Is a Recession Still in the Cards? ft. Ben Miller

29:09Does that communicate? Okay, so let's just go through this. higher cap rates, all else being equal, mean more cash flow coming off the property. Yes. Yes. But it also effectively tells you how much you paid for the building or how much you paid for the property. So here you're saying like$215 a house,$215 ,000 a house,$285 ,000 a house. if I could turn around and buy that house in the market and buy it and own it for$200 ,000 a unit, right? Or$250 ,000 a unit, then you're lending above the basis that you can buy it at. Right? That's what's so interesting. And so here's another way to think about it.

30:05if you're paying a... So you look at the down on the bottom, this is the price the issuer is going to pay$2.11 over for your US treasuries. So that means that if your treasury is at 4 % and you have a spread of 211 bps and you're paying 6 % to the lender, but the property only has 4 % cash flow, right? So how do you pay 6 % cash flow to the lender if you have bought the property for 4 % yield? If I'm understanding this correctly, what you're saying essentially is that the valuation of the debt is mispriced relative to the underlying asset. And you can actually buy the debt lower than you could at the underlying asset price, which would suggest that ultimately the value of the debt would rise.

30:59No, the opposite. You can buy that. You're buying the debt above the asset price of the property.

31:09So why would you want to be long if you were buying the debt above the asset rate of the property? You shouldn't. This is a very unhealthy sign for the market. Okay, so but these aren't the triple Bs you were long then. No, this is what happened last month. not two years ago. Got it. Okay. Got it. Sorry, I wasn't clear. Like this is where the market is today. Not where we're two years ago. It was like 50 % more than this. You know, you were, the cap rates were six. The debt yields were nine. LTVs were 60%. Your last dollar was, you know,$100. I mean, like, you know, this is like, there's nothing there.

31:50I'm trying to say today, we're not buying this market today. I'm just saying like, this is, I mean, this is, so maybe it's just too technical, but like the, the, the essence of what this is saying is that you're today lending, securization market lending to borrowers at higher prices, like they're lending above what I think is the actual purchase price of the asset. And that's the key. And that's, it sounds like a disastrous situation. is it a disaster situation so let's let's jump out back to maybe this just let's jump back to normal um uh uh back and forth here but like the the bet the bet is that over a five-year term of the loan the price of the house price of the underlying asset appreciates and so that like five years from now, if it appreciates, let's say, 5 % a year, that's 25 % appreciation over five years.

32:55And then they can sell the house and they're good, right? So it's a bet on... That's a bet about the underlying value of the collateral is going to rise to meet the debt service pricing on these instruments, which is, it would seem to me, to sound more like an equity type of bet than a fixed income kind of investment. Yes, exactly. Exactly. So, okay. So, I tried to bring that because it's a signal. Because I was saying to you two years ago, the signal was the opposite. It flipped. The complete opposite. Now, what does that mean? Why is it happening? What does that mean?

33:37So, there's a few possibilities. And certainly, it's a little bit... This is so fresh. These are things that printed in the last couple months.

33:48So there could be macro reasons and there could be micro reasons. So let me just do some of the macro. The macro, I think, is that the hot new thing is private credit. And there's been a ton of money raised for private credit. I mean, I don't know how much, but probably hundreds of billions. But they actually have a really hard time putting it out. and we have a private credit fund, but our private credit fund is like a more surgical and smaller. But you, and so what's happening is all this supply of private credit money is flooding into the market. And if you're a lender, you have to, you more or less lend when somebody buys.

34:28You have to have a transaction in order to be a lender, right? You can't lend to somebody if there's nobody borrowing. Right. And the borrowing has dried up because there's very few people buying today. And so there's not enough transactions. And as a result, the few transactions that come to market, like a securitization, is oversupply of money. Oversupply of private credit money. So I think that's a factor. Oversupply of private credit money. Oversupply of... Yes, that's... Oversupply of money. It's not just private credit. It's also probably debt funds, like bond funds. There's lots of people who buy bank funds.

35:10So it's not just private credit. I mean, it's... So you might just say oversupply of credit markets, which is counterintuitive to what you think would happen when the Fed raises rates and pursues quantitative tightening. So that's... Let me just pause here. Yes, please. So that people who are watching this can get a sense because it sounds like you're discussing potential fragility in these markets, potential risk ahead in these markets. So let's just walk through this just so people can get a big picture, because obviously this isn't something that I deal with every day. And it's really, it's hard for me to get my head around.

