Walker Webcast: The State of CRE (Mid-Year Edition)

I recently had the pleasure of sitting down to talk with some prominent members of the Walker & Dunlop team, including Kris Mikkelsen, Executive Vice President of Investment Sales, Aaron Appel, Senior Managing Director of Capital Markets, and Ivy Zelman, Executive Vice President of Research and Securities. In this episode of the Walker Webcast, we covered some of the most prominent issues the commercial real estate industry is facing, as well as some headwinds it will continue to face in the future.

Changes in Homebuilding and Consumer Spending

Although homebuilders had to offer incentives when rates first started increasing last year, they are still seeing a steady demand for homes, as demand still heavily outpaces supply. This imbalance is seen in the new and existing home market. Single-family homes in many markets across the country are in multiple offer situations, indicating that single-family residential real estate is still strong. This is incredible, given the fact that many existing homeowners are locked into mortgage rates in the 2-5% range, giving them little reason to move out of their current home.

How Mortgage Deals Are Currently Financed

Although we are experiencing some economically uncertain times, with interest rates rising rapidly and banks collapsing, there is still quite a bit of activity on the mortgage front, especially within Walker & Dunlop. While there has been some tightening in the liquidity pool, we’re not seeing the tightening that the market experienced during the Great Financial Crisis.

Some lenders are certainly pulling back in terms of lending. However, there is still quite a diverse pool of lenders out there willing to finance real estate deals. The lenders offering liquidity now may not offer the most favorable terms or interest rates, but nonetheless, the money is still there for great-quality projects or assets.

Challenges in Office Liquidity

While it’s relatively easy to get financing for any quality investment, there are still widespread difficulties in the office space. Many lenders already have a good bit of office exposure and aren’t looking to add any additional exposure, given the current trends in work-from-home that we’ve been seeing. Many believe that work-from-home is here to stay and will create difficulties for commercial office space in the near future.

What to Watch for in the Housing Market

While a widespread GFC-style recession seems unlikely in the near future, that doesn’t mean we won’t see economic uncertainty. We’ll likely see more regional instability, specifically in tech-heavy markets like the Bay Area in California. With tens of thousands of high-paid tech workers being laid off every month, tech-heavy markets will likely see some instability in both their housing markets as well as their job markets.

In terms of housing-related stocks, many companies tied to the single-family residential space will likely experience some difficulties in the near term future. Companies like Rocket Mortgage experienced the highest demand they have ever seen in 2021 and 2022 and likely won’t experience the same volume of demand for years to come. This means there will likely be a stagnation in the stock prices of companies like Rocket in the coming months and potentially even years.

The State of Multifamily

The past decade or so has largely been overwhelmingly easy on the multifamily housing market. However, it looks like the relative ease of investing in multifamily is coming to an end. The multifamily investment landscape looks like it will become a bit more difficult, given the current rate environment and increased values of multifamily properties. Given the fact that deals have become a bit more difficult to finance, well-equipped, savvy investors will continue to thrive in this market—whereas poorly equipped investors will struggle.

Is the Banking Crisis Over?

Given the recent collapses of Silicon Valley Bank, Signature Bank, and First Republic Bank, many people are worried that this is just the beginning of a much larger systemic failure of our banking system. However, from what we can tell, that doesn’t look like it’s the case. As of right now, there aren’t any factors that suggest there will be contagion following these collapses. Overall, the economy is faring quite well - inflation is on the decline, and unemployment is still very low. All of these factors, of course, bode well for the consumer.

What Needs to Happen in the Market Now?

Right now, we’re in a situation where if all multifamily projects under construction were to be delivered at the same time, we would be grossly oversupplied with units for rent. This means that we need to see a bit of a pullback in terms of new multifamily construction so that demand can catch back up with supply. Fortunately, given the current interest rate environment, we’re likely to see such a move. Given the fact that debt has become so expensive, many projects simply won’t be viable.

Year-End Predictions

Given that the stock market has rebounded quite a bit from the November 2022 lows we saw just a few months ago, it’s important to look ahead. Currently, the Dow is hovering around the 33,500 mark and the 10-year treasury at the 3.5% mark. Although a lot can change over the next 6-7 months, generally speaking, Kris, Aaron, and Ivy all agreed that the stock market and bond yields are likely to downtrend over the next few months. However, it’s important to remember that stocks and bonds are much more liquid than real estate, meaning they are much more volatile on a day-to-day basis than real estate. This means, although they expect a downtrend by the end of the year, we may see some wild swings in the meantime.

Want to Hear More?

Each and every week, I get to interview some of the most prominent thought leaders in their respective spaces, including members of Walker & Dunlop’s own management team. To hear the entire interview with Kris, Aaron, and Ivy, or any other episode, be sure to check out the Walker Webcast.

Webcast Transcript

Willy Walker: Good afternoon and welcome to another Walker Webcast. It is my great pleasure to have my three colleagues, Ivy Zelman, Aaron Appel, and Kris Mikkelsen joining me yet again to give our listeners insight into what's going on in the commercial real estate industry, as well as the single-family housing world at this time when there are plenty of moving parts in all of our lives and in the macro economy.

As Ivy, Kris and I have talked offline many times, we're all pretty happy that we're not Jay Powell right now because the gentleman seems to be caught in a very, very tricky position between trying to get rid of inflation at the same time, not raising rates to a point where this economy dunks into a long term recession or potentially even something worse. But we'll dive into that, and I'll get the perspectives from my three colleagues.

