Trend Czar

Another leg down

Goldman Sachs reported giant $3.5 billion quarterly earnings so suddenly we should all believe everything has turned around in bank and financial companies. The sector's stocks shot up in anticipation of the news.  Indeed Goldman was the best of the banking group at taking low interest government bailout money and investing it in trades at lucrative spreads. But these earnings numbers hide the fact that most banks aren't lending as much as building up their loss reserves.

The Goldman news aside most people I talk to sense the economy is about to suffer a setback--the stimulus programs stopped the free fall, but the still frozen credit markets fail to grease business expansions. People are saving what they can or paying down debt not spending. And the banks won't write down all their toxic assets for fear of creating more financial panic. The short-term trend outlook is dicey at best.
 
For those real estate borrowers counting on a near term economic recovery to cushion their down side, hopes fade along with all those economic forecasts about a second half upsurge. Yes, remember those fearless predictions from the beginning of the year? They can be tossed in the trash heap with the ones last year about economic recovery that should have started six months ago and those others about "soft landings." You get the idea--everything is getting pushed further out.
 
The mantra has been that economic recovery will track ahead of jobs growth, but the unemployment numbers get increasingly disheartening as companies ask surviving workers to pick up more slack with fewer benefits. Stimulus funds all those road construction projects that create traffic jam ups at 10 pm, but doesn't stop the free fall in office occupancies and rents. GM and Chrysler get through bankruptcy but then announce more job cuts. It's reported that the venerable "Business Week" is worth only a $1. I remember the days when pr guys got bonuses for placing executive interviews in that now obsolete publication.
 
As far as pr, Goldman continues to win plaudits off its trading acumen and AIG struggles with asking for government approval of more bonus payouts. Goldman's success comes at least partly at the expense of taxpayers who bankrolled their recent gains before the company gave back its TARP and bailed them out of AIG credit default swaps earlier in the year. It's a great business for the traders betting on spreads, but doesn't do much to capitalize future business growth. This is the same recent Wall Street model that sent us into our recent collapse. And AIG wouldn't exist without taxpayers, but since we bailed them out from oblivion and they think they are operating on the old bonus model so pay up.
 
These types of investment mindsets are indicative of why the economy will falter more before it slogs to any recovery. Until we start harnessing our public and private capital to fund long-term growth and get out of the casino, we don't have a chance. 

Lackluster Stimulus

Concerns grow about the lackluster results from stimulus funding as unemployment increases and more Americans face financial strain. Meanwhile, the real estate industry waits to be swept further down the rapids with the falls lying ahead—dropping tenant demand and rent declines threaten already dwindling cash flows in the face of frozen credit markets.

The problems with stimulus shouldn’t be a surprise. The tax cut part favored by Republicans has been stowed away in people’s savings accounts not spent. People are scared so they build nest eggs instead of spending in consumer land on things they really don’t need. Over the long term, a more frugal America will help strengthen the economy. It makes no sense to the average person to behave in a way that got us into this mess in the first place.

So the spending push must fall on the government. And as far as pushing out stimulus goes, the U.S. government lags well behind other nations, including China and the country some Americans love to hate—France.   The reason is we don’t have a national plan for major projects. China has engaged in long-term planning for national infrastructure—high speed rail, urban transit, port expansions, power systems—which will provide decades of support to economic growth. The Chinese can just speed up planning already in place. Here we fall back on the federal government sending funds to the states which spread the largesse out to counties, cities and towns for various ad hoc, disconnected projects. That takes time and is inherently inefficient. It also doesn’t address our huge needs for 21st century infrastructure systems. And we have no plan.

In fact, we learn in this morning’s New York Times that the states, as usual, short change their major urban areas where most of the country’s economic activity concentrates and plow the majority of their infrastructure stimulus into various rural backwaters. The money gets frittered away on road projects used by hundreds of people each day instead of on transport systems supporting hundreds of thousands. Indeed the stimulus amounts to earmarks on steroids, a pork barrel fest for governors and state legislatures dominated by rural interests at the expense of metros.

This bottom up approach threatens our economic viability not only in dampening any chance for a faster recovery, but also handicapping our competitiveness against other global powers with more modern infrastructure systems. The Feds must set national programs and priorities and push the states to get on board with clear guidelines and funding constraints if they don’t. The big gateway cities which generate most of our economic activity should get most of the funding. Sorry Montana and Arkansas you get a lot less and so do hinterland counties and villages in other states. There will be winners and losers, but the alternative is we all lose and that’s what’s happening now. 

Fireworks without Celebration

Fewer communities had fireworks this year, but there was no skimping on the displays I saw around the Northeast spread out over the past week. The Fourth offers everyone a reliable, annual celebration of our heritage--security, freedom, and prosperity. Unfortunately I find in my recent travels, our current financial distress takes an increasing toll, rattling people's confidence.
 
First off, young people struggle to find work. Summer internships are scarce--even the ones for little or no pay. I feel good about the college age nephew who runs the produce aisle at the neighborhood supermarket in Chicago. Kids scramble for the odd parking attendant job at the local golf tournament. Finding employment for recently released inmates and parolees--always a tough task--becomes more monumental and inner city youth unemployment must be rising to ever higher, more uncomfortable levels.
 
