinking the sizes of their products, something NPR creatively called “shrinkflation.” For example, Bounty may be the “quicker-picker-upper,” but it recently has been a “quicker-paper-shrinker,” reducing its package sizes by nearly ten percent.

And the market’s reaction to these higher inflation figures? Pretty much the same as the reaction I often get from students during one of my Zoom-based classes (and perhaps even the in-person ones), yawwwwn, if recent yields on ten-year Treasury yields – 1.17% at last glance – and other bonds are any indication. Keep in mind that ten-year Treasury yields were 1.75% at the end of the first quarter. Meanwhile, rates on high yield (read: junk bonds), averaging approximately 3.9% today, have fallen below inflation for the first time.
Plummeting bond yields are as strong as indicator as any that the market seems profoundly
unfazed by recent inflation data.

However, while headline inflation figures may have significant shock value, they become less
concerning when one realizes that more than a third of the inflation figures came from
increases in the prices of used cars. Yes, used cars. So long as Costco continues to charge
only $1.50 for a hot dog and drink, I maintain that inflation is not a longer-term systemic
problem. Rest assured, I will also be watching whether Costco’s hot dogs experience
“shrinkinflation” and will report back as needed.

Seriously, whether higher inflation is here to stay may be the most significant debate
between economists and market pundits these days. It is really an MMA battle between
competing forces. Supply chain disruptions caused by COVID will ease, as will pent-up
demand, both of which have created inflationary pressures. Meanwhile increased
investment in automation and unfavorable demographic changes (i.e., lower fertility rates,
later marriages) provide inflationary headwinds.

Perhaps one promising sign is the sharp reversal seen in lumber prices, which had risen to
record levels in May ($1,670.50 per 1,000 board feet on May 7th), only to drop more than
40% in June. You may recall that significant increases in virtually every commodity, from
oil to copper to aluminum to steel, had raised the cost of constructing a single-family home
by some 25% in a mere twelve months.

Obviously, Jerome Powell and the Fed are monitoring the data closely and they recently indicated that the discount rate may be raised earlier than expected, by late 2023. We will need to see how the Fed responds should higher inflation figures persist, and as usual, my popcorn is at the ready.

  • While the employment picture continues to brighten, countless businesses are unable to fill open positions, adding to the uneven economic recovery.

Following questions about future inflation, the second greatest economic uncertainty involves jobs and wages. While employers added 850,000 jobs in June, the unemployment rate rose to 5.9%, from 5.8%, as more folks began to look for work (remember that people not looking for work are excluded from unemployment figures). Overall wages increased 3.6% in June.

One significant uncertainty is whether recent wage increases portend a longer-term trend, and my sense is that they do. McDonalds recently announced that all 36,500 of its personnel (in-facility) will receive raises averaging ten percent, that entry-level hires will see wages increase from $11 to $17 an hour, and average wages for all staff paid hourly will reach $15 by 2024. Olive Garden and Chipotle have also recently announced wage increases.

However, countless businesses remain unable to fill open positions, with some 2.4 million job openings available in both the leisure/hospitality and manufacturing sectors. Those of us who have returned to in-restaurant dining have likely experienced understaffed locations. I recently visited a local mountain resort, Big Bear, and several restaurants were clearly short waitstaff and bussers, with the lack of affordable housing in the area receiving most of the blame when I raised the subject. A recent WSJ article, “Factory Jobs Go Begging as Wages Fail to Keep Up” indicated that increases in pay for factory jobs has been so anemic that they cannot even compete with fast food operators. That will need to change.

Many blame unemployment benefits (including the $300 federal benefit supplement) as the culprit, pointing out that they act as a disincentive for workers to return to their jobs. For some, this is likely the case. However, the true causes for labor shortages are far more numerous and complicated, and include everything from those enhanced unemployment benefits, a lack of affordable housing, increases in remote work, fear of (re)infection, a shortage of available childcare, and the pandemic-compelled exodus from urban cores to the burbs. Some workers may have used the pandemic to pursue other alternatives, everything from real estate brokerage to trading meme stocks and cryptocurrencies.

However, the reality is that real wages have stagnated in recent decades and have simply not kept up with increases in corporate profits or housing costs, even as labor markets tightened. As a share of GDP, worker compensation is lower than at any point in the second half of the 20th century, resulting from corporate consolidation, shrinking labor unions, automation, and Amazon. One data point that caught my eye and highlights the issue is that the average S&P 500 company CEO made 299 times the average worker’s salary in 2020, according to AFL-CIO’s annual, “Executive Paywatch report.” Executives received $15.5 million in total compensation on average, representing an increase of more than $260,000 per year over the past decade. At the same time, the average production and non-supervisory worker in 2020 earned $43,512, up just $957 a year over the same time period.

However, I believe these trends are going to change, and must change, to paraphrase Bob Dylan. First, just like the pandemic disrupted supply chains generally, labor supply was similarly impacted. However, challenges in labor supply may not be quite as easy to fix without significant additional incentives provided to workers. Second, thanks to the extraordinary rise in asset prices, including homes, some older workers are likely to retire sooner, perhaps also taking advantage of low rates to secure one of those reverse mortgages peddled by Tom Selleck. Third, lockdowns may have impaired some workers’ ability to return to their jobs due to health issues or a lack of childcare. And finally, while unemployment benefits will eventually burn off, they will create additional employment headwinds. Collectively, these factors suggest less labor force slack than is usual at this stage of a recovery, and higher wages are in our future.

Finally, wages need to increase to allow workers to afford housing in the communities in which they work. Several years ago, I was having dinner with two friends up in Seattle, and I asked them where they thought the busboy lived. They had no idea. I responded that we need to understand the answer to that question if we are not going to experience labor disruptions in service businesses located in tight housing markets. The math is simple, as reflected in the map below, that wages far above the minimum wage are required for workers to afford the rent in most communities.

  • The pandemic materially accelerated the domestic diaspora, a population exodus from the coasts to less expensive locales.

Over the past several years, I have written extensively about the population exodus from the coasts further inland, a sort of Manifest Destiny in reverse, as people sought more affordable housing, lower taxes, and perhaps places with less red tape and bureaucracy. However, one significant driver of this domestic diaspora that I have not discussed is how the Southwest has emerged as the country’s new factory hub.

Five states – Arizona, New Mexico, Texas, Oklahoma, and Nevada – added more than 100,000 manufacturing jobs from the start of 2017 to beginning of 2020, representing 30% of US. employment growth in the sector. As Silicon Valley’s influence becomes more widespread and fragmented, markets like Phoenix, Denver, Austin, Henderson/Las Vegas, and other cities should see increased tech-based jobs, and along with those high-paying jobs, greater demand for housing.

For example, Taiwan Semiconductor Manufacturing Corporation, the world’s largest contract chip manufacturer, whose products are in significant demand, selected Arizona as the site for a new $12 billion factory, which will employ some 1,600 workers. Intel is already active in that market and is expanding there. From Tesla to Lucid Motors to Steel Dynamics, numerous firms are expanding from traditional manufacturing hubs and coastal markets to places like Nevada, Arizona, and Texas. COVID and the supply chain disruptions it brought have only accentuated the trend.

  • Governments at all levels – local, state, and federal – continue to wrestle with how to minimize evictions of tenants delinquent on rents and homeowners behind on mortgage payments.

One significant uncertainty and concern of politicians (and others) is what will happen to tenants behind on their rent or homeowners delinquent on their mortgages when various moratoriums and/or forbearance agreements burn off later this year. During the last week of June, the Biden Administration announced a one-month extension of the CDC eviction moratorium, which was set to expire, and that the government will expedite the distribution of the $46 billion in emergency rental assistance established by Congress as part of the last stimulus bill. They also indicated there would be no further extensions, though whether they follow through on such an assurance remains to be seen. George Bush taught me long ago not to trust everything politicians say, even when you read their lips.

Meanwhile, California extended its eviction moratorium through September and has proposed paying landlords all missed rent for low-income individuals and families, a proposal that would cost a mere $5.2 billion. We hope California follows through on this proposal given how much we have at stake given the delinquencies we have experienced across our California-based assets. New York has extended its moratorium until the end of August. Most other states have let their eviction moratoriums lapse but are offering other rental assistance programs.

We continue to work with tenants when possible and have received payments for delinquent rents from various programs, but it is a slog as governments have not been exactly speedy (shocking, I know) in processing claims.

  • As usual, before I wrap up this edition of our quarterly update, there are a few other noteworthy data points to consider.
  • Biden Tax Proposals and 1031s: I am often asked whether 1031 transactions are going to go bye-bye if Congress decides to close an invaluable loophole that has been available to commercial real estate investors for nearly fifty years. If Biden has his way, 1031s would be eliminated or be significantly curtailed, closed to investors with pre-tax real estate profits over $500K. But political realities being what they are, I do not believe any meaningful tax reform is forthcoming. Heck, bipartisanship cannot even be found to pass an infrastructure bill.
  • Office Space Outlook: Last week, as I was driving past downtown Los Angeles, I noticed three large cranes putting what appear to be the finishing touches on three separate high-rise office buildings. I imagine all three are going to suffer significant losses, as they struggle to find tenants in a post-COVID world. Office vacancy rates have increased sharply since last spring, and I cannot foresee any forthcoming respite. It will be interested to see if some office projects are converted to alternative uses, but I imagine that will be no easy task, and certainly not an inexpensive one. Obviously, the outlook has improved in recent months, but I still foresee a very challenging office market looking forward.
  • IPOS, Corporate Debt, and Rising Zombies: Since the end of Great Recession, corporations have added trillions of dollars in debt, much of which is investment grade or lower. Globally, corporations owe over $80 trillion, nearly a quarter more than they did in 2008, with one long-lasting legacy from the pandemic being the sharp increase in corporate debt. Non-financial firms issued a record $1.7 trillion in bonds in the U.S. last year, some 30% higher than the previous record. By end of the first quarter of 2021, total debt for such firms reached $11.2 trillion, with some of the biggest borrowers being those hit hardest by the pandemic: Carnival Cruise Lines, Boeing, and Delta. Low rates are hard to resist, and while corporate bankruptcies have been few and far between as a result of government largesse and the willingness of investors to fund “zombie” companies, I don’t see this trend being sustainable.
  • Governmental efforts to increase fertility rates: One concerning trend I have mentioned many times in recent years has been the decline in fertility rates because of its longer-term impact on the economy and housing. At end of April, the Census Bureau reported that decade ended 2020, U.S. population grew at slowest rate since the Great Depression and second-slowest rate in any decade since our country was founded. However, declining fertility rates are a global phenomenon and governments are doing their part to stimulate reproduction rates (insert joke here). I recently read that China is now “allowing” families to have three children and two weeks later, I saw another article that said that China is poised to “lift all childbirth controls.” China clearly recognizes that policies limiting family sizes might have significant demographic and economic impacts looking forward. However, without associated economic incentives, I cannot see how such a policy will have any meaningful impact. After all, having children costs a lot, and is not getting any less so. Closer to home, the American Rescue Plan passed earlier this year increased the child tax credit to $3,600 for each child under 6 and to $3,000 for each child up to age seventeen. The Biden Administration has also proposed the expansion of paid-leave programs and improved childcare access. Regardless, I do not see any of these policies having any meaningful impact.

Overall, as the length of this update indicates, the second quarter had plenty of data to consider and evaluate, and while the outlook for housing – both single- and multifamily – is very positive, significant uncertainty surrounding everything from inflation, employment, and COVID variants remain.

Between the U.S. Department of Defense confirming that certain sightings by naval pilots were, in fact, UFOs, Richard Branson rocketing off to the edge of space, and an unidentified individual bidding $28 million to accompany fellow billionaire astronaut wannabe Jeff Bezos’ on a similar journey, the second quarter truly included news that was other-worldly. Oh, and by the way, the winning bidder for the Bezos space flight ultimately decided not to go, forfeiting the $28 million they paid for the ticket. If anyone happens to know their identity, would you be kind enough to pass along the name to our Investor Relations personnel?

Here, back on earth, there are many areas of concern, but perhaps ironically, nearly all provide foundational support and tailwinds for housing prices and rents. That is not to say that there are not areas of concern: elevated asset prices, continued speculation in meme stocks, cryptocurrencies, and SPACS (Special Purpose Acquisition Companies), high levels of corporate debt, the bloated Federal Reserve balance sheet, and the specter of higher inflation are all areas of concern, and I will be paying close attention to all of these issues, like many investors.

Meanwhile, the confluence of record-high values in single-family homes, equities, and virtually all commodities, coupled with record-low interest rates and tremendous liquidity has compelled investors to assume greater risk in the search for higher yields and returns. A recent WSJ article focused on how certain real estate investors, including Blackstone, are placing greater and greater sums into niches like data and research centers and life science labs.

While such a shift by Blackstone and others may prove prescient, I am always mindful of when investors – whether retail or institutional – shift strategies and move further along the risk curve. My experience is this tends to occur towards the end of cycles. Rest assured that Clear Capital will resist the temptation to move away from our core strategy that has proved well over decades and shifting market cycles.

Finally, I wanted to express my sincere appreciation and thanks to you, our investors and supporters, as well as the entire Clear Capital and Clarion Management (our captive management company) teams for their extraordinary efforts over a challenging period. I am beyond grateful and feel very fortunate to work alongside such a talented and dedicated group of individuals.

Best,


Eric Sussman

“What a Long Strange Trip It’s Been”
– Grateful Dead

“It is often said that there are two types of forecasts…lucky or wrong”
– Anonymous

During this past quarter, there were more than a handful of times that I read a particular headline and did a double take, just to make sure that I was actually reading the Wall Street Journal, Bloomberg, or other article from the mainstream news and not the Onion or similarly satirical news source.

In March, the Los Angeles Times had an article captioned: “Hottest Housing Market? It’s Fresno.” With no disrespect to Fresno, located in Central California’s San Joaquin Valley, the words “hot,” “housing market,” and “Fresno” do not usually appear in the same sentence. Yet, Fresno is just that when it comes to real estate prices and rents. Hot. The median rent in Fresno was up 12% during the last year, one of the top markets in the nation, and a modest single-family home that recently went up for sale there received over 100 offers, many offering all cash. In fact, Fresno, and cities like it throughout the Southwest, Sunbelt, and Mountain West – from Fresno to Boise to Gilbert (Arizona) to Riverside (California) – have been some of the strongest the past year, all benefitting from the pandemic, low interest rates, and more modest housing costs.

Then there was this doozy from CNBC in early April: “Paris Hilton is Fascinated by NFTs and Very, Very Excited About Bitcoin.” I have previously joked that when your Uber driver, barber, or gardener shares an investment idea with you, we just might be at a market top. However, I am sure Paris Hilton’s interest in Non-Fungible Tokens (digital art) and cryptocurrency is different, a uniquely bullish sign. #sarcasm. Then again, a digital collage – a Non-fungible Token – sold for a record, $69 million during the quarter, so perhaps Ms. Hilton is really onto something.

And then there was this classic from Bloomberg, which appeared a couple of days ago, “Everyone Loves the $100 Million Deli, Except David Einhorn,” about a rural New Jersey deli, which went public (symbol, “HWIN”) and, despite less than $14,000 in 2020 revenues, sports a market capitalization of over $100 million (actually $102 million at last glance, and if you include its outstanding warrants, over $1 billion), capturing the attention and cynicism of Mr. Einhorn, a well-known value investor and fund manager. Clearly, his value focus fails to appreciate the growth opportunities and potential in pastrami and corned beef. Imagine if this deli accepted Dogecoins or Bitcoins, or was acquired by a SPAC (Special Purpose Acquisition Company), its current valuation would seem like child’s play.

In fact, I think I could probably spare the time it usually takes you to read my less than pithy quarterly updates by simply providing you with a bunch of other headlines from the last few months, which really articulate the state of the real estate market, at least when it comes to single-family homes:

  • “A $400,000 House Got 122 Offers in Two Days,” Wall Street Journal
  • “Home Prices in Southland Rise 14.5% Amid Feeding Frenzy, Los Angeles Times
  • Home-price Surge Hits 15-year High,” The Real Deal
  • “More Real Estate Agents Than Homes for Sale,” Wall Street Journal

Meantime, multifamily real estate brokers echo similar sentiments when discussing the apartment market.  One Georgia-based broker told us that they had received 25 “serious” offers on one project and the “winner” was a group out of the Pacific Northwest, which outbid all competing offers by some $2 million, surprising even the brokers themselves.

In Arizona, deals are trading anywhere from five to 15 percent above asking price.  Brokers are consistently receiving at least 30 offers on projects, with over 10 invited to the “best and final” stage.  Such offers routinely include large (e.g., “7-digit”), non-refundable deposits.  I recently visited Phoenix and virtually every apartment project I visited had no vacancies whatsoever. If the two-hour wait time to rent a car from Thrifty Car Rental is an indication, Phoenix’s attractiveness as an investment destination will persist for some time.

The story is the same elsewhere, from Idaho, to Utah, to Colorado, to Texas, to North Carolina.  These anecdotes reflect why we are so interested in acquiring assets in these markets, but at the same time we must be especially thoughtful and conservative in our underwriting and negotiations.  It is really not surprising that we routinely find ourselves left at the altar and unsuccessful in those “best and finals.”  For every project in which we successfully reach the finish line, there are countless other times in which we are simply outbid.

Then again, to show how unique individual markets are, anyone who acquired residential rental property in New York City in the last 10 years is probably under water, likely having lost anywhere from 40 to 50% of their equity because of sharp declines in rental rates and increases in vacancy rates over just the past 12 months.  I can almost hear the lyrics to that Eagles’ song from many moons ago: “In a New York minute, everything can change.  In a New York minute, things can get pretty strange.”

While perhaps a bit of an “eyechart,” I found the following to be very informative, summarizing rent and vacancy statistics and changes across many cities in the U.S. between January and November of 2020, consistent with the perspective I just expressed:

Overall, the apartment market has stabilized in the past few months, but delinquencies remain stubbornly high.  While applications, move-ins, and lease renewals are rising, nearly six percent of residents across the U.S. have rent balances outstanding in excess of one month, and on average, such residents are behind some 3.5 months on their rent.  Nearly two percent of apartment residents are five or more months behind in their rent.  Across the Clear Capital portfolio, we are experiencing similar results, though not surprisingly delinquencies vary across projects and locations.  The following summarizes overall collections across the country, according to the National Multifamily Housing Council:

In any event, I have not seen any market quite like this, which shares distinct similarities to 1998 to 1999 and 2005 to 2007, when certain asset prices seemed profoundly disconnected from underlying fundamentals. How else can one justify the values of Dogecoin (a cryptocurrency competing with Bitcoin), GameStop, many SPACs, or that now world-famous New Jersey deli, among numerous other examples?

However, with a post-COVID economic recovery under way, historic levels of government stimulus (including the $1.9 trillion COVID relief plan passed this quarter), 10-year Treasury yields below 1.60%, record-levels of liquidity, and bank balance sheets in seemingly decent shape (a total of about 20 banks have failed in the last five years versus over 300 between 2010 and 2013), this time feels quite different from those two other auspicious timeframes, and I am more concerned about inflation than I am about a broad market downturn, as I have written about previously. In fact, consumer prices rose sharply in March, up 2.6%, which hardly sounds alarming, though it represents the largest increase since August 2018, so stay tuned.

In summary, the first quarter was extremely eventful, with some very wild market moves, even capturing the attention of investment stalwarts like Paris Hilton.  Residential real estate prices increased sharply, which may be one of the most significant stories of the quarter, whose impact will reverberate for some time to come. Oh, and did I forget to mention that UCLA’s men’s basketball team made it to the Final Four in the NCAA Tournament, before losing at the buzzer on a 45-foot bank shot?  In overtime?  As a double-digit underdog?  Or the Capitol riot of January 6th and the inauguration of President Biden?

Indeed, it was that kind of quarter.

