A "Hurricane" is Coming for the Real Estate Market - Billionaire Real Estate Investor

I like to say it's a hurricane over real estate right now. We're in the category 5 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.

One of the world's most successful and respected real estate investors is sounding alarm bells of the hurricane brewing in the real estate market. Barry Sternlicht is a billionaire and the co-founder, chairman, and CEO of Starwood Capital Group, an investment fund with over 120 billion dollars in assets under management. Starwood is one of the largest real estate firms in the world, and Sternlicht's position as CEO gives him an inside look into what's happening in the real estate market.

This is why it got my attention when in a recent interview, he talked about a quote "category 5 hurricane" that's months away from hitting the real estate market. Here's what he had to say:

But first, make sure to hit that subscribe button because it's my goal to make you a better investor by studying the world's greatest investors.

Let's talk about your other business, which is the non-lodging business. So, you are one of the best known and one of the best real estate investors in our country right now. Many people think the real estate market is going to be in trouble because high interest rates are making it more and more difficult for people to service their loans, and we're going to have a lot of defaults soon. What do you think about that observation?

Sternlicht responded, "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, and 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, I like to say it's a hurricane over real estate right now. We're in the category 5 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.

To truly understand what's going on in the real estate market, you first need to understand the relationship between real estate values and interest rates. Real estate is an asset that has what is referred to as a fixed income stream. A fixed income stream is a relatively predictable amount of cash year in and year out. If you are the owner of an office building, and your tenant has a 10-year lease, you know what you should be getting paid in rent over the next 10 years. These locked-in cash flows are the fixed income stream real estate produces.

Here's what Sternlicht meant when he said any asset with a fixed income stream decreases in value as interest rates rise. Imagine you're the owner of a small apartment building in your town or city. You have an apartment that generates one hundred thousand dollars in cash per year for you. Think of this number as the annual income stream this asset or the apartment generates for you as the owner. This would be the rent the apartment building produces minus any expenses associated with the property.

Some examples of expenses may include maintenance, property taxes, management fees, leasing costs. You get the idea. So, in this example, the annual cash the apartment building generates increases by five percent each year as rents rise. At the end of the five years, you will then sell the apartment building and pocket the money from the sale.

In commercial real estate, the value of a property is determined by what is called a cap rate. The cap rate simply represents the yield of a property over a one-year time horizon, assuming the property is purchased on cash and not a loan. The formula to calculate what the building can be sold for at the end of five years is simple: take the cash the property generates, or net operating income, as the pros call it, and then divide that number by the cap rate.

The number you get from the simple math is the value of the property. In this example, let's use a five percent cap rate. So now, with all of that information, how do we determine what the apartment building is worth today? We take the cash the apartment building is going to generate over the five years and discount it back to today using an interest rate. This is what is referred to as the time value of money.

Using a six percent interest rate, we can see the current value of our apartment building is approximately 2.28 million dollars. But let's see what happens as interest rates rise. Instead of using a discount rate of six percent, we can bump that up to seven percent. We see that the value of the apartment building fell to 2.18 million, a decline of roughly one hundred thousand dollars.

But that's not it because interest rates rose. The cap rate that this property will be sold for also needs to increase as investors are now demanding a higher return on their money. Let's take the cap rate on the property when it is sold in five years from five percent to six percent. Increasing the cap rate decreases the amount of money the property can be sold for in five years. This takes the current value of the property down from 2.18 million all the way to 1.89 million.

You can start to see now why interest rates matter so much when it comes to real estate. Let's get even more aggressive and raise the discount rate and cap rate more. Let's take the discount rate up to nine percent and the exit cap rate up to eight percent. We can see this causes the value of our apartment building to plunge to 1.41 million.

So, notice how nothing about the cash the apartment building produced changed. However, rising interest rates cause the value to significantly decrease. Currently, the fundamentals, aka the cash the properties generate in the real estate market, are strong. However, that likely won't be the case all that much longer.

According to Sternlicht, "Your view is because of the kind of things you see coming, we will go into a recession in the United States in your view?"

