Geopolitical Risks and Real Estate with Neal Bawa - REIA 488

Welcome to Real Estate Investing Abundance, the show for busy, fulfilled professionals like you to learn how to develop financial independence built on solid passive real estate investments. Now, here is your host, Dr. Allen Lomax.

Hello, enlightened investors. Welcome back to Real Estate Investing Abundance. I'm so delighted to have back with us again today Neal Bawa, who is no Stranger to the show and probably no stranger to any of you, but Neal is a technologist who is universally known in the real estate circles as the mad scientist of multifamily. Besides being one of the most in-demand speakers in commercial real estate, Neal is a data guru, a process freak, and an outsourcing expert. Neal treats his $1 billion-plus multifamily portfolio as an ongoing experiment in The efficiency and optimization. The mad scientist lives by 2 mantras. His first is, we can only manage what we can measure, and his second mantra is that data beats gut feeling by a million miles. And these mantras and a dozen others, disruptive beliefs, drive the profits of his 900-plus investor profits. So Neil, welcome back to the show. Delighted as always to have you with us. Thank you, Alan.

us.

And so we're going to talk a few minutes here today about the 3 inflation indicators that have just recently come out.

Yeah, well, thanks for having me back on the show, Allen. It's always fun to be having these kinds of conversations with you, especially at what I consider to be one of the key turning points to this real estate cycle. And when I say real estate cycle, I'm not just talking about multifamily, I'm also talking about single-family. There have been, you know, significant cracks in the single-family market in the last 6 months. I'm seeing prices decline in many super hot markets such as Austin and Phoenix and Boise. And people are just, you know, having trouble paying 7% interest rates for even the single-family market, which overall has been very resilient. If you look from the, you know, from the peak, which was around March 2022, the single-family market is actually up. It's up about 4 or 5, 6% since then. So, minor increases, but it's up. Whereas the multifamily market now, you know, most people have realized is down about 25% from peak in terms of overall prices based on a cap rate, not on, not on a price per door, but on a cap rate basis. Multifamily is down about 25%. So the, the last 3 inflation readings have been critical. The Federal Reserve, I believe, is, you know, is not perfect or they're far from perfect. They did make a mistake in 2021. But what I like about the Federal Reserve is, unlike our politicians, whether it's Democrats or Republicans, nobody will ever accept a mistake. As a politician, if you accept a mistake, your career ends. As a— the Federal Reserve in many meetings has accepted its fault for late 2021, where they said we thought inflation was transitory. And it turned out that it was transitory over a much longer period of time. So that term was wrong and we were wrong. So I like the fact that the Fed is the kind of organization that in a dozen interviews, their chairman, their governors can basically say, mea culpa, we made a mistake, and still have their jobs and be able to move forward. I love that. And so I listen to what they have to say about inflation, about interest rates, much more so than let's say CNBC or Fox News. Everyone of these organizations has an ax to grind and a specific purpose to move towards. where the Fed basically says, we are data-driven. We can say this direction today, and then a day later we can say that direction because new data comes out. And I like that. And so the Federal Reserve, 3 months ago, what they were saying and what they're saying this week is completely different, right?

Mm-hmm.

