Executive Summary
Real Estate veteran sees:
a) Real estate firms trying to hold on until 2025, when they are hoping rates will come down;
b) 'Cat 5 Hurricane' in some sectors where high interest rates are biting, including residential homes and offices blocks affected by WFH shift;
c) Rate rises haven't hit labour market due to factors like Infrastructure Bill (and we think re-shoring);
d) That means Fed is keeping rates higher for longer.
In summary real estate will be a space to face losses and potential litigation in the year to come.
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In this series we, the expert witness community, seek to bring you, litigators, knowledge curated from a broader range of professionals whom we follow and trust. We hope it will assist you with your practice. Today we draw from Barry Sternlicht, a seasoned real estate investment professional, who in a recent interview with Bloomberg set out some insights that we think are relevant to litigators. We also set out some explainers and thoughts on his views below each excerpt.
Mr Sternlicht has been critical of Federal Reserve policy over the past decade, arguing it was too easy for too long, before being raised very rapidly.
Sternlicht says the Fed and other Central Banks raised too fast:
They went straight vertical on rates. This had happened before we saw rates go up three or four hundred basis points, but (in the past) it was more gradual. This (time it) was a direct: ‘we got to stop this (inflation)’ (is what the Fed were thinking).
I am empathetic to Jerome Powell. When you have a government that's spending money hand over fist and then you have the Fed trying to break an economy and I'm critical of Powell because as you may know they use a portion of the data they use is quite lagging and they didn't see inflation when it was here and then when they showed up they showed up late and big.
This is a common criticism of the Federal Reserve in the markets. Many economists believe that the central banking community are driven by academics rather than practitioners. Practitioners, driven by profits, tend to analyse forward looking data as much as they can.
Sternlicht speaks of an anecdotal meeting with a Fed governor:
It's interesting one of my friends had a meeting with one of the governors recently last week and they're like ‘we hear all this noise about the real estate but we don't see the issues’; they're going to come and there is going to be a serious credit contraction.
The country in any asset class has not adjusted to that cost of capital yet but it's coming; the economy will slow you can see the numbers. Confidence is down; consumer confidence is down retail sales are down uh service economy is wickedly strong it feels like the last gasp before the we actually settle into what should be uh what you'd expect to
be. I hope it's a shallow recession I hope he (Jerome Powell) can pull that (a soft landing) off.
This is valuable. Sternlicht is well connected, and to have first hand, reliable, feedback from a Fed governor that confirms that they are not seeing in their ‘academic’ data what practitioners are seeing, confirms the risks for the market, that the Fed does not recognise the risks ahead, and that the most likely challenge for the market is that rates are kept high for too long.
Sternlicht says the transmission between rate hikes and the labour market is delayed:
Normally when you increase interest rates you decrease GDP growth and you increase unemployment. Your point is unemployment's not going up because the statistics aren't really covering the people who are really being laid off.
Unemployment isn't going up because structurally interest rates aren't affecting the labour market the way they would normally affect the labour market. You have the offset and construction from the infrastructure bill and you have the service sector which is still recovering the pandemic which normally would be tilting over.
Another important issue. The Fed watches labour markets closely, as that is a part of its mandate. I.e. if the unemployment rises, it can justifiably be easier on rates. There are different explanations for US labour strength. Some economists (like Ed Yardeni) point to re-shoring from China, and others to infrastructure spending. Either way, the Fed is explicitly looking for higher unemployment before reducing rates, but the high rates are currently not resulting in a weaker labour market.
Chart of US unemployment by Bloomberg Wealth
Sternlicht says the market needs to reprice (downwards) the cost of capital::
Anything with a fixed income stream is worth less when rates rise and the underlying fundamentals in most of the asset classes in real estate are okay right now in the United States. The apartment Market, the industrial Logistics Market, the hotel markets those are all in good shape but there's no question that the FED has reacted dramatically to try to slow the economy down quite late obviously and that has impacted real estate values. Yields on properties are moving up to reflect this higher interest rate and the supply of credit to the industry is curtailed dramatically.
So, um it's I like to say as a hurricane over real estate right now or in the category five hurricane and it's sort of a blackout hovering over the entire industry until we get some relief or some understanding of what the Fed's going to do over the longer term. COVID had the effect of letting people work at home so now people that are saying come back to work come into your offices and a lot of employees are saying I'd rather work at home so people are begging them to come in two days three days a week so is this going to mean in the end that we're going to change the way Office Buildings are really valued in the future because they're not going to need as much space for their employ for their tenants.
We agree. This is the core reason we are ramping up our efforts to reach out to the market, and why we think litigators should too. Higher rates are a serious cross current to the economy, and whether it is real estate or corporate debt, a material portion of the market will suffer when refinancing requirements arise. The technology wave is a second current that is unique to these times. When this occurred in past cycles, the market didn’t have to deal with such significant changes in the economy (like tech driving a work from home trend, and other changes, like AI).
The other points that Sternlicht pointed out were that as with most markets, the top end will likely be fine: newly refurbished office blocks, where people want to come and work are doing ok, but the old, tired offices that need to be redone are less appealing. Further, the trends vary by country: WFH is big in the US and Germany, but less so in the Middle East and Far East.
Here is a link to the full interview: https://www.youtube.com/watch?v=FN0eOHyPzs8&t=175s
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