Stocks fell yesterday and losses accelerated into the close as bank stocks again came under pressure, this time from threats that rating agencies would move to cut ratings across the board. Bond yields jumped around but ended the day near where they started.
One of the quandaries of this stock market and the economy has been the persistence of economic strength in light of the sharp increases in short-term interest rates. GDP grew by over 2% in the second quarter and forecasts see increases approaching 3% this quarter. Aren’t higher costs to borrow supposed to slow economic growth? Banks are increasingly tightening credit conditions making borrowing more difficult. One obvious explanation is that the economy remains dominated by consumer spending. The consumer is still living off of the handouts during the Covid pandemic and the fact that unemployment is still near record lows.
But higher interest rates are having an impact, even though the effect may be overwhelmed by consumers spending to fly around the world or go to Taylor Swift concerts. In addition, the impact this cycle is likely delayed compared to the Great Recession.
Let me explain. In the 2000s, most homeowners that financed homes used adjustable-rate mortgages. When rates rose, the impact was immediate. Once people lost jobs and cash flow dropped at the same time that monthly mortgage payments increased, they got behind on loan payments which ultimately led to foreclosure. The rest is history.
Today, 30-year mortgages are the norm. Banks hate them. Their capital base has a duration of just a few years. Even assuming most homeowners don’t live in their homes for 30 years, the average mortgage has a duration far higher than desired. Banks make mortgages to service customers but quickly sell them through companies like Fannie Mae to institutional and retail buyers in the form of mortgage pools. Banks maintain the revenues generated servicing the mortgage loans.
But financing of commercial properties is different from financing homes. First, there are construction loans used by builders in the development process. Lenders generally require buyers to have a certain percentage of floorspace pre-leased prior to the commencement of construction. But with that said, construction lending is expensive. Today the average rate is well north of 10%. Once the building is completed and rented to the point where cash inflow is sufficient to cover operating and debt service costs, the loans are converted to a more permanent form of financing. Rates, however, are not set for 30 years as they are for residential single-family homes. Rather they are set for a much shorter time frame, often 5-years.
From there, you can do the math. Rental income is a function of rates and occupancy levels. Problems have begun to show up in office buildings. The pandemic meant less space was needed as workers spent some or all of their time working from home. Given that renters often have leases of 5-years of longer, the impact took time to hit. But it is hitting today as office vacancies have risen and rental rates either stabilized or fell. Class A space has held up much better than Class B space. To entice workers to come back, employers need to make conditions more attractive. With rates stabilizing or falling, they take the opportunity to upgrade locations. Banks, meanwhile are raising borrowing costs as the lease cycles roll over. We see the impact most clearly in markets where occupancy levels have fallen the fastest. San Francisco is the poster child for this impact with some Class B buildings now worth 20-50% of what they were worth just a few years ago. Who takes that loss? The lenders. Owners who now find themselves under water walk away.
Banks are in the lending business, not the real estate business. They will do whatever is necessary to work with borrowers to enable them to stay in business. But only up to a point. Once cash flow falls to levels that only barely cover operating costs, there is nothing left to service debt and pay the lender. Properties get resold at a fraction of their prior value and the process starts anew.
When it comes to real estate loans, the primary lenders are regional and local banks. The big guys lend to giant corporations. Their “collateral” is the company itself. As long as Wal-Mart stays in business the bank that lends to support operations has little fear that it is going to be repaid. Wal-Mart isn’t interested in borrowing a few million dollars from the Second National Bank of Arkansas. For regional and local banks, the depositors and lenders are local people and businesses. They make the local real estate loans.
