In January, the S&P 500 fell 10%, European stocks dropped 11%, Japanese stocks slumped 12%, the Shanghai stock exchange suffered losses exceeding 15%, oil prices crashed another 30% to below $30 a barrel, the Canadian dollar depreciated 11 straight days against the US dollar to levels last seen a decade ago, and investors dumped junk bonds, fleeing to the safety of US treasuries, which sent the 10-year yield below 2%. The damage has been both brutal and global.

In our last investor update, we warned of a short-term correction in the markets following a Fed rate increase, but the panic in January spanning multiple asset classes has been alarming. While the dramatic decrease in investor confidence portends to more near term pain, it will give way to opportunity in the second half for long term investors. We do not anticipate a 2008-style crisis in this cycle, a conclusion detailed later in this report.

2015 was a dud for all asset classes, except for cash/short-term bonds in US dollars. If your portfolio, as a whole, had a positive return, you fared well. At Bridge Tower, our steady performance differentiated us from the volatility of the markets. All four of our funds had an outstanding year. We continue to believe an investment in Bridge Tower’s real estate fund can be a cornerstone in your retirement portfolio, providing high current income while guarding against the dangers of inflation.

Investment Activity

In 2015, the Fund’s average purchase price and all in cost of a single family home was approximately $155,000 per home (≈$95/ft²), well below our replacement cost estimate of $105/ft². Construction costs continue to rise in Dallas, yet at $105/ft², they remain substantially cheaper than the national average ($125/ft²). On a value weighted basis, the homes in our portfolio have risen 5% to about $163,000 in 2015.

We have deployed the remaining capital in the BT Select Fund and will start receiving income from these assets shortly. We have leased 100% of our rent-ready properties and continue to project long-term occupancy rate at >96% for our portfolio. The Fund’s gross rental yield of ≈12.3% remains favorable and significantly higher than our larger, publicly traded competitors. Additionally, because our properties are generating a cash net yield above 8.5% (after the initial construction/renovation and stabilization period), we can provide our investors with a safe high dividend.

Bridge Tower will add 150-200 homes to our inventory this year. For our investors, this signifies a premium opportunity to profit from the thriving DFW market.

Macroeconomics Outlook

On December 16th, the Federal Reserve raised short-term rates for the first time in almost a decade. The incremental change from 0% to 0.25% was largely symbolic. Although most borrowers will not see much change in the interest they pay for credit cards, car loans or mortgages, investor sentiment has worsened considerably around the globe in the month following the rate increase. The same worries we highlighted in the past year have now caused investors to dump risk assets from stocks to corporate bonds in both developed and developing economies.

To reiterate, at Bridge Tower, we DO NOT foresee a 2008-style crash in 2016. In fact, after the breathtaking rise of various stock indexes from a 2009 low, as well as some irrationally priced stock and junk bond prices, we anticipated this correction in the markets. We welcome it as a sign that markets can function despite constant meddling from the central banks. Our analysis is as follows:

1) Worries about the impact of the Chinese economy on the US are overblown. US exports only ≈$100 billion of goods annually to China (<1% of US GDP) and we estimate that China only accounts for about 1% of the profits in S&P 500 companies. So, beyond psychological, any direct spillover from China to the US will be minimal.

2) The fall of oil and commodities prices is actually a net positive to the US economy in aggregate. The persistence of low oil prices is similar to a multi-hundred billion dollar tax cut. Based on our estimates, the drop in oil prices has added about $800 in disposable income to the average US household and will lead to better economic growth in 2016 and beyond.

3) The asset that propagated the last crisis—fraudulent subprime mortgages—are no longer a problem. More importantly, the problems of this decade, student loans, subprime car loans, and oil/gas corporate bonds, though not investments I want in my portfolio, do not rival MBS in size or ability to wreak havoc on the financial system.

4) While stocks and junk bond valuations are rich (especially in the US), investor sentiments have not reached levels that signal an impending bust a la Nasdaq (2000) or Shanghai (2015).
In essence, expect more volatility, but not a crash.