Secondary and Tertiary Markets, Especially Those in the Southwest, Sunbelt, and Mountain West, Continue to Lead

Continuing a trend which has persisted for some time, the hottest real estate markets include markets like those mentioned above: Boise, Fresno, Greensboro, Gilbert, Riverside, Albuquerque, Tucson, and Memphis, where rents have increased anywhere from nine to 12% over the past year. Across the entire country, in the 134 markets in which data is available, rents were up very modestly in the past year, some 0.6%, and 0.8% during the quarter. Of course, these higher rents are not completely uncorrelated to both resident delinquencies and the inability to evict such residents, which artificially reduced available supply.

However, the demographic diaspora from the Coasts to less expensive and more suburban markets has been impactful.  According to Zillow, some 10% of Americans relocated during the pandemic, with Phoenix, Charlotte, and Austin leading the top destinations.  As one Austin homeowner put it, “They just keep coming.  The fleece vests, the tech bros.  That’s definitely imported from California.”  Austin has been the fastest growing city in the last decade, growing 30%, with half of the growth representing Texans relocating from other parts of the State to Austin.

Home prices increased in all of the 100 largest metros in the U.S., according to Zillow.  However, in some of the wealthiest, tightest residential markets – San Jose, Seattle, NY, Boston, Austin, SF, DC, LA, Chicago – rents declined, in some cases by more than 10%. The dichotomy is noteworthy, where home prices have increased while rents declined, both by double-digits.  I am not sure this has ever occurred, certainly not in my memory.

Perhaps another anecdote may be illustrative, this time involving a close friend, who relocated from West Los Angeles to Lexington, South Carolina, a quiet suburban neighborhood about 15 miles outside Columbia, the state capital.  As a personal trainer, the pandemic forced him to provide services remotely, and with products like Peloton and other products (e.g., the “Mirror” from Lululemon) providing in-home, yet interactive, workouts, it is clear that personal trainers and the like can live virtually anywhere and still engage with clients.  Not only are all gyms at great risk (that may be an understatement), but suburban housing markets have found a new source of demand.  COVID has made it clear that certain jobs can be performed almost entirely via FaceTime or Zoom.  His brother, a local realtor, is receiving dozens of offers on every home he lists, and on one transaction, he received a most unusual proposal, which offered to pay “$1,000 above any other offer received,” all cash, with a quick close. Again, I had never heard of an offer quite like that one, and this is for a single-family home in Lexington, South Carolina, population of less than 23,000.

A recent article in the Wall Street Journal noted that some suburban homebuyers are actually foreign investors, stating that “blocks of families are sending monthly rent checks to ventures backed by Canadian pension funds, European insurers, and Asian or Middle Eastern government-run funds.” Supposedly up to a third of institutional investors in single-family residential properties are foreign.  In fact, just last week, the German insurer, Allianz SE, said that it is investing $4 billion in U.S. rental homes, as if prospective homebuyers need additional competition.

In short, I anticipate continued growth in the same markets that have been leaders in recent years, those secondary, tertiary, and even quaternary locations (yep, including red-hot Fresno), with the biggest unanswered question whether supply can keep up with demand.  As discussed in more detail below, my sense is that it will be a challenge (read: perhaps impossible) to do so in many of these markets.

With Substantially Higher Commodity and Construction Costs, Widespread NIMBYISM (Not in My Backyard), Poorly Construed Public Policies, and Broadly Insufficient Supply, Housing Prices – Both Single- and Multifamily – Are Not Likely to Moderate Anytime Soon Even if Demand Moderates

In a recent memo and/or podcast episode I recorded (“Focus on Facts, available at Spotify and Apple Podcasts, admittedly some shameless self-promotion), or perhaps both, I indicated that those hoping for lower home prices would be “waiting for Godot” because of the severe imbalance between demand and supply in nearly every market. According to Freddie Mac, the U.S. housing market is nearly four million homes short of what is needed to meet demand, a 52% rise from 2018, when they first began to estimate and quantify the shortfall.

Historically low rates, unprecedented liquidity, COVID and related stimulus, institutional and foreign purchasers, record number of Millennials (30 to 39-year-olds) in search of permanent housing and perhaps experiencing FOMO (Fear of Missing Out) are driving unprecedented demand for homes. Imagine that on nearly every successful transaction, there are anywhere from ten to 150 bridesmaids or groomsmen, unsuccessful bidders who will likely be bidding on the next home available for sale.  With personal savings having accumulated over the past year of COVID, significant dry powder awaits both increased consumer spending and investment.

Meanwhile, the supply of homes for sale remains at record lows.  For example, there were about 1.3 million homes available for sale at the end of 2020, representing about 2.3 months of supply, down 22% from the prior year. Perhaps my very favorite (if not sobering) statistic revealed this quarter, in late March, was that real estate agents outnumber homes for sale nationwide.  At the end of January, one month later, some 1.04 million homes were available for sale, down 26% from the prior year and the lowest on record since 1982, while there are 1.45 million licensed real estate agents nationwide, up nearly five percent from the prior year.

While countless renters have relocated during the pandemic, homeowners are mostly staying put, especially Baby Boomers with their $10 trillion of equity, impacted by COVID and unfavorable tax policy (capital gains).  According to Redfin, the typical homeowner in 2020 had remained in their homes an average of 13 years, up slightly from 12.8 years in 2019, but far longer than in 2010, when homeowners had lived in their homes an average of 8.7 years.

While not concerned about increased debt levels in the short-run, as mentioned, I do fear the higher inflation and asset values they will likely fuel in the intermediate to longer-term. I don’t think for a second that the Fed’s “easy” monetary policies and elevated equity values are unrelated. However, at this point, the markets are not forecasting significantly higher inflation. It may just be that inflation in financial assets (including real estate) will be offset by broader deflation in everything from energy to consumer goods to office and retail rents.

A recent Los Angeles Times article highlighted the challenges, perhaps particular to California, noting that not a single of the more than half dozen bills introduced last year to address the state’s housing crisis was passed, in large part “because of campaigns waged against them by the state’s powerful construction-workers union.”  Union opposition is one of the principal reasons politicians have been unable to pass legislation streamlining and accelerating construction approvals and easing zoning restrictions.  The irony is not lost on me.  The sorts of individuals who would probably benefit significantly from lower rents and housing prices – blue-collar individuals who work in the construction trades – stymy new construction and exacerbate the problem.  Is it any wonder that it costs as much as $700K to construct an “affordable” unit, perhaps double what it costs to build a comparable market-rate unit?

Meanwhile, local opposition to building is so commonplace and the approval process so cumbersome, time consuming, and expensive, even when a proposed project complies entirely with requirements, approvals are not forthcoming, at least in an expeditious manner and needed supply is simply not provided.  Recently I heard of a new acronym to add to my vocabulary: CAVE, Citizens Against Virtually Everything, to be added to NIMBYISM and BANANA (Build Absolutely Nothing Anywhere Near Anyone).

Finally, commodity prices continue to climb, or “go through the roof,” as it were.  Crude oil, the key component of everything from paint to drain pipes to roof shingles to flooring, has increased 80%, yes 80%, since October.  Copper, used extensively in both plumbing and electrical work, costs roughly a third more now than it did a mere six months ago.  Prices for everything from insulation, granite, concrete, and brick reached record levels this year, according to the Bureau of Labor and Statistics. Drywall and ceramic tile prices have also increased, while significantly higher lumber prices have added something like $24,000 to the cost of an average home and $9,000 to an average apartment.  Ouch.  According to PulteGroup, Inc., one of the largest homebuilders, the average cost to construct a home in the fourth quarter alone was up 7%. American Homes 4 Rent, which constructed some 1,600 units last year and plans to build another 2,000 in 2021, said it spends between $20-25,000 per unit for lumber, more than double what it spent last year.

Lest you think this is merely a U.S. phenomenon, it is not.  In the 37 countries in the OECD (Organization for Economic Cooperation and Development), home prices hit a record last year, up five percent, the most in nearly 20 years.  From Bicester in the U.K. to Omaha, Nebraska, to Berlin, home prices are rising, up 11% year-over-year here in the U.S., 8% in the U.K., and 9% in Germany.

While Treasury and Mortgage Rates Rose During the Quarter, They Remain Low by Historical Standards. However, Higher Inflation Remains a Real Risk

During the first quarter, interest rates increased, and not insignificantly, at least in relative terms.  At the start of 2021, the yield on ten-year U.S. Treasuries was 0.93%, and at last glance, 1.56%, while average 30-year mortgage rates had increased from about 2.7% to nearly 3.1% today.  However, the increase has negligibly impacted demand, best I can discern.

One big question mark is how long the Federal Reserve can wait before it decides to raise rates.  According to Morgan Stanley, recent data implies a rate hike in 20 months or so, which essentially comports with Fed Chair Jerome Powell’s public statements.

Clearly some increase in inflation was inevitable given the collapse in consumer spending and demand following the COVID outbreak, but March’s increase in inflation to 2.6%, up from February’s 1.7%, represents the most significant rise since 2009. Inflation will soon surpass the Fed’s two percent target (it uses a different index), but the Fed will truly be engaging in a tricky balancing act worthy of Cirque d’Soleil.

Economic recoveries produce price pressures and the impetus for higher interest rates and the post-COVID recovery will certainly be no different.  On the other hand, higher interest rates can and will dampen economic demand for capital investment and other goods and services, and could threaten any economic recovery, so the Fed will be trying to walk a fairly narrow tightrope between now and the next 12 months.

Even in Quarantine, Elected Officials Have Been Busy

One of the things that will be fascinating to watch, and track is how governments at every level and across the globe continue to intervene in housing markets, as they try and protect renters from eviction, homeowners from foreclosure, all while trying to increase the stock of affordable housing and address ever increasing homelessness.  However, their efforts seemed doomed, at least in the longer-term, as they lack the political will and financial resources to do so.

Meantime, the CDC has extended its eviction freeze through June 30 and state and local governments will be moving aggressively to shore up their fiscal deficits, resulting from significant declines in tax revenues because of the pandemic.  Nashville instituted a 35% surcharge on property taxes last year, and Lord knows how New York City plans on dealing with its $9-10 billion projected budget deficit.  Knowing politicians, they will likely choose some profoundly suboptimal policies, but those that are palatable to constituents. Let me go out on a proverbial limb to predict that higher local and state taxes are likely coming down the pike.

As moratoriums surrounding the eviction of residents and foreclosure of homeowners behind in their mortgage payments expire, we will have to see how landlords, lenders, and the Courts respond.  I imagine many landlords and lenders will work with residents and homeowners to minimize losses and manage vacancy rates, while working aggressively to collect delinquent rents and mortgages. On March 11th, the latest COVID relief bill, the “American Rescue Plan Act” was passed into law, a $1.9 trillion relief package that includes $50 billion in housing resources, including some $27 billion for rental assistance.  Combined with $25 billion in rental assistance provided by Congress last year, over $50 billion is available to assist struggling renters and landlords who have also been impacted, including Clear Capital.  How quickly these funds will be distributed by individual states remains to be seen, and Clear Capital, like nearly every landlord, are understandably eager to collect as much of the nearly $2.5 million in delinquent rents we have experienced across our entire portfolio as we can.

Meanwhile, across the Pond, you may recall that Germany passed a five-year freeze on residential rents back in 2019 that prevented owners of any property built before 2014 from raising rents, the most onerous rent control regulation I have ever seen. And the preliminary results are in.  According to German Institute for Economic Research, rents for units built before 2014 are in fact down 11% as compared with those that are not regulated, but, as any economic analysis would have predicted, the Country’s housing shortage has worsened.  The number of units available for rent has declined by more than 50%, as tenants are hanging on to their rent-regulated units with both hands, while in other cases, landlords are using units for themselves, selling them, or keeping them vacant in hopes that the Courts determine the law is unconstitutional.  All these outcomes were entirely predictable to anyone with even the most basic training in fundamental economics.

Finally, and as usual, a few other noteworthy tidbits have caught my eye during the quarter

As usual, I would be remiss if I neglected to mention a couple other tidbits or relevant data points that might be of interest.

  • Significant Office Vacancies are Likely to Persist for an Extended Period of Time: Not surprisingly, office vacancies are piling up and in historic fashion, and I believe the slump will be long-lasting. From Houston to San Francisco to Los Angeles to Manhattan to Chicago to D.C., things are particularly ugly.  In the ten largest metros, office occupancy is only 26% of pre-pandemic levels, according to Kastle Systems, whose electronic access systems are found in thousands of office buildings throughout the U.S.
  • While hotels focused on leisure have already seen a modest recovery, convention-reliant hotels are in a world of hurt and won’t bounce back for some time: For the first time in nine months, I traveled recently, to Phoenix, as I mentioned earlier, to visit a new project we are acquiring, Urban Park, and an asset we acquired a couple of years ago, Aspire Glendale. Both LAX and Sky Harbor, Phoenix’s airport, were fairly busy, at least the Southwest terminals.  The flights were entirely, or nearly entirely, full.  Activity at the rental car counters was what I would have expected to see before COVID, and in fact, busier.

According to recent data from the Bureau of Labor and Statistics, the leisure and hospitality industry led last month’s job gains, adding 280,000 jobs in March, following the addition of 355,000 jobs in February. A recent poll indicated that some 87% of households plan to travel in the next six months, up from 60% just a couple of months ago.  Obviously COVID hit the travel and tourism industry with a stiff uppercut, but the industry is in recovery mode and pent-up demand, significant.  Full recovery is still a couple of years away, I would think, especially in international travel. And leisure hotels will fare far better and recover far more quickly than those that rely more heavily on conventions and conferences.

A couple of specific data points may be probative. Hilton had reopened 97% of its hotels as of February 10th.  Of the 989 licensed casinos in the U.S., 935 have now reopened.  However, it should also be noted that Nevada is limiting occupancy at reopened hotels to 35% occupancy until June 1st, when the State intends to completely reopen.  In California, rules vary by county, but the State intends to reopen on June 15th.  We shall have to wait and see, but fingers and toes are crossed.  I can tell you that Clear Capital intends on holding its annual staff meeting in-person this year, in October, if all goes to plan.

In any case, I don’t foresee substantial foreclosures in the hotel/hospitality space, as lenders don’t want to take back these assets and have learned their lessons from prior downturns.  It is usually best to work with borrowers to maximize recoveries and outcomes.

  • The Retail Industry is the One that May Never Recover, at Least in Some Segments: It is a secret to absolutely no one that retail faced significant challenges and headwinds before COVID, and I have routinely, if reluctantly, provided data on store closures and retail bankruptcies in nearly every quarterly memo. 2020 saw a record of permanent retail closures, with over 12,000 stores closing their doors.

So what’s the post-COVID retail reality look like?  That remains a big question mark, as I can’t imagine how large indoor malls, anchored not just by “big boxes,” but movie theatres will fare. We have all gotten used to watching everything, including first-release films, from the comfort of our couches.  Between higher-quality, large screen, smart TVs, surround sound, and decent homemade popcorn, we are more willing to enjoy movie fare at home.  I just don’t see movie theatres being able to remain open for some time.  I recently read that Los Angeles-based Pacific Theatres, parent company of ArcLight, announced that the company has decided not to reopen any of its theatres. And larger chains like AMC, and the malls in which they operate?  I think they face profound headwinds, and sadly, I anticipate that I will be reporting additional sobering statistics on retail assets looking forward.

While the Next Six Months Will Bring a Much Stronger Economy, the Recovery will be Uneven, with Anticipated Fits and Starts.  Residential Real Estate Will Continue to Fare Well, but Cautious and Conservative Underwriting Must Accompany Any Acquisitions   

The last 13 months seem almost surreal, and somehow, I could not have said it any better than Jerry Garcia and the Grateful Dead, “What a Long Strange Trip it’s Been,” even though the trip is not quite over.  However, we are certainly over the hump, though there will be fits and starts, and perhaps a spike here or spike there, a variant there, and variant here.  That is not to make light of any sort of possible resurgence, and I am sure the media will do its part to engage (read: scare) us during this period of time. But the reality is that the next six months will bring significant increases in economic activity, travel, and employment, terribly uneven as they might prove.

Meanwhile, residential real estate, both single- and multi-family assets, will continue to perform very well, as delinquent rents are recovered, evictions resume, the job market recovers, and a slew of 20-35 year olds vacate their parents’ basements or old bedrooms, and enter the rental market.  The demand-supply imbalances I discussed above and in previous missives will persist for the foreseeable future, and the private sector can only do so much to address a widespread public policy challenge.

Finally, you may have already received information about our latest offering, a 104-unit project in Phoenix, Urban Park Apartments, which offers compelling cash flows and upside as we increase rents to market and execute our value-add strategy to the Project.  I hope you might join us in the opportunity.  Meantime, we anticipate other offerings in short order, as we scour the Southwest, Sunbelt, and Mountain West regions for opportunities.  Stay tuned!

Thank you for your continued support of our firm and its endeavors.

Best,

Eric Sussman

People ask me to predict the future, when all I want to do is prevent it. To hell with more of the same. I want better.
—Ray Bradbury

Prepare for the unknown by studying how others in the past have coped with theunforeseeable and the unpredictable.
—George S. Patton

“Auld Lang Syne,” the poem by Scotsman Robert Burns, set to folk music, and routinely sung on New Year’s Eve to bid farewell to the year just passed, essentially begins with a rhetorical question: “Is it right that old times be forgotten?”

Should auld acquaintance be forgot,
And never brought to mind?
Should auld acquaintance be forgot,
And auld lang syne?

Well, unless you own a lot of stock in a videoconferencing company, bought Bitcoin early in the year, or have the last name Bezos or Musk, the answer is very likely “yes,” and you are overjoyed to say goodbye to 2020. Then again, with the way that 2021 has started, with an insurrection in our Nation’s Capital, along with sobering employment and COVID news, I am beginning to wonder whether December is holding January hostage.

Regardless of the year’s auspicious start, I anticipate that 2021 will mark a turning point, as vaccines become more widely available, people slowly revert to their old ways, and the Washington political scene (hopefully) returns to more boring norms. However, it will take some time before people become completely comfortable dining at restaurants, traveling widely, or fighting over free food samples at Costco. I have often joked that inertia is the most powerful force in the universe, which not only explains the B- I received in AP Physics, but why a “V”-shaped recovery was really never in the cards and why I disagreed with those who made such rosy forecasts.

At the same time, I maintain my cynicism that “this time is different” or that 2020 represents the permanent start of a “new normal.” That is not to say that certain trends I have written about previously (i.e., automation, Amazon, AI, domestic migration) were not accelerated by COVID and won’t persist, and our divided electorate will present substantial challenges going forward.

However, people will soon shed the Lulu yoga pants and head back into the office, though perhaps spending fewer days or hours there. Schoolchildren and college students will eagerly head back to campuses and live instruction, though perhaps engaging in more hybrid courses, integrating distant and in-person learning, creating opportunities and challenges in all levels of education. Young adults will leave their parent’s homes (can I get a hallelujah?), rent apartments, and return to urban cores, where social life is a tad more exciting than in the burbs. People will return to shopping malls, restaurants, bars, and even movie theatres; in time, and perhaps wearing masks all the while.

If history is instructive, and it so often is, the economy will bounce back sharply towards the end of this year and into 2022. My colleagues at UCLA Anderson recently predicted that we will reexperience the Roaring 20’s, Part Two. There certainly are eerie parallels between 1920 and 2020. Warren Harding, who won the presidency in 1920, following World War I and the Spanish Flu pandemic, campaigned on a platform that seems all too familiar, that “America’s present need is not heroics, but healing; not nostrums, but normalcy; not revolution, but restoration.”

