What a difference a year makes.
The S&P 500 is up 5.9% in the first quarter and was up in 2009 (27.1%) and 2010 (14.3%). Officially, the Great Recession (indicating that it was the longest economic downturn since the Great Depression) ended almost two years ago in June of 2009. United State Gross Domestic Product (GDP) has been increasing (adjusted for inflation) for the last six quarters and averaging 2.9%.
Most people would call that kind of economic and capital markets performance a recovery if not a bull market. At the time of the announcement that the Great Recession had ended the general public was skeptical at best and the thought was that the “Ivory Tower” economists were once again out of touch with what was going on in real life.
However, pundits continue to be pessimistic on a continued recovery for several specific reasons that are well worth discussing and could have an impact on our business together.
From the market pundits:
- There may be GDP growth, but it is supported by typical productivity gains in an early recovery, not the sustained gains driven by job growth in a sustained recovery.
- Also, GDP growth is fairly anemic for the early stages of a recovery; so far 2.9% is low.
- New and existing home sales are still at decade level lows, and oil is roughly $100 a barrel. Other commodities (gold, silver, and agricultural commodities) are at generational highs.
Some of this may seem like the obvious; on the other hand, from reading other investment manager reports these points seem like the fundamental assumptions everyone is supposed to know. In this quarter’s commentary, we are going to discuss these widely believed assumptions of policy and predictions and hopefully summarize for our investors and friends what risks and opportunities this presents for our business. These following points are at first general and then more specific to our business.
1. The Fed and QE2. The Federal Reserve (Fed) continues to buy assets and prop up the monetary system with excess liquidity.
- The risk to recovery: What happens when the monetary system is not being propped up by the Fed?
- Counter balancing economic force: A recovery increases income to pay off debt and increase consumer spending so the Fed can “back off the gas pedal” start to tighten monetary policy. Increased income would be what then leads to job creation and sustained recovery.
2. Government Debt. Once again we are the world leader – in debt.
- The risk to recovery: What happens when the rest of the world decides to not buy our bonds because they do not want to be the last bondholder that believes we will not de-value our currency with inflation (see point 1 on excess liquidity). It is easier to pay off your debts when you just print more currency.
- Counter balancing economic force or political policy: A recovery increases income to increase state and federal tax revenues to pay down debt. Also, the state and federal government cut spending (or at least increases in spending are reduced) with budget fights. This is currently a part of the political landscape. These forces would help the government debt pay down equation.
3. New Lending. With excess liquidity the Fed is increasing the coffers of banks which in turn are supposed to lend to consumers and businesses to increase economic activity thereby increasing income.
- The risk to recovery: What happens if the banks keep the liquidity build up to ensure a healthy balance sheet and don’t lend or the liquidity does not reach regional banks that continue to have problems with “Bad Assets”?
- Counter balancing economic force: Larger banks have already started to lend and even CMBS 2.0 has been gaining steam with predictions of origination in CMBS of $40-$50 billion this year. This force is occurring; however, it is becoming clear that regional banks have not benefited as the larger banks have in this regard. The question is when and if that will occur. Increased income could then help deposit levels and new business growth at the marginally healthy regional banks.
4. Problem Loan and Problem Asset Sales. We have more problem loans and problem assets since the early 1990’s – still.
- The risk to recovery: Problem assets continue to clog the financial system choking off a recovery a liquidity (as mentioned above) shores up bank balance sheets, but does not benefit consumers or business in the form of new loans (see point 3).
- Counter balancing economic or political force: Larger financial institutions are actually selling or collecting on some problem assets albeit more auto and consumer credit oriented assets. These larger financial companies are padding earnings with the releases of loan loss reserves. The OCC then FDIC (in order of operational importance) have been slowly dealing with the regional financial institutions and that will likely continue. There will be more regulatory and economic activity to clear the mechanism for financials over time.
What This Means for Us
If the Fed is successful in easing off of QE2 and easing the economy back to health, lenders will still have yet to sell large amounts of problem assets from bad real estate loans. We expect sales of these real estate loans or assets to accelerate. As we have mentioned before, as the economy improves and leasing demand for space improves, buyers for the distressed loans and REO will be more aggressive in purchasing assets as banks will be slow to “mark-up” the assets just as they were slow to mark them down. Ultimately, banks do not want to own these assets and they will focus on new deposits and loans with origination fees. Then the banks will sell the bad assets at improved prices as soon as the market will bear the poor appraisals (high values—poor work) they have commissioned. This will first occur for properties that have been recently appraised because of a bank closure (new bank owns or controls the asset and re-appraises) and then move on to stale assets on bigger bank balance sheets.
If the Fed is unable to manage the recovery our buying opportunity will be longer and better. This is the reason, as an investor, to remain patient, diligent and conservative, but persistent in acquisitions. This may also cause a second opportunity in CMBS.
The government debt problem is a game changer and not necessarily completely linked to the Fed’s success in managing monetary policy. This is because the rest of the world could just as easily lose confidence in our financial system and its long term outlook. The damage would be severe: higher interest rates, high inflation, higher taxes (to pay the higher interest and ultimately the government debt off), and a general stifling of economic activity. The likely toxic medicine (because shrinking government spending is a contradiction in terms) would be to print money and devalue the currency. While this would be incredibly painful, there are some silver linings. If you have a portfolio of reasonably leveraged real estate (you must keep it leased) the cash flow you collect will eventually go up with inflation and allow landlords to pay old debt with new inflated dollars. Ultimately, the cost of construction will have risen with inflation. That will cause growth in supply to be restricted and therefore rents will have room to increase to a level that will justify construction. Inflation works its way into real estate values through the increased building costs; it takes time and does not occur until supply and demand reach equilibrium. So supply and demand is the caveat here and you have to buy good real estate that tenants will want to lease! Also you have to underwrite investments with a focus on cash flow as your ability to sell assets during this higher inflation and interest rate environment with be severely restricted.
New lending and bad loan or asset sales really are dependent on the same macro-economic question of what the Fed and Government sector do in this early recovery. Either way, successful or not, the opportunities in front of us are just starting. As we have said before this could ultimately combine into the “Perfect Storm” for buying opportunities from 2011-2014. Below is mostly repeated from previous market commentaries, but we are consistent in our belief in the environment we are in and heading into for investment opportunities.
Here is why we are entering the perfect storm. First, as problem assets are held for longer by banks and servicers they become ignored and much harder to lease. Deferred maintenance can become a problem and leasing agents of prospective tenants know the lender does not respond with appropriate urgency and worry about delivery of the space by lender asset managers. Leasing brokers do not get paid for waiting, but for finding space for their tenant clients or tenants for their landlord clients. The leasing brokers will drive business to decision makers who will get them paid — period. Second, as banks and servicers get busy with new loans that generate new origination income they focus more on redeploying capital and human resources tied up in problems. People get bonuses for originating new loans not working out old ones. Third, everyone is stalling. Banks and servicers, to be rid of troubled assets, could end up with the pressure to all sell at the same time or the same period of time.
All of this means that, fundamentals of leasing are improving just as the vast majority of problem assets start to become available. That perfect storm is oversupply of investment sale product with improving leasing demand! That means properties could get cheaper and buying them means taking on less risk because there is more demand for space. We are definitely seeing better demand for space at our existing properties, and we are starting to see more well priced investment properties become available.