The Real Market with Chris Rising – Ep. 86 Neal Bawa

Chris Rising (00:50):

Welcome to the Real Market with Chris Rising. Pleased to have Neil Bawa back with me again. Neil and I spoke nine months ago or so about where the world was going and about all the great things happening in multi-family. Nothing’s really happened since then, huh Neil? Any big news in your world?

Neal Bawa (01:06):

No, it’s been very quiet. Occasionally a bank, $200 billion bank loss, but otherwise, it’s just the same.

Chris Rising (01:16):

It had to be the Silicon Valley bank that goes down that gave all the tech haters in the world something to grab onto. But not much of an on book real estate portfolio at that bank, but there are quite a few others and even the big ones who have tremendous exposure. But before we jump into that, just tell me how’s the last nine months gone for your business? Any major acquisitions or sales that you want to talk about?

Neal Bawa (01:45):

We haven’t sold anything in the last nine months because nothing made sense to sell. I think cap rates have now dramatically increased. So we see them being 75 basis points to 150 basis points higher depending upon the metro. So nothing made sense to sell. Nothing also made sense to buy. We bought one property where we were a little lucky. It was a bounce back, and so we bought a single property, a mid-size property, I think it was $25 million in Atlanta. Rather than that, we’ve just been focusing on completing the construction of our existing properties and starting a couple new construction projects, ones with locked in interest rates

Chris Rising (02:24):

On your deal that you just bought, what’d you do for financing?

Neal Bawa (02:30):

So this particular deal is, I think we did… Let me think about that. It had floating rate because my fundamental belief is that in about 12, maybe 18 months rates will come down. Based on what I’m seeing in the economy in terms of weakness, I’m pretty comfortable with that. So it had a floating interest rate with rate caps of course, and so that protects us. Most of the time we can’t get properties to pencil out with bloating rate debt at this point in time. So this was just an odd one out where things work.

Chris Rising (03:12):

We’re in the market right now trying to put a cap on something because things have gone down, but today they started to go back up. But the ability to… The problem with buying caps and all you get into the queue doesn’t mean you get to buy it that day. It takes five or six days to get in the queue and then, so you just don’t know where you’re going to be. But at the end of last week, it felt like people were saying, “Okay, rates have to come down,” so the forward curve was looking pretty good, but you look at it today here on the end of the day, Monday, I don’t know. I mean, the forward curve is now saying we may go to six and the forward curve is worth about what you pay for it. I mean, doesn’t mean it’s going to be true, but there is-

Neal Bawa (03:57):

I think the forward curve-

Chris Rising (03:59):

… a feeling that inflation’s going to be bad.

Neal Bawa (04:01):

So I’ll give you feedback on that. So I think that Wall Street, when they make projections on the forward curve on whether the interest rate’s going to go up or stay flat or go down, looking at it on any given day is going to lead you in the wrong direction. I think it is beneficial to let forward curve settle. When there’s a major issue in the marketplace we’ve had in the last three and a half weeks, you’ve got to let the forward curve settle because every piece of information tends to fluctuate way more than it should. So that’s really what’s happened.

(04:38):

The day that Silicon Valley crashed and then the four or five days after that when the stock market was down big time, that forward curve was showing bizarrely quick fed rate drops, not hikes, but rate drops. And then it adjusted when people realized that the world hasn’t ended. We had some banks that failed. Things have moved ahead. The feds have worked hard on bringing some stability to the marketplace, and now the Fed still has to deal with this inflation issue. So then it started to correct back up. I’m one that believes that looking at the stock market’s data on a day-to-day basis is problematic. You look at, once things settle down a little bit, they tend to be better at projecting because they’re not reacting to this piece of news or that piece of news, and we haven’t really seen that yet.

(05:25):

In my belief, the Fed will raise rates again in May. So they raised a quarter point in March, and there was a lot of pressure on them to potentially not raise. People like Elon Musk and a bunch of others saying, “You should be dropping rates.” There was some amount of pressure on the Fed and they mostly don’t fall prey to that pressure. So I’m glad that they did raise rates by a quarter point. I think that I feel that they’ll probably raise rates by a quarter point again in May, but I think beyond that point, I am in the school of thought that says, “No, they won’t need to raise rates. No inflation’s not going to be bad,” and I’ll explain why.

(06:03):

So for the last 10 months that the Fed has been doing this, all we’ve been saying about it, Chris, is that the Fed’s going to break something and the Fed broke nothing. The point is, we all knew that at some point the Fed would break something. Well, they’ve actually broken an extremely consequential part of the economy, which is the banking system, and while they haven’t technically broken the banking system, what we’ve seen is a crack, and it’s a big crack in what is literally one of the most important sectors of the economy. I wouldn’t consider real estate, for example, to be as strategic as the banking sector. There’s very few sectors that are as strategic as banking itself because banking is the underlying foundation of all other sectors and their liquidity.

(06:50):

And so we have a situation now where you are likely to see, and we’re recording this at the end of March, I believe that you are about to see weakness in the economy in the months of April, May, and June followed by a recession that starts in July. So-

Chris Rising (07:07):

Wow.

Neal Bawa (07:07):

… that recession was not going to happen before this crack. I think the economy was doing too well. We were creating a staggering number of jobs. Remember the US wants to create roughly 2 million jobs a year to keep things moving forward along on plan, and that’s about 170,000 jobs a month. Well, we were creating jobs in January and February at the rate of 400,000 jobs a month. That’s two and a half times that number. I think you’re going to see a dramatic deescalation of that because we may not have broken the banking system, but we’ve changed something very fundamental.

