Get Ready For Another Shock to Housing Affordability

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1:16Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal. And I'm Tracy Allaway. Tracy, you know, one of the big themes, obviously, in American life, in the most recent election was inflation. And there are a lot of things that people think of when they think of inflation. Maybe they think of egg prices. That's in the news these days. Maybe they think of gasoline prices. But a big story is like the cost of living is the cost of housing. Yes. Actually, it's kind of funny. Everyone has their own personal benchmarks for inflation. And mine is probably the cost of mayonnaise because I've been tracking that for a long time.

1:53Not because I eat that much of it, but I just find it interesting because it contains eggs and oil and packaging and labor and all that stuff and rent. And guess what, Joe? My rent's going up again. What about your mayonnaise consumption? It's funny to me. Sorry, when you said mayonnaise, I have to admit the first thing that came to my head was just imagining you in your apartment with the gigantic - Storing buckets of mayonnaise. A gigantic tub of Costco mayonnaise, eating it with a spoon. I'm sorry. And I was like, wow, you're really consuming a lot of mayonnaise if this is what comes to your mind when you think about the cost of living.

2:26Well, as part of my research for this, I can tell you, you can buy buckets of extra heavy mayo off of Amazon. Sounds good. We're actually not doing a mayonnaise episode. We're talking about the other one. We're talking about - I tried to throw in my rent stat. Yeah, I know. To keep you on topic, but you wanted to talk about mayo. We'll do a mayo episode at some point. But rent is really interesting. Actually, in the government's measure, there's so many moving parts with anything housing. But most recently, actually, the government's measure of rent price growth, which has been a key contributor to overall inflation, etc., actually has been moderating lately.

3:01We're sort of getting back to the point where we're like at pre-COVID levels of rent price growth. Right. So it's still going up, but just not as much as it was before. But the perversity, perhaps it's a perversity, is that obviously the Fed jacked up interest rates quite aggressively to fight inflation. Inflation has come down, took a little longer than people expected, but it has come down. But one of the things that we do know that happens is that when the Fed jacks up interest rates, that really has an effect on housing development, which of course requires a lot of capital and leverage, et cetera.

3:35And if you look at a chart of, say, multifamily housing starts, buildings, five units or more, that's come way down since its peak, like in 2022. Yeah. So we had this huge wave of supply in sort of late 2021, 2022. As you said, it's fallen quite a lot. The interesting thing that I see here is like, yields on bonds are still going up. So we're at 4.55 % or so on the 10 year. And that is higher than when the Fed started cutting rates. So the cost of financing these projects is still going up and there's not that much activity. Well, we did an episode in November 2023 and our guest said something really interesting to me that I've repeated probably many times, which is that for a lot of multifamily developers, they might prefer a hard landing in the economy because sure, that might mean demand for rent goes down or some of their tenants can't pay their rent.

4:32But if it means that you get a dramatic drop in interest rates because of how levered they are of the cost of money, that might actually work out better for them, which is sort of still blows my mind, but it is what it is. And so one of the other things that we're thinking about is like, well, what's going on with all these multifamily developers carrying big debt and so forth, given the fact that rates have not come down? Yeah, let's talk about it. Well, we are going to be speaking with the same guest who commented that in 2023. We're going to be talking about all of these dynamics. Really the perfect guest.

5:05Thrilled to welcome back onto the show, Lee Everett, head of research and strategy at Cortland, which is a multifamily owner operator, roughly 80 ,000 units nationwide. Lee, thank you so much for coming back on the podcast. Thank you for having me. I've actually just wanted to have you back on to talk about this specific. There's a lot we're going to talk about. But as Tracy mentioned, rates haven't come down. I know people were like, oh, the Fed's got started, right? This is relief is in sight. How stressed out are a lot of these entities by the fact that after all this time, we haven't seen any rate relief?

5:41It's interesting. I think stress is hitting sort of all sides of the market. You have your bigger, more well-established shops that have been managing through this, able to handle the higher rate environment, but have obviously taken a very real valuation hit on their existing portfolios, like 20 % to 30%, depending upon the portfolio composition. At the same time, you've had record demand hitting the sector because cost to buy housing is exceptionally unattainable today. And then on the other side, you're having a very material impact on the supply side. And I think that's what's really unique.

6:16If you think back to September, the 10-year was around a 3.6, I think, the day, Chair Powell, cut us by 50 basis points. Well, we're at almost a 4.6 today. And I remember that night you heard reports about developers out at local dinners and they were calling it Fed Day and getting ready to put shovels in the ground. Drinking champagne and stuff like that. Exactly. And what you've seen instead is increased stress on both the short end and the long end of the curve that's given you trouble on the short end to start new housing and trouble on the long end to afford longer term for ownership housing.

