Welcome to our latest episode! Today, we’re thrilled to welcome back Ryan Severino, Chief Economist and Head of Research at BGO and adjunct professor at Columbia University. Ryan is a seasoned economist, researcher, and thought leader who brings unparalleled expertise in analyzing market cycles, global economic trends, and real estate investment strategies. A repeat guest on the podcast, Ryan’s unique insights continue to provide clarity on navigating economic uncertainty and uncovering opportunities in commercial real estate.
In this engaging conversation, Ryan shares his perspective on the current economic landscape, reflecting on the implications of high interest rates, the potential for a soft landing, and why commercial real estate remains resilient. Drawing from decades of experience and meticulous research, Ryan discusses how real estate values respond to rate cuts, the role of transaction volume as an indicator of market recovery, and the nuances of risk premiums embedded in cap rates. He also provides actionable advice for navigating today’s market, emphasizing the importance of timing, intuition, and data-driven strategies.
If you’re looking to understand where the economy is headed and how to position yourself for success in commercial real estate, this episode is a must-listen. Tune in now!
HIGHLIGHTS OF THE EPISODE
00:00 – Welcome to the BigMikeFund Podcast
00:23 – Guest intro: Ryan Severino
02:08 – Transition to BGO and role as Chief Economist
04:08 – Discussion on high interest rates and potential Fed actions
08:30 – The impact of interest rates on commercial real estate
12:20 – Transaction volume as an indicator of market recovery
17:30 – How risk premiums and cap rates adjust during cycles
21:50 – Predictions for Fed rate cuts and their effect on valuations
26:10 – Now might be the best time for opportunistic investments
31:30 – Contrarian thinking and its role in successful real estate strategies
36:55 – The impact of rate cuts on NOI and market resilience
43:10 – Real estate as a superior asset class in today’s environment
51:00 – Closing thoughts and Advice for navigating market cycles
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Full Transcript:
Intro: Welcome to the BigMikeFund Podcast, where you’ll learn about advanced wealth building strategies from real estate investing to creating massive ROI and secure retirement profits. So pour yourself a cup of coffee, grab a notepad, and lean in. Because Big Mike has got the mic, starting now.
Mike Zlotnik: Welcome to the BigMikeFund Podcast. I’m the Big Mike, I’m Mike Zlotnik, and today it is my pleasure and a privilege to welcome back Ryan Severino. Hey, Ryan. Hey, Mike. How are you? I’m great. Thank you so much for coming on our podcast. Ryan is a past guest. He used to work at JLL. Now he moved to BGO, right? Yep. That’s exactly where I am. And he’s a chief economist and chief of research.
It’s a very important job. And he moved, I guess, from one side of business to another side of the business. Now BGO is more focused on getting investors great returns versus what he was doing at JLL kind of research and selling, I get that information, uh, to, uh, investors. So how have you been, what, what’s new in the world of Ryan Severino?
Ryan Severino: Um, I would say busy, but good. And when I say the word busy, that’s not a complaint. I think the way, you know, it almost feels like, uh, we’ve entered this kind of new period where a certain segment of society likes to tell everyone how busy they are, it’s almost like a badge of honor. I just say it as an objective statement.
Um, but I’ve always been a busy person. Uh, I don’t think that it will ever change. Even in retirement, I imagine being busy with different things. And so, um, but it’s been good. It’s been good to be back on this side of the business. This is really where I I started once upon a time when I was much younger and dare I say cooler than than I am now.
And so it’s it’s been nice to have some other experiences, see the industry from a few different points of view and then come back to where I started having, I think, gained valuable experience and knowledge from different perspectives than if I had just stayed on the side of the business for the last, you know, two to three decades.
Mike Zlotnik: Oh, it’s wonderful. Gives you diversity of, uh, of, uh, information, diversity of purpose. Um, so on this side, what have you been doing? What’s the most interesting part of your job? And you said you travel a lot. Just curious why you need to travel so much if you’re doing research and economic analysis. Are you speaking a lot or I’m just curious?
Ryan Severino: Yeah, so, so I’d say it’s primarily speaking, going to see clients, speaking at conferences, various presentations, but also because in the real, and I’m sure you understand this, but in real estate, because it’s a, it’s a physical tangible thing. I can’t just sit behind a desk all day. I need to go look at markets.
I need to see properties. I need to understand what’s going on on the ground. I can’t just sit behind a computer, um, You know, and write papers and crunch numbers all day. I actually have to get out and about and understand what’s to the extent that I can for what I do. I really have to understand what’s going on locally on the ground.
Now, obviously, I can’t do that in every market, but to the extent that I can, I really like to be out and about seeing different different markets, seeing different property types. Really trying to understand what’s going on in the world because I don’t, I don’t think it’s really possible to have a complete understanding of what’s going on.
If you’re not, at least in the real estate space, if you’re not willing to actually get out and see it for yourself, touch it, feel it, understand what’s going on. If you’re just hiding behind a computer all day, you’re going to have. A limited knowledge set relative to your understanding if you’re actually out and about in some of these markets from time to time.
Mike Zlotnik: Yeah, I agree. I happen to come out once in a while too. These field trips are actually very helpful. Uh, you get to touch and see things, get to talk to people. So from that perspective, it makes a big difference. So what are you seeing today? Where are we, uh, in the economic cycle from real estate perspective?
Uh, we are about to, we’re recording this, uh, early part of September, early to mid, we’re about to see Fed take their first action in the easing cycle. So we’ve seen a lot of pain in the commercial real estate, higher for longer interest rates have been very difficult. It’s massive, uh, headwind, but now we are about to see some relief.
Plus it’s an election year. I’m just curious, just give, give your 40, 000 foot view what’s happening right now and where we’re going.
Ryan Severino: From, you know, macroeconomic perspective, I still think that we’re in a good place. I think there are a lot of people who, um, I’m proud to say that I wasn’t in this camp, but last year was the most widely predicted recession that didn’t ever occur.
You know, everybody thought the Fed was going to raise rates and crash the economy, and I’ve I’ve consistently not been in that camp, even before the Fed started raising rates. One of the great things about what I do from my point of view is that I do this a lot. You know, I do podcasts and I talk to the press.