2016 US Housing Outlook

Capping a two-year resurgence in job growth that rivals the late 1990s boom, US economy added 292,000 jobs in December. Unemployment has plummeted from a recession high of 10+% to just 5%. Still, many Americans express strong dissatisfaction with the larger economy. 2015 had sluggish wage growth at a meager 2.5% and US GDP growth will likely muddle around 2% for the next few years due to slumping European and emerging market economies. IMF has now downgraded global GDP growth to around 3%, just barely above the level where people historically are positive about their economic prospects. Fortunately, inflation will remain low in the US, aided by the 25% surge in the US Dollar against other currencies along with the collapse in commodity prices. 2016, though faced with more volatility, will be just another ho-hum year in the stagnation decade for the US.

Ultimately, we remain bullish on US housing for the following reasons:

1. Strong new household formation: Employment gains have lured millennials out of their parents’ basements. We expect to see around 1.3 to 1.5 million new households formed in the US for 2016, a significant increase from the post-recession average of 720,000.

2. Fed will not raise rates beyond 1%: The strong US dollar, low inflation and low commodity prices will limit the speed of future rate hikes. The Fed will also continue its policy of reinvesting proceeds from Treasury maturities, amounting to over $216 billion in 2016. With interest rates staying at historically low levels and the treasury rollovers, the crisis era, easy-money policy lives on.

3. Mortgage rates will average below 4.5%: 10-year treasury rates have dipped below 2% from the recent market turmoil and will likely stay below 2.5% in the near-term. That should keep mortgage rates hovering below 4.5% for the year.

4. Home sales and home prices will both increase: New jobs, affordable mortgages, rising rents, and savings from gas prices will all contribute to buyers’ eagerness to purchase a new home. We project home sales volume to increase 5% in 2016 and home prices to appreciate 3% in the US.

5. Rents will increase faster than inflation: The number of rental households increased to 43M, up 9M from 2005, sending US vacancy rates to an all-time low 7%. Many desirable neighborhoods have vacancy rates well below 5%. Moreover, homebuilders have moved away from building sub-$200,000 homes and cheap apartments, dwellings that typically get turned into rental stock after a few years. The lack of new, affordable rental properties and the increased number of renters led to a shortage of rentals in 2015. The result? Rental prices growing quicker than inflation in the last 4 years. We are expecting more of the same in 2016—rents will likely continue to grow faster than inflation.

Outlook for the Dallas-Fort Worth Market

“We’re willing to move. We just want to live the American Dream.” -Toyota Employee, Torrance, CA

Imagine being able to buy a home after resigning to be a renter for life. That’s exactly what Toyota employees will do next year when they move from Los Angeles County, California to Plano, Texas (a suburb of Dallas). After focus groups revealed that employees were willing to move in favor of more affordable real estate, Toyota decided to make the jump from California to Texas, taking over 3,000 jobs along with them. And why shouldn’t they? The math is simple. The median home in Dallas is around $200,000 (3.5X income) but costs over $550,000 in Torrance (7X income). The decision spurred other major businesses to join them in Plano. The business park Toyota plans to occupy will ultimately house over 100,000 employees.

The number of transplants to the DFW is exacerbating the housing shortage in DFW. The situation is dire and calling the demand for real estate “high” is an understatement. In 2015, median homes prices jumped about 9% ($113 per square foot) to $204,000. Homes go under contract within a week and are sold within 45 days on average. Inventory remains low at 2.5 months, far below the 5-6 months needed to relieve the pricing pressure. We expect home prices to rise another 4-6% in the DFW through 2016.

We anticipate DFW housing demand to stay high from continued population growth underpinned by the creation of 100,000 new jobs in 2016. The latest employment data actually showed a net gain in the mining, logging, construction category when we expected to see job losses from the oil industry. From the data, we can conclude that laid-off workers in the oil industry are transitioning successfully to other jobs, most likely in construction.

Dallas certainly needs more construction workers! Homebuilding continues to lag pre-recession levels mainly due to a shortage of labor and lots. In 2015, DFW builders started 28,000 homes, still far below the 50,000 pre-recession average. Efforts to provide enough homes for the large number of transplants to the area will support the housing market at least through 2018.

