Summary: It will get super awkward if the labor market holds up too well while the CRE market starts to go into a too-visible tailspin. The Fed will have to cut rates. The Fed won’t want to look like it is riding to save the fat cats. But it will have to act before any tailspin gets out of control.
There is consternation about why markets keep predicting relatively early and rapid Fed rate cuts. The analysis usually centers on when/how the labor market cracks. But what if the market is predicting the Fed will cut rates to save the Commercial Real Estate market (and the banks that depend on it)? Just some musings. I am no Real Estate expert.
Having established in my last post that (gasp) inflation has a political angle, we can talk about the political elephants in the room.
The politics of inflation boils down to Labor vs. Property. “Property” decomposes to Real Estate + attached financial supports – Banks and other financing entities.
It is often said the Fed raises rates until something breaks. Seen in this light, a Fed rate raising campaign is really a “who can hold their breath the longest?” contest between Labor and Property. As financing costs go up, which market cracks first? The Labor market or the Property market?
For the past 30 years, Labor has lost those contests (or that is the dominant narrative). This is why the New York Times keeps soberly predicting that we “must” see higher unemployment to bring inflation down. The Labor market “must” crack first.
Then the benevolent Fed will step in to save the
proles hard working American people after (clears throat) some “necessary hardship.” Here comes the cavalry!
But what happens if the Property market cracks first? Labor comes into this hiking campaign enjoying record high savings and a record-tight job market. So Labor can hold its breath an unusually long time. Moreover, higher rates only affect the labor market indirectly. But higher rates directly pressure the Property market.
Any property’s value is driven directly by how much it costs to finance it. If financing costs go up, property values go down.
When you read “Real Estate,” the mind goes immediately to Residential Real Estate. But a lot of homeowners are sitting on sub-3% fixed rate mortgages. They don’t really care if lending rates are 6% (unless they have to move). They can hold their breath for quite some time.
The sector that can’t hold its breath much longer might be Commercial Real Estate (CRE). The smaller (Commercial Rents) elephant huddling behind the larger (Home Prices) elephant in that “Property” corner of the room. Commercial properties have shorter term financing. A lot of it is variable rate. They have rainy day equity cushions, but they can’t hold their breath forever. And that equity itself is best thought of as… “wealth.”
We have already seen some cracks. Blackstone closed the exit door of its $69 billion mega-REIT fund (which still carries highly suspect property valuations). We’ve also seen big, solvent Real Estate developers groups walking away from properties – handing the keys over to lenders for financially un-viable buildings in New York and LA. Making a cold-blooded decision that rents won’t support their financing/profit expectations. Especially with low (I’ve seen 50%?) post-COVID workplace occupancy rates. Long COVID is real in Real Estate.
If Commercial Real Estate breaks, their lenders also get hit. Never forget that 95% of the Fed’s day-to-day focus is supervising and shepherding the banks. It will protect its flock. CRE is a big chunk of business for most US banks. The keys to non-viable assets end up in their mailbox. At the same time, high Fed rates mean Banks also face a profit-destroying inverted yield curve. The math of borrowing from depositors at, say, 4%-5% while lending at 3%-4% is money-losing.
So maybe the Fed “has” to cut rates to save Commercial Real Estate and Banks? Some weak caribou can go under. But the whole herd “must” be protected. That isn’t a political statement. It would be an economic disaster if we had a CRE-driven bank crisis.
The Fed should act to avert one and it most definitely will. Why?
- Senators: Rich people tend to run (and win) Congressional Seats – especially Senate seats. Rich people also tend to have Senator’s cell phone numbers. The “rich families in town” usually own a lot of local Real Estate. Especially in Red States and “States without Tier 1 cities.” Even Rich people who make their money elsewhere usually end up investing in CRE. Commercial Real Estate is the bedrock of wealth in America.
- The banks. Like it or not, the financial system will always get bailed out. Because it is a disaster if it seizes up.
But politics dictate that we must NEVER speak of CRE and the Fed in polite company. The only acceptable elephant to talk about is the Labor market. Why?
- “The Fed just cut rates to bail out a bunch of fat cats and their lenders” is not a headline that plays well in Peoria.
- The dominant narrative just assumes Labor must suffer the “necessary hardship” of a rate-raising cycle. Thus assuming the passive-income-people who own (and lend on) buildings can hold their breat long enough to win the contest.
- [sputtering] To even utter the words Labor and Property together in a single sentence is… is…. why my dear sir!… that is socialism!!!!!
We will see.