(07:43):

We have laid bare the fact that there’s now several thousand regional banks in the United States that are over-leveraged from various perspective on instruments that are very long term, and they may need cash in the short term. And so these banks now are under federal oversight where before they were just doing whatever the heck they want. And now because they’re under oversight, they have to change how they act, and when they change how they act, they’re going to reduce the amount of exposure that they have in a number of sectors with ours being one of those sectors where they reduce exposure, not the only sector, but ours is definitely going to be one of the sectors that mid-size banks, regional banks will reduce their exposure to. And as they reduce their exposure that’s what’s broken in the economy, not the banking system, not the banks, but their inability now to provide liquidity to a number of key sectors. That’s what we broke, and we can’t unbreak that over the next six months.

(08:47):

And in my opinion, those sectors are important enough to take the economy into a recession, a mild recession, and I count that as a Q3/Q4 recession, maybe negative GDP of a half a percent, maybe even negative GDP of a 1%. And you are now seeing the Federal Reserve look at that. So the Fed is now saying that the US economy will grow at 0.4% in 2023. That’s their new forecast. They’ve lowered it. Now you might say, “Okay, that doesn’t look like a recession. That’s 0.4%.” Except you know that Q1 growth is likely to come in over 3%. So if Q1 growth’s 3% the whole year is at 0.4%, well that means that there’s a recession in there. That’s the only way math could work. So now the Fed itself is changing its forecasting to expressly include a recession in the second half of the year.

(09:42):

The fed’s usually pretty smart about these things, and so they understand that the consequences of what they’ve just done basically caused a mid-market, mid-size banking, liquidity crunch, credit crunch, that basically is going to cascade across the United States over the next 90 days. They know that that’s going to cause a recession because there’s really that large of a liquidity crunch is going to take our GDP down by several percentage points. 2% decline in GDP, you’re in a recession. Now, it’s very difficult for inflation to stay high in that environment because that recession will take a bunch of jobs from us. I think it’ll take somewhere around half a million jobs from us. Now, does it solve-

Chris Rising (10:25):

Do you think the unemployment rate’s going to go up because we’re going to have 500,000 new people on the unemployment roles?

Neal Bawa (10:33):

We will. And so I believe that that’s going to happen in the next five or six months, not immediately. So this is a process. So I’m not saying we’re going to lose 500,000 jobs in just the month of April and May, which are the next two months coming up. I think that it takes a little bit longer than that. I think what I’m trying to point out is all that does is it solves the Fed’s immediate problem of do I need to keep raising? Remember this, a lot of people have this belief which is completely irrational, that the Fed has to keep raising to lower inflation. No, they don’t. No, they don’t. There’s no such requirement.

(11:11):

The Fed has what is known as the equilibrium funds rate. The equilibrium funds rate is the point at which the Fed fund, the Fed is not hurting nor helping the economy. It’s the equilibrium rate. It’s not hurting, it’s not helping. And that rate is around 2.25%. Today, we’re at 5%. In case, you’re wondering that difference from 2.25% to 5% is like a 1,000 point weight on the chest of the economy. So if the Fed doesn’t go from 5% to 5.25%, all that happens is that 1,000 pound weight would’ve gone to 1,050. It’s still 1,000 pound weight. It’s still sitting on the chest of the economy and driving it downwards. And so the Fed simply has to say, “Inflation shouldn’t be out of control because if I feel it’s out of control, I have to keep raising. If I feel like it’s beginning to moderate because of the pressure on the banking system and the pressure on liquidity, then I can just let that weight sit on the chest of the economy, and I know that it’s going to slow things down over time.”

(12:16):

So the Fed’s decision making becomes simpler in terms of just looking at where is inflation in the coming month or two, and then it can just sit for a while and let that weight sit on the economy.

Chris Rising (12:29):

Well, inflation really, there’s three ways it can be controlled, two of which the Fed own. One is interest rates, which they’re using. Two is their balance sheet, which they were de-leveraging it and de-leveraging it. In the banking crisis now they’ve stopped that. Maybe they-

Neal Bawa (12:44):

No. So let’s talk about that because I think that that’s an area that is not as understood. So the Fed has a very, very large $4.8 trillion liquidity balance sheet. And what the Fed did during COVID is that they added trillions of dollars onto their balance sheet by buying all kinds of stuff. I mean, all kinds of bonds including mortgage bonds, a lot of bonds for Chris’s properties and my property, your properties, my properties. The Fed was buying. It was the buyer of last resort during that time. And then what it did was as those rolled off its balance sheet, it stopped buying, and by stopping buying, it was shrinking the size of its balance sheet by $80 billion, and it’s been doing that roughly $80 billion a month for about seven or eight months. So it’s basically shrunk almost two-thirds of a $trillion dollars in the last seven or eight months and that of course reduces inflation because there’s liquidity being sucked out of the marketplace.

Chris Rising (13:43):

Yes.

Neal Bawa (13:43):

Now, there’s a lot of media outlets saying the Fed has reversed that. They’ve added $300 billion of new liquidity. $150 of that basically got added in through the FDIC program that they launched, and then $150 billion of that was through the discount window. I don’t believe that at all because this $300 billion is not money that the banks are asking for, so they can lend it out into the economy. Liquidity has no impact on inflation unless the money gets loaned out. It’s clear that the banks are doing it simply to shore up their reserves. So this money has been loaned from the Fed at interest, and remember in the past the interest was practically zero. So banks would just take money and keep it, but now it’s significant amount of interest. Interest rates are high. So when you take money from the discount window at the Fed, you’re paying a significant amount of money.

