5 Scenarios to Consider for Real Estate Investing - Good, Bad, and Ugly
Most of our focus is on finding securities in parts of the market that offer deep value and can perform well in many different macro scenarios. Here are some big picture themes worth considering:
Fluctuations in interest rates are unpredictable.
Although recent economic data points suggest inflation is subsiding, economic data is inherently noisy and hedge fund positioning is likely to exaggerate near-term changes in treasury bond yields. In addition, relatively unpredictable exogenous shocks to financial markets are capricious and can bring yields down quickly. We still believe it makes sense to limit duration and invest in securities that can perform well irrespective of changes in interest rates.
Higher interest rates could start to bite the economy.
While the economy has remained resilient, higher borrowing costs for businesses and individuals could hurt the economy in the coming quarters. As corporate debt needs to be refinanced, corporations will likely be forced to borrow at higher interest rates and floating-rate debt will be at a higher risk of default. Investors need to remember that while floating-rate debt limits interest rate duration, it also increases default risk as borrowers face imminently higher borrowing costs. We believe we are experiencing the “long and variable lags” that Milton Friedman coined regarding monetary policy.
Problems with banks will likely persist.
Banks’ net interest margins will most likely continue to decline as they are forced to pay higher deposit rates. Deposit flight risk is also a major issue in the context of the proliferation of online/mobile banking. Banks’ asset values have declined recently, largely given mismanagement of rising interest rates. The next significant problem we believe they will face is asset quality issues from maturing commercial real estate loans. In addition, increased regulations will likely restrict banks’ ability to take risk and necessitate additional capital raises.
Commercial real estate is also a weak spot.
Less people working in office buildings and shopping at physical retail locations should put pressure on these subsectors. The larger issue for commercial real estate in the short-term is high interest rates. If building owners are unable to raise rents, higher debt yields/cap rates will reduce the value of buildings. Regional banks, a major funding source for commercial real estate loans, will be less likely to refinance debt in the context of their previously mentioned problems. We believe other funding sources such as CMBS, insurance companies, and private funds will not be able to fill the funding gap potentially creating a negative feedback loop.
Residential housing should continue to be resilient
Residential Housing is the bright spot. Although higher mortgage rates hurt demand, the story in the residential housing market is historically low supply. Residential mortgages do not face the refinancing risk that commercial real estate is dealing with since residential mortgages tend to be fixed for 30 years vs. much shorter maturities typically for commercial real estate. An underproduction of housing over the last decade combined with mortgage borrowers’ unwillingness to give up their low mortgage rates will likely result in continued low housing supply. Mortgage borrowers have a historically large amount of equity in their homes and borrower equity is the main driver of mortgage loan performance. We look for residential mortgage defaults to remain low as the economy slows down and for recoveries to be high in most default scenarios.