Finding Stability in the 2023 Rental and Mortgage Market

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This is a podcast episode titled, Finding Stability in the 2023 Rental and Mortgage Market. The summary for this episode is: <p>2023 will be about navigating and mitigating risk in your housing portfolios!</p><p><br></p><p>Our guest today is<a href="" rel="noopener noreferrer" target="_blank"> Josh Woodward</a>, CFO at<a href="" rel="noopener noreferrer" target="_blank"> Lima One Capital</a>,&nbsp; who gives an in-depth look at the forecast for the upcoming year as we delve into the potential risks of recession and inflation and how they may impact the market. How investors should be strategically based on the markets they’re working with, understanding, if it’s moving back down to normal rate levels or the market, is moving upward after a tough end-of-year in 2022.&nbsp;</p><p><br></p><p>Join as we discuss:&nbsp;</p><ul><li>Combating the risk of recession and inflation in housing for 2023</li><li>The supply and demand on housing in 2023</li><li>How the feds raising rates will impact investors</li><li>How Lenders are adjusting their business models in 2023</li><li>The unemployment rate impact on the housing market</li></ul><p><br></p>

Dalton : Welcome to the Real Estate of Things podcast. I'm your host, Dalton Elliot. I'm joined today by the second most handsome guy at Lima One Capital. I'll let you guess who the most handsome guy is. Our CEO, Jeff Tennyson, is climbing mountains in South America right now. He's the third most handsome, but if he were here, I would say he is the first most handsome. Office politics at its finest. Josh, our wonderful chief financial officer, how are you today sir?

Josh: I'm good, Dalton. It's clear you know who pays for this podcast.

Dalton : Bingo. Bingo. Better or worse. No, you're the most handsome. Dashing. I love that hair. Chris White shirt, can't get better. Give us some background. You're CFO, you truly, I've been here close to eight years. In terms of tenure, you've been here longer, but for some reason, I've taken back to one of the first big conferences we went to. You were on stage with a bunch of other CEOs and CFOs, and think you're 10 or 20 years younger than most of the in your seat. Truly impressive. You've led the firm through so much growth through also some, I don't know if we call it a little bit of crisis, when COVID hit, capital markets dried up, you kept the ship running from a numbers perspective, which is the most important perspective. You really are one of the trailblazers in this space. Give us some background on how you got to where you are in the CFO role.

Josh: Yeah, sure. I started in banking and mortgage finance literally when I was in high school. I know it still looks like I'm in high school, but I actually started in this general space that long ago. I was at Bank of America about 11 years ago, and then I moved here to Lima one. I'm telling you, it's been an incredible ride. It's funny because you forget how things were. Certainly the industry's evolved, and there's a lot more availability of financing for our business, which has allowed us to provide more financing to clients. It's just been tremendous to see not only product expansion, but geographic expansion. I'm just really proud of the solutions we've been able to build. We've obviously been fortunate to hire some really great people and built a great company along the way. It's been a little bumpy last year, and obviously 2020, but if you build a company that's nimble and can adapt to any circumstance, then you're going to be able to navigate even difficult waters. That's really what we feel like we've done. That's why we feel like no matter what happens in the future, we don't have to predict the future, we just have to make sure that we do the little things well, and we'll be in a really good position to help grow our business, and help our clients be successful along the way.

Dalton : Yeah, really well said. As we look at 2023, 2020, you had COVID. We as a space and us as a company, a couple months as capital markets were frozen, doing minimal lending. Then we came back with a vengeance, and produced way more than we anticipated, even if you take COVID out. 2021, spectacular year for us. Record year, but rates went up. That was the big theme of 2022. If you could read the tea leaves, what do you think the big story of 2023 is going to be?

