The Fed's Mistake, New Supply, & More

release edition [003]

read time [7 minutes]

Welcome to The Multifamily Download, a weekly newsletter where I provide institutional insights to help you build an exceptional career in Real Estate.

Today at a Glance:

The Fed: A 'no landing' scenario
New Supply: The story of 2025
Underwriting 101: Yield-on-Cost

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The Fed

You know who I would not want to be right about now?

Jerome Powell, because he is in a nearly un-winnable situation.

The Fed awkwardly now finds itself in seemingly a 'no landing' scenario.

The December CPI figures were released earlier this week, and the overall Consumer Price Index (CPI) rose by 0.39% (+4.8% annualized) in December from November, the sharpest increase since February 2024. It has been accelerating since the low point in June 2024.

The three-month CPI jumped by 3.9% annualized, the sharpest increase since April, and the fifth month-to-month acceleration in a row. The year-over-year CPI rose by 2.89%, the sharpest increase since July, and the third month in a row of acceleration.

What is going on in the economy, and how did the Fed miss this?

The Fed's potential misjudgment of inflation back in September stemmed from several factors, including persistent inflation pressures, the continued strength in services inflation, and possibly underestimating the impact of PPI on CPI.

Core services are about 65% of consumer spending and include housing costs, insurance of all kinds, health care, education, subscriptions, transportation, broadband, personal care services, financial services, food services & accommodation, etc.,

These service categories are where inflation is still climbing.

For example, the BLS graph below shows December YoY shelter inflation up +4.6% and transportation up +7.3%.

The question that we're all asking ourselves is this: How does the Fed create a scenario in which the costs in these services (and goods, for that matter) stop rising?

Enter: The reintroduction of Fed rate increases.

While I'm not (yet) predicting a Fed reversal, I expect the Fed to make no changes to their target rate later this month.

My biggest takeaway from the past 120 days is this: The Fed does not operate in a vacuum.

Outside market forces, public voices, and various pressures do influence Fed policy, whether we like it or not.

For example, read the below comments from the FOMC announcement in September 2024:

"The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. The Committee has gained greater confidence that inflation is moving sustainably toward 2 percent, and judges that the risks to achieving its employment and inflation goals are roughly in balance. The economic outlook is uncertain, and the Committee is attentive to the risks to both sides of its dual mandate." - FOMC Statement, 9-18-24

Based on the above statement, what do you expect the Fed should have done in September 2024?

Nothing!

But they didn't do nothing.

Instead, they lowered the Fed Funds target rate by 0.50%.

This is when the market began to realize that the Fed may have gotten it wrong.

If the Fed were just coming into existence today and had to establish an inflation target, it would be unlikely to choose 2.0%.

But, the Fed's goal has always been 2.0%, so adjusting the target upwards to 2.5%-3.0% would be admitting defeat and send shockwaves through the economy.

In short, the Fed has decided that it's better to remain anchored to (and miss) it's 2.0% inflation target, than to adjust the target upward and wipe out the market's confidence that the Fed can achieve it's goals.

The combination of the market's realization, the Fed's seemingly unachievable goal, and a blistering post-Election stock market rally to conclude 2024 created a perfect storm of bonds selling-off due to concerns around the rapidly-increasing Government deficit and it's maturing 2025 debt, as well as future inflation concerns under Trump.

This lead to a Treasury run up, and ultimately, to an uninverted yield curve for the first time in 26 months.

Oh, and did I mention that the December jobs print smashed expectations?

Two questions I'm asking myself right now:

What will the Fed do at their January meeting?
What should the Fed do at their January meeting?

I'm not so sure that my two answers to these questions are the same.

What do you think the Fed should do at the next FOMC meeting?

Supply

One of the main themes for Multifamily in 2025, aside from the Fed's conundrum above, will be the delivery of new supply.

As I touched on last week in my 'Predictions' section, 2022-2024 will go on record as the largest total supply of multifamily deliveries from a national perspective.

Even so, there are another 508K still under construction and expected to deliver in 2025 according to Yardi.

With the way the economy is trending from a consumer spending perspective, I find it difficult to fathom that the remarkably strong renter demand we saw in 2024 will have a repeat performance in 2025.

As such, I expect 2025 to be the year of winners and losers.

Some markets will surprise to the upside with 5% or greater year-over-year rent growth.

Other markets will surprise to the downside with flat or negative year-over-year rent growth.

The graphic below from RealPage is a great visual forecast of expected rent changes in 2025.

You'll notice that high supply markets are in the right two columns, including markets such as Phoenix, Charlotte, and Austin.

If you don't already have target markets selected for 2025, I will save you the 30+ hours of research that I did to choose our markets back in December: Look carefully at the markets in the left two columns.

While profitable deals can be found in any market, proper market selection can make Multifamily investing much easier.

Underwriting 101: Yield on Cost

When I'm evaluating new acquisition opportunities, an important metric to consider is the stabilized yield-on-cost.

Many investors focus on the cap rate, but cap rate doesn't tell the full story, and it can be easily manipulated.

As I wrote about here on LinkedIn a few months ago, the yield-on-cost is found by dividing the NOI by the total project costs.

This metric is important because it demonstrates the projected return on a relative basis to what is spent.

This is critically important, especially for owners/operators like myself that are essentially in the investment management business. (i.e. deploying capital into investments on behalf of outside equity partners).

Typically, institutional investors want to see a stabilized YOC that exceeds the prevailing market cap rate by 150 - 200 basis points.

For example, if a stabilized YOC is 7.50% and the projected market cap rate is 6.00% at exit, then there's 150bps of what's called 'spread'.

Evaluating the YOC spread is a common methodology for projecting the (a) viability of an investment opportunity, and (b) the embedded margin of safety that the investment may possess if markets were to turn. (It is important to note that this spread can adjust depending upon the product type, market profile, and economic environment).

Think about the YOC during your next underwrite and consider these questions:

"What is my trended (market rent growth) vs untrended (0% rent growth) stabilized YOC?"
"What is the spread between the stabilized YOC and the projected market cap rate at exit?"
"Does the YOC grow during the lifetime of the investment, or does it plateau or decline?"

Making investment decisions through the YOC lens will help better understand what it costs to move the NOI and achieve projected returns.

There is no 'magic formula' when it comes to underwriting Multifamily, but YOC is certainly a metric that should be carefully evaluated before your next visit to the closing table.

Weekly Listen

Once again, my featured listen this week is the Walker Webcast featuring Willy Walker and Dr. Peter Linneman.

This was Willy and Peter's 20th public conversation, and they pull no punches. Willy reflected on Peter's 2024 predictions, and they discussed what Peter got right or wrong, and why.

I believe you'll find this conversation to be both engaging and informative as we embark on 2025.

You can listen to the full episode here.