And so I’ll say things and people will say, well, what were you saying two years ago? And I’ll say, oh, just Google it and look it up. Like I’m in the press all the time. So you can go check things that I’ve said over the last 15, 20 years. Um, and I, and I, I was very adamant about saying that a recession wasn’t inevitable, that I didn’t think that we would be in one.
Yeah. And I still believe that. Has the labor market slowed down? It certainly has. But there’s no way the labor market was going to stay As hot and as tight as it had been over the last two years, but if you look at most of the actually all the major factors that the Fed that the well, it’s really the NBR is the arbiter of recessions, the Fed to looks at the business cycle.
We’re not close to a recession right now. Now, that doesn’t mean that we can’t end up in one, that the Fed might have overshot on this, but I still think, looking into the crystal ball, that, that the economy still has momentum, that the labor market is still strong, consumers are still spending money, businesses are investing at a more rose bust rate than they were Have been in a while.
Productivity growth in the economy is even stronger than it was before the pandemic. So it’s hard to be objective and look at the economy and think doom and gloom. If you’re if you have a political agenda, which I don’t, you can always find something to pick on, right? There’s never perfection in the economy.
But when I broadly look across the economy, With with some consideration for the fact that the labor market has slowed down, there’s still a lot of good things going on, but that almost doesn’t matter for commercial real estate at this point, because to something that you referenced. We are about a week away from the Fed starting to cut interest rates.
And that historically has been very powerful for commercial real estate returns. We’ve already seen that up to this point. Um, if you, if you go back over the, say the last, um, the last six monetary cycles. So if you go back to the 1980s, and I only want to go back that far, because before that we don’t, we don’t have really good real estate data, even in the U S where it’s, Probably about as good as we’re going to get in the world.
It’s still, you know, probably only dates back to the late seventies, early eighties, what you see is when the fed stops raising rates. Valuation stabilize and then total returns turn positive pretty quickly. Um, and then appreciation returns really start to accelerate and total returns really look more attractive.
I thought that that process would get delayed this cycle a little bit just because the Fed was so aggressive in raising rates so quickly and it took time for the real estate market to catch up to that. But we’re already back basically into positive returns, especially if you, if you exclude office, which is.
We could talk about office. There’s a, I think as everybody understands, there are things going on in office that are just outside of what’s going on across real estate as an asset class. Um, but we’ve already seen three of the four, four of the five, I’ll throw hospitality hotels in there, four of the five major property types.
Um, at least in the NACREF NPI already are back into positive total returns. Once the fed starts cutting rates, that will be like a, the risk of a crash analogy that will be like a performance enhancing drug for real estate returns over the next two, three, four years. So fingers crossed that the fed hasn’t, you know, gone too far too long, but I don’t think that’s the case.
Um, but I think either way, once they start cutting over the next few months into next year, um, that I think will be kind of this, um, Very potent. I don’t want to call it an elixir. That sounds a little bit frothy, but certainly this potent remedy for I think what you’ve you’ve referenced, which is things that have Ailed the commercial real estate market for the last two, two and a half years or so.
Mike Zlotnik: Yeah. I appreciate that wisdom. A lot of great nuggets. And if you’re already seeing the data and you are the, um, chief economist, chief, uh, you’re running, you’re running the research, right? So the data is already pointing that the recovery has started. Uh, and you, you can’t. Know it as it’s happening. You always have to look in our ears, right?
The data there’s some trailing in Time that it takes for the data to be compiled same thing happened on the reverse side when fed hike Uh, we know that the peak of the market. Um, sorry, not the peak but the I guess peak of the market was Right around middle of 22, they just started hiking, right? It wasn’t clear how fast they’re going to go, how much. They just sort of, it was still. But looking in their ears, the absolute peak was, was, uh, middle of 22. And now we are beginning to form a bottom. Maybe we’ve already formed a bottom. We just don’t know. It sounds like we are, which is great to hear. So on a former
Ryan Severino: So here’s, here’s one thing I would, I would say is this is a little bit anecdotal, so it’s not real data per se. But the one thing I could tell you. Now that I’m back on this side of the business is that certainly over the last quarter or two, and I think most people in a similar organization would say this, even though we haven’t seen a significant uptick in transaction volume just yet, um, we are looking at more deals than we were six months ago, 12 months ago.
So even if those deals are not getting closed just yet, because I think there’s still some, there’s some dislocation about pricing, especially with this, I think, more complete understanding, the Fed is going to start cutting rates. Um, probably as soon as next week, but we are kicking the tires on more deals than we were six months ago, 12 months ago.
And that to me. Even though it’s anecdotal is a pretty good leading indicator because if we’re looking at more deals than other organizations that we compete with, or, you know, we would consider peers in the industry are looking at more deals. And to me, that’s a pretty good sign that eventually there will be more of a meeting of the minds on the pricing for those deals.
Once we have more clarity on what the Fed is going to do, and those deals will ultimately get done. It might not be tomorrow. It might not be, you know, in a quarter or two. Um, but that to me signals that what I’m seeing in pricing. Um, what I’m seeing in, in cap rates. Is ultimately going to to not just be a stabilization in the market, but probably an acceleration over the next 6 to 12 months.
So again, it’s a little anecdotal. I don’t want to hang my hat on that too much, but it’s it’s clear as day in the activity that that that me and my team do as we’re revealing all of these. deals before they they go before investment committee. We are certainly looking at more deals now than we than we were over the last 6 to 12 months.
That is absolutely abundantly obvious to me when I look at what we’ve been doing. Um, you know, over the last quarter or two.
Mike Zlotnik: Thank you for that. Uh, great wisdom, right? So maybe transaction volume is a leading indicator of price improvement. I think you don’t know that, but I go back to what you said, the recession that never happened, right?
There was a lot of speculation. It was going to happen, but it didn’t happen. And it’s still not clear. We’re going to see a formal, uh, significant risk. Almost this point, you can’t really have recession with unemployment being this low. It’s almost like, how, how can you have a severe recession when people are working to this degree?
