ARCAN CAPITAL MARKET UPDATE

Macroeconomic Outlook

Overall, 2019 was a good – but not great – year for worldwide economic performance. While the U.S. continued to grow, headwinds in Europe and Asia led to near-recession in the former and significantly slower growth in the latter. Europe, and particularly Germany, flirted with recession throughout the year, as the Eurozone grew only 0.2%.[i] Manufacturing on the continent has been in a recession for nearly all of 2019 as the European consumer continues to keep the Eurozone economy afloat. We believe that there is a strong possibility that the Eurozone will fall into recession in 2020.

In China, growth has been more subdued than forecast at 6.1%[ii] with weakening manufacturing, auto sales and U.S. tariffs holding back the economy.[iii] We suspect that these trends are likely to continue as China’s growth continues to slow more[iv] than expected due to both endogenous factors as well as exogenous, particularly the new Wuhan coronavirus. Indeed, the longer China contends with the fallout from this novel virus, the more it will impact the global economy, including the U.S. A weakening economy in China will have a direct impact in direct investment in the U.S. as well as potentially upending existing manufacturing supply chains of U.S firms.

In contrast to the rest of the world, the U.S. economy continues to defy expectations and has continued its resilient, consumer-driven expansion. Nearly 130 months have passed since the 2009 recession and as of January 2020, the U.S. unemployment rate is near an all-time low with nearly 1,000,000 more job openings than job seekers.[v] The good news is that the consumer has proven to be a quite resilient and wages are finally starting to pick up for the average worker. Indeed, the consumer is going strong and driving nearly all growth in the U.S. There are serious concerns going forward, however, as many consumers are relying on debt to fund their consumption. As of the end of 2019, consumer credit card debt was at its highest number ever – $930 billion – and delinquency rates are rising to levels not seen since just after the 2008 financial crisis.[vi] Additionally, the job opening to job seeker mismatch could potentially have a detrimental effect on business expansion as firms have a harder time finding workers.

Headwinds on the Horizon

Trade is an issue

One sign of potential worry for 2020 is that worldwide trade volume has declined significantly as China and the Eurozone slow and the U.S. continues to impose tariffs on goods from a number of other countries. This has the effect of further dampening economic growth in the U.S. as well as increasing costs to both American businesses and consumers.[i] 

Business investment is a major economic drag

Declining trade is certainly an economic headwind, but it is compounded when business investment declines as well. Moreover, it is likely that the decline in business spending in 2019 is directly linked to decreased international trade flows.[i]

If we look at capital spending from another perspective: the IHS Market index reveals that the U.S. purchasing managers outlook is actually improving slightly, especially relative to other major economies:

Digging deeper, however, it becomes clear that there is a significant divergence between the  manufacturing and nonmanufacturing outlook. This is particularly concerning, as manufacturing tends to produce durable goods designed to increase long-term productivity of businesses. Our concern is that a decline in manufacturing could affect medium-term productivity and ultimately the growth of U.S. firms. This would likely put downward pressure on wages.  

Indeed, we can see this decrease in manufacturing activity and slowing of global trade has likely already had a tangible effect on the profits of U.S.-based firms.

Concerns in the credit markets

We are also begin to have concerns in the debt financing markets, as we watched the repo market seize twice in 2019. While the repo market has a negligible effect on commercial real estate, it was one of the first markets to experience major issues leading into the financial crisis.[i] As such, we regard it as an important bellweather as to the health of the U.S. financial system. Indeed, prolonged distress in the repo market often drives up U.S. government borrowing costs, which will very much affect other rates as well, particularly the 10-year treasury yield that is so closely tied to most commercial real estate debt. While the Federal Reserve is focused on preserving liquidity in this market, we will be watching it closely.   

Multifamily Market

Within the Southeastern mulitfamily property market, Arcan remains concerned about rent growth and value appreciation in the short-term. As the U.S. economy cools, we expect to see this cycle’s torrid rent growth flatten considerably. This would have real effects on revenue and net income and is likely to substantially affect property values. For long-term owners, this may reduce their IRR and real income slightly, but most should weather a downturn relatively unscathed. For those investors who have bet heavily on continued rent growth and ever-increasing asset values, we think that many will begin to see some distress in 2020 as their modeled increases fail to materialize and cap rates either stagnate or rise slightly as the balance between buyers and sellers shifts.

