Russell Gray, one of the hosts of The Real Estate Guys Radio Show, shares some very valuable insights on why this downturn could be the much worse than 2008. Russ is also a financial strategist with a background in financial services dating back to 1986. Russ also taught Real Estate Finance to Realtors® pursuing the prestigious GRI designation.
Tell us a little bit about you.
I’m the cohost of The Real Estate Guys Radio Show. I think that’s how most people know me, I’ve been doing that since 2004. I can’t believe it’s been that long. My partner Robert Helms started the show in 1997. And I started out like a lot of people, just as a listener. And then I went to an event and got to know him, found a way to get engaged with him. Back then I was in the mortgage business, and I was in that business up until about 2008. Then, of course, the whole mortgage industry imploded, took my business with it, took most of my portfolio with it. And from there, I went on a quest to figure out how could so many smart people who appeared to be wealthy, including myself, wake up one day and be completely broke and completely wiped out and have never even seen it coming. And so the last 10 years of my career has really been about studying the way financial markets work, trying to understand how to put the macro into the micro, because real estate investors tend to be pretty myopic, they’re very detail focus. They focus on transactions and neighborhoods and they go from deal to deal.
Whereas, you listen to the people on financial media, financial news, they’re always talking about what’s going on at the 100,000 foot view and these big ebbs and flows of financial markets. And I think for most mainstream investors, you listen to that and think “That really doesn’t affect me except for maybe interest rates”. When you go through what we’re going through right now, I think that you begin to realize that there is a connection. And if this is anything like 2008, I think there’s an argument to be made that it’s actually going to be worse. Which means on the flip side, it’s actually going to be better. So it’s not all doom and gloom, but you just have to be real. I think that right now there’s a lot of reason to be paying attention.
And because you guys have been around for a while, I would love to hear your thoughts on what you’re seeing is happening right now in commercial real estate. I also think it’ll be one worse than 2008, but I would love to hear your thoughts there too.
I think when when most people think about real estate, the rank and file person out there who gets interested, they think about flip this house, they think about residential housing, maybe they think apartment buildings, and from a lending perspective, even apartment buildings, multi unit residential, is still considered commercial. But you know, when people really think about commercial real estate investing, you’re talking industrial, office, big buildings. And that’s an industry that I think is really in flux right now, you’ve had all this We Work, which rolled on to the scene with a fairly unique business model. I’m not exactly sure how they pass themselves off as being a tech company, but they were basically leasing long and renting short. And I think one of the cardinal rules in any form of investing is never borrow short and invest long. So I think that that business model was a bit of a challenge.
But even more traditional models, like retail, were starting to get affected by technology, what they call the Amazon effect. I think most people are familiar with that. So on one side of the commercial real estate ledger, you had retail spaces under tremendous distress because their retail customers, the demographic they served, companies like JC Penney, whose business models were being completely disrupted, these anchor tenants like Sears and Kmart, were just getting wiped out by people ordering online. On the flip side of that, on the industrial side, you saw warehouse and distribution and logistics, just going through the roof. And so there’s always going to be winners and losers in this current environment. You’ve a lot of people changing the way they behave. Companies are finding out that they can have a remote workforce and actually get things done. They may decide, hey, we don’t need all this fancy office space, people would prefer to live at home, or work at home. So maybe we’re going to cut back. I think that if you’re in the office space, you need to really look at the nature of the work that the companies are doing. And does it require physical proximity and collaboration? Or is it something that could be moved to a more diverse workforce, people working at home? You could be vulnerable.
You look at assisted living that on the commercial side, you have the big boxers where you’ve got 100, 200 people all in the same building, especially a high risk demographic in the age of COVID-19. Those spaces and those business models are a little bit under attack right now. And on the other side of that you have what our friend Gene Guarino does, which is residential assisted living and in houses where you take these mcmansions and turn them into units. At home, somewhere between eight and maybe 12 to 15 people, you still have care and economies of scale, but you also have community and a sense of home. It had some advantages even before all this came up. But now, being given the choice, you have to put mom or dad someplace, you might prefer to put them in a smaller facility rather than a larger one, just to mitigate the risk of exposure. So I think anybody who’s in the commercial space really has to think about like any real estate investor, about their markets. And when I say market, I don’t just mean geographies, although geographies can be impacted, I mean demographics, the people that you actually serve, who pay the rent, or the customers of the people who pay the rent. And then also the product niche itself, because some niches are going to be winners and others are going to be losers. So even in the realm of commercial real estate, which is a niche of real estate, there’s still a bunch of sub niches under that you just can’t throw them all in a blender and say that they’re all the same because they’re not.
Why do you think this will be worse than 2008?
