Q4 ’09: Real Estate Reality
I have been fortunate in obtaining an excellent set of notes from the November Urban Land Conference, which make up the bulk of this letter. The comments are wide ranging and very informative.
First a few comments on markets and the political scene.
There are signs that the see-saw battle between inflationary and deflationary forces is tipping in favor of deflation. Despite the massive and relentless “quantitative easing” by the world’s central banks over the past year, inflation has remained quite subdued. The consensus is that the jobless rate will remain high for years. Also, there are concerns over possible default of sovereign debt by several European nations, and at the same time China is pulling in the reins on bank lending over concerns of developing asset bubbles. Markets across the board have been selling off sharply. Even gold has seen persistent selling pressure.
Most significant, however, at this juncture is the political chaos that has been unleashed in Washington by the victory of Republican Scott Brown in the Massachusetts special election for Ted Kennedy’s Senate seat. Democrats are now in panic mode and could do something seriously damaging. Our financial system is still in a very delicate state. Republicans have been successful in selling deficit hysteria to the media and making the feckless Democrats pay the price for salvaging their mess, thus executing the second half of their despicable “starve the beast” strategy. If Republicans had been concerned about the deficit when they were in the majority we wouldn’t be in this situation today. Cowardly Democrats are now moving toward cutting back on the spending, which would be the right thing under normal circumstances, but if they do so now we will find ourselves quickly in phase two of the market meltdown, and very likely into a real depression that could linger for many years. The New York Times has an excellent editorial on this matter in the February 7th issue entitled “The Truth About the Deficit.”
Of course the odds of a managing a successful “soft landing” from the epic abuses of the Republican era were pretty slim to begin with, but things could get much worse, and fast. Be aware and take precautions if you can. If deflation takes over, cash is the place to be. Any long term assets should be hedged if possible.
We have a SERIOUS lack of leadership in Washington. The health care fiasco was, and continues to be, a demoralizing affair for anyone who has been paying attention. Many are still holding out hope that Obama will step up and be the visionary leader we need, but so far he has been a big disappointment in the leadership department. Democrat leadership in general has been pathetic, especially in the Senate, and Republicans have been downright nihilistic. Judging from their actions, they seem intent on provoking as much chaos and pain as possible while Democrats are in the majority, regardless of the long term consequences. If Democrats were doing what the Republicans are doing, Republicans would be loudly accusing them of treason. Democrats, however, are too timid to call out Republicans for their outrageous behavior. See the Economist article “The Party of No.”
As if we don’t already have enough problems to deal with, Debkafile is reporting that Israel is finally getting ready to bomb Iran’s nuclear facilities. Iran, in preparation, has been training 5,000 Hezbollah troops for a planned invasion of Northern Israel with the intent of occupying several towns and taking the residents hostage. Iran has also reportedly recruited Hamas and Syria to open additional fronts against Israel once hostilities begin. Stratfor has published a rather alarming assessment of the situation entitled “Defensive Buildup in the Gulf.”
Moving on to the Urban Land Conference notes. Given the new developments visited above, the perspective reflected in these notes may be somewhat optimistic. Anything can happen, better or worse than the perspective at that time, but the trend in the short time since has been distinctly worse. The key here is that increased political turmoil has added a destabilizing element to an already unstable economy. Readers may want to contact their representatives in Washington to make this point and encourage them to focus on creating stability.
Urban Land Conference Notes
- Not one expert was willing to predict what things will look like in three years other than they think it will be better.
- One top economist said if you are a developer find another career for the next three years. There is nothing to do and it may be five years.
- Recovery will be slow. Unemployment will not drop back to more normal levels until 2014. First they will bring back people on four day weeks to five days. Then they will increase hours from the average 33 hours now, then part timers will become more full time, then they will start to hire.
- Real estate values are down generally 40% and there is a huge need for value reset to occur.
- Nobody knows what debt will look like when it returns other than it will be far more conservative. Nobody knows what securitization will be when it does return.
- The rating agencies will operate differently. There is a discussion among some of us that there needs to be an agency probably of Treasury that collects fees of some sort from issuers each time there is an issuance of debt to be rated and that agency will then hire a rating agency to be an analyst firm to determine the quality of the issue. There will definitely not be a continuation of investment bankers hiring the raters and paying them directly. There needs to be a rule that the bankers cannot talk to the raters. There was far too much threats of withholding fees and other inducements to the raters before making ratings about as accurate as appraisals which were also paid for by the bankers who needed high appraisals to justify the over leveraging.
- Housing in some bad markets is still bad and the first time buyer credit is making it a somewhat phony market. Phoenix has 45,000 housing lots so there is a literal lifetime supply of lots. Land prices in Phoenix, SoCal and other markets are 50% of the cost of the infrastructure installed on finished lots. The land has zero or negative value. In most areas it will be at least five years before any of this land will get built out in any quantity.
- There are still 2-3 million too many houses in the U.S.
- This time is really different than any recession in the past.
- The U.S. is no longer the world economic leader and will not lead the world out of this mess.
- Real estate will once again be an investment and not the trading vehicle it became, which is what led to this crisis.
