The text below is a transcript of audio from Episode 30 of Onward, "What happens when there’s no money in real estate markets."
Disclaimer: This transcript has been automatically generated and may not be 100% accurate. While we have worked to ensure the accuracy of the transcript, it is possible that errors or omissions may occur. This transcript is provided for informational purposes only and should not be relied upon as a substitute for the original audio content. Any discrepancies or errors in the transcript should be brought to our attention so that we can make corrections as necessary.
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Cardiff Garcia:
Hello and welcome to Onward, the Fundrise podcast, where you'll hear in-depth conversations about the big trends affecting the US and global economies. We are recording this episode on Thursday, November 9th, 2023, and before we start today's show, we'd like to ask that you please keep rating and reviewing the show in those podcast apps. We love hearing from our listeners always. Also, evergreen reminder that this podcast is not investment advice. It's for informational and entertainment purposes only. With that, let's get on with the show. This is the all things real estate. It's six-feet under, but is it dead or just hibernating for the winner? We'll answer that question. I'm Cardiff Garcia of Bazaar Audio. I'm joined as always my co-host Ben Miller, CEO of Fundrise. Ben, how are you?
Ben Miller:
I'm doing okay, Cardiff, but it's-
Cardiff Garcia:
That's so not convincing. It sounded like what you wanted to say was, "I've been better." You have been talking to a lot of people. That's what the impetus for this show was.
Ben Miller:
Yes. I've been out in market. I've had a lot of market intel. It's November 9th and wow is there a lot happening in the world.
Cardiff Garcia:
Who've you been talking to, first of all? When you say, "I've been talking to a lot of people," who are the participants? Not by name, just generally.
Ben Miller:
Oh, well, the big thing is that we went out and put maybe a dozen properties on the market, maybe dozens of properties on the market and went out to buy a bunch of stuff and happening on the ground is incredible, just I would say almost shocking to a real estate nerd. If you're a real estate person, it's 2008 financial crisis. That's how bad it is and most people don't know. Currently at least in real estate, prices have fallen for private real estate as much, if not more than 2008.
Cardiff Garcia:
Wow. I was going to say that's quite a teaser because if someone's listening to this show, they probably are a real estate nerd, but then you immediately followed that up by giving this really horrible pronouncement on what's happening out in the world, but it sounds like this is intel that you've gathered from being out in the market, buying some things or at least looking to buy some things and also putting some other things on the market. So give us more of a sense of you've been seeing out there.
Ben Miller:
I have to back that statement up. That's a big pronouncement because 2008-
Cardiff Garcia:
Yeah, it is. You just shocked me, to be honest. I didn't expect that coming in and that's shocking.
Ben Miller:
It is shocking. It's one of those things I feel like I can't tell if it's before the pandemic when I was like, "Why isn't anybody shocked yet?" and then everybody ends up falling apart. Somehow it's narrow sector. Let me back that up. So basically, I don't just mean office, I'm talking about all real estate, everything that an investor will buy in real estate. So I got to basically say what's happening on the ground. That's what I want to cover. Let me give you a bunch of market data and I'll give you what I'm seeing.
Ben Miller:
So according to CBRE and Green Street, 2007, 2010, prices moved 50% in private markets. So that's according to a bunch of different stats, 5.4% cap rates to 7.9, so that's a 50% move. They're saying prices are moved percent again, 0.2% to 6% cap rates. So imagine if housing prices fell 50%, people would be losing their minds. That's what's happening in commercial real estate in an investment world and that's apartments and that's public storage and that's anything that's an investment.
Cardiff Garcia:
Ben, let me jump in here and just ask you to define the importance of the cap rate in real estate because it does have analogs in the rest of the investment universe, but it's particularly important for what you're describing.
Ben Miller:
I've definitely gotten this feedback. So the cap rate is the yield. So you could think of it as almost like an interest rate. Basically a 5% cap rate is a 5% yield, you get 5% a year and real estate's priced by cap rate, by yield rather than stocks which are to earnings. So a 10 price to earnings would be a 10% yield or 10% cap rate. So it's just the inverse. It's earnings over price rather than price over earnings.
Cardiff Garcia:
As with bond yields, it moves inversely proportional to prices. If the cap rate's gone up, you can expect that real estate prices have fallen.
Ben Miller:
I got this feedback because often it's inverse of what you would think, a high cap rate is a low price and a high yield actually drives the price of bonds down. So it's confusing. I get this confusion also from investors because they say down the street in my neighborhood I'm seeing houses sell and houses basically seem to be doing okay, actually maybe they're up a little bit. I don't understand. How can you say real estate price is down 20, 30, 40, 50%. That's dissonant. That's strange and that's actually one of the most interesting things about this market.
Ben Miller:
So if I take a house or a pool of houses and I sell them to home buyers, I sell them for a gain. They can see housing sold to home buyers has appreciated and I take that exact same house I sell it to an investor, it's 25, 50% less. So I'm going to give you a bunch of real examples. By taking things to market, I can compare different things in the market. So we've taken houses to market home buyers and we've taken houses to market to investors.
