Well, this quarter’s market commentary is going to be a bit macro as there have been a lot of headlines to address. Some items are major themes and others are just trying to assess situations that are cause for caution and yet opportunity. Never forget that the two often occur in concert with each other.
Fear Mongering and Keeping Perspective
People seem to pander to the easiest sales pitch for investments. That is fear and greed (or Greed from fear), fear of recession, fear of higher taxes, fear of illiquidity, fear of fear and therefore irrational markets. We have had plenty of irrational behavior in the last few years. Long term, markets will return to rational behavior. Short term market behavior can be irrational and create opportunities. Long term market behavior is rational, but you need to be looking ahead and planning strategically to work off powerful demographic and economic forces to perform well and deliver consistent returns over the longer term. Short term fear has been prevalent in recent years, but that has seemed recently to not be consistent with anecdotal observations of our leasing activity.
One of the topics around our office right now is the good leasing activity we are seeing in certain markets. Particularly we are seeing some good to strong demand for space in Denver, San Francisco, and even Phoenix. However, while we have seen a pick-up in leasing demand, we are also cautioned by the high unemployment rate and tepid economic growth. The question is whether the country is really in a recovery.
In general there needs to be some tempered enthusiasm for the country’s economic outlook. The reason is that the economy was worse than many people realized:
1. The depth of the Great Recession and the stall that occurred in our economy was severe. People saw demand for space dry up completely. There was no frictional demand for space with tenants moving between properties. The only activity was where businesses went away or renewed leases when required.
2. This perspective of leasing demand during the Great Recession was skewed. Even in recessions there is still some frictional activity and market activity. Some well managed and recession proof businesses move and even expand during a recession as other less fortunate businesses contract. The Great Recession was a stall where activity all but dried up and this lull in activity lasted longer than many people anticipated.
3. The fact is we were so used to no demand during the Great Recession that even frictional demand from tepid growth feels like strength and maybe even recovery. We are probably in the second inning of a weak recovery that still is on life support and is not ready to be taken off life support. We are getting closer to the economy achieving self-sustaining growth and being able to wean itself off fiscal stimulus (government spending).
Keynes and Deficit Spending
John Maynard Keynes gave the US government an excuse to spend and then tax. The idea that a government may need to create fiscal stimulus and run a deficit to kick start an economy in recession has had consequences. Now politicians have rationalized deficit spending as a saving mechanism for the economy; therefore, they do not see the danger in deficit spending in years when the economy does not need it. The perception of economic risk, or selling fear by our politicians, created a tolerance for a spend then tax philosophy that comes from Keynesian deficit spending doctrines.
This has led to too much US debt (particularly owned by China and Japan) and will ultimately lead to a weaker dollar, higher taxes, lower growth, and a deleveraging not seen since the Second World War. Mostly this, immediate to medium term, future is a tough yet necessary road to follow. It is good that the direction is actually clear. Unlike a situation where there are many different outcomes, the path now is one outcome, which will ultimately be better for the US after a period of pain and muddling. We have seen pain, and there could be some more, but this is all preparation for an incredible time and opportunity. We cannot continue piling on debt to fix our problems and there is no magic bullet. Each consequence to overleveraging an economy has been seen in modern history.
1. Dollar devaluation is inflationary which in turn allows borrowers to repay old debt (originated with a higher value currency) with cheaper devalued currency. This will potentially cause higher interest rates that will continue to temper economic growth.
2. Higher taxes are obvious; the government gets a more powerful deleveraging because it benefits from dollar devaluation and more tax revenue. The issue, and risk, will be to make sure the debt gets paid down rather than the government using the increased tax revenue for social programs which will crowd out the private sector. Balanced budget amendment anyone? The public sector crowding out the private sector will also temper economic growth.
3. Lower growth will be a consequence of an overleveraged government and economy for quite a while. The end to the deleveraging cycle should come as the Echo Boom enters the work force and becomes the next economic powerhouse generation. Around 2020 the Echo Boom will drive innovation, job growth, spending, maybe some manufacturing jobs with our cheaper currency, and an economic boom. This economic boom will be off of a deleveraged economy and a cheaper currency. The Echo Boom is larger and spread over more years than the Baby Boom so the next economic boom may be more stable and longer than we have ever seen. It is also accentuated by the Baby Boom’s living and working longer and spending on medical expenses. Having both the Echo Boom and Baby Boom as active participants in the economy will be unprecedented and amazing.
Economic MAD and Détente with China
Like it or not the United States has been the target of other competitive countries as a superpower (either economically or through the military) since World War I. Germany, Japan, the Soviet Union, and now China have all taken a turn as challenger to the title. The most recent of those was the longest running struggle of fearful, tentative, and often brutal peace with the Soviet Union. Initially the foreign policy that was engaged was that of Mutually Assured Destruction or MAD where both countries had enough military and in particular nuclear might to destroy the other. In other words, organize a stalemate so the other side cannot win (like playing to a tie in chess). After a while Henry Kissinger and others deployed détente with the Soviet Union, once both countries nuclear inventories were large enough and no other countries posed a big enough risk, both sides saw the benefit of treaties to equally disarm which benefited the countries through reduced spending. Essentially the same thing occurred under Reagan when he expanded inventories and then used treaties to stop, but the damage was done as the Soviet Union could not keep up and collapsed.
