A Letter to Gray Capital Investors: Current State of the Economy

Gray Capital has changed our current market outlook and we are taking an immediate defensive posture given the current capital market and uncertain macroeconomic conditions. As President and CEO of Gray Capital, I felt it is imperative that I communicate this position as it affects our current acquisition strategy. It is also important to explain how we have arrived at this position and what it means for future Gray Capital projects and The Gray Fund.

I am at my core an optimist, continually inspired by human innovation, collaboration, and the entrepreneurial spirit. There are, however, new risks facing markets and the way that Gray Capital, and other private equity real estate firms, has structured acquisitions over the several years is the wrong strategy for the immediate near-term environment. These risks have nothing to do with the underlying fundamentals for multifamily apartments and are entirely related to capital market volatility, inflation, the Federal Reserve, and central planning.

Gray Capital will continue to pursue high quality, cash-flowing, multifamily assets in growing secondary and tertiary markets primarily in the Midwest, however our approach will adapt to achieve an appropriate balance between risk and return.

To be clear, the growth in multifamily is incredibly compelling. Continued growth will be driven by a historic imbalance between supply and demand, further accelerated by inflation, demographic shifts, investor demand, and housing unaffordability. However, one can have the right investment thesis and execute with the wrong tactics. Financing properties like we have been, which has been in a declining or relatively flat interest rate environment, invites unnecessary and non-linear risk to a solid investment thesis.

Gray Capital was founded by Alex and me with a long term vision, not on short term gains. We endeavor to build an institution that will evolve and persist beyond us. This goal requires thinking in decades rather than quarters and will only be achievable through the preservation and amplification of our partners, and our own capital.

Macro Risks

Inflation is at a 40-year high driven by an unprecedented increase in the supply of money, record demand, and constraints across the supply chain that increases scarcity.

The war in Ukraine is causing a variety of first and secondary inflationary pressures that appear to be catching central banks off-guard. Beyond Ukraine producing a significant amount of the world’s wheat, other input costs to food production such as nitrogen, potash, and gasoline have all risen dramatically which had not been previously priced in by central banks around the world.

Most central banks and many economists were predicting growth to quickly taper off in 2022, assuming a sharp reversion to the mean. Yet another black swan event has emerged, and it would appear that many are becoming numb to unprecedented and historic events of material consequence.

Bowing to political and societal pressure, the Federal Reserve may purposely, or inadvertently, manufacture a recession to bring inflation in-check by raising the Fed Funds Rate and selectively unwinding their balance sheet. The Fed’s endeavor of tightening monetary policy, using the tools they have, may only be partially effective. Most of the causes of current inflationary pressure are outside the control of the Federal Reserve, such as supply chains and the war in Ukraine. Other problems the Federal Reserve is the primary culprit of and itself manufactured.

The Fed has no real interest in reversing course on its past actions, such as propping up the stock market and real estate. The Federal Reserve will most likely not dump their holding of Mortgage-Backed Securities wholesale, as there are not enough buyers in the market and the housing market has been deemed “too big to fail” post 2008. The Fed most likely wishes it does not have the raise interest rates and prays that growth will slow organically or the market does their work for them.

We see this in real time as the yield curve between the 10-Year Treasury and the 2-Year Treasury inverted March 30th, 2022, further indicating a recession within 18-24 months.

Non-Linear Risks

Interest rates don’t typically move so quickly. The 10-Year Treasury, which is more driven by market forces rather than the Fed, rose rapidly from 1.7% on March 1st to just under 2.5% by March 25th. Also, in March the Federal Reserve announced a forecasted, rather tepid, .25% increase of the Fed Funds Rate. It has been broadcasted that the Fed will raise the Fed Funds rate by .5% at the next FOMC meeting at the beginning of May.

Multifamily cap rates, at the same time, remain all-time lows. 4% and below cap rates are the norm – which when the 10-Year Treasury was only .5%, made some sense speaking from a technical perspective, especially when factoring in record setting rent growth in 2021 that we are still seeing in 2022. However, with current long term interest rates between 4-5%, many assets will be acquired with negative leverage – which to me is a red flag.

Buyers using floating debt attracted to initially low interest rates and higher leverage, may be in a perilous position if SOFR (Secured Overnight Financing Rate), which is much closer linked to the Fed Funds Rate, rises more rapidly than the Fed is currently communicating.

Current SOFR futures are hovering around 1% and the median projection of the Federal Reserve of Governors places the long run rate at 2.5%, with rates ranging between 1.25%-3.1% by the end of 2022 according to the Fed’s latest dot-plot. This means interest rates on multifamily mortgages that use a floating rate based on SOFR (of which most are), could more than double by the end of the year.

Many multifamily syndicators, accustomed to a less volatile and declining interest rate environment, may not be not assuming that their debt service may double in the first year of operations. This could lead to some projects not being able to service their debt.

This potential volatility in short term rates creates an extreme, exponential rise profile for using un-hedged, floating rate debt in the current environment.