Ben Miller:
Let me give you an example of this project we own outside the Woodlands, which is outside Houston. Woodlands is Tony neighborhood in the suburbs enclave wealthy. So this is a nice neighborhood. We own a bunch of stuff there and one of the projects we own is called Amber Pines. It's a build for rent community. So we basically have 124 homes that were built for rent houses. So they actually are separately deed, so we could sell them a single house or you can sell them as a 124-unit essentially apartment project that's homes. We bought them at the height of the pandemic. So we bought them, we went under contract for them September, 2020. So that's a good time to buy things.
Cardiff Garcia:
Price had collapsed in the immediate aftermath of the pandemic for sure.
Ben Miller:
Yes, and we paid at that time $256,000 a home. That's what we bought these 124 homes for. So now there's been a huge run up in housing prices and everybody has seen that price run up over the last two years. If you go down the street from that community, and I'm talking about one-minute drive down the street, five-minute walk, a thousand feet, there are homes built by the exact same home builder. So it's basically almost the same home and I can give you the address as an example. I'm going to comp. Same home, the address is called Plan 2039. It's on Foster Ridge Parkway. D. R. Horton is selling it for $389,890. It's a four-bedroom, three bath, 2,060 square foot house for $389,890. So $390,000, okay, that's the house for sale on the market. Home buyer would buy that house.
Ben Miller:
We took our community, which is made of very similar house. So I'll give you an example, a four-bedroom house with two and a half baths, 2,088 square feet, took that and tried to sell it to the investor market to see where it would price and it's priced at 43% less for $220,000 a house. The investment market prices it at $220,000 a house and the home buyer is buying the same house through 390. That is weird. That's a strange dynamic and it tells you a lot because there shouldn't be two prices that are 50% different for essentially the same asset.
Cardiff Garcia:
What do you think is going on there? What is the significance of that?
Ben Miller:
That's the big question. There's a discrepancy and the discrepancy is the investor is buying in a very logical, quantitative way, and I think we should walk through the math of it. Potentially, interest rates have gone up a lot and that's basically made the returns. People expect it to be higher and it's driven down the price. So there's a lot around interest rates that we could walk through why essentially the investor would pay half of what the home buyer would.
Cardiff Garcia:
The first question that comes to mind is, well, interest rates are higher for everybody, for investors and for homeowners. So why would there still be such a dramatic discrepancy between the two?
Ben Miller:
Why is the homeowner who's paying an 80% interest rate too, they pay a higher interest rate than most investors actually, why are they paying a massive premium? I don't know why, but I know half the why. I know why the investor is paying a much lower price, but why is the homeowner paying a much higher price? If we can try to dig into that, half I can explain, and then also I think we need to talk about, do you think that persists? Do you think basically you can have this massive difference in pricing between two different buyers for the same asset over the long term? Either home prices have to fall a lot, we're talking about a lot, or rates have to fall, which would then raise the value of the house and would close that gap or both of those things have to happen somewhere in the middle. It's a sign of market dysfunction.
Cardiff Garcia:
It's a market inefficiency, clearly. If you have two very similar houses that theoretically should be priced in exactly where they are but one's priced way higher, you'd think that there'd be something exploitable there too where you would essentially sell short the higher priced house and you'd buy the other one and you're going to make a money on the convergence somehow. It'd be tricky how to actually pull that off and I'm not enough of an expert to know, but it seems like a market inefficiency and the question is, how do you explain that?
Ben Miller:
Fundrise platform owns 5,000, 6,000 houses? So some of those houses we're just selling to the home buyer because it's like, "Well, that's crazy. We should just sell it to the home buyer and turn around and redeploy that capital to buy at these lower prices." So that's something we got in motion about 90 days ago maybe over the summer because if selling thousands of homes is no small feat, imagine just anybody's bought a home or sold a home, it's fair amount of work and you do that a thousand times and you're only halfway through the 2,000 you probably want to sell. So that's one thing we're doing about it.
Ben Miller:
Here's another one that's also in the Woodlands. We own a community of town homes called Woodmill Townhomes. We bought it in January, 2021, so still pretty early, and that's when we went under contract, 171 units. Two years since we've owned it, the NOI has gone up 27%, the net operating income. The income from the property increased 27% because there's been a lot of inflation, there's been a lot of rent growth. So okay, you have your income go up 27%. There's a community of homes next door that are really nice because this is the Woodlands. This is actually in the Woodlands. Those homes sell for between $450,000 to $800,000. Comparable homes a little hard because they're very expensive homes, but you'd say maybe the closest comp is a $472,000 home nearby, and if we went to market today, offers would be at $236,000 a home, so 50% less than a comparable home 700 feet away.
Cardiff Garcia:
So again, you have the difference between the price for a potential home buyer versus the price for another potential investor.
Ben Miller:
We get this question so much from our investors. It's just, "You guys must be doing something wrong because I don't understand what you mean that housing prices have gone down a lot," and I said, "I understand why you might not understand that. It's pretty strange."
Cardiff Garcia:
This is fascinating. So if we look at the broader macro picture and how it might apply there, there's a difference between what home prices are doing nationwide, say, where they haven't fallen by very much, at least nominally, versus, say, the returns on an investment portfolio of houses where there have been falls and that's what you report to your investors. Is that right? Am I understanding this correctly?