As many observers have noted, rent growth in the region has dramatically surpassed wage growth. According to CoStar, Atlanta rents have grown nearly 35% since the 2008 financial crisis.[ii]  Wages, however, have not grown commensurately. As shown in the chart below from the Federal Reserve Bank of Atlanta, wage growth has gotten stronger in recent years but it still lags its pre-financial crisis pace. Given the wide delta between rent and wage growth, we are deeply suspicious that rent growth can continue at the pace that we have seen since 2010.

Conclusion

Headed into 2020, we are increasingly concerned that global economic headwinds, particularly those in trade, manufacturing and business investment will have a deleterious effect on the U.S. economy. While many forecasters believe that the U.S. will grow at a relatively subdued pace, 1.8%[i], we believe that the economic situation could start to decline as early as Q3 of this year. This should further impact wage growth and the ability of multifamily tenants to pay increasing rents. As rent grow abates and the economy cools, we strongly believe that we will see the beginning of distress in 2020. For short-term investors, especially those in the value-add space, this will likely present a major problem as they will not hit their target IRR’s and their equity will be displeased, forcing many operators to sell. At Arcan, we believe this will present an excellent opportunity to acquire good assets as better prices than today. We are patient, long-term investors and believe that a correction could do the multifamily market some good.

[1] Dr. Boersch, Alexander. “Eurozone Economic Outlook.” Deloitte Insights, November 18, 2019. https://www2.deloitte.com/us/en/insights/economy/emea/eurozone-economic-outlook.html [1] Elegant, Naomi Xu. “The U.S. Trade War Slowed China’s 2019 Economic Growth to its Weakest Pace in Nearly 30 Years.” Fortune, January 17, 2020 https://fortune.com/2020/01/17/china-gdp-growth-2019-weakest-30-years-trade-war/ [1] Bradsher, Keith. “China’s Economic Growth Slows as Challenges Mount.” The New York Times, October 17, 2019 https://www.nytimes.com/2019/10/17/business/china-economic-growth.html [1] Tan, Huileng. “China Says It’s Economy Grew 6% in the Third Quarter, Slower Than Expected. CBNC. October 17, 2019 https://www.cnbc.com/2019/10/18/china-q3-gdp-beijing-posts-economic-data-amid-trade-war-with-us.html [1] Henderson, Tim. “Help Wanted: Too Many Jobs and Not Enough Workers in Most States.” Pew Charitable Trust. October 14, 2019 https://www.pewtrusts.org/en/research-and-analysis/blogs/stateline/2019/10/14/help-wanted-too-many-jobs-and-not-enough-workers-in-most-states [1] Hayashi, Yuka “Credit-Card Debt in U.S. Rises to Record $930 Billion.” The Wall Street Journal, February 12, 2020 https://www.wsj.com/articles/credit-card-debt-in-u-s-rises-to-record-930-billion-11581442140 [1] “New Acosta Report Spotlights the Costly Effect of Tariffs on Consumers, Manufacturers and Retailers.” PR Newswire, December 10, 2019. https://www.prnewswire.com/news-releases/new-acosta-report-spotlights-the-costly-effects-of-tariffs-on-consumers-manufacturers-and-retailers-300972407.html [1] Francis, Theo and Gryta, Thomas. “U.S. Firms Pull Back on Investment.” The Wall Street Journal, November 24, 2019 https://www.wsj.com/articles/u-s-firms-pull-back-on-investment-11574591400 [1] Barrett, Emily and Hamilton, Jesse “Why the U.S. Repo Market Blew Up and How to Fix It.” Bloomberg, January 6, 2020 https://www.bloomberg.com/news/articles/2020-01-06/why-the-u-s-repo-market-blew-up-and-how-to-fix-it-quicktake [1] CoStar Market Report January 2020 [1] Kliesen, Kevin L.  “Forecasters See Lower U.S. GDP Growth in 2020 as Headwinds Continue.” Federal Reserve Bank of St. Louis, November 21, 2019 https://www.stlouisfed.org/publications/regional-economist/fourth-quarter-2019/forecasters-see-lower-gdp-growth-2020

PREPARING FOR 2020

A Change on the Horizon

The performance of the multifamily sector mirrored that of the commercial real estate and equity markets over the last several years. This success attracted a great deal of new investors in addition to the already seasoned professionals in the space. As the current economic cycle grows long in the tooth, performance and market statistics remained strong. Recent year-end results, however, may be an indication that market is beginning to slow. Given the shifting market conditions, we believe that investors should start repositioning themselves, in order to make money in a more challenging market environment.

