Q2 2023 Market Update

Kicking off this quarter, just as we did in the previous one, I'd like to start with expressions of gratitude. Although there is a lot to be grateful for, there are three things I'm especially grateful for.  First, our team has seen some new faces join us (more on this later). By investing in high-quality personnel and system enhancements, we are striving to be the best investment managers in the business. Our aim is to bring on the best talent to help us navigate this phase of the cycle, and we have done just that by welcoming these new team members.  

Second, we have adhered to a disciplined investment approach. In an environment where many sponsors are under distress and working to avoid asset forfeiture, we have been patiently executing our plans, with our downside protection measures functioning as intended.  

Third, and lastly, there are promising opportunities on the horizon. Contrary to the pessimistic foreclosure predictions that have been floating around since the onset of the pandemic, we are looking at an attractive sale of premium core and core plus real estate properties. These are now available at prices that would have been unimaginable just a year ago. As the core real estate market is currently facing a supply-demand imbalance due to a severe liquidity shortage, exit queues, and a worsening credit crunch, we are optimistic that this is setting up a stage for some of the strongest core plus investment opportunities in the past decade.

Market Summary from Last Update

The market was very volatile in Q1. Initially, the stock market reacted positively to data which indicated falling inflation rates and the Fed’s gradual reduction in rate hikes. In February, the data released indicated that the Fed's efforts to control inflation were not yet successful and the “higher for longer” sentiment returned. Then, in March, we saw the collapse of SVB and other banks further complicating the situation, prompting the Fed to consider pausing rate hikes to avoid exacerbating the situation. All told, the Fed raised the Fed Funds Rate 25 bps at its February 1st meeting and then another 25 bps on March 22nd. 

Market Update (Q2 2023 in Review)

The second quarter effectively kicked off with the Fed’s announcement of a 25 bps rate hike on March 22nd.  The 25 bps rate hike increased the Target Federal Funds Rate range to 4.75-5.00%.  The accompanying press release showed that the FOMC Committee members dropped a phrase used in their previous eight statements that said the Committee anticipated “ongoing increases in rates would be appropriate.”   Instead, the March press release dropped that phrase in favor of the phrase "some additional policy firming may be appropriate", clearly signaling that the Fed might be about ready to hit pause on the rate hikes.  Shortly after the announcement, the CME FedWatch Tool projected a 57% chance of no rate hike and a 43% chance of a 25 bps rate hike at the Fed’s next meeting on May 3rd.

Between the Fed’s March 22nd meeting and the Fed’s May 3rd meeting, February and March’s personal consumption expenditures price index were released, March’s JOLTS (Job Openings and Labor Turnover Survey) report was released, and March’s Consumer Price Index for All Urban Consumers (CPI-U) was released.  The February core personal consumption expenditures price index showed a year-over-year increase of 4.7% while March’s core personal consumption expenditures price index showed a year-over-year increase of 4.6%.  March’s JOLTs report showed that total nonfarm payroll employment rose by 236,000, and the unemployment rate changed little at 3.5%. Lastly, the CPI-U rose 0.1% in March on a seasonally adjusted basis, after increasing 0.4% in February, and over the last 12 months, the all items index increased 5.0% before seasonal adjustment.  

On May 3rd, the Fed announced a 25 bps rate increase, taking the Fed rate up to 5.00-5.25%.  However, the accompanying press release once again showed that the FOMC committee members’ tone about future rate hikes was softening.  Recall that the March 22nd announcement had dropped the phrase "ongoing increases" in favor of “some additional policy firming may be appropriate”.  Now, in the May 3rd press release, the language used was “in determining the extent to which additional policy firming may be appropriate…”.  When read together, the tone of the committee changed from “we believe rate hikes will be appropriate” to “we believe rate hikes may be appropriate” to “if rate hikes become appropriate.”  This represented a pretty strong and clear message that the Fed intends to pause rate hikes soon, so long as there were no surprises to the upside.  Based in large part on this change in language, the CME FedWatch Tool then predicted a 94% chance of no rate hike and a 6% chance of a 25 bps decrease in rates at the next Fed meeting on June 14th.  Although the 6% probability of a rate drop was small, it was significant in that it was the first time a rate drop had registered on the CME FedWatch Tool in roughly a year. 

However, hopes for a drop in rates was quickly dashed as the next batch of data was released ahead of the June Fed meeting.  That data included April and May’s JOLTS report, April and May’s CPI-U, and April’s personal consumption expenditures price index.  The April JOLTS report reported that total nonfarm payroll employment rose by 253,000 in April (exceeding the 180,000 forecasted), and the unemployment rate changed little at 3.4%.  The May JOLTS report showed that total nonfarm payroll employment rose by 339,000 in April, but the unemployment rate rose to 3.7%.  April’s CPI-U rose 0.4% on a seasonally adjusted basis, after increasing 0.1% in March, and over the prior 12 months, the all items index increased 4.9% before seasonal adjustment.  May’s CPI-U rose 0.1% on a seasonally adjusted basis, and over the prior 12 months, the all items index increased 4.0% before seasonal adjustment.  Lastly, the April core personal consumption expenditures price index showed a year-over-year increase of 4.7%, which mirrored March’s core personal consumption expenditures price index.

Nevertheless, and despite the April data which continued to depict an economy still struggling to get inflation under control, the Fed announced a pause in rate hikes on June 14th, leaving the Fed rate at 5.00-5.25%.  This rate pause put an end to ten consecutive rate hikes, dating back to March of 2022 when the Fed announced the first rate hike of 25 bps which took the Fed funds rate to 0.25% to 0.50% (i.e. a 500 bps increase in 16 months).  The June 14th press release noted that, “[h]olding the target range steady at this meeting allows the Committee to assess additional information and its implications for monetary policy”.  Immediately after the announcement, the CME FedWath Tool predicted a 34.5% chance of no rate hike and a 65.5% chance of a 25 bps increase in rates at the next Fed meeting on July 26th.