Yet I am not quite as bullish as my Anderson colleagues, if just because of how we have so profoundly bungled our response to COVID and the vaccine rollout. While Biden and the Democratic-controlled Congress will pass significant stimulus legislation ($1.9 trillion, they say) shortly after the inauguration, the economy and job market will take time to recover. Certain markets, especially Los Angeles, San Francisco, San Jose, Seattle, and New York will recover more slowly, as their relative high living costs create consequential headwinds. Meanwhile, the IMF issued a more subdued global outlook in October, predicting next year’s U.S. real GDP growth to be an uninspiring 3.1% (globally, 5.2%), following projected a 2020 decline of 4.3% (globally, 4.4%).

Regardless, it seems like the Roaring 20’s, if not 1999, have already reappeared in some parts of the financial markets. The initial public offering market is on fire, with the first day trading in stocks like DoorDash (up 85.7%), AirBnb (up 212.8%), and Poshmark (up 241.7%) providing 1999-like whiplash. These sorts of price movements, the record number of SPAC (Special Purpose Acquisition Company) or “Blank Check” public offerings, and values of certain equities completely detached from underlying fundamentals (e.g., Tesla) make me very uneasy. I have told many a class that significant increases in public offerings, including unique and widespread financial machinations – and SPAC public offerings certainly qualify – often mark market tops. In 2020 alone, non-financial firms globally raised nearly $4 trillion from public investors, including record levels of junk bonds, in the face of COVID and global recession.

And commercial real estate? Industrial and multifamily properties, which have been the strongest performers, should continue to be stars of the show. That is not to say that either asset type is immune to broader economic challenges. However, the continued shift to e-tailing, last-mile distribution, and on-shoring of certain manufacturing activities will provide strong tailwinds for the industrial real estate, while high, if not unaffordable, single-family home prices, reduced housing starts, low supply of homes for sale, and an improving job market should provide strong foundational support for multifamily assets. Apartment cap rates should remain below five percent. Distressed retail, office, and hotel/hospitality markets may attract significant institutional capital seeking higher returns, but these opportunities will come with commensurate risk.

A couple of other data points in the multifamily markets are worthy of mention before I get much further. One, the national apartment vacancy rate increased to 5.2% in the fourth quarter, up slightly from 5.1% in the third quarter and 4.7% in the fourth quarter of 2019. Apartment rents declined 1.4% in the fourth quarter and over 3.0% during the year, with major metros like Boston, Seattle, Chicago, New York City, San Francisco, San Jose, and Washington D.C. suffering double-digit declines, while more affordable markets (e.g., Boise, Albuquerque, Bakersfield) actually saw higher rents (increases of 6.0 to 8.0%), so national figures mask significant variances in individual submarkets.

Finally, while overall rent collections nationally remain high, collections are down year-over-year and more payments are being made during the latter half of any particular month. Our overall portfolio has experienced similar collection patterns. Presumably, stimulus checks and an improving job market later this year should help, though we will have to see how the second quarter shapes up, once the next round of stimulus checks goes out and most people await their turn in the vaccination lottery.

In summary, it is a mixed economic bag, with the promise of widespread vaccinations providing room for optimism and an economic recovery in the latter half of 2021 and into 2022. The record high deposits at U.S. commercial banks ($16 trillion), all realizing negative real returns, will continue to provide substantial support for financial and tangible asset values. With real estate collateral underpinning something like 60% of the U.S. banking system, monetary policy will also likely continue to support asset prices and economic growth.

Meanwhile rich equity valuations (if not speculation in some corners of the market), increased deficit spending, burgeoning government borrowing (at all levels), higher household debt, and political divisiveness create uncertainty. On the other hand, the contrarian in me is not disappointed with some uncertainty, as we seek to identify and acquire investment opportunities.

While I usually minimize political discussions in these quarterly missives, the November elections will prove very impactful and cannot be ignored

Now that it is clear that the Democrats will control both the executive and legislative branches through 2022, performing a Georgia miracle along the way, we can expect a flurry of significant legislation and executive orders regarding taxation, infrastructure, healthcare, immigration, housing, and the environment. In the short-term, Congress will be preoccupied with a second round of impeachment proceedings and the proposed stimulus package, but our elected representatives will be busy bees during the next 24 months. Expect significantly higher corporate and individual income taxes (for those earning in excess of $400K per year) and less favorable tax policy for commercial real estate investors, including the likely elimination of 1031 tax-deferred exchanges.

How influential the progressive side of the Democratic Party will be remains to be seen, but I expect President-elect Biden to promote bipartisanship and balance, if he is true to his word…which I realize may be an oxymoron when it comes to politicians. However, in this case, I expect it to be true. And while I am concerned about deficit spending and increased levels of government debt, I have never been much of a believer in “trickle-down” economics, as I made clear in my memo from 2018 following the Tax Cuts and Jobs Act of 2017. I have since expressed my profound concerns about growing wealth inequality, so it may simply be the lesser of evils. I don’t know how our Republic can survive without a solid middle class, and higher taxes may be the bitter pill to be swallowed to accomplish this objective.

In any event, I found the following effectively captures the impact of the proposed Biden platform and the $5.4 trillion in additional spending it would compel over the next decade, only partly offset by higher taxes:

Clearly, the U.S. Treasury will also be busy bees, issuing greater levels of debt to fund these ambitious plans, with debt to GDP ratios likely reaching all-time highs by 2025.

While not concerned about increased debt levels in the short-run, as mentioned, I do fear the higher inflation and asset values they will likely fuel in the intermediate to longer-term. I don’t think for a second that the Fed’s “easy” monetary policies and elevated equity values are unrelated. However, at this point, the markets are not forecasting significantly higher inflation. It may just be that inflation in financial assets (including real estate) will be offset by broader deflation in everything from energy to consumer goods to office and retail rents.

In short, while I am not projecting a return to the 1970’s and the 10 percent inflation it brought, the after-effects of monetary stimulus, deficit spending, and corporate investment may catch investors off guard in 2022 or 2023.

History is full of surprises and when consumers see the light at the end of the COVID tunnel, significant increases in spending and prices may follow. Perhaps anticipating increases in government stimulus, deficit spending, and government borrowing, interest rates have begun to creep upward during the last few months.

While the Fed has indicated that it will keep interest rates “at or near zero” until 2023, yields on 10-year Treasuries have been creeping up as of late, to 1.10% at last glance (end of second week in January), versus 0.68% at the end of the third quarter. They began 2020 at 1.88%. While short-term moves and 50-basis point increases in short-term rates may seem insignificant, they can materially impact borrowing costs tied to both residential and commercial mortgages. For example, 30-year mortgage rates for single-family homes averaged 2.84% this past week versus2.67% at year-end.

In short, I expect interest rates to move in a narrow range during the first half of the year, as the economic recovery proves sluggish and uneven, but to rise during the latter half of 2021 and into 2022, as economic growth and consumer spending resume and the Fed’s money-printing endeavors result in greater financial and real estate asset inflation.

Meanwhile, the multifamily market should remain solid in coming years, with physical occupancies remaining high and rental growth resuming later this year

With slightly increased national vacancy, modestly lower rents, and collection challenges caused by COVID, 2020 was a tougher year for multifamily assets, following years of strong performance. Regardless, multifamily assets certainly outperformed other classes of investment real estate (e.g., retail, office, hotel/hospitality).

However, not all multifamily markets are created equal, and national-level data obscures significant local and regional differences, as mentioned above. For example, overall rents dropped in all 10 of the most expensive cities for renters during 2020, with San Francisco, Seattle, Boston, and New York rents declining 20% or more between March and year-end. Yes, 20% or more. Eighteen of the 30 largest U.S. cities saw more renters departing, as opposed to 2019. With the option to work from home, many renters fled these larger, dense cities for suburbs, mid-sized cities, and even vacation rentals, resulting in higher rents in many locales.

Before the pandemic, remote work was already expanding in the U.S. In 2019, work-from-home employees accounted for nearly 12.0% of the total labor market, but in response to the pandemic, that figure shot up to 35%, according to a recent report from Newmark. While most of these workers will return to the office once the pandemic ends, it is clear that the remote-work segment of the market will grow significantly, perhaps evolving into an office-remote hybrid model. As a result, many apartment units are being reconfigured to better accommodate work-from-home needs, by creating indoor workspaces, adding balconies and more outdoor space, and providing high-speed internet and cellphone coverage throughout particular properties.

Meanwhile, the U.S. is becoming a “renter nation” yet again. According to RENTCafe.com, an estimated 45 million Gen-Zers (people born in late 1990’s or early 2000’s), will have entered the housing market by 2025, most of whom are likely to rent. Overall, renters still comprise 33.6% of the U.S., up from 33.0% in 2010. The reality is that renting remains more affordable than purchasing a home in 18 of the 25 most populated counties in the country, and in 29 of 44 counties with populations exceeding one million, assuming that potential homebuyers have the funds to meet down payment requirements.

Between the high cost and lack of supply of buildable lots, high land and infrastructure costs, volatile material prices (i.e., lumber, copper, brass, steel), a challenging labor market, and excessively lengthy entitlement processes and regulations, single-family residential home construction lags substantially below longer-term historical averages and the supply of new homes declined again last year. These trends are likely to persist longer-term, which may be mediocre news for prospective homebuyers, but good news for apartment owners and investors.

The combination of low supply of homes for sale and record-low interest rates (30-year mortgages under 3.0%), it can’t come as any surprise that home prices nationwide increased 8.2% between November 2019 and November 2020, according to CoreLogic, with virtually every region sharing in the fun. But with the median home price in the U.S. hovering around $320,000, affordability remains a challenge in many markets, providing additional foundational support to the multifamily markets.

Meanwhile, developers are poised to add over 300,000 apartment units in 2021, down slightly from 2020, as construction delays caused by both the pandemic and economic slowdown push some projects into 2022.

Finally, if you are interested in reading more about our housing markets and find yourself with substantial free time, I might refer you to this year’s “State of the Nation’s Housing,” published by the Joint Center for Housing Studies of Harvard University, which you can find here: https://www.jchs.harvard.edu/state-nations-housing-2020. The Report echoes many of the same themes from prior years: a lack of affordable housing, unequal access to homeownership, and calls for “comprehensive re-envisioning of national housing policy.”

Clearly, we need to watch the job market very closely to gauge the strength and sustainability of any economic recovery

In the absence of government stimulus, a resurgence in COVID cases (including a more contagious variant), and the fractious discourse voiced from certain politicians and their supporters, the job recovery has stalled. Employers cut 140,000 jobs last month, the first net decline in employment since last spring, and initial claims for state unemployment claims exceeded one million during the second week of January, a figure last seen in July.

Until we reach herd immunity from COVID and the Biden Administration settles in, I don’t think we will see marked improvement in the unemployment rate, which remains at 6.7%. The job losses have been especially hard on people of color and the younger demographic. In fact, as of the end of September, some 25 million young adults were living with their parents, two of whom happen to be cohabitating with yours truly. The silver lining is that these young adults will likely become renters in short order.

Overheated equity markets may represent the greatest economic risk beyond COVID-19

While calling market tops in the stock market may be a fool’s errand, recognizing when equity values become detached from underlying fundamentals is not. Having lived through a few market cycles, I am concerned by the recent flurry of initial public offerings, which have soared on their trading debuts, the widespread issuance of unique securities (e.g., SPACS, cryptocurrencies), increased speculation by retail investors (welcome to Robinhood), and substantial growth in margin debt. As I have stated before, significant liquidity and near-zero interest rates can create serious fuel for financial dislocations.

If a picture tells a thousand words, equity market returns have diverged from changes in real GDP in recent years, especially in 2020.

Meanwhile, “zombie” company debt is at an all-time high, exceeding $1.3 trillion. These are firms whose interest expense exceeds their operating income, whose survival depends on financing (and refinancing) with cheap debt. These firms comprise some 19% of the Russell 3000 Index, or 571 companies, employing more than 800,000 people. While recessions generally act – in Darwinian fashion – to restrict these companies and their operations, a combination of cheap and readily available debt and equity capital, along with government largesse (e.g., PPP loans), have allowed these firms to continue operating.

And margin debt? It recently hit an all-time in November 2020, a record $722.1 billion, topping the previous high of $668.9 billion and representing a 28% increase from the prior year, according to the Financial Industry Regulatory Authority (FINRA). I would note that March 2000 and July 2007 represented prior near-term highs in margin debt. Perhaps “this time is different” because interest rates are so low, but color me a cynic.

Finally, I should not neglect to mention the significant concentration in equity valuation, represented by large-cap technology companies. At the start of 2020, Alphabet (Google), Amazon, Apple, FB, and Microsoft were worth approximately $5 trillion, collectively, and comprised about 17.5% of the S&P 500. Fast forward to today and the figures are $7 trillion and 22%, respectively. While these firms are truly outstanding, and anything but zombies, this amount of market concentration simply makes me a tad uneasy.

And, as usual, if you will indulge me, there are always additional tidbits I think are worthy of discussion

  • Private Sector Assuming Public Sector’s Failures re: Affordable Housing: In a recent WSJ article, Amazon indicated that it would commit $2 billion to “create and preserve affordable housing in three of its employment hubs: Seattle, Arlington, and Nashville.” You may recall that I described in prior memos how Alphabet/Google, Apple, and Microsoft had previously made similar pledges of $1 billion, $2.5 billion, and $750million, respectively. Therefore, in sum, four of the largest tech companies I just described as representing such a substantial percentage of our equity markets, have committed $6.25billion to affordable housing. However, it is not clear how these “commitments” will translate into actual housing given broader market realities I describe elsewhere. Regardless, $6.5 billion is not really impactful, either to these firm’s bottom lines or overall housing affordability. However, these actions reflect how the private sector is trying to assume responsibilities normally tasked to the public one.
  • The Baby Bust Continues: Contrary to many predictions that quarantining and isolation might lead to a “baby boom” (one can only watch so much Queen’s Gambit, I suppose),analysts now expect up to half a million fewer babies in 2021 (3.3 million) versus 2019 (3.8million). My sense is that concerns about the economy are the principal driver, though COVID and the worries it has brought are not exactly aphrodisiacal.

Here is the upshot. The U.S. population is approximately 330 million today and growing only 0.5% per year, between sharp drops in fertility rates and immigration. Therefore, the country is likely within 10% of its peak population and may never reach 400 million residents. While there is a growing number of seniors living to 85 and beyond due to healthcare advances, the number of people in the U.S. under 60 is decreasing every day. Therefore, many metros will see no changes in their populations for the foreseeable future. Others will see population declines. These demographic shifts do not bode well for future economic growth (see Japan).

So follow the Baby Boomers, the growing cohort of those over 65, who are affluent and tend to favor cities in the South and Southwest, such as Phoenix, Vegas, Tampa, Orlando, Austin, Dallas, Nashville, Charlotte, and Raleigh-Durham. These markets ought to fare relatively well, while Millennials flock to some of these same cities, but also to Denver, Seattle, and Portland.

  • Domestic Migration Continues: Over the past several years, I have written extensively about domestic migration, how California, for example, has experienced population declines every single year between 2010 and 2019, a trend most certainly continuing into 2020 and beyond. New York City lost 376 residents each day in 2019. Previously these population outflows were offset by international arrivals and domestic migration. Not any longer. In some cases, the wealthy are moving to more tax-favored states (e.g., Nevada, Texas, and Washington). In others, corporate residents (and presumably a large number of their employees) are relocating. Oracle, HP Enterprises, and CBRE recently announced that they were moving their headquarters out of California to Texas. COVID has clearly accelerated the trend, as 18 of the 30 largest US cities saw more renters leaving compared to 2019. It should come as no surprise that we are mostly underwriting and evaluating investment opportunities in these “destination markets.”
  • 2020 Was, Unfortunately, a Banner Year for Bankruptcy Lawyers: As the economic repercussions from the COVID pandemic continued to unfold, corporate bankruptcies piled up. According to S&P Global Market Intelligence, 630 companies declared bankruptcy during the year, their worst levels since 2010 when 900 companies did so. By comparison, 578 and 513 companies declared bankruptcy in 2019 and 2018, respectively. High-profile bankruptcies included Neiman Marcus, J. C. Penney, Ascena Retail Group, Tailored Brands, and Chesapeake Energy. Some 23 companies sought bankruptcy protection during just the last two weeks of 2020.

As COVID forced lockdowns across the country, many retailers suffered terribly. According to Coresight research, retailers shuttered 8,400 locations through the third quarter of 2020, putting the year on track to surpass 2019’s record of 9,302 closures. Nearly 20% of all restaurants closed permanently last year. If a single graph indicates just how bad the retail apocalypse is in some locales, take a look at what has happened to asking retail rents in Midtown Manhattan. I think a 55% drop in rents qualifies as something between brutal and ugly. Amazingly enough, even with these far reduced rents, vacant storefronts still lurk on every block.

In closing, while the first half of 2021 will be challenging, I am optimistic the latter half of the year will represent a significant turning point and that the economy in 2022 will strengthen considerably

When I find myself with downtime (something of a rarity), I often reach for one of my favorite books, the “Complete Works of Calvin & Hobbes.” In fact, I believe that fictional “Calvin” is among my three favorite philosophers (as opposed to John Calvin, the 16th Century theologian). And if you are wondering, the other two are Yogi Berra and Dilbert. Anyhow, the very last published Calvin & Hobbes strip, released on December 31, 1995, made me think about 2021, and its message of hope, optimism, and the future:

We have been through an awful lot this past year, and perhaps it is darkest before dawn. With recent events in D.C. and sobering data and news on COVID, it can be hard to muster optimism, but I am certain that brighter days lay ahead, and with adversity and uncertainty, always comes opportunity.

The entire Clear Capital team wishes you and yours a healthy and prosperous 2021, and we look forward to sharing both our thoughts and investment opportunities with you throughout the year. For those of you who participated in our recent offerings in Carrollton, Texas, and Victorville, California, thank you. We appreciate your collective support of our firm and its endeavors.

Best,

Eric Sussman
Founding Partner

I figure lots of predictions is best. People will forget the ones I get wrong and marvel over the rest.
—Alan Cox

The best qualification of a prophet is to have a good memory.
—Marquis of Halifax

I must be off of my rocker to try and make sense of profoundly mixed economic data and provide economic forecasts immediately preceding a presidential election, especially this particular three-ring political circus. However, before you have me committed to Bedlam, please note that I strongly considered delaying this memo until after November 3rd, when we will all know who will control the Executive and Legislative branches of our federal government, and therefore be better able to predict what may be forthcoming as a result. I could have very easily blamed the delay on the hours I spent trying to get through this election’s War and Peace-sized California Voter’s Guide. Seriously, 112 pages? However, perhaps against my better judgment, I have decided just to get on with it. Time is money, after all.

In short, November’s election will likely and very consequentially impact future economic, fiscal, and tax policy. While I generally avoid political discussions here – Lord knows that we get plenty of that elsewhere and I care not to offend (any more than usual, anyhow) – the significance of this election cannot be overstated, if seen only through a fiscal and economic lens. COVID-19 is still wreaking havoc on the global economy, disrupting nearly every facet of life. Ten states reported their highest level of new cases just this past Friday. With the timing, availability, and efficacy of a vaccine unclear, when and how the economy and our way of life return to “normal” remain uncertain. While the economy will recover, the pandemic will leave deep scars, creating difficult policy choices and trade-offs no matter who emerges victorious in November.

Should Biden prevail and the Democrats take control of Congress, we should – at a minimum – expect impactful tax reform, reversing much of the Tax Jobs Creation Act of 2017 and substantially increasing taxes on wealthy individuals, estates, and corporations. I anticipate that some very favorable commercial real estate related tax laws (e.g., 1031 transactions, bonus depreciation, reduced taxes on real estate related LLCs) will go the way of the dodo bird. Additional and significant economic stimulus (read: trillions) will arrive, with aid directed to families, schools, restaurants and small businesses, airline workers, and those blue-collar workers particularly impacted by COVID-19. Government borrowings and our deficit will grow substantially, at least initially, expanding upon 2020’s already daunting $3.1 trillion budget deficit.