One of the recent, major shifts in major markets is that rental rates are still increasing, but the rate at which they are doing so has slowed significantly, and in a short period of time. In Atlanta, for instance, fourth quarter rent growth fell to 2.6% while less than one-year prior it was growing at 5.0% annually[1]. While 2.6% is still a healthy rate, it is the lowest quarterly rent growth in Atlanta since the second quarter of 2012. Moreover, rents in Atlanta have increased 35% from pre-recession levels. Simply put, the average cost to rent an apartment in Atlanta has increased by over a third in the last decade. Because wage growth has not kept pace, it is far more expensive to live in Atlanta than it was at the start of the cycle.

What does all this data mean? Is it possible rent growth is finally becoming too much for the average tenant to stomach? Possibly, but Atlanta also remains one of the least expensive major markets in the country which is why we are still bullish on the city and the Southeast generally. Is a major crash on the horizon? We don’t think so because statistics indicate that the economy is still growing and has fewer systemic issues than in 2008. No one knows what is going to happen but there is no question that the rent growth which fueled the apartment returns of the last decade is slowing. However, one must balance that with the need for affordable housing options in almost every major market. According to advocacy group Home1, 11 million Americans spend over 50% of their paycheck on rent. That is a benefit to the Southeastern United States, where every state except for Florida offers median monthly rental rates below the national average[2]. In addition, a recent survey by Freddie Mac indicates that an unprecedented number of renters (84%) believe renting is more affordable than owning[3]. This all-time high figure points to continued apartment demand.

The answer to the big picture economic questions that affect apartments may not be simple, but what is simple is how to avid the trap that can be caused by changing market dynamics. Real estate can provide consistent cash flow when purchased correctly. Nearly all trouble encountered in real estate investing involves a capital event, meaning you have a loan maturity and therefore need to refinance or sell. If a property doesn’t perform and you have time to adjust, you can salvage a difficult investment.  The Great Recession was a great example of this. Investors with a loan maturity that were forced to refinance high leverage loans in 2008-2010 were in a great deal of trouble. Those with lower loan to value ratios had the ability to allow rents and the economy to recover and were able to make money selling into a much healthier market later in the 2010s.

Interest rates remain near all-time lows and with long term financing you can avoid the trap of a forced sale or refinance in a down market. With conservative debt and well located, high quality assets, you can weather the storm of fluctuating asset values and still generate positive cash flow. Best of all, conservative debt doesn’t hurt you in an up market. Yes, it requires more equity and your returns and IRR may be lower, but your down-side is protected and you are still able to capture all of the value increase and post great returns. 

[1] CoStar Analytics Q42019

[2] Apartment List - Rentonomics

[3] Freddie Mac Survey February 2020

APARTMENT INVESTING IN 2019

Apartments have been a powerhouse investment in the current economic cycle.  Nationally, the average price per unit across the United States increased from a low of under $70,000 per unit in 2009 to over $160,000 per unit today.[1]  The bulk of that increase in value has been captured by investors generating massive returns across the board.  But despite increasing rents and net operating income, cap rates have also reached a cycle-low, reflecting extremely high pricing for new apartment acquisitions.  Does that mean, however, that you can no longer make money investing in apartments?  Not exactly.

Rental rates are still increasing in most major markets.  In fact, rent growth over the last twelve months in many major markets is still above any figure a prudent investor should feel comfortable underwriting. To illustrate the point, the following are examples of rent growth over the past year in markets Arcan tracks closely: Raleigh – 4.9%, Atlanta – 4.4%, Austin – 4.4%, Birmingham – 4.2%.[2]  These are not outliers. Provided rents continue increasing at this pace, you can still make money investing in apartments.  But you better be right about your pre-acquisition assumptions about the future performance of the property.

With rents continuing to increase, we expect prices to increase as well.  So why are investors starting to worry about pricing?  The answer is complicated.  Much of the reason is that prices are increasing (and cap rates decreasing) faster than rents and cash flow can match.  That means that not only are investors accepting lower returns, but they also end up paying for potential future rent increases before the property begins to generate them.  When you start buying future assumed increases instead of today’s actual income, trouble can follow quickly – especially when assumptions do not pan out.