First, thank you to the three of you for joining me. Let me start here. Ivy, you're always extremely insightful on what's happening in the housing market writ large. I would say that something that has surprised me is the strength in the homebuilder stocks year to date, where I thought homebuilding was sort of a risk off and that there wasn't any capital going to it. And surprisingly enough, the homebuilder stocks have actually performed very well year to date. So, from your perspective, covering the housing universe, what are you seeing that is both alarming to you? And then also maybe some opportunities out there?

Ivy Zelman: I think the homebuilders have really reacted to the expectation that the tightening cycle is over. And while we have seen rates decline, I think people are benefiting or the builders are benefiting from buyers stepping back into the market. Homebuilding companies were very aggressive initially in providing mortgage rate buydowns, offering incentives. Probably net pricing declined anywhere from the peak, from high single digits to double digits in some markets, as much as 20% net. So that really was a value opportunity when rates came back down, consumers were coming in, stepping in, while at the same time on the existing home market, new listings were plummeting as consumers were disincentivized to move. Given that 90% are locked in below five and 50% are locked in below three and a half. So the new home market's gaining share from the existing market. And I think that even today in the existing home market, if the home is in a good location and it doesn't need to be gutted and refurbished, you can even have multiple offers. But we're kind of stuck in a very low transaction market because the demand is not being met, the supply is not there. So the homebuilding industry is benefiting from market share gains in the new home market, which today has gone from a trough of call, a 10% of the total transaction market to probably 15-16%. Could it go to 20-25%? We don't anticipate that, especially with affordability constraints and potential weakness in the economy. But I think the homebuilding sector is benefiting from the fact that they have a new product that is more plentiful than the existing market. So that's why the stocks have done well and we've seen an acceleration in orders. And homebuilding stocks tend to be very much dependent on that type of acceleration or reacceleration, and they will underperform if things are decelerating. So spring brings eternal hope and it certainly has been this spring for the homebuilding industry.

Willy Walker: Let me pull on that thread a little bit for a second, Ivy as it relates to homeowners having locked in cheap debt on their home mortgage with that type of debt locked in for, in many instances, 25 to 30 years, depending on when they actually took it out. I guess there are two impacts to that. One is, as you said, a lack of new supply coming on of existing homes. People want to stay in those homes. There's also something there as it relates to consumer spending, is there not, that there's sort of this subsidized debt cost that typically would have been a much higher number for a single-family homeowner and therefore they've got an extra $5,000-$7,000 bucks a year to go out and go to Disney or improve the home or what have you. Which could continue to drive inflation a little bit further than it typically would. Is that a fair analysis?

Ivy Zelman: Well, I think that from a consumer spending perspective, you know, other than really home improvement, discretionary spending, from our perspective, you'll get personal consumer expenditures. You look at the non-discriminant portion, whether it be rent, utilities, health care is eating up a lot of income while there's wage inflation. So I think if anything, because of the significant level of pressure consumers are feeling on their wallet, it may be that they're keeping their powder dry. And that's why you see the savings rate got so high and now people are back utilizing credit cards. But I just want to add one thing I should have mentioned earlier, Willy, is that one thing that the housing market's benefiting from the new home market is still relocation buyers. And there is a great arbitrage that if you move from, New York to Florida or New York to the Carolinas, the difference is zero. If you're in New York versus, let's say Raleigh or let's say Tampa. So, we're still seeing builders are benefiting from relos. And one other thing I think that we're seeing is that people are willing to refinance. They've accumulated a significant amount of equity. And if they are looking to buy a new home, they might say, “You know what, yeah, I'm locking in at six or six and a half, but I can refi. And I made so much money on the sale of my home and I'm moving to a city that's more affordable.” So, there's a little bit of musical chairs going on. And I'm not sure about the consumer spending piece, to answer your question, more direct, but I do think that discretionary spending is under pressure, and we're seeing that across our mosaic with respect to home improvement, DIY, just people being more cautious, I think, with their spend.

Willy Walker: So, Kris, give us the perspective from the multifamily investment sales market and what you're seeing out there right now as Jerome Powell comes out and says they may or may not raise come June? It's clearly not stability, that's for sure. But is that foreshadowing that we might not continue to see this consistent uptick made it so there's some stability in the market where people can get pricing? Are we still, as you were describing back in December, when we all last got together, really, really difficult to actually determine price?

Kris Mikkelsen: Yeah, if I recall back in December, we were just in the early innings of talking about the ability to make a market and finding a little bit of a floor in pricing. I think we continued that for about six weeks. And then we went through a distinct shift in sentiment in February. That higher for a longer sentiment then shifted again in March. So, it's been a little bit of a roller coaster from a sentiment perspective. I think what's going on right now in the minds of sellers is a question about who's right. Is it policymakers or is it the market as it relates to the forward curve?

And I think there is a very healthy debate, and we could debate for much longer than 60 minutes here with the three of us what the implications are if the market is correct and the forward curve plays out the way that it looks today with rates declining pretty aggressively in the back half of the year and what that means for the underpinnings of the economy. So, I think you've got a lot of sellers that are trying to decide whether or not now's the time to transact or are things going to be materially better if they get some additional relief in rates in the back half of the year?

