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September 2024 Market Update

August brought another wave of market uncertainty, particularly concerning sustained inflation projections. The cooling of PCE and Core PCE in June, along with dovish remarks from the Fed, initially drove yields down, only for them to rebound later. July’s PCE data, which came in meeting expectations at 0.2% month-over-month, was a positive sign. However, strong consumer spending, which exceeded expectations by 0.3% MoM, and was 0.2% higher than June’s figures, is casting doubt on the market’s confidence in sustained lower inflation despite favorable data. When annualizing the last three months of PCE, the outlook appears brighter, suggesting the Fed should prioritize employment stability, as they have recently indicated. Data contradictions and geopolitical uncertainties will continue to influence market fluctuations, however, and participants should consider applying a higher risk rating in today’s environment, keeping yields higher than we would all like to see. Adding to the prediction confusion, the BLS revised non-farm job growth down by 818,000 in late August, following their original March 2024 YTD report, marking a staggering 30% downward revision, the largest since 2009. Despite this, non-farm payroll jobs still grew by 174,000. It’s no wonder the market is struggling to trust these economic indicators. Nonetheless, consecutive cooling in the Fed’s leading economic indicator (PCE) and a supposedly cooling labor market should provide further momentum for the anticipated rate cuts we are all hoping for. The last time we maintained such a high real interest rate was in 2008-2009, when real rates reached as high as 2.5%, and we all remember what happened then. Real interest rates are calculated by subtracting inflation from the nominal interest rates on risk free treasuries. When real rates are too high for too long, mechanics in economies tend to break. History usually doesn’t repeat, but it rhymes, and we should believe that this timed is no different.

Despite potential continued volatility in treasury yields, we must remember the origins of the debt in this credit cycle. Most of our elevated debt balances are at the federal level and consist of money owed to ourselves, not isolated to the private sector. However, we are not immune to concentrated pockets of inflated values and asset-specific losses as global and domestic dynamics continue to unfold. Anything can happen.

After the 10-year Treasury hit a 52-week low of 3.783% on August 5th, it now stands at 3.9%. Time will tell whether we break and hold above 4% or hit another 52-week low. Buckle up.

by: Christian O’Neal

A simple but powerful exercise to illustrate the importance of growth and why CRE transactions are so low right now.

Buyers solve for their weighted average cost of capital / IRR to determine the price they are willing to pay for an asset. What is often less stressed is something called weighted average cashflow obligations. WACO calculates how much yield (NOI) is needed to pay senior debt service and a certain annual cashflow coupon to equity investors. In low / questionable rent growth periods, in place cashflow becomes increasingly more important because in reality, we pay a multiple on income streams. Growth is not guaranteed.

In many cases today, buyer’s weighted average cashflow obligations are too high to be covered by in place cashflow. So, one of two things need to occur to close that bid / ask gap. We either need NOI growth (rent growth, in most cases) or lower weighted average cashflow obligations (these days, debt would have to move, not equity requirements). In an environment where you can lock in 5% + yields with no risk for 12-18 months, cashflow requirements for risky assets become stickier. Investors are less willing to accept stabilized cashflow below risk free rates of return, especially for sub-core assets, which makes all the logical sense in the world.

In this example below, we have a 200-unit apartment complex renovated 4 years ago, assuming mid 80s vintage in a secondary market, with an asking price of $24M or $120k/unit. The seller wants to sell for a 5.9% cap off of T-1 revenue, adjusted for reassessed taxes. There is a little bit of meat on the bone through optimizing expenses and increasing rents ever so slightly, so we can call this a light value-add. Based on true comps and realistic assumptions for other units nearby, we can assume to spend a light $3,000 / unit to achieve a 7% NOI boost on a stabilized basis over 2 years.

Does the deal work at the seller’s ask? Well, it depends on buyer’s willingness to stake their returns in future rental growth. It is hard to do that today.

On an interest only basis, a buyer would be able to meet their weighted cashflow obligations and pay a 6% coupon to investors upon stabilization.

On an amortizing basis, assuming a fairly reasonable agency execution at a 1.65% spread over the 5-year T, the buyer does not meet their weighted cashflow obligations. To meet obligations, a buyer would need to pay 11.6% less than ask for the property or grow NOI by 11.05%, on top of the 7% business plan lift.

While some investors may bite on future rental growth and the ability to meet weighted obligations during interest only periods of their hold, the buyer would still need to pay an inflated price. At the asking price of $24M, the buyer’s untrended ROC is a 6.01%, and if the market is a 6% cap, they did not create any value. In which case they’d rely on future growth or lower treasuries (highly speculative based on expected sustained inflation) to bail themselves out of the deal.