"Yeah, and any way to avoid it at this point or not really?"

"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. The service economy is wickedly strong; it feels like the last gasp before we actually settle into what should be. I hope it's a shallow recession. I hope you can pull that off."

"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 labor market the way they would normally affect the labor market."

"The offset is construction from the infrastructure bill and you have the service sector which is still recovering from the pandemic, which normally would be tilting over."

Real estate is what economists refer to as a commodity. The price of any commodity is dependent on the supply and demand dynamics at that given time. So, let's use the apartment building example from earlier. We know from earlier that the value of the building is dependent on the cash it generates.

However, what determines what rent you as an owner can charge for each of those units? It's the supply and demand of apartments within that particular real estate market. Let me explain. Here we have a supply and demand graph. On this line, we have supply. Think of this as the number of apartment units available in a certain area. This other line represents demand. Think of this as the number of people that are wanting to rent an apartment. The point at which these two lines cross represents the price.

So in our case, the monthly rent for the apartment for owners of the apartment building—so-called strong fundamentals—is when demand outstrips supply. Over the past few years, the economy has been extremely strong. Unemployment was low, and government stimulus programs were high. Add to that the fact that home prices skyrocketed, forcing many would-be home buyers to stay renters.

These factors cause demand for apartment units to increase, pushing our demand line here out to the right. Notice how the supply and demand line now cross at a much higher price. The higher rents increase the cash apartment buildings generated, making them even more valuable.

However, things can just as easily go the opposite way. During a recession, the demand for apartments can decrease. People lose their jobs and are forced to move in with their parents or other family members instead of living on their own. Additionally, people may be forced to move in with roommates in order to lower their portion of the monthly rent.

Some existing tenants will fall on tough times financially and have to be evicted. Evictions are costly for apartment building owners and lower the cash the building generates. A weaker economy tends to put downward pressure on demand, as we can see here by our demand line moving to the left.

Combine that with the fact that during strong economic times, investors want to build more apartment buildings. However, depending on the region, it can take 12 to 24 months from the project being thought of to when the apartment units are able to be rented. This is exactly what is happening currently. There are an estimated 560,000 new apartment units entering the market in 2023.

This is the highest number in 20 years. Construction on almost all of these projects got started in 2021 or 2022, a time when economic projections were much rosier. Additional supply causes our supply line to move to the right. We can now see that the point at which our supply and demand line now cross is at a much lower price.

While this example was about apartment buildings, there are actually two particular real estate asset classes that Sternlicht's attention is focused on. The first is office buildings. Here’s Sternlicht talking about how remote work is going to decimate the office market.

"The work-from-home phenomenon is a U.S. phenomenon. If you go to England or Germany—I just, we have some investments offshore and I was just looking at it—rents are up and vacancy rates in the top European property markets: Berlin, Frankfurt, Munich, Hamburg are less than five percent. People are back in the office."

"You and I go to the Middle East, they're full. We have offices in Asia, they're full. So this is a U.S. situation. In the U.S., you have two markets: you have the really nice buildings that are ESG compliant that are lovely, like the one we're sitting in—this place is buzzing and they're back because it's a fun place to be. And if you're in a building with lots of cubicles and it's dark and there's no life and love, so nice buildings—even in the city as currently destitute as San Francisco from an office market perspective, the best buildings are still leased."

"And so you're going to see a bifurcation of the market in office. The nice buildings will stay rented, and my guess is at pretty good rates, and the B and C stuff is going to be maybe fields of grain or something. You'll be very pretty. We'll have all these little mid-block parks in New York City because there won't be anything else to do with those buildings, and nobody will care about them because there's no hope."

"Some of the cities that have issues on commuting, like New York or L.A.—Downtown L.A., Downtown San Francisco—the cities that are difficult to commute to, that's where the pressure's so hard from workers saying 'I don’t want to drive into the city an hour and a half and drive home an hour and a half every day.'"

"But I also think a nice little recession will clear this, and you'll see people come back to the office. And I was in your town—take the Amazon HQ2—they're expecting people in those offices four days a week come the fall."

