I’m a great admirer of Jack Cohen and his periodic market commentary.  I answered his last one and then after the two of us talked, we decided we’d publish them together as a duet.  So here you go.

JackChat, May, 2019

By Jack Cohen | May 8th, 2019 | Categories: JackChat

Negligent in keeping up with my blogging, four months since my last, an attempt to catch up:

Multifamily – Sector affordability is a concern. While rent growth and rising property values have position connotations, these trends are not sustainable. Despite the stronger economic growth and wage growth in recent quarters, incomes have not and will not keep pace with rents rising at these rates. Yet to justify new construction, revenue must grow to cover the even faster rise in development costs. I am not aware of any major market, without aggressively trending rents, where development yields are above 5.75% to 6.5%; some are lower. Nor do we hear many operators pleased with recent Class A rent growth.

While the multi-family industry has seen too much Class A product and too few cost-based innovations, clever renters, developers and owners are addressing the situation. Smart first-adapters are testing new solutions (micro units, co-living, AirBnB relationships, hotel like apartment management) to make properties and the renter experience more attractive and efficient in delivering quality housing at attainable rents.

Four key investment conclusions: 1) despite new supply – and over supply of Class A in certain markets – continued demand in growing urban areas will keep the market stable. 2) expect more renovations and rehabilitations as higher costs enhance relative value and prompt the need for more of these projects. 3) in most localities, rent growth has outpaced middle and lower-middle class incomes. 4) existing properties produced at lower costs will be more appealing to renters than brand-new product that is less affordable due to higher development costs.

Yield Curve – We all have been reminded that the inversion of the yield curve has forecasted the last 9 recessions (with 2 false positives) happening within 18 months of the inversion. Don’t forget – 18 months leaves plenty of room for rising peaks prior to the deepening troughs. That aside, we also hear “this time it’s different”. Really? What if it was?

One new truth is that we seem to borrower shorter now (less than 3 years). As such, if relative borrowing long vs short was 50/50 as late as 2016, currently 80% of our borrowing is short duration. The artificially high demand for short paper therefore drives short rates artificially high. At the same time the larger balance sheet of the fed drives long term interest rates down.

Maybe it is, maybe it isn’t, different this time. What do you think?  One thing is for certain,  global debt has risen from $4.9T in ’07 to $9T today. And, much of corporate debt today is ‘covenant’ light. Sitting one tranche from junk.

Literally, where is your money on the bet if the next recession is garden style or a catastrophic failure/recession? My son tells me that “Situation X Behavior = Results”. I ask in this context, are we experiencing late cycle conditions or late cycle behavior?

What am I observing and/or concerned about:

  • I am all in on the benefit of the shadow banking system of the new alternative lenders. What has me worried are the small community banks beating the alternative lenders at price and proceeds. And they are qualified how?
  • There is a TON of capital in the system. I dig liquidity, especially with balanced fundamentals in most of our markets. However, are we climbing too high on the stack? Is the capital posting at unusually higher capital risk levels? Is it as simple as recognizing the risk of late cycle investing in the longest boom in history? Is risk being mispriced?
  • I cheer every day for inflation (for our Real Estate Industry); historic low unemployment globally means wage growth which means more consumer spending which drives a healthy economy and more inflation. More inflation means more rental growth which means increasing asset values.
  • Millennials are the largest demographic and have the biggest propensity to rent. See above on Multi-family; still a value and growth sector.
  • Is there anyone qualified left to hire? If not, where are companies putting money into training for existing associates to move up the chain of authority and future associates to be hired.
  • Feels like loan opportunities on the cusp – ready for prime time 6-9 months out in the future are being brought in for financing today. A leading indicator that borrowers think the end is near?

It continues to be a great time to be in our business. Innovation, liquidity, deal flow all on the rise. There seems to be more money than good deals in the debt space.  Is your discipline for a deal ‘strike zone’ a fixed principal or merely a suggestion of an idea?

For principles to be true, they need to cost something. If you stand for nothing you will fall for anything.

I’ll be back soon with comments before the Fourth of July. Promise.

Rick Jones Crunched Credit

It’s funny, Jack, just as folks say they hear me in my blog, I recognize you in JackChat.  That’s good.  Thank you, by the way, for your prescience.  Please give me a heads up as soon as you know exactly what’s going to happen next, because I’m really tired of my endless “who knew?” moments.

Notwithstanding vast seas of money sloshing around in the marketplace and the serial inanity of the small banks doing deals they really have no business ever thinking about, it just doesn’t feel like we’ve lost our minds circa 2006 yet.  I agree with you that when institutional lenders, whether they be of the prudentially regulated sort or alternate lending sort, are losing deals to sub-regional players, it’s fundamentally worrisome.  On the other hand, if half the small banks in the United States went castors up in the next recession and we all got to buy and securitized their inventory and we came into the next expansion with half our current inventory of delusional small banks, that wouldn’t be a terrible thing, now would it?

But really, we should neither kid nor congratulate ourselves on our purported sophistication and prudential care, should we?  When the deluge arrives (and it will), we’ll all be caught short and it doesn’t matter how good or careful or sophisticated we are.  Inventories accumulated for sale won’t get sold, portfolios will take hits, and even many of the best loans will fail.  When seven gold medal winner Mike Phelps and I are standing on the beach, and the tsunami arrives, we’re probably both dead, right?

The corporate LevFin marketplace does give me a case of the pips.  Certainly many, if not most, of our self-identified expert talking heads are tut-tutting about the risks in the sub or low investment grade corporate credit market just now.  We hear a lot about how the corporate debt funds and the users of capital are in a self-destructive race to the bottom with covenant light loans and more and more debt.  I can’t tell you that’s not more wrong than right.

On the other hand, my ratings agency friends tell me that a BBB- rating is extremely robust and that truly substantial damage would need to be done to a BBB- business for it to fall out of investment grade.  Of course, the knock-on effect of significant numbers of corporates losing investment grade status cannot be understated, so I’m trying not to think of that too much.

I don’t know how to react to all that is going on right now.  I worry about contagion.  I remember last time when distress began to ripple through the resi marketplace, I was cockily confident that since the commercial marketplace was much more disciplined, we’d be fine.  That worked out well, didn’t it?

The yield curve doesn’t really bother me a lot.  While “it’s different this time” never ends up meaning what the person who said it thought they meant, every cycle is different and some of the things you point out in your note, together with macro flows around the globe and a number of other factors, makes me rather doubtful that short and quirky inversions of the yield curve do a recession make.

At the end of the day, I am still feeling reasonably optimistic about the marketplace.  I don’t think the end is anywhere near like nigh and, if I may, posit the absence of black and orange swans in our professional life over the next year or two, I think this expansion’s got a couple years to grind forward.

That’s at least my base case business model, but I’m keeping my workout skills and liquidating trust technology near at hand.