One worrying sign for the DFW’s affordable home reputation, but very good for Bridge Tower and our investors, is that builders have only started around 800 new homes in the 4Q2015 that cost less than $200,000 (less than 15% of all new home starts). The shortage of these affordable homes will force more households to put off buying, remain as renters, thus exerting upward pressure on rents.

We are taking advantage of the void left by our competitors by building multiple single-family rental communities that cater to young millennials unable to buy a starter home. Our rental homes offer renters a brand new home, modern open layout design, upgrades such as granite countertops and laminate floors, and professional management that only exists in Class A apartment buildings. Lennar, a top-ten builder in the US, has successfully developed the first large single-family rental community in Sparks, NV. We believe the same model will be hugely successful in DFW.

Our Framework for Selecting Property

Continuing to exercise discipline in our acquisitions, rehabs and new construction, we seek: desirable location (good schools, safe neighborhood, quiet street), appealing home for the location (size, number of rooms, amenities), gross rental yield of 12% or more, and a purchase price significantly below replacement and market value.

Update on Business Building and Operations

BT Select Fund is now closed to new investors. To capitalize on a unique market, our latest US fund will launch in February of this year and will provide one more opportunity to invest in US real estate at exceptional gains. If you have been considering expanding your portfolio, or know of another accredited investor who wishes to invest in a Bridge Tower fund, we urge you to contact us as soon as practical.

We look forward to giving you an update next quarter. In the meantime, please don’t hesitate to contact us should you have any questions, comments or concerns. As always, we welcome the opportunity to speak with our partners.

Sree Annavarapu slept in a tent all night on September 28^th. Despite being six months pregnant with her first child, Sree camped out so that she could snag a corner lot in the Prestwyck development in McKinney, a booming town 35 miles north of Dallas. She was not the only one. All 83 lots in the development sold within 12hrs.           

We don’t have tents outside of our offices (yet), but our long waiting list of tenants confirms our long held thesis that residential property shortage, in the US and especially the Dallas-Fort Worth Metroplex (DFW), is worsening. DFW median home prices increased 8% in August (year over year) while rent surveys by Zillow, RentRange and Zumper showed that rents soared between 5-14% in the same period, far above the roughly 2% inflation rate in the US. We expect that the residential property shortage in DFW, caused by insufficient new home construction in the past decade, will persist until at least 2018.

Macroeconomics Outlook

The most anticipated Fed meeting in the last two years ended with a whimper in September. The Fed, as we expected, kept rates at zero. Fed Chair Yellen cited recent global economic and financial turmoil and subdued US inflation as the twin forces that pushed back the rate increase.

Taking Yellen’s logic further, we expect the Fed to raise rates in the next 12 months, but will keep rates below 1% until the end of 2016. We are predicting minimal impact on the economy and the markets, with the high-likelihood of a short-term correction, but nothing more.

Globally, China’s economic slowdown has claimed numerous victims, from Canada and Australia, to Chile and the rest of Latin America. Europe and Japan are no help, drowning in their own demographic and debt-fueled crisis. US will continue to muddle along at 2% GDP growth.

Despite the uncertainties, we are actually quite optimistic here at Bridge Tower. The US economy is adding jobs. The price of gas at $2.25 per gallon is giving consumers extra spending power. Low interest rates are keeping homes affordable in large parts of the country. Combined, these factors are contributing to an uptick in new household formation. Yes, millennials, armed with new jobs and a car, are finally venturing out from their parents’ basement.

Taken together, we continue to see mortgage rates hovering below 4.5% in the next 12 months and home price appreciation outpacing inflation nationwide.

Outlook for the Dallas-Fort Worth Market

DFW homebuilders went into overdrive in the third quarter, trying valiantly to catch up from construction delays caused by this spring’s record-breaking rain. Even with an almost rain-free third quarter, home builders closed only ≈6,800 homes (24,000 homes in the past 12 months) in the Metroplex.

