Special Report 2021 State of Affairs - Type here - Lucern Capital Partners
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Special Report
2021 State of AffairsJanuary 2021
Special Report – State of Affairs
Dear Investor,
It has been approximately nine months since our last report. That report, which we published in April of
2020, was in the early days of the COVID-19 pandemic. Back in April, the world as we knew it changed
overnight. Humanity began battling the largest public health crisis in generations, which deeply impacted
the global economy and will leave its mark for a significant time to come. Some of us lost friends, family
members, and business associates who will forever be in our minds and hearts.
In April, the world was hanging in the balance, day-to-day, evolving our standard of care and understanding
of this foreign virus. Our lives are different today than they were just a year ago – we check our pockets for
a facemask when leaving the house, along with the standard wallet, phone, and key check. We have become
accustomed to eating outside, irrespective of the temperature. We are currently a country of divides when
it comes to beliefs – on the pandemic, politically, and socioeconomically.
We are writing today to provide you with a special report on the state of affairs from our perspective. We
have built our reputation on stellar performance for our limited partners, transparency, and most of all,
counsel and accessibility in the times most critical. As always, today is no different.
General Economy & Pandemic
When we last wrote to you, we were amid the ‘Great Lockdown,’ where the economic impact was
incredibly severe and has since forced thousands of small businesses to shutter. After sustaining very
material tax revenue shortfalls, and the pandemic battering already stressed state budgets, virtually all states
have returned to some degree of ‘openness,’ albeit constrained by curfews and other restrictions.
Some of the challenges we faced in April – cascading non-payment of personal obligations, and the idea of
‘passing the buck’ (effectively), are challenges we still face. In our business, consistent extensions of a
federal eviction moratorium have left $70B of unpaid rent in question. Issues like these have still not been
addressed by policymakers and will continue to persist and worsen over time. These obligations will
ultimately be borne first by property owners, then by their lenders, and ultimately by the government.
Policymakers have rained down unfathomable sums of stimulus to the economy with the hope of prodding
economic activity. Much like the divide we discussed earlier, for folks that are both employed and able to
work from home, most have done considerably well during the pandemic. They avoided commuting costs,
additional food and daily expenses, and began eating and drinking at home instead of enjoying visiting a
restaurant or bar in their free time. This has led to a high savings rate and will unleash a torrent of spending
when the world fully reopens. In recent history, Fed rhetoric has stayed the course of ‘lower for longer,’
communicating to the broader market that the Fed will let the economy run hot before tightening. This has
brought inflation expectations and discussions to the forefront, with most now expecting some moderate
degree of inflation in the next twelve months compared to what we have experienced as of late.
With multiple vaccine candidates – both approved and unapproved on the horizon – we will soon begin to
see the light at the end of the tunnel. Virus mutations and vaccine reluctance will delay (hopeful) eradication
218 Broad Street │ Red Bank, NJ 07701│ 732-875-1190 │ www.lucerncapital.comof the virus and a full return to normalcy. However, we believe that we will put the pandemic behind us in
the second half of 2021.
Rate Outlook
In our last report, we wrote the following, which we still believe to be true and indicative of the situation
we are in:
“In a vacuum, the logical result from trillions of monetary and fiscal policy should be a sharp spike in
inflation – a resuscitation with the paddles cranked to high voltage. While we are expecting some
intermittent spikes in inflation in the short to medium term, even if tepid, we are of the feeling that rates are
going to have significant trouble moving up in a meaningful way for the longer term.”
The 10-year obligations of the US Treasury continue to be the flight-to-quality choice amongst developed
market sovereign debt for our safety and our ‘impossibility of default’. Aside from domestic central bank
asset purchases, which will hold down the rate, overseas demand for 10-year Treasuries is insatiable and
will continue to be so to the extent global developed market paper continues to trade at lower yield levels
and, in some cases, negative real yields. While the Federal Reserve’s balance sheet will swell, their ability
to unwind their asset purchases in a meaningful way over the coming years without material dislocations is
a large obstacle, further eliminating the potential for short-term upward pressure from unwinding.
In summation, we feel the interest rate climate will be ‘lower for longer,’ and continued market headwinds
will make the climb of rates, notably the 10-year Treasury, very challenging. While rates may fluctuate or
even drift upward slowly, we do not see any material rate risk over the next 12-24 months.