(14:33):

So the banks are taking this money, but they’re not deploying it. It’s not going out into the real economy. Right now, it’s just sitting in their balance sheet at Wells Fargo and Citi and Schwab. That’s not going to have any impact on inflation whatsoever. I believe what’ll happen is over the next few weeks, you are going to notice that some of that money will make its way back to the Fed because once the general public stops believing that we are going to have a general purpose across the board banking run, which I don’t think is likely to happen, then the banks will very slowly start to return that money back to the Fed because the banks right now are thinking we’re going to lend less. Why would they want to have all this extra money that they have to pay interest rates in interest on? So I do not believe that the Fed is reversing its policy of liquidity. Now, they may be forced to do that, but at the moment, it just simply means that for the moment, their balance sheet looks bigger than it actually is.

Chris Rising (15:34):

Well, let me go a little bit further into that because one of the things that hasn’t happened yet is you have a lot of money. I don’t know the number, so I don’t want to say it. Office loans, we own a lot of office. No matter what anybody says, cap rates are higher, interest rates are higher. There’s no way that building is worth what it was when we bought it. Hopefully, we created some value, and maybe we’re just at even for the things we own, but there is going to be a tremendous amount of commercial real estate that is either they’re going to get the keys back, these banks and these lending institutions, or there’s going to be some sort of federal legislation. I know some of the big landlords in New York are really pushing hard for that, and the real estate round table, our lobbying arm, is pushing hard for that.

(16:21):

But when you start adding some of these things to the banks where they are really getting hit and we’re talking about 50% of their book value just evaporated, how do you see that playing in to the overall Fed strategy?

Neal Bawa (16:37):

So think about it this way. Let’s say that there’s a bank out there that lends to a lot of commercial real estate players like you and me, and their book value does go down by 50%. 50% is a lot, but let’s just say for example purposes, it goes down 50%. You realize that if the banks, the value of its assets goes down by 50%, its ability to lend multiples of that is also shrinking at the same time. So the bank is now able to actually lend less. Well, if the bank is able to lend less and there’s thousands of banks in the same exact situation, liquidity gets hit. When liquidity gets hit, you’re not going to have inflation issues. You’re going to have reverse inflation because you were creating inflation by pumping liquidity out. So it solves the liquidity inflation problems, but it replaces it with an equally nasty problem of what the heck are we going to do with all these assets that are worth 50% of what they were?

(17:36):

So I think that there is no doubt in my mind that commercial real estate is going to have a very hard time in the coming 12 months, and there’s going to have to be various structures figured out to either fix the problem or more likely to kick the can down the road in some way so that there’s a possibility for interest rates to be lower so that some of these office assets can in fact be refinanced, or bailed out, or whatever it might be, recapitalized. So I think that there’s going to be solutions found to kick the can down the road for some of these assets where the rest of these, they’re going to go back to the bank. We know that. There’s a bunch of assets that no one can rescue.

(18:15):

Recently I was on stage at the Best Ever conference. I opened the conference, and one of the jokes I made was that most of the assets that are coming to me for rescue, I mean, if Jesus had a rescue fund, he probably wouldn’t rescue them. It’s so hard because there’s no equity. There’s $10 million, $20 million of negative equity in these assets.

Chris Rising (18:34):

Yes.

Neal Bawa (18:35):

So I mean, you’re just at that point, wasting your money by rescuing these assets. So this is good news for inflation, Chris. It’s very good news for inflation. And the Fed has realized that, begun to realize that in a severe liquidity crunch, the first thing that gets hit is inflation, so it’s going to come down. But on the other hand, now that the Fed has quote unquote “broken” the banking system, now they’re going to have to deal with all of these commercial real estate assets. And I refuse to believe that commercial real estate is the only asset class that has this problem. I think that there’s a bunch of asset classes that are going to come out of the woodwork in the coming months, and we are just the first one of those.

(19:17):

All of these asset classes are going to have to be shored up because what about stuff like Shell Oil? I mean, if you bought a bunch of Shell oil rigs, now their value has to be written down, blah, blah, blah, blah, blah. As the economy goes down, the Shell oil is going to fall to 60. Well, now these wells are not profitable. They can’t make money. They have to be shut down. Well, somebody has to pay mortgage on these things even though they’re being shut down. You see what I mean? So I think this is just the beginning of this process, but you get the inflation benefit when you deal with all this stuff.

Chris Rising (19:51):

How quickly do you think inflation can drop? I mean, we’re not seeing any break in our tenant improvement costs for the industrial that we own. We’re building out small offices and bathrooms. I mean, we are seeing no break whatsoever in terms of costs for drywall, plumbing, fixtures. So how quickly do you think it can drop so that the Fed will be like, “Okay, we see inflation going down.” I don’t see it right now. I’m hoping I’ll see it, but I don’t see it.

Neal Bawa (20:23):

I can guarantee that you’re going to see it in three months for the same reasons that… So the Fed doesn’t necessarily look at things that are selling at Home Depot right now because that doesn’t give them a sense of what is going to happen to inflation. The Fed looks at the cost of shipping containers that are being loaded at ports in China or being loaded at ports in Europe. They look at forward-looking information, and it’s beginning to show a significant amount of weakness. The cost of shipping containers is falling at a shocking rate at this point in time. It won’t show up for you at a Home Depot for at least three months, maybe even four months because that’s the lag of a shipping container loading in Shenzhen to basically stuff selling at Home Depot. So I think that there’s a lag. You’re going to absolutely see it. I think that there’s weakness there.

(21:11):

Here’s the other part. Today, more inflation is being caused by labor than by materials. Now, last year that wasn’t true. Last year it was materials. This year it’s labor because material costs have somewhat stabilized. They haven’t gone down. They’re still going up, but they’re now going up with inflation. They might be going up 4% or 5% where-

Chris Rising (21:30):

I agree with that.