35:49So I can imagine that people at home are probably having similar questions. First, for people who are not sitting in front of a Bloomberg terminal, who don't have Q-SIPS on the ABS that we're looking at, is there a way to measure the pricing in this market that's publicly available for free on the internet? Or is this something that you need to have specific information about the assets that are trading for qualified institutional purchasers? Is there any transparency in this market that we can see? Not that I'm aware of. Or proxy. Yeah. I mean, Bloomberg, Bloomberg terminal is like,

36:28and even Bloomberg terminal, like, you know, it's a lot of times you don't get, great data from the offering materials and you have to go supplement it with additional data about real estate markets. So I don't think so. I think this is Bloomberg. First thing that people need to understand, this is not transparent. You're not able to see this on your screen right now. That's what makes it actually very interesting for people who watch the big short. You know this, this idea that you're not able to see the pricing on it. I imagine these things trade probably quite infrequently when they do trade.

37:00They trade in large blocks. Some of them may be private transactions. I don't know what the ability to see that sort of listed is. Okay, that's the first thing you need to know. This is not something that you're seeing on your screen right now. So let's unpack this and talk a little bit about what the implications are. It sounds like for essentially rising risk in the underlying ABS and the mortgages behind that, talk about what does this mean for people who are listening to this right now, other than the fact that it sounds like you've made a pretty big bet on this market. Well, we did and then we shifted.

37:36But it's... I mean, this is what's so interesting. You could see it as a positive sign. And the positive sign is that the risk has left the market. Risk takers had left the market two years ago. And there was a lot of fear of a recession. And now the risk takers are back to the market. They're back. And they're back in spades. And so I do think it does reflect kind of the stock market's surprising climb is that there's plenty of risk money out there. And so if you could imagine a scenario where we have a soft landing because there's enough flow of capital, where businesses and borrowers can get access to capital.

38:32Even if it's more expensive, they can still get access to it. A lot of times, like 2008 financial crisis, it wasn't just about price. There was just no money. You couldn't get money. It was gone. So I think that you could take it as a positive. I think you could take it as a positive in the short run. And then it raises question in the longer term because it doesn't feel like that is necessarily good risk, that it's balanced. But from when I said there's macro reasons, micro reasons, I think the micro reason, micro reasons are single family has been very healthy through this downturn, much more successful than people thought.

39:16There used to be a saying that it's safe as houses because housing prices have never gone down. And in 2008, they went down and people started thinking housing was risky. But actually, traditionally, housing is very safe. And I think that the institutional market is starting to see housing as a much safer bet than I think most people appreciate. So I think that there's... So that's an interesting statement. I want to zoom in on it. The institutional market is beginning to see housing as a much safer bet than people realize. Now, this is something that ties into, again, things that aren't necessarily super transparent to people, private credit markets, private equity markets, the idea that there has been a tremendous increase in the amount of private capital flowing into real estate development on the equity side, on the private credit side.

40:07So this is an interesting question. I just pulled up on my screen here, the S &P Case-Shiller 20-City Index. I'm looking here over a 10-year period. We'll get a 10-year chart on this going from about 170 in April of 2014 to where we are right now at 333. This has been up at a 45-degree angle over a 10-year period. And it sounds like the crux of that – and by the way, slight dip, slight dip during the pandemic and then just continued at the same slope, same rate of trajectory upward. This seems to be consistent with what you're saying of the fact that there are institutional markets that are supporting this.

40:51I have to ask the obvious question is, is there risk in this? Is there the potential that we've seen too much capital flowing or overdevelopment or some other imbalance in these markets? You said development. These transactions are for existing homes. But I think no in the short run. I mean, I think this is... I mean, I'm very worried about it, but I'm always worried about everything. And so it's not a good gauge of whether or not everyone else should be worried. so the micro reasons are that what happens with institutional money is that things go into favor and come out of favor and so housing has gone into favor because of the run-up you said one, two, because of the resilience during the 2022 from COVID to now that resilience, the institutional market really values resilience, not just growth and then three a lot of money has to go somewhere.

41:55And it used to go places that are no longer available to it. So Office was a multi-trillion dollar market and the money can't flow there. A lot of private equity CLOs and things like that where you're funding private equity funds, acquisitions of real estate, of properties, sorry, private equity funds, acquisition of businesses. These are the collateralized loan obligations. Yeah, exactly. And so private equity funds aren't buying anything. So there's no borrowing. So there's actually not that many parts of the market that are still transacting. And so it's a combination of there's not that many choices that you can put your money into.

