August 2024 Newsletter
Dear friends & investors.
This month bore witness to what might be described as a “continued deterioration” of the economic situation – enough to drive the 10-year treasury below 4% and create substantial odds that the Federal Reserve would consider cutting rates by 50 bp at the September Fed Meeting.
The main news in August, though, were job revisions. ?Chart below is courtesy of the NY Times and does a good job of showing just how dramatically job growth figures were overstated over this period. And we’ve discussed, on this Newsletter, this phenomenon multiple times and in multiple ways.
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We have been saying, anecdotally, that job growth figures defied what we were seeing. It seemed like layoffs were being announced everywhere, and yet month after month the job growth figures kept defying this dark period. Something had to give – turns out the anecdotal experience was more accurate!
Of course, as a real estate investor, job growth figures defying reality kept interest rates high, which was ultimately poisonous for a lot of practitioners in this business. It sometimes felt a bit like that scene in The Big Short where the numbers refused to budge even when they knew the housing market was falling apart, and their investment thesis appeared to be failing. You can be right, but the market doesn’t reflect that for awhile – and in that time, a lot of bad things can happen.
The big question now is – what’s worse (for real estate investors), a recession and job loss, or high interest rates? Because it does seem like you either get one, or the other. Ultimately, I think the answer is lower interest rates. In a recessionary period, you would have a) reduction in rent and b) an increase in delinquency, but it would be coupled with an improving interest rate environment, and a more “risk-off” sentiment, which would further push rates down and therefore drop cap rates. Ultimately, we think the cap rate reduction and reduction in borrowing costs would be more beneficial for the asset class.
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Thoughts on rent control
?Another item that came up in the last month is the Harris – Walz administration starting to discuss ways to control housing costs. It seems fairly evident (to us) that the key to reducing rent and own costs is to build more. It’s an evident rule of supply & demand – you have excess demand; you need to increase supply.
However, what’s actually being bandied around right now is to increase restrictions, to minimize tax benefits for large owners of single-family homes, and some saber rattling on national rent control.
Look – to be clear – we like rent control (as a landlord). It serves every purpose we seek – it reduces supply and it drives rents up. That’s why we invest on the West Coast. It has hard to deal with structural and regulatory inefficiencies – it scares off a lot of investors, but it creates systemic problems in housing supply that ultimately benefit landowners (in the short term).
Let’s take an easy-to-understand example. You are a taco-truck operator. You work in a city where everybody can open a taco-stand. There’s no rules. It’s chaos. You open your stand right by your neighborhood Starbucks, because you figure – people want tacos with their coffees. But then so does another guy. Another guy opens his across the street. Pretty soon Starbucks Road is littered with taco trucks. What do you think happens to pricing? Are you making money?
We like markets where the government says it’s really, really hard to open up a taco stand. You happen to be one of the guys that bought a taco stand, and its location. It’s got a spot. Government says you can only raise the price of your taco stand by 9.8% per year, but also people just can’t build new taco stands. In our humble opinion, government sanctioned supply constraints are a nice place to do business.
In fact, do some research on Jack Kilroy, the founder of Kilroy Realty, who was a major landlord in the 1970s and 1980s in San Francisco and helped craft the initial rent control measures in SF in 1979. He wrote that “rent control was advantageous for business because it helped stabilize the rental market, reduced tenant turnover, and ensured consistent occupancy in his properties”.
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Anyways – point being – there’s some solid reasoning behind why a landlord would want rent control. There are some negatives, of course – it can become excessive. In our perspective the San Francisco Bay Area has moved into the realm of overly restrictive rent control – being capped at 2/3 of Bay Area CPI or 3% (whichever is lower) when costs are going up more than that is brutal. But that’s why we haven’t done deals in the Bay Area recently, and pricing is starting to look good there.
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Ultimately, fewer barriers to construct supply is good for society and for the economy. Rents being “floated” to the market is ultimately good – at the end, real estate owners want the economy and people to thrive. It’s not beneficial to have places that are so expensive that the middle-class cannot survive. And that’s why, in the end, rent control is a bad idea that deserves to go to the trash bin of history.
To understand why, beyond my taco truck example, consider this (a very familiar situation, as I suffered through this in the early 2010 period trying to live in San Francisco). If you are a young couple trying to move into a hot city with rent control, rent control benefits you not in the slightest. Your unit is still expensive. The only people it benefits are those who made an active decision a long time ago to become eternal renters and have lived in their unit for a long time. Generally, those people are past child-bearing years and might even be done working. So, a city is making a choice to favor older tenants without children, to the detriment of their city, because a young couple that is entering family rearing years is now choosing to live elsewhere. How that’s good for the long-term health of cities is beyond us. ?
Maybe, some argue, the city should also cap rents on vacant units (i.e. last tenant paid $1000 a month, so the next tenant can only pay $1100). This policy may have more short-term benefits for renters, but the impact to property owners (and the quality of those properties) is severe. The likely result of policies like this would be that owners would simply walk away, as the government would have effectively outsourced its own wishes onto private owners, who will opt not to own anymore. In this case, the government should be prepared to take over the job of providing housing, something it isn't prepared to do. If you think about it, as an owner, if you can never raise rents (even on turnover), you will be destined to lose money, and so the incentive to own and to invest in your building will vanish.
By contrast, here's a recent, and relevant, example of a country that stripped away rent control. Look what happened!
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In short – we love rent control for our markets. But conceptually, we can’t stand it and think a national rent control measure would be a negative. Conversely, it would be hugely positive for our own markets since we already dela with it. By contrast, the value loss in non-rent control states for owners there would be substantial as it isn’t priced into their valuations.
Touch base here if you want to learn more about our upcoming investment opportunities.
Arie van Gemeren, CFA
Founder & Managing Partner
Lombard Equities Group LLC
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Interesting Reads this Month?
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