All of a sudden, risk appears to be everywhere. Whether economic, geopolitical, domestic, public health, environmental or any others with the potential to keep us up at night, risk, and planning for how to best deal with it, rapidly re-emerged as a force multiplier in our daily lives last year. As the Fairway team reflects on 2022, we find ourselves actively considering the best course for navigating the knowable and unknowable pitfalls lurking in this exceptional time.
We pride ourselves on being all-weather real estate investment managers, and believe that value creation can occur at any point in the market cycle. Risk-taking is a necessary part of our business, and while none of us can accurately predict the second and third-order consequences of the current economic climate and its impact, we believe that Fairway is well-situated to navigate the economic storm. I’d like to share a few thoughts on how our model considers future investment opportunities when faced with a more challenging economic environment. But before we cover that, let’s start by taking stock of where we are today and the implications for navigating what we expect will be a volatile economic landscape for at least the next year.
After a stable first half of 2022, financial markets entered choppy waters as investors continue to react to evidence of economic stress fractures, which are largely being driven by the Federal Reserve’s relentless battle against the anchoring of elevated inflation expectations. So far, the Fed’s commitment has been unwavering, and, though it is impossible to predict the future with any certainty, it is our opinion that the Fed is determined to successfully contain and “normalize” inflation expectations in the overall economy. In our view the real question remains – can the Fed manage a soft landing by returning the economy to its historical price stability targets without damaging consumer spending and full employment? The Fed has focused on tightening financial market conditions, essentially pulling liquidity from the economy, and pouring cold water on aggregate demand. That’s a very challenging tight rope to walk given their main policy tools’ impacts, in our experience, will lag 6-12 months before we fully understand the full effect on business and consumer behavior. Our fear is that the Fed is overshooting and will damage the economy with its hawkish monetary behavior, which is a concern widely shared by a majority of economists who expect a recession in 2023.1 These economic signs threaten rough economic conditions ahead, especially for capital intensive businesses requiring leverage, and the wise investor should prepare accordingly.
To that point, a natural consequence of tighter monetary policy is the increased cost burden for capital intensive businesses, like commercial real estate (“CRE”). For over a decade, the financing costs for capitalizing CRE investments was muted due to accommodative monetary policy keeping interest rates low. This trend was further intensified by the Fed in its response to the global Covid Pandemic. While laudable in its efforts to stimulate economic activity, the loose monetary response clearly exacerbated our current inflationary situation, and having realized it was too late removing the punch bowl from the party, the Fed’s whipsaw reaction makes sense. Eight Fed funds rate hikes over approximately 12 months, moving its marquee short rate from a 0-0.25% range to 4. 5-4.75%, and the monthly potential run-off of up to $95 billion per month in Treasury obligations, has resulted is an unprecedented monetary tightening action not seen since the early 1980s.2 The moves have ripped through capital markets, increasing both bank and non-bank interest rate pricing nearly twofold over the course of 2022, and driving massive consequences for CRE equity and credit investors by driving higher debt service costs and reducing spot asset values for those owners that must trade. This is all before we fully understand the impact that an economic slowdown, notably an erosion in the jobs’ market and demand fundamentals, may have for CRE per the recessionary fear above. It’s a very challenging time to size value, either on the front-end acquiring new investments or in disposition, and the difficulty assessing value creates heightened risk in the asset class.
Despite this economic and financial backdrop, we firmly believe Fairway’s philosophy and business model are uniquely structured to withstand and potentially take advantage of the challenging economic conditions. First, we view the tighter financial conditions, specifically interest rate increases, as a healthy reversion to historical norms. In our opinion, many asset class valuations have been propped up for far too long by momentum rather than value creation due to cheap money. We believe the temporary economic dislocation will allow inefficiently deployed capital to reset and recycle back into what we believe may be more productive uses in the economy, and Fairway intends to seek creative ways to engage in this anticipated market reset.
Second, we believe that there is a direct relationship between taking risk and potentially realizing reward, and that this coming period will entail a return to a traditional risk/reward trade-off dynamic. We expect the next 12-24 months may be largely characterized by rolling recessions, whereby different sectors of the economy experience recessionary headwinds at different times – note the stumbling of housing, technology, and consumer discretionary and financials as of late. However, we project this recession will likely be milder than the 2008-09 global financial crisis, which was brought on by extensive systemic risk created by big banks’ off-balance sheet derivative positions specifically in the for-sale housing market. Right now, we’re experiencing significant financial market volatility, but not financial system instability (at least not yet), and only the latter scenario will trigger a sudden Fed policy shift prior to achieving their aims. Risk assets will need to reprice and reset expectations to more directly reflect not just the economic realities, but also deliver true value creation commensurate with the risk profile of the investment opportunity.
Third, we expect to spend a majority of our time and resources building and defending deep operating moats around our real estate holdings. With nearly 80 investments on the books, we have a diversified asset base within middle market real estate, which is spread amongst multiple major property types, 26 states in 54 MSAs, core to opportunistic risk profiles, and positioned up and down the capital stack. With value investing at the core of our investment philosophy, our current portfolio has been assembled with the intent to survive myriad complex risks, both financial and operating. We stayed disciplined in the total cost basis of the portfolio assets based on our own underwriting criteria and investment objectives, and we’re pleased with the asset strategies we’ve invested in within the secular trends in real estate we’ve identified. Specifically we believe in the potential of our portfolio’s heavy weighting towards housing assets, which enjoy strong inflation hedging features, a quicker rent mark-to-market cycle, and the longer-term supply/demand imbalance for affordable workforce housing options in the country.
Fourth, we believe the primacy of the current capital market volatility will continue to impact leveraged CRE operators who aren’t well-capitalized to service the increased borrowing costs. We predict that distressed investment opportunities in both equity and credit will become available as the rolling recession trend washes through different segments of the economy, and we’re actively positioning ourselves to take advantage of potential CRE investment opportunities associated with what we anticipate will be further deterioration in economic fundamentals next year and potentially beyond.
On a final note, I’d like to acknowledge that Fairway’s culture of excellence, high achievement, and drive to innovate makes all of the foregoing possible. Our most valuable resource is our people, who actively model our core values every day with the intent of making Fairway the premier real estate investment manager in the middle-market space, and who are committed to actively and skillfully navigating the economic uncertainty at whatever level of severity we may encounter. I couldn’t be prouder of the dedication and competency showcased by our team through their countless hours of intense, dedicated effort. They make Fairway what it is today, and our leadership team is deeply grateful for such high-performing and ethical individuals delivering value for our investors every day. Our diversity of employees, partners, and perspectives will continue to drive impactful conversations that help solve the biggest opportunities facing middle-market real estate, and remain a force for positive change in the communities that we invest in. While we clearly can’t predict the future, Fairway’s absolute focus is on creating and preserving value for its investors, and I believe fundamentally that we are up to the challenge.. There is a lot of work to be done, I’m excited for what’s to come.
1National Association for Business Economics, December 2022 Outlook Survey.
2World Economic Forum, “The pace of US interest rate hikes is faster than at any time in recent history”, www.weforum.org, October 12, 2022.
This communication represents Fairway’s opinions based on its own experiences and due diligence standards. Nothing in this document should be construed as a guarantee of a particular outcome, and past performance does not guarantee future results. Nothing in this letter is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks including a complete loss of capital. Consult with your legal and investment professionals prior to making any investment decisions. All Securities are offered through North Capital Private Securities, Member FINRA/SIPC.