We are in the same place, economically, with China, but it is a revised strategy. China needed a large technology transfer and buyer for its goods in order to develop and foster their middle class and improve the lives or their population and enrich the country. This may have been self-serving at the time, but the motive is kind of irrelevant at this point. The tools to achieve these goals were, in a very time saving manner, the simultaneous deployment of strategies used by Japan (trade surplus invested in US treasuries), and the Soviet Union (MAD and now détente with regard to a fear so great so as to require cooperation). At this point MAD is already achieved. It was symmetrical, with both sides having equal power and was achieved through our complicity. We bought goods and China made them and in doing so the surpluses garnered through free market trade with our challenger were invested in United States Government debt. Japan did the same thing in the eighties in its attempt to become the world’s economic super power.
The economic MAD principle is that China has become such a large owner of our debt, and our economy has become so dependent on the low interest rates achieved through having the debt not freely trade on the open market (around half of it owned by China and Japan), that if China were to start selling our debt it would destabilize the economy of both countries. Interest rates on US treasuries would rise due to the addition of massive supply and we could either go into an economic stall or print drastic amounts of money destabilizing the currency. On our end we could preemptively print massive amounts of money to pay the bonds back with the very same consequences. In either case our purchase of China goods would drop off considerably. That would in turn cause the economic destabilization and potentially political destabilization of China. A growing and affluent middle class in China would be very upset to see their standard of living decrease dramatically, especially when their complaints are not allowed. At least in the United States the economic stall is supported by the comfort that comes with the ability to change through free press and elections.
As shown below, as many of you know, is a graph showing China’s foreign holdings of US government debt. This amount has also continued to grow.
Make no mistake; China will perpetuate the situation. The US has become dependent on cheap goods from China. Our companies have become and will continue to be more dependent in the future on the developing consumer in China. Our multinational companies fight tooth and nail to get a chance to do business in China. In so doing, companies transfer badly needed technology to China. This will make China more self-sufficient, but also it is the basis for our dominance as an economic super power. Our ability to come up with new and different ways of doing tasks, making products, and selling goods and services is the creative destruction that has renewed our country quicker than others and kept the United States on top after each recession, war, scandal, and generation passed. It is ingrained in our culture, but we are not the only culture that has it and it can be lost.
Détente is therefore the next stage of development and it has already started. In this case disarmament takes the form of a steady and gradual reduction in the value of the US dollar. This is a systemic shift not a cyclical one. You could even see a day where the Renminbi (RMB) becomes freely tradable and a dominant currency. The RMB might not become the reserve currency of the world, given the political environment, but it could be important nonetheless.
Ultimately, the US currency will get cheaper relative to the rest of the world. This will cause our economy to rely less on foreign goods by manufacturing more and help us repay our old debt with newer inflated dollars. This is not a new economic consequence to being overleveraged and overly dependent on foreign goods. However, this time it is such a large issue with our trading partner in its survival that we have entered into an era of economic détente with China. The dollar has been slowly getting weaker and it will continue to do so while China sells US government bonds slowly into the next economic cycle. This détente will go on for a long time and will be a stabilizing force of foreign relations between our countries.
Combined with where we are in the economic cycle, the deleveraging cycle, and demographic trends, economic détente will provide an unstoppable muddling for the next few years in the economy that will only end with the advent of the Echo Boom and the end of deleveraging.
What this means for Us: Fear Mongering and Keeping Perspective
The tepid recovery means that we will find good real estate to buy if we are patient. Also, it means that when we buy it, at the right price, we will have some leasing demand to drive our execution. It also means we are not in a hurry. Banks and special servicers are still bloated with property that needs to work its way through the system and will increase the supply of properties to buy. This also means the leasing demand we need to improve properties is available and probably growing as the economy gains speed. The perfect storm of fundamentals of leasing improving and the vast majority of problem assets starting to become available is still in its infancy. That is a perfect storm coupling oversupply of investment sale product with improving leasing demand! That means properties could get cheaper and they could be bought with less risk because there is more demand for space.
Keynes and Deficit Spending
What matters is the problems will eventually get fixed by demographic and economic forces that are bigger than any politician that tries to mess up deleveraging. The message here is buy your real estate opportunistically over the next several years, maybe eight. Diversify by vintage (maybe every two years) as the deleveraging will occur in fits and starts and knowing when each is happening is difficult. So we are being diligent and patient, purchasing real estate that is downside protected, and bought at a value that would make Graham and Dodd appreciate real estate. Lastly, hang on for the ride in which the Echo and Baby Boom are both active in the economy.
Economic MAD or Détente with China
Our relationship with China will also have its ups and downs which are where the opportunity to buy and sell real estate will be realized by investors. When fear in the relationship exists it will be a good time to snatch up some real estate cheap. Inflation will then come and make the debt used to purchase the real estate cheaper and be repaid with inflated dollars later. The continued pressure form economic détente with China will make a cheaper dollar and deleveraging an unstoppable trend (of which we are only at the start). Buying real estate though this deleveraging cycle will make for a great portfolio with the advent of Echo Boomer entering the US economy.
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). 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.