As the market continues to outperform, underwriting standards are continuing to get more and more lax.  Buyer behavior is getting more aggressive as more buyers are offering non-refundable earnest money deposits to win deals and more are turning to higher leverage bridge loans to juice returns.  This is similar behavior to what occurred over a decade ago, in the years just prior to the 2008-2009 financial crisis.  We view the re-emergence of this behavior as a major warning sign.

Moreover, investors should keep in mind that July marked the longest economic expansion in U.S. history. We know that this expansion will not last forever, especially in light of the significant economic headwinds and geopolitical instability worldwide.  If there is economic turmoil on the horizon, higher prices and aggressive behavior can result in lower rents, occupancy, returns and even foreclosures. These events will almost certainly be the catalyst to drive prices down across the multifamily market.

Despite the many risks in the market today, there remains a proven strategy to make money: buy for the long term. While any market can struggle in the short term, over a ten-year horizon, quality markets are given a better chance to perform.  Interest rates remain historically low by almost any measure making loans particularly attractive.  Moreover, many long-term trends favor apartment investment including, reduced homeownership rates and slower household formation, lack of single family home inventory and historically high home prices.  We believe that these factors, among others, will continue to generate demand for apartment housing for years to come.

Ultimately, there are almost always good acquisitions available, they are simply getting more difficult to find.  As the market cycle approaches its end, this trend should continue.  If the U.S. economy experiences a serious slowdown or recession, we believe that many investors will struggle with performance.  This is particularly true of the many overleveraged and underexperienced operators in the market today. Strategic buyers with a focus on long-term ownership, lower leverage and higher quality, will limit their downside risk while still benefiting if market growth continues.  As the cycle reaches its end, we strongly believe that this style of investing will produce outstanding, risk-adjusted returns.

[1] “State of The US Apartment Market Update“. CoStar Q22019

[2] Ibid.

ARCAN CAPITAL MARKET UPDATE

July was a record-setting month for the U.S. economy, as it officially became the longest expansion in history at 10 years and counting.[i]  While a number of factors point to continued growth, such as strong consumer spending and solid job growth, there are clouds on the horizon.  Worldwide, economies are slowing, particularly in Europe and China.  Additionally, the trade war between the U.S. and China is heating up and this has already had a negative impact on business sentiment and investment around the world.  As we consider the medium-term outlook, we believe that a (hopefully) shallow recession and accompanying decline in asset values is likely.

Europe’s overall economic picture continues to be exceptionally weak, with the eurozone’s second quarter economic growth clocking in at an anemic 0.8% annualized rate.[ii]   The European Central Bank (ECB) data shows that this slowdown is most acute in the manufacturing sector, hitting export and manufacturing-dependent Germany hard.  IHS Markit’s July manufacturing index for the eurozone fell to its lowest level since December 2012.  PMI readings indicate that this trend is likely to continue.[iii]   As the largest eurozone economy, and the 4th largest economy in the world,[iv] Germany has a large impact on the health of both the eurozone and worldwide economies.  As Europe continues its march toward recession, we believe that it is only a matter of time before this begins to affect the U.S. economy.

Another major factor indicating headwinds for the U.S. economy is the burgeoning trade war with China. While trade negotiations between the two countries are making little progress, President Trump has ratcheted up the pressure on China by announcing tariffs on virtually all Chinese exports to the U.S.[v] These tariffs will hit the American consumer directly, as they should raise the cost of everyday products.  In a retaliatory move, China’s central bank announced that it would devalue the Yuan further, undercutting the intended effect of the new U.S. tariffs and possibly setting off a new round of currency devaluations around Asia.[vi]  As this trade war continues, it will likely weaken economies around the world and perhaps even drive the next recession.

On the domestic front, recent U.S. economic data is mixed. Second quarter 2019 GDP rose 1.8% on an annualized basis, which is the slowest pace since 2017.  Strong jobs growth and consumer spending offset what is likely to be the first decline in U.S. business investment since 2016.[vii]  While job growth and spending are up, however, wages remain stagnant and the labor picture remains complicated, with the average workweek shrinking as companies cut overtime.  Moreover, total hours worked by non-managerial employees have not grown since January.[viii]  This, coupled with the meteoric rise in consumer debt, specifically student loans, in the past decade calls into question the consumer’s ability to keep the U.S. economy growing in the medium-term. (For an excellent analysis on consumer debt, read this WSJ article).  One factor pointing to troubles ahead was the Federal Reserve’s decision to cut their target benchmark rate to 2-2.25%.  While this reduction was only 0.25%, it indicates that the Fed is concerned about headwinds affecting the U.S. economy, or, as Fed Chief Jerome Powell described them “downside risks”.  This, coupled with other recession indicators such as the inverted yield curve, are worrisome for continued economic growth.

