Q4 in Review: Strategic Reflections and Future Directions

The fourth quarter marked the quarter when all of the interest rate hikes, the incredible long term interest rate volatility, the regional bank failures and the resulting credit contraction as well as the general fatigue of dealing with more intense levels of uncertainty, finally showed up in our portfolio.  After working diligently to resolve issues without having to resort to enforcement of our rights as secured creditors, we had to become enforcers in Q4-2023.   At quarter end, we had three relationships that we considered to be work outs.  The term work out is used at the banks I used to work at.  Generally, it means work to get repaid and end the relationship.  Sometimes a relationship can be saved, but more likely than not, that has not been my experience.

I want to take a moment to put the challenges we face in context of this manager’s 15-year track record as a private lender fund manager.  Up until about 18 months ago, lenders and borrowers had the wind at our backs.  I said that in several of my letters to you.  Decreasing or zero bound interest rates make real estate investing and lending easier than it really is.  The challenges we faced for many of those 15 years were high competition, increased risk taking and thin pricing.  At Freedom, we avoided rapid growth considering those factors.  In hindsight, it was the correct decision. I know of many competitors that are facing much greater challenges than we are.  As for booking a loss, my first loss in 18 years (I am including my banking career here), it is disappointing and not taken lightly.  However, a 14-bps (unrealized) loss is small and can happen in any given day if you are invested in a bond or fixed income mutual fund.  My partners and I go through each loan in detail every month and we revalue the collateral every quarter.  Based on these reviews, current as of this week, the totality of our issues is as reported above.

I also think it is important to discuss the issue of the pundits making mass generalizations about the problems in the “Real Estate Market”.  There is no such thing as a Real Estate Market.  There is no public exchange (except for public REITs), so the world of real estate remains highly fractured, localized and very dependent on skilled management.  The is also a lot of talk by the pundits of a “Wall of Maturities” and how this wall will wipe out the Real Estate Market.  This is fear mongering and creates clicks in a data driven web-based news media.

Here are a few examples of what I am talking about:

Office is often cited in the press as a disaster.  For many it is, but not all.  The office buildings we have in our portfolio are in excellent locations, fully leased to credit tenants and based on current pending sales contracts to national scale real estate investors, highly desirable.  Generalizations are often wrong, especially in real estate.

The press will say values in the Real Estate Market have fallen.  However, one of the trends you will notice is that our overall Loan to Value (LTV) has not changed as much as one might expect if you follow the fear-mongering press.  The press ignores rent inflation except when it is using it to scare you (again).  While capitalization rates have increased, so too have rents.  It has not been a perfect match and values are down, but not in the extreme way headlines might portray.  Further, since we are always turning over the portfolio, our underwriting is dynamic and adjusts to the current market situation.

Multi-family is cited as overbuilt.  That is true in some submarkets and substantially all is in class “A” product.  Our multi-family exposure is centered in “B” class apartments, where overbuilding is nearly nonexistent.  Not only are our apartments in markets where class “A” overbuilding is not an issue, class “B” has proven to be the most resilient place to be in multi-family as move up tenants will move from “C” class to “B” class and move downs from “A” tend to go to “B” class.  While I just made a generalization about why class B is safer on average, the pattern I cite tends to be how tenants behave in all but the worst of scenarios.  Also worth noting is that because of cost, new buildings tend to all be “A” class because it is almost impossible to build a “B” class building in coastal cities or major metros due to land, entitlement, and construction costs.

As for the “Wall of Maturities” there are several points to make.  First, on X (formally Twitter) I have challenged the ones making the Wall of Maturity claims to discuss important factors such as what is the Debt Yield for those maturities?  Crickets.  Or what percent of the debt is non-recourse?  Crickets, again.  The maturity of a loan on a building that covers its debt payments by a factor of 1.5X is not the same as a maturity on a building that does not cover its debt service. Nobody is reporting how much of the debt is below breakeven and of that how much is not guaranteed by the owners of the properties. Perspective is required before a judgment can be made on the Wall of Debt and the information needed to assess the risk of mass default, let alone loss given default is not being reported. 

Last point on this topic of fear.  If the fear was so incredibly large, there would not be about a half a trillion dollars in wait for the impending disaster.  Given the size of the money reported to be on the sidelines, the magnitude of the problem may just be substantially smaller than all the fear mongers are predicting. Time will tell.

2024 will be an interesting year.  However, assuming interest rates volatility settles down, inflation moderates to a steady 3% (I don’t believe 2% is in the cards but that is for another letter) and the bank regulators continue to allow the banks to ignore their marked to market problems associated with legacy low priced fixed rate loans, the market may just have time to adjust and avoid big problems.  Also, all that money sitting in wait, if it is really there, will likely be a generous sized shock absorber.  Of course, this is a prediction and to credit Yogi Berra (I believe that is where credit is due), predictions are very difficult, especially when they are about the future.