Ryan Severino: Right. That, that’s exactly the way that I think about it. GDP is just a glorified accounting convention that gets asked to do more things than it was designed to do. But the labor market is the labor market. If people are working, if their incomes are growing faster than inflation, which means they have real wage growth, real spending power, and they’re out spending it.
It’s almost impossible to get a recession. You would really need to see significant deterioration in the labor market. And it might happen, but all of the things that we know about business cycles, when, when central banks raise rates, we just haven’t seen because we’ve seen insulation against higher interest rates, not immunization, you know, no pun intended with the pandemic, but we haven’t seen pure immunization, but we’ve significant insulation on the part of both households.
And businesses. Which is why we’re not the interest rate sensitive economy that people thought that we would have been. So a lot of households locked in low interest rates. They’re not as interest rate sensitive. A lot of businesses locked in low interest rates. They’re not as interest rate sensitive. So consumers are still out spending money because they have real purchasing power.
And as I said earlier, businesses are out investing They’re out investing. You know, to make their businesses more, more productive over the medium to long term. So as long as you have household spending money and businesses willing to participate in that, even if there’s a little bit of a rebalancing away from consumers toward businesses, It’s hard to get a recession without a serious disruption to the labor market.
Could we get one? Sure. Anything is possible in economics. The economy is a, is a very, very complex, difficult thing to understand. Um, but with the best crystal ball that I have, I’m just looking at the data that’s coming in. I’m looking at how the economy is behaving, and it’s really difficult to look at the data in September of 2024 and think we’re going to be in a recession, you know, imminently.
Like, you know, at some point, we’ll be in a recession again, and then the recessionistas will say, see, I told you so. I’m like, yeah, but like you were saying that last year, two years ago, three years ago, you know, like if you always call for a recession, Eventually, you’ll be right, because there’ll always be one, um, but notice those people never get the timing exactly right, or they never get the magnitude exactly right, or they never get the duration exactly right.
They just scream recession every, every other week, and then eventually they turn around and say, see, I told you there would be a recession, but they never give you enough details for that information to be useful or, or even remotely, um, indicative of a good forecast.
Mike Zlotnik: Well, it’s difficult. It’s a, the U. S. economy is so complex that the Fed is this expression, the action has long and variable legs. A lot of things are just not exactly the way they were in a previous cycle. And we are dealing with the, it’s called post COVID world cycle, which is a very different, it’s a black swan event that we haven’t seen in now a generation, maybe more than a generation.
So, but let’s, let’s continue on a forward outlook. So it’s pretty clear. Maybe they call it soft lending. Maybe it’s a light recession. Who knows? We don’t know what, whatever it’s going to be. Um, and the employment picture is obviously, uh, Unemployment rate can pick up from increased labor participation, a few other factors, but it’s not massive layoffs.
It’s pretty clear that’s what’s happening. So, um, real estate, uh, is likely going to get some tailwind from, from low interest rates. That’s, that’s pretty obvious directionally. And, um, What’s really encouraging is, uh, the fact that, uh,
transaction volume is improving. Transaction volume, well, it hasn’t improved yet, but the, the more people looking for deals. So just like recession never happened, maybe we will have, uh, similar experience on the, um, On the, on the recovery front, again, valuations have, have, have significantly fallen, corrected through the cap rates, right?
That’s basically what transpired. So, uh, a lot of people talked about distressed transactions. Maybe they will never really happen. Distressed transaction in volume may, may, may not really happen, especially now, when, uh, if you are a property owner, you could scramble, maybe raise capital, if you can, and survive.
And the forward expectation that valuations will improve, cash flows will improve as rates fall. So the big question becomes, do you hurry up and start taking action? You still tread waters very carefully for deploying new capital? Um, do you try to find deep buys or what if you can’t find them? What is good enough today to transact on?
What’s the trigger of action? Is it a certain discount to the past peak valuations? I’ve heard opinions where it doesn’t matter. We’re off 20 percent off the peak. Whatever the number is, right? We’re Whether it’s the bottom of the market or not, you don’t know, but it’s good enough today. Just, just, just, just go, just move, avoid office, agree.
But if you’re in a multifamily or a number of other asset classes, as long as the market is not oversupplied massively, we’ve seen some really weird local market dislocations, where a lot of new supply came in. And even, even with a lot of new supply, what I’ve heard is this, Because there’s a lot of new supply, the, um, occupancy rate or vacancy rate is too high.
But the new deliveries will be slowing down substantially in the next year or two. So by now, when you can get all these discounts, because in a couple of years, things are going to be significantly better from the Randcroft perspective.
Ryan Severino: That’s generally the stance that I take. Um, that You’re right. It’s always hard to call the bottom exactly right and it’s difficult to catch a falling knife or a bouncing knife, whatever analogy people people want to use.
But I am almost 100 percent certain that if we do this in 12 months, 24 months. And the Fed actually cuts rates even remotely the way that I think that they, they will or should over the next two years, that valuations will be markedly higher today than they are in two years than they than they are today.
And it’s not just, you know, my modeling my forecasting conjecturing about that. Again, I can go back six monetary cycles and show you the exact same thing. The magnitude is not always the same and the timing is not always the same, but the same general trajectory has occurred because. I think as everybody knows, this is a very real estate.
Real estate is a very interest rate sensitive part of the economy. There’s nothing that’s occurred over the last few years, even with the pandemic that has caused the real estate economy to fundamentally change the way that it works. So unless you think that’s happened, which I’ve not seen anybody make that argument and I’m certainly not making that argument, then there isn’t a really good reason to think that as the fed cuts rates over the next 12 to 24 months, that it shouldn’t turbocharge valuations and appreciation for real estate.
My argument, and I make this internally and I make it externally when I’m speaking at conferences, is that the valuations you can get today are not going to last. And that the, the Delta, the change in the valuations between today and two years, um, will almost certainly more than offset what’s going to happen in the debt market.