Should Trump prevail and Congress remain divided, the next four years will experience continued legislative gridlock, with the courts and judges playing an increasingly outsized role in interpreting, if not implementing, policy. Additional economic stimulus will be delayed and may never arrive. Late-night comedians, political pundits, former White House staffers turned book writers, and cable news personalities will continue to thrive. Much else is harder to predict, if just because political and other divisions will fester and likely produce unpredictable outcomes.

With this being said, it is not surprising that this has been the most uneven economic recovery in modern U.S. history, which some have aptly described as a “K”. White-collar workers and those owning financial assets are faring well enough, while the working class and those owning few financial assets, struggle. Consider that Wall Street experienced its best back-to-back quarters since 2009, with the S&P 500, DJIA, and NASDAQ up 8.5%, 7.6% and 11%, respectively, during just the third quarter alone. Domestic equity markets are up more than 50% since spring, with indices trading at or near all-time highs on both an absolute and relative (price-earnings ratio) basis. The median home price (asking) in the U.S. climbed to $350,000 in September, up over 11% from the prior year, according to realtor.com, an all-time record. Again, those who own equities and real estate are relatively happy campers.

Meanwhile, the labor market has stagnated, with the national unemployment rate sitting at 7.9%. While perhaps a noteworthy improvement from the double-digit unemployment rates experienced earlier this year, unemployment has more than doubled from pre-pandemic levels, and there are gloomy clouds on the horizon. Jobless claims have jumped yet again, with first-time claims for the week ending October 15th, hitting their highest levels since August (898,000), while some 700,000 workers have left the workforce. In addition, a number of large companies have recently announced new rounds of layoffs: Disney (28,000 across its U.S. theme park division), Royal Dutch Shell (9,000), and Boeing and several of the major U.S. airlines (as many as 100,000, collectively). The National Restaurant Association said that some 100,000 restaurants have closed over the past six months, putting three million employees out of work. Again, it is a tale of at least two economies, for those that have, and those that do not.

In this economic dichotomy, the multifamily market continues to perform fairly well, though headwinds and tailwinds are engaged in a fierce tug-of-war, providing mixed results. Overall, physical occupancy remains high, over 95.0% nationally, though rents have softened. Occupied apartments climbed by nearly 147,000 units in the third quarter, nearly four times second quarter figures. While over 90% of apartment households paid full or partial rent in September, these results reflect declines (about two percent) from the prior year, and in the absence of further government largesse and marked improvement in the job market and unemployment claims, I see more downside to these results, especially in certain markets.

However, as I have discussed previously, different market segments and geographies are witnessing different results. For example, New York and San Francisco have experienced double-digit percentage rent declines over just the past six months. I recently read that there are some 16,000 empty apartments in New York City, the highest level since the 1970’s, nearly tripling the vacancy rate. Meanwhile, other markets (e.g., Albuquerque, Colorado Springs) are achieving rental growth, albeit modest, and attracting residents from more expensive (read: California) locales. It is not surprising that it is these markets – principally in the Sunbelt – where Clear Capital is focusing its acquisition and underwriting resources. Our recent offerings in Lakewood, Colorado, and Carrollton, Texas reflect our views and perspective. Even with our principal focus on the Sunbelt, our primary focus is always on the upside of real estate. As such, we are seeking opportunities in the Golden State that we call home. While this is somewhat of a contrarian approach, we believe there are good opportunities in California – mainly in the Inland Empire region and in workforce housing assets.

In summary, I don’t anticipate the economy and employment to return to pre-pandemic levels until 2022, with a double-dip recession quite possible between now and the end of the first quarter of 2021. However, much depends on the upcoming election and what government stimulus programs arrive…or not, and whether lenders continue to work with borrowers and forbear delinquencies to prevent a wave of foreclosures and forced sales. Presently, some 3.5 million home loans (about 7.0%) were in forbearance as of September 22nd, according to the Mortgage Bankers Association, and commercial foreclosures have been creeping upwards.

Low interest rates and substantial liquidity will continue to provide critical foundational support to markets and asset values, and while we continue to believe strongly in the multifamily story, conservative underwriting and sensitivity analyses are a must.

While apartment fundamentals remain intact, transaction volumes have dropped sharply, and bid-ask spreads, have widened. Meanwhile, the single-family residential market has surged in the face of record-low supply and interest rates

Commercial real estate transaction sales volume (including apartments) dropped by two-thirds in the second quarter from the same period last year, and while data for the third quarter has yet to be released, I anticipate that it will reflect similar declines. According to CoStar, some $35.5 billion in transactions closed in the second quarter, down 69% from the nearly $114 billion in sales during the same period last year. Meanwhile, property listings dropped 15%.

Yet, apartments are still attracting significant investment capital. In one noteworthy transaction, CIM Group, a local institutional player here in Southern California, purchased a 2,346 unit portfolio in Alexandria, Virginia, for over $500 million. Closer to home, Clear Capital listed one of its assets for sale in the third quarter, an affordable project in Azusa, California (Iris Gardens), and attracted multiple bidders. Reduced rent headwinds are being offset by lower interest rates, liquidity, and certain demand tailwinds.

However, the pandemic has certainly shifted what renters seek in units. One is space. Prospective tenants want larger units and common areas. Bachelor, single, and studio units are not nearly as popular in the era of COVID as larger two- and three-bedroom units, and with good reason. Previously, tenants placed great value on swimming pools, gyms, and flexible common areas. Now, with so many residents working from and eating at home, balconies, package lockers, and HVAC/air filtration systems have become relatively more appealing. Record numbers of young adults (18-29) have returned to the nest as a result of COVID, university closures, and stubbornly high rents. Ultimately, these youngins will return to the rental market, so when the economy more sustainably recovers, these prospective renters should provide additional tailwind to the multifamily market.

Meantime, the single-family residential market continues to shine, reflecting pent-up demand, relocations to the suburbs from urban cores, record-low numbers of homes for sale, a dearth of new construction, and cheap debt, with fixed-rate, 30-year home loans available in the 2.9% range (if not lower).

Nationally, inventory of homes priced under $100,000 was down 32% in July from a year earlier, with homes priced between $500-700,000, down 9%. Baby boomers with some $10 trillion of equity in their homes are not selling or moving, certainly not in the midst of a pandemic. Finally, institutional home-rental firms like Invitation Homes (the country’s largest rental-homeowner, at 80,000 homes), Tricon Residential, American Homes 4 Rent, and Roofstock have been snapping up large swaths of homes in certain markets. Invitation Homes has been spending some $200 million each quarter in new acquisitions. A few graphs, capturing Case-Shiller housing data (threemonth lag), total volume of home sales, and national homeownership rates, tell a thousand words:

At this point, I see house price increases moderating in the absence of further economic stimulus or real gains in employment levels or wages, as mortgage rates have likely reached a near-term floor. The multifamily market should continue to attract tenants and maintain high occupancy rates, but rental growth will be harder to come by, and we are underwriting prospective opportunities with this perspective in mind.

With 10-year Treasury Yields hovering around 0.70%, mortgage rates under 3.0%, and Fed assurances that low rates are here for the foreseeable future, asset values have significant foundational support

If I had told you any number of years ago that you would be able to secure a fixed-rate, 30-year home loan at a rate of between 2.50% and 3.0%, you might have accused me of having inhaled or consumed a little of California’s most infamous herb (no, not kale). Yet, here we are. 30-year mortgage rates hit a record low just last week, averaging 2.81%, the lowest rate since Freddie Mac began publishing such data back in 1971. For comparison’s sakes, the 30-year mortgage rate averaged 3.69% a year ago.

If you think mortgage rates are strictly low on single-family residential properties, I am presently refinancing an existing commercial loan on an industrial portfolio here in Southern California at a fixed rate of 3.05% for ten years. You could have pushed me over with a feather when I received that LOI. Low rates are global and even real corporate bond yields (after inflation) recently turned negative.

Many moons ago, as an undergraduate economics major, I had to learn my John Maynard Keynes macroeconomic framework (“The General Theory of Employment, Interest and Money”) and views that the government had a significant role in managing economic or business cycles, through its power of the purse. Over time, Milton Friedman and the monetarists, who emphasized a focus on inflation through control of money supply, found their voices in the stagflation, high unemployment, and high inflation of the 1970’s. Paul Volcker, Chair of the Federal Reserve in the 1980’s, crushed inflation by constraining money supply, but in the process, the economic downturn worsened and unemployment increased.

In the last 20 to 30 years, it seems that a sort of marriage of the two disciplines evolved, with both monetary policy and fiscal policy being used to manage federal spending, economic growth, interest rates, and “reasonable” debt levels, based on an overall two percent inflation target. That is until recently, anyhow, perhaps because fiscal policy has become overly politicized, leaving the federal government with fewer options in its toolkit.

Sure enough, in an August speech, Fed Chief Jerome Powell, indicated that the Fed would ease inflation targets (read: can the 2% goal) and no longer necessarily raise rates preemptively to curtail higher inflation. Such a policy shift is not likely to be impactful in the short run, but looking back, the Fed probably would not have raised rates in the last five years as the economy recovered and fears of inflation arose. Essentially, the Fed is telegraphing that it wants core inflation above two percent to counter low growth in GDP, and that we should anticipate longer periods of lower rates and accommodative monetary policy (through 2023 at least). With core inflation presently running at less than 2.0%, and numerous economic headwinds still present, deflation remains a greater risk at the moment than any sort of significant or runaway inflation.

The punchline is clear. Low rates are here for the foreseeable future, which will provide some support for asset prices: equities, bonds, and real estate. Those seeking high yields are going to find few alternatives, and cap rates on commercial real estate investments will remain compressed. Couple low rates with excessive liquidity and you have a recipe for stubbornly high, and in certain cases (read: certain technology-related stocks), inflated asset values.

GDP and a fragile job market present the biggest risks to economic recovery and asset prices

In the face of lingering COVID infections, inconsistent policy responses across all levels of government, the absence of additional governmental intervention and stimulus, and yes, political uncertainty, the recovery in the U.S. job market has stalled. While the published principal unemployment rate improved to 7.9%, a 0.5% improvement over August figures, and half of the jobs lost since the start of the pandemic have been regained, some 700,000 workers have since dropped out of the labor force (as mentioned above), signifying that actual unemployment is far higher than 7.9%. While nonfarm jobs increased 661,000 in September, weekly jobless claims remain persistently elevated.

While third quarter GDP is expected to increase over 30%, that growth comes on the heels of a record-setting second quarter decline of 32.9%, both records since record-keeping began 70 years ago. Keep in mind that 30% growth following a nearly 33% decline still means that GDP is down more than 10% since the pandemic began. The question is what happens in the fourth quarter and beyond. At this point, I think the likelihood of a double-dip recession is significant, especially in the absence of additional federal stimulus. Without stimulus, herd immunity, or a vaccine, we will remain in an extended period of economic malaise. That is, even if we don’t experience a double-dip, hopes of a “V” or “U” recovery become significantly less likely.

Speaking of which, it’s unfortunate that government stimulus proposals have become so heavily partisan, when the economy might very well benefit from a kick in the pants

I recognize that many believe the government should take a hands-off view towards the economy and leave markets alone to their own devices, while others believe Uncle Sam and state governments ought to take a heavier hand in providing one form of economic stimulus or another. Frankly, it seems that individuals within their own political parties don’t necessarily agree on how much stimulus should be provided, if any, and/or to whom it should be directed. I fall in the middle of these two camps and believe that some form of stimulus will aid in accelerating economic recovery. One proposal that seemed eminently reasonable and logical to me was put forth from Senator Michael Bennett of Colorado, who wanted to link federal unemployment benefits to local unemployment rates. Of course, this means it has absolutely no chance of passing.

I know that growing national debt levels scare the pants out of many, though conservatives are far less focused on this issue today than they were four years ago. By 2021, if not sooner, our outstanding national debt will likely exceed the size of our entire economy for the first time since World War II.

The question becomes when are our national debt levels truly excessive? There simply is no consensus. Keep in mind that Japan’s gross debt is over 237% of its GDP, so one can argue that we have a long way to go before we are truly excessively indebted. Then again, knowing that we are quickly catching up to Portugal and Italy hardly gives me the warm and fuzzies.

So, should the government pass stimulus legislation or not? I guess it is the lesser of evils and risks in my view, and I believe some stimulus is necessary, while we can certainly debate how much and to whom the largesse should be directed. I suppose we will know soon enough. I wonder if Vegas is taking odds on whether it will happen, and if so, before or after early November.

If November’s California Ballot Measures are any indication, the public sector real estate creep is here to stay

Earlier in this memo, I half-joked about the length of the California Voter’s Guide, which includes no fewer than three very material real estate related measures: Propositions 15, 19, and 21. Proposition 15 represents the largest potential tax increase in California history. If passed, commercial properties (all residential properties are excluded) would be reassessed at least every three years, and taxed accordingly. Presently, property taxes are based upon a property’s last sale price, increased no more than two percent each year. Proposition 19 would modify property tax benefits accorded certain inherited properties, while Proposition 21 would significantly expand rent control. At this point, all three measures appear on their way to lose, and I am shedding no tears about that. While I willingly acknowledge that property tax reform is badly needed, these propositions are too onerous, and will have long-lasting negative repercussions for business and employment in the State, while failing to provide more and less expensive housing.

Meantime, any number of other ballot measures, laws and regulations across the U.S. are addressing evictions for both residential and commercial tenants, generally seeking to balance out the needs of both tenants and landlords. However, as I have said many times, there are far more tenants who vote than landlords who do so. The CDC has barred evictions for as many as 12.3 million renters through the end of the year, mostly tenants in buildings financed with federally-backed mortgages, extending protections provided by the CARES (Coronavirus Aid, Relief, and Economic Security) Act passed in late March. Those protections expired in July. While these measures generally do not relieve tenant obligations to pay rent and are arguably unconstitutional (“private property shall not be taken for public use without just compensation”), it is very unclear how landlords will be able to recover delinquent rent or pursue damages from regulations ultimately determined illegal.

This is not some theoretical issue as our firm – across our nearly 4,000 units – has a number of delinquent tenants, some of whom appear to merely be taking advantage of the situation, and we are hardly finding it easy to pursue any sort of meaningful recourse against them. Moral hazard is real. We are expending significant resources to collect delinquent rents and to work with tenants as best we can, within the confines of legal and political realities.

And, of course, there are a number of other interesting tidbits and trends which impact markets, the economy, and commercial real estate

Every quarter, there are a few other relevant and material data points, trends, or tidbits that are worth mentioning and discussing. The third quarter of 2020 was certainly no exception, so without further ado, here goes:

• The brick-and-mortar retail apocalypse continues: I know you don’t need me to tell (remind) you about what is happening to traditional retailers, who were being Amazoned (a new verb) and e-tailed before the pandemic, which accelerated the trend. The impact on just the job market alone is remarkable, and many of these retail-related jobs will not be returning anytime soon. 2020 is shaping up to be a banner year, and not in a good way. Here’s the sobering reality:

In time, will some of these jobs return and/or other retailers or uses occupy vacated leaseholds? Perhaps. But I don’t see any sort of “V-” or “U-like” recovery here.

• Expanding wealth inequality may be our single greatest economic and social threat: Over the years, I have repeatedly expressed concerns about the increasing chasm
between the “haves” and “have nots” in the U.S., and the impacts it has on housing, the economy, markets, and even our social fabric. In parts of California, and frankly, throughout much of the country, we may need to modify the list to the “haves,” the “have-nots,” and the “homeless”. I drive by entire homeless encampments each and every morning here in west Los Angeles. I am certain that some of the social unrest we witnessed this past summer, some of which persists to this day is based, in part, to wealth inequality. Perhaps some will disagree with me, but I believe it is not good for the stability, if not sustainability, of our economy, neighborhoods, and political system. If there is any silver lining tied to our business, it sure is creating demand for affordable housing, and we are actively looking for investments in that space, such as our present offering in Carrollton, Texas and our upcoming attainable workforce housing offering in Victorville, California. But I am not blind to the broader potential significance and import of this disturbing trend.

I do hope that whatever comes of the upcoming election that we – politicians and voters from all sides of the aisle alike – address the wealth disparity and homelessness issues, or
expect increasing social unrest and divisiveness to become recurring realities, and I can’t see any positives in that.

• Foreign investment in our real estate markets has declined sharply over the past year: It should come as no surprise that foreign direct investment in U.S. real estate
has dropped sharply in 2020, declining by nearly 40% during the first half of the year as compared to the same period in 2019. A recent Wall Street Journal, “Foreigners Buy Fewest U.S. Homes in Years,” says it all, though it is just not single-family homes, but all types of residential and commercial real estate for which foreign buyers have lost some appetite.
Obviously COVID is playing a role, but travel restrictions and constraints on capital outflows in places like China, have certainly not helped the cause.

While many predict a bounce in foreign investment next year – we are invariably an optimistic lot, after all – I am not nearly as sanguine, though I believe the U.S. will remain a
relatively safe and attractive place for foreign investment capital. I merely think CBRE’s anticipated 2021 bounce will be less robust.

• Higher property and casualty insurance premiums are a-comin’: Between the California and Colorado wildfires, hurricanes in the Atlantic, rain and flooding in the Midwest, and COVID-19, significantly higher property and casualty insurance premiums are coming our way, and all of us will be likely impacted, certainly any and all homeowners and investors in investment real estate. According to an industry report I just read (https://www.usi.com/content/downloads/2020_PC_Market_Outlook.pdf), premiums will increase by at least 10% for most standard coverages, while properties located in areas more prone to natural disasters or “catastrophic loss,” may see premium increases of anywhere from 25 to 40%. We are seeing premium increases across our portfolio, and these higher costs are not able to be passed onto our residential tenants. Meanwhile commercial tenants under triple-net leases are going to see far higher common area charges in 2020 and beyond.

• All that glitters is gold, and it’s not just Led Zeppelin who thinks so: Since the start of the pandemic, gold prices have surged, up some 25% in 2020, hitting an all-time high of over $2,067 an ounce in August, before falling back to around $1,900 an ounce where it presently trades. The decline in the U.S. dollar, the increased federal deficit, and lower interest rates (reducing carrying costs) have all played a part in the move.

Meantime, gold is not the only commodity that has “shined” of late. Lumber futures have more than doubled since early April, and prices reached the highest level seen since record
in spring of 2018. Prices have risen because producers idled plants and saw mills in US and Canada in March, beetle infestation, and, of course, the wildfires. Lennar, the largest U.S. homebuilder (by revenue), said that it is intentionally curtailing construction and sales to avoid higher material costs, hoping to make up difference in higher future sales prices.

If homebuilders truly cut back on construction and new starts as a result of these higher commodity prices, the supply of new home inventory will be further constrained, putting
additional upward pressure on pricing of existing homes for sale.

In closing, while the next few months will bring impactful news, Clear Capital’s core investment philosophy, approach, and focus have not wavered, as we continue to focus our acquisition and underwriting efforts in the Sunbelt and in our home state of California

First and foremost, I hope that you and those in your close circle of friends and family remain in good health. That is of paramount importance, of course. I also hope that you have voted or will do so, regardless of where you sit on the political spectrum. We should never take this most sacred of rights for granted. And while I won’t tell for whom you should cast your presidential vote, I might gently nudge you to vote “no” on Propositions 15, 19, and 21, at a minimum, for those of you casting your lots here in California.

As mentioned at the outset of this memo, making forecasts in this environment is no easy task, as the outcome of the election could profoundly shift the direction of the country: economically, fiscally, and certainly, politically. I warn students nearly every quarter about the use of “Ctrl-R” and “Ctrl-D” functions in Excel, where one merely copies certain spreadsheet cells down and to the right, as though one year’s results or forecasts can be mechanically extrapolated into the future. I am trying very hard not to fall into that same trap myself.

