ADISA Video: Investing in Real Estate Through all Market Cycles
With the increase in inflation, stagflation and rising interest rates, real estate is in the midst of various market dynamics that impact the industry in a way that experienced investors haven’t experienced in decades. Greg Mausz, chief operating officer and senior managing director of Skyway Capital Markets, interviews Warren Thomas, managing partner with ExchangeRight regarding the current economic dynamics impacting commercial real estate.
Video Transcript
Greg Mausz 00:10
Welcome to another edition of Focus on Alternatives, brought to you by ADISA, the Alternative and Direct Investment Securities Association. For more educational content like this, please visit on www.adisa.org and check out the resource library.
My name is Greg Mausz, I’m your host today. I have Warren Thomas, he is the managing partner on ExchangeRight. And we will be talking about real estate in these challenging times. So Warren, thank you for joining me.
Warren Thomas 00:38
Thank you, Greg.
Greg Mausz 00:39
So we have rising interest rates, we have inflation that’s been rising, and now we’re waiting to see the latest numbers. How is all these market dynamics affecting real estate?
Warren Thomas 00:53
Thanks, Greg. I’m glad to be here. And that’s a great question. There are so many things occurring here in the fall of 2022. Although I have been in this industry for quite a few years, we haven’t experienced anything quite like this in the past. What we’re seeing today is a rise of inflation, we’re seeing stagflation as a factor of the inflation rate being over 8%. And the wage increases being limited to about 5%, we’re also seeing a rising interest rate environment where the 10-year treasury, for instance, has moved, where we were looking at loans at 3 ½ a year ago. And now we’re dealing with 6%, 6 ½% money today. So, there’s a variety of things that have changed over the last few years, and particularly the last few months.
Greg Mausz 01:43
So, what should investors do?
Warren Thomas 01:45
Be careful. Investors need to be careful, they really need to understand what the investment is that they’re buying. They need to understand the fundamentals of the investment, how it’s going to perform in various environments, and they need to be taking a really defensive view on their investment dollars.
Greg Mausz 02:08
So, I’ll interpret that is make lots of small bets. I mean, to invest in lots of different asset managers, real estate programs, sectors in order to protect yourself?
Warren Thomas 02:21
Well, I think if you understand– You need to get an understanding of the sectors and the impacts on a particular sector of a– Particularly we’re in the middle of both of– We’re in the beginning, probably of a recession. And we’re beginning to see stagflation. Stagflation is being– That’s when we have rising inflation, but we have wages that are unable to keep up with that inflation. So, we’ve gone through a time where we’ve been in the 8% plus on inflation, and we’re capping out at about a 5% wage inflation. And so that margin is creating stress, and is stressing the consumers ability, both to pay rent, to pay mortgages to cover the utilities, all those housing costs. And we’ve been in a very low interest rate environment in the past. And so, the consumer that has been carrying debt, for instance, may have had manageable payments on that debt. But now if it’s a credit card, they’re seeing a significant increase in the cost of their monthly payment on that card. And if they are a homeowner, and they were lured to the adjustable-rate mortgages- They’re seeing adjustable-rate mortgages that are tied to what used to be LIBOR. But it’s really a federal funds rate. And they’re seeing something that would have been a 3 ½ %, just 8 months ago, that’s now hitting them at 6% – 6 ½ %, maybe even going to 7%. So that’s doubling some of their payments. So, in that environment it’s going to affect different asset classes in different ways.
For instance, in the multifamily when we begin to see a stagnant wage growth, but we’ve got inflation, then the actual operation of that multifamily property, you’re going to see that it’s going to be more difficult to retain good tenants in the asset, you’re going to have increased bad debts which we’ve seen big increases in bad debts already, we’re seeing more move outs occurring currently. We’re seeing more concessions being offered. And all of that is based upon this affordability, which is largely driven by the stagflation environment.
Back to those that actually own real estate. It’s kind of interesting, because even though we have stagflation, meaning a lot of things are inflating in value other than that wages not keeping up, we’re also seeing in certain sectors a decrease in value. So, we’re beginning to see the housing market in general decrease in value. I know a lot of our ADISA participants are in the DST space, or they’re in the REIT space. And if you’re in the DST space, you’re counting on that individual investor wanting to do a 1031 exchange. And yet, across the country, it’s still selective, but we’re seeing decreases in property values in certain markets.
Just to give you an example, we take the LA Market, 25 years ago, the average amount of an LA person’s monthly income that went to housing was about 36%. Now it’s about 72%. You imagine Greg, if you had to pay 72% of your income towards your housing costs, and those housing costs could be defined not only as the rent or the monthly mortgage payment, but they’re going to include the rising property tax. And when municipalities get in trouble, they raise their property taxes, because they’re trying to– You know, and then utilities, we haven’t even begun to see utility inflation. We’ve seen commodity inflation on oil and gas, but we haven’t really seen a winter yet. So, we haven’t seen this inflation hit the consumer. And back to 1031 exchanges. When you start to see those high costs come back to properties, you begin to see property values declining. And that’s what I think we’re heading into over whatever period of time we’re in a recessionary environment, a stagflation airy environment, we’re going to probably see downward pressure on housing, we’re already seeing it, but I think it’s got a long way to go to the negative.