42:40And it has done pretty well. and just like, I mean, my experience in 2008, just like individual investors, they always chase the past. If a line is up and to the right, they buy it, right? Rather than saying, oh, is that a sign that it's overbought? So, but let me just give you another, because when you look at these markets, what I love about being across multiple asset classes and multiple private markets, public markets, You can go look at the asset from different angles. And so another way to look at it is we are a lender into the home building market. We have 10 ,000 lots and we've lend to home builders who build homes.

43:29And that we went into that market in 2020, 2020, maybe 2021. Is this private credit or public debt markets? This was private credit. So we have a private credit fund. This is where we bought S-Bag Securities. And we are also in that private credit fund, mostly a direct lender. And so when the housing market sort of cratered, we lent to home builders. So that, which, because we found it really attractive. And I can talk about sort of how... Presumably you found it really attractive because of the yields you were able to generate on it. In other words, if there's no bid in the public markets, you probably have the ability to lend at a pretty attractive rate from your perspective.

44:19Yeah. I mean, I can jump to a new market and talk about it. And it can be... I hope I can bring people along. But the way home builders build homes today is they buy, let's say, a$20 million piece of land that's got 500 lots on it. And we would effectively lend to them to buy that and put in the horizontal infrastructure. So you have to put in roads and sewers and electricity. And that takes a couple of years. And then they start to sell those lots to build homes. So that takes about probably three years. And so... That's a lag from the time the capital comes in the door until the time the revenue starts flowing in, obviously.

45:10Right, right. And so that ended up being a good... It's funny because when we were telling everybody that briefly in 2022, people, our investors were a little bit worried because they thought housing would get hurt. But instead, the home builders had been very, very successful. This is what I'm saying about housing has come into favor and there's more risk-taking in housing. and we're not putting more capital into it today. And I could get into sort of homebuilder finance and it's really interesting. It's a totally different part of the market, but it's like I'm trying to just sort of summarize it in that it's now got too much.

45:54We stopped putting money into homebuilder finance because it's gotten much more amply supplied by other capital providers. There's much more homebuilding than there was. And it seems like the risk is not worth taking for the reward you might get. And so I can... So earlier on, going back two, three years, you saw that you were being rewarded for the risk that you were taking in the form of higher yields on the private credit funds. Obviously, now you're saying there's more capital flowing to it. And by the way, there are a lot of ways that retail investors do play these, whether it's in REITs or in ETFs, some of which are leveraged, some of which are not.

46:34But this idea that essentially that what you're seeing right now is there's enough capital flow to that market that it doesn't pay you the risk, the reward on the risk that you need to get. But it's interesting because I almost hear something that might sound, and I don't want to be alarmist here, but it might sound a little bit ominous to some of our viewers and our listeners at home when someone who had been lending into a market essentially says, I'm not bidding anything. yeah it's funny i mean fortunately we we you know we don't have to deploy billions so we we you know we have a we can be surgical and and what you have to do you have to i mean what we have done is you go into a market before the institutions go there and then when they show up you start to leave the market it.

47:27But often I find that I'm really early. Did you exit those positions or are you holding them to maturity or are they somewhere in between where you're offloading some of it? It's somewhere in between. I mean, I'm not worried about our risk because again, you can't look at the yield. You have to look at your basis. And so the fact that we're buying this land or lending in this land effectively, it's like a structured lending program at land prices that have since maybe doubled. It's like, I'm not that worried about... And also, it takes a long time for that land to get developed and get ready to be sold.

48:10So the fact that our pipeline is more mature means also lower risk. And the point is that I'm not worried about the... I'm personally not worried about the profile of our current portfolio. and I'm finding lenders are coming to us, big ones, the lenders, sorry, and home builders and taking them off our hands early. Because there's just like, there's such voracious demand for this asset class, which is now being institutionalized, which is home builder finance, or some people call it land banking. But it's... So I can get into it technically, but the broader point, doing full circle, is the broader point is that risk markets are back.

49:00There's risk taking, there's capital. And you can look at that and you can say, well, that happens. You look at the 2008 financial crisis, like risk markets were back. The stock market sort of peaked shortly before it collapsed. Same with 2000, in year 2000. So you can look at it that way, or you can say, oh no, this is actually going to facilitate a soft landing because there's ample capital. And it's not... These risks we're talking about, they're not risks I would take now, but they're not absurd. Right? Like it's, so I. And that's the implication for the soft landing scenario, that you don't believe that the risk taking has been absurd.

