Interest Rates Have More Than Doubled In Less Than One Year
It’s been an interesting past several months to say the least! Because I get asked on a regular basis my thoughts on the economy, I thought I would answer that in this month’s newsletter.
Interest rates have more than doubled in less than a year and that has never happened. The only time rates have increased at this pace was in 1980 and 1981 but rates were already in the double digits when that hike began. The Government is absolutely committed to driving down inflation, even if it means pain in the economy, which they have openly stated they are willing to do. Inflation is being stubborn and instead of waiting for quantitative tightening and rising rates to take hold, they continue to tighten the reins. Quantitative tightening is the Federal Reserve reducing its balance sheet, meaning they are taking liquidity out of the market. The balance sheet doubled in size during the pandemic and now there is more debt than the Government can afford to pay interest on. It is essential that this debt be reduced. The debt is in government bonds and mortgage-backed securities so you can see how reducing the amount of mortgages the Government owns, or is willing to buy, creates stress in the market.
Inflation: Where Are We Now?
Inflation remains sticky which is the primary concern, and it is remaining high because of the strong labor market. Although the pace of jobs being added is on a clear decline, the unemployment rate remains low at 3.7% in October. What I find fascinating is that Wall Street has had a negative reaction to this positive news, which is creating more fear in the media. Although not what you would expect, it is understandable when you think about it. The longer unemployment remains low, the longer inflation will stay high and the more the Fed will do to interfere. Tightening Fed policy brings fear, uncertainty, and higher rates.
Home sales have declined significantly and values in several markets have started to decrease. Back when I studied economics, we were taught that two consecutive quarters of negative GDP and you were in a recession. Now we are told that an inverted yield curve indicates a recession. As of today, we have both.
Recession? Where Are We Going?
The truth is that none of us really know. I have worked through multiple recessions and have studied many others. What I know is that people buy houses and sell houses in all economic conditions and that although we may see some price pressure, there is nowhere else I feel safer putting my money than real estate.
I believe we are in a recession now but that does not mean it is time to panic. Most recessions do not have a negative impact on real estate so that alone should not be a concern for the industry. What makes this recession different however, is the Fed forcing us into it with monetary policy. It would be naive to believe that real estate will not be impacted at some level as a result.
Rising mortgage rates will impact demand without question but basic economics tells us to look at supply and demand. That is why I love to look at months of inventory. This metric accounts for both demand and current supply. I have always been told that a neutral market is 4 months of inventory but when I look at the national historic chart, it seems like 5 to 6 months of inventory is closer to neutral.
Neutral would indicate an average amount of supply for the current demand and I would expect flat to moderate appreciation. Risk of notable price declines come when the market shifts to a buyer’s market. I would say there should be some concern when this hits 5 months. The markets we are concentrated in, Minnesota and Colorado, have low months of inventory which gives us room to weather a storm. As of the end of September, months of inventory for our two primary markets, Colorado and Minnesota, are 2.0 and 1.6 respectively and is even lower than that if you take out homes priced over $1,000,000.
Soft Landing? Reasons For An Optimistic Economic Outlook
Although as a company, we are planning for the worst, I believe we will see a soft landing. Here are some of the reasons I believe this:
Inventory
Inventory remains low as we discussed. Builders have slowed way down on production and people with locked in low rates are not moving. As we see job loses start to mount, we will see more homes hit the market, but I don’t believe there will be a flood which is what would be needed to see any kind of hard landing. This is something that we keep a close eye one.
Pent Up Demand
I have absolutely no statics for this, but I feel strongly that there is a significant amount of money on the sidelines waiting to pounce on opportunities. I have money ready to buy more rentals as do many investors that I speak to. I also believe there are institutional investors waiting for opportunities. If I am right, this will help hold up values.
High Credit Scores
According to Zonda, who I have a tremendous amount of respect for, credit scores are at an all-time high. 68% of loans have borrowers with credit scores over 760.
Equity
Homeowners have more equity now than they ever have. This is partly because of the rapid appreciation over the last several years but it is also because of the sound underwriting and regulation that came out of the crash in 2008. In fact, in last data I saw on this from CoreLogic, there was less than 3% of the outstanding loans with 10% equity or less.
Rates
Rates have risen dramatically over the last couple of months, and I believe we will see short term rates increase again this year, but I also believe mortgage rates are close to stabilizing. Freddie Mac agrees and puts out forecasts once a quarter. In the chart below you can see that they expect rates to steadily decrease starting in Q1 of 2023. PMMS stands for Primary Mortgage Market Survey.
Restrictive Lending
Credit is tight! It is much harder to get a loan now than it was even a month ago. Restrictive lending has been a theme since 2008 setting us up nicely to weather a storm. You can see this in the mortgage credit availability index put out by the Mortgage Bankers Association.
What Pine Is Doing?
Like I stated earlier, I do believe we are in a recession, and I believe housing is in for a soft landing. Real estate seems to be resilient. With this said, we should expect some softening with lower rents, longer hold times, and possibly a decline in values.
Pine has been planning for this. Because the majority of our loans are in assets that can be rented for cash flow, we feel we are in a good position. We always have the option to hold the assets and weather a storm. We have and continue to adjust underwriting guideline changes, have increased our loss reserves and are paying more attention to our portfolio to identify problems and support our clients.
With all of this said, tough times create opportunities and Pine is well positioned to take advantage. We see a slower housing market as positive for our clients that have actively been looking for quality projects to buy. Combine that with restrictive bank lending and we will be in a position to help more real estate investors.
I know this can be a scary time, but rest assured we are in a strong position and are laser focused on protecting each and every one of our fund investors and helping more real estate investors fund their transactions.
We are absolutely committed to continue bringing stability to your passive investments and supporting our borrowers with the opportunities that are sure to come.