3 months ago they were saying, we are seeing some encouraging signs about inflation, but we don't think that the fight against inflation has ended. Right? We, you know, there's a lot more to do. Those are the— and Fed governor after Fed governor, I basically, you know, read about 6 or 7 or 8 of these ranking Fed governors. They all basically sing the same tune. There was one of them, his name is Austan Goolsbee, who felt that we should start cutting rates. With the exception of that one guy, I think he's a Chicago Fed, everyone else was saying pretty much the same thing. But last week and this week, there have been interviews from Fed Chairman Jerome Powell. Powell appeared before Congress last week, and this week he had a big conference that he was there and they asked him a lot of questions. And his tune has completely changed. His tune is we've had 3 very good readings about inflation. Right. And those 3 readings tell us that, you know, we are ready to start cutting interest rates. So the chances of the Federal Reserve cutting interest rates now in September is at 93%. So there's actually— this 93% number comes from a survey of Wall Street folks, you know, how confident are they. And so they sort of aggregated together. 93% is very high. And there's now a greater than 50% chance that we will get 2 rate cuts this year, one in September and then one in either November or December, the last meeting of the year. And I think that those numbers are going to rise over the next few weeks because I am seeing significant weakness in the economy in Q3 of this year. I'm looking at, you know, lots and lots of different things that I look at. I look at manufacturing indexes. I look at, you know, consumer confidence. I look at what's happening in the political space, which obviously can create nervousness. And, you know, nervous consumers don't spend big money. They don't buy cars. They don't buy homes. And what's happening in the political arena is definitely creating a great deal of nervousness. So I I believe that that will have a short-term impact on the economy. So I expect that we will get more positive inflation readings. But, you know, before I tell you what I think that means for real estate, let's dive deeper into those 3 inflation readings. Right. So inflation peaked in, I believe it was June 2022 at 9.1%. So that was the peak of inflation, 9.1%. Before that, if you look at the 10 years before that, before we had this spike, inflation was below 2% for for the 2-year, 10-year average. So it might have been somewhere around 1.5%. And so the Fed actually had a bigger challenge of creating inflation than having inflation that's too low. The Fed likes inflation to be at 2%, 2.5%. And, and so, you know, we peaked at, you know, in 2022 at 9.1%. And then inflation smoothly came down, very smoothly if you look at the decline to 3%. And then it got stuck there for about 9 months. stuck, right? It wouldn't go down further. It got stuck at 3%. And this is not unusual in previous Fed hiking cycles. You know, there have been 9 of them since World War II. We've seen that it's actually very easy to reduce inflation when it's very high. But then, you know, that last 1% of getting back to 2% is actually the hardest, right? Because people's, you know, people have these beliefs about inflation staying high and you have to basically break through that belief and it takes a while to break through. And so, Bottom line is that the numbers that we were seeing in Q1 of this year, which were showing inflation potentially going back up, was a head fake. And in the last 3 readings, all 3 of these numbers on an annualized basis are under 2%. Okay. They're individual monthly readings. Right. So let me give you an example. So, Alan, if I say, you know, month over month inflation is 0.1%, then I have to take that 0.1% and multiply by 12 months. So I end up with 1.2%. So I'm basically saying on an annualized basis, if I annualize this, it's, it's, you know, going to be 1.2%. So we had some really low numbers around 0.1% and 0.2% over the last 3 months. But the Fed doesn't look at these numbers individually because one high reading, one low reading shouldn't mean anything. So the Fed typically looks for 3 consecutive readings to understand the direction. And now we've had 3 consecutive readings below 2%. Right. And so if you annualize the last 3 months, we're looking at inflation around 1.2%, 1.3%. Now, if you look at the last 12 months, we're at 3%, which is the lowest reading we've had in a while. So clearly, on an annualized basis, we're above the 2% mark. But the Fed realizes that looking at the past can be problematic. So they're looking at the last 3 months and saying, where are we for the last 3 months? Well, we're well under 2%, Alan. And that's why today, for the first time since we started raising rates, the Fed feels comfortable in saying we are ready to cut rates and they're ready and saying that publicly. Right. Where before their statements were always filled with caution on, well, we'd be data-driven and we're looking, the fight isn't done. That's not what Chairman Powell is saying in his meetings this week that are public. on television, on YouTube, he's saying something different. And that's why I think that we are at the point in this cycle where there could be, you know, significant change and significant turn. We can talk about what that means for real estate, but, but that's really what I meant when I talked about those 3 inflation readings.

Well, so that— so this does take place and interest rates do come down, um, are there any predictions on The rate of decline?

Rate of decline for inflation, you mean?

No, for interest rates.