However, whatever happens on November 3rd and thereafter, I remain steadfastly optimistic about the multifamily market and our acquisition, underwriting, and investment strategy. I am profoundly grateful to the entire Clear Capital team, which has faced the COVID-related challenges head on and worked extremely hard through some trying times. For those of you who invested in our recent Lakewood, Colorado opportunity (Falls at Lakewood), which was over-subscribed, and for those considering our present offerings, a 244-unit, affordable opportunity in Carrollton, Texas, and a 200-unit attainable workforce housing opportunity in Victorville, California, thank you for doing so, and for your continued support of our firm.

Best,

Eric Sussman
Founding Partner

I always avoid prophesying beforehand because it is much better to prophesy after the event has already taken place.
—Winston Churchill

There are decades when nothing happens and then there are weeks where decades happen.
—Vladimir Lenin

As I reflect upon the first half of 2020, I can’t help but think about the book, “Fooled by Randomness: The Hidden Role of Change in Life and the Markets,” written by Nassim Nicholas Taleb, which I read nearly 20 years ago, when it was first published. A fairly quick read (and one that I recommend), it provided me with an appreciation for statistical aberrations and those seemingly random events – wars, financial crises, and yes, pandemics – which, while perhaps precisely unpredictable, routinely and very materially impact life, markets, and investment returns.

However, though I recognize that these “black swans,” as they are often labeled (and coincidentally, the title of one of Mr. Taleb’s subsequent books), are bound to occur over a long enough timeframe or investment horizon, I can say that neither a global pandemic nor widespread protests over police brutality and social/economic injustice appeared on my 2020 Bingo card. Over 140,000 Americans have now died from COVID-19, and records for new infections are occurring daily, most notably in Florida, Texas, and California, which, along with several other states, are in some form of economic lockdown. The deaths of Kobe Bryant and Qasem Soleimani, the Australian wildfires, the impeachment acquittal, the collapse in oil prices, and the Tiger King seem like distant memories, reflecting just how unusual (dystopian?) this year has been, with each day feeling a bit like Groundhog Day. I have never asked myself, “what day of the week is it today?” more than I have in these past four months. Thank goodness the murder hornets have not yet reached our shores.

In summary, the second quarter of 2020 was one that most of us would rather forget, distinguished as it was by several inauspicious records. We have already witnessed more bankruptcies this year than in all of 2008, the year that Lehman Brothers – the largest single bankruptcy of all time – failed, along with record levels of unemployment and the sharpest quarterly decline in GDP in U.S. history. The second quarter Chapter 11 graveyard includes firms such as Hertz, JC Penney, Neiman Marcus, Frontier Communications, Chesapeake Energy, Intelsat S.A., and Diamond Offshore. I am not exactly going out on a limb when I suggest that there will likely be several more names added to this list before 2021 arrives, not a moment too soon.

In fact, the WSJ and Coresight Research report that U.S. retailers are on track to close as many as 25,000 stores this year, more than double the previous record. However, it is simply too early to be sure what the ultimate fallout will be. Last week, the Wall Street Journal reported that JP Morgan, Citigroup, and Wells Fargo have set aside some $28 billion in reserves to cover anticipated pandemic-related losses, adding over 30% to previously accrued loan loss allowances.

Although the June unemployment rate of 11.1% represents a marked improvement over the 14.7% and 13.3% rates reported for April and May, respectively, these employment gains will likely prove transitory as more cities and states mandate closures (e.g., Atlanta, West Virginia), while others reimpose them (e.g., California, New Mexico, Oregon); the requirements that employers maintain employment levels under the Paycheck Protection Program burn off; and, both federal and state unemployment benefits expire (the $600 additional federal unemployment stimulus expires this month). Just this week, an additional 1.4 million claims for unemployment were made, representing the 18th straight week of unemployment claims exceeding one million. Not surprisingly, the U.S. economy shrank dramatically during the quarter, and while final figures are not yet available, consensus estimates are that U.S. GDP declined over 40% in the second quarter. Ouch.

And if this were not enough, CNBC recently reported that 32% of U.S. households missed their July mortgage payments, at least through the first week of the month. However, because most mortgages allow a ten-day grace period before late fees apply, we cannot be sure just how deep or pervasive the problem might be, at least not yet, but I can’t imagine that mortgage delinquencies on single-family homes, hotels, and retail assets will be anything but significant, if not record-setting, despite recent 30-year single-family residential mortgage rates recently hitting an all-time low of 2.98%. I recently read that over two-thirds of Americans have less than $1,000 in savings, so unless labor markets continue to rebound, which appears unlikely, or unemployment benefits are extended, both mortgage and rental delinquencies can only go in one direction.

Perhaps the only bright spot, and one that even I find surprising, has been the performance of the domestic equity markets, which have rebounded sharply from their March lows. While the Dow is down approximately 6.4%, the S&P 500 is up fractionally, about 0.3%, while the NASDAQ is up a truly remarkable 16.8%. Keep in mind that the equity markets were down nearly 30% earlier this year, so the rebound has been noteworthy, if not downright astonishing.

While the equity markets are forward-looking and perhaps anticipating a COVID-19 vaccine, persistently low interest rates (10- and 30-year Treasury yields ended the second quarter at 0.66% and 1.41%, respectively, essentially flat from the end of the first quarter) and continued Fed largesse, there does seem to be a disconnect between the present economic environment and recent equity returns. Perhaps it is simply that investors are that desperate for yield and return. Perhaps it is algorithmic trading. Perhaps it is novice investors (read: speculative) trading via Robinhood. Perhaps it is all that liquidity and Fed monetary policy. Frankly, it is likely a combination of all these factors.

Keep in mind that even with the strong equity market performance, domestic money market assets remain at record levels, in excess of $4.6 trillion, some 40% more than prior year levels. Presumably, these assets sitting on the sidelines will ultimately find their way to more risky investments, including equity markets and real estate. Remember that in the latter half of 2019, Blackstone, Goldman Sachs and others raised record levels of capital (over $20 billion) in various real estate funds, and just recently, Blackstone’s secondary and funds solutions business, Strategic Partners, raised another $1.9 billion to acquire secondary interests in real estate funds and assets. In short, liquidity and investable capital remains plentiful and should provide some foundation for asset values.

Meanwhile, we continue to maintain strong physical occupancy and rental collection rates across our portfolio (over 90%), which compare favorably to broader industry trends. The National Multifamily Housing Council disclosed last week that 87.6% of apartment households made full or partial rent payments by July 13th, based on a survey of 11.4 million units across the U.S. However, it is very difficult to forecast what lays ahead without i) clarity as to when or if a Coronavirus vaccine is found; ii) how or when it might be subsequently administered; iii) what sorts of government stimulus (at every level), if any, might be forthcoming; and, iv) local, state and federal limits on residential evictions. The extraordinary politicization of the pandemic and the added uncertainty of an election year present additional forecasting challenges. We are acting accordingly, continuing our considerable efforts on tenant retention, asset management, and expense control.

Looking forward, multifamily assets should continue to perform fairly well, certainly relative to other classes of real estate. While high unemployment and weak GDP figures present clear headwinds for the remainder of 2020 and likely into the first quarter of next year, low interest rates, significant liquidity, reduced residential construction, challenging underwriting for prospective homebuyers, fewer people relocating for new jobs (or staying put due to health concerns), continued migration from the coasts to less expensive housing markets, and renter demand in secondary, tertiary, and yes, quaternary markets – those on which Clear Capital focuses – should present tailwinds for multifamily assets, at least in many markets, and a foundation for continued high physical occupancy levels. The biggest question is whether that same percentage of rents is actually collected in the absence of economic recovery and a renewal or extension of unemployment benefits or other governmental largesse.

All in all, multifamily rents, including the impact of move-in offers and rental concessions, will likely soften during the latter half of 2020 before rebounding next year, and we are underwriting new opportunities through this conservative lens. At this point, however, I do not see significant distress in asset values. During the Great Recession, distressed asset sales represented about a third of transaction volume, according to CoStar, and median cap rates rose between one and two percent across asset types. But this downturn is different in that it arrived via supersonic jet and will probably play out like snail mail because of concerted intervention by both the public and private sectors. According to Real Capital Analytics, overall deal volume fell 71% in April, as compared to the prior year, though prices on consummated transactions remained steady, as reduced demand was offset by reduced inventory of assets for sale. With so much cash sitting on the sidelines and interest rates so low, I believe that investors waiting for bargain basement prices will find themselves waiting for Godot.

Finally, despite the pandemic, or perhaps because of it, we continue to evaluate dozens of potential opportunities each and every week, most of which simply don’t satisfy our underwriting criteria, especially in this new reality. However, we are teeing up a couple of attractive offerings, one in Carrollton, Texas (we circulated a teaser about this opportunity several months ago) and another in Lakewood, Colorado so keep an eye out for those opportunities, in which I hope you might consider participating.

Beware of predictions that claim that COVID-19 will forever alter the way we live, do business, and interact. I anticipate that life will return to normal in due time

In 1974, a sociologist at the University of Houston, Jib Fowles, coined the term “chronocentrism”, which he defined as “the belief that one’s own times are paramount” and “that other periods pale in comparison.”1 During the last few months, I have read numerous op-eds proclaiming that the Coronavirus will forever alter the way we live, work, and play. Some have predicted that people are going to permanently flee urban centers for the suburbs, forever work from home, abandon brickand- mortar retailers and shopping malls, and travel less frequently, decimating the hotel, retail, and office markets. We will never hug or shake hands again. Each time I read or hear these bold proclamations, I roll my eyes. You need not look any further than at some of the large social gatherings routinely occurring in the face of the pandemic, including people actually hosting COVID-19 parties (talk about an invite that ought to be declined “without regret”), to get a good glimpse of human nature. Imagine how we will behave assuming a vaccine is found.

In the 2000’s, when suicide bombers routinely attacked cities like Baghdad and Tel Aviv, or when France encountered terrorism just a few years ago, most people went about their daily lives. Many countries with high levels of violent crimes (e.g., Brazil, Guatemala, Mexico) are not exactly known for boring, staid night lives. Old habits are simply hard to break, and we are social creatures by nature. In five years, I predict there will be as many mass gatherings as there are today, and travel, while perhaps not returning back to 2019 levels, will have substantially rebounded. And in 10 years? COVID-19 will likely (hopefully) be a distant memory.

Will people more routinely wear masks, especially during the winter flu season? Will universities perhaps change instruction approaches, including ending the fall quarter/semester at Thanksgiving, or providing more hybrid educational platforms, combining live and remote instruction? Will we wash our hands and use hand sanitizer more often, even carrying around Purell everywhere we go? Sure. But if anyone thinks that virtual conferences, meet-ups, and happy hours are going to act as permanent substitutes for the real deals, I think they are nuts. As I told my students at the end of the spring quarter, I don’t think employers are going to hire them – ostensibly the best and brightest – so that they can work from home, in isolation. Innovation and solving challenging business problems require collaboration and networking, which is far more effectively accomplished in person.

Perhaps a quick anecdote will highlight the flaws of chronocentrism. For better or worse, I have joined several private groups on Facebook, including one which is purely nostalgic, focused on the San Fernando Valley here in Southern California (where I grew up) during the 1970’s and ‘80’s. I imagine many of you are members of similar groups. Anyhow, as I was recently scrolling through various posts, including countless photographs of life back then, I noted how much had changed, how many retailers I once frequented had come and gone, and how groves of orange trees had been converted to single-family residential housing tracts. However, I also noticed how much essentially remains the same.

In about ten minutes of scrolling through these old photos, I noted all the retailers now relegated to the dustbin of history, some of which you will likely recognize and remember: Zody’s, GEMCO, Woolworth’s, Fedco, PicN’Save, Pacific Stereo, Carpeteria, Fotomat, and Federated Stores, all replaced by new retailers like Costco, Best Buy, Bed, Bath, & Beyond, and Ashley Furniture. And now I read that Bed, Bath, and Beyond will be shuttering 200 stores this year, so the cycle of evolution, devolution, rebirth, and rebuilding continues anew. As I have said countless times, the only constant is change when it comes to how people live, work, shop, and even invest. We should just be a tad cynical when people predict that things “will never be the same” or will be “forever changed.”

A recent Economist article noted that over the past two decades, the investment world fell “in love” with property, and then asked rhetorically whether “it is the end of the affair?” The article included a couple of graphs to highlight the point. My terse response is “no, it is not the end of the affair.”

Anecdotally, when I started teaching real estate investment and finance courses at UCLA Anderson in the spring of 1996, we offered but a single elective class each year that attracted about 35 MBA students, and I don’t remember if any of them pursued real estate as a career. Today we offer nine different real estate electives, enrolling hundreds of students each year, many of whom end up working in real estate, whether on the buy, sell, or advisory sides of the industry. The shift has been remarkable, as MBA students and their employers also appeared to “fall in love with property.”

Do I see this trend reversing? No, I don’t. Perhaps it is my views on chronocentrism. Perhaps it is the impacts of the Internet and technology on the industry. More likely, it is due to the increasing challenges the industry faces (e.g., increased local regulations, need for repositioning or redevelopment of assets and markets) which will require creative solutions, rigorous analysis, and significant capital, just the sort of resources that institutional and quasi-institutional investors (and yes, MBAs) can bring to bear to real estate markets.

Multifamily assets should continue to be a relative bright spot in an otherwise challenging commercial property market

Not surprisingly, the global pandemic and resulting economic fallout has been especially hard on many segments of the real estate market: hospitality, restaurant and retail, office space, in addition to student and senior housing. Not surprisingly, occupancy in senior housing hit a 15-year low last week, to less than 85%. For the week ending, July 11th, the national hotel occupancy rate was 45.9%, and in the 25 largest markets, just 39.2%.

Meanwhile, the multifamily market has weathered the storm fairly well, with both physical occupancies and rental collections generally exceeding 90%. In many markets, collections have exceeded 93% (e.g., Sacramento, Virginia Beach, Denver), while in others (e.g., New York, New Orleans, Las Vegas, and Orlando), markets disproportionately tied to travel and tourism or those without industry diversification, landlords have struggled with collections. Needless to say, the combination of shelter-in-place orders, furloughs and job losses, eviction moratoriums, and general fear and uncertainty are responsible.

Nationally, multifamily rents have declined 0.3% since March, when the pandemic began. At first blush, this decline seems modest. However, keep in mind that the second quarter is usually strongest for multifamily rents due to seasonality. Since 2014, rental growth between March and June has ranged from 1.0 to 1.7 percent, highest of any other quarter during the year.

Over the past twelve months, national apartment rents have increased by just 0.2 percent, by far the lowest year-over-year growth rate over any of the past five years. Landlords, including Clear Capital, have had to respond to this new reality by reducing rents and offering increased concessions (e.g., free rent) in order to fill vacancies or renew existing leases that are expiring. Not surprisingly, changes in rents vary markedly by location, much like rental collections. Of the 100 largest cities, 56 experienced lower or flat rents, and in 88, rents are growing slower than last year. Here in Los Angeles, rents dropped 3.3% in May, following a drop of 0.8% in April, and at the end of the second quarter, the vacancy rate exceeded 5.5%, the highest ever witnessed in the market, according to CoStar.

Longer term, the pandemic’s effect on rents will depend heavily on how quickly the economy is able to recover. My sense is that the recovery will be more drawn out than many (including yours truly) had hoped, making it likely that we will witness many households facing financial hardship begin to seek more affordable housing, increasing demand for apartments generally, especially Class-B and C units. Class A or higher-end luxury units will find filling vacancies more challenging. Migration from the coasts, a trend I have discussed for years, will accelerate.

We will also see a significant slowdown in new household formation and fertility rates (see additional discussion below), as more Americans move in with family or friends to save on housing and other costs. As longer-term remote work gains traction, we may also witness a shift away from expensive downtown markets and toward more affordable suburbs, though I am skeptical that such a move will persist longer-term. Again, I am mindful of both chronocentrism and economic and social realities, which may conflict with one another.

Other housing data remains decidedly mixed

Generally, data surrounding housing – permits granted, construction starts, units completed, sales volumes, pricing, and occupancy levels – is really a mixed bag depending on the particular data set and related timeframe. On the one hand, the Commerce Department just announced that nearly 1.19 million new housing starts commenced in June, following very steep declines in March and April and a modest recovery in May. However, even after a second consecutive month of growth, construction activity remains four percent below the prior year. Building permit applications follow a similar track, rising 2.1% in June to 1.24 million units, well off the April lows.

Last Thursday, the National Association of Home Builders/Wells Fargo survey of builder confidence jumped for the second straight month in July to a reading of 72, near pre-pandemic levels (any reading above 50 indicates a positive market). The index had plunged 42 points in April to a reading of 30, the largest single monthly change in the history of the survey.

Finally, to show just how mixed housing data is, we can look at two bookends, the San Francisco Bay Area and New York City. In June, home sales in the Bay Area surged nearly 70% over May’s results, and prices rose 3.6% from May and 4.2% from the prior year, all representing sharp turnarounds from the previous three months when Bay Area sales fell 51%, 37%, and 12%, respectively, as compared to the same periods last year. I suspect that strong performance in the NASDAQ, coupled with the ability of many tech employees to work remotely, have contributed to these favorable results. Meanwhile, in Manhattan, the number of closed sales in the second quarter was down 54% compared to last year, the largest decline in 30 years, while median sales prices declined 17.7%, according to brokerage firm Douglas Elliman. NYC apartment leasing was down 76% in June, year-over-year.

Not surprisingly, the economic and market uncertainty has made lenders significantly more cautious in their underwriting

According to the most recent data from the Mortgage Bankers Association, released this past week, commercial and multifamily mortgage bankers are expected to close approximately $250 billion of loans this year, a 59% drop from 2019’s record volume of $601 billion. Total multifamily lending, including loans made by small and midsize banks, is expected to decline 42% to $213 billion in 2020, a sizeable drop from last year’s record of $364 billion.

As anticipated, lenders are employing far more conservative underwriting standards, hearkening back to 2008 and 2009, though lenders are not grappling with the same sort of balance sheet challenges they encountered back then. For example, where lenders might have been willing to previously lend 70-75% of a property’s value, they now require greater borrower equity, and may only lend 65-70% of a property’s value, while requiring additional reserves, including anywhere from six to 12 months of pre-funded debt service and reserves (e.g., property taxes, insurance). Most lenders have increased the “spreads,” the additional pricing premiums they might require over a relevant underlying index, on both fixed and variable rate loans. For example, where Fannie might have charged an interest rate of 1.90% over the 10-year Treasury yield prior to the pandemic, they are now charging an additional 50 to 60 basis points on such loans. Life companies, popular fixed-rate, longer-term debt providers to multifamily operators, are offering 60% loans, with 10% debt yields, far more conservative than prior underwriting standards.

In short, lenders are also engaged in “price discovery,” as they underwrite loans in an increasingly uncertain marketplace. I expect this underwriting waltz to continue through the remainder of 2020.

Inflation remains tepid at present, but unprecedented quantitative easing and action by the Federal Reserve significantly raises the specter of future inflation

While the 0.6% increase in the June Consumer Price Index (CPI) may seem surprising, core inflation, excluding volatile food and energy, rose a far more modest 0.2%. Through the first half of the year, annualized core inflation is up 1.2%. At this point, it really appears to be a tale of different markets: that for financial assets, consumer goods generally, and finally, for food and energy. While modest inflation is desirable, greater growth in economic activity and higher inflation, closer to 2.5 to 3.0%, should be our target.

During the last decade, the CPI increased 19%, or 1.8% per year, below the 2.0% target set by the Fed, reflecting the impact of those three A’s I have mentioned several times in the past: Amazon, automation, and artificial intelligence, which in turn resulted in increased efficiencies and flat real wages. Meantime, the S&P 500 was up 188%, or nearly 19% per year, while commercial property values increased 175% as measured by MIT’s NCREIF (National Council of Real Estate Investment Fiduciaries) Index.