Taking it all In

There’s a lot of numbers being thrown around so I will begin my summary with a short table showing how these numbers have been trending year to date.  In each instance, I am depicting the year-over-year change.

As a reminder, a positive Core PCE reading indicates an increase in the price that people pay for goods and services, excluding energy and food prices.  Therefore, what we can see is that the cost people have been paying for goods and services in the United States has consistently been in the range of 4.7% more than the same time last year, which is much higher than the Fed’s mandate of 2.0%.  This is an indication that inflation is still much too high and remains persistent. 

On the other hand, CPI-U has been on the decline.  Like Core PCE, CPI-U measures the average change over time in the prices paid by consumers for a market basket of consumer goods and services.  A positive CPI-U reading indicates an increase in the prices paid by consumers for a market basket of consumer goods and services.  In this case, although the prices paid by consumers for a market basket of consumer goods and services still remains more than twice the Fed’s mandate of 2.0%, we have been seeing a clear and definitive decline in the rate of these increases.  This is an indication that inflation is on the way down.

Lastly, the JOLTS report shows two important factors–the number of nonfarm payroll jobs added and the unemployment rate.  A positive nonfarm payroll employment reading indicates that jobs were added and a positive unemployment rate means a lower rate of employment.  Looking at the data, we can see that the unemployment rate has been relatively flat year to date, although we did reach the highest level of unemployment of the year in May.  Similarly, the number of nonfarm payroll jobs added has been relatively flat the last several months, but is down significantly from the 517,000 nonfarm payroll jobs added in January of this year.  

Taking everything into account, it's hard to argue against the notion that inflation remains persistently elevated and that the Fed may have some more work to do.  However, history has indicated that economic impact historically lags between six and nine months from Fed action.  If this holds true, this would mean that we are just now starting to see the impact from the Fed’s actions in September through December of last year.  From September to December of last year the Fed increased the Fed funds rate by 200 bps (75 bps in September, 75 bps in October and 50 bps in December).  Recall from before, since March of 2022, the Fed has increased the Fed funds rate by a total of 500 bps.  That means that we are just now beginning to feel the impact of roughly 40% of those increases, there’s another 15% yet to go, and we have only experienced the impact of 45% of the Fed’s rate increases.   Stated alternatively, it seems rather obvious now in hindsight why the Fed made the decision to pause and is taking inventory of the impact it has caused.

I will again preface my opinion on the future by reiterating that I am not a prognosticator and I certainly do not have a crystal ball.  The opinions I express are entirely my own and you should do your own due diligence and research before making any decisions.  Having said all of that, it seems more likely than not to me that we will see some additional Fed action this year.  At least one more 25 bps rate hike seems all but certain this year, and calls or predictions for a rate decrease before the end of the year seem optimistic at best.  If I had to bet, I would bet that as of my next update email, we will be sitting at a Fed funds rate of 5.25% to 5.50% and wondering if there’s one or two more rate hikes left.  

Happenings at Hanson Capital

We would like to formally announce our new Chief Financial Officer, Marissa D. Worley.  Marissa has 18 years of accounting/business experience, with 11 years in the real estate industry. She has a Masters of Science degree in Accounting from New Mexico State University and is a Certified Public Accountant licensed in Arizona. Outside of work she enjoys hiking and road trips around Arizona.

Also, we would like to formally welcome our new Chief Investment Officer, Jeff Thompson.  Jeff oversees financial operations, analysis and cash management for the company, as well as investor and banking relations. In addition, he is responsible for raising debt and equity capital for new development and acquisitions projects and any refinancing opportunities. With nearly 30-years of real estate experience, Jeff has structured and financed close to $4B in real estate over his career. Jeff graduated from The Ohio State University with a Bachelor’s and Master’s in finance. Prior to joining us, Jeff served as the Chief Financial Officer at PB Bell and held Chief Financial Officer rolls at PB Bell Companies and Harsch Investment Properties.

Jeff and Marissa bring an incredible amount of experience and a wealth of real estate knowledge to the team.  We are very fortunate to have them, and we are excited about the additional capacity they will bring to the team. 

In other big news, we have decided that we will be launching a property services division.  We will be making a formal announcement regarding the launch of the property services company once we finalize all the details, but we are very excited about this opportunity.  We have secured an incredible talent to lead our property services division.  He brings an incredible amount of experience and should be able to make an immediate impact on our existing portfolio. 

On the lending side, we saw the residential real estate market bottom out in January of this year.  Inventory ended with a high of 20,000 active listings on the MLS in Q4 of 2022.  From a historical standpoint in a normal market 20,000 – 25,000 active on the MLS is a “balanced market”, meaning there are as many buyers as sellers.  By Q4 however, the market was a far cry from balanced.

The month over month increases in traditional mortgage rates were at historical levels.  Rates almost doubled from the beginning of Q1 2022 to Q4.  Many home buyers were priced out and the uncertainty of what was to come had many sitting on the sidelines.  This was the catalyst of the increase in active listings on the MLS, as well as prices going down 10% to 15% depending on the city.

Going into Q1 and Q2 of 2023 we have seen a persistent decline in inventory, which gave everyone some hope.  Additionally, in the last 60 days active listings on the MLS  have been hovering around 12,000 homes (including attached and detached homes, across all price points).  That’s a 40% decrease in properties for sale, pushing values up fast.

During the same time period (last 60 days), traditional lending rates have inched up into the high 6’s again.  This has become the “new norm” for many borrowers that are still eager to purchase. However, less qualified borrowers without the ability to afford higher monthly payments have made this a very unique market with shrinking inventory and fewer buyers. Though this may be a unique situation, looking at it from a simple supply and demand lens, the data shows property values trending up. Average sales price per square foot has increased from $264 in January to $287 by June 12^th.