So the other thing about office, David, is AI. "AI is going to hit a couple of these industries that have been big users of office space. The vast majority of office workers do not want to be in an office five days a week. This is having devastating effects on the office market as companies simply don't need as much space as they once did."

The situation is so dire that many of these office buildings, once filled with workers, are going to be completely vacant with no alternative but to be torn down. Take San Francisco as an example. We can see in this chart here that vacancy rates are at nearly 30 percent.

This means that 30 percent of all office space in the city is sitting completely empty. Not all office buildings are being impacted the same. Office space is classified in one of three categories depending on things such as the building's age, location, quality, and amenities. An office can be rated A, B, or C class, with A being the best and C being the worst. Demand for high-quality A-Class office space remains high.

Companies that are making their employees come back to the office want to at least make it so their workers have a nice building to work in. The problems in the office market are really concentrated in the C-Class office buildings. These buildings are outdated and located in less desirable areas. The prospects are so grim for C-Class buildings that in many cases, it will be cheaper for the owner to tear down the building than continue to maintain an empty office building.

Another area of the real estate market people are worried about is single-family houses. Starwood, the firm Sternlicht founded, owns over 3,200 single-family houses throughout the country.

"Fair to say he is following what is happening in the housing market closely. You see a recession there because prices are going to come down at some point, or you don't see a recession in housing?"

Sternlicht replied, "I think the housing market's had a very unusual situation where Powell's increase in rates has diminished supply, and people—I'm not sure we've ever had a situation where so many people have locked in their mortgage costs. So right now, people are sticking in their houses, which has diminished the supply of homes for sale."

"I wonder when rates come down, homes will be sold like people will start because the mortgage will no longer be a reason to hold on to the house, and whether that will offset—will probably be an increase in supply as the builders resume a more normal cycle. So maybe the housing market just stagnates for a while, but over time, it's headed up."

Housing affordability in the United States has plunged to near historically low levels. This chart from Goldman Sachs shows a home affordability index dating back more than 25 years. The lower the number, the less affordable it is for the average American to buy a house. Metrics like this are a big part of the reason why many people are worried the U.S. housing market is in a bubble.

Home affordability is low for two main reasons. The obvious being that home prices across America have skyrocketed. The median sale price of a house in the U.S. was a staggering 416 thousand dollars in June this year, compared that to 315 thousand in June of 2018.

The rise in home prices only tells part of the story though. A likely even bigger contributor that is putting home ownership out of reach for the average American is the recent increase in interest rates. The average interest rate on the standard 30-year fixed-rate mortgage was 2.65 at the start of 2021. Since then, that interest rate has shot up to as high as seven percent.

This dramatic spike in interest rates has made it much more expensive to purchase a house using a mortgage. Here’s what I mean: as we can see here, a four hundred thousand dollar 30-year mortgage with a two percent interest rate has a payment of one thousand four hundred and seventy-eight dollars. If we keep everything the same but bump up the interest rate to seven percent, our payment skyrockets to two thousand six hundred and sixty-one. The higher interest rate resulted in an 80% increase in the monthly payment despite the loan amount remaining exactly the same.

Based on what we've talked about so far in the video, you would think that these higher interest rates would cause home prices to fall significantly. However, that has not been the case. People who bought houses when interest rates were low suffer from a phenomenon referred to as golden handcuffs.

People are hesitant to list their current property for sale because if they sell their house to buy a new one, they lose the lower interest rate. This is keeping the supply of houses available for sale artificially low. Going back to our earlier example of the supply and demand chart, when supply decreases, it causes prices to continue to increase.

So, in summary, only time will tell what ultimately happens in the real estate market. Sternlicht thinks that the next 12 to 18 months will be a rough time for many people. There may be some good news, however, because Sternlicht has used the phrase "survive till 2025."

This means that if you are able to weather the hurricane until 2025, there may be great opportunities on the other side of this economic storm. So there you have it—make sure to hit that subscribe button because it is my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon.