Trend Czar

How hard the fall?

I will start writing Emerging Trends 2009 soon, and the challenge this year is to calibrate just how negative I should go. Will next year be a bit better than 2008, worse, or really bad? I'm sure I'm not giving away the store by revealing everyone I've talked to sees at least some rough moments, and no one expects a sudden rebound. Most people are not very sanguine, to say the least and they have been growing increasingly pessimistic.

We've had some posters comment that the markets aren't that bad and real estate has been doing comparatively well. Occupancies have held up in many markets and development has been under control except in some condo markets and, of course, in single family housing. By the numbers, the economy may not be in a recession, they say. Yes, the transaction markets have been dormant, but that's because of the credit crisis, and once that clears up commercial real estate should be in decent shape. So why be negative, they argue?

Well, there are a host of reasons to consider, at least. Most mark-to-market investors haven't felt much pain yet. The dearth of transactions has delayed appraisal recognition of the value loss picture, and sellers continue to hold out for higher prices, while buyers wait for better deals that they know will be coming. For now, many lenders have been working with shaky borrowers to avoid defaults, limiting the number of motivated sellers. But at some point they will have to clean up their balance sheets. Consumers continue to pull back and more retailers show strain. Unemployment heads higher. If companies aren't belt-tightening, they're certainly not expanding. Interest rates are pressured upward by inflation, not a good thing for cap rates, especially if fundamentals can't pick up the slack. And those credit markets, which provide nourishment for real estate businesses, appear sicker than ever. Unless investors are prepared to buy with cash, the transaction markets will remain relatively gridlocked.

Commercial real estate hasn't taken its hit yet. That will largely be 2009 event. The question remains how hard will that fall be.

 

What's the New Model?

Continuing on thoughts about the $300 billion said to be sitting on the sidelines, waiting to cushion the coming downslide in values, these fund sponsors who raised all this cash over the past few years must be struggling figuring out how to deliver the returns they promised investors. Their investment model was largely based on leveraging up performance in a sky's-the-limit pricing frenzy, providing 20% plus returns. It worked splendidly for more than five years in an almost free-money lending environment that suddenly evaporated 12 months ago. But without the leverage, the investment model no longer works and the sponsors can no longer make the promotes which drives their business bottom lines.

Given the depths of the credit morass, free-flowing debt will not be coming back any time soon. When lenders finally sort out all their issues and regulators finish with implementing stricter guidelines, borrowers will pay more for less. We're in a deleveraging environment for some time to come.

So what's the new model--filling the void in the debt markets, offering distressed owners loans that could provide equity like returns or loan to own features? Maybe. Or buying core-like properties in all or mostly cash transactions once the value floor looks like it's taking hold? That's a possibility. There are always homebuilder lots, going for cents on the dollar today.

But then investors will need fundamentals to improve quickly to push up rents and net operating incomes, and/or homebuyers who can obtain ready financing. Neither the economy nor the credit markets offer much hope for any sort of rapid recovery.

So either that $300 million accepts potentially lower returns than advertized in different investing schemes or maybe it goes elsewhere. That also goes for the investment bankers and advisors, sponsoring these funds. 

         

Never make assumptions

An almost universal real estate investor assumption today gives everyone some comfort that values won't fall too precipitously. That assumption is there is somewhere in the neighborhood of $300 billion in equity capital waiting on the sidelines to snap up bargains and keep a floor on pricing. This money includes sovereign wealth funds, pension fund dollars committed to opportunity funds, foreign institutional monies as well as high net worth capital.

Someone very wise and close to me always pounded into my head "don't make assumptions." So let's examine several counterpoints that may chip away this cushion.

First of all we have the return of the denominator effect. The bear market has reduced stock values and increased the percentage of real estate in overall pension portfolios. That means many pension plan sponsors will look to reduce property holdings or at least hold off on new real estate investments until their portfolios have been re-balanced to meet their asset model targets.

We haven't had any backlash yet, but at some point the politics may work against foreign entities buying up our choice U.S real estate, especially if spotlighted as the gains from Middle East oil regimes gouging us at the gas pumps. Some of these sovereign funds got burned badly backstopping major investment bank declines earlier this year before the full extent of exposures to bad loans was known.  These generally savvy investors may now wait until real bargains appear on the real estate front before extending themselves. In any case these cash-flush international players will continue to focus on prime, trophy properties (like the Chrysler and GM buildings) in the best markets. New York and San Francisco may benefit from their infusions. It's doubtful secondary or tertiary markets will derive any support or interest from them.

