This content was originally sent by email to RealtyMogul registered users on March 14th, 2020.
Dear Investor,
We are sure living in strange times.
While we believed that our next economic cycle would be the result of a black swan event, we did not predict that it would be the result of a health pandemic sweeping the world. First and foremost, we hope that folks are staying healthy, keeping distances, and are adequately supplied to hunker down at home for a few weeks if that is what this crisis leads to. Family and health first.
Regarding the economy and its potential impact on real estate, we thought it would be helpful to share some potential outcomes and what we have been seeing in the market since this pandemic began.
While the stock market has been incredibly volatile and has posted losses north of 20% as I write this, we have not seen a similar slowdown in real estate – yet. We continue to see aggressive terms being required to win deals. One of the reasons is interest rates. The Federal Reserve dropped interest rates 0.50% (50 basis points) on March 4, 2020, in response to the crisis. Some economists are expecting a further drop of 75-100 basis points at the next Federal Reserve meeting next week on March 18, 2020. Lower interest rates can increase the pro-forma returns of real estate deals, making them appear more attractive under the same underwriting criteria, as financing costs are cheaper.
However, we do not believe real estate has had enough time to absorb recent news or integrate the full impact of the stock market decline and likely economic slowdown. Deals that are closing today were placed under contract to sell 30-90 days ago, based on information available at that time.
So what happens in the future for real estate?
We see a few scenarios that could play out. In one case, real estate continues to perform because of cheap debt – which might get even cheaper next week after the Federal Reserve meeting - and the lack of better investment alternatives. Even before this current crisis, there was a tremendous amount of capital chasing deals, domestically and internationally. As the economic impacts are felt around the globe from this downturn, we believe people will still maintain confidence in the relative strength of the US economy. We believe folks will still invest in US real estate as part of their “flight to quality.”
We believe it is possible that we will see zero to negative interest rates for the first time in history in the United States. This Oaktree memo on negative interest rates is particularly interesting if you want to learn more. Negative interest rates are one thing, but the real question is what impact they could have on cap rates – which are a key driver in the value of real estate. Keep in mind, the lower the cap rate, the higher the value of the real estate, and the higher the cap rate, the lower the value of the real estate, all other factors being held equal (namely net operating income). Interest rates are just one factor affecting cap rates however, with demand for real estate and other risk assets being the other key factor. The effect of fear could outweigh any positive impact from interest rate cuts.
So, if we end up in zero or negative interest rate territory, what happens? Short answer, we don’t know, but it has happened in other countries. German, French, and Japanese government bonds have yielded 0% or less on 10-year bonds and in Berlin, Paris, and Tokyo, all three cities have sub 3.00% average cap rates for real estate.
Now we are not suggesting we will see sub 3.00% cap rates in all markets of the U.S., but it does make us question if the already low (by historical standards) cap rates we are seeing today do in fact have room to move down.
On the other hand, there is no way that real estate will escape this crisis unscathed, and while you may not see it in cap rate expansion, we think you will see an impact in net operating income or “NOI”. For those unaware of the term, net operating income is all revenue from the property minus all operating expenses, before taxes and before any payment on loans.
People are going to get sick. People are going to cancel vacations. People are going to cancel events. People are already losing their jobs. People are going to hoard cash if they can, and discretionary spending will decline. The fact that the price of oil has moved so dramatically helps put some additional money in people’s pockets, but the reality is that fear breeds behavior that is not good for the economy. We are lucky in that the U.S. was running at historic lows in unemployment prior to this crisis, so we are starting from a good place. But it is hard to say today how many hard-working Americans may lose their jobs. Many Americans live paycheck to paycheck, so a job loss could mean an inability to pay rent. We expect bad debt across our multifamily portfolio will go up. Other Americans who were stretching beyond their means will go from living in Class A apartment buildings to cheaper Class B or from Class B to cheaper Class C. And still, other Americans will move home or move in with others – increasing vacancy.
The real question is whether cap rates decline enough as a result of the low interest rates to offset the loss in net operating income, or whether market fear and asset revaluations causes risk premia to increase, notwithstanding any drop in interest rates. If cap rates don’t decline, will both cap rates expand and net operating income decline, leading to a double hit and possibly lower valuations in real estate? This is the multi-billion-dollar question, and my answer is: I don’t know.
But I do know what we are doing today at RealtyMogul.
We remain vigilant and proactive.
We have conducted a strategic review of every asset in our portfolio to identify assets that can and should be refinanced to take advantage of lower interest rates.
Across the existing portfolio, we are recommending that capital expenditures and rent increases are put on pause where possible. We are making all efforts to avoid additional vacancies and keep cash on hand. The top priority is bolstering the balance sheet of each individual transaction. Maintaining occupancy and cash in real estate are the keys to weathering any downturn.
In addition, we have played defense. The majority of the RealtyMogul portfolio, 73%, is in apartments with the majority of that in workforce housing. Historically, this product type has shown resiliency due to its affordability in times of economic distress.
With market dislocation may come opportunity. We are sitting on cash in both of our public, non-traded REITs, and we are cautiously looking for opportunities where we can take calculated risks while ensuring we keep investor protection at the forefront.
To those who have invested with us at RealtyMogul, we do not take the job of managing your capital lightly. We continue to believe in real estate as one of the best asset classes in the (still) strongest economy and country in the world.
Keep healthy,
Jilliene Helman, CEO
All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.