Overall, we see economic growth slowing and the risk of recession rising.  This could affect multifamily real estate in several ways.  First, slow or negative economic growth will likely put downward pressure on wages and employment.  We think that this will reinforce the recent return to the long-term trend of homeownership rates in the low 60%’s as consumers will be unable to afford to purchase homes.  While this will likely also drive down home prices, we believe that one of the biggest barriers to home purchases today are not nominal prices or mortgage rates, but rather the purchaser’s ability to afford the down payment required.  This will benefit multifamily owners and investors as many people will continue to rent and well-managed, properly underwritten assets will continue to perform well.

We also believe that slower growth and/or a recession should lead to a correction in the multifamily space. We think that this will hit newer Class A and smaller Class C/D properties the hardest.  One of the primary contributors to a market correction will likely be newer market entrants who are overleveraged and have poorly executed management programs at their properties.  This will likely lead to an overall reduction in pricing for multifamily assets, allowing those with readily available cash and financing to find numerous deals at attractive prices.

As we look toward a period of slower and potentially negative economic growth, we think that a shallow recession and correction in the multifamily market would be healthy for the long-term outlook. At Arcan, we are preparing for both and believe that we are well-positioned to take advantage of the coming uncertainty.

[i] Lee, Yun. “This is now the longest expansion in US economic history.” CNBC, July 2, 2019. https://www.cnbc.com/2019/07/02/this-is-now-the-longest-us-economic-expansion-in-history.html

[ii] Hannon, Paul. “Europe’s Stalling Economy Sounds Alarm for Global Growth.” The Wall Street Journal , July 31, 2019. Web. https://www.wsj.com/articles/europes-stalling-economy-sounds-alarm-for-global-growth-11564563688?emailToken=6c23f219932d49ad77ab739ae48e4017l2eyosz5tKdwlgAsrK5jHFCwS01DoS9DPDx1wQvWj51DUsbYyS0RX2U5WOGv3+IK2MtKcBG4HSxsD7ktkUItk2d7IdUzl4X96WQk/sJbM0JGKErgIsuAqtPF9hlttAje&reflink=article_email_share

[iii] Williamson, Chris. “Eurozone manufacturing downturn accompanied by falling payrolls and lower prices.” IHS Markit, July 1, 2019. Web. https://ihsmarkit.com/research-analysis/eurozone-mfg-downturn-accompanied-by-falling-payrolls-and-lower-prices-190701.html

[iv] "GDP (current US$)". World Development Indicators. World Bank. Retrieved 4 May 2019.

[v] Lee, Yun. “Trump says US will impose 10% tariffs on another $300 billion of Chinese goods starting Sept. 1.” CNBC, August 1, 2019. Web. https://www.cnbc.com/2019/08/01/trump-says-us-will-impose-10percent-tariffs-on-300-billion-of-chinese-goods-starting-september-1.html

[vi] Stevenson, Alexandra. Swanson, Ana. Smialek, Jeanna. “China Uses Currency as Weapon in Trade War, Rattling Markets”, New York Times, August 5, 2019. Web. https://www.nytimes.com/2019/08/05/business/economy/us-china-yuan-renminbi-trump.html

[vii] Dimitrieva, Katia. Haar, Ryan. “U.S. Economic Growth Seen Stumbling as Trade Hits Companies”, Bloomberg, July 25, 2019. Web. https://www.bloomberg.com/news/articles/2019-07-25/u-s-economic-growth-seen-stumbling-as-trade-weighs-on-business

[viii] Sparshott, Jeff. Ip, Greg. “Real Time Economics Special Edition: More Jobs But at a Slower Pace”, The Wall Street Journal, August 2, 2019. Web. https://economics.cmail20.com/t/ViewEmail/d/A7CAAEC15336FA382540EF23F30FEDED/F3BC317E6931E19E981D23A7722F2DCD