I think in general, our view in the conversations that we're having with sellers is if you have the ability to go long an asset and ride through this period of instability, then you should absolutely do that. And on the other hand, if you've got an asset where you need to make a decision about a capital event over the course of the next 12 to 18 months, it's difficult to look at all the volatility and all the shifts in sentiment that we've been through over the past 90 days and feel like time is your friend. So, we are seeing a little bit of a pickup in activity. I would say one surprise, Willy, we talked a lot in January that the pressure that was being created on borrowers with floating rate debt and the pressure that those interest rate escrow caps were really kind of creating on those owners. We thought that that would probably manifest itself into a little bit more kind of forced selling. Those owners have gotten a little bit of relief in those cap costs, and we really have not seen any material for selling at this point in the market. So probably thought we would see a little bit more of that manifest itself over the course, the last 30 to 45 days when we were kind of making our initial plans for the beginning of the year. But we really haven't seen that materialize.

Willy Walker: I think all those people who at the beginning of the year were concerned and sort of griping about the cap costs all of a sudden looked at the person who owned the office building and said, Man, my life is pretty good. I'm just going to step up and pay that cap and move on.

Kris Mikkelsen: For the multifamily people on the call we went to NMHC, if cap costs were X at NMHC, 30 days later they were 35% higher than X at the end of February. And then at the end of March they had gotten another 40% relief off of that number. So they were kind of back to where they were in January. So it's been a bit of a roller coaster.

Willy Walker: So, Aaron, you and your team are some of the most entrepreneurial mortgage bankers I know. And I know a lot about mortgage bankers. You've been able to get deals done in this market, whether it be a multifamily construction loan that you did in Brooklyn, whether it be an office refinancing. Everyone listening knows that the capital is tight there. We're in the midst of a banking crisis. How are you and your team actually getting deals financed in these markets today?

Aaron Appel: Yeah. Look, I think everybody knows what's going on with the commercial banks and the depository issues that they've had and some of the shutdowns. And, you know, the interesting thing that I find about it is the markets really absorb these shutdowns pretty well. I mean, you still see a few other banks that are under pressure. But when you look at the funding at the Fed window, First Republic was borrowing a tremendous amount of money from the Fed. And since they've been rolled into JPMorgan that window, the funding window has tightened a lot. So, there's really no contagion effect that we're seeing amongst the banks. I go back and forth on the opinion of what's going to happen with rates, but what's interesting about the market is there is liquidity.

There is certainly much more liquidity than there was in 2009 where there was no liquidity. I think there's a problem in the banking market. There is a huge restriction in commercial bank liquidity. There is a pullback amongst investment bank liquidity and credit from liquidity. But the truth of the matter is there are so many different alternative lenders in the market today versus what there was 15 years ago. And there are so many different options available. People may not like those options. There's a lot of expensive capital in the market. Credit spreads have distress levels to them, leverage is certainly down. But you know, for good projects or good assets that make fiscal sense regardless of the asset class, our belief is that there is credit available for those assets, whether the owner or sponsor likes that liquidity that's available is a different story. But we have not had any transactions that we've worked on that should get financing not be able to get financing. We have deals, you know, when a market is better, we have a lot of deals that shouldn't get financing, that get great financing. And today we have a lot of deals that shouldn't get financing. And we still occasionally get some of those financed, but there's a lot of them that just can't get financed right now.

Willy Walker: If we look at non-multi, we'll dive in on the agencies and their role in this market today and at what rates they're putting capital out. But the back of the envelope for everything non-multi right now essentially SOFR plus 250 to 350?

Aaron Appel: Yeah I mean look I think it's leverage specific, but I would tell you cash flowing industrial of high quality is SOFR 200 at moderate leverage I'd say, cash flowing super high quality offices you know 300-ish over. Hotel is, probably high threes I would tell you. Retail is somewhere in that upper two handle range, I would tell you. Self-storage is probably in a similar range to where retail is. You know there is some liquidity out there. I would tell you that the office market is probably the most challenging. There is just a level of illiquidity that exists for office, whether existing capital providers have too much office exposure. So regardless of the quality of the asset or how good the sponsor is or how strong the cash flows are relative to the loan request, there is just an inability to lending to that sector due to allocation, and a lot of credit has that issue around the country, whether it's banks or insurance companies or different types of credit funds or mortgage REITs or pension funds. They all have substantial office exposure. We're all trying to shrink that exposure. I think that's creating more liquidity.

The other thing I would also point out is, the markets are not as bad as what you read in the papers or in the media. Any time the headline is a pure panic - CRE disaster coming, wall of maturities, office is completely collapsing. I can tell you wholeheartedly that none of that is happening in the fundamentals on the ground or dramatically better than what we're hearing in the news. Albeit we are operating in a market with substantial less liquidity than we have at any time in the last 15 years.

Willy Walker: So Ivy, you a) called the great financial crisis and then had a very interesting, if you will, perch to see what was happening to the liquidity crisis that Aaron was talking about the credit crisis. We're in a very different market today, are we not, as it relates to the overall macro fundamentals and as you sit there and are trying to figure out whether we're going to dunk this thing into a recession or whether we're going to have a soft landing, what are the what are the key things you're looking at and your team is looking at as it relates to opinions on the various stocks that you cover and more broadly, the housing market?

Ivy Zelman: Well, I think we recognize that we're not in any kind of credit bubble. I mean, when you go back and look at what caused the GFC, it was credit and too much of it and, you know, very loose underwriting. And that's not an issue today. The mortgage market is very sound. So we think, if anything, we're going to have what has been historically more of a regional type recession that will be job dependent.

