Motley Fool Hidden Gems Investing - The Great Lag

Episode Date: October 15, 2023

The Federal Reserve may act on a forward looking basis, but the bank isn’t always quick in action. Ben Miller is the co-founder and CEO of Fundrise, a real estate investment platform. Deidre Woollard caught up with Miller to discuss: - How slow reaction times from the Fed impact the economy. - The home equity buffer. - Opportunities in innovative investing. - The AI boom in private markets and start-ups. Company discussed: NVDA Host: Deidre Woollard Guest: Ben Miller Producer: Ricky Mulvey Engineer: Rick Engdahl  Learn more about your ad choices. Visit megaphone.fm/adchoices

And so the result of that essentially is that it's super lagging. Like today, the Fed would say that, like, I think, I don't remember, but I think that, you know, rents are currently 5% and they're slowly getting down to where they should be, which is 3%. On the ground, they're negative 2.5%. I'm Mary Long, and that's Ben Miller, co-founder and CEO of Fundrise, a real estate investment platform. He's also a returning guest to Motley Fool Money. Deidre Willard checked in with Miller for a chat about what real estate data says about inflation, the boom in artificial intelligence investing, and the great lag between the Fed and the economy. we last chatted a tail end of last year and you were putting out some gloomy podcasts and

forecasts about future real estate credit and this phenomenon that you called the great deleveraging so tell us what is the great deleveraging and what are you seeing right now wow yeah so that thesis was that zero interest rate policy for 15 years and quantitative easing led to an excess amount of debt build-up and as that debt build-up came comes due in a new higher interest rate environment people have to pay down the amount of debt they have right because used to have a 3% mortgage. Instead, you have a 7% mortgage, which means that if you're a company or you're a commercial borrower and some individuals just can't support that and they're going to have to pay down or sell. And that's a deleverage, reduce the amount of leverage

in the system. And you're talking about trillions and trillions of dollars of that. And so it's great, a great deleveraging as a result of higher interest rates hitting the economy. Yeah, one of the things I remember you saying was turtles all the way down. So this idea that the debt would keep, we keep going and going and going and, you know, borrower after borrower and lender after lender. Yeah, people don't realize this, but the biggest borrower in the market is the lender. The banks, maybe they do now because you started seeing Silicon Valley Bank and other banks blow up. But there's actually like very few people or companies that don't leverage their credit. They make a loan, a bank makes a loan, and then they borrow against it.

And so there's a lot more debt in the system than might be apparent. And typically that debt or debt in general makes you fragile. and so that fragility is the risk and so far we've seen some breakage but but we've not seen a collapse and um even a month ago people would have i think would have said that like no there's gonna be soft landing this great deal leveraging thing was way off base but i i think we're starting to see a turn even like just recently and that maybe all of this uh leverage combined with high interest rates are actually going to hit the economy harder than what was consensus in the summer. So, yeah, it's interesting because of what happened with the banks. So,

you know, you were talking about the great deal leveraging before that, then we had Silicon Valley and some others. I know Signature Bank, there's a need to sell off those loans. What are you looking at in terms of the commercial real estate loans that are coming due and being sold off by banks? Yeah. I mean, it is a great time to be a lender because the banks have stopped lending. So there's a supply-demand mismatch. And you make great investments when there's a mismatch between the markets. Either you can sell when there's a lot of demand, there's not enough supply, or you can buy when there's a lot of supply, not enough demand. And so right now, it's an incredible time to be a lender

because everybody's being forced to borrow more because of the great deleveraging. And the normal lender's out of the market. I mean, banks, virtually out of the market. And so you're stuck. We're making loans of 12% to 15% interest rates would have been half that one year ago. That's definitely something we're focused on. It's a problem for some parts of the market, and a problem is an opportunity.

Yeah. Those are some spicy rates there, and you're absolutely right. You would not have gotten those before. I know you now have a closed-end fund for opportunistic credit investing. So obviously I understand why now to do this. So are you amassing money to then invest in different things? Yeah, I mean there's – I think the part that – where there's still a disconnect is there's been a big lag. And somebody started saying you should call it the great lag because you have a great deal of averaging. But the lag between when monetary policy gets tight or when interest rates go up and when they're actually – the impact seen in the economy is much longer than people intuitively expect. And so – and it's funny.