Ben Miller:
Definitely. You have to set the value of the fund or the share price based on the combined value of each property, the combined value of the property, essentially how much you could sell it for. So what's happening is, and we can get into [inaudible 00:12:16] behind this, but what's happening is that the high interest rate environment is lowering the amount you can sell investment property for to a place where you look at it on price per unit and you're like, "Well, this doesn't make that much sense." What's happening essentially is that nobody wants to sell an asset 50% of what it was worth 24 months ago. So if you think about it, if you have a home and you have a mortgage and basically your mortgage is 3%, you're not going to sell that for 25% or 40% less than it was worth 24 months ago because you don't have to.
Cardiff Garcia:
You can just stay in the home. The other problem also is that if you sell the home and then you go to buy a new home, well, mortgage rates are now at 7.5%, 8%, so there's a much higher mortgage rate, you might as well stay where you are, and even if you do want to sell the home, you just wait. I will say, and this is purely anecdotal, I know some people who are trying to sell homes and they're also just waiting because you don't have the situation that you might have in other markets where people just accept where things are and say, "Well, I'll just drop the price of the home by 20% or 30% or whatever." They're keeping the prices high, they're just not selling. You just have a lot more lock-in, a lot fewer transactions than otherwise you might expect in a healthier market. You just don't see it. You don't see the big price decline even though maybe in some hypothetical fundamental terms, the prices of those houses really are lower than what's being reflected in the market. Is that right?
Ben Miller:
So this starts to get to the why. So who is selling an investment property, 50% discount or 40% discount? Only people who have to. So what you're starting to see is that the market is failing, and one of the signs of a failed market is there's no transactions where it's thinly traded. So what happened is a year ago, the market started to freeze up and the volume fell a lot, but there were still random sales to happening. You could still find an institutional class a apartment building selling in Dallas and it would sell at much lower cap rate, much higher price than you would think.
Ben Miller:
I remember going to one of these big institutional investment banks and saying, "Why do you guys buy this at this 4.5% cap rate? Treasuries are 4.5%. I don't understand,"' and they said basically that they're a forced buyer. There are forced sellers in the market and there's forced buyers in the market, forced buyers not because your spouse said you're buying a home, I don't care, which is a thing, but in the institutional world, it's usually driven by tax. There's a tax reason that somebody's a forced buyer.
Ben Miller:
So what's happening was prices actually weren't so bad because about 10% of the market was forced buying and prices were in the mid to high fours, which is basically pretty normal but doesn't make sense when treasuries were so high. Now what started to happen is that there's forced sellers and the forced sellers are driving their prices to basically collapse. So the short answer is that in this economic environment, I shouldn't sell a property. If I don't have to sell properties, I won't.
Ben Miller:
Our problem is twofold. Under our regulations, we have to price things according to fair value and you get market value of each property and you combine that and that creates something called a net asset value or NAV, which is the share price and it's very challenging, so that's one. Two, when investors redeem out of our fund and liquidate for cash, it puts the pressure on us to sell an asset and turn into the cash to give them their redemption, their liquidity, and that pressure is a pressure to have us sell within this environment, which is basically not what you want to be doing. So we had a bunch of reasons why we went out to market and basically we found, I think, a broken market.
Cardiff Garcia:
When you talk about forced sellers, Ben, just one point to clarify here, are you referring to individual homeowners? Are you referring to institutions that own office properties or factories or industrials? Who are the forced sellers that you're talking about here? Are we still talking about individual homes or multifamily, complexes? What are you referring to there?
Ben Miller:
In my experience, basically, in a downturn, everyone's a forced seller for more or less the same reason. It really comes down to whether you're a big institution or an individual, you're selling because you need money and you have to get money. Typically, you have to get money because you have too much leverage. It's the turtles all the way down thing. So whether you bought a property or your loan's coming due or you lost your job or you have some pressure making you sell, I've seen banks as forced sellers. I've seen some big corporations vacate buildings they own because they were leasing them and sell those.
Cardiff Garcia:
If they can't refinance, then maybe that's your only remaining option.
Ben Miller:
The fundamental reason is you can no longer carry it. That's normally why you sell. So actually, I want to give you a couple examples of some sales processes we ran because a sales process in the institutional world, it's like selling a home where you have a broker and you go out and it takes a month to property ready and then a month to put it on the market and then the buyer usually has a month to close, but when you're buying a hundred million dollar property, it's usually a longer process.
Ben Miller:
As I said, we took a bunch of stuff to market because we were basically looking for pricing and we put a lot of stuff in motion in the middle of the summer. Here's an example. We took a 500,000 square foot industrial building in Atlanta to market. It's basically new, 100% leased, high credit tenant, a class A high quality property. We engaged brokers in August. They went out and got bids in September. We got 27 bids in September from tons of big name institutions. If I started naming institutions, you would've heard of a bunch of them.
Cardiff Garcia:
If it's 100% leased though, I would imagine that a lot of people would be interested in buying it, and it's also happening in Atlanta, which is different from buying something in midtown Manhattan.
Ben Miller:
Nothing about the real estate, it's all driven by capital markets. In October, treasury rates increased 25% in 60 days. So by the end of October, how many offers did we have?
Cardiff Garcia:
I don't know. A lot fewer?
Ben Miller:
Zero offers.
Cardiff Garcia:
This is how monetary policy works. It's how it's supposed to work is it makes it super safe to still get very high yield on something else so you don't go bidding for something unless it's offering more in excess of that safe yield.