6:51You mentioned that some of the bigger players are better able to deal with higher rates. Can you talk about how people try to offset some of these higher rates? And is it the case that there is still an ability to refinance and term out your debt? Or is that starting to go away now? I think extend and pretend, which you're referring to in the always popular looming maturity wall discussion, is what you're hitting on. And what we're seeing there is the established owners that have strong relationships throughout either Fannie and Freddie, balance sheet lenders, etc. They're able to continue to negotiate and work out loans and delays.

7:34The people that got out really far over their skis, the syndicators, the new entrants to the place, and a lot of what we talked about last time, those players are sort of hitting the end of their window here. And what we've seen in the financing space, actually, as we delve into this a bit more, is there's so much liquidity on the debt side that wants to come back to work. They want to be rid of these sort of balance sheet hindrances that are these unproven players in the market. And they want to get back to work with the sponsors they appreciate. And we've generally seen spreads come in about 100 basis points from their peak.

8:10So that has helped limit some of sort of the financing pressures, but it's certainly a far cry from a 1 % tenure to a 4, 5, 10 year. So it depends a lot on who you are in the space and how this has impacted you today. Right, because 2021, probably part of 2022, we were like in that era where Instagram influencers were posting about get in, you know, rent prices always go up. multi-family landlords. Yeah, TikTok multi-family landlords. Rent always goes up. We have a new project. It's probably called The Reserve. It's in the suburbs of Houston and it has a pool table and there's no kids allowed in the pool table.

8:52And you guarantee me. And a bunch of them got wiped out. What happened to them since we talked? And then how talked about it from like the more established operators and how much of a relief has it been that some of this, I don't know, new money, whatever you want, TikTok money has maybe gotten washed out. Tell us how that story I would call it a thinning of the herd that we're still going through. I don't want to necessarily call out people by name. You can see in the news there is a certain prominent syndicator that basically doubled their positions and became a top 30 owner in 2021 or so. And banks are personally suing the founders of that company on carry guarantees today.

9:30you've seen potential investigations and some of the debt funds being talked about in the space. And that relates specifically to valuations on some of these assets that weren't maintained or taken care of by certain owner operators. So you're seeing a high level of delinquency. A lot of these properties that were these new money and TikTok landlords have a ton of liens against them because they weren't paying their contractors. They weren't executing their value ad plans. And ultimately, they're going to be in a world of pain would be my sort of outcome at the end of all of this. Because as I said before, the banks are just getting tired of carrying this on their balance sheets.

10:11Same with the debt funds. Like you can't make money with this much bad money hogging your buck. I have a really basic question, which I feel kind of bad asking because I used to cover commercial real estate. And I should know this since multifamily is the forgotten commercial real estate, as I sometimes call it. But what's the best thing to look at if you want to just get a gauge of multifamily markets health? So, you know, I can look at like permits or something like that, but that number is really volatile. I'm not sure how much it's actually telling me. Yeah, I think there's sort of two high level factors.

10:47One is going to be your rent growth, because that's going to feed your NOI growth. The other factor is going to be your cap rate, which we talked about this a little bit last time. Your cap rate is essentially your yield, your income over your price. As money is entering the space, prices go up so you get healthier cap spaces. And that's on the sort of for sale side. And as NOI goes up, you also can get tightening of cap rates because you get a higher value on the NOI. And that also would be sort of your high level indicator. And what we've seen in cap rates is they've just started to flatten in the last few months, but they're up roughly 100 basis points across the board.

11:24And that's where sort of that 20 to 30 % hit in valuations I mentioned has come into play. All right, let's talk about from the perspective of a renter. So I have some familiarity with the Austin, Texas housing market. Supply and demand apparently has worked very beautifully there. A lot of people wanted to move there. And then there's just towers up everywhere, including deep into the suburbs and then actually rent price, I believe it's actually negative for many years in Austin, which, you know, seems like good news. Overall, that's a rare story though, but we've had this big fall and anyone can just go on Fred and search new privately owned housing units, started units and buildings with five units or more and see that we've had this big drop over the last two years, roughly since the peak of all these developments.

12:13What's going to happen? play this out a little bit over the next two years where supply meets demand here. And, you know, we already have these affordability. Rent is already basically expensive everywhere, even in Austin with the declines. Is it going to get worse? Yes. I think, frankly, we're about to transition from what has been a very renter-friendly market to, again, a landlord-friendly market over the course of the next two to three years. And that's going to be particularly driven by what we're seeing on the supply side. We're going to have over a million units come to market over a two-year period here in 24 and 25.

