Turning up the Heat and Icarizing the Economy

CWS Turning up the Heat and Icarizing the Economy

Last week was my birthday, and I chose to celebrate it by heading to my home in the desert to check out some work that had been done and to play tennis.  This picture from my car dashboard shows a couple of pieces of interesting information. The first is the 106-degree temperature that was in place on Thursday (my birthday) at around 6 when my tennis round-robin began. The second is that I have been listening to the always enjoyable Good Ol’ Grateful Dead podcast. This season has focused on the 50th anniversary of their 1973 tour. If you’re a fan, I highly recommend this podcast.

Here Comes Sunshine Good Ol' Grateful 106 degrees June 29, 2023 CWS

I have found that playing in the heat, particularly in the desert, is not much of a problem for me and can actually be a competitive advantage when playing against those who are not as well acclimated or don’t have the mindset that it can be a challenge and opportunity and a great test of one’s fortitude. 


Since starting at CWS, I have benefitted from the experience and, hopefully, the wisdom that has accrued from navigating through four downturns. I’m not going to say that I necessarily look forward to them, but I will acknowledge that there is nothing like challenging times to focus one’s time, talent, and treasure to identify the most pressing issues that need to be triaged, to get ahead of potential problems, and communicate proactively and honestly so all key stakeholders are aware of what is happening and can be enrolled to help work through the challenges collectively. I have also come to learn that we are often reasonably well prepared when downturns come and can come out the other side stronger. Taken together, I would say I look forward to the challenges downturns can present, but like playing tennis, I would rather keep growing from a position of strength than have to dig out of holes.

CWS is a pretty deep and talented organization with highly capable people in key leadership positions who have also experienced downturns, have a long-term perspective, and always put the interests of our investors first. This creates great alignment and a powerful esprit de corps that helps our teams gel when challenges arise. In addition, everyone is well aware that our paramount goal is to always be on the playing field so that we can take advantage of the opportunities that inevitably materialize when all hell breaks loose, as it periodically does.

In order to live to fight another day, we have learned how important it is to be prudent about our leverage in terms of focusing on accessing the lowest rates with the most amount of interest only and terms. Proceeds have almost always been secondary. It’s also been of paramount importance to capitalize on our investments with healthy cash balances and to do our best to maintain them while still investing in the upkeep of our properties. This is not always easy, but prioritizing this, even at the expense of investor distributions, has enabled us to navigate challenging times, including this one (so far).

There will inevitably be times when cash will be needed to support an investment so it’s critical that sponsors have access to fairly priced capital to help buy time for the property until it can be refinanced, sold, or the operating income improves, or some combination of the three. We are entering a time when a lot of properties are going to have challenges either servicing their debt or refinancing, or a combination of the two, so this is going to become even more important.

Why do I make this assertion? Let’s do the math. Let’s assume that a property was bought five years ago at a 4.50% cap rate, and Net Operating Income has grown 4% per year. It wasn’t unusual for borrowers to access loans at 65% to 75% of the purchase price. Given where interest rates are and more conservative underwriting parameters, the borrower would not qualify for enough proceeds to replace the loan without adding additional cash unless the original loan was approximately 70% or less of the purchase price. This is probably a manageable hurdle for those properties bought five years ago or more, so there probably won’t be a huge problem as loans come due. With that being said, there will still be seasoned loans maturing that will have proceeds shortfalls, but it should be a manageable issue overall. That is not where the biggest problems lie.

The real problems will come from the large number of properties that were financed in 2021 and 2022 when the acquisition market was most frenzied, equity capital was eager to invest in apartments, and cap rates were in the 3.5% range (generous as many properties traded for lower cap rates), and leverage from non-regulated lenders was accessible in the 70% to 80% range at high floating rate spreads. Add to this that loan terms were typically three years, and these borrowers will undoubtedly be facing a real problem as their loans come due over the next two years. 

By my calculations, based on underwriting parameters from Fannie Mae and Freddie Mac, these properties would have needed to utilize approximately 50% financing at acquisition or previous refinance to qualify for enough proceeds today to replace their maturing loans. This is a material shortfall and can only be made up by very high-cost debt from aggressive, opportunistic lenders, preferred equity infusions, capital calls from existing investors, or a combination. This is a very big problem for multifamily, and the office market is far worse. The risk of significant equity loss through foreclosures, distressed sales, or dilution from new capital raised is material and growing for many of these groups that borrowed using these aggressive loan structures.

Despite the inevitable collision course between many overleveraged real estate borrowers and maturities resulting in a shortfall in proceeds or the more current, widespread problem of cash flow not being sufficient to cover paying the monthly debt service in full, Jay Powell and the Fed seem to savor turning up the heat on the financial sector and seeing who can play through it and who will wilter. It’s akin to my enjoying playing in the hot desert, although I don’t control the sun like Powell and the Fed do.

After finally pausing in June after raising interest rates 10 consecutive times, Powell is now signaling that two more rate hikes are on the table. This chart shows how the market is now pricing in the Federal Funds Rate hitting a peak of 5.50% in this cycle.

US Market-Implied Terminal Rate June 29, 2023

Inflation is clearly coming down, and where rates are, even with no further increases, significant pain will be inflicted on many types of borrowers across the economy, particularly if loans are coming due over the next couple of years and/or have floating rate loans that were financed when rates were much lower and asset values meaningfully higher. Powell is forcing many credit-sensitive players in the economy to fly much closer to the sun than they ever intended or expected. It will be interesting to see how it all unfolds and who gets burned, incinerated, or is able to come out stronger and healthier.

Admittedly I never thought that rates would get this high, and we are not immune from feeling the pain at CWS. On the other hand, our loan structures are much more conservative than those who chose much more highly leveraged, higher-cost, and shorter-term loans. We have made a concerted effort to keep our cash balances high, communicate openly and honestly with our investors, and have access to capital to get us over the hump if necessary. And while we are definitely feeling the heat, like my tennis matches in the hot desert, I intend to use this operating environment to help CWS turn this into an opportunity and outperform those of our competitors who don’t have the conditioning to fly so close to the sun without getting terribly burned or taken out of the sky completely.

It now seems clear to me that Jay Powell is turning up the heat and Icarizing the economy.

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