Neal Bawa (21:31):

… last year they were going up 20%.

Chris Rising (21:33):

I agree with that.

Neal Bawa (21:34):

So labor inflation is what we have to control. Labor inflation is predominantly controlled through layoffs, and we haven’t seen significant layoffs in January or in February. Now we’re beginning to see them in March. So now you’re seeing cascade after cascade, 10,000 for Accenture, 10,000 for Amazon, 10,000 more for Facebook. Now you’re beginning to see a significant cascade of those, and it was always going to happen. It was a matter of time, but now they’re going to cascade faster because of the liquidity crunch because once Wall Street and the 100 biggest companies in America realize that there’s going to be a way less liquidity in the next six months, they start the layoff process. So I think most of that inflation reduction that you’ll get in 90 days, ironically, is not going to come from the goods. It’s going to come from the labor.

Chris Rising (22:22):

We’ll jump in on the job growth in the past and how you think they’ll continue layoffs. I was shocked to read that Microsoft literally had people they hired who would show up either online or in the office and had nothing to do. I mean, just irresponsible amounts of hiring. I would have to bet that if they hire that way, they’d probably fire that way too, where they’re just taking huge amounts of layoffs. I mean, look at what Elon Musk did at Twitter where he probably threw out some really good employees because they just didn’t have the time or the inclination. They just were cutting heads. You think that’s going to happen out there at a lot of the tech companies and some of the other companies out there? Wall Street companies?

Neal Bawa (23:05):

I think it will. I think it will. I live in Silicon Valley, so I have a good understanding of how tech companies think. Believe it or not, tech companies hire employees based on just their stock price. So if the valuation of the company is going up, they just hire a bunch more people and then figure out what to do with them later. And as their valuation starts to drop, they lay off a bunch of people, even if it’s extremely painful to lay them off. So it’s very tied to valuation that the tech companies are more tied to valuation than any other vertical that I’ve seen. And so now that valuation is falling, the NASDAQ’s been down, it was down 33% last year. It’s still in negative territory this year, though the S&P 500 is in positive territory.

(23:47):

So I think we are likely to continue to see layoffs, but I do not believe that the tech industry is the only one that’s going to lay off. I think they’re usually the canary in the coal mine. They tend to be the leading edge of layoffs simply because their business is software driven, so they can start laying off things faster. I think it’s going to be across the board. I think you are going to see across the board layoffs. I think you’re going to see the companies that make up the Dow Jones Index, the companies that make up the S&P 500 start laying off. If I had to pick one sector that is going to be very hard hit, besides real estate, clearly we all know the story of real estate. It’s going to be automotive. I am absolutely certain that the US automotive center sector and the world automotive sector are on the edge of a potential meltdown.

Chris Rising (24:41):

Wow, that’s a big statement. What is the generating, I mean, what’s going to generate that? What’s the reason?

Neal Bawa (24:47):

Well, generated already in the past. So there are two elements. One of them is that the eurozone, which is a major market for vehicles, has an extremely punitive law coming into effect on July 1st. Millions and millions of cars that have already been manufactured that were supposed to go to the eurozone can no longer be sold in this eurozone after June 30th of this year. So that’s only three months and three days away. And these cars are already made. You can’t unmake cars that you’ve already made. With the exception of Tesla, the car industry is very heavily indebted because they take a huge amount of money. They take money and they use that to make cars. Then when they deliver the cars, they pay it off. So GM and a bunch of other car manufacturers have huge amounts of debt.

(25:36):

Tesla is an extreme exception in that they have very little debt on their balance sheet. They paid off most of it, which is stunning by the way. They have an incredible business model. Keep in mind, Tesla makes roughly four times the profit on one car as General Motors or Ford does. So they’re in a completely different class, but other than them, these guys, they have to deal with these vehicles that were manufactured by the Japanese, by the Germans, and by the Americans to go into the eurozone market that are just sitting there now. Nobody wants them. So an extraordinary wave of price cutting is happening right now. You aren’t hearing about this. Wait, 30 days, it’ll be all over the news. And it started in China.

(26:17):

So in China, unreleased models of Toyota products are down $25,000 a car, unreleased versions. So these are cars that haven’t even been released, and usually the demand is extremely high when you’re releasing a brand new model. The price cutting war was started by Toyota because of some extraordinary benefits that Toyota have. It’ll take me a while to explain that. Sorry, not by Toyota, by Tesla, and now has spread to every Chinese EV manufacturer and everyone who sells gas cars in China. So Volkswagen, Nissan, Toyota, they’re all looking at a very, very, very, very troublesome next six months, and you’re going to hear more and more about this every week.

Chris Rising (27:08):

What do you think then? How does that translate here? Do you think that means a bunch of layoffs in the car industry? I mean, it’s scary what you just said, but now I’m saying, “Okay, that’s in the eurozone. What does that mean for here?” I mean, used cards are still pretty expensive, and will it be just a quick drop do you think because there’ll be layoffs, and car prices will come down, and they’ll stop making as many?

Neal Bawa (27:35):

I think there’ll be layoffs for every auto manufacturer in the US, but not as many in the US as there are going to be in the eurozone where Germany is going to take a huge hit. And then in Japan, which is going to take the biggest hit. The Chinese have already taken a hit. All you have to do is Google price war for cars in China, and you’re going to be stunned by what’s going to come up on your browser. I mean, there are 30 plus electric vehicle manufacturers in China. At least 40% of them are going to die before the end of this year because they’re all selling cars at $10,000, well, maybe not $10,000, but $5,000 below their price at this point, and we don’t know how long the price war is going to last because the only one that can end the price war is Tesla, and Tesla is not selling cars at a loss. Everyone else is selling cars at a loss.