Overall, in Q2 we saw 3% appreciation (almost 6% since January), making opportunities to lend on Fix and Flips, as well as new construction consistent.  We are seeing our competitors push LTVs from 70% to 85% or more.  As we analyze the data going into Q3 we are making adjustments to increase LTVs to be in line with the industry, while maintaining our attention to overall plausibility of scenarios. 

We feel very comfortable adjusting our LTV to meet the market demand and to compete.  We pride ourselves on our risk assessments and underwriting. We’re seeing our clients starting to find properties at discounts of up to 40% off of as-is value.  With a minimum of 15% down, we frequently are able to maintain an LTV of 70% prior to improvements being done to any project.  Based on inventory at historic lows, we feel 70% LTV is low risk while the reward remains high.

With Q3 and Q4 in sight we see great opportunity in debt.  As inflation comes down from a historical perspective, interest rates typically follow, which will bolster buying prower and increase property values even further.  That should make for an extra HOT summer in AZ real estate!  

Last but not least, on the real estate deal side of things, we have written several LOIs over the last 30 days or so, which is an indication that deals are starting to shake loose and there has been some pricing realignment between buyers and sellers.  This stands in stark contrast to Q1 2023 and Q4 2022 in which we wrote zero LOI’s.  We continue to focus on Arizona but have also started writing offers on strategic opportunities in California.  Despite some of the headlines in the news about California, the market fundamentals for industrial real estate remain very strong in California.  Overall, supply remains well below existing demand and new deliveries continue to be absorbed quickly.  I have spent the last month in Southern California meeting with local industry professionals and I am more convinced than ever that California’s industrial real estate market is on the upswing with deals selling at a discount to historical pricing.  I look forward to some exciting new transactions coming up in Q3 and Q4 this year. 

In closing, I wanted to express my appreciation to you for your investment and ongoing support as we continue to develop and mature as an investment platform.  We look forward to continuing to perform at a high level and work with each and every one of you.  

Q2 2023 Update Data:

• March fed meeting announcement on 3/22: 25 bps
  • The Fed announced a 25 bps rate increase today, taking the fed rate up to 4.75-5.00%.  The opening paragraphs from the Fed's press release state, 

• Recent indicators point to modest growth in spending and production.  Job gains have picked up in recent months and are running at a robust pace; the unemployment rate has remained low.  Inflation remains elevated.

• The U.S. Banking system is sound and resilient.  Recent developments are likely to result in tighter credit conditions for households and business and to weigh on economic activity, hiring, and inflation.  The extent of these effects is uncertain.  The Committee remains highly attentive to inflation risks.  

• However, the most important sentence came later when the Committee said, "[t]he Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time."  I read this and it very much so felt like a departure from the rhetoric we have been hearing from the Fed, implying higher for longer.  As I dug into this statement, and after reading a bit on other people's take, I found this nugget from the WSJ, "Officials dropped a phrase used in their previous eight statements that said the Committee anticipated 'ongoing increases' in rates would be appropriate."   Dropping the phrase "ongoing increases" in favor of "some additional policy firming may be appropriate" seems like a pretty clear signal that the Fed thinks it might be about ready to hit pause on the rate hikes.

• The plot map, shows that 17 of the 18 officials expect the Fed funds rate to rise to at least 5.1% and to stay there through December.  If that's the case, we should expect to see one more 25 bps rate hike and then a holding pattern through the rest of the year.  

• The next Fed meeting is May 2nd-3rd, with the announcement coming on May 3rd.  The CME FedWatch Tool currently projects a 57% change of no rate hike and a 43% chance of a 25bps rate hike.