Ben Miller:
Well, that's not exactly what's happening on the ground. What happened in this case is that when treasuries went from 4% to 5% in 60 days, which is a huge move, 20% to 25% move, in October people thought, "Well, if it went from 4% to 5% in 60 days, it could go from 5% to 6% in the next 60 days and go to 6% to 7%." If you go back October, people were saying, "Federal debts and deficits are going to balloon the amount of money that country has to borrow and that's going to drive interest rates to infinity 10% or more." Ken Griffin from Citadel said that this morning.
Cardiff Garcia:
I will say that is also how monetary policy is supposed to work. It's based on the expectation of where it's going and not just where it is right now. Those things, I think, are compatible, but in any case, it's working the way it's supposed to work, which is to make it harder to sell something unless it's offering an excess either of the current yield or the yield that investors expect to get later on, for sure.
Ben Miller:
Well, we got zero offers that people were freaked out. So this is the part, the psychological part because you're talking about the national part, but the psychological part is taking hold of the real estate market. We took a lot of stuff to market, built for rent, multifamily houses, industrial, and I saw real fear. People were really afraid and that made them afraid to do anything. They're froze. The market is freezing and I think that basically it's not going to unfreeze. Once it freezes, it doesn't matter if, "Oh, interest rates are stable now. It's going to take a lot more to unfreeze it or maybe it took how long, 18 months to freeze it, so maybe it takes 18 months to unfreeze it. There's a lag, long and variable lag here. We're starting to see acute consequences to high rates.
Cardiff Garcia:
That is what you've seen on the ground, but you also just gave a picture of the macro environment and how that's affecting some of the projects that you've been directly involved in. I will say that if you step even further back and look at the overall macro picture, this also gets at another question that I think everybody has which is, to what extent is the pain in the real estate market, in this case both commercial and residential that you've just described? To what extent will that eventually filter to other parts of the economy because the more positive recent story is just that consumer spending has continued, wage growth has slowed, which the Fed wants, but it's still pretty healthy, and the labor market has softened but it hasn't cracked. It's still creating jobs each month.
Cardiff Garcia:
So one of the, I think, hypotheses for why the US would, if it does, avoid a recession next year, just that there will be a lot of pain in, let's say, real estate, but that it won't spread to other parts of the economy. Meanwhile, if inflation keeps coming down, maybe that'll also lead to lower interest rates and then that will end up softening the real estate market as well. That is the positive hopeful story for next year. You and I have been quite worried about next year for some time and I am still quite worried about it and that's not a prediction. That's just me saying, "Well, higher rates like this for so long eventually do inflict pain on the broader economy," and I'm worried that that's going to happen, but I suspect based on what you just said and based on your experience out in the market that you're even more pessimistic than I am. Is that a fair thing to say?
Ben Miller:
Well, I've been worried that this would happen and it's happening. So on one hand you'd say it keeps getting worse because it's not like interest rate policy or quantitative tightening is really giving us relief yet. So that's on one hand. Other hand, yes, there's been good inflation print or softening of employment data earlier this month last week. Yield actually flipped on November 2nd when Treasury issued less than the long than they thought, but then at 1:00 today, the Treasury auction went badly. So equity markets are firmly in the hands of the credit markets. That's where we are, which is usually the sequence how things go. So the positive version, which actually you probably saw this too, Goldman Sachs came out with a 2024 forecast with a headline of the report, "The hard part is over."
Cardiff Garcia:
Basically, inflation is already headed and likely will continue to head in the right direction. It will keep going down towards 2% and that'll make it easier for monetary policy in those credit markets to ease up a little bit. They have been, I will say, the most optimistic on the street big players for a while now, and to this point, I think you could say they've been largely proven right, not on everything, but they've been largely proven right, right, but they're optimistic now also about 2024. It is 2024 that I've been the most worried about for a while. I actually thought 2023 would be okay heading into the year, but in any case, let's go back to that discrepancy though between what you're seeing and this more positive story, the hopeful version of what could happen in the economy and what you think about the possibility for spillover effects from the markets that you're most directly engaged in and everything else.
Ben Miller:
I feel like the part that's potentially being missed, psychological consequences of the monetary tightening. Anybody who was in real estate in October who was close to it, it was like a near death experience. It was shocking to see Treasury value go down 20% in a short time. Just to put some stats on this, a treasury issued in May, which is supposed to be the safest asset around, a 30-year treasury went down 20% from May to October. So you buy this free asset and it goes down 20% in five months and treasuries from peak to trough, from 2021 to 2023, lost 50%. Treasuries lost 50% on the long end of the curve. So that is 50% loss on treasuries is catastrophic, and the consequences of that have been muted so far since they're held in accounts until maturity and people are saying they can basically hold that and not have to recognize those losses is, again, it's only a 50% loss if you sell, if you're a forced seller, but anybody, I think, in real estate, if I go talk to institutions, which I did in the last week because I said, "Okay. Here's a deal. You want to do it with us." Interesting always a find out, "Here's a deal that you should do. It's a 7% cap rate."
Cardiff Garcia:
Gauging interest at least too.
