One year ago this market commentary was about economic and market conditions getting better generally, but that risks to the economy still remained. It was the beginning of 2011 which was a lot different from a fear perspective than the beginning of 2010. In the market commentary one year ago there were some major themes which merited discussion. They focused on continued risks and opportunities that were continuing to develop in the economy. In rereading that report in preparation for writing this quarter’s market commentary it occurred to us that it might be a good time to revisit these themes again and see if anything has really changed. Sometimes we do not recognize change by small increments, but are taken aback when those small increments of change add up over time.
The first theme discussed was QE2 and how the Fed policy was still propping up the economy in hopes of kick starting job and income growth. The reality is that QE2 turned into Operation Twist and thoughts of QE3. Ultimately the Fed made it clear that interest rates will stay low for the foreseeable future reducing the need for forcing liquidity into the system and ensuring at least a status quo the market has been able to trust, so far, to ensure economic stability. Whether this is a continuation of QE2, QE3, or Operation Twist is of little consequence. The economy has grown at a slow rate and this has resulted in some job creation and record corporate profits, but not the reduction in consumer or government debt many would have liked to see in an economy that is gaining health. The lack of drama within our own markets has made the pundits and business news outlets refocus on European economic woes as an absence of bubbles creates a news vacuum that only seems to be able to be filled with “disaster news”.
The second theme discussed was government debt. The United States is still the world leader in government debt. We are currently the currency of choice for the world and this along with our debt burden (owned by others) has and will continue to force an economic détente relationship with China. Paying down debt will still only come over time through currency devaluation, higher taxes, and growth. As the economy muddles through problems both domestically and abroad the debt burden can be reduced if income grows more than the overall government and consumer debt burden. So far this debt burden has been stagnating and not reduced. Really not much has changed in the past twelve months in the debt problems of our country or the world.
The third theme discussed was new lending. Slow progress has been made in new lending. The Fed injected capital into the economy and that shored up balance sheets of the larger banks. This shoring up improved the balance sheets of the banks, but did very little to stimulate the economy by allowing the banks to provide new capital for the economy in the form of new loans. This is slowly starting to change. Also, CMBS 2.0 has continued to increase liquidity in the mortgage market. Neither of these is substantial, but it is a stabilizing force in the economy to have new lending occurring even if it is not at a quick pace. Some banks are also starting to lend tentatively. These are all good modestly positive signs of recovery and growth.
The last theme discussed was problem loans and asset sales. A lot of the problem assets are still problems. Special Servicers and banks are slow to sell bad loans and assets and have been provided the flexibility to rationalize the losses that come from these assets in order to minimize the losses associated with the problem loans and assets and in doing so, create additional fees for themselves. This in itself may be a reasonable approach to a massive problem, but it is just the size of the problem and the adopted solutions will cost the economy in terms of time needed to recover. This approach to problem assets and liquidity provided by the Fed as insurance against more problems is a slow burning fuel for the economy. These combined forces are the reason the economy will muddle through the next few years before real economic growth occurs.
There is one additional theme worth adding here that was not discussed one year ago. That is the reoccurrence of the “moral hazard”. The economy is muddling along with a high debt burden which is currently only achievable through low rates and federal support. The biggest risk to our whole financial system now is another shock as we do not have a safety net anymore. This should be an interesting topic of debate as the Volker rule starts to become implemented on July 21, 2012 as part of the Dodd Frank bill, especially considering the fact that the Fed chairman himself has suggested that the deadline will not be met and that financial institutions will have two years to comply and legislatively marginalize the impacts through lobbying. The gambler at a casino who has lost all his money usually thinks very little of betting even bigger with what they have left. Essentially the leaders of our financial institutions are the gambler and now they are playing with house money, the Volker rule was supposed to stop that from happening. Watch closely.
What this means for Us
To us this feels like more of the same, meaning a muddling through tough economic headwinds of debt burden until growth is forced through other more fundamental measures like demographics from the Echo and Baby Boom generations. This means that we need to stay patient, diligent in underwriting, and buy when fear is pervasive. Pick the niches that will benefit more than typical real estate. For us that is student housing and multifamily (Echo Boom), medical office (Baby Boom), and convenience retail (both Booms are consumers). There is also a place in real estate portfolios for destination entertainment oriented retail and fortress level office in major urban areas. The weakening dollar could make the value of these assets seem cheap in just a few years. We will also be investing, as we have discussed, in preferred equity and mezzanine debt as the gap financing market in transaction sizes below the institutional market. These investments are very attractive with strong cash flow characteristics and these structures allow us to participate in more of the real estate we like with excellent downside protected returns. In particular these preferred equity and mezzanine debt structures will be very attractive to deploy as the mountain of debt coming due in real estate mortgages occur in the next five years.
If you have any questions about this market commentary or the Redwood-Kairos Real Estate Value Fund III, LLC please contact us.