So if you’re sitting there thinking like, Oh, I’m just going to wait for. For debt, you know, yield, you know, cost of debt capital to come down. And then I’m going to jump in. You can do that. You will almost certainly, or at least in, I don’t want to be too absolutist about this, but in many cases, the change in the pricing that you’ll have to digest as the fed changes rates will almost certainly be more than what you save an interest cost.
By waiting six months or 12 months. Now, if you don’t have the capital to go out and buy without the debt, I understand that, right? Some people like using leverage or they’re leveraged investors. I understand that. But if you don’t have to do that, and I’ll tell you, I’m not, I’m not, this isn’t me just, you know, telling you things.
We do have certain funds at BGO, one in particular. It’s an industrial fund where we are putting money out that I just voted on a deal on investment committee on Friday because I sincerely believe this. Now, some of our other strategies can’t do that. They’re not in a position to do that. But this particular strategy, it’s a low leverage strategy.
It’s it’s designed to be that I am thrilled every time a deal comes up to committee and we can vote on it because I am 100 percent sure the pricing that we are getting on that deal today will not be there in 12 months or 24 months. And even if we decide at a subsequent point in time to put debt on it, we will do ourselves a massive favor by buying at this pricing today rather than waiting for.
Cost of debt capital to come down and then jump into the market. And again, not everybody can do that. Not all of our funds can even do that, but in this particular fund, I’m always thrilled when it’s time to vote on a new deal, because I’m more than happy to put the capital out today in good quality assets. Because I know that that pricing is not going to last much longer.
Mike Zlotnik: The words of the wise. I agree with you 100%. Everything you said makes a lot of sense. Good old wisdom, buy when the rates are high, right? I mean, we’re pretty clearly at the peak of the cycle, and the arguments that the rate’s gonna go back to wherever they were in the 80s, or it’s an emission, impossible.
We are literally at the peak of the cycle, uh, as far as the current, um, kind of experience. We’ve been in a zero interest rate policy for too long. Now we’ve seen the rates in a five and a half percent range. Um, now we got at some point going to get to the normalized rates. So what are the normalized rates?
The next question is, how much down are we going over the next couple of years? Whether it should be assuming that we sort of normalize as We all know, and the Fed Chair said, that the current policy is highly restrictive. They’re a restrictive policy, which is doing what it’s supposed to do to cool the economy.
It’s not breaking the economy, it’s cooling the economy. But are they going to 2 percent target, 2. 5 percent target, and how fast? What do you think?
Ryan Severino: So, I’ll tell you that my model estimates that what’s known as R star, which is, if you haven’t heard of R star, R star is basically the real, when I say real, I mean after inflation.
So, the real, neutral fed funds rate. So my model estimates it at call it about 1%. Like it varies depending a little bit on when I run the model and what’s going on. But just for argument’s sake, let’s say it’s 1%. I have no reason to think that we won’t get back to inflation target. I mean, if I’m being honest about it, I’ve been highly critical of how we measure inflation in the US, which we could spend a whole half an hour discussing, but I will simply say we are mismeasuring inflation in the US.
And right now it’s, it’s, it’s, overstated because of how we measure housing inflation. If we net that out, I don’t care if you’re talking about the CPI or the PCE. Once you account for this nonsense way that we are measuring housing inflation, inflation in the US is basically at or below the Fed’s 2 percent target.
So I have no reason to think even with the nonsense that we are doing with housing inflation that we can’t get back to target because we’re basically already there. It’s just mathematics that is giving us this kind of false signal. So let’s Let’s assume because I don’t have any reason to think that this shouldn’t be the case that we will get back to the feds.
2 percent target rate. I take that 2%. I added to the 1 percent of my model, and it tells me that the neutral rate at the short end of the curve, the fed funds rate should be somewhere about 3%. You know, plus or minus because it’s a model. It’s it’s an estimation. So that tells me that we probably have somewhere around 250 basis points for the Fed to cut before we get back to neutral again.
I don’t want to see zero percent, Mike, to be honest with you. Zero percent, which we’ve seen twice now in the last, you know, 15 years or so, 15, 16 years, tells me something’s really gone wrong in the economy, right? The balance sheet recession with the GFC in 2008, 2009. And then we had a pandemic recession.
I don’t want to see 0 percent and we don’t need 0 percent honestly. This, this economy doesn’t need 0 percent to grow. It never has. It never will. The real estate markets don’t need 0 percent to generate positive returns. Um, I’ve grown very fond of saying over the last, you know, 12 to 24 months, there are a lot of people out there over the last, you know, Two, three, four decades, even in commercial real estate that have confused their own genius with structurally declining interest rates, because we’ve been in a, you know, downward trajectory on interest rates from the early 1980s to where we are today.
But fundamentally, this asset class is so good. You don’t need zero fed funds rate to make. Positive returns, but you do need to be smart about the asset class. And so we’re going to separate, you know, the people who think they know what they’re doing from the people who really know what they’re doing.
Once we’re in a more normalized interest rate environment over the next, you know, 12, 24 months, 36 months or so.
Mike Zlotnik: Yeah, I appreciate that wisdom. Uh, your target of 3 percent is a little above what I was thinking. My personal view is two and a half to three. You, you, you, you’re, you’re fine.
Ryan Severino: And if we’re in that range, it would be fine. Honestly, like if we’re a little bit,
Mike Zlotnik: that’s a net neutral rate. We don’t want a zero. I agree with you a hundred percent. We do not want a zero zero means we’ve got a problem of sorts. It’s a zero means it’s an emergency. Some kind of a, uh, prices or, or, or, or another problem. Now, what happens with the longer end of the curve?
What happens with the 10 year treasury, uh, yield, um, essentially what drives financing on most of the, uh, commercial real estate mortgages.
Ryan Severino: Yeah. So it probably settles into a range a bit above that. Again, if I use the model, the model tells me something like. Long term capacity growth in the economy. The ability of the economy to grow on a sustained basis is somewhere around 2%.
Again, you add the Fed’s 2 percent inflation target to that, it gets you on a long term sustained basis to about a 4 percent nominal treasury yield, but it’ll be above and below that, right, because there are technical factors in the market. So I, and somebody, you know, I, somebody asked me last week, do I think that the 10 year treasury yield could fall below?