The Storm Before the Storm: How Hurricanes Can Disrupt Your Insurance Process

 

For states along the Atlantic and Gulf Coasts, hurricane season presents varying challenges for businesses each year. During this time, the insurance industry frequently emphasizes the importance of disaster preparedness—a crucial topic that often gets overlooked. However, one major concern that isn’t typically discussed is the difficulty in obtaining insurance during storm season, which can be severely restricted or entirely unavailable.

When a hurricane or named storm approaches, many insurance companies impose a temporary pause on new policy applications and coverage binding. This is mainly to limit their own risk, leaving businesses exposed and unprepared to handle potential damages from strong winds, flooding, and other hurricane-related hazards. Without the ability to secure coverage, business owners may face significant financial loss since standard policies usually don’t cover natural disaster damages unless they were in place before the storm forms. Additionally, many established businesses might assume that their insurance will automatically renew, but this is not always true. With natural disasters inflicting billions in damages annually, many insurers are looking for ways to avoid paying hurricane-related claims, which includes not automatically renewing policies during the hurricane season.

 

When seeking new insurance or renewing an existing policy, it’s crucial to remember that if the storm has a name, it will likely impact your ability to secure coverage. So if you have the upcoming need to bind an insurance policy, make sure you take measures and reach out to your broker early to ensure you can bind your policy before its too late. This is especially true if you’re in an acquisition, as the inability to bind insurance can delay a closing. If you have questions or concerns, the insurance division at Aline Capital is here to help, so please don’t hesitate to reach out.

August 2024 Market Update

In the past week alone, rate cut expectations have changed dramatically due to cooling labor data, uncertain Fed speech, and easing inflation data. Unemployment increased from 4.1% in June to 4.3% in July, a level last seen in October 2021, creating hysteria in both the equity and bond markets. Investors have sharply raised their expectations for a rate cut at the September 18th Fed Meeting. The BLS employment report revealed a drop of 65,000 jobs from June to July, with only 114,000 jobs added, missing forecasts. On August 1st, the market estimated a 22% chance of a 50-basis point cut at the September meeting and a 30% chance of a 100-125 basis point cut. However, after the job and unemployment data were released, these probabilities jumped to 68.5% and 80% on August 2nd, respectively, marking a swift change in sentiment and bets. As of August 6th, the market believes in a 72% chance of a 50-basis point cut in September, while the FOMC members median prediction points to 25-50 basis point cuts by the end of 2024.  The current rate discussion abruptly shifted gear from cuts happening at all to the number of cuts we will see and how quickly they will happen, given the alignment of inflation data with what appears to be a cooling labor market altogether. The Fed’s dual mandate of managing inflation, or “price stability,” while maximizing employment, is a very challenging task, but signs are pointing to a shift in focusing on unemployment and the inherent risks associated with a weaker labor force as greater geopolitical risks present themselves.

 

 

Source: CME Group FedWatch

The 10-year treasury yield dropped to a 52-week low of 3.783% on August 5^th as recession fears drove capital into the long end of the risk-free yield curve, elevating 10-Year Treasury pricing and suppressing its yield. This figure represents a 40-basis point decline from a 4.2% 10-Year Treasury just a week earlier. June’s PCE and Core PCE data rose 2.5% and 2.6% year-over-year in June, meeting expectations. Although these figures are still above the Fed’s 2% inflation target, they indicate sustained cooling, with PCE having peaked at 7% in 2022. This positive headway on inflation suggests that higher borrowing costs are effectively curbing spending. Personal income and spending numbers also met expectations, increasing by 0.2% and 0.4%, respectively. The Fed hinted at potential rate cuts in their last meeting, highlighting market uncertainty and moderation in job gains. They also emphasized the need to remain attentive to market risks, marking a shift in their hawkish tone from previous meetings.

Despite what economists, reporters, and headlines tell us, it is challenging to predict whether the recent dip in treasury yields will hold steady or continue to move, as the market often overreacts to data before stabilizing. While the data points suggest progress in controlling inflation, numerous variables make it difficult to forecast the future with certainty. Recent fear-driven equity selloffs have compressed bond yields on the long end of the curve as capital re-evaluated risk and sought safety in longer-term treasuries. Given the current low treasury yields, it may be prudent to transact on CRE now before additional supply enters the market, regardless of anticipated rate cuts.

 

The Liquidity Conundrum

by: Christian O’Neal

Despite the Fed’s QT engine and recently announced tapering, liquidity in the system has remained strong. How is that possible? Under normalized circumstances, quantitative tightening reduces the money supply, and sucks liquidity out of the system as maturing treasuries roll off the Feds balance sheet. When the Fed sells treasuries, bank reserves typically decrease resulting in lower liquidity, directly impacting domestic capital flows. This cycle, however, the Fed has created liquidity backstops behind the scenes, keeping liquidity high and stimulating the system as the private sector (money markets) have been absorbing treasury issuance that would otherwise be absorbed by banks, thereby preserving and increasing liquidity (bank reserves).

