Iran and the Fragile Real Estate Recovery

The war in Iran has taken some air out of the real estate industry, primarily multifamily. Interest rates were trending lower, rents were stabilizing, and optimism seemed to be slowly returning. Rents haven’t been impacted yet, but interest rates and near-term optimism have been damaged. That’s enough to make an already unstable recovery wobble some more.

The financial results of the war thus far are contrary to President Trump’s objectives. The Federal Reserve recently held the Fed Funds rate unchanged, but it is now poised to rise. This is antithetical to the President’s desire for rates to be cut 100+ basis points from current levels. It also impacts the President’s newfound interest in affordability, prompted by New York Mayor Zohran Mamdani’s successful political campaign. For-sale housing is more expensive with mortgage rates above 6.5% again. Gas prices are up more than $1.00/gallon over the past month and breached $4.00/gallon nationally this week. President Trump also likes to tout stock market gains during his presidency, yet the Nasdaq is down 10% year-to-date and the S&P and Dow are entering correction territory as well. Everybody’s 401(k) plans don’t look so hot over the past five weeks.

The argument is that there is short-term pain to deal with Iran and that we’ll go back to normal soon. This sounds to me like the Fed calling inflation “transitory” during the pandemic. Clearly it wasn’t transitory, and the Fed was late raising interest rates. I think the impact of this war is yet to be felt. Let’s look at two of the biggest economic issues: interest rates and inflation.

Rates Are Moving the Wrong Way

The broader real estate market, not just multifamily, has been hoping for lower interest rates. And President Trump has been very vocal about doing just that. Lower interest rates often lead to higher valuations—which would soften the blow from acquisitions made at the market peak in 2021/2022. Rising valuations would also improve transaction volume, stoking more interest and confidence in the market. It won’t make investors whole from those peak purchases, but it would bring the industry out of the doldrums.

Rising interest rates driven by slower growth and higher inflation, on the other hand, don’t improve confidence. Over the past month, the 10-year US Treasury has risen from 3.962% on 2/27 to 4.311% on 3/31—nearly 35 basis points. It’s not the end of the world, but it’s a signal in the wrong direction. If you’re underwriting a new acquisition, the price you’re willing to pay has either dropped or you’re putting more equity into the deal, as loan proceeds have decreased. If nothing else, this creates more uncertainty. Today’s rates are one thing, but if the Federal Reserve starts hiking to combat inflation, we’re going to wish we locked in a loan today.

Inflation: The Real Wildcard

Inflation is the big wildcard. We’re not back to the Fed’s target of 2.0%, but it seemed like we were close enough to be on a path toward a lower neutral rate. Now, if oil prices remain elevated and gas prices stay above $4.00/gallon, how does that impact inflation? The Wall Street Journal had an interesting article this week arguing that 1) gas prices on an inflation-adjusted basis aren’t that bad, 2) consumers should have enough money to absorb the increase, and 3) cars are more fuel-efficient today. However, it does mention that “gasoline prices can play an outsize role in consumer psychology.” It further notes that “…high gasoline prices can have ripple effects on purchases of other items. Car purchases tend to weaken, for example, perhaps because in their mental accounting, people place cars and gasoline into the same spending bucket.”

The consumer psyche is fragile despite most economic signals suggesting consumers should feel confident. A Brookings Institution paper “found people were unhappier on days when gasoline rose above $3.50 and $4.00 a gallon.” It’s not just the daily commute that will be more costly. Airlines will need to pass along higher costs. The cost to ship your recent online purchase will increase. And products where oil or petroleum is an input will have to raise prices in order to offset higher costs.

If this persists and the trickle down effect is real, the Fed will have no choice but to raise interest rates. Don’t you want to own real estate in periods of inflation? Generally, yes. Rents tend to rise, but so do expenses. The net effect is still growing net operating income. However, that NOI growth is offset by higher cap rates, which can negatively impact value. You’re still largely better off than staying in cash. Unfortunately, higher rents will stress an already overburdened renter, at least at the workforce housing level. Unless they receive commensurate increases in pay, rent will make up an even greater share of their monthly income. That’s not good for delinquency, evictions, or occupancy.

Where to Focus Now

Much remains unknown. There are even some hedge funds suggesting we’re on the precipice of 1970s-style stagflation. Not much does well during stagflation. The chart below from Mark Hulbert’s article in MarketWatch shows that small-cap stocks and housing produced real returns above inflation during the 1970s. Further, REITs delivered positive real returns of ~4.5% during this period of stagflation, according to NAREIT data.

By itself, this isn’t a reason to jump head-first into real estate indiscriminately. I stand by my earlier view that this market is very fragmented today. Suburban markets in the Midwest continue to do well because there hasn’t been overbuilding and their economies are still growing, albeit slowly. Then there are markets like the San Francisco Bay Area that are accelerating because of AI investment. Many markets there are seeing real rent growth and should continue to do so during a period of inflation. AI spending may buck an otherwise slowing economy.

In light of the latest bout of uncertainty, I’d focus on three things: 1) target a niche market or product-type where you have real potential for alpha, 2) get very good at operations and managing the P&L, and 3) sell when your business plan is complete. This is true in all markets, but the margin for error is slimmer.