Once again, it seems that we have both substantial inflationary headwinds and tailwinds. On the one hand, those three A’s are not going away anytime soon, and if anything, the pandemic will likely intensify their impacts. Clearly we are now using Amazon more often than we did before March, as we make more than good use of our Prime memberships. On the other hand, the Fed’s liberal use of their unique printing press, adding trillions in liquidity to the markets, their balance sheet, and our debt, has to ultimately and meaningfully impact markets and inflation, principally financial assets and markets (including real estate).

More than a handful of us remember the late ‘70’s and early ‘80’s and the sky-high interest rates and inflation that period experienced, if not Studio 54, polyester slacks, and bell-bottom jeans. My concern is that we are going to experience substantial asset inflation in 24 to 36 months from now, once a vaccine for COVID is released, life returns to “normal,” and all that liquidity now sitting in cash and money market funds leaves the sidelines. It is one of the reasons I believe asset prices will not witness significant declines in the short- to medium-term, and will see even higher asset values by the end of 2021, and precisely why we remain committed to invest in what we believe to be attractive investment opportunities today.

Even without the arrival of murder hornets, local, state, and federal politicians have been busy, busy bees

Since the start of the pandemic, more than 25 states have passed some sort of eviction moratoriums, preventing landlords from evicting tenants who have not paid rent due to COVID-19. Not surprisingly, these include those states with larger renter populations (e.g., California, Texas, and New York). In some states, like Nevada, the moratoriums also apply to commercial tenants. Meanwhile, the FHFA (Federal Housing Finance Agency), the federal agency overseeing federallyinsured
loans (e.g., Fannie Mae and Freddie Mac) has extended the moratorium against foreclosure or eviction for those with such loans through August 31st, extending the original July 25th deadline.

The million (trillion?) dollar question is what happens once these various moratoriums expire? I have read that some 23 million renters could be evicted from their units and millions more could lose their homes. I anticipate that landlords, lenders, and government at all levels, will work together to prevent this from happening, but that remains to be seen. If the government takes too heavy of an interventionist hand, markets will be substantially disrupted, and lawsuits filed. In New York and Los Angeles, landlords have sued to overturn these moratoriums, but it is hard to assess their impact, since courts are essentially closed, and moratoriums will presumably be lifted before the cases are actually heard.

It is impossible to summarize all of the various regulatory initiatives that politicians are proposing to deal with the pandemic’s impact on homeowners and both residential and commercial tenants alike. Here in California, politicians have proposed any number of bills, including the following:

• SB 1410, the COVID-19 Emergency Rental Assistance Program: would give tax breaks to landlords for forgiving rents and halting evictions, provide for direct payments to help tenants who cannot pay their rents, and allow tenants ten years to repay debt to the state. The estimated cost to taxpayers would be up to $10 billion over the life of the program.

• AB 1436, Tenancy: Rental Payment Default: would ban evictions until April 2021, or three months after the state of emergency ends, whichever comes first. Tenants must prove their financial hardships were caused by the pandemic under the bill and would be given an additional 12 months to repay back rent, and landlords could collect the debt through civil courts. Property owners would be banned from evicting residents for unpaid rent due to COVID-19.

Meantime, a new statewide rent control initiative, the “Rental Affordability Act,” will appear on this November’s ballot. If passed, landlords will not be allowed to increase rents to market rates when a tenant vacates a rent-controlled unit, which would include single-family homes and condominium units. Instead, the ballot measure limits rent increases of vacated units to five percent per year.

Outside of California, the most far-reaching political maneuver comes from Ithaca, New York, a smallish community of 30,000 residents upstate, which passed a resolution that requests the New York State Department of Health to authorize their mayor to forgive rent debt from the last three months for tenants and small businesses, the first city to actually propose canceling rent during the pandemic. This resolution appears unconstitutional on its face.

Anyhow, I expect governments at every level to be under tremendous pressure to act and pacify their voting base, especially in such an important election year, which means that any number of tenant-friendly bills will be proposed and some passed. I further anticipate that politicians will try to thread a challenging needle in so doing, knowing that constitutional challenges and litigation await them if they push things too far. Stay tuned.

And, as usual, just when I think I should wrap up a memo, I realize that there are a few other noteworthy data points or issues, whose impact on multifamily real estate and perhaps all else, remains to be seen

One of the things I like most about real estate is that it is impacted by nearly everything, from politics to economics to sociology to psychology, and so I like to end these memos with food for thought, at least for those of you who have gotten this far…

• Wealth inequality: In previous missives, I have expressed the view that expanding wealth inequality poses the greatest threat to our economy, our political systems, and overall stability. I still feel that way, as I am very unclear as to how a true democracy can persist without a strong middle class, which in turn requires greater wealth equality, it seems to me.

The interesting question is whether COVID-19 will exacerbate the trend towards greater wealth inequality, or will the pandemic result in greater wealth distribution? Thus far, it seems to be the former, with financial markets steadying, and the NASDAQ actually up sharply for the year, which principally benefits owners of these assets, i.e., the wealthy. Meantime job losses and the virus itself have and will most significantly and disproportionally impact the working class and poor, including populations of color.

One historian and faculty member at Stanford, Walter Scheidel, has argued that only four forces have managed to sustainably reduce wealth inequality: war, revolution, state failure, and pandemics. Whether there might be causation or correlation issues here, I will leave that for another day, but his thesis is interesting to note. The Great Depression led to “welfare capitalism,” an increase in safety nets, and more unionized labor. By 1950, according to the Economist, the top 0.01% of the wealthiest Americans controlled about 2.3% of the nation’s wealth, less than a quarter of what they controlled in the Roaring ‘20’s.

Obviously, this changed over time, as the data clearly demonstrates, and the disparity accelerated after the Great Recession, impacted by everything from Federal Reserve policy, the propping up of corporations and banks, the increase in automation and artificial intelligence, the weakening of labor and unions, and flat real wages. Downturns are especially rough on those entering or exiting the labor market, and this pandemic feels no different. Perhaps it depends on how the government ultimately responds to the pandemic and changes it will bring, at least in the short- to medium-term. To the extent welfare capitalism and safety nets are expanded over the next couple of years or not may ultimately be most impactful on wealth inequality.

Finally, I would simply note that as owners of principally Class B, workforce housing, we certainly benefit from our actual and prospective tenant’s greater wealth and financial wherewithal.

• Fertility Rates: Last year, I presented some data on the declining fertility rate in the U.S. and discussed its possible ramifications and impact on everything from future GDP growth rates, housing needs, and immigration policy. One need not look further than Japan to see the impact of declining birthrates and an aging demographic on economic growth.

• Unfortunately, data released in late May indicates that total U.S. births in 2019 fell to the lowest levels in 35 years, while the general fertility rate (births per 1,000 women aged 15 to 44) fell to its lowest levels since the federal government began tracking data in 1909. This does not bode well for future growth (including demand for housing), and the U.S. needs to seriously rethink immigration policy sooner rather than later. I recently read that even at a fertility rate of 2.1 (2.1 children born to each woman living through child-rearing years), the population will actually decline.

• Cargo Issues, Imports, and Impact: In March, U.S. imports from Asia fell to their lowest levels in seven years, as retailers and manufacturers canceled orders of non-essential products. In fact, cargo volumes at U.S. ports are expected to drop by 20 to 30 percent yearover- year in the first half of 2020, according to the American Association of Port Authorities. Year-to-date imports from China are down 37 percent compared to the same period in 2019, and Mexico is now America’s number one trading partner. In fact, twice this year, import volumes for the Laredo, Texas port-of-entry surpassed those for Los Angeles County ports, the nation’s largest international gateway for inbound products.

The excess of inbound consumer goods presents a potential for a national bottleneck of loaded containers throughout the U.S. port system, as some retailers and manufacturers are failing to pick up merchandise ordered due to lack of storage space. Consequently, demand for industrial space to be used strictly for storage has increased, at least anecdotally, based on conversations I have had with local brokers, who have also told me that local developers here in Southern California are moving east to places like Banning, Beaumont, and Perris in the Inland Empire to build very large (million square feet plus) warehouse facilities and converting retail stores near consumers to “last mile” fulfillment centers.

In the longer-term, COVID-19 might result in more on-shoring of critical supplies and nearshoring of many products in Mexico which have historically been produced in China.

In conclusion, the remainder of 2020 will likely be historic, between the November election, the pandemic, and the search for a COVID-19 vaccine

I believe it was Confucius who expressed his wishes that each of us should “live in interesting times.” Well, I don’t think many of you would argue with me that if the first half of 2020 has been “interesting,” while simultaneously supporting the notion that Confucius might want to reconsider this particular philosophical musing. That is, I think we all would probably prefer something a tad less interesting than what we have individually and collectively experienced during the first half of
2020.

In any event, I remain optimistic and hopeful that so many brilliant minds working around the globe to develop a vaccine will prove successful. However, in the meantime, the politicization of the pandemic, along with the uncertainty as to when a vaccine might be found and broadly administered and how long it might take for things to return to “normal” thereafter, are making precise forecasts challenging.

However, I know that when there is broad consensus as to what is to be, something different is bound to happen, and therefore, widespread uncertainty creates potential opportunity, and should be embraced as much as it might be feared. Meanwhile, I feel fairly confident that low interest rates, coupled with the Fed’s affinity for money-printing and the significant liquidity already sitting on the sidelines, will compel higher prices for financial assets and real estate looking out two to five years, once the pandemic ends. And it will end.

Two final thoughts. One, please keep your eyes out for a couple potential offerings that we believe are attractive opportunities; and two, and far more importantly, the entire Clear Capital team hopes that you and those close to you remain in good health.

Best,

Eric Sussman
Founding Partner

If you’re going through hell, keep going. —Winston Churchill

You may encounter many defeats, but you must not be defeated. In fact, it may be necessary to encounter the defeats, so you can know who you are, what you can rise from, how you can still come out of it. —Maya Angelou

Before you read beyond the first sentence of this newsletter, I might advise you to take three deep breaths. Maybe four. It has never been my nature to sugarcoat reality or mince words (just ask my students), and I am not about to change long-formed habits. There is simply no way to paint a rosy picture from the more than 39,000 Americans that have died thus far from Coronavirus, adding to the over 162,000 deaths globally, not to speak of the more than 2.3 million people worldwide who have been infected by this scourge. Or the 22 million Americans that have filed unemployment claims in just the last three weeks, including 5.2 million claims just this past week, increasing our unemployment rate to somewhere in the high teens, I gather. Or the significant financial losses and head-spinning volatility that investors in just about everything have experienced in what seems like the blink of an eye. Or the routine virtual meet-ups and happy hours posing as modest substitutes for the real deals. It has all been surreal and painful.

But if you have come to read a memo that echoes the view of many that the world is coming to an end, as perhaps the media and others might have you believe, read no further. Because while this missive won’t sugarcoat, underestimate, or ignore the heart- and mind-wrenching realities of what we have experienced and are living, and the significant impact this will have over the near- to medium-term, I know that this shall pass, and be but a painful memory in time, fully recognizing that not all pain is created equal. As I mentioned in my recent podcast, the 20th and 21st Centuries (to date) have witnessed two World Wars, the (misnomered) Spanish Flu, the Great Depression, the Cold War, Vietnam, Korea, 9/11, the dot-com implosion, the Savings & Loan crisis, the Great Recession, and more natural disasters than be counted. Oh, and I should not neglect to mention the ‘62 Mets, Heaven’s Gate (Google it), Joe Exotic (Google that as well, if needed), and my Bar Mitzvah.

Yet I imagine that none of you gave any of these things much thought (especially my Bar Mitzvah) when you made investment decisions over the last decade of bull market and general economic, if uneven, prosperity. We are wired to move forward and, yes, forget. Thus, the markets and economy will rebound, the job market will improve, and traffic will eventually return to the 405 Freeway. However, I fully recognize that even if a vaccine were to miraculously appear tomorrow, it will take some time to get the economy back to any semblance of normalcy, and behaviors from greeting customs, to social gatherings, to the acceptance of wearing a mask even as you enter a bank with nothing but good intentions, will be different, at least for a while.

However, the combination of time, unprecedented federal stimulus, record-levels of cash on the sidelines, and human ingenuity will ultimately ensure an economic recovery. For one single objective anecdote, I read that the Vanguard Group just closed its Treasury Money Market Fund to new investors, as a record $7.3 billion flowed into the Fund during the last month (a 20% increase in assets), as investors sold risky assets and sought refuge from volatile and uncertain markets. Meanwhile, government money market funds collectively added over $900 billion in assets in just the past six weeks. All of these risk-averse actions will eventually unwind and these assets will find their way back to riskier assets and markets in time.

In addition, between unprecedented action and intervention by the Federal Reserve and recent, if clumsily rolled out, Congressional aid packages, some $6 trillion of federal stimulus has already been provided, and even more is likely on the way. Candidly, my biggest concern at this point is not whether the markets will recover, but that all this stimulus and quantitative easing will eventually result in future inflation and asset bubbles. While there is absolutely zero inflation risk in the near-term, between the demand shock we have experienced and the impetus to save rather than spend, the long-run is an entirely different ballgame.

As you know, I am a huge fan of graphs and data, and I think these three tell a compelling story, consistent with the perspective set forth above, that markets will recover, and that now is probably a good time to actually invest spare cash, if you are able and are investing for the medium- to longer-term:

Finally, before I lay out what Clear Capital has been up to in these unprecedented times, and get too deep into the economic weeds, the markets, and our outlook, let me first express my best wishes to each of you and those in your close circles. I am not really sure how many people read these quarterly memos, or even how many get past the first page once they start, but I am sure that more than a few of you have been very directly and significantly impacted by this epidemic, and I, on behalf of everyone at Clear Capital, want to pass along our very best wishes.

I also wanted to acknowledge and thank the entire Clear Capital team, which has been working tirelessly with our residents, partners, vendors, and on-site management teams in every area of operations – communication, safety and security, leasing, revenue, expense and cash management, staffing, and resident/tenant support – as we seek to preserve capital, position our portfolio for future growth, and seek investment opportunities in dislocated markets, just as you would hope and expect from us.

So, how has Clear Capital responded to the Coronavirus pandemic?

Over the years, I have often told my students that crises, in whatever form they arrive, separate wheat from chaff. That is, in a bull market, the rising tide generally lifts all boats, new competition emerges, and returns compress. However, in times of crisis and bear markets, skills, abilities, and resources – human and financial – are severely tested, and the more capable players not only survive, but position themselves to ultimately thrive in post-crisis environments.

I recognize that all of our inboxes have been inundated with emails from everyone we have ever done business with, as firms lay out how they have responded to this crisis. I have thus far resisted the temptation to circulate such an email, under the assumption that it would soon be relegated to your email’s “deleted items” folder, lost in a sea of similar emails. But I would be remiss if I did not let you know what Clear Capital has been up to and what actions we have been taking, so let me quickly summarize how we have responded to the crisis, so that we indeed not just survive it, but are optimally positioned once it ends.

Oversight and Communication

• Implemented daily reporting protocols for each property (e.g., cash collections, leasing activity, notices)
• Initiated daily leadership teleconferences to share information and coordinate action across our portfolio of assets
• Instituted weekly property-level forecasts, in order to prepare for different economic scenarios

Safety and Security of Residents and Staff

• Modified standard operating procedures to conform with CDC guidelines
• Discontinued routine maintenance in occupied apartments
• Closed common areas (e.g., pools, gyms)
• Discontinued resident functions
• Closed leasing and management offices to foot traffic
• Encouraged team members to work remotely when and if possible
• Require staff to wear protective equipment when appropriate
• Practice social distancing

Leasing

• Pivoted to virtual leasing, by creating video tours of vacant apartments to share with prospective residents, and use of FaceTime and/or other similar software applications
• Contacted all residents scheduled to move out to encourage them to stay and extend their leases
• Reduced rental rates on expiring leases to entice renewal
• Transitioned tenant application process, lease application, and lease renewals online

Expense Reductions

• Discontinued all discretionary capital expenditure projects, including unit upgrades
• Reassigned certain tasks and services from third-party contractors to in-house maintenance personnel (e.g., janitorial, groundskeeping, painting)
• Reduced, halted, and/or discontinued all non-essential regular service contracts
• Withdrew spending authority from property managers. All purchases and expenditures require express approval
• Limited variable expenses to essential materials and services only

Staffing

• Reduced staffing levels through reductions in work hours and furloughs, but have not terminated a single employee
• Refocused staff to essential services only (e.g., leasing, resident support, and asset preservation)
• Supported key personnel by ensuring their full-time status, by sharing their available hours with other portfolio properties

Resident Support

• Assembled a team to research and become familiar with all resources available to residents (e.g., unemployment insurance and other state and local programs, SBA grants, loans and other federal programs, loans and grant programs offered by non-profit and charitable organizations)
• Created reference guides and instructions to assist residents to determine eligibility and process applications for each resource
• Created and implemented COVID-19 claims process, documentation, forms, and tracking protocols
• Proactively reached out to residents to inquire about their well-being and to offer assistance where needed
• Waived late fees and withheld eviction proceedings against delinquent residents affected by COVID-19
• Negotiated repayment agreements with delinquent residents affected by COVID-19

In short, we have been very busy, not necessarily doing things we would like to do, but things that we must do. I am confident that these endeavors will pay dividends both during and subsequent to the crisis, and again, I send my sincere thanks and appreciation to our team.

So, let’s start with an overview of recent events, as sobering as they might be

Unless you have been living under a rock and practicing social isolation as a way of life, you don’t need me to tell you that we have witnessed unprecedented economic and market contractions, and spikes in unemployment and market volatility never seen previously. In my last memo, I marveled at just how resilient the markets had been over the past decade, withstanding all the slings and arrows flung at them. But not this time. While the equity markets have recently rallied, substantially cutting year-to-date losses, all market indices are lower, and the spikes and declines in volatility, as measured by the VIX, have been unnerving.

An enemy invisible to the naked eye and a contemporaneous collapse in oil prices (oil prices hit an 18-year low on Friday) have proved a toxic pairing, and the related job losses have simply been stunning. The 9.9% and 12.3% national and California unemployment rates that we witnessed in 2009 seem like distant memories, and will pale in comparison to what the Bureau of Labor and Statistics is likely to report in coming months. 57 economists surveyed by the Wall Street Journal project that 14.4 million jobs shall be lost in coming months, and the unemployment rate will rise to a record 13.5% in June, nearly four times February’s 3.5%. While I am always skeptical of consensus, I don’t think these folks are going out on a limb. After all, this data speaks an immutable truth.

Obviously the travel, hospitality, tourist, and retail trades have been hardest hit, but white-collar job losses will not be far behind. Hopefully, some government intervention (e.g., the Paycheck Protection Program) will mitigate job losses to a degree. Meantime, Las Vegas, the Southwest Florida Coast, Orlando, and Houston, whose economies are dependent on hard-hit industries and lack industry diversification, have been and will be especially impacted.

And while a drop in consumer spending, travel, and overall economic output would provide headwinds for oil prices in any case, a Russian-Saudi Arabia standoff surrounding oil supplies could not have come at a worse time. Keep in mind that the U.S. is now an energy exporter, and the oil and gas industry is especially significant to Texas, the Gulf of Mexico, California, North Dakota, and Oklahoma. Such low energy prices would lead to significant job losses and bankruptcies in even the best of times.

Finally, keep in mind that consumer spending makes up 70% of the U.S. GDP, and the incomparable job losses we have sustained will leave a mark, no matter the largesse of our federal and state governments. I suppose we will have to wait until the government releases March and April data before we can know for sure just how badly the consumer has been impacted.1 It is simply too early to be sure, like predicting the end of a pro basketball game based on the halftime score. However, this reality – the power and impact of the U.S. consumer – is what is providing the greatest pressure from politicians to reopen the economy.