When you look at what happened in 2008, it had its genesis in the subprime market, and you had a small percentage of subprime borrowers, which made up a small percentage of the overall mortgage market that got those 2/28 loans where they got a two year teaser rate, they were qualified, and a lot of times not really well qualified, because that was the era of liar loans, no income, no assets, no verification. And so these people would go in with no downpayment and really no income, not qualified, and they were using their ability to obtain a loan with weak underwriting as a way to control a property and speculate on the upward price. Well, when the price didn’t continue to go up, selling out on the back end for a capital gain went away when that to 2/28 adjusted, they couldn’t make the payment. And now all of a sudden, these triple A rated mortgage backed securities that have been sold off by Wall Street to unsuspecting investors started to underperform, which meant that they had to be revalued. And this is really what a lot of people don’t understand about the way all this money that makes it to Main Street where it comes into existence. But what happens, because I was in the mortgage business, is the loan officer, the mortgage originator, the company that’s out there writing the loans typically aren’t funding out of their own money. Normally what they’re doing is they’re funding out of a warehouse line of credit, like a giant Heloc and they fund the loan. They then get a whole bunch of these loans, package them all up, and then they sell those loans. They securitize those loans. They put them together in a mortgage backed security and sell them off to Wall Street and Wall Street investors who purchase the streams of income.
But they have to perform at a certain level, you can imagine, based on the small interest rates, it doesn’t take too many defaults before those things aren’t performing very well. And so that’s part of the food chain, once they get to Wall Street, those bonds become assets to the people who’ve invested in them. And they leverage them the same way somebody might margin their stock. So if you’ve stocks in your stock account, you may decide to head off and decide you want to raise some money, but you don’t want to sell the upside of your stock. So you hold on to the stock, but you borrow against it, you pledged as collateral. Well, unlike real estate, where if the price goes down, the property value goes down. You don’t have to make up the difference or restore the original LTV loan to value. Anybody who has ever margined stocks knows that that’s exactly what happened. So if you margin the stock and the stock goes down, then you have to either bring cash or sell the stock to restore your leverage. It’s called a margin call. And that happens to individual investors and it happens to big institutional investors. And so that’s what happened in 2008, these mortgage backed securities started to go bad or at least lose value. And they had been collateralized. They had been re-hypothecated.
So now you’ve got people out there getting margin calls. When you get a margin call, you have to sell everything or anything to raise cash to make that call. And the problem is, when the mortgages are going bad, nobody wants to buy them. Now you’re in freefall, when any asset goes no bid, the price is basically zero. And the Federal Reserve had to step in and print hundreds of billions of dollars, which was a lot of money back then, to buy these things up under their Toxic Asset Relief Program between them and the Treasury. They bought up all these these toxic assets and the Fed’s balance sheet ballooned from 800 billion at the beginning of the 2008 crisis to about 4.5 trillion before they started to try to wind it down and they got it down to about 3.7 which started to create a recession, they had to back up, they had to lower interest rates.
And then COVID-19 hit. And now the Fed balance sheet is over 7 trillion. It has nearly doubled just in the four months that we’ve had COVID-19. So on the one hand, you’ve got the powers that be the Federal Reserve and the Treasury way in front of the crisis as opposed to 2008 where they were way behind. That’s the good news. The bad news is, this is so much bigger because it isn’t just a small percentage of subprime borrowers that are having a hard time making payments. You have major corporations like Hertz, companies that have been in business for 100 years that are declaring bankruptcy. And the quote in the article that I just read, in fact, I featured it in today’s newsletter is, “No business is structured for zero revenue”.
So what we have is a health crisis that turned into an economic crisis, which means that we shut the economy down. It’s like having a giant heart attack. And if you can imagine currency, money stopped, like blood stops flowing because the heart stops beating, the economic heartbeat stops beating, the blood stops flowing, then, individual cells, people, and organizations, or organs, they all start to die. And if you don’t get the heart started quickly and get the blood flowing quickly, then you get permanent damage. And it remains to be seen if that’s going to happen. But when those payments stop being made, then the debt goes bad. And now we’re right back where we were at 2008, but much, much bigger. And the problem is everything we did wrong leading into 2008 with the margin and the rehypothecation occasion of the debt in Wall Street, the derivatives are worse today, global debt is worse today than it was in 2008. And the cessation of payments and the defaults and the bad debt out there is much bigger. So just based on that alone, it says that this is probably going to be worse.
The difference is the Fed which makes monetary policy, lowering interest rates and printing bunches of money. And the US government, which makes fiscal policy, the spending of gobs of money which they’re doing, They’re way in front of it.
Does that mean that the dollar, who’s having to really suck up all of this because all these dollars are being printed, at some point could have a consequence, a dollar crisis. If people lose faith in the dollar globally, if the dollar ceases to be the world’s reserve currency, now we go from a health crisis to an economic crisis to a financial system crisis where credit markets and banks fail to a dollar crisis. The entire burden of saving this whole thing right now is squarely on the shoulders of the dollar. And so time will tell if the dollar is strong enough to handle the burden. And I think that what most Americans aren’t prepared for is what would happen to them and all their dollar denominated earnings and assets if the dollar were to fail. For the rest of the world, it would be difficult if the dollar failed, but they’re used to other currencies that aren’t the world’s reserve currency. But Americans only know the US dollar. And they think the whole world revolves around the US dollar and if the dollar changes, if the dollar goes bad, American’s portfolios probably aren’t ready for what happens. So I think that’s something people really need to start to study and pay attention to. I know I am.