3738. Absolutely. Some of this will depend on how the Fed signals to the market, what it intends to do with the short end of the curve over the next few years. 4 percent to me is just where it should be on a long term basis. It doesn’t mean it needs to be there every month or every day or every minute.
And so if we’re below 4 percent as the Fed’s cutting rates and the yield curve kind of slopes, you know, is a little more steep for a while. I will not have a problem with that because it’s not, again, a forecast is not designed to tell you this is where the 10 year treasury yield needs to be every day of every month forever.
It’s just saying on a long term basis, it will probably vary around 4%. If underlying capacity growth in the economy, again, is about 2%. And my model estimates that other models I’ve seen estimate that. And the fed is really able to get us to about 2%, which again, we’re probably already there. If we just, measure inflation correctly, then there’s no reason to think that we should be too far away from 4%.
Almost like we were just saying at the short end of the curve, the 10 year yield should not be 1 percent or 2%. Like if it is something’s gone wrong in the economy, it should not be that low. We’re not that slow growth of an economy. We’re not Germany. We’re not Japan. We should not have long bond rates at that low of a level.
For for a prolonged period of time. So I know a lot of people, you know, we haven’t seen a normal recession since maybe the early 2000s. So people don’t have a good sort of anchor point to what a more sustainable long term rate should be. But again, if the economy can grow on a real basis at about 2 percent and inflation is anchored at about 2 percent than a 4 percent Treasury yield over the long term is not catastrophic for economic growth in the United States.
But it does mean that we’re going to separate the people who really know what they’re doing in real estate from the people who pretend to know what they’re doing in real estate.
Mike Zlotnik: Yeah, understood and agreed. Execution will make all the difference. Uh, but now let me just jump to one more, um, consequence.
So if you think 10 year treasury is almost where it needs to be. We are, I don’t know what we’re trading today, we’re reporting, but we’re somewhere around 3, 3. 7.
Ryan Severino: Yeah, give or take.
Mike Zlotnik: Yeah. Plus minus. So you’re saying four, maybe three and a half to four is a, is a long term range where it can settle. Right.
Yeah. So we’re sort of already in that range. The cap rates, we saw significant expansion in the cap rates as rate rates spiked. Um, but we haven’t seen sort of the cap rate contraction yet, or at least not meaningful because transaction volume is not there. So I’m just curious, how do we get there? Is this something that, um, Just naturally happens as, as buyers start coming in into the market, they start beating up the prices and get the cap rates to come down.
Is that what, what’s likely going to happen? Um, the alternative thought process would maybe in the short term, 10 year drops further. Maybe we, we overshoot and we get down to, let’s call it 3 percent range, right?
Ryan Severino: Which we certainly could, there’s no reason to think that we couldn’t, right? It’s a technical market, it’s based on how people feel in trade, so it wouldn’t surprise me at all if we got, you know, three to three and a half for a while, not in the least.
Mike Zlotnik: So I’m just trying to think, uh, when the cap rates kind of recover from a timing perspective, uh, as, yeah, the Fed will continue to cut. Speed and ferocity of the cuts is a function of data, right? I mean, they’ve been very clear on that. Uh, the bond market tries to be ahead of the Fed and project and predict what the Fed will do.
And the rates may continue to, um, uh, to fall further on a long end of the curve. But what happens with cap rates? How do cap rates actually normalize to a lower level than where they are today? Cause today they are, they feel, how do we get the price, uh, improvement? Uh, of course it’s a function of execution, right?
Execution growth, NOI, all that stuff. Uh, but that’s given and, uh, the, that’s the difference between bad and good operator versus the market. Where it’s a function of the cap rates and they depend on the interest rates more than anything else
Ryan Severino: So here’s the thing that has to adjust, and I think that will almost certainly adjust. The risk premium that’s embedded in those cap rates is high right now, because people have had a pretty kind of dour outlook on the economy. They weren’t sure what the Fed was doing. The Fed kept, you know, saying they were, you know, they kept saying, well, we don’t know. We’re leaving rates higher for longer.
And so because there was so much concern about that, there was so much uncertainty about that, Investors put a pretty wide risk premium above treasury yields into those cap rates. And that happens every cycle, right? When, when you see things, when the wheels start to fall off a little bit, when uncertainty goes up, that’s when cap rates widen out.
As the Fed starts cutting rates, And there’s more certainty about the direction of cap rates and there’s of interest rates. And there’s more certainty about, about monetary policy and investors feel more confident. Then you’ll start to see those risk premia that are embedded in discount rates and cap rates.
They’ll start to compress because they’re cyclical the same way interest rates are cyclical. People think that there’s this constant premium and that it just goes up and down with interest rates, but that’s not how real estate works. If anything, the correlation between the risk premia and the, and the interest rates.
Are are frequently like very low positive or sometimes negative. So as interest rates start to back off and the interest rates actually start to filter through to people’s expectations about risk in the future, that’s when you’ll start to see that risk premium compress and cap rates will start to back off.
But it takes time. People need to have confidence and it doesn’t happen immediately. It tends to take a couple of quarters for the market to have a little more confidence. So give it a quarter or two after the Fed cuts. Um, but if they really signal clearly to the market that we are on a path Of monetary easing, then again, nothing fundamental has changed about, about the real estate economy.
There’s no reason to think that those risk premiums shouldn’t further compress over the next two to three years. As long as the fed is being clear and consistent and unambiguous about what they’re saying. Um, there’s no reason to think that the market shouldn’t, shouldn’t take that, uh, and run with it a little bit.
Mike Zlotnik: Yeah, I love it. This is the, you know, people ask me the question or I like to ask myself the question. What’s the difference between the stock market and real estate? At least, this is kind of, I’ve cut my teeth on this, on this question. And the answer is predictability. Real estate is supposed to be more predictable in the stock market.
Stock market has more volatility and less predictability. And we’ve seen the lack of predictability in real estate last couple of years because uncertainty and volatility and the lack of guidance has been missing. And that’s exactly what you just said, that the risk premium has been so high. For the lack of forward guidance and at least we, we, we will know soon enough, um, where the guidance is going to take us.