Ben Miller:
Yeah, because one of the things people in institutions do is basically not tell you what's really going on behind the scenes. So they'll say, "Oh, we're doing deals but it need to be 20% return," or, "Here's 20% return deal." "Well, actually we need a 30% return deal." "Okay. Well, here's a 30% return deal." "Well, actually we need 50% return deal." "Okay. Actually, you can't do a deal and you just don't want, you can't say it." So I think that institutions are going to be frozen for, I think, six months. They need to see the positive progress on inflation for another five or six months before they really believe that we're done.
Ben Miller:
Goldman came out really early. It was bold and I amend them. Let me give you another psychological effect. When markets fail, they operate in very weird day. Here's an example of how they fail. So in a normal sales process, you have a burger, you have property to market, let's say a multi-family building, $50 million multi-family building, $100 million multi-family building. I think we took one to market in the summer. We had 38 offers, and then when they start disappearing, and those 37, they're really high and five, they're really low, and I'm talking about someone might bid 100 million, someone else might bid 60 million.
Ben Miller:
Why the heck does somebody bid 60 million for something that other people are bidding 100? Because basically if the seller goes back to them and says, "Okay. Actually, your offer's interesting," the dynamic flips. So normally, you have 25 offers, 30 offers, pick the top five, and they basically bid again in final offer and the highest bid in the second round wins. In a market, if you go to the low bidder, something's wrong. They say, "Wait a second, you came to me, you shouldn't accept this bid. This bid makes no sense in any normal course. You must be a forced seller." So if you go to a low bid, when you go back to them, they lower their bid again because they want to see how desperate you are, and that process is called a worst and final rather than a best and final because it actually ratchets down in almost illogical sense because it's no longer about price, it's only about how desperate you are.
Cardiff Garcia:
Interesting. Not knowing anything about the logistics of how these markets work is something you obviously understand very well. Didn't even know you could do that, that you could submit a low bid like that, have it get hit and then say, "No, no, no, actually, we're going even lower," and see how low you can keep going. I didn't know that was even allowed. I didn't know it was legal.
Ben Miller:
In commercial real estate, there's no such thing as potentially laws.
Cardiff Garcia:
As legality.
Ben Miller:
No, it's common practice. Most sellers, the package you get from the seller is 50% lies. It would be securities fraud if it was a regulated part of the industry, but the income's wrong, the rents might be wrong, the occupancy might be wrong. There's just tons of stuff that's basically not really true and your job is to figure out what part's not true. That's the game. There was a very efficient or you might say nasty process.
Cardiff Garcia:
We're going to do a separate episode on that I hope someday because I bet there's a lot of great stories about how that works. That's great.
Ben Miller:
How many can you tell, but part of what you're trying to do when you're selling is you're trying to figure out if the person you're talking to is actually, do they have $100 million dollars, and a lot of times people who are trying to buy it, trying to get ahold of the contract so they can turn around and raise the money. So what's happening is that there are very, very few actual buyers in market because most institutions froze. So the buyers are deluged with sellers.
Cardiff Garcia:
With lots of sellers and that also, I think, can be driven by the dearth of credit. Here, I just want to stop to point out some statistics. There was a really great article within a week or two ago by Peter Grant of the Wall Street Journal, just went through what was happening in commercial real estate and parts of residential as well. By the way, I'm doing something that you're never supposed to do in podcasting. You're never supposed to do a stack of facts as we call them, but I am going to do it because I think this really brings home the point and the facts get more and more troubling as we go through them.
Cardiff Garcia:
So here's one. This is, again, from Peter Grand of the Wall Street Journal, "Total volume of commercial real estate loans held by banks, the largest source of debt financing declined during the first two weeks of October." Then he goes on to make the point that that's only happened in two months since 2014. That's almost a decade ago. We can keep going. How many loans? What volume have been converted into commercial mortgage-backed securities this year? 28 billion. That's the lowest figure since 2011, a decade and a half almost.
Cardiff Garcia:
If you look at the entire commercial property debt market, so that's debt from banks, commercial mortgage-backed securities, non-bank lenders, everything, it went up less than 1% in the second quarter. Again, that's the lowest quarterly climb since 2014. He goes on to say that it's also started to infect other commercial borrowers like those for warehouses, apartment buildings. So it's everywhere and even some private credit lenders, private credit, the big thing these days are starting to get spooked because so many of their borrowers, including big name developers are struggling to refinance because of higher rates. So I think this all goes back to the point you're making about forced sellers. They're typically the places that would need to borrow money and even the providers of that credit are really freaked out at the moment and that contributes to the whole thing continuing to spiral down, and that sounds like what you're getting at here.
Ben Miller:
I've been focused on the fact that there's not a lot of equity and I actually think there's less equity than there's debt, but there's also very little debt. Think about when you buy property, a home, you typically have 80% of the money coming from the debt because there's 80% debt or commercial real estate be a little less, might be 60% to 75%, but it's coming from the lender. Saw a lender last week. If you want to borrow from them, not only do you have to put down probably 40% equity, you also have to give them 20% to 30% in deposits to match the loan. So if you're going to get a $10 million loan, they want $2 to $3 million in deposits. So you basically have to put down two down payments to buy something because the bank doesn't have any liquidity. They're desperate for deposits because they're so short on dollars, so they'll only lend to you if they, basically, they take the money from you in deposits and they lend it back to you and they need basically two to three times what they lend to you. Deposits basically make it worth it for them. Their liquidity is disappearing from markets.
