Trend Czar

(un)Happy New Year

Despite what you've read here in the trends department, I'm really a pretty positive guy. For example, 15 years ago when nobody else believed it, I predicted New York and other major cities would mount a major come back.

I'm trying to find a silver lining for 2008, but I'm struggling. The housing numbers get worse, and Christmas retail was less than jolly, a particularly ominous sign since our economy is nearly 70% consumer driven. Many Americans are simply tapped out and the government sinks deeper into the red.  Fallout from the credit crisis will crunch Wall Street volumes and transaction activity in coming months. States and cities tighten their belts and prepare to cut back spending.  The nation's unemployment rate has nowhere to go but up (and update--on 1/4 it did to 5%) . Recession here we come.

The good news for commercial real estate is that the industry has only two strikes against it -- overleveraging and overpaying. Unlike housing, most markets are not overdeveloped -- excepting Florida condos and Las Vegas everything. Plenty of money has been warehoused by institutional and foreign investors to swoop in and prop up markets from swooning too far. But some repricing can't be avoided and expect baleful headlines to trumpet various blow-ups.  Bad press will inevitably turn some investors more skittish -- especially pension funds. 

The world scene, meanwhile, remains inescapably problematic. The potential grows for unwelcome exogenous shocks. The entire Middle East is a tinderbox. Al Qaeda central operates unfettered in nuclear Pakistan, which is a disaster waiting to happen, and Iraq is a remorseless pit. And we're worried about Iran?

My resolution for 2008 is to become more upbeat... I'm trying. I'm trying.         

© Miller Ryan LLC 2007

Business faces a pivotal year

If the punk economy isn't enough, business folks start to get a tad anxious over possible regulatory backlash from the mortgage mess and an overleveraged marketplace. Campaign contributions flow into both Republican and Democratic party coffers at a record pace. These inflows accompany a message for holding the line on laissez-faire government oversight and discouraging new tax policy which might constrain the take from private equity horse trading. And so far the Chamber of Commerce "lobbying" has worked to keep government's hands largely off the markets. Now that subprime lenders have imploded, the Federal Reserve takes somewhat half-hearted steps to rein in future lending. The President and Republican congressional delegations, meanwhile, mount an effective firewall to protect mostly anything goes business practices. Even New York Senator Chuck Schumer bends over to shield private equity firms from higher tax bills -- in return he takes a pittance of their oversized profits to help finance Democratic Senate candidates in competitive races next year.

But the pressure increases for greater regulation as home values plummet and consumers feel increasingly pinched. At some point voters may get their fill of investment bankers who short investments they sell to clients and lending schemes that create windfalls for brokers and bankers but leave many borrowers for dead and threaten to tank the entire economy.  Expect populist politicians to get on the campaign bandwagon for more oversight as we approach the November elections, especially if the economy continues to sag.  They will try to make hay out of how a small minority of business elites game the system to the detriment of everyone else. Tax-the-rich rhetoric may finally gain traction.  If the electorate feels economically vulnerable next year, big business interests could take it on the chin at the polls no matter how much they funnel into campaigns.  After the recent debt binge and fee-for-all, 2008 could be a pivotal year for reordering what has been an extremely pro-business landscape.

© Miller Ryan LLC 2007

Reach for your wallets

"It's going to be hard." 

President Bush was referring on Monday to finding ways to pay for looming and necessary improvements to the nation's deteriorating transportation systems. Remember that Minneapolis bridge collapse? The "no new taxes" and "smaller federal government" approach has not served to maintain and expand the country's highways and mass transit in a way that can meet the demands of the growing population and the realities of a globalizing economy. The federal government had funded the interstate system through the gas tax in the 1950s and 1960s. But since 1980, our Washington politicos have refused to raise the gas tax, sending the Highway Trust Fund into the red by 2009 and leaving the states to fund road improvements most can't afford.

