Real estate in our new reality: bank failures, money printing, and a new round of inflation.
April 3, 2023
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Understanding inflation is critical to making intelligent real estate investment decisions. As many of us thought we had just entered a period of disinflation, our financial system was shocked by bank failures. In addition, we live in a time when mortgage rates have more than doubled in the last year, and construction costs are still very high, creating a challenging scenario for real estate transactions. Investing in real estate now carries new significant risks to unpack and understand as we enter an unprecedented time.
How we created bank failures
We witnessed a perfect storm unfold recently. It started with the liquidity challenges in the crypto space, forcing Silvergate to announce that it closed its doors. During the same week, the contagion spread and hit SVB as they unsuccessfully came out to the market to raise over $2b to shore up their balance sheet. This caused pandemonium over social media and with venture capitalists advising their portfolio companies to withdraw funds, triggering a run on the bank. This absolute train wreck forced the FDIC to step in over the weekend, take over and fully backstop the deposits for SVB to get it operational again the following week while introducing their Bank Term Funding Program. The challenges continued. Soon, this contagion was hard to stop and spread to First Republic Bank and Signature bank banks. At this point, the problems were too systematically essential to ignore.
As of today, we're still working things out. SVB was sold to First Citizen Bank, but the deal could be better, requiring the FDIC to accept a loss-sharing agreement with FCB. Currently, we are in a situation where the federal government and numerous bankers are collaborating to enhance the stability of our financial system. It is quite possible that this could involve using new and unprecedented solutions. One thing has been abundantly clear: we will be printing more money.
Why new money is the response
We've had decades of loose monetary policy since the great financial crisis and the pandemic. It wasn't until this past year that the Fed began to aggressively raise rates to curb inflation that seemed almost out of control. Their efforts to tighten up worked too well, and our landing will be a hard and bumpy. Since the SVB debacle, we've watched nearly ¾ of the money supply changes come undone in days, putting us back on track for diluting the dollar's value because we've had to print more money and help banks.
Historically, we've seen the Fed pivot to quantitative easing after large financial systemic shocks where we had a quick emergency repair. It's still being determined whether or not the Fed will allow for this as it's trying to fight inflation right now and, at the same time, buoy up the financial system. JPMorgan believes that this will require an injection of nearly $2 trillion dollars to sort out the unrealized losses on balance sheets. To put things in perspective, we printed $7 trillion in 30 months recently, causing a 30% jump in dollars circulating.
In the most recent FOMC meeting, the fed rate was raised by 25bps in their continued effort to curb inflation. The immediate reaction sent the markets rallying, which the Fed did not want. We don't believe that this will end well.
Inflation - the second act
It's impossible to know where we go from here, but introducing more money into the system this quickly will only look good for some consumers. We are now in a situation where the cost of borrowing capital is high while the dollar's value continues to erode for many.
As policymakers consider how to adjust interest rate policy, it's essential to consider the far-reaching consequences of such decisions. Any changes will impact borrowers, lenders, and investors, and the economy's health is at stake. The Federal Reserve Chair, Jerome H. Powell, and his colleagues must carefully weigh the potential consequences of any changes they make.
What makes things more challenging today is that BRIC countries are settling in non-US dollars. This adds additional pressure that may devalue our dollar long-term. If the inflation rate is high and sustained, it can lead to hyperinflation.
Delayed effects on real estate
We're still seeing the delayed effects of a new interest rate environment on the real estate market today. Transaction volume has dropped by 22.6% year-over-year, with an increasing home inventory that has nearly doubled since last year. Real estate moves slower than publicly-traded markets, as it takes time for previous transaction data to influence new transactions. The difference still needs to be bigger of a gap between buyers and sellers.
This brings us to our next problem: the growing commercial real estate debt risk. At a high level, most commercial real estate loans are shorter term than most residential loans, typically with 5-10 year terms. Many of these loans that originated a decade ago are expiring, and those operators will need to look for a new rate. The challenge here is that they'll be forced to refinance in a new environment with a speed that essentially has doubled. This challenge is one that many operators with expiring loans face today, but the concentrated pressure will land unfairly on community and regional banks. Many of these regional bank stocks are trading at half their valuation from just a few weeks ago, causing a lot of risks to build up on their balance sheets and signaling a potential over-reliance on the Fed in the upcoming months. We expect this will force banks to become more conservative in lending practices and further slow down the real estate market.
On the surface, these headwinds that we see in the financial system, lending practices adjustments, and interest rates seem unfavorable for investing in real estate, but there's more to this story. We've already seen a 17.9% reduction in February's housing construction starts compared to a year before. And the absorption rate indicates still that we're in a seller's market when we look at Southern California, which has seen one of the most significant price declines this last year. Demand still looks high even with the large spread as the market recalibrates.
This market is not for the light of heart, but investors can still take advantage of an opportunity that seems obscure. At Concreit, we invest in real estate and give access to strategies that typically require millions of dollars. Investors buying primarily with cash have a few advantages that can make a huge long-term difference in today's market. They'll have better control over their acquisition pricing and negotiate with a more substantial hand in today's market. In the future, if rates return to a level that makes sense, they can refinance and pull out some equity for their next opportunity. Generally speaking, in inflationary environments, both the asset valuation and rental income should adjust with inflation. It's a market pushing buyers to the sidelines and creating a once-in-a-lifetime opportunity for those with the right cards to play.
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