Josh: It's an interesting question and one that I know I've wrestled with, as well as my peers and colleagues here. Let's just take and look at what the experts say. I slept at the Holiday Inn Express of Greenville last night. We'll just take a survey of what most of the researchers and economic forecast are predicting. What the general consensus is is what I would describe as okay to potentially slightly negative. Now, this is purely from just a housing market perspective, and I draw that distinction importantly because then if you look a little bit broader, like the total industry projections, and I see a lot more negativity, honestly. You hear a lot more 30, 40, 50, 60% chance of recession. I do think that's a little incongruous and it does make me wonder if maybe we're being a little bit too optimistic with respect to housing industry viewpoints, but these things, we look back where we started 2022, and interest rates for example. I think most people recognize that the quantitative easing of 2020 had come home to roost, and we needed to figure out ways to get inflation under control. People knew rates were going to go up, knew the Fed was going to get involved, knew Fed was going to tighten, but I think people thought, " Well, maybe it's 150, 300 basis points of tightening of Fed funds increase." It was about 400, and it was probably much quicker than people anticipated. The pace was really breathtaking. To answer your question directly, while I say I think things are going to be okay overall from a housing market standpoint, I don't think we should underestimate the firmness and fastness with which we can be wrong. There's a wide range of outcomes, and while the average I think of those outcomes is pretty fine, there's certainly some tails that we should be cautious about and keep in mind.

Dalton : That's a really good kind of box and whisker plot reading of the tea leaves for it. It feels like one of the more honest answers I've gotten as I ask folks in the space, " What do you think?" Yeah, I think one thing though that I keep going back to is when you look at housing, you have a lot of headwinds, but in my mind, one of the stronger pieces is that you still have a true inventory issue. When you look at the great financial crash, '07,'08, we were over- building, and then building just dropped off the edge of the cliff. Up through COVID, it never got back to kind of a normal, healthy level, which means we still have a big deficit, millions of homes have a deficit for where we really need to have a normalized housing economy. How big of a role do you think that's going to play in keeping the bottom from falling out in housing when you look at the scenarios that are more in the worst case bucket?

Josh: I actually have a little bit of a perhaps contrarian viewpoint there. Oh, this is fun, right? We're going to have a discussion. I've said this a lot too, because what you're alluding to is exactly right. There is this extreme underbuilding, the houses constructed versus the new households being formed. I've heard anywhere, in fact, I've said anywhere from four to six million units short of housing. Let's just call it a five million unit housing shortage. Then I think about that. I say, " Okay, well there's over 300 million people in this country. There's little over a hundred million households in this country," so call it 5% of households short. Then I also say, " Wait a second, we're trending towards having less than a million existing homes for sale." We're saying, " Wait, we actually need another 4 million on top of that." What I struggle to reconcile sometimes, okay, well, if we had 5 million homes today available for sale, would those really get absorbed? Even if it was just rental units incrementally, I don't know. I'm not sure. What I'm really saying is I think there's some natural, it's almost like unemployment. You'll never have a hundred percent employment, so you'll never have that" shortage" completely filled. With all that being said, it's still a fundamental supply versus demand problem. That problem, yeah, I would say in 2007, 2008, whatever, it was clearly over supply relative to demand. I don't see that being the same case here. I know that's not necessarily a novel concept, but think about any given market. There's certainly a multitude of factors that you have to consider. What's the net migration into that market? What's the absolute amount of housing transactions, housing demand units that people desire in that market? Well, that's going to ultimately drive housing price in that market. That demand is also going to be linked to things like interest rates, specifically purchase mortgage interest rates. I think it's almost too simple to say that housing market is going to just be good, because there's plenty of demand, and there's not enough supply. Well, both of those things could be true, but if they're true in different places. One market has oversupply, like a lot of California markets, a lot of higher end markets, there's oversupply there. They're seeing decline prices, where other markets where there's net inflow, the opposite is true. There's still not enough houses for people to buy or rent. I'll probably get into a little bit more, but I think that also speaks to how you think about next year, and how you take advantage of what opportunities do present themselves in today's conditions, which is a lot about playing into that belly of the curve versus going after, I'll say, the fringier elements of the housing market. I'll define what I mean by fringier a little bit later too. Anyway, so I was poetic a little bit there, but hopefully that answers your question.