Political Outlook
When we last wrote this report in April of 2020, we had predicted President Trump would be re-elected for
another term, riding on the wave of economic prosperity and progress. The election has come and gone,
and the result is a new President, a perfectly split Senate, and a Democrat-controlled House of
Representatives. The Senate has only been perfectly split in three other occasions in history, the most recent
of which was 2001. This 50-50 split could not be any more indicative of the broad challenges and deep
division we are facing as a nation. While the vast majority of constituents are center adjacent folks, we have
let the splinter factions of both parties drive the proverbial bus. For this, we will continue to see division
instead of unity and backwardation rather than forward progress.
Historically speaking, candidates seldom achieve the majority of their campaign promises – something that
is evidently clearer in the age of constant and targeted communication, overzealous media coverage, and
24/7 social media. We believe we are in for another bout of gridlock with very little in the way of delivered
campaign promises that will materialize over the next several years. We think challenges surrounding 60-
vote minimums will be considerable and hard to overcome without compromise from both sides of the aisle.
Until mid-term elections, independent(s) will wield considerable power and leverage when brokering
legislation, and deals will be considerably watered down, likely not appeasing a large portion of the new
Democratic base. We have already seen early signs from Senator Manchin and others who have moderate
views pledging to block removal of the filibuster – one of the biggest things that stand in the way of
legislative free-reign. Where we could see some change is on tax issues, which could be accomplished
through budget reconciliation. This is a process that happens twice per year, where certain spending and
revenue legislation changes can take place. Budget reconciliation only requires a simple majority, which
218 Broad Street │ Red Bank, NJ 07701│ 732-875-1190 │ www.lucerncapital.comwe believe will be used to fulfill some campaign promises related to increased tax levels, capital gains, and
others. Mid-term elections generally favor the party that is not in control, and to that end, Democrats will
have a narrow window to achieve real policy change before potentially losing control. It will undoubtedly
be interesting to see what unfolds in the coming years.
The Real Estate Market
We feel very strongly about core pieces of our last outlook/prediction(s): The real estate market this
downturn will be much different than the last. Generally speaking, this downturn was not a result of real
estate or an asset bubble like the last crisis, and valuation, while elevated, is not in peril. Fundamentals
going into this crisis were fantastic – mortgage rates were favorable, a housing shortage existed,
employment was strong, and wage growth evident. An important point of reference is the difference in pre-
and post-Great Recession underwriting, both residential and commercial. The latter is much more durable
and resilient to economic shock than the former. By and large, credit quality has improved dramatically
since the Great Recession, with lower overall leverage and rates, allowing for greater cushioning to both
valuation and cash flow.
We had formerly predicted that the residential housing market would take a hit of 8-12% in the short-term
and correct as consumer confidence grew. This was true; however, the market corrected much quicker than
anticipated, and housing and mortgage activity has been much more robust, much earlier than expected. It
has not been uncommon in major markets for existing inventory to have literally dozens of offers
competing, with sales prices going way over asking and often to non-contingency buyers. This has, by and
large, shut first-time homebuyers out of the market. Fueled by additional purchasing power resulting from
historically low mortgage rates, prime borrowers have bid up prices, especially in the luxury home segment.
Suburbs, primarily those in or within striking distance of major metropolitan areas, have seen a resurgence
of demand as buyers seek space, home amenities, and blue-ribbon school districts. While valuations look
extended on a historical basis, when put into context in a low rate environment, volume and pricing begin
to make a bit more sense, especially if you believe the rate climate will remain low for a protracted period.
Generally speaking, assets directly serving the business of leisure and hospitality and their support systems
have and will be most impacted. This includes all hospitality assets irrespective of location and all asset
classes in markets that are hospitality and leisure anchored. Yardi, a leading provider of real estate
intelligence, recently released an employment bulletin highlighting the metropolitan areas that are most at
risk. The qualifications for ‘most at risk’ include a high combined percentage of leisure, hospitality, retail,
and construction employment. Unsurprisingly, the core Florida markets of Orlando, Ft. Lauderdale, and the
Southwest Florida Coast (south of Tampa) comprise three of the top five worst impacted areas, with Las
Vegas and Houston rounding out the mix. Metropolitan areas that we have focused on for investments on
behalf of our limited partners have always had diversity in employment, strong wage and population
growth, and most of all, reasonable cost(s) of living. The Great Recession taught us important lessons which
we have built our firm and investments on to remain durable and consistent in any environment.