 

If capital can lock in 5%+ yields for 12-18 months, they will continue to do so at it is a great risk adjusted opportunity relative to investing in risk-on vehicles that have not presented asymmetric bets relative to inherently safer ones. The market demands a premium over their quantification of inflation, or risk-free rates. But what happens when the risk-free nature of the system is at question altogether? The US government won’t default on its debt anytime soon, but at the same time, history has taught us that the US is on an unsustainable fiscal path, and eventually other sovereign nations will ditch a currency that prints away its value. In the near term, we may see increased spreads as investors demand additional risk premiums until we reach a greater consensus about the future of policy, growth, and security.

Sizing Debt 

Most commercial real estate debt is levered, meaning, investors typically use debt to capitalize real estate development & investment projects. Using debt to fund projects helps boost total project returns, as well as total returns to the equity investors in the projects. While higher returns are nice and all, they come with a set of serious risks. In fact, refinance risk is the most severe, and impactful risk that CRE investors alike all take on when they use debt to capitalize deals. But why? Well, leverage and risk are positively correlated because the higher leverage taken on any one deal, the greater the chance things can go wrong on the backend or exit of the project. Conversely, mortgage loan terms are negatively correlated with refinance risk because the shorter time in which an investor must pay off a lender, the riskier the investment project is.

Business plans often deviate from expectations and underwriting projections given our economy and industry, making things even more challenging, like in today’s investment climate.

If the market cannot meet an investor’s sale or exit valuation projection for a particular project and the loan is coming due, that investor is faced with the decision of selling for less money, or refinancing the debt when the loan term comes do. Stress testing refinances is more of an art than a science, however, it is by far the most important sensitivity analysis to run when looking at a deal. Doing so helps equity partners or borrowers quantify risk for that opportunity based on their projected yield for taking on that much risk in the deal. In lieu of risk, returns don’t mean all that much in the relative world that we live in. In other words, not all risk is treated equally because of opportunity cost and the time value of money. For a deeper dive into risk/reward, check out our blog on the DISCOUNT RATE, here. To illustrate a quick risk/return example, imagine you invest $100,000 into a project that is using 100% equity and no debt to fund the deal, and you receive $200,000 back in 5 years, giving you a 2x multiple on invested capital. All else equal, would you require the same $100,000 net return if the same project used 75% debt from a bank to give you a 2x multiple in 5 years? I sure hope not. If the project did not perform as expected and the borrowers defaulted, the bank could take control of the asset and foreclose on it, wiping away your $100,000. That couldn’t happen if the deal was capitalized with just equity. To quickly gauge whether a project is taking on conservative debt or leverage, an investor can compare the deal’s unlevered IRR (annual return without debt) against its levered IRR (annual return with debt). If the unlevered return comes in below an array of acceptable returns, but the levered projections look strong, then you should scrutinize the project a lot harder as it may be artificially boosting projected returns with risky debt.

The holy grail of debt sizing lies in a metric called the debt service coverage ratio. Loan proceeds are underwritten so that the net operating income of a project exceeds the annual debt service by at least 1.25x, as that is the minimum industry standard coverage. Think of DSCR as cushion for the lender. As an overly simplistic example, if I lent you $100 to use for your business, I would want you to bring in $125 that year to ensure you could pay my required debt service. Same goes for commercial real estate. Depending on the type of lender and loan structure, the required DSCR could be anywhere from a 1.25x to a 1.40x based on either in place, or future income once a business plan is executed. To calculate the annual payment needed to satisfy the DSCR constraints below, lenders use an amortization period (typically 20-30 years) which coincides with the time until the loan is fully paid off. Deals can be sized to interest only DSCRs, or amortizing DSCRs, depending on the loan type and utility of the loan itself. CMBS loans can often be full term interest only loans, in which the loan proceeds are sized to an interest only 1.25 DSCR ratio, granting a borrower higher proceeds. Fannie Mae and Freddie Mac, however, will size and price their permanent loans to different tiers depending on leverage and risk level.

Aside from DSCR, lenders also look at debt yield, which is simply the net operating income divided by the loan amount. The greater the risk the loan has against the collateral, the greater the stabilized debt yield the lenders will require. Lenders want to quantify what their return on total cost would be if they were to take control of the property. In doing so, they can quantify their margin of safety, and potential returns if they were to sell the note, or collateral, to the open market.

In summary, there are many things to consider when placing debt on an acquisition. It is of utmost importance to understand the logic driving the loan proceeds behind the biggest capital partner to any given transaction, who is almost always the senior lender.