I was just reading, not to get too nerdy here, but I was just reading a paper in 1961 by Milton Friedman where he wrote the famous line. And he said, empirically, monetary policy has long and variable lags. So long and variable lags is sort of this famous quote among economists. And that's 1961. And so he says typically two years from when they raise rates to when you see the impact in the economy. So they started raising rates summer of last year, started in April, really got going by summer of last year. And so we have, you know, we're still nine months away from really seeing the impact on the economy. And already, you know, you could argue that inflation has come down a ton.

And so we're sort of, it's like there's a, this happens a lot in like rivers where there'll be a flood upriver. It takes a long time for it to come downriver and finally wash out the town. but that's definitely, in my view, definitely going to happen. I mean, I guess it's not definite. There's a possibility this Fed reverses itself, but I think it's highly unlikely. So, that preparation for the flood, whether it's a defensive or offensive opportunity, is, I think, the big thing happening in real estate markets. So, what you're saying is you don't feel like the soft landing is happening. You feel like the Fed's impact is has not been felt yet. And so does that do you think that there's a possibility

that that the Fed actually has to backtrack? Or do you think that they are going to sort of stick there? Because I don't think there's any way that we might really get to that two percent inflation rate anytime soon. I don't I don't know what you think about that. Yeah, I mean, there's like there's a few different factors in there. There's sort of pure economic questions. And then there's like institutional psychological questions. You know, what will the Fed do? So let's just give an example. In 2021, inflation appeared roaring. And it was May 2021. We own, Fundrise has something like 20,000 apartments. And we saw, you know, like a switch went off in May 2021. And our rents increased over that period 20, 30%. You know, and that never happened before. Normally rents

increased 3%. So May, it hit. It was obvious that inflation has just gone rampant. The Fed did not raise rates until March 2022, a year later. And then they really didn't get going until May. So it took them one year from when you could see it. I mean, it wasn't like inflation is coming inflation was like already here was very high and they didn't raise rates for a year until after that it happened so i i expect and this is the this is a more of a this is not a mathematical uh projection like like the way monetary policy lags that the fed will be slow because of sort of institutional bias and there's a great quote i don't know if you know this quote It's the Fed talks like a trader but acts like an accountant.

So they're forward-looking in what they say, but they're backwards-looking in what they do. Right. And so like – and another thing I see is that like – so multifamily construction, today if you're going to borrow multifamily construction debt and go to a bank, you're going to pay eight and a half probably nine percent nine percent if you go borrow

and you have 50 percent leverage 55 percent leverage nine percent interest rate and 18 months ago that was 70 percent leverage at three percent interest rate okay so there's a and and you pretty much can't get bank lending it's really difficult like a normal bank lending So you're talking about that's a quadrupling of multifamily construction interest rate costs. And that had happened, and that was obvious to me and the team here and anybody in the business, almost a year ago. Almost a year ago, you could be on the ground and see that multifamily construction was basically going to grind to a halt. And we started doing lending, MES lending and bridge lending and gap lending, emergency rescue funding lending into that space starting about a year ago. I think we closed the first one in October.

I think it was October. So – and it only showed up in the data, like the Fed data, the Fed, the FRED, which is the Federal Reserve. St. Louis has a great source of data. And it only really showed up in their data this summer, right? So it fell off a cliff in the data really in August, September. And so you're like there's just this massive lag just in the data. And then there's a lag in the reaction to the data. And so there's just a lot in the system that basically likely we're going to stay too high for too long, just like we stayed too low for too long.

Right. and and the consequences of that are likely to be painful so in terms of rent you mentioned that the you know what we saw in 2021 with multifamily rents going higher they've been getting lower and lower with multifamily with these uh you know developers taking on more cost do they then have the ability to to raise rents enough are they there are they kind of stuck no no rents nationally have gone negative. So this is another example. So rents today, this is how the Fed does housing inflation. I don't know how much you know about this. It's sort of like an obscure piece of knowledge. But basically, they used to have housing inflation based on housing

price. And that went crazy in the 70s. And so under Reagan, they changed how they calculated inflation, and they called it owner-occupied equivalency. So it was this strange formula that basically doesn't look at asset prices. And so the result of that essentially is that it's super lagging. Today, the Fed would say that, I think, I have the number, but I think that rents are currently 5%, and they're slowly getting down to where they should be, which is 3%. 3%. On the ground, they're negative 2.5%. And I think they go more negative. And as they go more negative, like that's going to hurt the over levered borrower. But also, like, you know, I think housing is 30% of inflation, and you have literally at a negative