49:49You just don't believe it was as favorable as it was two years ago when you took the risk. And just to underline this, essentially what you were saying, the reason that you're not worried about your own book of assets, in your view, is because if you've had, if you're lending against land and it's risen by 50 % since you took those initial risks by lending in the private credit markets, then the implication is that even if there were a drawdown from the peak price, you're still protected because of the cash flow that those properties can generate relative to where you took the lending decisions.

50:23Yeah. And the home building industry is really matured. It's like people don't appreciate how much the home building industry has developed since the 2008 financial crisis. And it used to be a wild, wild west. and since 2008, it's become institutionalized. It's much more efficient. They really use technology. And so I think that there's a strong argument that the home builders are going to weather, they could weather a storm. And so like lending into that ecosystem, I think that is a good argument for it, even though I think we're not. I can make the argument both ways, even though at the end of the day, I say we're not going to.

51:09And so what I've tried to do, right, is I take, you know, we are in the asset-backed series market. We're in the home-building finance market. We're in the apartment market. We're in the technology market. We sit across a lot of the sort of economy and it gives me a sense of what's happening. And it sort of boils down to,

51:35because no one believes there's going to be a hard landing anymore, a lot more risk is being taken. And that could be a very positive sign because it's self-fulfilling that it's hard to have a hard landing when there's a lot of risk-taking in the market. There's a lot of money. Usually, it's a hard landing because things just go worse. And it just doesn't seem like... It seems like the Fed may pull off the immaculate landing, even though I think there's a 20 % tail risk that they don't because of things they can't control, like politics or global geopolitical events. So that's, I mean, I was convinced there was going to be a recession.

52:35And I now think that there will be one, but it's not going to be as extreme as I feared.

52:47Ben, we have a few minutes left, but I wanted to take a look at two charts in your deck that I think are especially compelling because they speak to precisely these points. The first one on page five, the annual net absorption of market rate apartments in the U.S. Walk us through this chart. Explain what we're about to see on the screen in just a second. Yeah. Well, I want to show you this slide and the one that's sort of underneath of it. But so you're seeing the net absorption, which you saw is that it went negative in 2020. What does that mean, net absorption? That's not a phrase that most people in the retail markets are familiar with.

53:25So net absorption is the total amount of supply of rental housing kind of minus the total amount of demand or demand minus supply, supply minus demand. So you have sort of net. So if you have in Nashville, 10 ,000 new renters, but you've built 20 ,000 new apartments, then your net absorption is negative 10 ,000, right? So you saw oversupply of housing in rental apartments. And there was more supply of new apartments than there was demand for new apartments. And everybody in the real estate market thought 2024 was going to be a bloodbath. And the absorption demand shocked everybody because supply is easy to measure.

54:15You can see what's under construction. You can know when it's going to deliver. But the demand really surprised people. and that's because of two things. One is that higher rates meant less people were buying homes and so more people were renting. But the thing that was most surprising, which I think is this slide before this, which is the demographic shift. And so this is John Burns. I love their work. John Burns Real Estate Consulting. I think they're the best source of data for housing. And so what you're looking at here is the annual number of new working age population. So if you look at the 80s or 70s or 2000s, we were adding 2 million new workers to the U.S.

55:11population every year. Okay. And this is growth. So this is the second derivative. This is the change, not the aggregate number on a stock basis of workers. This is the net change. Yes. Yeah. So what you saw, the U.S. has been growing for 200 years. We would add immigration and people would have kids and those kids would eventually turn 18 or 20 and go to work. And so you had growth in the working age population in America for the last couple hundred years. And then what happened since the 2008 financial crisis is that people started having less kids. And then COVID, people even had less. And so you really saw a fall in number of natural births in America.

56:04Plus, immigration policies really started tightening up. And we started seeing at the end of 2019 that we were on the path to having no more growth in working age populations. Two interesting things jump out at me at this chart. Number one is on the left where you see those bars being the highest, that is the period of highest inflation that we've seen in our lifetimes in this country. The period after the early 1970s into the early 1980s. The second is this, that as population in aggregate rises, these increases on an absolute quanta level represent smaller increase on a percent change basis.