Yeah, so I think we are in a better position today than we were 2 or 3 months ago. I would have— if you'd asked me this month— this question 3 months ago, I would have hedged my bets a lot, right? Nobody wants to be wrong on air. This interview is going to be on YouTube. But I feel very certain now that we will get 2 quarter-point interest rate cuts this year. And there's a possibility, though not a strong possibility, that we'll get 3 and that we will certainly get 3 or 4 next year. So here's what I'm willing to say, that 1 year from now, rates should be 125 or 150 basis points lower. So we're, you know, we're doing this in some— sometime in July 2024. And so I'm going to say July 2025, you know, between those, those 12 months, we should see 5 or 6 rate cuts of a quarter point each. What does that really mean for the consumer? It means that mortgage rates are probably going to be about 125 basis points to 150 basis points, which is 1.25% to 1.5% lower than they are right now. So if you're looking at a single-family home, You're right around 7%. So July next year, you should be right around 5.5%, you know, 5.6%, somewhere in that range, right?

Mm-hmm.

What does that mean for multifamily? Well, today multifamily, if you're trying to get a fixed Fannie Freddie loan and your property is 90% occupied and doing fairly well, you're somewhere around, I would say, 6.2%, 6.3%, depending upon the day. Probably closer to 6.2 right now because the Treasuries have adjusted. And so, 150 basis points for you takes you down to 4.7, 4.8. Now, multifamily doesn't exactly work the way single-family. So, I wouldn't say 4.7. I'd say probably 4.9, could be 5, somewhere in that range. It could be 4.95 in July next year. That's my prediction. 5 to 6 cuts. multifamily, you know, fixed rates a little bit under 5%, maybe 4.9%, maybe 4.8%, a year from now, and the bridge market coming back. Now, a lot of people don't understand that the reason why the bridge market really doesn't exist— bridge loans are available. You can go out and get a bridge loan today if you want. But the problem is you can't really buy buildings with a bridge loan for 2 reasons. One is your investors won't give you money because until they see a significant number of rate cuts, you can't sell it to them that, hey, a bridge loan is the right way to go, even though I'm 100% convinced today that if I could convince my investors today, I would get a bridge loan because my bridge loans are going to get— see a step down, right? So as every time interest rates come down, my bridge loan comes down. But, but it gives me the flexibility to refinance into the future where a fixed loan doesn't. So hard for me to convince my investors. I think it's hard for anybody else to convince investors. But one year from now, I am predicting that you will be able to, and most of us will be able to convince investors because they would have seen 5 or 6 cuts. And so at that point, we will be able to convince investors to take on bridge loans. And second, bridge loans will be easier. Today, bridge loans are hard because bridge loans are currently still factoring in the fact that interest rates may not go down. And bridge rates are composed of, you know, let's say the SOFR, which is, you know, basically kind of think of it as the, the U.S. Treasury rate. So Treasuries for 10-year fixed are right now in the 4-ish percent range, 4, 4.5, somewhere in that range. And so on top of that, there is something known as the spread, right? Or— but on top of it, right? So you got the, the base rate, which is a Treasury rate or equivalent, right? SOFR. And then on top of that, you have something known as the bridge— uh, sorry, the, the, the spread. Well, that spread is elevated right now. Why? Because banks see potential risks. They don't know if inflation's really dead. And so, they don't want to take a risk. So, they put a bigger spread on it. But next year, not only should you see the rate portion come down, right, whatever that rate portion is based on what I just said, 5 or 6 cuts, but you should also see some reduction, not a huge reduction, on the spread part. So, bridge loans will benefit twice. They'll benefit from the base rate going down and the spread settling down a little bit as we start moving into a 2% inflation environment. And that's why I think that we will actually be able to make bridge loans work next year. So, when bridge loans work, multifamily becomes very bullish because when you use bridge loans, you have the ability to get higher leverage. You have the ability to do a lot of things that you cannot do with fixed loans. and you have the ability to forecast, oh, I'm going to get rent increases over the next 3 years and then I'm going to basically refinance or I'm going to do this or I'm going to sell. It opens up options for you that you don't get with fixed financing. So, it can bring an element of bullishness back into the market around Q2 next year. So, you know, hopefully, long answer to your question, Allen, but hopefully that answers your question about, you know, where do I see the reduction in interest rates. And You know, I try to sort of also pigeonhole that with what that means for the multifamily market.