• March Core PCE Announcement 3/31/23 (February Data)
  • The core personal consumption expenditures price index increased 4.7% in February from a year earlier.  This was slightly lower than anticipated but remains 2.3x higher than the Fed’s target rate of inflation of 2.0%. However, it’s important to note that this data does not account in any way for the banking turmoil which occurred in March.  
    • January 2023 4.7 %
    • December 2022 4.6 %
    • November 2022 4.8 %
    • October 2022 5.1 %
• April Jobs Report announcement 4/7/23 (March Data)
  • Total nonfarm payroll employment rose by 236,000 in March, and the unemployment rate changed little at 3.5 percent, the U.S. Bureau of Labor Statistics reported today. Employment continued to trend up in leisure and hospitality, government, professional and business services, and health care.
  • Total nonfarm payroll employment increased by 236,000 in March, compared with the average monthly gain of 334,000 over the prior 6 months.
  • In March, average hourly earnings for all employees on private nonfarm payrolls rose by 9 cents, or 0.3 percent, to $33.18. Over the past 12 months, average hourly earnings have increased by 4.2 percent. In March, average hourly earnings of  private-sector production and nonsupervisory employees rose by 9 cents, or 0.3 percent, to $28.50.
  • CME FedWatch Tool:
    • 32.6% chance of no rate hike, and 67.4% chance of 25bps.
• April CPI announcement 4/12/23 (March Data)
  • The Consumer Price Index for All Urban Consumers (CPI-U) rose 0.1 percent in March on a seasonally adjusted basis, after increasing 0.4 percent in February, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 5.0 percent before seasonal adjustment.
  • This was slightly below the expected 5.1 percent increase.
  • CME FedWatch Tool:
    • 29.5% chance of no rate hike, and 70.5% chance of 25bps.
• April Core PCE Announcement 4/28/23 (March Data)
  • The core personal consumption expenditures price index increased 4.6% in March from a year earlier.  This was slightly higher than the anticipated 4.5%, and remains over 2x higher than the Fed’s target rate of inflation of 2.0%.  On a monthly basis, Core PCE rose 0.3% for March, matching February, and analysts’ projections.  
    • February 2023 4.7 %
    • January 2023 4.7 %
    • December 2022 4.6 %
    • November 2022 4.8 %
    • October 2022 5.1 %
• May fed meeting announcement on 5/03: 25 bps
  • The Fed announced a 25 bps rate increase today, taking the fed rate up to 5.00-5.25%.  The important language to note is depicted in the change set forth below…
    • January/February Fed Meeting
      • The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time. In determining the extent of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.
    • March Fed Meeting
      • The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time. In determining the extent of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.
    • May Fed Meeting
      • In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments. 
  • The tone of the Fed has thus changed “we believe rate hikes will be appropriate” to “we believe rate hikes may be appropriate” to “if rate hikes become appropriate.”  This is a pretty strong and clear message that the Fed intends to pause rate hikes, so long as there are no surprises to the upside.  
  • The CME FedWatch Tool currently predicts a 94% of no rate hike and 6% chance of a 25 bps drop in rates.  This is the first time a rate drop has registered in roughly a year. 
• May Jobs Report announcement 5/5/23 (April Data)
  • Total nonfarm payroll employment rose by 253,000 in April, and the unemployment rate changed little at 3.4 percent, the U.S. Bureau of Labor Statistics reported today.  Employment continued to trend up in professional and business services, health care, leisure and hospitality, and social assistance.
  • Expectations had been 180,000 and the result was slightly higher than the most aggressive estimate by Goldman Sachs (250,000).  The Unemployment Rate fell to 3.4% in April, matching the lowest reading since 1969.  Adding fuel to the labor market fire, Average Annual Earnings growth accelerated to 0.5% for the month, ending a 3-month streak in the 0.2% - 0.3% range.  Year over Year, the increase was 4.4% - slightly higher than the 4.3% previous reading (revised upward from 4.2%). 
  • The CME FedWatch Tool currently predicts a 88% of no rate hike and 0% chance of a 25 bps drop and a 12% chance of a 25 bps increase.
• May CPI announcement 5/10/23 (April Data)
  • The Consumer Price Index for All Urban Consumers (CPI-U) rose 0.4 percent in April on a seasonally adjusted basis, after increasing 0.1 percent in March, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 4.9 percent before seasonal adjustment.
  • The annual rate of inflation has fallen sharply since hitting a 40-year high of 9.1% last Jue.  April’s 4.9% slightly below March’s report and market expectations, which were 5.0%.
  • The CME FedWatch Tool currently predicts a 98.5% of no rate hike and 0% chance of a 25 bps drop and a 1.5% chance of a 25 bps increase.

Q1 2023 Update:

• Dec fed meeting announcement on 12/14: 50 bps
  • Stocks rose before the decision, fell after it, and then returned to breakeven while Fed Chairman Powell spoke on the decision.  On the day, the S&P finished decision day down +/- 0.6%.
  • Fed Chairman Powell continues his hawkish stance as he vowed NOT to consider rate cuts until inflation is moving “in a sustained way” towards 2%, and reiterated the need to avoid prematurely loosening policy.
• Data on S&P
  • Can use this to show what happened in the S&P since the decision (e.g. total change, average daily change, etc.).
• Next Decision Dates:
  • February 1, 2023
  • March 16, 2023
  • May 4, 2023
• Use the cap rate sheet Pike got from Phil
  • Phx is a primary market.
  • Data from the various markets.
• Utilize Investment Bank Forecast
• Labor Report Came out last Friday and its more of the same.  Added even more jobs this month but at a slower pace that November, but above forecast.  Market generally reacted favorably and as a sign that the market is slowing. 
• Feb 1 Fed meeting announcement: 25 bps
  • Fed announced the widely anticipated 25bps rate increase today.  This raises the target rate from 4.25% - 4.50% to 4.50% - 4.75%.  Overall, the stock market has responded favorably as it appears to be interpreting this announcement as an indication that the Fed is getting closer to pausing rate hikes to assess things.  
  • The official minutes from today's Fed meeting will be released in 3 weeks, but as is customary, the Fed released a short statement regarding today's decision.  Of most relevance from the summary are the following quotes:
  • The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time. 
  • In determining the extent of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.
  • In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in its previously announced plans.
  • In english...
  • Fed currently believes more rate increases are necessary (note the plurality of the word "increases").
  •  The Fed is focused on the effect of past rate increases, the delay between such increases and their impact on the economy and inflation gauges, and such other developments that may arise.
  • The Fed will continue with its Quantitative Tightening policy (reducing its balance sheet by selling bonds and letting bonds mature).
  • The next Fed meeting is March 22nd and the CME tool that I like to monitor currently projects a 14.4% chance of no rate hike and an 85.6% chance of a 25bps rate hike at this meeting. 

Q1 2023 Market Update

I wanted to begin this market update with gratitude.  I am extremely grateful for all of you that reached out to share your feedback and encouragement on our last market update.  We were blown away by the reaction to the update and to the number of requests we received to continue sharing our perspective on the state of the market.  It is in response to those of you that requested we continue to share our perspective that we share this market update with you all. 

Market Summary from Last Update

For those of you that read our previous update, you may want to jump ahead to the next section.  For those of you that either did not read our previous update or simply want a refresher, we provide you with this condensed summary of our update.

We began our last update with an overview of the “Federal Reserve System” (the “Fed”) and how it operates.  Recall that the Fed’s mandate is to conduct monetary policy "so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."  Think of this as the “Goldilocks Effect”.  The Fed’s mandate is to ensure that the American economy is running neither too hot nor too cold.  When the American economy is too hot in the eyes of the Fed, the Fed will step in to cool it down and vice versa. 

In March of last year, the Fed determined that the economy was running too hot as inflation surpassed 6% (as measured by Core Personal Consumption Price Index (“Core PCE”)).  Therefore, at the Fed’s March 2022 meeting, the Fed raised the Target Federal Funds Rate by 25 basis points to 0.25-0.50%.  Recall further that raising the Target Federal Funds Rate tends to cool the economy because when the cost of borrowing rises consumer demand tends to fall.  