So where you have high job losses, you'll see more pressure in those markets like the tech markets today, whether it be in Seattle or in Northern Cal or in Denver, you see more pressure in those markets.

Willy Walker: And in that ecosystem, Ivy, there's obviously the homebuilders there, the brokerage firms. I actually saw today that Compass loses $150M in the first quarter and actually gave a pathway to making money, which quite honestly surprised me as a single-family brokerage company that has had such significant losses that they think that volumes are going to pick back up or they actually could make money on the single-family brokerage side. But they're obviously the homebuilders. There's the SFR/BFR space, there's the home improvement space. Out of that ecosystem, what do you and your team like right now as it relates to who has the opportunity for growth in what seems to be a relatively dislocated market, for instance, Rocket? There's another one there. I mean, Rocket, I scratch my head thinking about when Rocket ever gets back to volumes that they had in 2021. You probably have some model that'll show you exactly when they do it. But my thinking is it'll be a very long time.

Ivy Zelman: Well, you know, I think of the ecosystem as all in the same high rise building just on different floors. So, it's all impacted by the same macro variables, just the magnitude to what extent. And, you know, if there's a collapse, the whole building comes down, everybody goes down and it's just, what floor are they on and who falls the hardest. And I think that today it's about the management and how well they're executing and what their strategy is and how they're allocating their cash flow that they're generating and where the smart C-suite executives are going with their capital.

I think that we try to differentiate, therefore, between the companies within the industries and the various silos. And I think that we have individual companies that, for example, Rocket is a company that is probably one of the few in the mortgage industry that actually has a balance sheet that can actually invest in their growth and look to innovate the industry and is providing significant opportunities for consumers today. Their market share is growing in the purchase market and in the refi market. But when you add the two together, because the refi exposure has been so significant, it looks like their market share is going down. So, you know, people that have a more optimistic view that rates are going to come down with a soft landing, Rocket would be a great buy right now. And when you think about the individual companies, I think it's really about the management teams and execution. And you have to pick the winners. It's a stock picker market today, Willy, no more just buy them and run with it. Because as you said, we don't know which direction Jay Powell is going to go and yeah, it's a stock pickers housing sector today.

Willy Walker: I will point out that as we were going through our earnings script and I was trying to prognosticate on the macro market, you were like, “Just focus on what we're doing at W&D. Don't tell the world where interest rates are going. That ain't your job. Your job is to make sure that your investors understand where the company is going,” which was sage and very helpful advice.

Kris, as Ivy talks about the various levels of the skyscraper and how far down you want to fall - as far as multifamily is concerned and assets that are actually trading right now and actually have both sellers putting them on the market and bidders coming in on them, who's on the first floor and who's on the 30th floor?

Kris Mikkelsen: The first floor being you're safe and you can walk out unscathed?

Willy Walker: You’re safe. You’re not falling that far.

Kris Mikkelsen: That's going to be the clean de-risk, Core and Core Plus assets that are out there. The further you move up the elevator to the 30th floor, the closer you get to the opportunistic side of the risk spectrum or the tertiary side of the gateway to primary to secondary to tertiary kind of market continuum. That's where there's still challenges and still a pretty large bid ask spread. You know, Ivy, I think there are a lot of similarities across all of our industries. We've talked so much about really kind of thinking about the world as shelter, as you put it, and housing and how the for sale market and the for rent market ultimately are kind of converging and, maybe build for rent is in the middle. But you talked about a scarcity premium that's really kind of keeping a solid floor under housing values and pricing in the market. You talked about limited trades. That's exactly what we have going on. You talked about the importance of being kind of a stock picker market.

Anyone that's been active in multifamily investing for the past decade, almost without exception, has just had indiscriminate success. And we're moving into a period now where there will be winners and losers and we will see the savvy investors really start to emerge. So, I think that that's something that we're kind of paying attention to, and we're really focused on paying attention to what the groups that have been ahead of trends for the last few years, kind of paying attention to what they're doing. And I think what you see them doing right now is trying to fill gaps where there’s really kind of levels of illiquidity. And Aaron will talk a little bit about that in the credit space.

But if you have the ability to go play on a new construction pre-stabilized asset today when the only buyer with the only capital structure today that allows you to compete in that transaction market versus 12 to 18 months ago when the debt fund space was as liquid as it was, there were 10 to 12 competitors for that same asset, those start to be pretty compelling opportunities and pretty interesting opportunities that are being pursued by some of the groups that we pay a little bit more attention to,, like I said, that are typically a little bit out ahead of the pack.

Willy Walker: On that, Kris, cap rates have adjusted to what? Obviously, it’s market specific, it's asset specific, but I saw one of our competitors put out a research report that said that broadly across the country, multi cap rates have gone up to 4.72% mark. What are you seeing in the market today?

Kris Mikkelsen: Yeah, I mean, we're paying a lot of attention to the buyer interview surveys that we're conducting on all the transactions that we're conducting across the country. I would say in general return metrics, again, this is in that kind of de-risk Core to Core Plus side of the risk continuum, unlevered return targets are kind of solid right now in the mid to upper sevens. Residual cap rates have really kind of settled in on the margins of 5%. We've seen a couple of anecdotes where they've been underwritten by groups inside five, call it four and three quarters. But I think on the margins of 5%, I think we're pricing is really differentiated today as is where buyers kind of feel emboldened about the underpinnings of the economy and the growth assumptions.

