October 1, 2022
Will There be a Recession?
Last week the Fed raised its benchmark interest rate by 75 basis points. This is the fifth rate hike this year and the third consecutive 75 bp rate hike in an effort to tame inflation, which is near a 40‐year high.
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The Fed’s efforts to cool strong demand coming out of the pandemic lockdowns and trillions of dollars of fiscal stimulus appear to be paying off, as reflected in the August jobs report. The central question on most investors’ minds is can the Fed steer the economy to a soft landing and avoid a recession. If historical precedent is any indication, you can see why the mood of the stock market has been largely pessimistic this week.
We expect the likelihood of a recession to be high over the next 12‐18 months (inverted yield curves are highly reliable forward indicators), but we are optimistic about the prospects for a relatively robust recovery thereafter due to several factors: a tight U.S. labor market, relatively healthy financial sector and growing trend of onshoring manufacturing.
Rising interest rates have had a significant impact on value‐added real estate investments. Putting aside the demand side implications described above, every 1% rise in interest rates reduces loan proceeds by about 10 to 15%. This has forced many value‐added investors who were reliant on 70%+ bridge financing to sit on the sidelines right now, as that source of debt financing has all but dried up in the last few months. For well‐capitalized investors like Paladin who don’t rely on high leverage, this creates opportunity.
Paladin has always favored conservative levels of fixed rate financing with loan durations that match our business plans. Consequently, our existing investments have been relatively well insulated from the recent rate hikes. Due to the specific type of investments we target (i.e., Class B/C apartments with current rents 30% below market, subject to AB1482 rent control), inflation has provided more of a tailwind to our strategy than a headwind. Going forward, we will continue to assume increased debt costs, lower leverage and higher exit capitalization rates in underwriting new investments. For existing investments, we continually monitor market rents and renter traffic for potential indications of softening demand, and will adjust our renovation strategies accordingly.
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