Unfortunately, inflation remained persistently high, so the Fed continued raising the federal funds rate throughout 2022, including 50bps in May, 75bps in June, 75bps in July, 75bps in September and then 75bps in November.  These rate hikes took the federal funds rate from 0.25-0.50% to 3.75-4.00%. 

At the time of our last update, we believed that the Fed was ready to begin slowing the pace of these rate hikes to assess the impact of rate hikes. We further said that if the Fed began to slow the pace of rate hikes, we could see some relief in the markets as this could indicate the beginning of the end of Fed rate increases. 

Market Update (Q1 2023 in Review)

As predicted in our last update, the Fed announced a 50bps increase to the federal funds rate on December 14th (taking the federal funds rate to 4.25-4.50%).  Overall, stocks rose before the decision, fell after it, and ultimately returned to breakeven as Fed Chairman Jerome Powell spoke on the decision.  On the day, the S&P 500 finished decision day down roughly 0.6%.  Fed Chairman Powell reiterated his hawkish stance and vowed not to consider rate cuts until inflation was “moving in a sustained way” towards 2% and reiterated the need to avoid prematurely loosening policy.  

On January 6th, the Bureau of Labor Statistics released its December jobs report, which reported that the American economy added 223,000 jobs in the month of December, and the unemployment rate fell to a historically low 3.5 percent.  The Fed has continuously pointed to the tight labor market and corresponding rise of wages as a major red flag that inflation remains untamed. The argument goes, when the labor market is tight and there is significant competition for high quality work, wages will rise.  When wages rise the cost of goods sold tend to rise as company's begin to pass on those additional costs to consumers.  When the cost of goods and services rise we have inflation (by definition).  As the cost of goods and services increase, so does the need to earn more in order to be able to afford such goods and services, which creates a sort of "death spiral".

Then, on January 27th, December's Core PCE reading was announced at 4.4%.  This was consistent with the downward trajectory we saw previously as Core PCE fell from 4.68% in November, 5.05% in October and 5.20% in September.   Despite the sticky labor market report, most prognosticators projected that the December Core PCE reading would solidify the now widely anticipated 25 bps rate increase at the Fed’s next meeting on February 1st.  

Indeed, on February 1st the Fed announced a 25bps rate increase.  This raised the target rate to 4.50% - 4.75%.  Shortly after the announcement, the Fed released a short statement regarding the decision, which included a few important nuggets:   

• The Fed anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time. 
• In determining the extent of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.

Translated into english…

• The Fed believes more rate increases are necessary (note the plurality of the word increases).
• The Fed is focused on the effect of past rate increases, the delay between such increases and their impact on the economy and inflation gauges, and such other developments that may arise.

Immediately after the February 1st Fed decision, the CME FedWatch Tool (a widely recognized tool that measures the probability of Fed action) predicted that there was a 14.4% chance of no rate hike and an 85.6% chance of a 25bps rate hike at the next Fed meeting, March 22nd.  

However, on February 3rd, the Bureau of Labor Statistics released its January jobs report, which reported that the American economy added 517,000 jobs in January.  The 517,000 jobs added was nearly 2.8x what was forecasted which caused the unemployment rate to fall further to another historical low of 3.4%.  

Unfortunately, the Bureau of Labor Statistics January jobs’ report was the beginning of a string of bad news. On February 14th the US Bureau of Labor Statistics announced that their gauge of inflation (the consumer price index) had increased by 50bps for the month of January.  The 50bps was generally inline with expectations and forecasts, but how it got there was the problem.  The "shelter index" (think costs of housing and rents) rose 70bps, far exceeding expectations and forecasts.  Then, on February 24th, the Core PCE index for January was announced at 4.7%, exceeding the forecasted 4.3%.  Recall from above that we had been seeing a downward trend in the Core PCE readings but January’s reading of 4.7% represents an increase from December's Core PCE reading of 4.4%.  

As a result of that string of bad news, we saw a major swing in the stock market as investor fears of the Fed continuing to raise interest rates and then holding them at elevated levels for longer sunk in.  On February 14th (heading into the CPI announcement) the S&P 500 was at $4,136 (up 8.16% YTD) but then fell to $3,970 (up 3.8% YTD) shortly after the January Core PCE announcement on January February 24th.  Stated another way, more than 50% of the YTD gains were wiped out by the news over those 2 weeks.  In addition, recall from above that the CME FedWatch tool had projected a 14.4% chance of no rate hike and an 85.6% chance of a 25bps rate hike at the Fed's next meeting on 3/22.  However, the CME FedWatch Tool then projected a 0.0% chance of no rate hike, a 30.6% chance of a 25bps rate hike, and a 69.4% chance of a 50bps rate hike. 

Then came the news of the failure of Silicon Valley Bank (“SVB”), Signature Bank and Silvergate Bank.  There is a lot going on here and I won’t try to unpack it all, but here’s what happened in short…SVB became the go-to bank for startup companies, tech startups in particular.  As is customary in the banking industry, in order to do business with SVB, their borrowers and customers were required to establish deposit accounts (in essence, if you want to borrow from us you need to open your checking and savings accounts here).  As a result, some of the largest technology companies and tech startups in the country held massive deposit accounts at SVB.  With the large infusion of cash via deposit accounts, SVB chose to invest in longer term mortgage backed securities (“MBS”).  

