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A Flight to Safety As we come into the summer heat of Texas, real estate operators are gauging whether or not the market is going to cool off. Many companies have pulled back, many have pressed on the gas, and many have taken a wait and see approach. Meanwhile, investors have one thing on their minds : A Flight To Safety. Rule number one of investing is, "Don't Lose Money." Rule number two of investing is, "Don't forget about rule number one." In the midst of inflation, interest rates rising, political unrest, and supply-chain bottlenecks, investors are asking the question, where do I put my money?
Inflation Many middle-class Americans are starting to really feel the effects of inflation. The latest consumer price index (CPI) figures, which measure a broad range of goods and services, has shown an annual rate of inflation at 8.3%, which is a level unseen since the 1980s. Used cars cost 40.5% more than last year and gas prices have topped $5 a gallon which is more than double what consumers were paying 2 years ago during the pandemic. As we unpack the true source of inflation, we have looked to The Federal Reserve System. Since February of 2020, the federal reserve has increased M2 (which is a measure of the money supply that includes cash, checking deposits, and easily convertible near money) by 41.2%. Clearly the Fed has overcooked it.
We do not endorse the Notorious B.I.G. here at Patmos, but Mo Money Mo Problems is a principal that can be applied based off of what we've learned from the Fed. When an increase in money circulating the economy is higher than the increase in goods produced, there is more money chasing not as many goods, which causes inflation.
Supply Chain: We should also speak to the supply chain shortages and political unrest. Shout out to my son, Brady. I love him, but I don't love searching for baby formula for 4 hours on my Saturday afternoons. Even through early in the pandemic, consumer demand dropped as people hunkered down, but ecommerce goods started to soar. Demand for products significantly outstripped the market's capacity to produce or ship what was ordered. Supply of products has in large part been constrained because global supply chains have not healed from lockdowns. Labor is also a large piece of the puzzle. In the U.S., we have 4.6 million more job openings than workers to fill them. We are for the government providing subsidies for people who have a temporary need, but the government is meant to be a trampoline, not a hammock. Until there is policy that fosters an environment to work, we will continue to have supply chain shortages which will keep inflation at an undesirable level. Many studies have also shown that political instability contribute to inflation volatility. This is especially applicable for countries with central banks that have limited independence from the larger political system. Russia is a major supplier of oil, gas, metals, wheat, and corn. The Ukraine-Russia region is responsible for roughly 30% of the global exports of wheat, 65% of sunflower, and 14% of the world's total supply of oil and gas. Their invasion of Ukraine has no doubt caused a global ripple effect that has driven up prices of goods. There is also another unappreciated risk to global supply chain. China has recently imposed restrictions and tariffs on many commodities such as steal, fertilizer, and pork. All of these foreign and domestic policies have had a tremendous impact on inflation. The debt markets are the other key factor we are having discussions on daily. The current Fed funds rate is up to 1% and is projected to be at 1.90% by the end of the year.
The fed funds rate is the overnight rate at which banks lend to each other. This is a rate set by the Federal Open Market Committee (FOMC) and it is a measurement of where interest rates are and where they are going. Interest rates are one of the main drivers of asset prices and we have already seen an adjustment in public and private asset prices. The Nasdaq is down 23% to date, the S&P is down 13%, and the Dow is down 9%. Private markets are harder to gauge, but we have seen pricing adjustments for real estate go down 5-10% from earlier in the year when the funds rate was near zero. The question is, how long is the fed willing let asset prices fall? They have often used the same playbook over the last few decades. In January of this year, Jerome Powell was asked if quantitative easing would become routine. Powell's response was that in any recessionary environment, the Fed would consider cutting rates first, then asset purchases. Patmos does not have a crystal ball on what interest rates will do, but we do have a reason to believe the Fed will cut rates when we go into a recession. Notice I said when, not if. Recessions are inevitable. They are part of economic cycles and investors who don't overpay and don't over leverage are the ones who survive. As Warren Buffet likes to say, "Only when the tide goes out do you discover who's been swimming naked." Whether we are on the brink of a recession or not, we do believe the Fed can't afford to keep raising rates at such an aggressive pace. They have a much harder job than me, but the Fed needs to look more at solving the supply chain and labor issues in this country more than anything. If the Fed were a doctor, I think they have misdiagnosed the patient and are giving the wrong medicine. Interest rate hikes don't solve supply chain issues.