I think on the low end, we're seeing kind of two and a half to 3% revenue CAGRs over the course of the hold in some markets. In some situations, we might see 50 to 100 basis points. On top of that, maybe more muted growth over the course of the next few years and then recovering pretty robustly in the 26-27 time period. And so, when you kind of put those return targets and those growth assumptions into a blender, you see year one cap rates in that upper 4 to 5% range and we've seen a pretty solid footing in that range.

Willy Walker: Aaron, we've seen the agencies pricing debt that allows you in that high fours, low fives to actually, we just did a deal last week. It was $140 million Fannie Mae fixed rate loans, seven-year term at 4.98, and the buyer bought the asset at a 5 cap. So, they actually have a little bit of positive leverage on that. In the other non multi asset classes given where cap rates are on retail and office, can buyers actually get positive leverage given where spreads are and where cap rates are in non multi assets or is it still pretty upside down?

Aaron Appel: You're going to call that the mile high deal?

Willy Walker: Haha. Yeah. Exactly.

I've got to give our listeners a little bit of background on what Aaron just said, which was just that I was actually on an airplane boarding and the CEO of the company that had bought this asset that was coming to Walker & Dunlop for financing, walked by me and we had a nice conversation and I texted the banker and asked, “Have we rate locked this deal?” because it was brought to the loan committee at Walker & Dunlop the day before. Banker came back to me and said, “No, we're waiting on the sign off from the CEO.” So, I walked back to the CEO and said, “You ready to go? ten years at 335?” And the CEO said to me, “Can't we just lock tomorrow morning?” To which I said, “In this market, if it looks good, I'd take it.” The CEO said, “Go.” At 3:59 in the afternoon. We got it to the desk and the desk rate locked it. Last Friday morning, the jobs report came out. The seven year was up seven basis points and investor spreads went up by four basis points, which an 11 basis point change in the rate from a it was 498 was our all in coupon rate. So add 11 to that and that ended up saving the client over the next seven years, a million bucks in debt service. So that's why Aaron said it is that the mile high one because we were taken off to go up well over a mile into the air - but it's not a Denver asset, which is what I thought you originally were talking about. Anyway, sorry for the long anecdote, but yes, we got that done.

Let's go outside of multi for a second, though, because clearly you're right that in multi with the agencies pricing where they are, you can find positive leverage or just a little bit of negative. Is that something you're seeing in other asset classes given that retail cap rates are in the sevens and you can finance it for SOFR plus 250-300 or is that out of the question right now?

Aaron Appel: I would tell you that it's worth the retail that we've seen. First of all, there are very few acquisitions. So let's start there. The acquisition market is not active. We've seen positive leverage on retail, we've seen secondary retail, there is some decent tenancy that has good operating history, trade in the 9-10 cap range where you can find positive leverage. But you know it's very costly. If you talk about high street retail and top tier urban infill corridors or elite suburban corridors, that stuff is not moving. It's not trading right now. That's a product that, hypothetically speaking, should trade somewhere between a six and seven and whether you get positive leverage depends on where the Treasury is on that given day. But it's very, very iffy. And, you got to look at longer out on the curve. So borrowing five year money and ten year fixed rate money right now is substantially less expensive than borrowing shorter duration floating rate credit where SOFR is above 5%. Meanwhile, the treasuries have condensed on top of each other pretty much and we are in that sort of three and a half percent range floating around. There's a huge savings there. Look, can you find a credit office deal and find positive leverage? Yes. If you have a commingled triple-A building, can you get positive leverage potentially? I think so. But you know, for anything else outside of that, the answer is most likely not.

Willy Walker: And on that, Aaron, when you are advising your clients right now, given your view of where rates are going, is your advice to take a five- or seven-year fixed rate and lock it in and hang on? Or is it, you know what rates are coming back down, you ought to float?

Aaron Appel: Look, it's tough. I would tell you and I've talked about this a lot with a lot of people over the last week or so. The Fed, if they want to stem the regional bank issues, they are going to have to either buy those, hold maturity assets and reimburse those banks with cash at par, or alternatively, they're going to have to cut the short term credit rate substantially, because right now a lot of the regional banking business models don't work with the rates that they need to pay to retain deposits versus, what JPMorgan or Citigroup were paying a quarter point or even less in some cases on deposits. Their net income margins are vastly stronger. The regional model is a bit broken. And I think it's creating a lot of pressure.

Willy Walker: Ivy, one of the things I've heard you say is that if Jerome Powell has to cut that may sound great from a rate standpoint, but that's going to be in the wake of some pretty ugly other stuff going on in the economy.

Ivy Zelman: And I would imagine it's fairly grim if he has to cut. And so, I don't know that we should be celebrating. I think that we have a real conundrum. And I told you I wouldn't want to be Jay Powell. So it's not an enviable place to be in. I think that when you go back to housing, what I really concluded is that housing is dependent on confidence. If there's fear in the air, people are concerned that they're buying at the peak of the market or they're locking into any commitment that could be the top of the market, irrespective of its home improvement or even paying top dollar and rents.

I mean, they're going to be hesitant, and fear will dictate, incrementally, where consumers go and what they spend and the assets they purchase or in the case of rental. But if fear like we saw, rates are stabilizing, people's home prices are going down. I'm not buying at the top. I feel better and I still have a really good job or I feel confident about my job. And so ultimately rates are important. But what's the most important thing? I think it's confidence to see the volatility in the market. That will dictate a lot.