Dalton : No, I like it. It is a different view outlined than other folks I've spoken with on the podcast. You mentioned rates. Let's unpack rates and fees a little bit, because the rate increased pain of 2022 is going to persist into 2023. That's the best guess is that we're going to continue to go up a little bit. How much further up do you see us going, and what impact do you think that's going to have on production and availability in this space?

Josh: Yeah, it's a great question. I'll separate what I'll say are financing rates to borrowers, whether that's investor borrowers or owner/ occupant borrowers, versus the cost of lenders to run their businesses, their cost of funds to go out and lend. Let's tackle that one first. Most of that is going to be driven by Fed funds, target rates, and what effectively banks are borrowing from each other at. Whether you're a bank directly lending your own funds, whether you're a Reid, whether you're a hedge fund, even whether you're just raising capital independently, your cost of capital is going to start with that risk- free rate. You can find that as treasury, you can find that as swaps, but there's that level that with virtually no risk, the risk of US government you can borrow. Let's take two year treasuries. That's been right around 4%. It's a little closer to four and a quarter right now. We'll see how that changes over the year. Let's just say that it stays in this, call it, four a four and a half percent band. I'm not saying that it will yet, but let's just ride with that assumption for a moment. Well, the thing that I don't think people are appreciating enough is that that's really just a starting point. Even if the Fed stops raising rates, which we know they're not, I think the forecast is five to five and a half percent Fed funds rate, well, they're still going to be what's called a credit spread on top of that, which is to say, even if the risk rates are 4% or four and a quarter, four and a half, well, when I go out and make a real estate loan, that's not a risk- free loan. My cost of financing to go make that loan is going to be higher. What could actually happen, and what I think will probably happen soon, we'll see some flattening or at least slowing down of those risky rate increases. Again, remember, we started 2022, and it was basically zero. Now, those risky rates are in the 400-450 basis point rate. That's a precipitous increase. What I don't think we fully appreciate is how much incremental cost has been added because of this perception of extra risk in the housing market today particularly. In other industries as well, we talked earlier about recession forecast, and so none of us business operators get to borrow at that risk- free costs. Then we have to say, " Well, what risk is being prescribed to the businesses that we're running?" For me, I promise I'm going somewhere, so it really wraps back around to what do we think house prices are going to do, and what do we think that market is going to look like, at least specific to our business and real estate lending? If you look at those forecasts, you've got anywhere from five to 10% up in house prices, to five to 10% down in house prices. Again, there's a huge range of outcomes. If on average, we're at 0%, home prices are flat this year, that's okay, and that probably won't cause us to incur a higher risk premium to our borrowing. What is really important is to note is if you start seeing delinquencies move, and we start seeing delinquencies trend up, that's going to keep the cost of funds elevated. I'll spare any more technical rates discussion for now, but truly just that there's the risk- free the Feds fund that everybody sees and hears about, that's probably going up, again, another a hundred basis points at least. Then there's also this risk premium, which could also come in. We could also say, " Hey, things are performing. We don't have really any issues," we start going up. You could have the Fed funds rates go up, the credit spreads come down, and we're flat on rates by the end of the year. Again, so rates for us to borrow, for lenders, for financiers to borrow, but then that will ultimately translate to cost of capital for borrowers as well. That'll get passed through almost one for one in my view.

Dalton : You touched on delinquency, and I know for any lender, that's a massive part of the business, managing delinquencies, loans that you take back, properties you take back. What's the trend been in delinquencies recently? Do you have any thoughts or any predictions for this year? Do you think there's going to be a flood of foreclosures? What do you think?

