I trust your week is off to a good start. The family and I returned from our Canada trip last Wednesday and it’s good to be home. They all got a nice vacation and I got a change of scenery while I was working. Sometimes a change of scenery can help clear the brain. I was initially worried about being productive but with three screens and a makeshift office setup, it worked out great. It was nice to have a couple weeks of that crisp fall air but I’m happy to be back in Florida.
Last week I promised to get an update on economic performance so here goes!
Economic Update
As I’m sure you’ve heard by now – the Fed took a pause on hiking rates last week but hinted that there may be another in store this year – and more importantly, that rates may stay higher for longer. What’s in store next? It’s a good idea to ignore personal predictions and instead examine what the markets can tell us about the business cycle. The economy is doing well, so equity market valuations are high. However, the yield curve is deeply inverted.
The yield curve inversion has been a reliable predictor of recession for many years. The Federal Reserve has identified two measures that indicate inversion: the spread between the 3-month and 10-year Treasury and the 3-month to 18-month forward Fed funds yield. Both measures indicate a deep inversion of the yield curve. The Fed’s recession probability model is frequently cited and our own research confirms the likelihood of recession. Typically, an inverted yield curve occurs when short-term rates are rising, indicating that the Fed is increasing rates. The Fed has a reputation for struggling to engineer a “soft landing” in which growth slows without a recession.
The inversion of the yield curve can cause stress on the banking system. When banks have to pay more for deposits than they earn on loans, it can lead to tighter credit conditions. Analysts have already discussed the possibility of a liquidity drain as deposits leave the banking system. This is expected to continue to affect growth until at least 2024. Interestingly, the severity of recession does not always correlate with the depth of the yield curve inversion. For example, the Great Recession had a much worse outcome than the recession of 2001, despite the inversion being only -60 bps before the Great Recession. However, the fact remains that the current yield curve inversion is the most extreme in 40 years, which suggests increased stress on the banking system.
Despite the robust economy, consumers are still more cautious than they were before the pandemic. In 2022, many households were concerned about the possibility of a recession. Google searches for the term “recession” peaked in the middle of the year, coinciding with a period of high inflation. Since household spending on goods and services makes up 69% of the US gross domestic product (GDP) and is a key driver of the economy, we closely monitor consumer confidence. While the economy has been strong, consumers remain cautious, which could leave them vulnerable to any inflationary pressures or anxieties about job security. In fact, the cushion of excess savings that many households had built up during the pandemic has largely been depleted by this point in the cycle.
What does this all mean? Where do you allocate your cash/investments as we head into the final quarter of 2023? Although we hope the U.S. economy will avoid a recession, it’s important to note that today’s equity valuations suggest there may be more moderate returns in the medium-to-long term. The current S&P 500 forward price-to-earnings (P/E) ratio of 19x is historically very high. Investing in the S&P 500 at these levels has resulted in an average forward two-year return of only 3.5% in 94% of cases. Because of this, I continue to believe that multifamily investments with an experienced sponsor offer some of the most attractive returns available in today’s market.
Market Update – San Antonio & Cincinnati
San Antonio: The common belief that San Antonio is a city of slow and steady progress does not apply to its income growth. In fact, the South Central Texas region has narrowed the income gap with the rest of the nation by around $2,000 over the past five years. This was achieved by creating more job opportunities in higher-paying sectors. As of late summer 2023, the median household income in the greater San Antonio area was estimated to be $73,205, which is only roughly $2,600 less than the national median income of $75,811. It is important to note that due to inflation, the dollar’s purchasing power has decreased over time. Despite the national economy’s volatility over the past five years, San Antonio’s commercial real estate market has remained relatively stable.
We’re making progress on wrapping up our 264-unit development refinance on the west side of San Antonio where market comps are valuing our deal at $190-220k/unit versus our projected all-in cost basis of $170k/unit. We’re also seeing positive growth in income for our value-add C-class deal, Villa Nueva, just up the street. We’re on target to close out the month at 91% occupancy and record revenue.
Cincinnati: While the Midwest can’t claim all the headlines for population growth, Cincinnati is turning heads for it’s continued rent growth. Year-to-date Class B rent growth was 5.1% and Class C rent growth was 6.1%! Compare that 5.6% average growth rate to neighboring Nashville’s -1.5% growth rate, Indianapolis’ 3.5% growth rate, and Columbus 3.6% growth rate.
Our 772-unit midwest portfolio, primarily anchored to the Cincinnati MSA, is on track to close out the month at 93% occupancy where we’ve seen rent growth of 5.3% just in the past four months. Our biggest challenge continues to be delinquency as we tackle resident screening, retention strategies, and efforts to convince our residents to pay their rent first instead of last.
Rate Cap Solutions
Last week I talked about some of the risks we’re facing with renewing rate caps coming up Q2 of 2024. With the latest Fed guidance, the option of refinancing our more profitable properties to avoid a rate cap altogether could become more attractive. One of the metrics that I look at to make this decision is the delta between the cost savings we could potentially receive as rates begin to drop in 2024/2025/2026 vs the cost of the rate cap. If the relative cost is very high, as is the case currently, it begs the question – if we locked in a 5, 7, or 10 year loan at today’s rates, what is the potential missed savings vs a floating rate with a rate cap. If we think rates are going to stay higher for longer, it makes sense to just bite the bullet and do a refinance. If we think rates are going to drop back to earth in the near future, maybe not.
I’ll be keeping a close eye on what’s happening to market expectations. In our case, we have the potential of avoiding $3MM in rate cap costs so the math looks pretty attractive if indeed interest rates are staying higher for longer. More to come on that analysis as we get closer to these decisions.
That’s all for now. I hope you have a great week!