And of course, you know, the companies in my mosaic, when I talk to management teams, I'll say, what are you doing today with respect to hiring? What do you do in CapEx? What's your plan for the next year or two? And a lot of them will say, you know, we're pulling back and everything and that's self-fulfilling that so that's, and then of course, if you can't get access to capital and there are small businesses, and it affects the food chain. I think we almost create a recession ourselves just because the banks stop lending, and the companies pull back. And so I feel like I say that it's a death by a thousand cuts as opposed to a plunge. And we are just going to keep in this range that maybe the Fed's going to keep us in. I personally don't see rates coming down. I think they're in a tough spot, so inflation's too much of a concern.

We do anticipate that at least the housing CPI is going to decelerate, and we anticipate that rates are normalizing for rental rates and that's going to relieve some of the pressure on overall CPI with 40% being shelter. But not being able to predict every other aspect of the 60%, I think it might be more stubborn. And I think that they're going to be more pragmatic. So, I just think that people are hunkering down, and they don't know which direction things are going.

Kris Mikkelsen: But Willy, it's a great question. And I'll give you a flavor for some of the conversations we're having on our end. We've probably been as busy as we've ever been providing brokers' opinions of values. So BOVs left and right and will submit a BOV and we'll have a follow up call with the seller and they'll ask us to revise the value, assuming that rates come in 50 basis points by the end of the year and it's a Q4 sale. And it's back to what I was talking about earlier, where they've kind of fallen in love with the forward curve and they've got this idea that everything's going to be better in the fourth quarter.

But back to Ivy's point, you know, we are in a period of deceleration and a reversion to the mean as it relates to operating fundamentals and irrespective of the rate environment, our message to those potential sellers is there's nothing more detrimental to the value of your asset than deteriorating and declining fundamentals. We can get through the deceleration of fundamentals, but once you start to see negative trends showing up and manifesting itself in the rent roll, there's nothing harder for Aaron to go finance and for us to go sell at a price and any seller is going to be pleased with. So having that conversation in concert with the what if there are cuts in the back half of the year and we're in a more friendly rate environment, what that means for the underpinnings of the economy and asset fundamentals is a delicate balance.

Willy Walker: Yeah, it's an interesting one as it relates to employment and what would have to happen to employment to get the Fed to cut. Because my tummy would tell me that they want to see five and a half percent unemployment. I, quite honestly, find it to be unbelievable that our federal government wants to see more people out of work than in work. But I also understand the calculus. They're like, we need 2% inflation. And right now, the driver of that is this very, very tight labor market until we get some relief from the labor market.

But, you know, so much of the housing market is dependent upon employment, rent growth is dependent on employment and new home building is dependent on employment. And so you sit there and you sort of say, well, what they really want to do is slow down the economy, slow down employment to get to the number they want to. But exactly to what we're talking about, if all of a sudden someone says, well, that's going to be great, I'm going to pick up 75 basis points on the ten year. It's going to be a really ugly outlook in the macro picture to get the Fed to get there. And therefore, what's the underlying performance of your asset and can it sustain the 75-basis point pick up you're getting in rates? And I see Ivy, you're nodding on that one. I mean, isn't that sort of right? I mean, don't we sort of want things just to kind of hang tight here and not have a not have rates come back down?

Ivy Zelman: Yeah, I think rates coming back down will just reinflate the economy and that will obviously put us right back where we started. And so, I think that's the delicate balance. As we think about what we should do and recognizing the best thing is to be sort of prudent and not do anything knee jerk reaction. But I do think the economy seems to be at least flying out to L.A. today. I mean, every flight looks jammed and things are oversold and you're just like…

Willy Walker: Just wait, though, Ivy, the Biden administration is coming to the rescue. I'm just talking about having delayed flights. I have to tell you, for the life of me, I read that article this morning in The Wall Street Journal and last week I was flying from DC back to Denver and there was a front of storms. And so they diverted our United flight to land in Wichita, Kansas. And I'm sitting there with, quite honestly, the entire congressional delegation from the state of Colorado, Montana, Wyoming and Idaho, because they all come to Denver and then connect through.

I'm sitting there now in hindsight thinking, well, if United was going to have to pay, I don't know what the number would be. Let's just say $50,000 in fines because they diverted us to Wichita, Kansas, and we were three hours late getting into Denver. Maybe they just say, let's just barrel through that front of weather and see whether the plane makes it through. And I'm just like, just take me to Wichita and get me home safe. Thank you. I'm okay. I didn't like being home three hours late, but I'll take that rather than some fine being imposed on them by the Biden administration. Anyway, sorry, I digress. That one really seems to be a reach. But yeah, to your point, you're seeing people on airplanes, you're seeing people out moving around the economy, and the economy still has a lot of life to it.

Ivy Zelman: Well, you know, and you think about the shortage in the labor market. I mean, the housing market's reaccelerating and builders are going to start more homes and assuming they're going to have difficulty doing so because there's a shortage of labor and the material industry, the building products, overall building materials haven't deflated. And so, as they start more, and demand is accelerating and then you get supply chains. So I don't know how quickly housing will reaccelerate. We think it's going to stay relatively in an improving mode in starts for single family, but not gangbusters. But that's the risk. They are damned if they do and they're damned if they don't.