(28:26):

So you have one company that’s selling at a profit, and everyone else that’s selling it at a loss. Of course, granted it’s China, so their government could step in and say, “Let’s do things a different way.” And their government can do stuff that ours can’t, but you never really know. So I think layoffs in Japan, layoffs in the eurozone, especially in Germany and layoffs in the US all tied back to firstly the transition to EVs and then also to this draconian law that the Europeans have implemented that comes into effect on July 1st.

Chris Rising (28:55):

Wow. So it’s starting to look from the way you’re describing it, that we might have a pretty… I can see where recession words start coming in over the next six months or so. What do you think that does to our economy and where should people be really afraid, especially if you own real estate?

Neal Bawa (29:14):

Well, so I’m going to discount the edge cases, the likely case is that we have a shallow recession. And the reason for that is fundamentally the US economy is very strong. Yes, we’ve got commercial real estate. You and I have talked about that. But the US economy is so large for in terms of the size of the US economy, it’s massive in size. Somewhere around $3 trillion a year that a $100 billion meltdown in commercial real estate is likely to be that number or close to that number is, I don’t want to use the word rounding error, but it’s not an extraordinarily large hit. It is not the $1 trillion dollar hit that we took in 2008. Also in 2008, there was contagion. I see no evidence of contagion. Bank balance sheets look pretty secure. They’ve just got this issue of they’ve bought too many of these long-term bonds, and now they have to basically write them down.

(30:14):

So the good news though is when a recession starts, the Fed can choose to cut interest rates. They probably won’t cut a lot, but they might cut once or twice, and that’ll give the banks some breathing room in terms of those long-term assets because now they can start marking up their value. Remember, if interest rates go down, those assets go up in value at the same time. So now the banks are like, “Okay, well now these assets are going up in value. We’ve got some breathing room, we’re not in any trouble.” So I do think that those few rate cuts can significantly support the banking sector, reduce liquidity. I don’t expect the recession to be very deep. I expect this one to be fairly shallow. So I’d say two quarters, the usual two quarters, cut some rates. Do some things, the government does some things to help you out, that sort of stuff.

Chris Rising (31:04):

What do you see as the opportunities that will bring in real estate, whether it’s say within your expertise, multifamily? Do you think that will present some opportunities?

Neal Bawa (31:13):

I am telling my investors I am buying nothing right now. I don’t believe I should be buying anything right now, but come July, August, I’m going to put as many properties as I can in contracts with extremely long terms. I’ll give you another $25,000 and kick it down another 30 days. I’ll give you another $50,000 and kick it down another 30 days. I want the longest possible timeline to close because I have very strong fundamental beliefs that interest rates will decline sometime in the second half of the year. And because I have no clue when in the second half of the year I just want to be in contracting properties.

(31:48):

It’s very likely that by July or August, we’ll be getting properties 25% off of peak price. Peak price being defined as Q4 of 2021 or Q1 of 2022. Those two quarters were basically the lowest cap rates in US history. So from that timeline, we’re going to be down about 25%. Right now, we’re already down somewhere around the 17%, 18%, 19% range. So another 6% drop in just the next three or four months, and then I want to be in contract with as many properties as I can get away with.

Chris Rising (32:26):

Interesting. And how are you funding most of your deals right now from an equity standpoint? Are you raising money basically off the internet and are you using any of… Do you have your own capital? How are you financing them?

Neal Bawa (32:42):

I raise money only from retail investors. I don’t use crowdfunding and I don’t use equity razors. So all of them are my own investors. We have 900 investors that directly are tied to us, and we’ll continue raising money through them. It is a painful process to raise money right now, which is why I am engaged in a three month effort to educate my investors on the extraordinary benefits of having a 25% price discount combined with a potential decrease in rates.

Chris Rising (33:21):

Interesting.

Neal Bawa (33:21):

The 25% is pretty locked in at this point. The decrease in rates, of course, is speculative in nature, so they have to drink my Kool-Aid to give me money.

Chris Rising (33:31):

Well, we’ve seen, it is been amazing to us as we’ve watched, and we have lots of capital relationships that are traditional private equity real estate relationships, but we dipped our toe into the crowdfunding world and had some really great success until the end of last year. And to us, you could really see a correlation between people’s feeling of their own wealth and they’re willing to invest, and as they’ve felt less wealthy, they’ve just gone away for a while. And it’s tied to… I didn’t think it would be so correlated to just the general news and the general feeling out there, but it is when it comes to those kind of investors. So we find it very interesting.

(34:12):

The people who invest money for a living, they’re still out there. In order to get their bonuses, they got to get money out. And so we are finding some really attractive deals because cap rates have changed so dramatically. Just as you said, I don’t really want to be a seller right now if I don’t have to be. But what are you seeing out there in multi-family in terms of just occupancies, rent growth, those kind of things?

Neal Bawa (34:42):

Well, from what I can see, occupancies are down, but by a very small amount. So they’re down. In most market, by coming down, they’ve gone back to historical norms, which were between 94% and 95%. We hit a record of 96.8% occupancy in multi-family during that boom, about 18 months ago is where the numbers were high because household formation in the US was extraordinary. It was spectacular. And so as a result, we were up in that 96.8% range for the US. A lot of markets have come down since then, and in the 94s, and some of the hottest markets, some of the markets that had the highest increase in rents are even lower than that number. So Austin, Phoenix.. Phoenix is particularly hard hit. So we’re seeing numbers there in the 91%, 92% range in some markets, 93% in some markets markets with 90%.

