Take Five – Q&A with our CIO

Is now a good time to invest in the front-end of the yield curve? This five-minute Q&A with Merganser’s CIO, Andy Smock, discusses just that. Andy shares a few thoughts on the dramatic year thus far for fixed income markets, how relative value has shifted and a look forward over the next twelve months. He also provides some insight into the current macro backdrop and the Fed’s path for monetary policy in light of inflation and employment trends.

Transcript

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Jeffrey Addis:

Welcome to our podcast. My name is Jeffrey Addis. I'm the Chief Operating Officer of Merganser Capital Management. Before we begin, a few important regulatory disclosures. This presentation is for informational purposes only and should not be considered as an investment advice or a recommendation of any particular issuer, security, strategy or investment product. Now, on to our podcast.

David Fishman:

Hi, this is David Fishman from the Structured Products team at Merganser and I'm here with Eric Draeger from Berkshire Residential. I can't believe it, but we've known each other for 20 years now.

Eric Draeger:

Wow.

David Fishman:

Today we're here to discuss the multifamily market for our community of fixed income investors. Here at Merganser, multifamily makes up by far the largest part of our commercial mortgage portfolio, with over one-third of our exposure backed by multifamily housing, which we view as a stable asset class. That is twice the level of any other sector. Our multifamily exposure includes agency multifamily, non-agency multifamily, and single family rentals. Before we go any further, Eric, would you please tell us about your background?

Eric Draeger:

Happy to. Thank you. And I didn't realize we'd known each other 20 years. I feel older than I did. I got into multifamily by accident in 1994 when I was working for a law firm, before law school. Decided not to go to law school when they put me into the finance department and I began financing their multifamily assets and buying them. At which point, I didn't know what a cap rate was or a rent role. I learned it pretty quick.

Following that, I went to join Berkshire Mortgage, so a predecessor firm to our current role, which I worked there, culminated as the Chief Credit Officer at the time of the sale to Deutsche Bank in 2004. From 2004 to 2010, I was transitioned to Deutsche Bank where I worked at a combination of roles, all multifamily related, before returning to Berkshire in 2010 to start first the debt origination in debt investment group, and then now I'm the CIO.

David Fishman:

Terrific. It's great to see the progress in your career. Can you give our fixed income audience a quick elevator pitch of who Berkshire is, where your capital comes from, and what makes your shop unique?

Eric Draeger:

Berkshire is a vertically integrated multifamily investment manager, so what that really means is that we do everything soup to nuts. We buy assets, renovate them and manage them, lease them ourselves, do the renovations ourselves, and then sell on the equity side of the business. That business currently owns about 35,000 units. I never get it exactly right, nationally, in about 25 of the top markets, with a pretty heavy concentration in both Texas and the rest of the Sunbelt.

On the debt side of the business, which is about half of our business as well, we invest in multifamily securities, much like you, only backed by multifamily assets that we don't play outside of our food group. And we also have a lending brand, MF1, which makes bridge loans to people that look and feel like me, that buy assets and renovate them and or need them for lease up. We started that business in 2018 in conjunction with Limekiln Real Estate, and since that date< we've done about $10 billion origination. Our current AUM is about $25 billion. That's roughly evenly split between debt and equity investments. Our investors run the gamut, and we run both open and closed end funds.

David Fishman:

It's really interesting to talk to Berkshire because of their presence in markets and debt and equity across the country. I follow the REITs, I look at their earnings. Each one tends to have their niche, but Berkshire really sees the entire landscape. Can you tell us what you're seeing out there right now?

Eric Draeger:

On a broad basis, all the underlying fundamentals are still pretty solid, regardless of what you see in the press. I think the September numbers were just released nationally, and rents went up just under 10% nationally. The bigger market's probably a little bit above that and the smaller markets a little below that. That is down from what we had been seeing post-Covid. So we had a Covid shutdown down, which really lasted about three months. Thereafter, we've seen, across the country, surprisingly strong rent growth in the neighborhood of high teens to mid 20%, which with operating leverage at about 35% typically, means your NOIs are going up anywhere from right now low to mid-teens to mid-20s to 30s during the height of Covid in some areas.

We are seeing a slowdown in occupancies, so we reached national peak of about 97% in the institutional side. That's probably coming down closer to 96%, and will trend down, I would think over time, back to long-term averages, which are more 94% to 95%. As you see in the run-up in costs, you are going to see household formation slow. One nice thing about multifamily, and single family for that matter, is it's relatively easy to predict demand. We know how many people need a roof, just a question of how many of them choose to rent and how many choose to own, and that number doesn't really fluctuate that much. So we've got a pretty good idea of what our demand will be for the next three or four years, notwithstanding what immigration does.