Josh: Yeah, I'll be honest, I'm not sure. I've seen mixed add on it. I've seen commercial side, your class retail is struggling a bit more. Seven, eight, 10 percentage. By the way, it's important to find what delinquency, is it 60 days past due? Is it in foreclosure specialty service? I'll just say kind of 60 day past due rates all the way up, of course, through special service and foreclosure. I haven't seen as much distress in housing in terms of those delinquency metrics, at least not in what I've seen in NDA production information. There has been more murmuring about more foreclosures coming through. Perhaps that's a canary in the coal mine. On the business purpose lending space specifically, yeah. There really hasn't been any, and maybe that is also a testament to just the operators in this space, and how quickly they're able to adjust and understand what's going on locally, and adjust their business model accordingly. As we're going forward. I'll tie it right back in to home prices, but not just the pure number. We could have 0% home price appreciation next year, but if you have down 20% in the first six months, and 20% up in the last six months, you're still at 0% on average. That's obviously a big difference in scenarios, versus just a flat 0%. I think the timing and the pace of house price changes is really important. Again, in this business purpose lending, construction, rehab, lending, value add lending space, that's going to really tell the tale of how well our operators are able to navigate, and again, address their business models. I will just note on inflation, these things aren't free. We seem like it's some just thing happening, but it's really increasing the costs of projects, and it's really making the numbers harder. All the inputs, labor, materials, those have gone up. Because those have gone up, it's harder to make the numbers work. I think there's some other reasons that you're seeing investor purchases declined by 30%. It's not just purely a function of rates going up and that cost increasing, but literally just the projects themselves don't make as much sense as they did a year ago.

Dalton : Yeah, especially on the short term side of the fence. Even, right, you have rates up, and rents have continued to grow. I think I've seen the estimates on rent rate increases for 2023 have pulled back some. Thinking back even three, four months ago, I think estimates were six, 7%. You would see some wild estimates at 10%, but it seems like most of them were at six 7%, and now it's pulled back to the three 4% range, which is healthy. Nothing to scoff at, but certainly a normalization and a pulling back from the last couple years where you've just had insane rent rate increases. Go ahead.

Josh: Well, yeah, no. In a lot of ways, my personal view is that that's super healthy. We need that, it's unsustainable. Affordability is at a fever pitch, not even just for buying houses, but renting houses as well. Again, back to supply and demand, there's only so much demand when you've got to pay 35, 40% of your income to be able to buy a house or rent a house. The rent is an important point too. I think that's going to be especially tied into what happens with unemployment. Unemployment, it's been very strong, in that we're almost at full employment, and we just haven't really seen that retrace at all. There's been some more tech, you started to hear a little bit more tech, Silicon Valley, those types of layoffs. I think that's going to be key as well, especially with respect to the rental business and how that functions going forward. To some extent, the Feds told us that for inflation to really come down and get closer to that 2% target. We're at 7% now. For us to get closer to 2%, unemployment has to go up that. It's counterintuitive in some ways, but I just don't see a world where those two things can be true, that you're at a 2% inflation rate and unemployment is still at 3. 5%. That's just mathematically difficult. When that unemployment does start to creep up, I think consensus estimates are somewhere in the 5% range. 2% doesn't sound like a lot, but when you really think about the magnitude of that, I do have concerns. That could cause some ripple effects in both owner occupied and rental housing. That's something that I'm keeping an eye on as well.

Dalton : Yeah, I was reading last night just some estimates and guesses about knowing that unemployment has to rise and normalize. You and I were talking before this started that you were probably introduced to this concept the same time I was, which was early on in college in economics classes, that 0% unemployment is not healthy. Then there's no mobility to go down the line. We could talk about Adam Smith and everybody else, but we'll save that for another podcast.

Josh: You might have people unsubscribing as we speak on that one.

Dalton : Precipitous unsubscribing. It'll just be just like the unemployment rate.

Josh: Yeah, yeah. I know. I might be killing subscribers myself here, but we'll keep trying.

Dalton : Well yeah, that three, four, 5% rate, and one thing that I found interesting is I saw a lot of talk about who it hits being different. You mentioned tech layoffs. You've seen it hitting higher paying jobs. Whenever you look back to'07,'08, you had finance just demolished, that more so than any other space. Then you had kind of the retail, more of the frontline workers being laid off. Looking at estimates for this year, and as we know that most likely, unemployment's going to take up and that's healthy, the consensus I was reading was that white collar workers are going to be, and that's a term that was used, white collar workers, the more traditional...

Josh: I'll literally have a white collar on. I'm literally wearing a white collar. Is that what this is about?

