Knox Q4 2021 Investment Update

2021 has surely been an interesting year for investors. Property investors have had a banner year and there’s a lot to think about going into 2022. 

Rents are going up

Across the Knox portfolio, we’re seeing rents going up. We expect this trend to persist for the foreseeable future. As the price of housing goes up, one can usually expect rents to follow, albeit with some time lag. The spread between the cost of owning vs. the cost of renting ebbs and flows over time. In recent months, a rather large gap has formed. It is reasonable to expect that gap to narrow. If housing prices don’t correct, rents will rise, and few voices expect a housing correction. 

Inflation

The top economic topic in our country is surely inflation. For starters, supply chains are strained. The pandemic has fundamentally altered how goods move around the globe. We’re not seeing empty shelves at stores, but we are seeing lower inventories, ships sitting at anchor awaiting ports to unload, and longer delivery schedules for just about everything. Try buying the appliances to outfit a kitchen and you’ll be lucky to have them 90 days from now. A year ago, you could have your pick of washing machines delivered in a day or two. Labor shortages are driving inflation, too. The economy shed millions of jobs at the beginning of the pandemic. Many Americans have not reentered the workforce. There are far more job openings in our economy than workers to fill them. To fill this gap, we need our workforce participation to rise. Absent more workers, wages are rising, along with the cost of goods and services they produce. As if that wasn’t enough, we’ve been pumping money into our economy for the last year and a half — buying bonds, issuing stimulus checks, bailing out industries. The Fed has been buying $120 billion in bonds every month, leaving corporations flush with cash. Yes, that means they’re creating that money when they make those purchases. Corporations borrowed $19 trillion dollars in the past year. It takes time for all that money to fully impact the economy. We’re feeling that impact in many ways. Inflation is the one that catches the headlines. Capital doesn’t just sit. It moves and those movements take time. We’re seeing the lagging impacts of flush consumers and corporations. It’s likely that the economy has not yet seen the full impact. Wages are rising. Prices are rising. The cost of housing is rising. 

What we’re watching

In a word, Evergrande; the mega huge Chinese real estate developer known for building high end units in China’s new and ever-growing cities. Recently, they missed some bond payments. It’s safe to say that in the US, Evergrande would be called too big to fail. However, the Chinese government has not bailed out Evergrande. One could argue that the Chinese government is letting capitalism take its course. But Evergrande’s financial problems are leaving thousands of homes unfinished, even though owners have already written deposits for those homes. This may seem half a world away from the US housing market. However, let’s remember that at the headwaters of the great recession, was the US housing market. This rippled into a financial crisis that spanned the globe. It remains to be seen the scale of Evergande’s impact on the Chinese property market and whether this will spread to other markets. We’ll be watching. 

Big funds are still stocking up on housing

Wall street and private fund home buying for the purpose of renting out those homes continues. In some markets, as much as 20% of homes are sold to institutional owners who plan to rent them out. This model, unlike the ibuyers, is built on a long-term hold strategy. As this is a strategy we advise for our clients and know it well, we are certain that the market conditions remain favorable, and this trend should continue. Not only do these institutions enjoy similarly cheap cost of capital as private investors, they are also hedging that rent rates will, over time, widen the net operating income within their portfolios. This sound strategy will follow the inflation and housing price pressures addressed above. 

Wall Street market pressure on iBuyers

Astoundingly, Zillow recently announced that they’re getting out of the ibuying business. After years of being exclusively a lead seller to real estate agents, Zillow, several years ago, started a second major revenue stream. They would offer to buy homes for a slightly below market rate. They’d then fix and flip the properties, the plan was, for a profit. As it turned out, Zillow was losing about 5-7% on each property and burning capital at a rate of roughly $1.5BB/yr. This all happening in a climate of rising home prices is surprising, to say the least. Maybe more interesting is the long list of competitors, most notably Open Door, who think they’ll be able to make a profitable go of it. It’s interesting to note that none of these ibuyers has existed through a prolonged down market for housing. Zillow found several challenges with the model. First, the aforementioned labor and materials shortages made the ‘fix’ part of fix and flip untenable. Next, they found it hard to predict the selling price of a home. That may sound a bit crazy as this is Zillow after all. They built a brand on their ability to tell you what your home is worth, didn’t they? Economists would call this the lemon problem. It’s fine to understand market trends broadly and Zillow is probably pretty good at that – if you want to know price trends in your zip code, their numbers are likely reliable. However, when Zillow gave a homeowner an offer that came from an algorithm, they didn’t know if the basement had cracks or the floors needed refinishing. The owners did. So, if your home needs some TLC, and you know it, Zillow’s offer felt rich, so you take the deal. If a seller knew their home was in great shape, Zillow’s offer probably looked somewhat low. So, they didn’t take the deal. Zillow, it seems, couldn’t adjust their algorithm to successfully correct for the rate of lemons. Sigh. 

Housing and construction prices

There are unusual forces currently impacting housing prices. One might think that rock bottom mortgage rates, now seen for 18 months, are what’s driving up housing prices. However, this is only part of the story. Houses have become more costly and take longer to build. Labor shortages have impacted most industries and the building trades are no different. Further, the supply chain challenges mentioned above are impacting building materials too. Lumber prices have retreated from the records set a few months ago, but still remain about 50% higher than where they were 24 months ago. From doors to windows to flooring, it’s all on back order. This means that supplies are not going to catch up to demand and provide any downward price pressure until the supply chains catch up. No one is predicting that will happen shortly. It’s likely to be several quarters, at the very least. Over the first few months of 2022, we’ll be keeping a close eye on everything from inflation, to real estate prices, and global economic events that could have an impact on your investment property portfolios. Expect another newsletter from the Knox team in March. Until then, happy holidays!  

Dave Friedman
CEO & Cofounder