(35:40):

Why? Because when you have this crazy 30% increase in rents, well that’s going to hit affordability. People are going to find other solutions. They’re going to go live with mom, in their car, in their dad’s basement, whatever it might be. They’re finding ways or maybe two families are living together, and all of that affects occupancy. So we’re seeing that. We’re also seeing negative rent growth. Now, across the US, rent growth hasn’t been very negative. We’re basically seeing about a 1% reduction in rent in the last three or four months. Before that, rent growth was positive. After five months, rent growth was positive in February. So that was good. There was a little bit of an uptick. Now, one could say it was only positive on a nominal basis. On an inflation-adjusted basis, rents continue to be negative. Because inflation’s at 6% in February, if you have a little bit of rent growth, let’s say 0.2%, well, it’s still nominally positive. From an inflation-adjusted perspective, you’re still going backwards.

(36:39):

So we’re still going backwards. We have seen significant rent declines in the bubbly markets. So Phoenix, again, worth mentioning about 7% or 8% declines in rent some markets. Some markets are 10%. And again, other sub markets appear to be following suit with the notable exception of Florida, which has simply ignored everything that has happened in the last nine months. I see no evidence of any market in Florida, and I’m very jealous because I don’t have much that I’ve purchased there, of any evidence, either with home prices or with rent growth of declines. And obviously, there’s some price declines in Florida that are happening because of cap rates, but I don’t see any evidence that their rents are affected in any way. I think it’s because of the continued migration of rich people from Connecticut and New York into Florida. That doesn’t seem to have slowed down for the moment.

Chris Rising (37:33):

So you live in California like I do too. You’re in northern California. I’m in southern California. Do you continue to see numbers that show people moving out of the state, and does it make you concerned about the viability here in California?

Neal Bawa (37:48):

I’m not concerned about the viability of California at all. I think that I am concerned that people continue to move out. It seems to have slowed. So I think the peak was maybe about 18 months ago, coinciding with work from home and the boom that we were seeing in Phoenix in Austin and Boise and Las Vegas. A lot of that was Californians moving out. It certainly slowed, but it hasn’t stopped. So California has lost… There’s two big surveys, so I’ll quote both to you. They’ve lost 500,000 people in two years based on one survey and 700,000 people in three years based on a different survey. Either way, they’re close to losing a quarter million people per year. I think that may seem like a staggeringly high number, but for a state that has 40 million people, it’s actually a number that is sustainable.

(38:36):

Keep in mind that states don’t break when they lose population. The entire Midwest would’ve broken for the last 50 years because all of them were losing population. So Ohio’s lost population. Pennsylvania’s lost population. Philadelphia, I mean, there’s so many places, Michigan. I mean, states don’t break because they lose population as long as the population loss is very slow. And because California is so large a state, 250,000 people, I think is a loss that they can sustain. I think California was very slow to react to this population loss, but I can’t say that that they’re slow right now. I think that all of their alarm bells have gone off. They’re making changes. They’re taking away zoning. Oakland’s getting rid of zoning. I think they’re finally beginning to wake up to the possibility that they may not be top dog in the US anymore.

Chris Rising (39:26):

Well, I think what’s concerning to me is in the last 15, 20 years, it’s been a barbell where the middle class was moving out, but somehow the less fortunate and the wealthiest stayed. But you’re starting to see now the wealthiest start to leave, which is a new thing, and it concerns me. It concerns me. Our tax policy really concerns me. San Francisco passed this before, but Los Angeles passed a mansion tax, which is anything but a mansion tax. It’s just taxing small business. And so the tax policy to me is not making sense for a place that wants to grow. And I’m a big fan of California, and I believe there’s a lot of reasons to be here, but I do feel like sometimes they make it very difficult to make the arguments.

Neal Bawa (40:11):

They are. I think that the concept of the rich leaving California is a little bit overblown. Yes, billions of dollars of rich money is moving out of California, but California is a trillion dollar economy. So once again, it can sustain some losses. I’m concerned that this flight of rich people will accelerate. That’s what I’m really worried about.

Chris Rising (40:36):

Well, the interesting, and I know because you were right there to see Tesla announce the headquarter for engineers staying in the Silicon Valley. Makes a big statement about where the talent is.

Neal Bawa (40:47):

I think that’s the key. I still see continue to see California as a key magnet of talent. Also, I’ll say something in a minute on why I’m very bullish in California. Just a fair notice, I have not bought a single piece of land or a building in California in my career as a professional syndicator, and I don’t have any intention of buying any properties or building any properties in California. But I think California’s future is extremely bright due to two letters. And the two letters are AI or artificial intelligence.

(41:25):

We’re about to see the greatest increase in wealth that a single technology has ever created, far greater than the personal computer and the smartphone combined. And that is generative or general purpose, artificial intelligence. It’s a far greater revolution than we’ve had. The only revolution that I think is comparable to it is either the steam engine or the graphical user interface. So when Apple and digital invented the GUI, and that’s what got both Steve Jobs and Bill Gates started. I think that revolution was potentially as big as this one, but certainly not the smartphone. I think that generative AI is far, far superior to the smartphone in just how radically it changes the world.

Chris Rising (42:14):

I wrote some notes for this conversation, and that was one of my questions for you, so I’ll just follow up it up right here. Where do you think we will see AI impact us? Will it be on investments or will it be on operations more? Or maybe neither? I don’t know, but how do you see AI affecting what we do for a living?

Neal Bawa (42:43):

It’s very difficult for me to answer the question the way you posed it, so maybe I’ll answer it in a slightly different way.