Cardiff Garcia:
There's no money in this market. It's feeding into activity in the real world. To your point about transactions, $89 billion in US commercial property purchased in the third quarter, that's down more than 50% from the third quarter last year. In terms of commercial property starts, construction starts, this is all from the same article. They're estimated to fall to 935 million square feet this year. That's 17% down from last year, the biggest annual decline since 2009, all according to that same Wall Street Journal article.
Cardiff Garcia:
There's no money and there's nothing happening. That's the bottom line in so much of the real estate market here, not just talking about homes and freeze up there that we already discussed. Everywhere, there's nothing happening. It's extraordinary in a sobering, chilling way, but nonetheless remarkable to see.
Ben Miller:
I feel like most of the data you're describing is lagging to stuff I'm seeing. They're talking about Q3, I'm in Q4. Q4 is when treasuries increased by a lot. So I think Q4 is going to see a huge collapse. I've always been surprised how much the Fed and data seen the newspapers lags in my experience. Two or three quick examples, we saw multifamily construction lending disappear in September, 2022, about a year ago because I know that because we started lending in that moment and closing the gap about a bunch of money at really high rates, 13%, 14% gross yields, but you didn't see that in the Fed data till June, nine, 10 months later. By now, it's fallen off a cliff. It's hugely lagging on the ground because bid, you get a term sheet, it closes, and then it makes its way to the bank's reporting, which makes it way to the Feds. There's this massive lag.
Ben Miller:
Another obvious one, which everybody saw, I feel. In May 2021, our rent growth went from 3% a year to 20% a year in May 2021. The Fed didn't raise rates until physically May 2022, a year later. Such a lag. What I'm worried about, really convinced of is that what's happening on the ground is tough and basically it'll become obvious to everybody within six months is the serious softening. Probably the beginning of the softening is celebrated by the markets because they're going to be happy inflation's finally going away, tamed and that'll rally the market, but it's like a train, a freight train, just keeps softening, and by midsummer next year it's actually a problem and then the Fed doesn't act until end of 2024. What I'm seeing on the ground, literally, it'd be hard to be closer to the edge of what's happening in markets. We won't see the consequences of that for half a year.
Cardiff Garcia:
It's a really interesting projection. I actually think we should even make more explicit for listeners what you're referring to when you talk about the softening, which is a very economicsy term that's being thrown around right now. The idea here is that Fed has been trying to obviously bring inflation back down to roughly 2% year over year. That is its target. We're still above that. The US economy is still above it. Inflation is closer to about 4% right now, and essentially what's happening is that if economic activity, economic growth slows down enough, inflation is likely to keep coming down with it.
Cardiff Garcia:
So at first, even though the economy is either getting worse or at least not growing as quickly as it has been through the third quarter of this year, people will still be happy about that because inflation will be coming down. That means interest rates might start coming down. So you might see a rally in some asset markets that benefit from lower interest rates in the expectation of lower interest rates.
Cardiff Garcia:
The problem you're describing is that if there's enough downward momentum in the economy, it's not just the economic growth is going to slow, it'll keep slowing and slowing and slowing until it actually reverses and then you're in a recession. That's what negative economic growth is, the economy starts to contract. Then after this period where people are happy that inflation is down and that asset prices went up for a little while, people will come to the realization that actually we're in a recession that's getting worse and worse and that the Fed and policymakers generally might be behind the curve in terms of getting the economy back to growth again. That's the projection you're making here, and it's a very interesting one. I myself, as we've said before, have the luxury of being agnostic on all this, but that all strikes me as quite plausible. That sequence of events does strike me as very plausible, I will say that.
Ben Miller:
On one hand you could say I've been wrong because there hasn't been a broader recession. On the other hand, you could say I was right because there's been a very acute recession in real estate because investment real estate is as bad in pricing as 2008, which is as bad as it's been since the depression. So looking forward, the irony is that recession is probably going to cause real estate to appreciate. It's counterintuitive, but real estate is much more driven by interest rates than by the real economy. So the real economy has been pretty healthy, unemployment's been low. There's been a lot of good consumer spending and interest rates have been high. Interest rates have been crushing real estate values. Actually, I thought about doing some math to show people a little bit of that.
Cardiff Garcia:
You're making me nervous, man. We're going to do some heavy math here?
Ben Miller:
Not heavy math, but essentially, I'm talking about real estate prices down between 25%, 50% because of interest rates. If you look at the 2008 financial crisis and what it did to rents, at least for apartments, and 2008 was a financial crisis, absolutely off the charts bad and rents went down in 2009 and '10 by negative 4%. So one hand you have interest rates causing 25% to 50% decline, and on the other hand, you have a recession, a bad recession, I think much worse than we're talking about for 2024, and it went down 4%. So this is one of the reasons why people buy apartments. They're actually very resilient to recession.
Ben Miller:
So if we have a recession, it's actually bullish for real estate prices because interest rates come down and they're not really that impacted by a recession. So 2024 is negative I am about it eventually affecting the economy is actually a positive thing for real estate prices for investors.