During the process, homebuilders discovered that they could not find enough skilled construction labor to increase their pace of building. After the last downturn, 2 million construction workers were laid off.  570,000 of those workers, emigrants from Mexico during the last housing boom, have now left the US for good. Domestically, young workers never took up craftsmen trades due to the lack of construction jobs in the past decade. Now, carpenters, electricians and plumbers are hard to come by, and those that are available for work come at a huge premium. In Texas, many workers chose work in the oil fields over work in the construction industry. The labor shortage is exacerbating the supply shortage of residential properties.  Single family home inventory sold in 38 days or fewer in August, faster than anywhere else in the country. Available homes for sale in DFW remain near all-time lows at around 2.5 month’s inventory, compared to 6-7 months historically.

Rental demand in DFW remains robust. By our own survey, DFW class A rental properties have a vacancy rate of just under 2%. Even as crashing oil prices finally slowed down job growth in Texas, DFW continues to create around 100,000 net new jobs per year, while the rest of Texas will add only around 100,000 new jobs in the next year. Demographics have contributed to the pressure on the rental supply. Millennials, when venturing out on their own for the first time, are more likely to rent than to purchase a home. 

The latest rent versus buy study by Trulia showed that DFW median rent has risen to $1,550 per month while DFW homeowners pay only around $1,100 per month (about 40% less). Thus, while homes prices are rising faster than we would like, DFW homes, compared to rents, are cheaper than 90% of US metros and arguably as cheap as it was three years ago. Indeed, home price gains are simply reflecting a multi-year supply-demand imbalance, current rental and mortgage rates, and low median home prices at the start of this multi-year run.  According to the latest Zillow estimate, DFW median home price is $168,000, still 6.8% below the national average of $180,100 and less than 3X median income.

Our Framework for Selecting Property

We continue to be disciplined in our acquisitions, rehabs and new construction. Our four criteria for selecting property for the Fund are 1) desirable location (good schools, safe neighborhood, quiet street); 2) appealing home for the location (size, number of rooms, amenities; 3) gross rental yield of 12% or more; and 4) a purchase price significantly below replacement and market value.

By only purchasing homes that fit our strict criteria, the Fund expects to achieve a minimum net rental yield of 8%. Combining the rental yield with our projected 3-6% annual increase in home prices, the Fund can provide investors with good current income and total return of around 12% annually.

We look forward to giving you an update next quarter. In the meantime, please don’t hesitate to contact us should you have any questions, comments or concerns. We always welcome the opportunity to speak with our partners.

We continue to believe US residential rentals, Dallas especially, will be one of the best investment opportunities in the next 3 years. US rental vacancies dropped to 6.8% in the second quarter, a level last seen 26 years ago, with average rental rates hitting another all-time high. All recent reports validate our thesis: The supply of homes available for rent in the US is insufficient to satisfy the surging demand for rental properties. The combination of slow wage growth, low savings, tight mortgage lending standards, and lack of starter homes for sale all contribute to the current shortage. The situation is even more extreme in Dallas, where the vacancy rates in desirable suburbs have dropped below 2%. We expect the current supply and demand imbalance to persist until at least 2018. 

Macroeconomics Outlook

US economy grew 2.3% in the second quarter, rebounding from a lackluster first quarter growth of 0.6%. Unemployment rate dropped down to 5.3%, close to the level of full employment. However, globally, China is slowing down rapidly, Europe and Japan are barely growing, and emerging markets are struggling from the drop in commodity demand and prices.

As the US economy picks up this summer and unemployment rates continue to drop, we expect that the Federal Reserve will attempt to raise the short-term rates this year, for the first time in almost a decade. However, the drop in raw material prices and the strengthening dollar is keeping the Federal Reserve’s measure of inflation below their 2% target, where an increase in short-term rates is warranted Thus, we do not believe the economic conditions will allow the Federal Reserve to raise short-term rates beyond 1% in the next twelve months. Fed Chair Yellen confirms our view in her July 15 testimony to congress, “What matters for financial conditions and the broader economy is the entire expected path of interest rates, not any particular move….Indeed, the stance of monetary policy will likely remain highly accommodative for quite some time after the first increase in the federal funds rate…”

As a result, we still believe mortgage rates will hover around 4% for the remainder of 2015. Accordingly, home prices will increase (though slower in the second half of the year).