Dalton : I have some news for you, Josh. I'm going to be okay. You, on the other hand, for anybody listening, I have a green collar on. Josh has a white collar on. Inaudible this conversation, but my prospects are looking good. No, that's what is going to be hit. Some of the logic behind it was that the shortage you've had, and for our operators, partners in the space, folks who are working with us on the fix and flip, new construction, multi- family, rental fronts, they've had the last couple years, a really tough time with labor, not only finding labor, but the compensation has gone up. That cuts into margins. What I've read and how it seems to tie into our space is that the manual labor jobs and the more blue collar jobs, employers are really going to try to hang onto those folks knowing how hard it has been to fill those spots, and that those jobs are generally, you can't shift over that work to somebody else and have the same outcome. You need boots on the ground to build homes, to fix up. Seeing that potentially the hits are going to be more in the white collar side of the fence, how do you think from an operator's standpoint, when I try to put myself in their shoes, a lot of the homes, our average loan and then after repair value, so the average sales price for a property that we lend on is probably somewhere in the three to 500 range? That's probably the band. How do you think that the creeping up unemployment is going to affect operators, like the average operator in this space, for a new construction or rehab project?

Josh: Yeah, it's a fascinating dynamic between the white collar, and I'll say, more of the blue collar workforce. I don't see a lot of changing of demand for construction without material continued sustained high interest rates. The reason is, we've seen it in our lending practice, construction costs have come in some, material costs have come in some, but labor remains stubborn. As long as there are houses that need to be built, at least the current levels, then there's not today, more people coming into that workforce. I think there's a big time labor supply constraint with respect to construction. That goes back to the math equation I was talking about earlier, where if you're an operator and you're trying to do a project, the numbers just get tighter and tighter, because you're paying 10, 15, 20% more for labor. Maybe materials are only 10% more, but that starts to add up. Oh, by the way, now in your model, you've got to say, " Well, I think the house is worth 400,000, but maybe it's only worth 350 or 300 because of factors that I can't necessarily control." That's why, one of the several reasons why I think you see investor purchases of real estate going down. I think Adam put out a statistic that said it was 30%, investor purchases are down 30%. That's where you really see it manifest. Then a little bit maybe of a knock on, but with respect to the higher paying jobs, the white collar jobs, if those do go away, I think it really challenges, I'll call it the luxury or higher end market. We're already seeing some of this, where luxury home prices are going down at a pretty rapid clip, 20 to 30% in some markets. I talked about fringier places earlier where maybe you want to be a little bit more cautious. If you're a luxury spec builder right now, that's a place where you've got to put even more cushion in your model for labor and materials, but then also some of those potential home price decreases. Of course, it's all local and every project's specific, but I'm speaking in broad generalizations here. I think that surveys and addresses some of the questions and issues you brought up, but there's unfortunately no real easy solution or one straight answer to it. I think it's just a combination of factors that have to be evaluated on each deal.

Dalton : For sure. Yeah, super local. You and I were in credit review committee yesterday, and the Austin market came up. That's a market that's had the most, at least from a headline perspective, the most notable market in terms of growth the last couple years, 35 or so percent growth, which is just absolutely wild. Subsequently, that market is seeing one of the more precipitous normalizations, I would call it. I struggle to call it a drop off, because the levels that it seems like it's going to normalize to or level off to still outpaces what normal appreciation would've been the last couple years. I think you have to take a global perspective when you look at housing and say, " Sure, housing, some markets are going to come back and cool off," but even if you see a little bit of negative growth there, if you look at a 24, 36 month window, still well above where you would normally expect home prices to appreciate over those few years. I think that's something super important to keep in mind as well. As we...

Josh: A hundred percent.

