The Charles Dickens quote, “it was the best of times, it was the worst of times”, aptly describes the COVID-induced tumult unleashed upon the private lending industry. Had this been penned as a reflection of 2021, less than 12 short months ago, this piece would have been raving about record volumes and surging profitability. The looming menace of surging inflation was nothing more than a fleeting annoyance deemed transitory by the experts, but today, we find ourselves in the shadow of its winter. We will forever remember 2022 for the whiplash that COVID brought upon our space.
In 2019, the industry was just starting to find its footing, with institutional capital increasingly willing to provide liquidity and a housing market buoyed by a lack of supply as far as the eye could see. March of 2020 was the first real post – great financial crisis test for the industry when a novel virus caused the shutdown of the US economy. There were not many sectors spared from the initial jolt, and lenders certainly were not immune, despite the dizzying monetary policy printing-provoked surge that was soon to follow. Nevertheless, the damage was done, and many of those lenders that faced liquidity challenges early on withered away and were relegated to second class status even as markets quickly recovered.
A group of well-positioned lenders emerged as frontrunners, but the short-lived nature of the initial shock reincarnated even the ravaged players to resurface and compete (often by offering a looser credit box or below market rates). These euphoric times were also not long for this world. In early 2022, markets came to the realization that the Fed had to stamp out inflation and was about to embark on one of the most aggressive and draconian tightening cycles in its history, replete with simultaneous interest rate and quantitative tightening (QT) measures. As if this were not enough, they were doing this when every other central bank was making similar moves, soaking up worldwide liquidity. Interest rates surged so quickly that it left lenders scrambling. The spectrum of responses was varied, but those denialists that chose the path of inflexibility in the face of rising rates paid the price, eventually forced into selling their loans below par or even worse, caught with loans and their now impaired balance sheets, while others still were driven
As the year progressed, liquidity became even more scarce. Institutional capital poured out at a furious pace, reversing years of flooding. The securitization markets eventually froze up, not necessarily because the world’s deepest-pocketed institutional investors lacked interest in sourcing real estate investor loans but because the market became crossed. Borrowers were not yet ready to pay rates that were now “market”, so volumes declined across the space. As mentioned, many lenders had not rate-locked or hedged their loans and had to sell loans to loan buyers or into securitization SPVs at a discount. Some thought that insurance company capital would save the day, as though such magical capital is naive to market forces and relative value investments. As sure as the last tree leaves eventually succumb to winter’s relenting frosts, most lenders realized that it made little sense to originate loans at below market rates, often lower than the prevailing rate of inflation. After relentless battering and aside from a few shallow unnatural pockets of capital from callow venture-backed tech bros, we now observe a pricing discipline across most actors in the space.
While the fiercely opposing forces of low housing supply and affordability make a housing crash unlikely, private lenders are left wondering what needs to crack for their origination machines to crank back up again. If prices remain elevated but relatively stable, and the market shifts from the bidding wars of yore to a “buyer’s market”, that is a decent environment for buy-rehab-sell investors. Rents have historically lagged house price appreciation by as long as two years, so landlords, too, can find solace for the higher financing costs with viable DSCRs, (debt service coverage ratios), supported by rising rents. With COVID headwinds of higher labor and material costs subsiding, perhaps tailwinds will begin to emerge. Beyond the linear thinking of assuming today’s pain will persist forever, perspective is also important: projecting today’s conditions into the eternal future has never proven to be a good strategy for predicting and is certain to lead one astray today.
As we saw with the November CPI print, conditions can change quickly. Now approaching the third anniversary of getting on the COVID roller coaster, it is necessary to note that China, the world’s largest exporter, continues its quarantine lockdowns. Ukraine postures that it will push back the offensive of one of the largest military powers in the world and even retake Crimea, annexed by Russia in 2014. Paired with aggressive QT, corporate layoffs, supply chain reinforcements, excess inventories, forecasts of a warmer than usual winter, and the potential reversal of China/Russia/Ukraine-related issues – is it unreasonable to think that inflation might wither away? Perhaps the experts were right in calling it transitory inflation, but they were too anxious and impatient to define its slightly longer duration. It is not like there are no other modern-day examples offering hope on the inflation front. For example, Japan has stuck to its zero-interest rate policy (ZIRP) for over 20 years, with today’s inflation rate in the 2% range (like the US pre-Covid), even after much more substantial money printing than the US (Japan’s Debt to GDP ratio today is 237%; whereas, it is 107% in the US). Whether or not inflation persists, we can be sure that the chances of a smooth landing seem slim after practically every human being on the planet simultaneously quarantined for years.
Here at Roc Capital, we are taking the long view, and there is much to look forward to. Real estate investors have a history of transacting through all market cycles, and they will continue to do so and need financing as they rejuvenate the nation’s aging housing stock. We look forward to the continued institutionalization of our asset class, with rating agencies likely to begin rating RTLs (residential transition loans) as early as 2023, thus possibly enhancing liquidity. Even in today’s environment, institutional interest remains high, at the right price, of course. During the end of every challenging market cycle, there are usually periods of great prosperity. We remain steadfast in our mission of delivering innovative products that make it easy for everyone to renovate, own, or invest in homes. We have always focused on ensuring the resilience of our balance sheet and funding capacity, and even though it is impossible to “fight the Fed”, our outlook is undeterred, and we continue to invest in technology and products that will help power the future of our industry. On the origination front, we continue offering the same products and services and have doubled down on our commitments to our origination partners.
To end on a somewhat optimistic note, I will misquote Winston Churchill in describing the phase of the market where we find ourselves today: “Now this is not the end. We are now past the end of the beginning. But we are, perhaps, now at the beginning of the end.”