The predicted asset class winner from this crisis is multifamily, which is expected to have the lowest current
and cumulative default rates. As a point of comparison, Trepp, a data provider that focuses on real estate
loan information, released their projections for the COVID-19 crisis earlier this year. Default rates for the
broader commercial real estate market related to the pandemic will range from 6-8% this year, while hotel
and lodging loans will soar to over 10%. Multifamily assets are expected to have default rates of 0.50%.
This is above their historical loss rate of 0.20%, however still immaterial from a notional perspective.
Putting this into perspective is an expanded data point known as a cumulative default rate, which projects
218 Broad Street │ Red Bank, NJ 07701│ 732-875-1190 │ www.lucerncapital.comthe total of losses over a five-year look-forward period. While hotel and lodging loans will experience
cumulative defaults of 35% or greater, multifamily is expected to generate cumulative losses of 3.3% over
the same period.
The case for multifamily is simple and enduring. There is a housing shortage in America, which is expected
to take decades to correct, especially housing that caters to most Americans. This housing, known as
‘workforce housing,’ generally falls into two classes – B and C, with the former being more middle income
oriented and the latter lower income. Both are non-subsidized housing by economic necessity rather than
lifestyle or discretion. Part of what makes this housing so attractive is that there isn't any more of this
housing being built, except for real affordable housing, which is largely housing voucher and subsidy based.
High cost of land and construction means that only the highest quality product, often lifestyle rather than
workforce based, makes economic sense to develop. The multifamily asset class is also unique as it meets
a universal need – that of shelter. The tenant base, as a result, is also universal, differing from an office or
retail tenant that needs a particular space, location, fit-out, etc. This also means universal demand, durability
of cash flow, and declines that are far less severe in times of stress than other asset classes. In fact, in the
2001 recession and the Great Recession, multifamily declined significantly less than office, industrial, and
retail counterparts and had the fastest recovery to pre-recession peaks and longest post-recession period of
growth.
Trends in America are also changing, with homeownership rates continuing to decline driven by the
millennial age cohort who are waiting longer to settle down, are more transient, and have less desire to
purchase a home. This trend will be further supported by the double hit this age group will take between
the Great Recession and the Great Lockdown. Statistically, when adjusted for inflation, millennials are
already behind their Generation X counterparts in real wages at this level of their careers. This will only
hurt their ability for continued wage growth, encouraging longer-term renting.
We built our firm on the general premise of acquiring value-added and opportunistic B and C class
multifamily in metropolitan statistical areas (MSAs) with populations exceeding five million and that
shared the same qualities as mentioned above. Over the last few years, we felt that yield expectations for
deep workforce housing, i.e., Class C housing, had become disconnected from the asset class's overall risk
profile as a result of significant capital inflows. This was driven by a search for yield by investors and a
widely held belief that Class C housing had built-in immunity from recessionary shock. We were of a
different view and took the opportunity to exit Class C product we owned.
We took advantage of valuation and mature business plans to amplify our value creation, generating
exceptional returns for limited partners. Though no one could have expected our next downturn in its current
form, our move to exit the Class C space could not have been more prescient. Class C assets in this crisis
are expected to fare the worst out of the multifamily asset class. This tenancy is the most vulnerable to
income disruptions, most likely to have underlying health issues that will be exacerbated by the COVID-
19 virus, and the least likely to be re-employed when the dust settles. Notably, full employment (5%
unemployment) and better is when you begin to see significant pickups in the lowest wage earners. We
expect wage growth for these individuals to slow, and low wage growth directly affects rent growth
potential. Ultimately over time, these assets will be less attractive, and valuations will suffer.
Our platform shift was to higher-quality workforce (B) and lifestyle-lite housing (B+/A-), where we felt we
could generate higher risk-adjusted returns for our limited partners. Our most recent acquisitions fit this
model, and we have begun to prove this thesis out to our investors. We have seen an uptick in deal flow
related to broken transactions, changes in valuation, and more. The forbearance and payment delays that
218 Broad Street │ Red Bank, NJ 07701│ 732-875-1190 │ www.lucerncapital.commost lenders allow borrowers to have acted as an effective ‘put option,’ preventing properties from entering
a distressed state, with the goal of avoiding steep declines. The strength of the multifamily market combined
with forbearance has all but eliminated the potential for severely distressed opportunities for purchase.