2.5% today, right on a year over year basis, and over a week over week basis down 0.1. So it's equivalent to negative 5% on an annualized basis. So it's about like the economy is like a freight train, like a giant 350 million person freight train. So once it gets going one way or the other, it's hard to turn it. And so it was going like a freight train up, and now it's going like a freight train down. And 2021 was so crazy, right? The pricing got so crazy in the stock market, meme stocks, SPACs, and NFTs. And so that those high highs can also happen on the low lows.

And I think people are not prepared for that type of problem that I think is basically a natural consequence of the high highs. It's like winter follows summer in a very natural way. Well, it's it's interesting, though, because you've got the situation with jobs staying relatively steady. And so that's keeping things up. And, you know, so consumers are still spending. We're starting to see a little bit of weakness in terms of like credit card delinquencies and things like that. But so far, the sort of the consumer sentiment is that we're still OK. And I think that that contributes as well. And maybe people aren't seeing it. Well, so like if you look at the history, which is that jobs is a lagging indicator.

Right. So people look at jobs, jobs lag. So what are leading indicator? And so typically – and you go back to 2007 or 1999 or before – I went back and pulled quotes from like before every recession and like right before every recession, jobs – unemployment was super low. Unemployment in 2007 was historic lows. In 1999, it was historic lows. And everybody was saying, look, jobs are so strong. And then it falls off a cliff and it typically moves, on average, across every recession in U.S. history, it's moved 3.3 percent in 18 months. So that would take us – that would put 5 million people out of work in 18 months. And it would happen – it would basically start hitting most acutely in the spring of 2024 or late spring of 2024.

That's what the historic average is because there's a lag. because companies on the ground and i i see it right you're not going to build apartments um you're not going to you know manufacturing and industrial is like slowed down because they're worried about you know uh they get the cost of borrowing to actually build anything so i i i i've been i've been consistent on this and people call me bear i'm a i'm a bull on ai and we talk of ai and i think there's and i and i i'm not i think everything will turn will turn back up again like as a cycling and it goes up and then it goes back down and then it goes back up again and and and so i'm not i i think it will go up again 2025 is going to be a you know we'll get back on

track but like this is how it works but this one of the things that is different this time though is, at least for homeowners, they have so much more equity in their homes. I mean, nobody's moving right now. The whole market's at a standstill. But people do have equity. There is something, hopefully, to be able to tap into. Yeah, I totally agree. And before 2008, there was a saying, it was safe as houses. Because before 2008, across whatever, 100 years, houses have never gone down. So people are looking at 2008 and say, oh, housing, but like housing's going to be looks like housing is going to be fine yeah housing is almost always fine 2008 was an exception so i think housing and households actually will be um okay like you know i don't

think it's actually a source of the risk most people have locked in long-term interest rates and and they have home equity and they aren't on arms and things like that so i think this more in the corporate sector it's it's it's um the problems aren't i think going to come from housing i think housing should be fine yeah like it's not you know maybe maybe it goes down a little bit but it's it's not a source i don't think it's a source of risk i think it's it's really all the all of the um i mean i just the companies that have like private equity and and some some real estate i mean there's lots of business borrowers out there who have debt that will come due and and and they won't be able to service it and or any business i mean the business the ability for businesses to

expand in this environment is really difficult except for ai which i still want to talk about we will and so that's an opportunity i'm not saying it's a it's it's a problem for i think it's an opportunity if for people who are prepared and and that's like that's a problem is always an opportunity it's just you have to you have to reframe it but denying that there'll be a problem is usually a bad approach yeah well let's let's talk a little bit about some of the other things you're investing in because you've got the innovation fund uh you know the one of the things we talk about all the time is like the ipo market is is slow companies are looking for funding anywhere they can get it you've been investing in a variety of different companies