I don’t know if Jay Paul was actually going to give us the final target. He probably won’t on the way up. He didn’t give us and on the way down. But at least, um, some level of immediate, uh, stability and predictability will return, uh, and to the degree of, um, whatever folks can feel comfortable. At least it’s going to be.
Um, tailwind versus headwind, right? And what happens next? We’re just going to see, but it might trigger action. And a lot of a lot of investors are sitting and waiting for these great deals that are just not happening. And at some point, it’s going to be exactly this. You’re going to miss the boat if you don’t act now, and maybe that will quickly establish the button and accelerate the recovery in essence, sort of.
Ryan Severino: Yeah, I make this joke all the time that that we work in a business where when there’s a big sale, nobody shows up. People only like to buy stuff when it’s really expensive. Um, I’m, I’m not, I’m not a contrarian because I’m trying to be, you know, transgressive or subversive, but I’ve been in this business, you know, Longer than my, my youthful enthusiasm lets on.
And the one thing I can tell you is the people I know in this business that are the consistently the most successful are the ones that have a little bit of a contrarian view to them, that they’re not afraid to do something. Um, when everybody else doesn’t want to do those things. And so that’s how you outperform, right?
Cause you’re always going to have to make a bet on something that somebody else is not willing to bet on a market, a property type, a time in the cycle, a capital structure, whatever it is. Um, if you’re just going to do what everybody else is doing, you’re never going to outperform, right? By definition, you’re just doing what everyone else is doing.
So if you really want to outperform what everyone is doing, then you have to have the conviction to go out and do something different. Um, again, I don’t, I don’t think I’m a, I’m not clairvoyant. I don’t, I don’t really have a crystal ball, but I, I’ve looked at our models. I’ve looked at my models. I’ve looked at what’s happened over the last 45 years.
I find it very hard to believe that we won’t be in a place two, three, four years down the road where valuations are higher and appreciation returns are better than they’ve been over the last, you know, two and a half years. I find that very difficult to believe.
Mike Zlotnik: I concur with you. Uh, you are, uh, you’re a data guy. You, you look at data, you analyze, this is your forte. This is your strength. I’m a bit more of an intuitive thinker, right? I’m a chess master. And the way chess, at least when I grew up playing chess and learning chess, it was an intuitive game. Of course, today chess is played by super strong computers that computationally beat the intellectually intuitive players just because, uh, Research, uh, and your intuitive thinking is one thing, but data in the long run beats you.
However, intuitive thinking still, still prevails in the short run, when you can’t compute everything. Chess is a perfect problem for computers because all the rules are defined.
Ryan Severino: Right. Like, all the parameters are fixed, so you have a fixed number of permutations and combinations that, like, the computer can play every chess, like, almost literally can play every chess game possible.
But, to your point, in real estate, And I say this when I’m teaching with my students, even the best data in the world will maybe get you 70 to 80 percent of the way to a perfect decision, there’s still going to be that, you know, 20 to 30 percent where you’re gonna have to use your intuition, your experience, your gut instinct.
And that’s what I love about this asset class because the same people can look at the same information and come to a completely different conclusion. And I still think there’s room for. Human judgment and intuition. Um, but I never want to go purely against the data. To me, that’s a very dangerous game to play.
Mike Zlotnik: Well, I agree 100 percent and the fact that you, you, your research has showed that we’re already sort of in this, uh, from that should pick up right where we are. We’re beginning to to form, uh, the bottom and recovering. It’s very encouraging and I, I, I certainly support the idea and you have to think like Warren Buffett, no matter what.
This is why he, he’s been able to produce an alpha over many, many years. Be greedy when others are fearful, be fearful when others are greedy. Uh, the, the tribal behavior or the, the group behavior leads us to write checks when things are great and contract and, and, and be hiding under, you know, uh, Like an ostrich head in the sand, when things are not going great, and it’s the reverse, it’s now the time to, um, Take action.
And today is that time. It feels to me at least that the opportunity is deep and it’s great and things may change and may change relatively fast if a lot of dollars come out of the closet and do it fast. Suddenly we can be in the middle of our accelerated recovery.
Ryan Severino: Yeah, because the one thing I know we haven’t admittedly we haven’t, we haven’t quantified this very well over the last four to five decades, but there is almost certainly You know, the record amounts of the proverbial dry powder sitting on the sidelines, even if all of that doesn’t come back in, there’s still a lot of it.
And I say this, like even our firm, like we don’t want to be sitting on cash. I don’t get paid to sit on cash. My firm doesn’t get, I’m not, you know, I’m not telling you anything you don’t know, or the listeners don’t know. So, but I don’t, I don’t want to be. hasty about that. I want to be smart about it, but I also don’t want to be sitting on cash forever.
And there are a lot of organizations that are in the same position as we are. There are a lot of individuals that are in the same position as we are. And so if things really improve, I think it will start to accelerate faster than, than people think because they, you know, fear of missing out, you know, they, they won’t want to miss the boat on some of this stuff, but they’re going to wait.
So they have a little more confidence in the Fed and where the market’s going before they’re willing to jump in. And I can understand that. I’m not, I’m not trying to be overly critical. Um, but as I said, once the pricing starts to move, um, it might move faster than you think. And you might miss valuations on deals, um, that you could have gotten just, you know, a few months prior.
Mike Zlotnik: Yeah, I concur in the other real basic, um, economic effects, substitution effect, right? When the demand deposits are paying less and less, when Fed cuts, right, every time they cut, the, uh, There was even an article a little while ago that talked about CDM maturity, Uh, wall or cliff or something, uh, which they talked about the maturity cliff on commercial mortgages.
But on the other side, as a lot of these investments mature, you, you, you, you, you, you, you placed your money in the bank at a five and a half percent, and now you’re going to get Four and a half or even four and a quarter or even four, uh, we’re not that far off. If you, if you think about this could be three cuts this year, right?