David Fishman:

Thank you for that perspective. You mentioned Covid a few times and the shock to the system that apartments experienced, and there was a giant eviction wave that many feared during Covid, which never occurred. Is that likely to change with the recession that's being priced into markets for 2023?

Eric Draeger:

I really don't think so. I think what you saw both during Covid, and then if you look back at the prior recessions, people's propensity to pay rent is strong. If you really think about the way people allocate their cash when they have a job or even unemployment, it's first food and then probably shelter second. So people will tend to pay money to keep their rent going. During Covid, we did have some interesting changes where you did have both rental assistance come into play pretty quickly, and that you also had eviction moratoriums that generally lapsed. The one current outstanding is really still LA, which has a restriction in place to last until the start of next year. But most of the rest of America has caught up. But even with that, we really didn't see the rent delinquency we expected. I mean, no one had been through anything like this, so we really didn't know what to expect.

I personally predicted much worse collections than we saw, and we really just didn't see it. In fact, we saw the opposite. We saw rents really improve, and as people were able to move and relocate for jobs, you saw a big exodus from the northeast and the west coast to Arizona, Texas, Florida, and the Carolinas, Georgia. That probably is slowing now, it appears to be out of the northeast at least. And the data's still coming out of the west, but I think the same is showing there.

But we saw occupancies move pretty dramatically up, and rent's the same. So really, the opposite of what we expected. I would expect the same this time, although I wouldn't expect you'd see the same occupancy and rent changes.

David Fishman:

Yeah, we also consider it to be a stable asset class, and we're really happy to see that that eviction wave never occurred. But thinking back to the last recession, the post-global financial crisis, delinquency and loss rates in multifamily far outperformed other sectors. Do you expect the same again in this cycle, or have values run too far or bond yields climb too high to avoid larger losses this time around?

Eric Draeger:

I think it's probably too early to tell on the second half. You have seen absolutely a much different backdrop to what's happening in the market versus what we've seen historically. Historically, almost all the recessionary pressures were started by some sort of housing supply demand imbalance, and here we have the opposite. We have a supply demand imbalance, but we just don't have enough supply, we have a lot of demand. With that, we have seen obviously higher valuations given by higher rents, but we're seeing cap rates stay relatively stable. They have moved up for sure, but not dramatically so you're not seeing major valuation changes.

And you've seen such run [inaudible 00:07:25] lies over the last three to four years that most people should be generally in pretty good shape on the bottom line. And you also haven't seen the leverage this cycle as you saw historically. If you look at multifamily, has one huge advantage on the liquidity side. Fannie and Freddie are always there, HUD to some extent as well. But so you have government backing for that, and most people tend to be a little more conservative than the leverage, as a result, by going to the agencies. So I think you'll still see the same type of performance, but maybe in a different area.

David Fishman:

Thank you. It's reassuring. Can you talk about how the change is afoot with inflation and bond yields that you referenced? It starts at the residential mortgage market, and then bleeds over into lending conditions in the multifamily market. How is that playing out this time around?

Eric Draeger:

It's exactly what does happen, so you hit it on the head. We're not seeing the change from rent to own. So if you look at both rents, as I talked about, have gone up even, of course recently, 10% year over year, that's not much when compared to the cost of housing. I think Fannie Mae released today is still about 11%, 10.7% I believe, year over year housing cost increase. But you'll see mortgage rates go from 3% to &. So if you kind of add those two things together, your mortgage cost increase at an 80% mortgage is about 158%. So rent looks pretty good relative to that. But you are getting an affordability question, so housing prices will likely come down. But again, with that mortgage rate, it really doesn't make it economical to switch from rent to ownership. We're not seeing the opposite, so we're not seeing people come out of single family into rent, and I believe that's probably driven by the fact that a lot of those people do have 3% mortgages, so there's really no impetus to sell, and there really is no credit issues.

Jobs are still running strong, wages are strong, and long-term fixed rate mortgages are relatively attractive historically. The same is supply in the multifamily side. Everything is indexed off either the 10-year treasury or LIBOR primarily, or sorry, SOFR today. With that, we've seen, obviously, SOFR go from almost zero to about four. That's passed through directly to sponsors. And spreads have gone, on the agency side, are up, but they're not up dramatically, so you haven't seen quite the same change on the spread side. On the bond capital market side, we have seen spreads gap out. So you've seen rates go from someplace in the neighborhood of 3% to 4% for long-term fixed rate, to now someplace in the neighborhood of 6`% to 7%, and floating rate have probably gone from 2% to 3% to someplace in the 7% and up. So, pretty dramatic.