- We will go back to financing real estate with long term debt, and not the short term floating rate debt used to allow a quick flip.
- The Internet completely changed unemployment trends. Instead of just pumping up the U.S. economy and bringing back production jobs, the Internet has caused the entire world to be competitors for many jobs in the U.S. It ranges from call centers to research, financial analysis, medical research, and on and on. This may be one of the most historic changes in history and one everyone needs to be aware of. It likely means wages in the U.S. will be reduced below where they might have been were it not for this competition.
As several economists put it, the young in China and India and other Asian countries are hungry to get ahead and enjoy the good life, while U.S. kids feel entitled and poorly educated. Those of us who built businesses were very hungry. Today there are still some like us, but many are too comfortable and unwilling to really sacrifice to make it like we were. The Asians want to learn. Our young people think they already know it, whatever it happens to be.
- Third quarter GDP number is inflated by clunkers, home buyer subsidy, etc.
- Growth next year (2010) will be more like 1-2% in the first part of the year.
- Inflation will return in 3-4 years.
- U.S. corporations are sitting on record cash balances way beyond any they ever had. They will be doing more acquisitions.
- The best market in the U.S. is Washington D.C., for obvious reasons.
- Investors fled real estate completely in the early 90’s. This time they see the long term opportunity to create wealth and will be back as soon as the opportunity to buy appears.
- There is an enormous amount of cash on the sidelines.
- The Fed is intentionally holding rates at zero to try to force investors to invest in longer term riskier assets instead of collecting nothing on money market or CD’s.
- The banks are still weak.
- All values are still dropping and we have only gotten to 80% of the drop so far. Office and retail are only 80% there, industrial is only 60% and will be hurt by further inventory liquidation and lower levels carried going forward. Rents are only 75% of the way to the bottom.
- In the 90’s it was easier to fix the problem because the damage was much more confined to a small number of large new buildings which were revalued and then re-rented. Now the damage is widespread and covers a lot of older buildings so it will take a lot longer to solve. Quality really matters now. The best buildings will return; a lot of others will struggle.
- Office vacancy will hit 18.6% nationally, retail 23%, and multifamily 8%.
- The unwind of the massive Fed stimulus is critical to how it goes. Everyone thinks Bernanke is great but nobody ever did this before. It is truly uncharted waters. Then there is the politics and what will the rest of the world do.
- As you will read below there will not be the massive foreclosure and asset disposal we all expected. The lenders are going to hold on. When assets do come to market prices will be higher than they should be due to very few deals being chased by massive dollars. There is already evidence of this in the multifamily market.
- Mobile phones and other devices are now becoming all sorts of tools and multiple use devices. Social networking is growing faster than anything anyone can imagine. The growth rates are beyond comprehension. This is everything in the world is going from ordering food or reserving a car on Zip Car, to reading the news or anything. If you are over 30 you can’t grasp what is happening and how fast. The growth in usage is by tens of millions in months, and it is worldwide. You can’t get your mind around this. There has never been anything in modern times that is even remotely like this. The growth rate makes the growth in TV usage look like it was glacial. This is the biggest transformation in how the world functions in maybe hundreds of years. You need to learn all about this or get run over.
- Here is the real stunner. A senior person at Treasury said to a small group of us that it is now official Treasury policy to extend and pretend on real estate loans. In other words, the policy statement from last week says that if you can make an analysis that says even if the current value is less than the loan, if you can do a spreadsheet that shows if you extend for 3-5 years, and if the economy gets better, and if the loan can be amortized down to where the loan is no longer more than the value, then the lender does not have to take an impairment/write down. Loans are to be modified by rate reductions, deferral of reserves, deferral of amortization or whatever. Just not principal reduction. This is just like they are doing in housing.Giant make believe. The free market seeking an equilibrium price is no longer economic policy. In short, the working of the free market is suspended. She went on to say that it was administration policy that they will create new employment and by doing so they will boost the economy, and so then real estate values will return to old levels. There were 50 of the most senior and smartest real estate people in the room. They ripped her to pieces. It looked like one of the town hall meetings of August, except everyone there was a very senior, polished professional. At one point everyone was calling out or moaning at her. It was clear to all that she had been given a few talking points and she was told to stick to them no matter how foolish she looked. The group told her in no uncertain terms that this is terrible public policy. They said for jobs to be created you need to lower rents so the cost of occupancy was at a level to encourage more hiring. If the loan is kept at old levels and building values not reduced, then landlords can’t reduce rents to where they need to be to make taking space by tenants economically viable. Retailer’s costs remain higher than they should be by making it harder to lower prices to induce sales. So there is a massive make believe going on. When I pressed the issue of political interference she said, “what do you want us to do, bankrupt all the banks?”
That is the choice.
What does this tell you?
- The problem is going to take much longer to solve than it should.
- The banks are still very weak, so lending will not return any time soon.
- A massive refi problem is being deferred to 2013-2015.
- The administration is playing politics with the economy to a degree that is dangerous. There has to be a massive value reset for real estate. We are deferring the inevitable.