Enlightened Investors, if you haven't done so already, be sure and click that like button and also click that share so others can take advantage of the content. And finally, be sure to subscribe so you don't miss a single one of our upcoming episodes. So with it becoming bullish, I guess that would follow that we're going to see price increases.

Yes, but I want to be very careful. So I want to say yes, but. I'm going to say yes, but. So the way cap rates work is they lag. Okay? They lag. So remember, interest rates go up, cap rates go up. Interest rates go down, cap rates go down. But there's a lag. And part of that lag is that it takes roughly 5 to 6 months to close a building. So if I make an offer now, Some buildings might close in 90 days, but most of them will close in 120, 150 days from now. And then it takes CoStar another couple months to even figure out that that building has closed and what the cap rate was for that to show up in CoStar's numbers. So I am one of those fans of the CoStar curve. I study the CoStar curve for every submarket and every market that I'm interested in because I want to understand why is CoStar saying, well, here's the peak of cap rates. Remember, all of us are looking for where's the peak of cap rates. And the peak of cap rates on a national basis is currently projected by CoStar to occur in Q1 next year.

Mm-hmm.

Okay? So, Q1 is where we get the highest cap rates. But remember, Q1 next year for CoStar means that the rate was actually hit more like September, October this year because that's when the offers were being made and we went into best and final and the properties got locked in. And it just took until Q1 for the properties to actually get sold. And, you know, CoStar has to calculate the, the rate based on date of sale, not the date of contract, and there's a 5-month lag there.

Yeah.

So, I think that I agree with CoStar on that. On a national basis, the highest cap rates that we are going to see are probably Q1 of next year, which means that on a sale basis, the highest cap rates that we are going to see is in the coming 3 months, right? So, July, August, September is probably the lowest— the highest cap rates that we see, which means the lowest prices on, you know, for the same net operating equivalent, right? So, remember, you know, a property that's doing phenomenally well today is worth more every day regardless of what's happening with cap rates simply because, you know, a cap rate is a multiple of net operating income. So, if your income is going up, your property is worth more every day anyway, right? that all of these properties, their income is exactly flat, exactly the same. Then what I'm saying is the lowest— the price point where the property is worth the lowest is in the coming 3 months: July, August, September. And starting October, even if that property's income doesn't increase by a dollar, it's worth a little more, and then a little more, and then a little more, and then a little more. And that process, that curve, is what you see in CoStar reports where they're saying that the market should return to low cap rates, but not, not to the cap rates that we saw in 2022 because they were They were absurd. They were a bubble. But the market will return to low cap rates in 2027. And we will see the start of that decline in cap rates, which means increase in prices, in Q1 of 2025. So, and basically starting Q1 of 2025, every quarter is a lower cap rate until sometime in 2027 where we start seeing a flattening at a pretty low basis.

Right? Mm-hmm.

And so, 2025, 2026, 2027 are all years where we should see declines in cap rates or increases in prices. Unless, of course, there is a future, you know, inflation spike, which I would not rule out at all. I mean, I'm not ruling out a future inflation spike at all. But I think that that's what you'll see for cap rates. That's what you'll see for prices. And again, as I said, from a sales perspective, those of us making offers, the lowest offer is probably in September this year. And then after that, for the same exact property with the same exact profit, I'd probably have to bid up a little bit beyond that point of time. Why? Because I have— and you might say, why? Well, the answer is because in September we get a rate cut. The moment you get a quarter-point rate cut, you can bid that property up a little bit more because the bank will give you several hundred thousand dollars more for a 200-unit property the moment that rate cut happens, right? And then if you get another rate cut in December, once again, you get several hundred thousand dollars more for a 200— You know, unit property. So now people have more room, which automatically has an effect to stabilize and then finally increase prices.

Well, fascinating information there. So tell us, Neal, about your company and how it is we can get in touch with you.