Outlook for the Dallas Market

Heavy rain in the spring caused widespread damage and construction delays in Dallas. Luckily, only 2 of our homes suffered any water damage. The construction delay is exacerbating the supply shortage of residential properties.

Employment in Dallas/Fort-Worth metroplex remains robust, feeling no ill effects thus far from the crash in oil prices. We expect the metroplex to produce at least 100,000 net new jobs a year for the next 3 years. The creation of new jobs and associated demand for housing far outnumber the 25,000 new single-family homes being built in 2015. Anecdotally, we spoke to three large apartment operators who are turning away tenants after reaching 105% occupancy – an unusual situation caused by the operators leasing more units than available and then hoping some future tenants fail to show up.

Dallas home values jumped 8.4% in May (year over year), about twice as much as the national average. Unlike the pundits who are calling the Dallas home price surge a bubble, we believe Dallas homes remain extremely undervalued, especially when we factor in the low mortgage rate, low median home price, and the strong job growth in the city. According to the latest Zillow estimate, Dallas median home price is $164,200, still 9% below the national average of $180,100 and less than 3X median income. Compared to other large metros either in the US or abroad, where home prices are typically 5-10X the median income, Dallas homes remain an incredible value.

Foreign investors, especially the Chinese, have taken note of Dallas’ strong economic growth, excellent higher education system, and superior home affordability compared to California and New York. Chinese investors have increased their purchase of Dallas homes by at least 30% this year, now accounting for over 20% of sales to foreigners in the city. As more investors discover Dallas’ great value, we expect Dallas home prices to rise above the national average in the next few years

Our Framework for Selecting Property

We continue to be disciplined in our acquisitions. Our four criteria for selecting property

are 1) desirable location (good schools, safe neighborhood, quiet street); 2) appealing home for the location (size, number of rooms, amenities; 3) gross rental yield of 12% or more; 4) a purchase price significantly below replacement and market value.

We look forward to giving you an update next quarter. In the meantime, please don’t hesitate to contact us should you have any questions, comments or concerns. We always welcome the opportunity to speak with our partners.

Macroeconomics Outlook

Our three major 2015 predictions for the housing market – 1) mortgage rates will hover around 4%, 2) Fed will be unable to raise short-term rates much, 3) home prices will appreciate at least around 4% – remain on track.

US economy disappointed in the 1Q, with preliminary 1Q GDP growth coming in at just 0.2%. The dismal result pushed projections of a mid-year interest rate increase to the fall. We continue to believe a small 25-50bps interest rate move, if it happens at all this year, will have little to no impact on our business and the US housing market. We strongly doubt the Fed has an appetite for more since the ensuing US dollar strength from a large interest rate move will likely push the US economy into a recession.

Outlook for the Dallas Market

Employment in Dallas/Fort-Worth remains strong from a combination of internal growth and corporate relocations to the region. The metroplex is currently producing around 120,000 net new jobs a year and unemployment hovers around 4%, more or less at full employment. Yet, builders will start construction on only 25,000 single family homes in 2015, just 25% of the number of net new jobs created. The severe shortage of desirable housing has caused homes values to jump 9% in the first quarter (year over year).

Despite the unsustainable surge in the 1Q, Dallas homes remain extremely undervalued, especially when one factors in the low mortgage rate and the moderate median income growth in the city. According to the latest Zillow estimate, Dallas median home price is $157,900, less than 3X median income. Compared to other large metros either in the US or abroad, where home prices are typically 5-10X median income, Dallas is cheap. We continue to be hugely bullish on Dallas housing for the next 3 years.

Our Framework for Selecting Property

We continue to be disciplined in our acquisitions. Our four criteria for selecting property are 1) desirable location (good schools, safe neighborhood, quiet street); 2) appealing home for the location (size, number of rooms, amenities; 3) gross rental yield of 12% or more; 4) a purchase price significantly below replacement and market value.

By only purchasing homes that fit our strict criteria, we expect to achieve a minimum net rental yield of 8%. Combined with our projected 3-6% annual increase in home prices, we can provide investors with good current income and total return of around 12% annually.