12:47Okay. But peak supply is hitting in the next six months. And if you look at relative time from A, peak supply, and then B, to getting to a level of lower supply than you saw last cycle, every major market in the country will be there by the end of 2026. So delivering less housing units than they did on average from 17 to 19 in apartment buildings. So you're going to go below prior cycle supply very quickly. At the same time, we do have exceptionally strong labor markets here and the demand story has been outstanding. So 2024 is going to end the year, depending upon the data provider you use, as the first or third highest year for rental demand ever.

13:312021 was the prior record. So we're seeing people form rental households at unprecedented rate in the U.S. And as that supply comes down, you're going to see that demand struggle to, frankly, find high quality, well-located assets to move in. And you're likely to see that relationship flip at that point.

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14:46Giving teams across your organization an easy way to order from a huge variety of restaurants, all on one platform. All while consolidating your corporate food spend so you can control costs, streamline billing and payment, and simplify reporting. EasyCater, your business tool for food. To learn more, visit easycater.com slash podcast. So the other thing that affects multifamily housing construction other than interest rates has to be just general confidence, I guess, in the direction of the economy, the direction of the world. And certainly there's a lot going on right now. We're recording this on January 28th, and there's news that the Trump administration is freezing a whole bunch of federal spending.

15:32I think it's something like 20 % of federal spending. That includes presumably stuff like Section 8 and other affordable housing measures. Would that be expected to hit multifamily as well? Yeah. And I think it's probably easiest to sort of start at the top, right? When you're building multifamily, you're generally trying to build to an acceptable return on cost. But frankly, what we're doing is putting an investor's money together and generating returns for them. Multifamily isn't built for free, and it can't be in this sort of economic world. And a general rule of thumb is a six plus percent return on cost.

16:11So cost to build, you want to yield over 6 % of that to get a building to pencil that tracks up closer to seven, depending upon the institution. Because you need to build to that yield on cost, you have to have rents that are high enough to generate enough rental revenue to drive that return. So in order to build today, you have to build at exceptionally high rent levels because of the cost to build, because of the cost of interest rates. The only way to drop that is to drop the cost. And that cost drop typically comes for affordable housing from the federal government, be it HUD grants that are then deployed through the local housing agency, be it LIHTC, be it any sort of an ensemblage of ways to cut costs, that's how you can get to affordable rents on the supply side.

16:57And then on the demand side, you can cut rents by literally giving people a rent check, which is what Section 8 is. And that, again, comes from the federal government via grant given to the local housing agencies to deploy. And if that money dries up, you have immense problems in terms of A, fueling the demand for these people because you're cutting rent on the Section 8 side, and B, encouraging future construction of affordable apartment buildings. Just to be clear, though, because there are projects that have their market rate rent, and then they have some allocation to what people call affordable units, right?

17:38And different cities or whatever have different rules about how much you need to allocate. Is that Section 8 housing too, or is Section 8 housing, like how much does it commingle? Does this also affect development of buildings? that people don't think of as quote affordable housing projects so in those sort of mixed buildings you're going to see more of a price lock you're going to see a supply side affordable building be it tax credit be it a locked price on x percentage of ami which is ultimately what you're going to say am i area median income which is how fanny freddie all of them essentially set what's affordable through hud so that won't be destroyed or eliminated frankly usually when people are building, they understand in Massachusetts, you need X percentage of the building to be affordable.

18:26So they need the building to pencil around that. Honestly, typically, it just means higher rents in the rest of the building to fund those units. So I don't expect that to dry up. What I expect are larger scale community investment projects to revive an area within a town like a Pilsen. We looked at buildings with one of the states prior at a prior job and that was looking at doing a massive housing development that would be entirely affordable for the community there. And this is in Chicago. So stuff like that's going to disappear. Purpose built is going to disappear. Anybody who was planning to build an entirely voucher building through Section 8, that's going to disappear.

19:05So you're going to have real pain in that stuff, at least in the short term. I mean, in theory, this could be a quick turnaround And it's just a big wave of disruption that goes away in four weeks. But there is a world where it severely impacts housing construction at the lower level. What are people in the market saying about it right now? Or is everyone just sort of in wait and see mode? I think like most things, it's wait and see mode. I think that's been the general markets approach to this entire administration transition, just because you need so much clarity to start figuring out real world impacts here.

19:39And that very much trickles into the cost to build stuff with the tariffs, with the deportation impacts on labor and things along those lines. Let's talk about deportation impacts on labor. What are the estimates for what percentage of the multifamily workforce, whether it's construction or maintenance, whatever else, is undocumented labor? It's estimated 20 percent of construction workers in this country are undocumented labor. I'd venture to guess it's similar for the whole multifamily industry when you look at staffing and things along those lines. And I think when you look at a combination of deportation of construction workers, as well as the sheer amount of labor it's going to require to rebuild huge swaths of California, I think you could be looking at a massive deficit in labor within the construction space.