The problem “began” when the Fed began raising interest rates as aggressively as they did. Again, without going into too much detail, when interest rates rise the value of bonds (MBS’ are bonds) fall. Now, recall that all this cash SVB was investing in MBS came from deposit accounts.  This means that the deposited cash is accessible and withdrawable at any time.  Well, what happened was SVB announced that it had sold some of their bond holdings at a loss ($1.8B to be exact) and the overall health of SVB’s balance sheet started to get scrutinized.  Peter Thiel, one of the largest and most well respected venture capitalists, became concerned with SVB’s ability to meet its cash deposit obligations and advised his startups to pull all of their money out of SVB. Others followed suit and began flooding SVB with withdrawal requests.  Now, these are not your average mom-and-pop companies or individuals who hold a few thousand or maybe even a hundred thousand dollars in their accounts.  In fact, 97% of SVB’s accounts were over the $250,000 FDIC insured limit, which is far in excess of what you would typically find at a “regular bank”.  These are massive companies that began withdrawing millions of dollars at a time and the “bank run” was on.  A total of $42B was sought to be withdrawn, which sank SVB for good.  

The Fed has now stepped in and has advised all customers of SVB (as well as Signature Bank and Silvergate Bank) that all their deposits will be insured, so some sense of calmness has set in.  However, this is far from over.  As a result, the CME FedWatch Tool now projects a 44.5% chance of no rate hike, a 55.5% chance of a 25bps rate hike, and a 0% chance of a 50bps rate hike. 

Taking it all In

As the quarter winds down I can’t help but notice the never ending up and down emotional market reaction on a near daily basis.  Q1 of 2023 got off to an incredible start as the primary gauges of inflation continued to indicate falling rates of inflation on the tail of the Fed slowing its pace of rate hikes from 75 bps in November to 50 bps in December and then 25 bps in February.  The stock market reacted bullishly and we saw significant gains in the stock market as investors wrestled with the real possibility that the Fed was successfully engineering a soft landing.  

However, then came February, where nearly all of the data released made it hard to argue against the opinion that the Fed's fight to get inflation under control is far from over.  All indicators were then flashing “higher for longer” signals, but then came the collapse of SVB and the other banks and it seems the Fed must now strongly consider the need to pause these rate hikes to avoid throwing gasoline on the fire and stroking fears of an imminent demise of the American banking system.  A common sentiment that we’ve been hearing is that the Fed won’t stop hiking rates until the Fed breaks something, or perhaps someone, and I can’t help but wonder if this is that “breaking” point. 

The next Fed meeting is now only a day away (March 22nd), and things are as murky as ever.  However, what seems very clear at this point is that a 50bps hike is completely off the table.  What also seems clear to me is that but for the recent events surrounding SVB we would have certainly seen at least a 25bps rate hike and probably would have seen a 50bps rate hike.  Therefore, the real question the Fed will have to wrestle with is to what extent does it believe it needs to pause rate hikes, at least temporarily, to assess the fears and impact of what has happened at SVB.  If the Fed is confident that the public sentiment surrounding SVB and the banking system as a whole is under control and relatively calm, I would expect a 25bps rate hike.  However, if the Fed is not confident in, or otherwise questions whether public sentiment is under control and relatively calm, then I would expect it to pause the rate hikes, at least temporarily.  We are not prognosticators and certainly do not have a crystal ball, but if I was a betting man, I would bet we see a 25bps rate hike. 

Happenings at Hanson Capital

The whiplash we have seen in the markets generally applies with equal force to real estate.  In January we were hearing lots of bullish rhetoric for 2023 from industry veterans who pointed to the vast sums of cash or “dry powder” sitting on the sidelines and the Fed’s slowing pace of rate increases as evidence of what's to come.  However, as the capital markets have been once again thrown into another round of volatility due to the February data readings, the bullish rhetoric has quieted down.

Here at Hanson Capital, high quality deals remain elusive and underwriting remains challenging.  The single greatest challenge in underwriting in this economic environment is determining exit cap rates.  Our last acquisition was in September of last year (over six months ago) and we are prepared to wait another six months or more if necessary.  We remain committed to securing deals that deliver disproportionate reward against minimized risk and will not deviate from that principle.  

For those of you that know how cap rates work, you can skip ahead to the next paragraph.  For those of you that don’t or want a refresher, cap rates (or capitalization rates) are a measure of annual cash flow from a property (before debt service) expressed as a percentage of the purchase price or value of the property.  Therefore, if a property produces $100,000 per year in net operating income and it costs $1,000,000 to acquire, we can say the property has a 10% cap rate.  From a valuation perspective, if the market cap rate for an industrial building is 5% and it produces $100,000 per year in net operating income, the value is $2,000,000.  Thus, as cap rates fall valuations rise (and vice versa). 

Given the volatility and uncertainty in the market, it is difficult to determine with any level of certainty where cap rates will be two to five years from now.  The difference between a 5.0% and a 6.0% cap rate is a 20% change in value, which in many cases can be the difference between a good deal and a bad deal.  Given what is happening in the markets, and in particular the debt markets, it has become extremely difficult to get comfortable with deals because of the uncertainty around exit cap rates.

However, in good news, Phoenix (where we own a substantial majority of our real estate) has now become a primary market.  I won’t bore you with all the technicalities and implications, but I share this with you because it again reinforces the long term prospects of the Phoenix metro area.  As a primary market, we now see major influxes of institutional investors which further drives valuations.  

Also, I was fortunate enough to receive a copy of the 2023 annual outlook forecasts from all the major investment banks (19 in total), which included JP Morgan, Wells Fargo, Goldman Sachs, Morgan Stanley, Bank of America, BlackRock and others.  I wanted to share with you all some things I took away after reading these forecasts, but if you would like a copy of the forecasts to read yourself, let me know and I will send you a link.  

The forecasts from the Investment Banks are pretty consistent.  The general consensus from the investment bank is as follows:

• The Fed will continue to raise the target federal funds rate to 5.00% - 5.25%.  This means we are in store for three more 0.25% rate increases.
• The Fed will raise the target federal funds rate through Q1 of 2023 and will then sit tight to assess the impact.
• We will not see any decrease in the federal funds rate before 2024, with some predicting a hold through 2024.
• The US will narrowly avoid a recession (two consecutive quarters of negative GDP growth) or, if a recession does happen, it will be mild.