Meanwhile, the federal government has brought out the heavy artillery to combat the economic fallout from COVID-19, and while these have stabilized financial markets in the short-run, the longer-term implications are worrisome

To say that the federal government has brought out the howitzers to offset the unprecedented economic dislocation we have witnessed would be an understatement, from CARES (Coronavirus Aid, Relief, and Economic Security Act), to PPP (Paycheck Protection Program), to $4 trillion of Fed stimulus and quantitative easing, under several different programs. In the short run, our federal government is going to print money like there is no tomorrow, with deflation the bigger near-term concern. But longer-term? What will be the efficacy of these unprecedented moves, and are we making some sort of Faustian deal in the longer-term?

In short, these questions are probably academic, as I don’t believe we have a choice, unless a second Great Depression is on the menu. I felt the same way in 2008 and 2009, while fully recognizing the same Faustian deal we arguably made back then and the moral hazards and unintended consequences bailouts and heavy-handed governmental intervention can bring. The last time our federal spending represented such a significant percentage of our GDP was during World War II.

1) Some argue (see https://www.nationalreview.com/exchequer/70-percent-myth-consumer-economy-kevin-d-williamson/, for example) that the actual percentage is less than 70%, perhaps “only” 40%, depending on how it is measured. It is sort of an academic argument, as it is extremely material in any case.

And keep in mind that Central Bank balance sheets were already bloated, sitting at record levels before this crisis hit.

The long-term implications of these extraordinary actions remain to be seen, and reasonable and educated pundits might disagree. Me? I see asset bubbles and inflation in our future, though I cannot say when that will occur. Depending on how quickly improved treatments and/or a vaccine for COVID-19 are created, the asset appreciation and related inflation which I anticipte may happen sooner rather than later.

What about real estate markets, now and looking forward?

Not surprisingly, the real estate market has also taken it on the chin, with the hospitality, retail, and office sectors being especially hard hit. Many hotel owners and retail landlords, along with many of their tenants, will not survive this downturn. Neiman Marcus and JC Penny missed debt payments this past week, and many others will likely follow suit. The list of retailers not likely to survive this crisis include not just Neiman and Penny’s, but Macy’s. Others like Kohl’s and Nordstrom’s have been drawing down lines of credit, joining a long list of companies taking similar actions. I imagine most retailers, including Kohl’s and Nordstrom’s, have six months of cash on hand, maybe eight to ten. But nobody should feel guilty or alone in their efforts to increase liquidity. Firms seeking increased liquidity are part of a very large fraternity:

Prologis, the largest industrial landlord, indicated that 25% of its tenants have requested some sort of “rent relief,” though I suspect the industrial market will perform better than retail or office looking forward because of the continued growth in e-tailing and the likely future return of on-shore manufacturing of certain essential health care products and equipment that had previously been outsourced to China. I assume the mask, ventilator, and protective equipment markets will be quite robust for the foreseeable future, and domestic supply chains for these products strengthened.

Meanwhile, the National Association of Homebuilders/Wells Fargo Housing Market Index, based on a monthly survey of homebuilders and designed to take the pulse of the single-family housing market, plunged 42 points in April, to 30 (a 42% drop), the largest monthly decline ever. At 42, the Index stands at its lowest level since June of 2012, and represents the first reading below 50 (indicating industry contraction) since June 2014. As though the single-family residential market needed other headwinds, JP Morgan Chase just announced that it is raising its mortgage borrowing standards, requiring potential homebuyers to have FICO credit scores of at least 700 and 20% down payments at the ready. I have to believe that all lenders will be tightening underwriting standards, across every asset type, such that lower interest and mortgage rates won’t be nearly as impactful as one might think (or hope), as a result. That is, lower rates will be more than offset by higher spreads and tighter underwriting.

While multifamily assets are probably the safest place to be, they are not immune from the economic realities of job losses and furloughs, reduced wages for those still employed, and stay-at-home orders. While we have collected about 90% of April rents across our portfolio, not all assets fared equally well, of course. Moreover, we expect May’s results to be worse, simply recognizing the number of unemployment claims filed so far this month. Federal stimulus efforts will help, but can only do so much. Frankly, until the employment picture brightens, multifamily investors will feel the pinch. The drop in single-family home demand and purchases will provide some buffer and a modest tailwind, as will stay-at-home orders, boosting lease renewals.

The pressure will be greatest on lower-income households, who not only spend so much more on housing (as a percentage of their total incomes), but have minimal savings or safety nets. And in those communities where housing costs are highest, especially California, the impact will be even more widely felt. As a result, the pressures on California residents to move elsewhere for lower housing costs, will become even greater from Coronavirus, at least in the short- to near-term.

The multifamily market remains the safest and best place to invest, with the trends favoring secondary and tertiary (and don’t forget quaternary) markets well intact.

Over the past several years, I have discussed, at length, the exodus of residents from California to other states, namely Texas, Arizona, Colorado, Oregon, Utah, Washington, and Idaho. It is why Clear Capital has
mostly shifted its investment focus to these other markets. After all, the price of an identical home in California costs three times as that same home in Texas. The median house price in California is up 72% since 2009, versus a 6.5% increase in median household income. With routine shortfalls in housing construction, due to everything from excessively burdensome regulations to NIMBYism to a scarcity of land to high costs of doing business to labor shortages to an ever-growing homeless population, California will continue to see residents depart for other states. Recent events will only increase motivations to leave. I found this simple picture to be sadly informative.

Therefore, I anticipate that we will continue to pursue investment opportunities in places where California residents are headed. These two pictures speak quite directly to the exodus of Californians, all pre-COVID-19.

I recently came across one other interesting tidbit, and that is a look at which states have seen the largest changes in “Adjusted Gross Incomes” over time, as reported to the Internal Revenue Service on personal tax returns. Granted the data is from 2012 to 2018, but it is nevertheless entirely consistent with other data and trends. California and New York have seen the highest outflows, while Florida, Arizona, and Texas, the greatest inflows.

Finally, I read an interesting article in the (failing!) New York Times about how this population exodus from California is impacting politics in neighboring states. The 7.3 million people who have left California since 2007 have turned Colorado blue, likely resulting in a flipped senate seat. In Nevada, Democrats won the governor’s mansion and a second senate seat in 2018. And last, but certainly not least, Arizona may turn blue in short order. Texas, the top state for California’s diaspora, is in play, though the State is not likely to turn blue quite yet. But Democrats are growing their influence in major metros like Dallas, Austin, Houston, and San Antonio, and the overall trend cannot be ignored.

And multifamily rents? Between economic and political pressure/activism, they are likely to drop in the short-run, especially in those regions with high “at risk” employment and high housing costs. However, they will likely continue to rise, longer-term

Over the last decade, multifamily rental growth, nearly anywhere you looked, was robust. In certain markets, especially on the coasts, the growth rate far outpaced inflation. However, more recently, it has been the secondary and tertiary markets that have shined, as residents fled the coasts in search of better job opportunities, lower housing costs, and higher net wages, as described above. Markets like Phoenix, Aurora and Colorado Springs, the Inland Empire, and Boise have led the pack in terms of rental growth.

So, what now? In those markets with average levels at-risk jobs, I actually expect rents to remain fairly flat in the short-run, as residents mostly stay put, remain in whatever job they might have (as opposed to relocating), receive stimulus and unemployment checks, and fail to buy homes. Over the next year, however, I do expect rents to decline, though modestly, mainly due to job dislocations and additional supply delivered to the market. There will be new projects coming on-line (some 330,000 units in 2020), and some residents will be doubling/tripling up and/or moving back home with parents, trends we witnessed during the Great Recession. It is really a question of how quickly the economy and job markets rebound.

In some markets, those with especially high levels of at-risk jobs, such as Las Vegas and Orlando, all bets are off, quite frankly. It is why I would avoid any market with excessive single-industry exposure, or a significant lack of employment diversification. Last year, for example, we evaluated a portfolio of multifamily assets in Midland, Texas. The purchase cap rate and buy-in were far more attractive than what we typically see cross our desks (or emails). But given the unique exposure that market has to the oil and gas industry, we did not pursue the acquisition, a prescient decision in hindsight.

One significant unknown is how lenders will reprice and restructure both existing and new loans

How real estate assets are ultimately repriced as a result of this crisis depends, to a significant degree, on how lenders respond. Obviously, innumerable outstanding loans will need to be restructured, mostly involving deferred payments and maturities, and waivers of certain fees and costs. Presumably, for most assets, such modest modifications will do the trick, provide time for the markets to recover, and allow borrowers to satisfy their obligations. In other cases, perhaps loans on certain hotel and retail assets, more dramatic and draconian actions will need to be taken, with assets needing complete or partial do-overs or redevelopment.

As expected, the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, the largest residential lender, is offering forbearance of loan payments for up to 90 days, if borrowers can demonstrate that they have been impacted from COVID-19 and agree to suspend evictions of affected tenants. I have yet to see the formal forbearance documentation to understand the precise terms and conditions attached to any forbearance, perhaps because we have not yet requested any. At the end of the day, nearly all lenders, including banks, insurance companies, and debt funds will be motivated to work with and modify loans if the underlying assets and underlying fundamentals are solid, and borrowers, trustworthy. Workouts of CMBS loans will be trickiest, as they always are, due to the manner in which these loans are securitized and require the involvement of special servicers.

For new projects and investment acquisitions, I suspect most lenders will require additional reserves, employ stricter underwriting processes and procedures, resulting in lower loan-to-values, higher debt service ratios, immediate amortization (no interest-only), with lower rates on underlying indices, as seen below, offset by higher credit spreads. These restrictions should ease in time, but markets like these create dislocations everywhere.

What’s interesting is that before the virus hit the fan, all real estate lenders were active. Obviously, we will just have to see how this data from the fourth quarter changes throughout 2020.

And finally, I sure was wrong when I predicted that 2020 would be a quieter year in terms of public policy initiatives and housing. If anything, COVID-19 has fanned the housing regulation flames

I suppose the one area in which I should just stop making predictions is politics. I honestly thought that after politicians were so busy in 2019, extending efforts to almost nationalize several residential housing markets, they might take a breather in 2020. Wrong. Maybe I should have hired the Houston Astros bench players and coaches to help me make better predictions. Obviously, much of the recent political machinations are responses to the Coronavirus. This simple map provides a bird’s eye view of what happened before 2020.

With that backdrop, allow me to provide a summary of what different cities and states have been up to this year:

• Countless cities and states have passed emergency legislation to protect residential tenants from being evicted, if they are unable pay rent because of the Coronavirus. These include Arizona, California, Illinois, Kansas, Louisiana, Massachusetts, New York, among several others, both red and blue. Practically speaking, because unlawful detainer courts are closed everywhere, actually processing evictions would be hard, if not impossible. In addition, the CARES Act put a 120-day national eviction moratorium for tenants in properties that are part of government programs or that have a federally-backed mortgage loan.

• California Assembly Bill 828, if passed, would establish a moratorium on evictions and foreclosures while a state of emergency related to COVID-19 is in effect, and until 15 days after that state of emergency has ended. And if this were not restrictive enough, tenants impacted by COVID-19 and subject to an unlawful detainer action, would be entitled to reduce their rent by 25% for a year. While seemingly unconstitutional on its face and unlikely to pass, I would think, such heavy-handed tactics scare the bejeezus out of me.

• Meantime, and ironically, California once again shot down a bill (SB 50), which would have allowed more mid-rise apartment buildings near transit and job centers. The Bill failed to pass because it took too much power away from local governments, those same local governments that have essentially done squat to meaningfully address housing shortages. California should be building 250,000 housing units a year, plus or minus, and yet we are producing less than 100,000. No wonder the exodus from the state continues. There is no monopoly on myopia or stupidity.

• Before COVID-19, Utah was considering statewide rent control, as were the cities of Seattle and Atlanta.

• Also prior to the arrival of COVID-19, the mayor of San Francisco was pushing a ballot initiative to streamline approval of 100% affordable projects or where developers agree to set aside 15% additional units as affordable above what would be required. On Super Tuesday, San Francisco passed a ballot measure to charge a “vacant storefront tax,” a tax on commercial storefronts that remain vacant for at least six months, which sounds both absurd and illogical. Let’s take a group of landlords, already struggling financially with vacancy (assuming these landlords have been unsuccessful in finding commercial tenants) and tax them! Yet, in a surprise to absolutely nobody, the measure passed with almost 70% voting in favor of it. Being a landlord in the Bay Area must feel like what it feels to be a UCLA football fan in recent years.

• Oregon’s governor, Kate Brown, and the state’s lawmakers are considering adding transfer taxes to real estate transactions to pay for affordable housing.

And across the Pond, Berlin’s five-year freeze on residential rents (“Mietendeckel”) went into effect this quarter. In addition, the new law will allow renters paying more than $10.80/sq. meter to petition the city to force landlords to reduce their rents. As bad as California and New York might be, I am not sure there is a place anywhere which dislikes its residential landlords more than Berlin. In some very perverse economic thinking, supporters of the new bill indicated that it will give renters time for supply to “catch up” to demand. From Spain to Toronto, renters are feeling the pinch of higher rents caused by urbanization and the failure of supply to meet demand. According to the Economist, 68% of the world’s population is expected to reside in urban areas by 2050, up from 55% today, so these challenges are only going to worsen over time, and anti-landlord sentiment and pro-tenant legislation are sure to follow.

In closing, while the COVID-19 crisis has presented us all with unique and unprecedented challenges, I remain optimistic about our ability to confront them, persevere, change, and grow.

I believe it was Teddy Roosevelt who said that “nothing worth having comes easy.” I am not sure I believe this to always be true (just ask a Super Lotto or PowerBall winner!), but it sure rings true today. Crises have a way of inducing fear, panic, and gratitude, all at once. I am, by nature, a “glass half-full” sort of individual, and while this crisis has been extraordinarily difficult and disruptive, I am truly grateful for friends, family, our Clear Capital team, our partners, and investors, and of course, our collective good health. I reiterate my sincere well wishes to you all, and hope that my next memo will celebrate an end to social isolation and a return to greater normalcy, in whatever form such normalcy may take.

Meantime, we will continue to evaluate investment opportunities, believing that market dislocations and crises always present opportunities, so please stay tuned.

Best,

Eric Sussman
Founding Partner

“If all the economists were laid end to end, they’d never reach a conclusion.”
-George Bernard Shaw

“Prophesy is a good business, but full of risks.”
-Mark Twain

First and foremost, on behalf of the entire Clear Capital team, allow me to express my very best wishes to each of you and your families for a happy, healthy, and prosperous 2020. We had a busy, productive, and successful 2019, and we hope to carry this momentum into the New Year and beyond.

Over the past year or two, I have quoted everyone from Jerry Garcia to PT Barnum to Rod Serling as I have endeavored to reconcile the seemingly contradictory and confounding data points that the economy, investment markets, and national and geopolitical environment have provided. Yet, despite all the uncertainties and risks, nearly every investment vehicle – equities, bonds, commodities (e.g., oil, gold), and residential and commercial real estate – performed very well in 2019. The S&P 500 returned nearly 29%, its best performance since 2013, and all 11 sectors comprising the Index finished in the black. Oil, gold, and bonds achieved double-digit returns.

Even U.S. Treasuries, which tend to decline when risky assets rally, generated positive returns during the year, as the Fed cut rates three times. And if you had any doubt how good a year 2019 was, consider that Greek 10-year bond yields dropped in half (to 2.05%!). So instead of PT Barnum, perhaps I should quote Pangloss, as it truly seems to be “the best of all possible worlds,” at least when it comes to recent investment returns. Significant liquidity and low interest rates are indeed formidable and impactful dance partners.

Taking a longer view, U.S. stocks returned 252% during the last ten years, and for the first time, an entire decade passed without a bear market or recession. That is not to say that there have not been some fireworks along the way. During the last decade we experienced six separate market corrections (declines of at least ten percent), the May 2010 “flash crash,” Europe’s sovereign debt crisis (2011-2012), the devaluation of the yuan, the Arab Spring, global trade wars, Brexit, Trump and impeachment, negative interest rates and inverted yield curves, riots in Hong Kong, the implosion of WeWork, Australian wildfires, a couple royal weddings (pre-Megxit!), the closure of tens of thousands of brick-and-mortar retail locations, and even a total solar eclipse. The financial markets more than withstood each.

However, plenty of risk, uncertainty, and conflicting data points remain. For example, while labor markets may be buoyant, retail sales strong, and inflation tame, domestic and global GDP growth is tepid and manufacturing data mixed, while trade tensions persist, the federal deficit topped $1 trillion for the first time in seven years, and even more brick-and-mortar retail locations seem to close each week. Furthermore, the Fed has signaled that no additional interest rate cuts are in the cards, at least for the near future. Washington remains as dysfunctional as ever, with impeachment proceedings and the fallout from the recent bombing in Iran increasing macro-level uncertainties.

My biggest concern is that investors, desperate for yield in a very low (and in some cases, negative) interest rate environment, have become complacent, and may not be properly pricing risk. The reality is that it is easier to find Sasquatch or political compromise than yield these days, and some investors seem to be ignoring macro-level risks. The Volatility Index (VIX) remains at near-term lows, while the price-earnings ratio of the S&P 500 has increased to more than 24 times earnings, up from 15 at the end of 2018. A mere five companies (Apple, Microsoft, Google/Alphabet, Amazon, and Facebook) make up nearly 20% of the entire market capitalization of the S&P 500, an unprecedented level of concentration. The ten largest stocks in the Index account for nearly a quarter of its value. Interest in and capital flows to secondary, tertiary, and in some cases, quaternary (first time using that word, best I can recall) real estate markets have increased significantly, reaching record highs.

So what were the most significant events from 2019 that impacted real estate (and other) markets?  Which might have the greatest impact on markets looking forward?

In the spirit of the cinematic awards season, here are the nominees for “Most Impactful Event on U.S. Commercial Real Estate Values” from 2019, in no particular order:

  • Implosion of WeWork (Adam Neumann, Producer): With 528 locations in 111 cities across 29 countries and over 12.2 million square feet of leased space, WeWork has been an extremely active player in core office markets. For example, WeWork is now the largest private tenant in all of New York City. The company will clearly be consolidating and cost cutting this year (and perhaps beyond), and many office assets and markets will be affected, though the ultimate fallout remains to be seen.
  • Sharp decline in foreign investment activity (Numerous Countries, Producers): In the first half of 2019, cross-border commercial real estate investment dropped 54% from the prior year, reflecting global uncertainty and capital constraints. In fact, cross-border investors became net sellers of U.S. commercial real estate in the second quarter of 2019 for the first time in seven years. One need only look at New York City where nearly half of the Manhattan luxury-condo units that have come onto the market in the past five years are still unsold, according to The New York Times, as developers bet big on foreign plutocrats—Russian oligarchs, Chinese moguls, Saudi royalty—looking to buy their second (or seventh?) homes.  Those bets appear to have been losing ones.  While 2020 should be stronger as the U.S. remains a safe(r) haven and is still growing faster than other regions, I doubt foreign investment in the next year or two will match the substantial activity we witnessed in the latter part of the last decade.  Reduced foreign investment will affect nearly every property type, mostly core assets in primary markets.
  • Fed’s reversal on interest rates (Jerome Powell, Producer): In 2019, and to the surprise of many, the Fed lowered rates three times, reducing the Fed Funds rate 75 basis points (to 1.50%), the last time in October. However, while the Fed has signaled that no further rate cuts are in the cards for at least the near term, I recently read that UBS predicts that there could be as many as three additional rate cuts in 2020, in light of slowing economic growth and the impact of trade tariffs.  Others say the Fed will stand down in an election year.  We shall see.
  • Passage of statewide rent control in California, Oregon, and New York (Gavin Newsom, Kate Brown, Bill de Blasio, Producers): As I have described in prior updates, local and state governments have been pulling different levers in order to address housing affordability.  Three states implemented statewide rent control during the year, and more may soon follow.  While these efforts are destined not to succeed, in my view, I do not expect politicians to pursue alternative (and probably more effective) approaches any time soon.  They lack the resources, both financial and political, to do so.