With that in mind, let’s switch to apartments. To date, apartments haven’t had the problems of office buildings. Young singles and families, priced out of the single-family home market by high prices and high mortgage rates have flooded to apartments. This trend has led to a massive increase in new apartment construction. As families grew, however, they outgrew the size of their rental units. High prices or not, many are moving to single family homes. For a while, rental rates followed home prices. As home prices rose, rental rates rose in tandem. But when home prices stabilized or declined, rental rates have followed suit. Now, with a record number of new apartment units starting to come to market, and continuing into next year, supply is starting to overwhelm demand. Rents are falling and debt service costs are rising. Over time, apartment owners have to refinance their debt at current market rates. It won’t take long for problems to escalate. Rents stay flat. Occupancy rises. Operating costs rise with inflation. Debt service costs rise when loans have to be refinanced. The problem is a rolling one. And, as with office space, lower quality rental unit owners will feel the pain first. Those new flashy buildings will fill up, leaving older buildings with space to fill at lower rates. Financially, the apartment market is more than twice the size of the office market. You have been reading about problems in the office marketplace for a couple of years. Problems in the apartment market are only beginning.
In 2007, as subprime mortgage lenders failed, it was generally assumed the problems could be contained. A year later, as foreclosures increased, we found out that wasn’t true.
I am not suggesting that today’s problems are anywhere near the scope of the massive home foreclosures we saw in 2008 and 2009. But what I want to point out is that higher rates are a problem. They are not a problem that surfaces overnight. Those with several years of low rates remaining have time. But the longer rates remain high, the larger the problem gets.
Cheap money fosters excessive expansion. Five years ago, no one heard of Covid. Investors financed new office space based on visions of continued economic expansion. Ditto for apartments. But there are always economic cycles. The key here is that we have morphed from a world of artificially cheap money fostered by two decades of central bank largesse to a return to normality. TIP spreads are now pricing in real returns for 10-year bonds of almost 2%. For decades, that was normal. It wasn’t when new money was poured into the system. We all lived just fine in the 1980s and 1990s when there was a real cost of capital, when money market funds paid 3% or more, and when markets allocated capital better than governments or central banks.
The problem isn’t just a U.S. problem. China’s real estate market is a disaster with major developers reeling and looking to the government for support. The value of the Russian ruble is collapsing, requiring its central bank to hike rates to unprecedented levels.
In the U.S. chatter has morphed from recession to soft landing. Now there is talk of “no landing”. What is no landing? It’s when, despite higher short-term rates, the economy keeps growing too fast. Why? Pent up demand, too much excess cash still sloshing around, and government spending growing at a double-digit annual pace. In that scenario, inflation continues well north of the 2% target, ultimately forcing the Fed to hike rates even further. The Biden administration passed something called the Inflation Reduction Act. Previously, the Obama administration passed the Affordable Care Act. Politicians label acts whatever sounds good. But the Inflation Reduction Act hiked spending to new levels. It has had as much to do with reducing inflation as the Affordable Care Act did to bring down the cost of health care.
In June and July, as the pace of inflation declined and the economy continued to grow, equity investors celebrated. But as interest rates kept rising, and as debt related problems moved closer to the surface, August has been a more sobering month. The notion that the economy can accelerate while inflation decelerates makes no logical sense. The Goldilocks scenario isn’t “no landing”. It may not even be a soft landing. The best outcome is likely to be a modest recession that recreates enough economic slack that will allow world economies to grow roughly 2% alongside a sustainable 2% inflation. A return to a world of 2% growth with 2% inflation, after decades of easy money and inefficient investment decisions made when money was free in real terms, isn’t likely to happen miraculously and pain-free. The world ahead can be a rosy one. But to get there takes some adjustment. That adjustment is going to be particularly painful for investors who used ultracheap money but who won’t be able to sustain those investments once rates normalize. While I don’t expect a recurrence of the Great Recession, as we saw with several bank failures in the spring, the transition back to normality won’t be pain free. Those bank failures weren’t the last; they were the first. The problems show up in real estate and banking because these are two industries that are highly leveraged. There will be others squeezed by high debt service costs as well. It’s all part of a process.
Today, Steve Carell is 61. Madonna turns 65. Film director James Cameron is 68. And a special happy birthday to my daughter Sarah. We’ll just call that 40-something.
James M. Meyer, CFA 610-260-2220