The risks to be on the lookout for are:

• Stagflation (i.e. despite all the cooling efforts, inflation remains high due to factors outside the control of the Fed).
• The Fed supplies too much coolant to the economy and throws it into a recession because of the lag time between monetary policy and impact on the economy.
• The onset of new political or geopolitical conflicts.

It's worth reiterating that these are forecasts for 2023 that were issued ahead of the December Fed meeting, so please take this into account.

In closing, I wanted to reiterate my appreciation to you for your investment and ongoing support as we continue to develop and mature as an investment platform.  We look forward to continuing to perform at a high level and work with each and every one of you.  

If you've read this far and you have questions, we're available to you to discuss these and other topics related to our investments and future plans anytime.  Thanks again, and we are looking forward to an even more prosperous 2023 and beyond! 

Year End Market Update

2022 is coming to a close fast!  We can't believe we're almost through the whole year.  I wanted to send a note to all of our investors to provide an update on what we've been up to at Hanson Capital, and to shed some perspective on some of the news floating around in these fast changing times.  As you have probably seen, there's a lot of conflicting and confusing information in the news about real estate, interest rates, and the economy in general.  Being in the position we are in, we have the luxury of engaging with key principles of banks, private equity companies, investment banks, wealth management companies, brokerages, the top real estate and securities regulations law firms in the country, as well as some of the most sophisticated investors that work with and invest alongside us.  That puts us in a unique position to glean insight from the titans of the real estate industry.  As we continue to seek greater insight and expertise in an effort to become a little better at our craft each and every day, we're constantly on the phone or taking in-person meetings with these people and polling them on what they're seeing, what they're hearing, how we can improve on what we are doing, and how these pieces all interact together.  We're looking for an edge, looking to stay ahead of the trends and looking to make sound investment decisions with the best information available.  

With that being said, I wanted to share my opinion on the state of the economy and what we think is in store for ourselves and the market as this year comes to a close and we put an eye on next year.  It goes without saying, but the opinions expressed herein are just that, my personal opinions, and are in no way a promise of outcome or any other sort of guarantee on our investment performance.  We strongly encourage you to educate yourself and seek insight from your trusted advisors. However, we consistently receive feedback from our investors that they want to hear from us on the state of the market and what we are up to so I wanted to provide that information to you all.  

The Market and Overall Economic Outlook.

The Federal Reserve System (the "Fed") is tasked with conducting monetary policy "so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."  The Fed's target rate of inflation is two percent (2%) (as measured by the annual change in the price index for personal consumption expenditures).  For a whole host of reasons I won't go into here, the rate of inflation has been over 6.0% each month of this year.  

Against this backdrop of record breaking inflation, the Fed has been on a mission to cool inflation down to its target rate of 2%.  

One of the primary tools the Fed uses to influence the rate of inflation is by adjusting the effective federal funds rate.  When the effective federal funds rate rises it tends to slow borrowing activity which in turn tends to slow down economic activity.  Conversely, when the effective federal funds rate falls it tends to increase borrowing activity which in turn tends to increase economic activity.  Therefore, in an effort to cool inflation, the Fed has been incrementally increasing the Fed rate from the historically low target rate of 0.00%-0.25% seen earlier this year (which was a holdover from the response to the COVID-19 pandemic) up to 3.75-4.00% where the target rate currently sits.  The Fed's next meeting is today and tomorrow, where it is widely expected that the Fed will increase the target rate by 50 bps, a meaningful drop from the unprecedented four consecutive 75 bps increases.  I believe this is the most important meeting of the year.  Nobody we speak with predicted the velocity with which the Fed would push rates, which is the fastest pace of rate increases in history.  That being said, if the Fed now begins to slow the pace of rate hikes, we anticipate seeing some relief in the markets as this could indicate the beginning of the end of Fed rate increases while the Fed assesses the impact of the prior rate increases. 

Historically, the markets have lagged behind Fed activity by 6 to 9 months, and we therefore anticipate that when we see a plateau, we would expect to see economic conditions tightening for an additional 6 to 9 months.  However, due to this lag time in impact, many people believe we might see rate decreases sooner due to the velocity with which the Fed raised rates.  

We are seeing extreme volatility in the markets as the markets digest the daily deluge of new data, much of which seems to contradict yesterday’s data.  If the Fed does in fact raise another 75 bps increase we think that will bode substantially worse for 2023 as it would signal that the Fed is not ready to begin even slowing the pace of these historical rate increases.  The depth of the looming “recession” is likely going to be dictated by how far they push rates and not necessarily how long they stay there.  

The obvious question then is, how does all of this impact me?

The Impact on Real Estate

Historically, there is an inverse correlation between rising interest rates and real estate values. This means, in a rising interest rate environment we would expect, based on history and logic, values will fall.  Interest rates and real estate values are not directly correlated because there are more factors, like rising construction costs, to contend with.  From our vantage point, the rising interest rates have pummeled multifamily values as cap rates expand.  Cap rate expansion has occurred across all asset classes, but multifamily has disproportionately been impacted compared to other asset classes like industrial real estate.  In recognition of rising interest rates and the contemporaneous rise in cap rates, we, and nearly all institutions, are “pencils down”.  The common consensus is that now is the time to pause, observe and wait for a clearer picture to emerge from the Fed before finalizing our next course of action.

Hanson Capital's Existing Portfolio

Our portfolio is diversified into 3 buckets today: debt, equity, and development.  We own debt in the form of short term loans through our mortgage banking platform (est. $40M market value) to keep access to liquidity.  I was less enthusiastic about debt as an investment vehicle previously, as inflation can erode away your net returns, but today I’m actively deploying my capital in debt as I’m less concerned about future inflation and it provides great cash flow with short term commitment timeframes.  