Multifamily in the aggregate is more likely to have opportunities that can be capitalized on rather than
stolen; short-term dips that warrant buying, perhaps 50-100 basis points improvements over prevailing yield
expectations just several months earlier. Forced sellers ranging from institutions rebalancing to sellers with
time constraints will present these opportunities for attractive going-in basis levels on quality real estate.
We continue to actively seek and be selective toward these opportunities for our limited partners.
Key Economic Takeaways
➢ We know more about the virus than we did nine months ago, and we are slowly moving towards
reopening
➢ Multiple vaccine candidates take morbidity off the table and provide some light to the end of the
tunnel
➢ Vaccine rollouts that are delayed, aversion to taking the vaccine, and new strains will delay
eradication
➢ Policymakers have showered broad stimulus on the economy, which is expected to lead to some
inflation
➢ Significant questions need to be answered – inevitable economic problems that were delayed, not
fixed
➢ The second half of 2021 should see a material return towards normalcy
➢ Unemployment will settle in between 5-6% in 2021
➢ Rates will be lower for longer as a result of significant economic obstacles but will be net positive
for real estate
➢ Our 50-50 split Senate could not be any more indicative of the deep and broad division we face as
a nation
➢ Congressional margins are slim, and the Democrats will likely get more symbolic than meaningful
legislation passed to energize their base, although there is a road to tackle tax reform
➢ A significant housing shortage in America will continue to dictate real estate performance for
decades to come
➢ Residential real estate prices in the most desirable areas have rebounded, and increased competition
has all but shut first-time homebuyers out of the market
➢ Commercial real estate impacts of COVID-19 will be asset class and geography specific
➢ Multifamily is projected to emerge the strongest out of all real estate asset classes, with loss rates
of 0.50%
o While there will always be one-off opportunities, large distress in multifamily will be all
but avoided
The Future of Lucern Capital
It feels like each time I write an update, my optimism for our firm and our future gets brighter. Through
every downturn comes great opportunity. We finished 2020 strong with the launch of our first fund vehicle
Lucern Philadelphia Value Fund I, L.P., which will focus on the markets where we have been most
successful, Philadelphia, Charlotte and others. This is an incredible milestone, and I could not be prouder
of our team and what we have accomplished in such a short time together. Our skill sets are very different
218 Broad Street │ Red Bank, NJ 07701│ 732-875-1190 │ www.lucerncapital.combut very complimentary. We moved to a larger location and grew our staff. We created a new brand and
platform, Lucern Living, to manage all of our Tri-state area assets and provide a deeper level of control,
oversight, and performance to our assets. We acquired more than $20 million of product in December and
have some very exciting projects in the pipeline for 2021, including an adaptive reuse of a failing hotel into
multifamily. These projects in the pipeline should push us over $100 million of transactional volume since
inception, something I could have never imagined just several years ago.
We are well positioned and capitalized to seize the opportunity that has and will continue to knock. Mark,
David, and I have built our firm to be durable and resilient, and our underwriting is as strong as the day we
opened our doors. While 2020 was a brutal year in many respects, it also taught us many lessons that we
will draw on as we move forward. We all learned how to be remotely effective and overcome challenges.
We spent more time with family and rekindled personal relationships that were disrupted from long work
schedules, travel, and the impact of the daily grind. For all of these and more, we are thankful.
We have a saying here at our firm – “first time it’s beginner’s luck, second time you got lucky, third time
it’s a streak, and fourth time it’s a track record.” Our track record is exceptional, our investors are growing
and loyal, and we are transparent and accessible. We as global citizens will emerge better than we were
pre-pandemic. It will take some time. It will take understanding, cooperation, and kindness. 2020 was the
year of negative energy, 2021 is the rebirth.
As always, we are incredibly proud of our success, and we thank you sincerely for your continued interest
and investment in our platform. We hope that you and your families are staying safe during this challenging
time.
Regards,
Frank Forte & Team Lucern
If you have investment inquiries or would like to learn more about Lucern Capital Partners’ value-add
multifamily investment strategy, please reach out using the contact information below. One of the
members of our team would be happy to speak with you.
David Hansel Frank Forte Mark Callazzo
Managing Partner Managing Partner Managing Partner
Head of Capital Management Chief Investment Officer Chief Operations Officer
David.hansel@lucerncapital.com Frank.forte@lucerncapital.com Mark.callazzo@lucerncapital.com
732-515-5371 732-515-3586 732-515-4734
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