I met my wife at Palisades High School. Many of our closest friends and business associates live in the Palisades. It is shocking how many have lost their homes to the fire that began January 7.
The concept of a Black Swan didn’t enter contemporary vernacular until Nassim Taleb’s book was published in 2010. Prior to 9/11, we experienced events that were often repeats of similar historical occurrences. Wars (some larger, some smaller, one Cold), recessions (and one depression), good and bad leaders and the occasional cultural upheaval (e.g., the 60’s). History took time, or so it seemed.
The 2000’s have been different. 7 years after the World Trade Center was attacked (the first Black Swan of the 21st century), the Great Financial Crisis hit. We went a decade or so, thinking things had normalized, and then Covid began its deadly spread. While the fires that hit Los Angeles are regional in their location, the impact will be far reaching.
All of the above are Black Swans. The frequency and sheer magnitude of impact is, to my mind, without precedent. And the interconnected nature of our world economy and society (e.g., supply chains, air travel) means we are all affected by not only the events, but by their consequences. Some of these consequences are self-evident, such as the spread of Covid, while some are less obvious but no less related to the Black Swan that caused them.
While the connection between subprime home mortgage bonds, a global pandemic and a massive urban fire may not seem obvious, these events have and may continue to have profound ramifications for the commercial and multifamily real estate industry. In no particular order of importance:
- New Construction, Lower Rents: Following the GFC, nationwide construction of new multifamily units slowed to a trickle for many years. Only after the economy recovered, did we see new multifamily starts begin to pick up (aided by sustained low interest rates) and for the last 3 years, we have seen more new apartment deliveries than any time since the 1980’s. In fact, the 518,108 units delivered in 2024 marked a new record high. This has placed upward pressure on vacancy and downward pressure on rents even in the healthiest metros such as Dallas, Austin, Phoenix, Nashville, and Salt Lake City. These remain excellent markets with strong employment, in-migration and quality of life for residents. In the next one to two years, as new deliveries taper, supply and demand should come into balance and upward pressure on rents should return, making these among the best markets in which to own apartments. Until then, cash returns for investors in these metros will be lower.
- Dramatic Change in Interest Rates Impacting Property Valuations: Make no mistake, those of us in the real estate business are still living with the effects of economic long Covid. The Federal Reserve lowered interest rates to near zero and kept them there (arguably longer than it should have). This inflated asset prices, making many of us a lot of money, but caused many to be ill positioned when rates eventually rose. The Fed left rates too low for too long and then overreacted by raising them too fast, too high and for too long. Yes, inflation has been largely curbed but it is far from clear that higher interest rates should get the credit. There is a better argument that healthy supply chains brought supply and demand into balance and inflation to heel. Either way, many sponsors are going or will go out of business, having relied on an unhealthy diet of high leverage, floating rate debt and lack of experience operating properties in difficult markets. Surprisingly, this dynamic has not resulted in a wave of distress/foreclosures as banks have thus far preferred to “extend and pretend”, hoping to be bailed out when their bad loans can be refinanced or sold. As the Fed has now made it clear rates will stay higher for longer, we would expect to see foreclosures increase. This may create opportunities for investors but also weigh on property values as more properties hit the market. Lastly, as the Fed raised rates, Treasury bonds owned by banks lost value causing the failure of Silicon Valley Bank, Signature and other lenders. While the banking system generally is strong, there remains the potential for future bank failures, specifically smaller regional banks with significant commercial real estate loans.
- Refinancing at Higher Rates, Lower Cash Flow: Even for those of us who are not overleveraged with floating rate debt, properties which have had to be refinanced since 2022 at today’s higher rates are experiencing reduced cash flow, even as those properties are otherwise performing well.
- Anti-Landlord Legislation Harming Property Performance: Covid triggered a panoply of ill-conceived eviction moratoriums and other anti-landlord legislation. These laws make it harder to screen tenants, collect rents and evict tenants who don’t pay. Cities like Denver (which, ironically, was moderate during Covid) have become very difficult for apartment owners who want good tenants who pay their rent on time.
- Remote Work, Office Devaluation, Urban Decay: The advent of remote work in response to the pandemic destroyed untold value in office buildings throughout the country. In the process, cities like San Francisco spiraled into an urban hellscape. Only time will tell whether burgeoning return to work efforts by employers will bring workers back to office buildings and health to the cities they are located in. Keep in mind that banks made loans at very high valuations to owners of office buildings whose value is now dramatically lower than when the loans were made. The health of bank balance sheets determines the amount of available credit to apartment investors (thus impacting the value of non office assets since cap rates vary inversely with the availability of credit).
- Disasters Bring Higher Insurance Rates: It remains to be seen what impact the LA fires—as well as Hurricanes Milton and Helene—will have on insurance premiums (both home and commercial) but our industry has seen dramatic increases in property insurance in response to the many devastating hurricanes of the past several years. Sadly, rates were beginning to stabilize until the hurricanes and fires. Of course, higher premiums reduce investor cash flow and property values.
I have left out the impact of President Trump’s tariffs, immigration reform and proposed tax cuts. All have the potential to be inflationary which would impact interest rates and, in turn, property values. Real estate investors had expected higher transaction velocity following the Fed’s interest rate cuts in Q3 and Q4 but, paradoxically, Treasury investors have driven rates higher in anticipation of the potential inflation caused by policies advocated by President Trump as well as the Fed’s stated intention to keep rates higher for longer.
It’s counterintuitive that an illness originating in Wuhan, China, or a hurricane destroying Asheville NC would impact the ability to collect rents at a workforce housing asset in Lakewood Colorado. But that is the reality, and the impact is that operating apartment buildings has become much more challenging the past 5 years as a result of distant and seemingly unrelated random events. Those of us with experience have been through difficult times before and we roll up our sleeves and do the hard work necessary to generate positive outcomes. But even for experienced operators with healthy balance sheets, cash flow and business plans done several years ago are and will continue to be impacted by the knock-on effects of multiple Black Swans over the past two decades.
Fortunately, Jacobson Equities’ portfolio performance in this challenging climate reflects 50+ years of experience. Average rent growth across our portfolio exceeds the average rent growth in the markets we operate in. On a market-by-market basis, our average property occupancy exceeds, with one exception, average market occupancy. Our student housing pre-leasing percentages also lead their market averages.
With all that said, you will be pleased by this timely Wall Street Journal article from last week which demonstrates the cyclical nature of the real estate business and how we are now returning to a period of insufficient apartment supply and upward pressure on rental rates. Please click here to read the article entitled We’re Headed Toward a Landlord-Friendly Era. Expect Higher Rent Prices.
While we naturally fixate on how our portfolios are faring, sadly, all of us have friends and/or family (including some of our investors) whose lives were torn asunder by the recent Los Angeles fires. For them, the impact has been direct and painful. We are thinking of them and wishing them strength during this challenging time.