20:29And when you think about that, that's going to be your strongest lever that's going to hit your cost to build. And that's what's going to drive up those rents that are necessary is all of this immense pressure you're going to see in the labor costs. Tracy, I hadn't even thought about the huge demand for construction labor that's going to come out of California. Oh, yeah, because of the wildfires. So we have the fires, we have deportations, we have the end of a lot of affordable housing projects, at least temporarily, and the interest rate shock all coming together. So far, this is what we've covered so far at the same time to sort of like constrain the supply of new housing in the coming years.

21:09Well, the irony is like everyone's building at the same time after the wildfires, right? So like everything is just going to go up. Actually, that reminds me, we should talk about insurance rates because I think this is another source of pressure on multifamily, which is that insurance rates for a lot of these operators have also been going up quite a lot. And there aren't that many levers they can pull in order to reduce that particular cost. Yeah, I think this is another situation of kind of the haves and have nots. At Cortland, we insure our entire portfolio. And when you're able to sort of spread risk over 80 ,000 apartment units, you can get far more beneficial rates.

21:50If you're a small owner in LA, if you're a small owner in California, Florida, and Texas, I don't know what you do today. Rates had hit an estimate of 300 per unit at one point in Florida to insure some buildings. Well, there's been some normalization since then, and costs have generally stopped with the massive spikes, again, pre-wildfires. But it's just a huge, huge cost that hits everyone. And it's tough at this point in time to enact in certain markets. And that includes also Texas. Tornado alleys had as much of an increase as you've seen in Florida and California to date. So where does the rubber meet the road?

22:32We're going to have you back on sometime in 2026, maybe somewhere in 2026, if the pattern goes. What are we talking about? I think what you're looking at in 2026 is a very investor-friendly rental market again, and we sort of have returned to where we were last cycle. What I think is really interesting and what I see in the housing market today is almost a displacement of people living where they want rather than people not being able to afford housing. And it starts at the top. The baby boomers have the vast majority of three plus bedroom homes in this country, and they aren't giving those up despite plummeting bedroom utilization rates.

23:08So the millennials can't really push into the housing they want. So millennials continue to rent or buy first time homes, things along those lines. Gen Z at the same time is the richest earning young generation on record because of, frankly, the baby boomers exiting the labor force. They don't feel it that way, though, from what I understand. No, they do not. But the Fed strongly disagrees with their feelings. So when you look at - The Fed doesn't care about your feelings. Sorry. Anyway, keep going. No, it's fine. When you look at this confluence of factors, what you've seen is really higher earning people living lower down what used to be considered the quality spectrum.

23:46So in our portfolio, we've seen incomes jump to almost$100 ,000 per unit on average. Our credit scores have spiked to around 700 and our age is in the low 30s. That's a well-earning, strong, young American worker. And that's across our portfolio that's primarily in the Sun Belt with some mid-Atlantic and Western exposure. So you're seeing an exceptionally high-quality, credit-worthy tenant, and you're seeing huge demand for that housing. And that's because nobody's building in the well-located areas. You can't build single-family homes in good school districts today. The local builders are entirely out of the market.

24:22They've been absorbed by the big boys since the great financial crisis. And you're seeing starts in those high quality locations plummet at a greater rate than you're seeing them in the further out locations. So you're going to have this tight labor force. Everybody is going to need to work preventing some kind of crazy AI situation. And you're going to have these high incomes and everyone's going to want to live in the same well-connected, good areas. And you're likely to see rents in those areas begin to pop because that's where this supply wave is winding down the quickest. And that's where starts aren't going to backfill the current supply.

24:57Just to be clear, though, the expected increase in rents, is that enough to offset all of the pressures from higher interest rates? I think you're likely to see what's happened in the single family sector after the GFC happened a little bit in the multifamily sector where there is a thinning of the herd. I don't think it'll get to the point where I think four home builders have 50 % of new home listings today or some crazy number like that. But you're likely to see the small developers end up consumed by the bigger developers that can handle it better. and you're likely to see continued pressure in the multifamily space where smaller funds, smaller operators, people that can't afford interest rate caps, that can't ride out long term higher for longer are going to have to exit or ultimately be absorbed into a larger player.

25:47So to answer your question, it would be much easier for the industry on the whole to have lower rates. I think a three to a three five, the industry is just fine. Three to three five on the 10-year, to be clear. I don't know how soon we can get there. And I think in the meantime, we're going to see a calling of the herd, if you will. I'm very bullish on driverless cars, but assuming that they're not in mass production or mass deployment in the next couple of years, talk to us about how far people are going to be having to commute. If it sounds like the desirable places, there's no building, people are having to build further and further out.