I noticed that you invested in Canva, which is the content creation platform. Everybody seems to love Canva. How are you thinking about the opportunities right now? Are you seeing a lot of companies looking for money? Are they feeling that pressure? Well, so, AI is a big deal. And I think it's even unclear to people what AI even means. was like it's but it's this there's like there's like wheels within wheels here so the generally venture capital is is i think the best performing asset class in the u.s history right venture like you know private tech companies and historically individuals have no access to it it's just it's it's not an area you can invest in both regulatorily and also sort of structural

to the market so our mission was always been to democratize um good investments and so we've been chasing that for a while and then we were sort of we were lucky because right when we launched the fund there was a generational breakthrough and ai is a generational breakthrough it's as you know it's bigger than i mean is it bigger than the internet i think probably ends up being bigger than the internet definitely bigger than a personal computer i mean it's so fundamental that that it's hard to actually, it's hard to actually get your, your mind around and we can talk, but there's patterns to it and it's, and it, and essentially it's really exciting. And there's going to be a lot of like money and growth and excitement. And most people won't be able to

participate because it's happening in the private markets. There's like 10 companies in the public markets that are, you know, leveraging AI and NVIDIA is like one of them. And you can buy NVIDIA at like 1,000 times revenue, whatever it is. But like most of the stuff's happening with startups and you're just, you can't, individuals couldn't invest in that until we sort of created a new way. And that's like, that's what's so exciting. I mean, that we've basically like kind of broke the oligarchy, like, you know, hammerlock on it or something. But it's a little bit different than investing in real estate because your end is different. You're looking either for the company to be acquired or to have an IPO.

So the exit is a little bit less clear. So how are you thinking about that and how you sort of prepare investors to understand the ways that this is different? Yeah, yeah. Well, so it's different because it's fundamental. That's one thing, right? Because what's happening with AI or in some of these technologies is fundamental. It's generational. It doesn't have anything to do with interest rates or inflation or anything like that.

And fundamental things move. Like they don't care what you want, right, when you want to exit and how exactly it works. Like people mostly want to orient investments to what they want to have happen. but like you know if if you're inventing the future like what's happening with open ai like you need to give them what they need right that and that's that's how you get great value so but in some ways it's similar to real estate so the companies we've invested in so far or the majority vast majority of the dollars have have been later stage companies that are still private that i think of is like you know like databricks we invested in databricks we invested

in canva both those companies i think have decade decade plus two decades of growth ahead of them there it's there i mean databricks is like i think like the next generation fang like it'll be well known as like the guts of ai but nobody knows about it now who's not like deep in tech but it it's it's like the inner workings of the data and technology revolution happening with ai and so it has such a long horizon on it that is a little bit like real estate and that even if it goes public doesn't mean you're a seller like selling google after they went public would have been insane. So with Databricks, they just had a series I at $500 million. That gives them this massive $42 billion valuation. So they've been talking about IPOing for a while. So your plan

there is to hold on after the IPO. And is that something that you're seeing for a lot of companies? Is that part of the innovation fund is that you'll hold for longer? Yeah, I think that But, I mean, the fund is mostly private, but we do hold and expect to hold some publics. And that you, I mean, the essence is you should be agnostic about public or private. The problem is at private, you are blocked from investing for most people because it's a regulatory barrier. And the interesting thing about being a private investor is you get a lot more information. Like, it's funny. People talk about public companies and transparency, but you actually – like the Ks and Qs of public companies don't actually tell you that much about the business.

You get a lot more information from a private company when you're investing in them, a lot more information. So you actually have a lot better understanding of their business. And so, yeah, I – we would be a holder. I mean it's sort of irrelevant because today we're just buying privates. But when they go public, which I think Databricks will, that doesn't change our strategy. What you want to own is the best companies. And you can look back and say, oh, it was so obvious that NVIDIA was a great company. But I think you really have to have known a lot about the tech to really have known that earlier.

And I think that's true with Databricks. And like DBT, we invested in a company called DBT Labs. dbt is like the fastest growing data and ai software i think in the world most people never heard of it and we invested in it and and that's incredible we're it was amazing and um and you know you just let the compounding power of their technology just drive growth as always people on the program may have interest in the stocks they talk about and the motley fool may have formal recommendations for or against so don't buy or sell stocks based solely on what you hear i'm mary long thanks for listening we'll see you tomorrow

Thank you.