If I had to add one other nominee to the aforementioned list, it would have to be the 2.1 million jobs that were added during 2019.  However, these results were not a 2019 phenomenon as we have now witnessed ten years of job gains, including 2.8 million new jobs in 2018.  Regardless, such a noteworthy data point at least deserves an “honorable mention.”

Unfortunately, Price Waterhouse Coopers was not available to count ballots and determine the victor, so we will have to declare a four-way tie for now.  Perhaps a clear winner will emerge sometime this year or next.

So, with all this being said, what should one expect in 2020? 

I recall someone telling me once that when there is broad consensus about something, it is likely that something else altogether different will occur, though I am not sure if there is any academic research to support this platitude.  However, with U.S. equity markets now having experienced the longest and least volatile bull market in history, and nearly every economic pundit not anticipating a recession this year (or even into the first half of 2021), one with a longer view of history has to be wary.  Recession fears have significantly abated, and the UCLA Anderson forecast believes there is a less than 20% chance of a recession through the third quarter of 2020, consistent with the model below, courtesy of Morgan Stanley.

While mindful of the dangers of joining any consensus (I would hate to join any club which might have me as a member, to channel Groucho Marx), I tend to agree with the view that a recession this year seems unlikely, simply based on the strong fundamentals underpinning the markets: low interest rates, significant liquidity, low unemployment, and tame inflation. The $3.4 trillion in cash sitting on the sidelines (highest level in a decade) remains a downside buffer. I find these two graphs, presented side-by-side to tell the story quite simply. While the S&P 500 has risen sharply, so have cash reserves, measured in part by the growth in assets in Money Market Funds.

As I mentioned in the last quarterly memo, Blackstone recently raised their largest real estate fund (over $20 billion) and Goldman Sachs has reentered the real estate fund game. In fact, real estate fund managers raised over $150 billion in 2019, a record.  All that additional equity awaiting investment should also prop up commercial real estate values, or at least create some downside cushion in the event of a downturn or significant decline in asset prices.

However, investor and market psychology can turn very quickly, and the broad complacency extant in the markets is concerning, given the uninspiring growth in GDP here and abroad, recent market returns and valuations, the continued reshaping of the retail landscape, and substantial political and geopolitical risks.  Investors are well served by reducing leverage and maintaining adequate liquidity in markets like these, and I think such an approach is especially prudent today.

Meanwhile, the most significant issue in residential real estate will continue to be “affordability,” as prices and rents continue to rise and outpace inflation

The statistics surrounding affordable housing are sobering, if not staggering. The U.S. has a shortage of at least seven million homes for the country’s lowest income households, and less than 40 affordable homes exist for every 100 extremely low-income households.  Since 1990, the market has lost more than 2.5 million low-cost rental units and rent growth has substantially outpaced wage growth and inflation. For example, during the last decade, rents in Los Angeles and nationwide increased roughly 65% and 36%, respectively, outpacing growth in household income (36% in Los Angeles, and 27%, nationwide).  Homelessness plagues nearly every city, and here in Southern California, one need not look very hard to see the pervasive impact of constrained housing supply.

The underlying causes are several-fold, but the challenges of building in supply-challenged markets remains the most significant impediment to greater affordable housing.  Developers consistently rank NIMBYism (“Not in My Backyard”) as the largest barrier to construction.  The largest markets where building is “easiest” include Cleveland, Milwaukee, Chicago, Dallas, and Houston.  To be candid, we have experienced the impact of easier entitlements in our Dallas/Fort Worth portfolio, as projected rental growth has been lower than projected, though I anticipate supply growth will moderate substantially over time with increasing land acquisition and building costs, and rents will rise substantially in time.  The low inventory of homes for sale nationally sits at its lowest level in 37 years (adjusted for changes in population), and only adds to the demand-supply imbalance.

Not surprisingly, many California markets rank highest in difficulty of adding supply.  It has gotten so bad that the private sector has had to shoulder more of the burden.  Apple recently announced that it is committing $2.5 billion to affordable housing in the Bay Area, following the lead of Alphabet/Google and Facebook, which have similar, though more modest, $1 billion commitments.  Microsoft has committed to invest $750 million to Seattle housing.  However, a lack of capital is merely one impediment to adding to the affordable housing stock.  It is incumbent that local and state politicians simplify zoning regulations, reduce bureaucracy, and accelerate the entitlement process to promote construction and increase housing supply.  Meantime, the affordable and workforce housing shortage is not limited to primary markets like the Bay Area or Seattle. Supply-constrained markets are spread throughout the country.  Secondary and tertiary markets such as Austin, Charleston, and Raleigh are also experiencing a significant need for more supply as residents struggle to find affordable housing.

Rising construction costs are not helping the cause, of course, nor the fact that most multifamily housing building during the last decade was Class-A, and not targeted towards working-class households.  Fortunately, construction material costs remained fairly stable last year, despite the ongoing trade tensions.  Lumber prices actually dropped, declining about 10%, after an 11.2% rise in prior year.  Gypsum (wallboard) costs dropped 8.0%.  However, the persistent, longer-term trend has been quite different, and a shortage of construction labor and contractors (both general and subs), coupled with glacial approval processes are not helping the cause.  Lenders remain bullish on apartments and seem more than willing to fund new construction, but prospective projects are getting harder to pencil, and lower interest rates can only do so much.

The net result is that multifamily rents will continue to increase, though at a slower pace.  Through the third quarter of last year, rents in 79 of the 82 markets tracked by REIS experienced increased rents.  Effective rents nationally grew by one percent and 0.5% in the third and fourth quarters of 2019, respectively, the lowest growth rates in more than two years.  Net absorption of 21,500 units was less than half of that experienced in the third quarter, and 30,159 units were completed, about sixty percent of third quarter activity.  Overall occupancy among multifamily assets nationally has remained between 95 and 96%.

Secondary, tertiary, and even quaternary markets will be the primary beneficiaries of increased housing costs, the sort of markets Clear Capital is focusing on to source potential acquisitions

In 2019, the best performing multifamily markets, measured by annual rent growth, did not include a single core or primary market.  Instead, cities like Midland-Odessa (TX), Pensacola (FL), Las Vegas, Phoenix, and Wilmington (NC) dot the list, locales with strong employment and job growth.  As discussed many times before, companies are relocating to these markets from more costly primary markets, and employees follow suit.  Another source I read identified “Boomtowns in America,” based on the fastest-growing cities in terms of population and economic growth.  The largest markets making the list were Miami and Denver, but Longmont, Colorado is the BCS Champion of this particular list, with appropriate apologies to LSU’s Tigers.

In mid-November, the LA Times published an article, “California Exodus Makes Waves: Boise’s mayoral race is a referendum fueled by those from the Golden State.”  One sentence from the article captures the tension between core and secondary markets: “Candidate Wayne Richey ran on a very simple platform: Stop the California Invasion.” One local Boise newspaper article likened California transplants to a “plague of locusts,” putting things in biblical terms.  While California’s experiences record low growth rates, population outflows, reduced household formation, and lower immigration, tertiary markets like Boise and Longmont are the principal beneficiaries (or perhaps the opposite, if one thinks locusts a nuisance) of the trend.

While these smaller markets may present additional risks, the vacancy rates in secondary and tertiary markets are actually less than one percent greater than vacancy seen in core markets.  With these risks, however, come stronger cash flows. Cap rates average 150 to 200 basis points higher in secondary and tertiary markets than in primary markets.  Not surprisingly, more than half (55%) of multifamily properties bought in 2019 were located in secondary and tertiary markets, up from 43% ten years ago.  While apartment vacancy in core markets has dropped to 3.4% from 5.4% a decade ago, the decline even more pronounced in secondary and tertiary markets, from 7.2% to 4.8%.  Obviously one has to be especially mindful of the risk-reward tradeoffs and perform due diligence accordingly when evaluating acquisition opportunities in such markets.

With all of this being said, it will come as no surprise that the faster-growth secondary and tertiary markets are where we are evaluating potential acquisition candidates, in our belief that most opportunities in core markets simply do not pencil.

But finding value in any market – primary to quaternary – remains no simple task

With so much investable cash sitting on the sidelines, and investors searching far-and-wide for yield, it should come as no surprise that the first three quarters of 2019 witnessed higher multifamily sales volume (nearly $131 billion) than any comparable period in the last ten years.  REITS were particularly active, having spent $7.1 billion on apartment acquisitions, the most they have acquired since 2014 and more than all of what they spent in 2018.

Meantime, while overall volume of cross-border investment in U.S. real estate has declined and slowed, as described above, apartments remain popular destinations for foreign capital.  Cross-border investors spent over $16 billion on apartment property acquisitions during the 12 months ending in June of last year, a 10% increase.  The biggest buyers, by far, have been Canadian investors.

The net impact is that substantial capital is seeking opportunities in the multifamily space, and finding value is no easy task.  Each week the Clear Capital underwriting team is underwriting between 20 and 25 opportunities, in markets across California, Arizona, Colorado, Utah, New Mexico, Texas, Ohio, and Florida.  We hope that our casting a wide net in markets we find attractive will ultimately pay dividends.

Low interest rates should persist well into this decade, meaning the chase for yield will continue

If a single picture can tell a thousand words when it comes to what has happened with interest rates both here and abroad over the last decade, perhaps this is it.

While yields on 10-year U.S. Treasuries were volatile in 2019, they ended the year at 1.92%, as compared to 2.66% at the start of the year, and 1.68% at the start of the fourth quarter.  In mid-December, after reducing interest rates at its three previous meetings, the Fed voted unanimously (10-0) to leave the Central Bank’s benchmark rate where it presently stands (1.75%), and indicated that it would take an indefinite breather on reducing rates further.

The Fed’s statement comes as no surprise, given asset values, recent market performance, and low unemployment.  On the other hand, GDP growth remains uninspiring and inflation remarkably subdued, with the CPI-U up a modest 2.3% in 2019 (0.2% in December).  Perhaps this is why UBS is predicting that the Fed could lower interest rates three times in 2020, in contrast to other banks and prognosticators.  Meanwhile, the previously inverted yield curve has quietly “uninverted,” another indicator that perhaps a recession is indeed not in the cards.

The biggest question mark is whether the Fed can use its usual monetary policy toolbox to combat a recession, should one arise.  After all, the Fed already holds about $3.8 trillion in assets which still includes bonds purchased to stimulate the economy following the 2008 global financial crisis.  As mentioned in my last memo, the Fed has recently had to purchase short-term treasuries and inject cash to alleviate reserve shortages in the banking system.  How many bullets does the Fed have left in its arsenal and how effective will those bullets be in the event that we experience a meaningful downturn?  That remains to be seen.

As mentioned, these low interest rates are, in part, a byproduct of uninspiring GDP growth, here and globally, so the message is mixed

Real U.S. economic growth slowed in the third quarter of 2019 to a whopping 1.9%, reflecting the impact of the tariffs and a decline in consumer spending, which was up 2.9% (versus 4.6% in the second quarter).  Keep in mind that consumer spending typically constitutes 70% of GDP growth.

Meantime, I recently read an interesting piece from Stanford’s Institute for Economic Policy Research, which has created a “World Uncertainty Index,” a broad metric (143 countries) to measure “global views on uncertainty” in the view that “uncertainty” creates a drag on investment and economic expansion.  Their most recent results and conclusions align with those of the IMF, that global economic growth will be 3.0%, the slowest growth rate since the end of the global crisis and down 0.3% from forecasts made earlier in 2019.

But the employment picture here in the U.S. continues to shine…mostly

The U.S. added 145,000 jobs in December, marking the longest stretch of annual increases in employment in 80 years, a truly remarkable data point.  An alternative measure, which captures the “underemployed” and those “marginally attached to the workforce,” the U-6, fell to 6.7%, the lowest figure on record since 1994.  Ironically, the share of adults working or looking for work held steady in December at 63.2%, but remains well below the peak of 67.3% in 2000.  In one dark spot, wages advanced only 2.9% from a year earlier, the smallest annual gain since July 2018.  This most recent data on wages is a little sobering because October’s wage growth (3.8%) eclipsed the average fixed rate, 30-year mortgage rate of 3.7% for the first time since 1972.  However, that achievement sure did not last long.

In any event, this conundrum, an economy experiencing more than “full employment” and yet, minimal real wage growth, will continue to affect everything from multifamily rents to politics to GDP.

Job Growth by Decade

One other employment tidbit I read recently is that the most common occupation for American males lacking a college degree is as a driver – truck, taxi, bus, and/or Uber/Lyft – jobs which may ultimately be replaced with Level 5 autonomy (self-driving cars).  While I suspect this remains at least a decade away, it is at least worth noting as we look into the labor markets of the future.

Of course, I would be remiss if I did not at least pass on a few tidbits about the public sector’s efforts to further regulate housing markets

At the risk of sounding like a broken record (or perhaps a corrupted Mp3 file), here are some noteworthy recent anecdotes from the annals of public sector efforts to further regulate housing markets and tackle the “affordability crisis”:

  • In late November, I read an LA Times article, “Rent Fears Scuttle 577-Unit Project,” about how planning officials rejected a high-rise (six story) residential housing project in South Los Angeles because of “gentrification fears” surrounding “market-rate” housing. The project was rejected even as developers made a last-minute offer to designate 63 units as “affordable,” charging below-market rents.  In a telling quote, one of the Council members voting against the project said, “If the current residents cannot afford it, we should not build it.”  I can certainly appreciate the sentiment, but it essentially ensures that no meaningful housing will be built, affordable or not, without significant financial incentives from the public sector.  After all, where is developable, high-density, housing able to be built and needed?  Beverly Hills?  Keep in mind that the proposed project was consistent with local zoning ordinances, adjacent to two light-rail lines, and therefore “transit-oriented.”  It is truly no wonder that Governor Newsom wants to take control of the project permitting process, ensuring that should a project comply with local zoning laws, it must be approved.  Stay tuned and have your popcorn ready.
  • In early December, the Los Angeles City Council approved a ban on donations from developers, limiting the ability of real estate developers to donate to campaigns of City Council members, mayors, or city attorneys, while the City weighs key approvals for any of their projects, including zone changes or similar issues. Opponents wanted an outright ban on donations from developers.
  • A Portland suburb is about to vote on new law that would tax anyone who demolishes a home ($15,000), with funds used for maintenance of local parks. I am not arguing that maintenance of local parks is not important, but it seems far less important than homelessness or the “affordable housing crisis.”  Moreover, such taxes may mean less development of new housing, at least on the margin.

I suspect that 2020 will bring fewer headlines regarding real estate regulation than we saw in 2019…thankfully. I suppose this means these memos might be shorter, and that is not all bad.  However, let’s not kid ourselves.  The longer-term trend towards increased public sector intervention is clear and will be ongoing.

And finally, a few additional data points or newsworthy items worth noting…

  • The Senior Housing market has cooled: While the broad trends appear very favorable for senior housing with Baby Boomers (folks born between 1946 and 1964) representing one in five Americans, the senior housing market has cooled off lately, in part because of technologies allowing seniors to stay in homes longer than ever before (e.g., sensors responding to various medical conditions, flexible housing fixtures). Senior housing occupancy rates dropped in the third quarter of 2019, to 88%, as compared to 90.2% in the fourth quarter of 2014.  Meanwhile, a recent article in the WSJ, “OK Boomer, Who’s Going to Buy Your 21 Million Homes,” discussed how aging Baby Boomers are going to need to sell their homes in the coming years, but these homes are not necessarily located in markets or locations where younger families want to buy.  According to the article, some 9.2 million homes in the U.S. are expected to be vacated by seniors through 2027 (21 million, in total, through 2037).  Hardest hit will be retirement communities in places like Sun City, Arizona, or Delray Beach, Florida, and the Rust Belt, which have aging populations where young people probably do not want to live, all else equal.  The precise impacts remain to be seen, but it is an interesting phenomenon worth tracking.
  • Apartment sizes have shrunk over the last ten years: As developers build more new apartment buildings in busy urban areas, they are focusing more on studios and one-bedroom units to meet the needs of the market, principally unmarried individuals and childless couples. These smaller units are most commonly found in the urban cores of California, the Northwest, and Northeast.  In buildings developed since 2010, new apartments have averaged approximately 940 square feet, down from roughly 1,000 square feet built previously.  In California, the “shrinkage” has been most dramatic (858 square feet from 974 square feet).

Even if it were not an election year, 2020 should provide plenty of interesting story lines.  The biggest question is whether the markets and economy can continue their unprecedented run

Whether we like it or not, we will find it nearly impossible to ignore the 2020 news headlines, whether political or economic.  While the upcoming election and impeachment news will inevitably bombard us at every turn, I will mostly be interested in economic news and whether this unprecedented run we have experienced in the markets is sustainable.  The S&P 500 is already up over 3.0% thus far in 2020, but three weeks in January do not a year make, especially in an election year.

While I remain optimistic that we will not have a recession this year, I still expect greater market volatility and remain cautious.  Maybe that is one of the things I like most about multifamily assets, as they are more of a longer-term macro bet on housing and demographics, which I find

easier to evaluate and predict than what the equity markets might do this year.  Regardless, no matter what 2020 brings, we will stay the course, remaining the best stewards we can be for the capital you have entrusted with us.  Finally, for those reading this newsletter for the first time, feel free to contact us at clearcapllc.com if you would like to be added to our mailing list. You will receive all future newsletters and information on any future investment offerings.

Thank you, again, for your support, for which we are profoundly grateful.

Best,

Eric Sussman
Founding Partner

If you have to forecast, forecast often.

  • Edgar Fiedler

“An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.”

  • Evan Esar

As I reflect back on the recently concluded third quarter, I would like to start by engaging you in a simple thought experiment.  Imagine that you emerged from hiding on October 1st after a three-month vacation on a deserted island in the Pacific, and someone handed you the following list of data points from the most recent quarter.  After you had a chance to peruse the list, they asked you to predict how the domestic equity, bond, and real estate markets fared during the period, in light of what you had reviewed.  Here is the list:

  • Impeachment proceedings against a U.S. President commenced for only the fourth time in our nation’s history
  • The September U.S. Manufacturing Survey (the Purchasing Managers’ Index from the Institute for Supply Management) had its worst showing (47.8%) since June 2009, and its second consecutive month of contraction, a decline from 49.1% (any reading below 50% is indicative of economic contraction)
  • The New Export Orders Index (also published by the Institute for Supply Management) was only 41%, its lowest level since March 2009
  • Job growth slowed in September (135,000 new jobs added versus 168,000 in August, 223,000 in the same period in 2018, and forecasts of 145,000 new jobs), while wages rose just 2.9% (year-over-year), the lowest rate of increase in over a year
  • California passed statewide rent control, joining Oregon and New York in this select (read: auspicious) group
  • The Fed embarked on this decade’s first rate reduction “cycle,” with two 25 basis point cuts to the Federal Funds Rate
  • In August, the yield curve completely inverted, with all maturities of treasury securities yielding less than that same Federal Funds Rate
  • In mid-September, the Fed implemented “temporary operations” to relieve short-term stresses and soaring borrowing costs in the short-term funding markets (money markets) for the first time since 2008
  • Brent and WTI (West Texas Intermediate) crude oil prices declined 8.5% and 5.8% during the quarter, respectively, despite attacks against Saudi Arabia’s oil infrastructure
  • WeWork was forced to scrap its highly anticipated initial public offering, seeing its most recent valuation of $47 billion (from its last capital raise) evaporate to near insolvency in weeks, the latest in a string of stunningly weak public offerings of previously highflying “unicorns.”
  • Utilities and real estate investment trust’s shares, generally considered safer and more conservative investments, significantly outperformed broader market indices in September

Further imagine that I added one other data point, that retailers, through the third quarter, had already announced nearly 7,900 store closures in 2019, easily surpassing 2018’s entire total of 5,844.  Now I am going to go out on a proverbial limb to suggest that you (and I, for that matter, along with nearly everyone else) wou