Willy Walker: Aaron, one of the things that you talked about was sort of TARP 2, because if you think about what we just talked about, you really kind of want the economy to muddle along here. You really don't want them to cut again because cutting is going to basically say the rest of the economy is really in bad shape. But you've underscored the banking crisis and the fact that we do have a confidence crisis in banking. And until the Feds do something here to get all these bank balance sheets from being upside down, we're stuck because capital is going to continue to move around and deposits are going to continue to move around. So does that lead to a desire to say, hey, set up TARP2 buy a bunch of these assets, clean up some of these balance sheets and allow for the banking system to move forward?

Aaron Appel: I would tell you yes. But the problem is there's no signs of contagion from this banking crisis that we've had so far. There's a few that could collapse. Okay. The equity holders in those banks get wiped out. They've made it clear they're protecting the depositors. And it seems like you may have consolidation, which is sort of what happens here, but you know, the asset quality is not toxic. You will get repaid as opposed to 2008 when the asset quality and the collateral was absolutely toxic. There is little money to be had.

So, when you see the service sector, wages still growing and you see service orders still through the roof. Manufacturing orders are substantially down. But I think people had their fill of buying cars and refrigerators and other hard goods they did the last three and a half years. You know, people want experiences, that still cost a tremendous amount of money. And you're not seeing the job losses candidly. You know, you may see in the transactional business a slowdown. So people are making less money. You may see in the real estate market, for example, certain assets being hurt, and you may be seeing some sort of level of asset deflation to a certain extent. Part of that has to do with the use of those assets. Part of that has to do with the cost of funds. But you look in the public markets and the S&P 500 is barely down. You know, the triple cues are down, you know, 14-15% from the highs, there's just not enough pain out there candidly. We feel it more because our sector has been hit sort of in two different directions, one with interest rates driving up borrowing costs. And secondarily, we see it with some of the non-functionality tied to the office asset classes in the different ways people are using real estate. But, you know, look, there are winners and losers in the investment business, and we sort of forgot that. And that's sort of the risk to the market.

But, the one thing I would say is it pertains to commercial real estate, which I find to be interesting, is there is absolutely little to no equity bid for commercial real estate development. The project has to be so unique, so special, in order to garner institutional equity right now at any level for a development project, family office capital candidly. You know, this goes on for another year you will start to see, in my opinion, the huge lag in multifamily housing starts. You're going to see a big lag in for sale housing. I think you're going to see more and more antiquated office space. I think you're going to see underutilized other types of real estate. And it's going to be very, very interesting to see how this plays out because there is certainly a strong, strong sentiment and push back from the capital base in terms of investing in new development projects right now. And, you know, to me, that means more than anything, I'll be the one to say it, I think we're functioning as someone in the strong direction of a stag-flationary environment.

Willy Walker: Yeah. I just add one thing to that, Aaron, that I think about is that I mean, it seems to be the sentiment that you can get equity yields on debt today, so why would I go into the equity position? I'm just going to go buy debt or be a lender because for the first time we actually have money that has a return on it. And so, I do think that that's part of this piece about equity investors saying I don't want to really go into a construction loan right now because I've got a lot of risk. And unless I'm getting paid some massive premium over what I can go from just making a first trust mortgage, I might as well sit in the first trust mortgage position.

Aaron Appel: And the math isn't there. I mean, if you just want to take your standard multifamily development project, let's say your first mortgage costs you 8%. Let's say that cuts off somewhere between 55% of cost and to get to 70%, which used to be relatively the norm, that money costs you 13 or 14%, debt equity is going to look for a 20 plus percent return and candidly almost impossible to find right now where exit caps are, where cost for construction are, and the cost of funding is for a project. It makes it very, very challenging. So, that should lead at some point to offset any sort of rent pressure there is for rents to go down and lead us to another boom cycle at some point, I would imagine.

Kris Mikkelsen: The market is littered with five and a half to five- and three-quarter return on cost multifamily development projects that are utterly stuck. And I think Aaron's spot on. I think this ultimately, as we kind of work our way through this, will probably create some opportunities as capital starts to come back to the market. I think that's probably an interesting place where that capital can play. But the other thing that it's going to do is it's going to exacerbate the affordability issue that we have in a lot of these major cities, which is a real problem. So as we think about policy making conversations about setting up construction loan vehicles to get some liquidity to this space - if this current situation persists for the intermediate term, Aaron is spot on. It's going to create real pressure in that ‘25, ‘26, ‘27 time period, once the backlog that's delivering right now is as we've talked a lot about, gets absorbed, we're going to see a real housing shortage issue.

Aaron Appel: I also want to add one other thing as it pertains to unemployment. The Fed is fighting yesterday's battle. There's been a massive push forward of the baby boomer generation to move into retirement. That got accelerated with COVID. We have not replaced that population. We just do not have enough skilled laborers in the market. Look, the hope is that technology through AI and robotics starts to substitute for some of that skill that we need. But I still think from a true usability expansion we're still a substantial way off and it is going to be almost impossible for them to crack unemployment without really, you know, dangerously harming the economy in the long run.

Willy Walker: Ivy, anything on what Kris and Aaron just threw out there or I'll move to our closing thoughts?

Ivy Zelman: No, I feel like I'm going to be outside my lane if I start opining on my views.

Willy Walker: Both Aaron and Kris are sort of saying, look, if construction dollars and if both debt from banks as well as equity are as scarce as we see them today, there's a good chance that we go through 2023 with very few starts, which would then say jump out two years from there and you have very few deliveries. And so, I do think that that's one of the things that a lot of people are very focused on right now. And I'm assuming you and your team are also focusing on that because that has a big impact on both the single-family world as well as the multifamily world.