It’s pretty, almost baked in and it’s even possible for half a percent cut to be somewhere along the way, if something breaks or something looks a little heavy. So before, you know, if you had another few more cuts, six months from now, we could be 100, 25, 150 basis points lower. And if that’s the case, it’s a very different experience.
Um, for, for the cash that’s sitting in, in, in short term deposits or money markets and earning at that point, it’s even more triggered to take action. Right? So maybe the next six months are more opportunistic if you can actually find the right deals and go into leverage is still conservative. That’s one thing I actually wanted to point out.
To comment on said industrial, low leverage, conservative deals, there’s nothing wrong with that. You can do a deal with 60 percent leverage and feel great about it and, uh, you will be ahead when the rates, uh, fall most likely.
Ryan Severino: I am 100 percent sure of that. There’s three things that I’m sure of. If the Fed is really going to embark on this path of cutting, which I don’t see any reason to think that they, they are lying to us at this point, then There will be that substitution effect because the interest rates on on deposit accounts will go down.
The cost of debt capital for real estate will absolutely go down because the premium that are the premium that are embedded in commercial mortgages will start to compress. And even if the NOI doesn’t increase, then just lowering interest rates will lower discount rates and cap rates that will put upward pressure on valuation.
So all three of those things will ultimately play out over however long this monetary cycle takes. Again, nothing fundamental is broken about the bond market or the real estate market. So I’m pretty sure that’s going to play out. The time horizon is a little fuzzy because we’re going to have to hear from the Fed on this.
But if, if, if this really happens over the next 3, 4, 5 years, Some people who are forward thinking on this are going to make a lot of money in the real estate space. And a lot of people who are fearful and trepidatious about this are going to wait too long. And I’m not saying they won’t make money. Um, but they’re probably not going to be the alpha dogs, the outperformers over the next three, four or five years.
Mike Zlotnik: Yeah. I appreciate that. I, I, a lot of people are dealing with recency bias, which is not a fun thing to have. And the recency bias could be painful and it could be emotional. Uh, but it’s almost like this. You have to look at what happened and, uh, last couple of years, the same way you look at a stock market, even though real estate investors are different.
So if you bought IBM, we’re going to pick on IBM for whatever reason. You bought IBM stock and it came down 20%. It’s not fun. Sometimes you just sell and you’re lucky in the loss. But you find and you move the capital where you actually can, uh, get an alpha. You can get an approved return, right? But this thesis, uh, I continue to certainly Sing the song that if you are a stock market investor, although I can’t, you know, predict where the market is going to go But if you’re sitting on heavily appreciated, uh, dollars in, in the form of these greatly appreciated stocks, you’re over concentrated.
You haven’t diversified. Real estate has been beaten up. Maybe it’s the opportunity today to do some re allocation, repositioning and sell some appreciated stocks and move into commercial real estate where the alpha is likely. If you take action soon, the opportunities ahead could be significantly better than the stock market. Although we don’t know that, of course.
Ryan Severino: No, but again, the one thing I’d be willing to bet on is that almost certainly the performance in the real estate markets will be better over the next few years than they’ve been over the last few years. And that alone is enough to make me,
Mike Zlotnik: that doesn’t say anything in the last couple of years. We’ve had years of struggle, right?
Ryan Severino: No. But my point is, is even if you don’t know where the stock market is going, The relative value argument suggests a higher allocation to real estate than what you would have had over the last few years because of the relative attractiveness, even if you assume that equity market public equity market returns stay constant, the spread between them will converge as the performance of the real estate market gets better and any reasonable asset allocation framework that would argue for a higher allocation to commercial real estate than you’ve had over the last few years.
Mike Zlotnik: Yeah. I appreciate the clarification. I agree. So your, your return expectation in 21, 22, where if you really looked at this as a peak of the market, they’d be negative, right? If you really understood what was going on, uh, and today they are highly positive because of where we are with interest rate and real estate is so sensitive to interest rates.
It’s almost like this. I’ve had this discussion and again, this is back to intuitive versus, uh, versus, um, um, Uh, data driven in an intuitive, intuitive space. You made decisions based on where the park is going, not necessarily past data. Cause data points to the past. You, you, you, you can’t collect future data because it doesn’t exist.
So I have to say that, uh, I talked to a number of folks of common podcast and they, they, they said you should have, you know, not you as a person, but we should have all realized we were at the peak of the market. We don’t know exactly where the peak was, but we’re approaching the peak. So forward return expectations should have been very, very different.
And most people were not really understanding that. They were just throwing money at what was hot. And this unfortunate, whatever you call it, recency bias. Recency bias was hot then, and today it is cold. But the reverse is true. Yeah, exactly.
Ryan Severino: This is why being a good Trarian always works in people’s favor, because that’s what people do, right? You said it recency bias, they extrapolate from what they’ve seen recently, and they think it’s going to persist. And it almost never does because there’s cyclicality, the economy, their cyclicality to the real estate market. There’s even a cyclicality to the stock market. It’s, it’s harder to see because it’s so volatile on a day to day basis.
But if you look back over time, you can see the equity market generally goes up. Yeah. And it does have peaks and valleys, even though it trends up in the long term. So, but it’s hard to look at the future if it’s going to be different from the past and not want to extrapolate from the recent past. That’s a very difficult psychological fault that people have that you have to actively work to surpass.
Mike Zlotnik: Yeah. Yeah. I appreciate that. One thing that’s really kind of been shocking for me for the stock market, uh, and maybe at least I misunderstood, uh, normally when the rates go up, stocks don’t really do well in the high interest rate environment. That was the theory of the past. This time around, it actually didn’t happen.
The stock market, I guess, enjoyed, uh, inflation driven increased earnings. And as a result, it didn’t really suffer corrections the way it should have suffered. So where we go from here is unknown, but it’s a, it’s a, there are cycles and patterns, although they don’t always repeat themselves. And that’s what we’re observing right now.
It’s a little bit of the, um, uh, let’s just call it the new chapter. Of the spiral that that doesn’t always do exactly the same but real estate’s pretty clearly Uh heavily dependent on the cost of money and the interest rates is is a massive, uh influencer where things gonna go Uh any final comments and then uh, we do need to talk more about uh immigration other subjects. We have to do episode two Yes, we’ll do that again last time. We got to do it again.