Real estate, as it sits today for us at Hanson Capital, consists of 18 industrial assets (est. $221M market value), 3 multifamily assets (est. $33M market value), and 1 multifamily development (est. $48M market value).   As for the multifamily assets, in May of this year we sold one of our multifamily assets for $27M.  At an all in basis of roughly $10M, we are excited about having created a major win for our partners as we completed exchanging those funds into two industrial assets in September.  As for the remaining three multifamily assets, we are in escrow on two of the three assets, with one closing this month and another scheduled to close in February.  As we mentioned before, we are “pencils down” and therefore do not anticipate executing an exchange.  We think the greater opportunity is to move cash to the sidelines (or place it in short term debt with our debt fund) for what we think will be incredible buying opportunities later in 2023. 

As for the ground up multifamily, we believe we are in a great position to do well.  However, we have suspended further multifamily development pursuits. Ground up projects bring additional risk such as longer investment time horizons, supply chain, labor and material shortages, rising expenses etc. that are not adequately rewarded and therefore fail our principle of providing superior risk-adjusted returns.  We believe we can achieve similar, if not better, returns in our value-add industrial strategy without taking on the additional risk.  

As for our industrial assets, as you can tell from the ratio of capital we have deployed relative to our other three asset classes, $221M (industrial) vs $121M (everything else), we continue to opportunistically acquire assets that meet our minimum risk-adjusted return expectations against our rigorous underwriting standards.  Midway through the year we started to see a noticeable increase in the demand for high quality industrial assets in our markets (Texas and Arizona) as investors sought better yields compared to other asset classes that are often trading above replacement cost (see retail, multifamily, and even office).  This increased demand for industrial assets against still constrained supply has kept pricing strong compared to the multifamily asset class despite the rising interest rates.  With institutional development of new industrial assets largely on pause, supply will only be further constrained which should boost or at the very least provide stability for rental rates in the future.

Our industrial portfolio has irreplaceable debt in place on each property, and there is sufficient time to maturity to weather a period of higher interest rates, which reduces our risk of being forced to sell if any future softening in prices is worse than expected.  The other major upside to our strategy is by acquiring the entirety of our portfolio with below market in-place rents we have a tremendous amount of future income potential to unlock (or in a decreasing rental rate environment, safety).  Our current portfolio stabilizes to a 12+ cap at our acquisition basis.  That is irreplaceable in today’s environment.  We intend to be very selective in any buying over the next 6 months.  We believe there will be some opportunity in the future as some institutions are forced to sell assets to fulfill fund redemption requests and other similar factors that force sellers to sell now.  We expect those opportunities to be limited and we will not be in a rush to deploy capital for the sake of deploying capital.  We are committed to only making the best acquisitions regardless of how long we have to wait to do it.

The Future and What's Next

Current asset values for multifamily assets are well in excess of replacement cost and we therefore will not be buying any multifamily assets, as it is a fundamental tenet of our strategy to only buy assets that are below replacement cost.  Multifamily values have also been trending down since about May of this year as interest rates continue to rise and we think that will continue until we get some relief from the Fed on future interest rates.  In addition, as investors focused on traditional investments (i.e. stocks, bonds and mutual funds) begin to shift their asset allocations into alternative assets (such as real estate) to seek refuge from historic inflation and a volatile downward trending stock market, the demand for multifamily assets, as the so-called "darling" of commercial real estate, has created a dangerously overheated market.  I routinely get inquiries from new investors to real estate that want to get into multifamily.  I think this is one of the worst times to pursue new multifamily and I relay that regularly.  We are happy to own the assets we own due to having acquired them at the basis we did, but we sit idle with respect to acquiring new multifamily assets until such time as the market cools and opportunity reappears.

As for our industrial value-add strategy, we believe we are uniquely positioned to capitalize on this market.  For those of you that are invested in our industrial fund, this will be redundant, but our strategy was strategically designed to combat and thrive in the event of a downturn or a rising interest rate environment.  Specifically, we were looking to capitalize on the great arbitrage of in-place rents that provide immediate cash flow upon acquisition with major upside (or downside protection) upon stabilizing with a market rental rate.  Our unrelenting commitment to only buying well located assets, below replacement cost and with in-place rents well below market rents insulates our assets from the risk that is plaguing many other operators today.  While other operators are now worried about longer than anticipated vacancy if their tenant vacates, we know that if our tenants vacate we will be able to quickly lease the property at a rental rate well in excess of the in-place rents due to the discount in place between in-place rents and market rents.  

In addition, we have recently been approached by a number of major institutions (Insurance companies, public and private REIT’s, and private equity) with interest in either acquiring the portfolio or re-capping the portfolio, which, in either event, would allow us harvest the incredible amount of value we have created in a short period of time while at the same time de-risking the portfolio in the face of the uncertainty that lies ahead.  As I mentioned above, no final decision has been made on the course of action we will pursue.  We are absorbing all of the information we can in order to ensure we make the very best decision for our investors.

We are very excited about the possibility of working with one or more of these institutions while we look to expand our industrial investment strategy into new markets.  Having an institutional partner will provide us with the opportunity to scale Hanson Capital to the next level in the years to come.  However, I would be remiss if I didn't mention that we are making it abundantly clear to any prospective institutional partner that we will not, under any scenario, accept a proposal that does not allow us to continue to work with our network of incredible investors--the people like yourself that help make all of this possible in the first place.  No matter what decision we make in this regard, we will always ensure that there is a place for each and every one of you to invest with and alongside us in the future.

In closing, I wanted to express my appreciation to you for your investment and ongoing support as we continue to develop and mature as an investment platform.  We look forward to continuing to perform at a high level and work with each and every one of you.  Our why really is focused on creating wins for our partners and we've held strong to that through our institutional partner search.  

If you've read this far and you have questions, we're available to you to discuss these and other topics related to our investments and future plans anytime.  If you'd like to see these types of updates more regularly please send me a comment or feedback, and I'll continue these macro updates if there's interest from our partners.  Thanks again, and we are looking forward to an even more prosperous 2023 and beyond!