Cardiff Garcia:
Actually to some extent, that also is built into the way it's hoped monetary policy will work. The idea being that if you're in a recession, one of the ways that the Fed can help drive the economy out of the recession is by lowering interest rates which have a very direct effect on housing and real estate as opposed to the rest of the economy where it can take a while for those interest rates to start to affect it, to start to juice it. What you end up having is, ideally, a housing market recovery that starts relatively quickly after interest rates start falling and that that housing market activity then starts to flow into the rest of the economy, thereby getting it going again. So that is in some ways the way the system is designed or the way maybe it's badly designed, but it's the way it actually does work right now.
Cardiff Garcia:
So that's also fascinating, and I just want to make the point that you just hide together two strands of this conversation. You started the conversation by describing the idea that the housing market for potential home buyers, much higher prices than the housing market for investors. What you've just said essentially is that next year, if in fact we end up with a downturn but interest rates also end up falling, then you might see a recovery in housing values for investors essentially as well back in the direction of where those housing values are for home buyers. That sounds like the fundamental point that you've made throughout this chat. Is that right?
Ben Miller:
Right or another way to say it is today is not the time to sell. Today is not the time to liquidate. Today is the time to wait until you want to buy and you want to be buying sometime on this inflection point because my experience is institutional investor lags by three to six months because they are much more worried about being fired than being right. So they really have to wait until there's clarity and there's usually group consensus about moving out of the market. I believe that sometime early next year when it feels the worst, it's actually the time to ... and I've been very pessimistic for a long time, at least from my little part of the world. It's played out fairly negatively, but I can see, I don't know if it's February or March and it is, but it's not that far away where I feel like there's actually, I don't want to say a bottoming because it's going to be a bumpy ride, but their prices just start to make crazy sense. If I go back to this house I started with, buy a house near the Woodlands for $220,000, that's nearly 50% less, 45% less than market. That seems like a really good deal to me.
Cardiff Garcia:
That's a perfect segue, I think, to closing our chat with a discussion of what all this means for Fundrise because we've covered the macro environment, we've covered what you've seen directly in the market, covered what all this might mean for the world, which is obviously speculative, but we've talked about it. What does this mean for Fundrise itself and for Fundrise investors?
Ben Miller:
One of the biggest challenges, I think, of having the platform we have with half a million investors nearly is that get a lot of momentum investing. So our fundraising peaked in 2021 and our fundraising is, I don't want to say trough, but much lower than it was in late 2023 because it's been going down because all of the market agencies in real estate. So investment committee and I and few other people who are in the investment seats went back to say, "Okay. What did we do right? What did we do wrong? What could we have done differently? What are our lessons here?" If you look at a good comp is to look at the Vanguard Read Index and say, "Okay. All the public REITs in an index is a good way to benchmark our performance." All client return, essentially.
Cardiff Garcia:
All client return, does that mean clients who are invested across your real estate funds?
Ben Miller:
All our Fundrise investors, essentially, what has been their return over the last two or three years. Interestingly, Vanguard is down the beginning of the pandemic. Prices are below where they were January 1st, 2020. That is probably not what people would think considering all the headlines about inflation and prices that the public real estate index would be down from the pandemic and down also, obviously, from peak by, I think, about 30 some percent, 33%, 30%, which is pretty close to what I'm saying, where basically we're buying a property, you're probably down compared to buying it as a home buyer. As of November 3rd, which is the last time I looked, we've beaten Vanguard by a good measure. So then I say, "What do we do right? What do we do wrong?" So the things we did right, my refrain is often a lot of the things you do right are simple, not complicated, and some of the things we did wrong, I think, were complicated.
Ben Miller:
So on the product type, we bought apartments, industrial, single family homes. That did really well. We avoided and didn't buy office and retail, which have not done as well. So that's in retrospect, oh, man, I'm glad we don't own all this office, but it wasn't so clear over the last 10 years that office would basically devastated. The second, I think, is geography. Sunbelt may have heard it a million times from us and the big blue cities, the New Yorks, San Franciscos, LAs, Chicagos, DCs, they've really suffered in the pandemic and that's been a form outperformance. If you're just comparing us to Vanguard Read Index, income fund or a fund that's a lender, bonds are down 50%. So that's a lot. Why have we actually done really well is because we actually didn't take any leverage at the fund level. We basically didn't take interest rate risk in our first order consequences way.
Ben Miller:
We focused on real estate credit underwriting. So our income fund has outperformed, God, by some massive amount, absolutely off the charts because I think real estate people are always freaked out by interest rate risk and essentially don't like to take it, and that's an advantage, disadvantage because when interest rates were zero, that's something, I think, financial investors got more benefit of.
Ben Miller:
Then lastly, assets we bought. We usually buy things that are, I don't want to say boring. We don't buy trophy assets, we don't buy downtown skyscrapers. We try to focus on meat and potato, housing, class B multifamily, workforce housing or industrial. We don't buy the big fancy industrial buildings. We buy the smaller hundred thousand square feet or a hundred thousand square feet, not that million square foot. That was really hot actually 18 months ago. We bought one and that one we had to mark down. So this the outperformance.