Greg Mausz 07:03
It’ll be interesting. But that’s okay. So how are you seeing cap rates be impacted by all the things that you just described?
Warren Thomas 07:11
Yeah, so cap rates, you know, usually the individual property owner, the guy who’s- he and his wife have owned the rental property for 30 years. They don’t think cap rates, what they think about is my property was worth $1,000,000.00 five months ago, and now my realtor is telling me I can only get $800K for it.
Well, you’re going to think cap rate, I’m going to think cap rate, because that’s what we do. But all they’re thinking about is 200,000 that they don’t have, that they would have had if they sold 8 months ago. So, from their perspective, they are being impacted by cap rates, the cap rate is adjusting, but not in the same way as the commercial property.
Now with what we do with ExchangeRight, we’re very heavy in the net lease marketplace. So, we deal with necessity, retail necessity, medical. And in that cap rate market, I would have been buying at, say a 5, 4 average cap rates if I’m buying Kroger’s and Walgreens, and Walmart’s and all of that. And now I’m seeing above 6 as my base. So, we’re seeing cap rates go up, which means prices are going down.
Frankly, I like that environment. I like it because I think in the long term, it de-risks our investors by having higher cap rates is going to give the investors more margin. But those cap rate adjustments are affecting multifamily. And multifamily is not only getting impacted because of rising cap rates, which are not directly tied to interest rate, but they usually lag it.
So, they’re beginning to see the impact of cap rates going up, they are seeing them go up as interest rates are well ahead of that. And that’s going to drive the value down on multifamily. And then if we get into even worse recession, worse stagflation than it hurts them more because they’ve got operating expenses. In the necessity retail side, the inflation isn’t as bothersome. But it does affect in all of these classes the way that we put debt on a program.
Greg Mausz 09:30
Okay, explain that more.
Warren Thomas 09:32
So a year ago, I could get my debt, I’d put together $100 million net lease portfolio, and I could get my debt at a cost of say 3.3% on a 10 year fixed. Now, that same portfolio, if I was bringing it out today because of this increase in interest rates, I’m going to end up having to have take up about a 6% 10 year fixed financing maybe 6 ½%. And so, what that does to the investor in the past, I could create positive leverage even if I was buying at a 5 ½ cap or 5.4, I’d create positive leverage. Well, now if I buy at a 6 cap, and by the time I’ve got my costs of putting the product together, and then I marry it with a 6 or 6 ½ interest rate, I’m creating negative leverage, and it’s driving cash flows down. So, the investors don’t like seeing that cash flow drop on new product. But that’s the reality that we’re now in. And then that’s creating a product that we’re going to be intentionally having less debt on the product because it’s not benefiting us. And
Greg Mausz 10:48
So that’s not necessarily a bad thing, either.
Warren Thomas 10:50
It’s not a bad thing, because what we’re really doing is de-risking our products for the current and for the future.
Greg Mausz  10:57
So based upon everything that you see going on right now, where are the good opportunities,
Warren Thomas 11:01
I think it’s a good time for us with our particular asset class, it’s a good time for us to be buying. Now we don’t know how long cap rates are going to continue to go up, meaning prices going down. But I’m betting more on a deflationary environment coming because I don’t think monetary policy can continue to keep these higher interest rates for that long- How long is that long? 6 months, 12 months? But I think now is a good opportunity to be buying and…
Greg Mausz 11:37
All classes of real estate?
Warren Thomas 11:39
I know it is for our class.
Greg Mausz 11:41
Which are what?
Warren Thomas 11:42
Net lease, necessity retail, lease to investment grade companies that will do well in a recession. Where you got to be careful right now is- as we started talking about earlier was multifamily need to be careful because you better be planning better be watching your rent growth assumptions, you need to be really careful what markets you’re in. You see the markets where people are leaving certain states and going to other states, that migration may continue, then again, it may not- so far, it’s been a healthy migration. But you need to watch out because multifamily is going to have more pressure on it for concessions, bad debts, stagnant rent growth, because if you have stagnant wage growth, you cannot have significant rent growth. So, you got to be careful with that industrial, probably a safe place to be as long as the credit is good. And as long as you’re not overpaying any asset today, you have to make sure you’re not overpaying.
Greg Mausz 12:43
Sure makes complete sense. Thank you for this timely conversation. I got a lot out of it. And I hope you all did as well. So thank you for watching another episode of Focus on Alternatives. And again, visit a www.adisa.org for more information. Thank you!
Warren Thomas 13:01
Thank you!
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