The New England resort business has been sketchy like everywhere else. In New Hampshire, rows of Franconia Notch hotels and motels were empty last week, just a few days before the Fourth. Now the miserable spate of rainy weather wasn't helping, but the absence of vacationers in early July was striking.
 
Homes aren't selling in the northern Adirondacks, a notably poor section of the country, unless you own lakefront or hilltop acreage. One local who has his place up for sale succinctly told me: "People don't have money."  So well put.
 
You hear anecdotes about friends and family whose credit cards are no longer accepted, who can't meet co-op maintenance payments, or are struggling with their health care deductibles, which thanks to company cutbacks can approach $5,000 or $6,000. And we were not talking about the 50 million Americans without any health insurance. Furloughs, the end to 401K matches (how temporary will those be?), and job cuts forcing longer hours on remaining employees were all part of the cheery Fourth discussions around the grill. Two brawny guys I know who worked construction in now moribund upstate New York Rustbelt cities apply to become nurses and correction officers (but states can't afford so many prisons/inmates and that gets back to finding jobs for the parolees who are pushed back on the streets early).
 
The stock market has run out of gas, and gas prices trend higher--today's small drop aside.
 
The fireworks were a nice distraction.
 
PS: Last week I attended a convergence of fellow members of the Citistates Group. Mary Newsome, associate editor of the Charlotte Observer, penned this column following the meetings. She gives an interesting perspective on the special challenges in hot growth suburbs, part of the legacy of uncontrolled homebuilding.
http://www.charlotteobserver.com/480/story/815414.html 

Chaos in the States

State governments around the country are in big trouble, ballooning deficits and dysfunctional legislators hamstring officials in confronting the financial crisis. That’s not good news for real estate players. Cutbacks hit slews of companies and not for profits, which depend on government contracts and grants to carry on business and rent space. Developers looking for support from government tax breaks or special consideration gain little traction in the chaos. Furloughs of state workers and hiring freezes portend potentially more permanent reductions in state services—when state governments have been one of the most reliable tenant sources in many markets.

Of course, plunging property values, increasing defaults and foreclosures as well as the feeble real estate transaction market all contribute to falling state government revenues. But the sad sack state of the states just digs a deeper hole.

And state government problems aren’t simply a result of depleted tax coffers. The current financial distress exposes systemic dysfunction and widespread corruption. The country’s two most important states with the nation’s biggest economic generators--California and New York-- desperately need constitutional conventions to revamp legislative process and anachronistic systems which gridlock in the face of emergency. Legislative districts need to be redrawn to reduce advantages for incumbent politicians, who comfortably play the system for their own financial gain without meaningful ethical strictures to rein them in. Earmarking run amok and legislator slush funds for local pet projects show an utter disregard for responsible budgeting.

In many states, including Pennsylvania and Illinois, rural legislators continue to wield power that siphons off funding from cities’ economic engines and disproportionally favors their less populated, lower functioning districts. It’s all part of a destructive Nero fiddling mentality.

Sales taxes, user fees and local property taxes have been increasing for years to fund all this dysfunction and now budget gaps reach scary proportions. Taxes have no choice but to go up more while services retrench to plug shortfalls. And that will stem any recovery momentum.

Time to Sober Up

In talking to various investment advisors, I get the sense they think they’ll need to promise 20% returns to get investors’ attention in the next generation of fund marketing. Placement agents “won’t give us” any attention otherwise, says one manager. The rationale is low returns won’t sell since investors will expect big opportunistic gains coming out of the downturn in a rebound to the pre-crash mindset. Maybe more significantly, a big part of the sponsor market, including the investment brokers, hopes to recapture the just recently bygone days of outsized large promotes and giant fees.

But let’s get realistic. Sure some buy low ride the market up transactions will score.  And eventually investors could reap ample gains on discounted loan purchases—once lenders start selling them. But real estate is essentially not so much a value add or opportunity play as a core/core plus style investment. The last 10 years were an anomaly enabled by a cheap-debt energized transaction market.  If you believe lenders will be constrained for some time to come and interest rates are headed up, the leverage will just not be there to jump start returns.  And if you believe a recovery in tenant demand will be slow because of the need to deleverage the economy and absence of growth drivers, then the buy low sell high strategies will be strung out over longer time horizons with less chance to register quick investment pops.

And are investors going to readily buy into sales pitches of opportunistic returns when their existing investments in opportunity style funds have ignominiously cratered? One investment advisor told me that his company wouldn’t be able to support a 20% target if a prospect challenged their pro formas. They won’t pencil out, especially without any leverage.

Real estate managers might be better positioned if they refocus their stories on the asset class’s income-oriented fundamentals, looking to find value in recovery by rebuilding property-income streams through aggressive asset management and leasing strategies.  

Hey everyone, it took nearly 75 years to return our asset markets to Roaring Twenties style excess. After the current debacle resolves, the capital spigots won’t blithely re-open if for no other reason than heightened government regulation.

It’s time to tone down performance expectations for these new fund concepts and maybe get back to the idea of under-promising and over delivering.  Hung over investors might welcome the more sober approach.