“…There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.”
– Donald Rumsfeld
I doubt that there have been many times in history when then-Defense Secretary Donald Rumsfeld’s words rang more true than over the past few weeks. The Wuhan virus/Covid-19 is also a near-perfect example of the butterfly effect – the idea that something so small and insignificant as a butterfly flapping its wings could eventually lead to a tornado half way around the world. In other words, if you had global pandemic brought about (allegedly) by someone shopping at a wet market or eating bat soup in a province in central China on your End of the Longest Economic Expansion in History Bingo card, congratulations, I guess.
What we are currently dealing with was the epitome of an unknown unknown. The economy had been cruising along with the hum of a well-oiled machine. Unemployment was at a record low, wages were (finally) growing at the low end of the curve and stability was the order of the day until very recently. This is not at all like the financial crisis over a decade ago, that was a slow burn that started in 2007 but really didn’t pick up steam and lead to an epic market crash until late 2008. All the while, there were signs that growth had topped out and prediction of a coming recession (with varying degrees of severity) were rampant. This time, it feels more like hitting a wall.
There are plenty of perma bears who will claim credit for “seeing this coming” but most are full of shit. In large part, those who have been professing doom and gloom have been doing so for the better part of the past decade and have been wrong at every single turn. Generally, their shtick has been that the Fed has inflated a massive asset bubble by keeping interest rates too low for too long which would eventually lead to some sort of hyper-inflationary episode. Instead, the opposite is what now looks nearly certain to end this record setting expansion – deflation, brought about by a viral outbreak that stopped the global economy dead in its tracks, now coupled with a good old fashioned oil price war, just for good measure.
So, what does this mean for real estate? It’s a bit complicated. Let’s start with what most people perceived to matter – cap rates, and by extension, interest rates. Its virtually impossible to keep track of how many times I’ve heard that cap rate expansion would lead to the next big commercial real estate slowdown and yet, here we are, on the precipice of a slowdown with interest rates at an all time low and cap rates not far behind. Fact is that you need inflation or a massive market clearing even with oversupply for wide-scale cap rate expansion and while that has been a fear – see above paragraph – it has not been a reality.
Low rates have certainly led to higher asset values but they have not been the primary driver of the longevity of this cycle. So what has been? In a word, liquidity. To be a bit more descriptive, the willingness of investors to refinance maturing debt, warts and all. I wrote about this as recently as late January – which seems like an eternity ago, by the way. Highlighting an Institutional Investor Article comparing private credit and its willingness to take speculative risks to the deadly street drug Fentanyl. Here is the key passage from that excellent II article:
Default cycles require not just insolvency, but also a lack of external funding to give highly leveraged companies another chance. If there is no funding source to replace that which is lost, then the weakest companies default, trading and credit losses mount and fund flows get even worse.
That passage was referring to private equity buyouts but could just as easily be referring to the proliferation of private capital in the commercial real estate debt space. We’ve seen more than a bit of anecdotal evidence that the fire hose of liquidity that has flooded the private debt space in recent years has provided ample cover for maturity defaults and cost overruns that have been present for the better part of this expansion. The willingness of lenders to extend bridge-to-bridge and construction-to-bridge financing to otherwise busted projects has masked a lot of issues that otherwise would have come to the surface much sooner. If/when that wave of liquidity dries up, things will change quickly and there is already some evidence that the ultimate sources of that capital are beginning to run into issues. Much of the real estate market has benefited from low supply which will provide some cushion, at least in terms of asset values should this liquidity tidal wave run dry. But rest assured, the inability to recap struggling projects is the immediate risk in the market right now.
