Finding Your Path
Told You So
By Lorne Polger, Senior Managing Director
Here at Pathfinder, we’ve been barking about a looming crisis with inflation for over a year now. We didn’t believe the statements from the Federal Reserve Governors back in early 2021 that inflation was “transitory.” That made no sense. The government had injected trillions of dollars into the system through a variety of programs (stimulus checks, Paycheck Protection Program loans, debt forgiveness programs, loan deferrals, etc.) in an unprecedented fashion. When money is plentiful, and the cost of borrowing is at historic lows (remember mortgage rates in the 2’s? That was just last year!!), inflation was, to us, a foregone conclusion. This is not to suggest that a policy of low interest rates and other economic stimulus were not the correct things to do during the heart of the pandemic; we were in unchartered territory and things could have been much worse without those measures. Instead, we’ve been suggesting that the Fed was very slow to react to what was an apparent and significant uptick in prices that began more than a year ago and continues now. Many pundits forecast elevated levels of inflation at year-end, even well into 2023.
For many of the same reasons, I called a peak in single-family home pricing back in March. Since that time, mortgage applications have fallen by 28% from their peak, new home sales are down by 17% and housing starts have dropped by 13%. I believe pricing may be the next shoe to drop.
Notwithstanding our current sticker shocks over gas, groceries and just about everything else, this is not the Great Recession, version 2.0. The underlying inflation drivers now are very different from those behind the surge in real estate prices that occurred in the mid-2000s. Back then, a bubble in house prices was inflated by a rapid expansion in mortgage debt facilitated by lax regulation and sloppy underwriting. When the bubble burst, overleveraged homeowners quickly found themselves with negative equity and forced selling created a rapid downward spiral.
It's different today. There is less leverage in today’s housing market. Household debt as a share of income increased sharply between 2000 and 2007, but we returned to more normal levels after the Great Recession and the household debt numbers have been relatively stable since. Meanwhile, regulations and oversight instituted after the last crisis means that banks are now in better shape. Fog a mirror loans? Long since in the rear-view mirror. We’re not going to see the banking failures that we saw in the early ‘90s and 2009-2010. (Full disclosure, I’m on the board of directors of a San Diego-based community bank.)
That said, looking in the rear-view mirror, did the government stimulate too much, too quickly? Possibly. When the government was throwing free money from the sky, virtually everyone was taking it. That turbo-charged business and consumer spending. On the other hand, it probably wasn’t just monetary supply that caused the rapid increase in inflation that began in early 2021. Pandemic-related supply chain challenges and labor shortages contributed. This year’s war in Ukraine and additional Covid lockdowns in China certainly have not helped, as both events have contributed to lingering supply chain issues and cost increases.
At a macro level, what are some of the implications of a rapid increase in inflation and a corresponding rapid rise in interest rates? Well, we’re starting to see them over the last few weeks. Certainly, corporate and personal spending retracts as borrowing costs increase and folks get squeezed. I expect we will see some increases in unemployment as companies begin to “trimm the fat” as profits get leaned out. On the consumer side, most essential spending is likely to be maintained, but discretionary spending will suffer. It’s harder to take that family vacation or even go for dinner and a movie with $5/gallon gasoline ($6+/gallon in California).
How has rapid inflation impacted the multifamily business?
Well, there have been both positives and negatives.
First, we’ve seen a significant increase in rents. Our lease renewal increases and “trade outs” (that is, the increase in rent for an existing unit between the previous tenant and the new tenant) since the beginning of the year are some of the largest we’ve ever seen. There are a few factors at play here in addition to inflation. Although lots of apartment buildings have been built in the past decade, the majority have been Class A product, which will typically command a 30-40% premium in rent over Pathfinder’s Class B properties. And in the markets that we invest in, the housing stock is significantly undersupplied, for both rental and for-sale housing. That has led to continuing increases in both occupancy and pricing (remember the old supply/demand equation…). We’ve stayed in the Class B space for along time now, and we continue to believe that the sector offers our investors among the best risk-adjusted returns.
Second, we’ve seen meaningful wage growth in our markets. Residents of the cities in which we operate can generally afford today’s Class B apartment rents.
Third, the significant increase in mortgage rates (from a low in the high 2’s, to a recent high in the low 6’s, now in the low 5’s) means fewer renters will leave to purchase a home, either because they can’t qualify for the mortgage, can’t afford the increase in their housing costs and/or they can’t come up with the required hefty down payment.
Fourth, chaos creates opportunities. We believed in that mantra when we started the company back in 2006 and we remain firm believers in it now. The dislocation in the capital markets has resulted in a steep drop off in apartment sales during the last few months. The higher-leverage debt fund lenders have all but left the market, leaving low-leverage bank and agency lenders the primary sources for debt capital today. Many traders and buyers used the higher-leverage debt fund capital to make their acquisitions pencil during the past few years. Thankfully, we stuck to our principles and did not reach to the sky to make deals work, but that wasn’t the case with some very active buyers in the market. I’ve always had a pretty good nose for deals, and I’m starting to smell some things cooking in the kitchen now. It may not be today or tomorrow, but there definitely will be some opportunities arising out of these inflationary times.
Don’t get me wrong, there are some headwinds too. Inflation can work well if the expense side of the ledger remains steady (i.e., fixed rate debt – the loan payment is often the largest expense line item). If your interest rate floats and your rate jumps over the course of a year or two, it won’t be pretty. We’ve been good at stabilizing our other costs as well, but it’s an ongoing effort and inflation means higher electricity, insurance and payroll costs.
The current market volatility has also made it more difficult to predict the future trends. That makes it more difficult to plan future sales and acquisitions.
It’s also not a great time to sell properties. Many buyers are sitting on the sidelines waiting for the markets to calm down, the recent spike in interest rates to be digested and stability and predictability to return to markets. Less buy-side competition and lower transaction volumes generally mean lower pricing.
We’ve always been patient at Pathfinder. Our long-term fixed rate loans on our properties have allowed us to take the long view and ride through any bumps in the road along the way. Our properties are full, rent growth is extremely strong and we have long runways with five to ten years remaining on our loan terms.
We believe that today’s volatility may create tomorrow’s buying opportunities. We also believe that there may be a time in the not-too-distant future to take advantage of some opportunistic acquisitions that will come our way, especially given our reputation in the marketplace as a credible buyer.
We told you a year ago that the government’s spending in ’20-’21 was likely to bring about inflation. But we’re also telling you now that this is a good time to be calm and shortly it may be a good time to be an opportunistic buyer. It has not been a fun time to gas up your car or buy groceries. But it’s a pretty darn good time to own or invest in apartment buildings. We think this is a good time for our company and our investors.
Lorne Polger is Senior Managing Director of Pathfinder Partners. Prior to co-founding Pathfinder in 2006, Lorne was a partner with a leading San Diego law firm, where he headed the Real Estate, Land Use and Environmental Law group. He can be reached at firstname.lastname@example.org.
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