Ben Miller:
When I think about it really, really simply, it went up 20%, 25% and prices fell 50%. So I think, basically, okay, we got the 25%. I don't know if that's how it's going to play out, but that's where markets are today because interest rates went from zero to five or even more, and that basically interest rate movement was just bigger that anything you could have done, and this is one of the lessons learned. In the beginning of this year, we had 23% of the portfolio in cash and credit lines. We literally had massive amounts. 23% is a reward chest. It was 683 million. I think we had some asset securities, maybe $700 million. So that's a lot of what I thought reserves were, but in retrospect, to really have outperformed, it would've needed to be 50% to 75% cash.
Ben Miller:
Essentially, we slowed our role on buying. We basically stopped bidding for new real estate around February 2022, so 20 months ago. So I've been talking about being worried. We leaned back a long time ago, but we would've needed to stop buying June 2021, six months before that, in the middle of when everything was just blowing up, stock market was up, industries were zero, we were raising tons of money, and we would at that time needed to put most of the money in 0% cash and held it in 0% cash for two and a quarter years to basically not had this price movement against us.
Cardiff Garcia:
Well, this year, obviously, cash has been giving you a lot more than 0% too.
Ben Miller:
Yeah, but in 2021 is cash was trash, it was 0%. It's hard to sit in cash. Investors don't like us. They gave us their money and we charged them, they say, "Well, what are you doing in cash for two years?"
Cardiff Garcia:
Well, if the asset class that you invest in is collapsing, cash is pretty great, but I understand.
Ben Miller:
What I mean to say is we're supposed to be investing in real estate, but it turns out that cash was the best investment despite all the inflation or at least one of the best investments I'm aware of for the last 24 months. That shows you how much that market has moved on everybody. Anyways, I look back and I think, could we have done more defensive because I'm fairly offensive, but it's painful because I knew that the market was easy, heady at the top, and I was trying to be defensive. It kills me that we weren't more on top of this.
Cardiff Garcia:
To synthesize, it sounds like what you're saying now about what happens next is that you're counseling patients that now is not the time to sell at these rock bottom prices, and are you also considering deploying more money when the timing is right in the coming year if in fact the pain continues and before perhaps interest rates fall and valuations start going back up?
Ben Miller:
That's the goal. That's the dream, this comes around. The last time this happened was 15 years ago. It doesn't happen very often. That's why I wish I had all this cash. I'd just be buying everything under the sun. I could get more into the weeds of the interest rate derivatives I wish I had bought, and I underestimated insurance costs in Florida, which basically was a huge hit to expenses around hurricanes and climate change. You don't move the needle very much, 0.1% or something, but it's still painful. It's painful because I knew I was just scarred from '08, just absolutely scarred from it. I just was obsessed with this thing that I knew was coming eventually, and it came, it's here. Back in some 2008 moment, and the question says it spread, and I don't know if it spreads, does it spread to the rest of the market? Goldman says it doesn't, and they're a lot smarter than me, but I don't really understand why it's so limited to banks and real estate and private equity and things like that. I just imagine small business and consumers eventually will feel it, but I hope they don't.
Cardiff Garcia:
Any parting thoughts for listeners or investors as we close the chat? We've talked about so many different things. You've just done a right side, left side, what we got right, what we got wrong assessment. Is there anything else that you really want to leave listeners with as we close this episode? Keeping in mind that our last episode of the year, coming in about a month or so, can be a assessment of the year. We look back at our predictions from the beginning of the year, the end of last year, and we do our new ones. What do you want to tell people?
Ben Miller:
The prices for real estate have come down and that they're not necessarily at bottom. I think we probably have another month at least of that, but I hope that as frustrated as they are that prices have come down, that we can be greedy when other people are fearful because I think the lesson in 2021 was to be fearful when other people were greedy. So if we can basically lean in when everyone else is leaning out, pay huge dividends for us. So I do think that we will come out of it. I don't think this is a depression. It's just it's a time of stress, and that's a time of opportunity, and I'm hoping we can see the problem as an opportunity.
Cardiff Garcia:
Final question. There does seem to be the possibility of a good outcome on rise in real estate more widely even without a downturn, which is that inflation continues to come down even in the absence of a prolonged hit to economic growth. This is, by the way, the Goldman Sachs story because it sounds like what the recovery in these asset values depends on is lower interest rates, just a better economic environment for real estate, specifically, regardless of what's happening in the wider economy. That is possible with lower inflation even without worsening and worsening economic growth.
Ben Miller:
Basically, whether you have a soft landing or hard landing, all of those scenarios would be positive for prices from the start of the year, and it's just a question of how long it takes to basically see the recovery. Goldman would say you'd see it all throughout 2024, but I think that most scenarios in 2024 are very constructive, very positive for real estate.
Cardiff Garcia:
Well, just had to end on that more hopeful note. After an episode full of dispiriting information, I thought we had to end there, but this was fun as always, and we got one more episode this year, Ben. Looking forward to it.
Ben Miller:
I'm looking forward to the predictions and measuring our forecasts.
Cardiff Garcia:
You've been listening to Onward, the Fundrise podcast featuring Ben Miller, CEO of Fundrise. My name is Cardiff Garcia of Bazaar Audio. We invite you again to please send your comments and questions to onward@fundrise.com, and if you like what you heard, rate and review us on Apple Podcasts and be sure to follow us wherever you listen to podcasts. Finally, for more information on Fundrise-sponsored investment products, including all relevant legal disclaimers, please check out our show notes. This podcast was produced by The Podcast Consultant. Thanks so much for listening. See you next episode.