Call To Action: In a world faced with uncertainty, the temptation is to always fall back on what has worked in the past, but past performance is not always an indicator of future results. Many portfolio managers have long been pushing a traditional construct of 60/40 portfolio of stocks to bonds to deliver an attractive risk-adjusted return in any environment. As our company looks ahead, all our research suggests we are entering into a new environment for investing. Looking ahead, we do believe a thoughtful portfolio construction should involve enhancing the equity component with asset classes that are more likely to appreciate in an inflationary environment. Alternative investments, specifically real estate and private infrastructure (Energy, Transport & Logistics, & Utilities), provide a hedge against inflation that is not provided in public markets. At Patmos, we are biased towards real estate and have seen a tremendous amount of investors seek safety through investing specifically in Multifamily housing. Multifamily performance is comprised of two main components: value appreciation and recurring cash flows. All else being equal, property values should appreciate with inflation. Rents go up with inflation, and values go with it. Another factor is construction cost. When inflation continues, construction costs rise with it and causes uncertainty with real estate developers trying to build new product. Many investors have also asked about stagflation. Stagflation is characterized by slow economic growth and relatively high unemployment accompanied by rising prices or inflation. This is a possibility in the future, but that's why we are focused on markets with a high amount of economic growth. Dallas-Fort Worth continues to add jobs at a clip of over 100,000 jobs per year. I will save my DFW pitch for another date, but our market is one of the most pro-business, pro-growth, and politically friendly environments in the country and corporations are flocking to relocate. Investing always goes back to fundamentals. The fundamentals of multifamily real estate are still extremely strong. Rent growth is at an all time high, occupancies are 97-98% across the country, demographics are continuing to have a renters first mindset, housing prices are through the roof, and it's very hard to build right now (No offense to my developer friends). Multifamily is a flight to safety right now. The asset class has continued to perform year after year and is becoming one of the safest investments you can make, especially in our current environment. There has been a robust amount of institutional capital (a lot smarter than me) flock to Multifamily even within the last few months. The 2022 Pension Real Estate Association Survey found that 31% of planned capital deployments by institutions this year are targeting multifamily. Our current portfolio is seeing new lease trade-outs of a 25-30% increase from last year and we are seeing around 12-15% lease trade-outs on renewals. We do not project those trade-outs to continue at that pace, but when your top line revenue is increasing at that clip, interest rates and expense inflation doesn't poke enough holes into the asset class. Our portfolio is also benefiting from a lack of new supply in DFW. Before Covid, DFW was usually on pace to deliver around 25,000 to 30,000 apartment units per year. During the pandemic, DFW saw 44% less apartment supply than in 2019. That has had a dramatic impact on rents over the past 2 years as there has continued to be a shortage of housing. We also try our best to buy in pockets that are harder to build in and usually feel great about buying at 50-60% of replacement cost, which is just how much it would cost to build the asset. It is important to keep a perspective with all of this information. It is a good data point, but it isn't everything. High quality businesses are built by high quality people. Our goal at Patmos is to build a business with a world class culture that will thrive no matter what cycle we are in. I'm constantly reminded by my friends and coworkers that who you are when no one is looking, is alone who you are. It's no secret that we are a young company and we are young in age, but I can promise you one thing: we will do things the right way. Age isn't always everything with investing. Yes, you have more data points, but sometimes age can be an advantage. We have more to lose. If we bankrupt investors, it's a whole lot harder for us to come back from that. Reputation is everything in business. We are forced to sweat the details and become an expert at our craft. I'd be very well off if a had a dollar every time an investor told me to buzz off because I'm not old enough to have worked through a real downturn. Patmos will never be about timing the market. Patmos will always be about people, culture, fundamentals, and risk-adjusted returns. Buckle up. Your flight to safety has arrived.