Chris Rising (42:48):

Sure.

Neal Bawa (42:49):

Artificial intelligence is the great hope of mankind because what is holding us back as a civilization at this point of time is that we are not able to solve really big problems, really problematic problems. We live on a finite planet. It has finite resources, and that creates problems with our ever-rising increase in living standards and the fact that we have rising populations, and that creates all sorts of problems. We are also raising our debt at unsustainable levels. These are problems that are extremely difficult to solve. I think they’re all solvable, and I think that humans are not particularly well designed to solve problems of these magnitudes. I believe artificial intelligence is exactly designed to solve extraordinarily difficult problems with thousand or millions of inputs.

(43:41):

I think that AI solves most of the fundamental problems of humanity within the next three or four decade. Whether those problems are food, energy, housing, we’re going to end up solving all of these with AI because from what I’ve seen already, the ability of a human being compounded by AI creates an end result, a productivity end result, an innovation end result that is truly, truly, truly extraordinary. It makes the smartphone look like child’s play. And I think that’s what’s going to solve the problems. The only thing I’m afraid of that most people are afraid of is during those three or four decades, unsupervised AI can also create an extraordinary number of wars and also biological weapons. It is fully conceivable to pour every medical text into a unsupervised version of ChatGPT-4 and ask it to create the most perfect biological virus, and it’s likely to give you precise instructions on how to create one, as long as you let it learn for a while.

(44:45):

So it takes a while. It’s not just you pour something in, and it immediately becomes the world’s best chemist. It doesn’t work like that. But these things learn, and they learn at an incredible rate. Which means that in a number of years, if you have an unsupervised AI, I’m sure the Iranians, the North Koreans are cooking unsupervised AIs right now. It’ll take them a while to get their hands on something as powerful as ChatGPT, but they eventually will. So I think that’s my fear, and I think it’s everyone’s fear. But setting that aside, AI resolves pretty much all of our big problems within the next three or four decades.

(45:19):

It certainly solves things like food and energy. Food and energy are really one problem because most of our food is made through energy. If we run out of energy, we also run out of food. So it’s really one single problem, not two different problems. So artificial intelligence essentially makes all of us smarter. It has the same impact that we saw with Excel. This is an older anecdote. Excel, when it was launched, it put entire floors of accountants in Wall Street out of business. There were entire… The sixth, seventh, eighth, ninth floor, laid everybody off because now everyone can use Excel to do what these people used to do. It’s just a little formula that people write in Excel and then their whole job is gone. But how much unemployment did that really create? Actually, what it did was create the biggest employment boom that we’ve had in history.

(46:11):

So artificial intelligence makes everyone more productive, and I’ll tell you why that is so critical. What is the only way that any economist knows of… If you ask an economist, what is the only way for us to create ever more wealth, ever greater wealth without inflation? The answer is increase in productivity. If you can have 5,000 people make 100,000 Teslas, instead of 10,000 people making 100,000 Teslas, well then those 5,000 people mean that every Tesla ever made is going to be a lot cheaper. So productivity is unquestionably the greatest benefit that we have to mankind. And it’s very, very clear to me that five years of artificial intelligence applied to selective situations, and we’re going to get the biggest productivity boost that we’ve gotten ever.

Chris Rising (47:12):

That all makes sense to me. How do you think it’s going to just impact not 30 or 40 years from now, but over the next few years, what you do as an investor?

Neal Bawa (47:22):

It’s very difficult to tell because what I’m seeing already is the speed at which it’s moving is so radically faster than let’s say a smartphone. The thing with the smartphone is you first had to figure out how to get a physical device into the hands of billions of people. That took time. So it necessitated the process to be slower because it took a while to invent chips that would support cameras and things like that. What we are seeing now is the breakthroughs are coming by the day. ChatGPT-4 came out. It was radically better than 3.5, and then within weeks of it coming out, plugins came out.

(48:01):

So now there’s a plugin for Kayak. I can tell ChatGPT-4 I want to fly from here to Miami. I want to get there by 6:00 PM. I want the ticket to be cheaper than $400 bucks, and it basically immediately goes into Kayak through its plugin, finds it, puts it into the cart, and shows you the page on Kayak that has the exact right flight. And so I can just click buy. That just happened a few days ago. It also did Instacart. So now I can-

Chris Rising (48:30):

Yes, I read that article.

Neal Bawa (48:33):

So this stuff is happening with an incredible speed. It’s extremely difficult for me to understand what that means for real estate. So I’ll just make a general statement. Increase in productivity, increases affluence across the board, while an increase in affluence is generally good for real estate.

Chris Rising (48:54):

Well, you’ve mentioned the smartphone a few times. I’ll tell you, I’m just still amazed that I can run a full business in real estate on my iPhone. I mean, it just amazes me that we’ve come that far when just 10 or 15 years ago, you might have a big laptop you’d carry around, but you still have two boat bags full of paper and 15 people on today it’s a one person job. So it has changed so radically in a rather short period of time. And then I agree with you, this ChatGPT example. I think it’s going to be on steroids how quickly it’s going to change. What you need from owning and operating, and how you deal with vendors, and how you price things, all of this is going to change rather quickly and get us more and more efficient. But as you look at your world, do you think it changes dramatically how people live? So will multi-family projects, do you think that they will change dramatically in the next five or 10 years with some influence from AI?