David Fishman:

It's quite a change in just a few months. What has that meant for the competitive landscape as you look to originate mortgage product, and has this translated to better structure and pricing for lenders? I'm guessing that there are less active lenders in the market today?

Eric Draeger:

Yeah, it seems like it. I mean, it's hard to really get a sense for that, but it does seem like there are less players. And I think some of that's also, the demand for mortgages clearly goes down as rates go up. Multifamily does stay pretty stable though. The biggest lenders are going to be Fannie and Freddie. So when you look at that, the market share is going to be pretty consistently around 40%. It might go a little bit higher as rates move and their cost of capital is a less than everybody else's. But you are going to get better structures, you're going to get lower loan-to-values. Again, rates are going up faster than cap rates, so your loan-to-value and leverage is just going down as a result. With that, you can get, frankly, probably better credit at the end of the day, but it's going to be a tougher field to play with.

David Fishman:

Eric, do you have an outlook for Class A versus Class B versus Class C multifamily, and how those might perform relative to each other?

Eric Draeger:

I do, and it's different than I've historically said. Actually right now, all are really moving together with potentially in the last couple years, Class C actually outperforming it. I think there's a couple reasons for that. Rental assistance was important. I think raising minimum wages mattered a lot, and there were relocation into generally cheaper areas where you could charge more rent as a result. That probably is coming to slow down, so I think you might see more consistency across the board.

With Class A, you do have the coastal effect. A lot of Class A tends to be in nicer areas, brand new in the south and/or in urban areas. So with return to work, you've seen some pickup there. But I do think all are generally have a good niche. We don't really see supply concerns anywhere. I think the one place you probably have supply concerns is in the Class C. They're not building it, no one will build it, so you're always going to run into just probably higher occupancies, but a tendency to have probably assets that cost a little more to maintain.

David Fishman:

Talk a little bit about the population moving from some of the larger coastal northeast or even west coast cities to some of the smaller places in the Sun Belt. Are you seeing any other broad trends geographically?

Eric Draeger:

No. We saw that the start of Covid really did show the northeast relocation to, really, call it Miami to West Palm, really moved rents, really moved occupancies. And obviously, single family home prices moved dramatically as well. And then you saw the West Coast relocation to Phoenix, Boise, Salt Lake City and Las Vegas. We've seen the pace of change in that slow, but we've not seen it change.

So in other words, we expect that to continue, and you're seeing it as you look at data, you are seeing consistent but not as fast at relocation. We do think that household formations will probably slow, and they have so far as just out of affordability, which will change some of the, and you'll also see people double up. You'll see less trade out from two people in a house or two people in an apartment to one each. So I think you'll see the formation slow and that should slow the demographic switches, geography as well.

David Fishman:

What about any trends by the size of asset or the type of owner? Do you see the public names being stronger hands than the small regional private names?

Eric Draeger:

I think the more well capitalized and less leveraged buyer is much more positioned today to succeed. So if you look back a year or two when you had relatively low rates and readily available capital, and skyrocketed analyze, the levered buyer had a huge advantage over the unlevered buyer. That has shifted. When you go in today, that someone who takes moderate leverage, which I would categorize as anywhere from 40% to 65%, 70%, rather than 70% and higher, has a huge cost of capital advantage today.

So I think that's where you're seeing more of the trades happen. So you're seeing less of the small assets that tended to attract the lever buyer, and more of the more core or core-like assets, or larger assets in major metros, which are catering to that buyer base that doesn't need the leverage.

David Fishman:

Well, that's reassuring to hear that it still is all about location, location, location in real estates.

Eric Draeger:

It always is.

David Fishman:

Some things never change. Different cycles, different stories, but that lesson has always remained. So, I want to thank you, Eric, for taking the time to do this with us. Yeah, it's been interesting conversation today. Appreciate the friendship and being able to check in with you at any time on multifamily.

Eric Draeger:

Anytime. Always a pleasure to talk. See you soon.

Jeffrey Addis:

This commentary contained or incorporated by reference certain forward-looking statements which are based on various assumptions, some of which are beyond our control. Opinions and estimates offered constitute our judgment and are subject to change without notice, as our statements of financial market trends, which are based on current market conditions. No part of this presentation may be reproduced in any form or referred to in any other publication without the express written permission of Merganser Capital Management. For more information, please visit our website at www.merganser.com. Thank you.