Dalton : Yeah. As we look to wrap up, what else is on your radar for this year for operators, from a lending perspective? Any markets that excite you? I'll just open it up to you. What's kicking around in the brain?,

Josh: How much time you got? Oh yeah, that could take a while. No, I'll put it this way. It's hard to paint with a broad brush. You get this question a good bit about what markets are good, what markets are bad? Of course, you can say, " All right, well, there's certain states, Texas, Arizona, Florida, North Carolina, South Carolina, Georgia," like mathematically, definitively they have net migration. Theoretically, more demand for housing. Not even theoretically, actually more demand for house. There's other states, New York, California, Massachusetts, net departure, so less demand. Again, if you're trying to just paint with a broad brush and say, " What are the places where I want more or less exposure to housing?" Those are probably some states that you would want to pay attention to. The reality is, very few of us operate at a state level or even a MSA or city level. We're dealing in neighborhoods and zip codes and things like that. The way I think about it, if I'm buying a house, the potential change in pricing for that market is a factor. What's more of a factor is am I buying that right? What are my inputs on materials and labor? What are the immediate comps in that area? What have they looked like over the last six to 12 months? I mentioned earlier fringier products and projects. I think there's just certain projects that it's harder to line up all those variables. Build to rent's one that, when it works, it's great, but it's just hard to get all the stars to align because you got to buy the land ride, and you got to make sure you got the demand there in terms of net new rental demand. You're not just competing against the apartment complex, you're also competing against the option to buy. You've got to strike that balance between being affordable enough that you're better off renting, but making sure that you can hit your operational numbers. Yeah. I talk about luxury. Those can be home runs, and those can also be really hard houses to sell that take a long time. For me, as I put my investor hat on or put myself into the shoes of our clients, I think about, how do I do projects that are just right in the belly of the curve? Available for a single,, first time home buyer all the way to the person who's downsizing. That just gives you up and downstream receptivity. Again, that price is going to be different for each market, but we're really talking about the central infill type development housing that's in the highest demand, again, that's in that belly of the curve. Then on the rental side, that would be more of your Class B apartment complexes. I really like taking a Class C, doing value add. Not only does that create more better units, but you've got your Class A tenants, who, let's say they lose their job or they take a pay, whatever, they can always come down. Then that Class B is really where kind of 60 to 70% of the demand is anyways. I just think those are the places that you really want to target as an investor and as a lender, and really as anyone who's trying to put some chips out in the housing market.

Dalton : Yeah. Not the time, or at least it doesn't seem like now's the time to be real risky and frisky. Crunch numbers a little more deeply, have more conservative estimates, know that, was it past performance is not indicative of...

Josh: Yeah, well what did they say, fortune favors the bold? Yeah, that might be true, but I would suggest that now is a good time to make sure you got just a little extra margin in your deals. You're buying it even more right than before. You're really making sure that you got some excess spread between your costs and your expected sales price. Also, you got extra liquidity, because we didn't talk a lot about time to sell, but we are starting to see time to sell stretch. It's not just that you only have five potential buyers instead of 10, it's taken a hundred days to sell instead of 60. That's something that is also important to be cognizant of.

Dalton : Yeah, really good call out. I may be the most handsome person in the company, but I think you're the smartest person in the company, so we could sit here all day. I have a million questions, but thank you for carving out some time and chatting with me through this. I really, really appreciate it. I always benefit greatly listening to you and going back and forth picking your brain. I certainly know the audience will as well. Thank you very much, Josh. I really appreciate it.

Josh: Well, I love it. I appreciate you. Thanks, everybody, for listening and really enjoyed being on today. We'll talk again soon.

Dalton : Beautiful. Thanks again, everybody. Take care.


2023 will be about navigating and mitigating risk in your housing portfolios!

Our guest today is Josh Woodward, CFO at Lima One Capital,  who gives an in-depth look at the forecast for the upcoming year as we delve into the potential risks of recession and inflation and how they may impact the market. How investors should be strategically based on the markets they’re working with, understanding, if it’s moving back down to normal rate levels or the market, is moving upward after a tough end-of-year in 2022. 

Join as we discuss: 

  • Combating the risk of recession and inflation in housing for 2023
  • The supply and demand on housing in 2023
  • How the feds raising rates will impact investors
  • How Lenders are adjusting their business models in 2023
  • The unemployment rate impact on the housing market