Neal Bawa (50:01):

In the next five years, no. In the subsequent five years, I think an extraordinary and dramatic change is underway. In the short term, no I don’t. The problem is when you go from bits and bytes to physical stuff, it slows it down. Now, when you go from bits to bytes to physical stuff that’s heavily legislated, it slows it down even further. And real estate is all physical and extraordinarily heavily legislated, which means that it takes a while to disrupt or it takes a while to speed up. So I think the next five years, I don’t see very significant changes coming because of AI. Beyond that point, yes, I have very, very strong fundamental belief that we will be able to basically ask artificial intelligence what the best way to do things are. And I do not believe that US real estate, either in existing real estate or in new construction real estate knows how to do things the best way.

(51:00):

Everyone does things their own way. And when you get to the point where there’s a consensus on what is unquestionably the best way to do things with the highest optimization, that changes things extraordinarily dramatically in both good and bad ways. So it’s possible that existing buildings could become unviable or some portion of them may become unviable. Nobody might want to live in ’70s buildings anymore because there’s a wave of new construction that comes through because of appropriate use of combining modular and 3D printing. Some people do modular, some people do 3D printing. Right now, they’re doing it at a scale that’s so small that it never bothers any of us. But I think that with using artificial intelligence, you would be able to combine those elements into building some portions of a home modularly, meaning in a factory and other portions on site using a 3D printer. And the combination of those could get through the hurdles that stand in the way of these individual technologies today. And if that happens, you could see dramatic changes.

Chris Rising (52:08):

So you don’t think Adam Neumann and Flow is going to change anything in the first five years of their existence? It’ll still be the… He’s not bringing anything new to anything?

Neal Bawa (52:17):

I don’t think. I haven’t no belief in Adam Neumann whatsoever.

Chris Rising (52:22):

I had to get the question out there. Since he’s now decided that he’s in our business in a way that he hadn’t been. I thought it was foolish, but somebody said to me the other day, who knew that Andreessen Horowitz was a Mezz lender?

Neal Bawa (52:40):

Well, it seems like this I mean, Andreessen did something very clever. So Adam Neumann owns a very large multi-family portfolio, and I think essentially as part of Flow, he handed over… They mortgaged that portfolio. So I mean, he’s a billionaire. He had bought all this stuff. He doesn’t have any mortgages on it. So Andreessen were like, “We’ll cut you a $350 million check, but if you waste it, well, we’ll come take your portfolio.” And I think that’s not a terrible bet, I don’t think Andreessen is foolish. I’m not sure about Adam Neumann.

Chris Rising (53:17):

Well, I had to go there with someone who’s versed in technology as you are. As a technologist, I had to put it out there because that’s probably the biggest faux technologist I’ve ever met in my life. Well, let me ask, this has been a great conversation. Every time I talk to you, I get inspired. Are there some things out there that should be inspiring to people who are in the business of owning and operating real estate that you seeing right now and you mentioned it a few times. You think there will be buying opportunities in a few months, and is there anything else out there that you think people should be focused on for those who want good news on things?

Neal Bawa (53:54):

Yeah, and it’s inflation. I think that right now, inflation is this horrible thing that’s making everything hard for everybody else. And it’s just this thing that you’re beat over the head with. It’s like, “Oh my God, inflation. It’s making my life so hard.” The question I ask is this, the only reason real estate is a great business, one reason is because of inflation. Think about it. If Chris bought a car in 2010, let’s say a nice Camry, that car, and he bought it for $40,000 or $30,000, today, that car’s probably worth $8,000. But if Chris bought a house in 2010, and it wasn’t even a 2010 built house, it was a 1970s or 1980s built house, that house is now worth four times. Now, notice inflation does not support the Camry, but it does support the house. And that’s because it’s extremely difficult to build more houses in the US for the same cost, where it’s much easier to build new Camrys because Camrys come off a production line and that production line has become more, and more, and more, efficient over the last 12 months.

(55:08):

So on an inflation-adjusted basis, Camrys today are cheaper than they were in 2010. You see what I mean? Because production lines are faster and robots are cheaper. So real estate’s one of those things that is the primary beneficiary of inflation. In fact, Chris and I wouldn’t even be in business if we didn’t believe that inflation is going to cause the value of assets to go up.

(55:30):

So my question is, once things adjust and interest rates come down a little bit, and we get out of this hole that we’ve dug for ourselves, I don’t entirely see a problem with 3% inflation. There’s actually benefits to 3% inflation to real estate people. It’s problematic for the rest of the economy. It’s very problematic for people on social security. It’s also problematic for federal debt. Why is it problematic for people in real estate?

Chris Rising (55:59):

Why is it? You’re asking me?

Neal Bawa (56:04):

Why is it? Why is it? I don’t see it being problematic? I think 6% inflation is problematic. I think skyrocketing inflation is problematic, but once you get it in control, the fact that it’s very unlikely to come back down to 2% and it’s going to stay up at 3%, I’m going, “Should that bother me?” No. Data science shows that that shouldn’t bother me. That’s actually a good thing, as long as it’s in control at 3%. It’s not spiking up and down 6%, 10%, 15%. The spiking is a problem.

Chris Rising (56:32):

That’s exactly right.

Neal Bawa (56:33):

3% inflation is pretty awesome for those of us in real estate.

Chris Rising (56:38):

Well, and I agree with everything you just said. All of our performers have 3%. The pain that we’re all feeling now on inflation is we didn’t expect TIs to double. We didn’t expect those kind of things. So if we have a little more sense of normalcy, I agree with you. I think it’s all a great thing. And the good thing is maybe we can have another conversation in six months and see how things are.

Neal Bawa (57:00):

I hope so, Chris. Thanks for-

Chris Rising (57:02):

I always enjoy you. I always enjoy our conversations. I hope the world is treating you well despite inflation and higher interest rates, but I look forward to a conversation another six months or so.

Neal Bawa (57:14):

Sounds good. Thank you, Chris.