Absolutely. So, you know, I happen to be lucky and unlucky in the sense that I am the only Neal Bhow on the World Wide Web. So as long as you spell my name correctly, N-E-A-L B-A-W-A. Everything that's happening on the web, everything that you see, the YouTube videos, they're all about me. So not hard to find me. But the right way to find me is Multifamily University, which is multifamilyu.com. That's www.multifamily followed by the letter u.com. Because we publish all of the data that I've just given you in a much more detailed format with 12 data-driven webinars. For our audience each year. So, we go out and do these data-driven webinars and they're related to various aspects in real estate. I'm writing one for Airbnb right now. I'm writing one for industrial. And so, we do all these interesting, unique webinars and our teams go out and build these decks. We do several hundred articles worth of research and we put all of that together into a real estate toolkit which is then hosted on this website. Everything's free. There's no subscription. There's no upsell. There's no, you know, oh, you have to pay $1,000 a year or $25,000. There's nothing like that. We don't sell education. We don't have any intention of ever selling education. What we do and what we're good at is research as data scientists. Gather research, distill it down into something that's easy for people to understand, and share it on this website. And you might say, what benefit do we get out of it? The answer is very straightforward.

Yeah.

roughly 1.25% of the people that are in our ecosystem that come in and use that data become our investors. That's it, right? So, you know, we've, we've had over 100,000 people, uh, or maybe 90,000 people use this data in the last 5 years. We currently have 1.25% of them, which is slightly over 1,000, as our investors.

Well, Neil, there's been some huge changes in the world, uh, in, uh, essentially the last 2 years, and you're talking about the Fed They're willing to say that they have made a mistake. Well, in 2022, they seem to have made a pretty huge mistake in the fact that they thought sanctioning Russia was going to crumble the Russian economy, and in fact, it didn't do that, and in fact, it drove a very, very strong alliance between Russia and China, and which changed a whole lot of things in terms of world economics. So how is that going to play into real estate investing in the United States?

I think all forms of investing, not just real estate investing, are going to be difficult in the next 10 years compared to the previous 10 years. So I'll just say that every form of investing is going to be riskier, And on average, returns from any form of investing are going to be lower. The only exception to that rule may be Bitcoin. I'm not a huge fan of Bitcoin, but Bitcoin benefits when there is— people are scared. It benefits when there is upheaval around the world and systems and processes break. You know, when there's distress, Bitcoin benefits. So Bitcoin may be the exception to that one rule. But any and all form of investing will become more difficult in the next 10 years because the world order is breaking. And basically it breaks every 50 years or so, or 50 to, you know, and we've actually had an incredible amount of peace starting 1945 to now. But that era of peace and stability and having one world order is ending. And I don't know what the new form will take. I am convinced absolutely that the United States will come out stronger from this break, you know, in terms of world GDP or proportion of world GDP than it is today. But that's on the other side of this. And I don't know how long it takes to get to the quote unquote other side of the current world order. But there's going to be sure to be upheaval, and that upheaval is going to affect the United States as well. I see potential inflation spikes, one because of oil challenges, which the US is insulated against. We are the world's largest energy producer. We're not the world's largest energy exporter, which is good because we don't sell energy to other people. We use it in-house, which is great, right? So that insulates us from oil shocks to some extent. But if the price of oil were to rise worldwide, the price of oil here will rise too. So it's not fully insulated. It's just we never get to the point where we don't have supply. It's just the price is higher. The other thing that can cause inflation is a breakdown in relationships between China and the United States. Russia is simply not a functioning economy at this point. Russia is the world's gas station, and it continues to be the world's gas station because now it exports oil to other countries. So it doesn't send oil to the US or to Europe. It, you know, ships it to other parts of the world. And so it continues to be the gas station, but it's not a functional economy. It doesn't really play any role in worldwide supply chains, with some small exceptions like uranium and other things that it that it has control of. China is 100 times more important than Russia to the world economy, and not just to, to the, you know, US and Europe. It's, it's important to any part of the world. It is the world's factory. And, and despite all these comments about manufacturing return to the, you know, returning to the United States, these are trivial comments. For manufacturing to return to the United States, if they're— if it's returning at the pace that it's currently returning, it will take roughly 5 decades, 50 years to rebuild those supply chains in the United States, Mexico, and Canada. So that— are we doing something about it? Yes. Is that rate acceptable? No, not even close. We need to, you know, increase that rate by 10x or 20x, and there's no money to do that. So it's not going to happen. Bottom line is the biggest single risk to real estate, the biggest single risk to inflation is a You know, an outbreak of hostilities between the United States and China over Taiwan. And the Chinese are preparing, uh, the Chinese are continuously adding to their fleet. They're, they're clearly making the right steps to go in that direction. The only piece of good news is this: due to an extreme piece of luck, China does not have a land border with Taiwan where the Russians had a land border with Ukraine. And so the US and Ukraine knew about 30 days before the attack that Russia was going to invade, because at the 30-day point, it's pretty obvious that you're doing a bunch of things that you would only be doing if you were planning, planning to invade. That is not the case with China and Taiwan. The Chinese would need to do a bunch of very obvious things roughly 1 year before they invade Taiwan, 12 months before, because there is 100 miles of sea Between them and Taiwan, this means that we'll get plenty of warning. Does it mean that we won't get an inflation shock? No, but we'll get plenty of warning. We'll know. We'll see it coming. We'll have people saying, you know, Democrats and Republicans six months or twelve months before the actual invasion that's going to happen. So we'll have a little bit of time to adjust, a little bit of time to work with our supply chains, but it'll still be the most insane inflation shock. Will it be like 2022? No, it will be far, far. worse, right? Because what was— what happened in 2022 was not a break in the supply chains. There— we— stuff was coming from China every single day. It was just slower. It was taking longer to get out of ports. So all we did was we slowed down the supply chains, and that took us to 9% inflation. What if we cut those supply chains off entirely for 6 to 12 months?