Economies outside the U.S. are following us into a funk. Europe is cooling. What happens to China after all the Olympics hoopla as the rest of the world reduces consumer spending on their prodigious exports? Will foreign investor fervor in the U.S. slacken despite the generally weak dollar or will the dollar start to strengthen more, making buying opportunities here somewhat less attractive in any case?

The world remains an extremely unsettled place, ripe for stopping investors in their tracks. We're one event away from rekindled Mideast turmoil which sends oil prices back up whether in fractious Iraq, the powder-keg Israel/Palestinian territories, or snarly Iran. Afghanistan gets worse. And now Russia flexes its restored muscles (thanks to petro power) in Georgia and signals a willingness for confrontation on other fronts. Who knows what could happen?

Lastly, the debt markets remain in intensive care and highly risk averse. Equity buyers preying on motivated sellers can't depend on leverage strategies to juice returns. Even that $300 billion on the sidelines assumption can't come close to filling the gap in missing debt capital from the marketplace.

Never make assumptions.

    

Broken China (revisited)

The TrendCzar is currently on vacation.  With the Beijing Olympics upon us, we thought we would revisit an earlier post about China. Comments?

Broken China (Originally posted February 11, 2008)

For the past several years, China has been the hot place to go for opportunity investors. All the major investment managers have lured institutional money into the emerging economic goliath. No doubt the arguments seem compelling for China continuing to grow into a dominant power over the next quarter century. Unprecedented development builds out and modernizes the country's cities and entirely new urban areas mushroom as rural populations move to industrial job sites. An evolving middle class moves into high rise apartments and shops in new shopping centers. Office buildings pop up to accommodate commercial expansion and more hotels are needed for all the offshore visitors -- business and tourist. Beijing gets a total facelift for the upcoming Olympics. The powers that be also fund massive infrastructure projects -- a highway network, the equivalent of the US interstate system, has been built in just the past decade; mass transit facilities, high speed rail lines, and state-of-the-art airports start operations.

But recent news out of China should make investors wonder whether the growth track won't hit some bumps. Last week's pre-New Year snow storm crippled the country. Several factory buildings crumpled under the weight of snow, raising questions about construction quality. The government grudgingly admits it might have made a mistake with Three Gorges Dam and resulting environmental damage. Air and water pollution creates dangerous health conditions in much of the country -- about 50% of the country's vast population does not have potable water. The U.S. Olympic team will ship in food for its athletes, fearing that high steroid levels in local meats could trigger doping failures. Marathoners worry about noxious Beijing air quality. Manufacturers manage to ship overseas everything from tainted tooth paste to unsafe cancer drugs. Who knows what the locals are ingesting and breathing. And more than 300 million Chinese are smokers. Oh, probably no surprise, the government runs the cigarette franchise. In short, it would be charitable to say the country seems to play fast and loose. You could wonder how transparent the growth numbers are and whether they are sustainable. I do.

© Miller Ryan LLC 2008 

    

      

Inflation Hedge (revisited)

The TrendCzar is currently on vacation.  We thought we would use this opportunity to revisit some previous posts.  Comments?

Inflation Hedge (originally posted April 28, 2008)

My next door neighbor who develops houses in Vermont has three unsold and unrented, and lamented to me yesterday the vagaries of the housing  market.  "You always know where  you stand with the stock market,"  he said. "With real estate it's so hard to tell, and all of a sudden it hits you."

At that point another neighbor drove up and got involved in the discussion: "Haven't seen inflation like this in quite a while," he said. "I bought a loaf of bread and a half gallon of grapefruit juice yesterday and I couldn't believe the cashier wanted $9.50 for just the two items."    

"Yeah I got some plums and peaches the other day, and it cost $11," said my next door neighbor. "It's amazing."

I joked with the other guy that he had "just burned up a couple of dollars worth of gas," idling his car while talking to us. But maybe it was no joke--I paid my first $60 gallon fill up yesterday.

"Hey, you're right," he said, before taking off.

You know it's really getting out of control when Costco limits the number of bags of rice you can buy. And we think we have it rough when people in many parts of the world have suddenly been priced out of survival staples--rice and grains.

Which brings me back to real estate. The commercial markets haven't taken their big hit yet, but you know it's coming. We're taking it on the chin from factors now extending well beyond the credit crunch fall out. The economy's swoon now embodies a powerful one-two punch of recession and inflation, which could lay out a lot of businesses, hitting shopping centers and hotels first as consumers cut back and summer vacationers stay close to home. Expect the unemployment rate to take a sudden jump by the end of the quarter, which will just fan the fire.

It reminds of the early 80s when our biggest selling point for real estate was that it's a great inflation hedge. Well, it's time to dust off that old slogan again.