Somewhat ironically, while commercial real estate will likely run into a rough patch if liquidity starts to dry up, residential (both for rent and for sale) actually seems to be fairly well positioned. There are few if any markets where oversupply is anything close to an issue and thanks to Fannie Mae and Freddie Mac, liquidity is abundant. We will be in a period of positive demographic growth for several years and people need places to live. In fact, there is already anecdotal evidence that the US residential market is being viewed as a safe haven investment as other sectors get hammered. Couple that with the fact that refinancing activity is off the charts and nearly 70% of American homeowners are now in the black when it comes to potential refinance savings and its not difficult to see how a much-maligned housing sector becomes a tailwind in an economy that is suddenly facing more than a few headwinds. This will be especially true if mortgage rates revert to their historical 10-Year Treasury + 180 basis point spread, rather than the elevated 250+ basis point spread that they are priced at today. Liquidity will be more important than cap rates, if it starts to dry up, there will be pain but also opportunity for those who are well positioned.
In closing, we are highly likely to hear a lot of hot takes in the coming weeks and possibly months along the lines of “this crisis will forever change how people gather in person.” You would be best not to put much stock in them as there is a high likelihood that such predictions will age as well as those about how people would “never” want to own homes again due to the housing crash. There is a massive amount of data out there that, while the world is frequently a strange and chaotic place, the way humans respond to things is fairly predictable – and we have incredibly short memories. I suppose that its possible that this episode will alter millions of years of evolution, but I wouldn’t count on it. Stay safe out there.
And for God’s sake, wash your hands!
Lack of Scale: Small businesses are the most at-risk during a pandemic. See Also: Tax cuts are great but we are really going to need fiscal stimulus in order to fight this sort of economic slowdown.
Day of Reckoning: The withdrawal of capital from the oil industry as prices crashed is a massive threat to a sector that has been a pillar of the debt markets. See Also: The last thing that we needed in the middle of a market panic is an oil price war…and its exactly what we got.
Probing for the Bottom: It is possible that the US is already in a recession: See Also: Jeff Gundlach of DoubleLine thinks that things are going to get worse as crashes typically lead to credit defaults. And: JP Morgan is seeing early signs of stress on credit and funding.
Sounding the Alarm: Venture firm Sequoia Capital is sounding the alarm about a coming economic fallout.
No Surprise: Regular readers know that I’m not a fan of open offices. Now it turns out that they could help spread coronavirus.
Quick Turn: Amazon is even more focused on infill warehouse development in an effort to provide more same-day deliveries.
Redlining: The American restaurant industry was already on the ropes before the coronavirus outbreak. See Also: A virus-induced shopping slowdown is about the last thing that retailers needed right now.
Upside Down: Mortgage rates are moving higher despite plunging treasury yields as a result of market volatility.
Insatiable Appetite: How Wall Street fell in love with owning and renting single family homes.
Running on Empty: Already-fragile retirement funds are going to get clobbered by bond yields that have gone even further into the toilet.
Can’t Quit You: Companies that got out of China before coronavirus hit still find themselves tangled in its supply chain. See Also: Tim Cook and Apple bet everything on China. Then the coronavirus hit.
Until Further Notice: From the NCAA Tournament, to Coachella, to South by Southwest, the NBA and MLB, here’s a summary of the major events that have been cancelled or postponed so far due to coronavirus.
Chart of the Day
This is potentially good news as early signs point to the Wuhan Virus behaving much like the flu:
The new epicenters of virus were all roughly along the 30-50o N” zone; to South Korea, Japan, Iran, and Northern Italy. After the unexpected emergence of a large outbreak in Iran, we first made this map in late February. Since then new areas with significant community transmission include the Northwestern United States and France. Notably, during the same time, COVID-19 failed to spread significantly to countries immediately south of China. The number of patients and reported deaths in Southeast Asia is much less when compared to more temperate regions noted above.
Source: Calculated Risk
Always Use Protection: A strip club is offering face masks to customers in order to fight the spread of coronavirus because Florida.
Mistaken Identity: A clearly strung out car thief in New Mexico attempted to convince the police that she was Beyonce when arrested. Shockingly, it didn’t work.
Now For Some Good News: A malfunction caused red wine to flow from faucets in an Italian town.
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