Mm-hmm.

So we'd, we'd get, you know, 50 or 100% inflation. So that is certainly a possibility. And I see it happening in the 2028 timeframe. The only likely scenario where it doesn't happen is if Chairman Xi, who, who is the supreme leader of the Chinese people, dies. If he doesn't, then I think that we're pretty much locked in for a conflict in 2027, 2028. So, you know, because we'll have a year worth of warning, you'll start to see inflation rise in 2027. Why 2027? Why not now? That's because the Chinese still need another 2 to 3 years of making ships at a frenzied pace to get to the point where they can attack.

Or we could just back off and form an alliance with China, but that ain't gonna happen.

That's right. And, and, um, you know, and, and we could also see unicorns tomorrow morning. I think that the, the problem with politics is that things tend to go in only one direction, right? So here, and how does it adjust? It adjusts through war, right? War is actually the adjustment. War is the only thing that allows politicians to eat humble pie, right? And nothing short of war. So we have not seen in the past these kinds of things sort of back off unilaterally for people to back off for any reason. It happens when politicians die. For example, if Putin or Xi were to die, then there would be a chance for a reset. But short of that, it doesn't matter. And the United States, because we're a democracy, it's a different guy every 4 years anyway. So all of these guys at this point can't, you know, back off because all of them would look weak if they were to back off. You're saying anything complimentary about China today is political suicide, even though there's actually a million things that we could say, good things that we could say about China if we were Let's say the Federal Reserve.

We could, yes, indeed. Anyway, we're getting into strange territory here that a lot of people in the United States do not want to look at, so we'll end it there. Well, Neil, it's been wonderful being with you today, and thank you for sharing your data-driven information. It's always greatly appreciated. Thanks, Neil, for being with us.

Thanks for having me on. We've come full circle. I've been on your podcast for years, and, and so, you know, we— during that time, we've sort of seen a circle, and it's nice to kind of be at the point where the circle's touching again to where we started.

Excellent. Thank you, Neil.

Awesome. Thank you. Bye-bye.

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