Organic Hedge

The counterweight to the above risks is the established observation that rents outpace inflation, and interest rates are only rising with inflation – the price increase of debt and rent will cancel each other out at the minimum. The general premise is true, and if one bought last year, one would have reaped the benefit with incredible growth with lower rates – providing a degree of headroom and an increased margin of safety. I would include Gray Capital and our partners in the camp that made some excellent investments over the last several years.

Inflation also devalues debt. Higher leverage may increase risk, but should be offset by growth, at least theoretically. Regardless, the higher returns provided by increased leverage have a direct correlation to increased risk.

There are other factors that will hopefully keep the US economy moving and will not cause a deep recession, but a rather quick recession. The US consumer is in an incredibly healthy position with record savings levels and high home equity levels on fixed rate debt. While wage growth is not keeping up with inflation, we are seeing some of the fastest wage growth in decades with unemployment at record lows. Indianapolis, for example, hit an all time low in December of a 1.2% unemployment rate.

These factors do make them more optimistic, however they also might provide the technical indicators the Fed will read and interpret that their hawkish position will be somewhat tolerated and is certainly warranted.

The risk remains that due to extraordinarily low cap rates, some multifamily buyers will speculate incredible growth beyond reason while continuing to assume the interest rates of today, or even worse the rates of a few weeks ago. To hit returns that many investors have grown accustomed to, syndicators may take exponential risk that does not justify a slight increased return.

Sponsor Complacency

Mistakes will be made by simply not adapting to a changing environment. Gray
Capital refuses to make such mistakes. These are the reasons I am concerned for
passive investors:

• Syndicators are solely focused on raising capital and winning deals, not on risk management.
• Many are using unprecedented high rent growth as a “new normal” projected for years into pro-forma without accounting for expense inflation.
• The use of short term, floating bridge debt without an interest rate hedge has a significantly increased risk profile that adds unwelcome volatility to real estate investments.
• Relying on supply chain and labor market to stabilize in order for heavy value-add projects to deliver. And/or relying on the rescue of another 20% yearly organic rent growth and further cap rate compression to accomplish their business plan for them.
• Newer or inflexible sponsors may use higher leverage due to capital limitations or indifference, rather than choosing a level of leverage appropriate to the risk.

Is Now Not The Right Time To Invest In Apartments?

I asked myself this question. Even though my business is focused on acquiring cash-flowing apartment assets, I primarily see myself, and Gray Capital, as a steward of our partners, and our own capital.

The answer remains the same, that the incredible supply and demand imbalance of housing, combined with investor demand for uncorrelated and less volatile assets, will continue to support and lead to further growth over time. It actually would be healthy to see cap rates normalize upwards slightly, with prices still increasing due to continued revenue growth, or possibly flatten over the short term as capital markets disrupt acquisitions.

As conditions normalize, I anticipate a renewed slide downward of cap rates due to incredible demand from domestic and foreign investors for stable US multifamily. This simple answer is apartment values will be higher over the medium and long term, and since we always take a long-term outlook, today is still a better time to invest than tomorrow.

Risk Mitigation

To take advantage of the future growth opportunities in the multifamily market, we have decided to approach the task in a way that mitigates the current risks and uncertainty to achieve the most appealing balance of risk and return. To do so we’re structuring accusations in the following way:

• Fixed Interest Rate Loans with 7-12 year terms is our preferred financing strategy
• Any floating rate debt must be hedged (with a rate cap or similar)
  • Underwriting model should assume highest rate
  • Longer term hold projection (5 years minimum, 10 years ideal)
  • Allow for flexibility including refinancing or early exits if market conditions are ideal
• Lower leverage
  • 55%-70% LTV
• Invest in markets that are not “heating up”
  • Midwest secondary and tertiary markets remain ideal conditions.
• Avoid negative leverage
  • Identify opportunities to efficiently add-value and force appreciation

What does this mean for returns?

Taking a more defensive approach may lead to lower projected returns. We are standing by our total return criteria, targeting 15%+ IRRs or 2X EM over 5 year holds. Our cash-flow projections for future acquisitions have decreased due to the lower cap rate to interest spread. Average cash-on-cash returns projected to average 8%+ over a 10-year hold, compared to 10% on average a year ago. We are cash-flow buyers and require cash-flow at acquisition without speculation, this may slow our pace of acquisitions.

Preparing For Opportunity

While I do not anticipate a real decline in apartment pricing, it is possible. The market may simply normalize and leave the “insanity” we’ve seen over the last few years in the past. There is also the chance, albeit I believe small, that we could see a slight decline in valuations. This could lead to an attractive buying opportunity for investors that were able to weather the storm.

We Do Not Know

No one can predict the future and this letter is the last thing from an attempt to do so. The potential lost opportunity costs of maintaining the same acquisition strategy used over the last two years is relatively in-material when compared to the risks of complacency and the desire to achieve the highest return possible. Our more conservative approach may be unnecessary and appear reactionary in hindsight, and that’s a fact I am more than comfortable with. I do know that our current approach reduces risk significantly and greatly increases the chance of success that will insure the preservation of principal and achieve the best return over the long term. I appreciate your trust, and value your partnership. Please feel free to contact me with any questions regarding our current strategy.

Sincerely,

Spencer Gray

President and CEO

Gray Capital, LLC