Ivy Zelman: Right. I do think that assuming we see development and starts contract significantly, especially in multifamily, where backlogs are at the highest level that they've been in decades. That needs to happen because otherwise we're oversupplied if all that backlog gets delivered right now, we're not oversupplied really today, but we would be if we delivered it all today. And so then we have a correction because we don't have anything coming in the funnel or very little is coming in the funnel. So you start to see a recovery of ‘25 and beyond. There's too many economic backdrop is positive. So we could see through to that period where we'll be through the tough completion delivery impact that may have on fundamentals that will revert the market to that lower call it rent growth in the low single digits, kind of 1 to 3% nationally or even sub two. And so, thinking about that, then you see past that to Aaron and Kris’s point.

Aaron Appel: It's been so long since we've had a market cycle that people forgot that we had market cycles and that is exactly what's happening right now.

Willy Walker: So, let's end on this. And only because their proxy is not because any of you are in the stock trading market on a daily basis. But the Dow closed at 33,500 today and the ten-year closed at 350 today. Easy numbers, just ballpark, I'm off by two basis points on the ten year and a couple and change on the Dow. But 33,500 and 350 on the ten-year. So think forward to December 31, 2023 to give a sense of where you think things will be from either the overall economy on a Dow or interest rates on the ten-year. Give me your throw the dart at the wall and give it a guess. Aaron, I'll start with you.

Aaron Appel: Well, if you go back a year or touch over a year, when rates were at 1%, the ten year was at three and a half and the Dow was somewhere around 33 five. So we've brought rates up from 100 basis points, 500 basis points or up over 500%. And the stock market in the major indices are in the same exact place and the ten-year treasuries in the same exact place. So, you know, that still means to me that there's way too much steam in the marketplace. I think we'll go down. I anticipate a ten-year treasury somewhere between three and 315. And I think the Dow is somewhere in the 3000ish range would be my guess, or 30,000 to 31,000 range.

Kris Mikkelsen: All the listeners really want to know is where Aaron thinks Bitcoin is going to be.

Willy Walker: Exactly, you got it. Where we got it where Bitcoin in the price of what was it, lemons, or eggs?

Kris Mikkelsen: Bitcoin and eggs. Exactly where is BTC? Are we at 29 or 30,000 right now?

Aaron Appel: Failed banks are good for Bitcoin.

Willy Walker: Failed banks are and a weakening dollar with no other fiat currency for people to go into. Kris 335 on the Dow and 3.5% on the ten year - where are you going?

Kris Mikkelsen: Yeah I'm a little suspect of the equity indices because so much of their resiliency is tied to the larger cap tech stocks. And the reason why they've rallied is they've got religion around their business models. They all got fat over the course of the last decade, and they've returned to focus on profitability. And that's really been the leading edge of the white- collar job recession that we're in right now. So I think there's going to continue to be earnings pressure in the public markets. I'm going to say probably call it 8 to 10% lower on the S&P from where we are today. And I tend to agree with Aaron. I think that we'll see the ten-year bond trade down. I'm not going to go three to 315. I'm going to be a little bit less controversial and just call it range bound between 325 and 335, which the reality is, is that's been the median forecast for 24, 36 months out from the majority of the fixed income analysts that we've been surveying for the past couple of years. So I'm going to stay in the fat part of that fairway and call 325 to 335.

Willy Walker: Nice ten basis point range there. The last word. Ivy, what's your thought?

Ivy Zelman: Well, barring anything like war or something like the government failing, I think it's going to be more of a slow bleed. So, when I think about today's optimism at the stocks reflecting a much bigger recovery and thinking that the Fed is going to start cutting and we're back to the races, I wouldn't want to own equities. And in that backdrop, I think you have to think about owning fixed income, owning treasuries, just recognizing we shouldn't be very optimistic right now. There's not a lot to be excited about. Equities seem to be too in my mind, I don't know what I'm missing. Why is the market up as much as it is?

And it's all about the Fed ending the tightening cycle. We're back to the races. So I think that's where I would just not be incrementally long equities and thinking about, if anything, where the ten-year goes will dictate where equities go, just because that's the near term sort of trader mentality. So, if Aaron and Kris are right and rates are headed lower, you know, it might go higher before we go lower. But I just don't see a lot of optimism. And therefore, when you think about whereas a ten-year ago, I think it kind of just is in that trade, it is more of an a trading range. I just don't see with that sort of prudent perspective, I think the Fed has to have and being more pragmatic, we just might be slugging along for a while. This is not my area of expertise calling rates. I don't think any of us will get it right, to be honest with you.

Willy Walker: Yeah, I got it. Well, thank you all. I would say as the point of not a whole lot to be optimistic about - we've got our debt ceiling coming up. We've got some significant skirmishes around the globe. We've got a U.S. election coming up before we know it. And there's a lot of stuff to navigate. But as we all know and have all said many, many times, I wouldn't bet against the United States of America and our economy. So, we'll figure our way from here to the other end.

Thank you very much, the three of you. Thank you to everyone who has joined us today. I always love these discussions. And I have to say, when I get on this webcast with my three exceedingly talented colleagues, I have to sort of pinch myself that we have this type of team at W&D that we do. So thank you, Ivy. Thank you, Aaron. And thank you, Kris. Have a great day. And we'll be back next week with another Walker webcast.

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