56:50Yes. And this story, which you probably have a demographics expert on the show, but this is one of the three most important things happening in the world today is that demographics in the world, human population are radically changing. I mean, you're talking about demographic growth in the world was a fact for 100 ,000 years. The only period where you saw extended demographic decline was in the 1300s because of the bubonic plague. And that, I think 30 % of people in Europe died. And that caused the collapse of feudalism and the beginning of Renaissance. And so a period of demographic decline is like, you know, we're uncharted territory.

57:46And so that's a global phenomenon, Western phenomenon, developed nation phenomenon. But the United States was on that path. And I think that path was a dangerous path. And then we just had an immigration surge, legal and illegal. And we can talk about the, you know, the political decision of whether that was good or bad, but from an economic decision point of view, it's been extremely good for housing, for real estate and for just aggregate growth. And so that's been a shock, a shock to the system, absolute shock to so many parts of the economy. And we're just getting started here. And I know we're about to run out of time, but this is a big, obviously, political, philosophical, and obviously economic issue as well.

58:40I just want to show the last slide here because this is really striking to me as well. This is the new home sold by sales price. This is a pretty striking chart. We're going to see it in just a second. Yes. Yeah. I tried to bring some data so people could. This is also from John Burns. And John Burns is, again, I'm just going to, I'm showing their work. I want to give them all the credit. But you're seeing a lot of lines on this page, but the two lines that focus on the upper right pink line, the number of expensive homes being built in America has skyrocketed. So obviously, partly it's a base effect because of inflation, but home builders are building more expensive homes than ever before.

59:25And then the$200 ,000 home, They're building much less of the affordable homes. And I think why I like this slide is that a lot of times what's happening in a market is a microcosm of a larger macro dynamic. And that is in this world, half the economy, half of the consumers in America have fixed rate long-term debt. and so they're really wealthy and healthy. Half of the consumers do not have fixed rate debt and they are seeing the full brunt of these high interest rates. And so you have this sort of divided economic environment between those who have and those who have not and that is very difficult to then determine a policy because rates have an asymmetric effect and you're seeing that here than just the low-income buyer can't afford to buy homes so the home builders aren't building them.

1:00:33And this is such a great chart because it talks directly to the political and cultural questions that we have right now. And by the way, one of the things that that's highly correlated to, I would imagine, is age. So you have folks out there who bought houses in the 70s, 80s, 90s, fixed rates, who have done extremely, extremely well. And then you have people in their 20s out there who are really attempting to figure out, hey, where's my slice of the American dream? How am I gonna form a household, form a family, raise children the way my parents and grandchildren parents did? Because housing is remarkably unaffordable, as you said.

1:01:17As a consequence, you see the inability to find supply creation to meet those demands. Boy, this is a powerful slide, a powerful conversation. Ben, I know we've just barely scratched the surface. With this, we're going to have to just have you back to continue this conversation and talk more about it. And I'm still learning about this as well. I spend most of my time focusing on public markets. By the way, if you were confused in this, you're not alone. I was a little bit confused. Private markets are very confusing. Asset-backed securities and the way that people, investors in real estate think, it's very complicated.

1:01:47Ben, we're going to have you come back and talk about this some more. But what are the final thoughts and key takeaways that you'd like to leave our viewers and our listeners with? Um, I get, maybe I'll even just, I'll go with this slide here, which is that, that a lot of times what's unclear in the short run is clear in the long run. And what's clear in the long run is higher rates make things less affordable. Uh, the country has a lot of debt and it's just a matter of time before that starts to bite. And so the path of interest rates in the near term is uncertain, but in the long term, there's no way to afford the, the, the debt service we have.

1:02:25at higher rates, but that rate's coming down. And so we're going to be in this sort of like choppy period. But the argument that rates don't come down, I think, does not hold water for me. So that means the Fed's going to have no choice but to cut because of the debt, because of the weight of all the debt stock. It's just, it's, yeah, the amount of debt repriced is recessionary. Like there's no, there's no way out of that, you know, fact. And so it's a question of time, not a question of if. And so that's, you know, in the short run, you can trade the market, but in the long run, you just have to be aware that America's debt levels are too high to afford interest rates where they are today.

1:03:16Really interesting stuff. Don't be ashamed if you have to watch this twice. I think I probably have to watch it again myself, But Ben, fantastic conversation. Hope you come back and join us again soon. Yeah, thanks for having me. Thanks for listening. Thanks for watching. Have a great afternoon, everybody.

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