Ryan Severino: No, so the last thing i’d say is um, You It’s interesting to be sitting in this position because I really want to come back in six months, 12 months and have this conversation again, because again, some of it will depend on where the Fed goes, but it’s always difficult when you’re on the precipice of something to, to, you know, have full confidence in it.
And I think that’s where the market is right now. But if you give it six, 12 months of the Fed cutting rates and clearly communicating that. I guarantee you, the sentiment in the market will feel different, the volume will be different, the pricing will be different, even the tone of this conversation, and I’ve been, I think I’ve been objective, but still pretty positive in this conversation, will almost be even more positive in 6 or 12 months than you feel in the marketplace right now, as we’re literally a week away from the Fed about to cut rates.
Mike Zlotnik: I agree. I’m already very positive. You’re super positive. Uh, we just can’t get reinforcement. We’re going to look at the data six months from now and we’re going to say, yeah, we were correct or not. We’ll see. The time will show. We don’t know.
Ryan Severino: Here’s the last thing I’ll say. And then, cause I know you want to wrap up. Even if there’s some downturn in the economy, right? Even if something happens, then all that means is the fed has a stronger argument to cut rates in which case You’ll almost certainly see real estate values go up because you’re probably not going to see enough of an impairment in NOI to have a big impact.
But if the economy does slow down, the Fed might cut rates more aggressively than they’re thinking right now. And that will again, like the real estate economy is not broken. That will put upward pressure on real estate valuations. Unless you think, NOI is going to massively implode, which we never see during a recession, then there’s no reason to think even in a downturn, if the Fed’s going to cut rates, then you shouldn’t see valuations higher over the next few years than they are today.
Mike Zlotnik: Brian, these are, again, the words of the wise. Uh, I appreciate you bringing up this point because this is an insanely important point. I’ve heard this multiple times, but I was at a conference and a very similar discussion took place. So, I’ll reinforce this argument. Discussion is like this. So what happens when they, when unemployment rate increases by 1%?
Let’s just, let’s just call it how it is. Let’s just say unemployment rate increases by 1%, which is pretty significant. So you have, um, let’s call it what it’s labor force is about what, 150 million?
Ryan Severino: Uh, these days, yeah, give or take.
Mike Zlotnik: Million and a half people lose jobs,
Ryan Severino: right?
Mike Zlotnik: Terrible. Terrible. Bad news. But that’ll give a lot of ammunition to Fed to act more aggressive.
Ryan Severino: Right. That’s exactly right.
Mike Zlotnik: The crazy part is 1 percent of people losing, um, losing job. It’s going to impact certain amount of demand for sure. So I know why we’ll, we’ll, we’ll, it’ll take some pressure as a result of these cuts, but the improvement in the interest rates. Uh benefits real estate so much more and so much more powerfully and faster And and that’s that’s essentially the great wisdom, which you just said and I strongly believe it in some ways Um, you know as people pray I like to put a real estate investor prayer For a light recession for a little more employment and employment so the Fed can act a little faster.
Ryan Severino: I’m always a little worried about, I never want to be rooting for a downturn, but here’s what I would say. You don’t even have to take my word for it or my modeling for it, you can go look back over the last You know, three, four, five business cycles in the U. S. in the real estate market. And you’ll see the exact same thing, that the deterioration in NOI was, was not enough to offset the benefit that you got on the appreciation side.
Like it’s as clear as day as you look at the data. So again, I, I never want to root for a downturn. But there’s a safety net there. If you’re in right now, at least where we are in the cycle, there’s a safety net there in the real estate space that there would almost certainly be more of an improvement in appreciation returns that would offset any deterioration in income returns that would still make total returns go up like it again.
Don’t take my word for it. We’ve got 45 years of pretty good data at this point. 47 years. Go look at the last 456 business cycles in the U. S. You’ll see the exact same thing in the data.
Mike Zlotnik: Let me conclude hearing you here, it doesn’t matter what’s going to happen. We have two possibilities, let’s call it soft landing or a recession.
In both of these outcomes, real estate wins, right? So the way we’re looking at this, we almost can’t lose. And every possibility, either we win a little more, we win a little less. But on a formal basis, we are sort of geared up for, uh, likely great next couple of years.
Ryan Severino: Unless, yeah, my only caveat to that is that unless something really idiosyncratic, some kind of tail event happens. As long as we stay on anything reasonably predictable, right? Like no collapse of the global economy, no new pandemic, something like that. And I’m not even sure those would be as disruptive as they’ve been, but excluding something really out low probability event, we stay pretty much, you know, even, you know, within reason in the economy, it’s hard to see how real estate isn’t in a better position over the next few years. It’s really difficult to see that.
Mike Zlotnik: Yeah. And COVID taught us something that the Black Swan events do happen. Unfortunately, uh, we can’t predict and prepare for every Black Swan event. Uh, you know, God forbid something catastrophic happens in the world, a terrible mid, you know, some kind of meteorite
Ryan Severino: war. Like there’s geopolitical risk out there. I don’t want to make it sound like it doesn’t exist, but that’s usually not enough to completely derail the economy and certainly not enough to derail the real estate market.
Mike Zlotnik: Appreciate your wisdom. Thank you so much for coming on a podcast. We have to report second episode. Uh, so grateful. And, uh, what’s the best way for folks to reach out if they wanted to learn more? Is there a good website? I remember you were a professor at the, uh, NYU, right? You, you still do a little bit of teaching?
Ryan Severino: I do teaching. Uh, the easiest way to find me is on LinkedIn. Um, you could follow me directly. Actually have a, a newsletter that I write almost literally every week. You could sign up for that pretty easily. I’m. I am always writing about something. I’m always thinking about something. I’m always commenting on what’s going on in the world, in the real estate markets. That’s probably the easiest way to, uh, to track me down these days.
Mike Zlotnik: Thank you, Ryan. Thank you for your wisdom. Thank you for sharing.
Ryan Severino: Thanks for having me. It’s always my pleasure, Mike.
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