Many cities, regions and states, meanwhile, have short-changed mass transit alternatives to the car and encouraged suburban sprawl. The result -- most of America is car dependent, we face a trillion dollar plus infrastructure deficit, and congestion saps productivity, increases driving costs, and creates more (global warming) pollution. Been in a traffic jam lately? Noticed traffic gets worse and worse?

Mr. Bush doesn't want to consider increasing the gas tax ("no new taxes") so he says he has asked the Secretary of Transportation to study alternatives like increasing "user fees" also known as tolls and even "congestion pricing."  He is right about how "hard" it will be to face up to the infrastructure issues in this country. What he means is people will need to pay a lot more for our roads, trains and subways if we are to be competitive in the future. Whether it's higher gas taxes, more tolls, various other user fees, or plain old higher general taxes (federal, state and local), taxpayers will need to shell out more. And people may need to rethink how and where they live. Driving around in a car will become much more expensive in the future. Those places with subways and light rail look better and better.   

© Miller Ryan LLC 2007

      

New Year Money Makers

It's time to re-invent, go back to basics, and hunker down. The credit crisis increasingly looks like a credit crunch. The deal-o-rama is over. CDOs look down for the count (although don't we know Wall Street will resurrect them at some point in the future) and no matter how low interest rates go, credit terms will be much tighter. The sideways economy piles on more hurt -- property revenue growth slows or stalls. All the bankers, brokers and other intermediaries should expect "an off year" in 2008 as their volumes slide.

So who will make money in the New Year? 

Folks with plenty of dry powder, cash will be king in an environment skittish about leverage. Players who can make deals off market with motivated sellers may do better.  Some owners will want to avoid the blackmarks associated with high profile failures and will quietly take on "money" partners. Everybody is looking for cents on a dollar steals for languishing homebuilder lots.

Property and asset managers: Suddenly these folks will become appreciated again for squeezing more income out of properties or reducing expenditures. Crack leasing agents will be more in demand, although landing deals may be somewhat problematic as tenants hold back for lower rates or retrench.

Workout specialists: Over the past 15 years, workout skills have turned rusty.  A generation of new real estate players has never engaged in the finer points of problem loans and fractured joint venture agreements. Complications involving special servicers and the myriad intricacies of failing loans in CMBS and CDOs should prove especially taxing and convoluted.    

Attorneys: Law firms are recession proof. They charge as much for taking deals apart as putting them together.  Workouts and bankruptcies can be lucrative -- plenty of billable hours.  The CMBS conundrums are tailor made. Bankruptcy counsel will do better than M&A.

Investment bankers:  The fix is in. Wall Street still controls the capital spigots and their fund vehicles have plenty of cash on hand. They will look for vulture plays and find some new bail out formula, which will make them ample fees along the way. But transaction volume will be way off from the recent fee fest.   

Addendum: Have you noticed that the big banks continue to increase writedowns on bad loans. What happens when they move past residential real estate problem loans and take a hard look at commercial real estate and commercial paper?

© Miller Ryan LLC 2007

The game has changed

Remember when your grandma asked you what you wanted to be when you grow up.  Doctor,  nurse, policeman, teacher, fireman were probably high on the list.  After watching enough "Perry Mason", you might have added lawyer. When it was time to go to college, your smart classmates talked up premed and pre law, and so did your parents ("My son the doctor."). For the math whizzes, engineering and science programs were big. J-schools had adherents in my day too. If you were shooting for a business degree, most grads had their eye on working for a Fortune 100 company or starting their own business, building something that would last while you made a decent living along the way. That was then.

Circa 2007, going to med school is passe. Who wants the billing and malpractice insurance headaches? Science and engineering give way to dreaming up the next software/internet scheme. The best and the brightest in business, meanwhile, have become (let's be crass) brokers -- investment bankers, traders, private equity players, or hedge fund investors. You make your (tons of) money out of fees, promotes, and complicated structures using other people's money and lots of debt, cashing in as soon as possible on the next trade. The more transactions, the higher the volumes, the more everyone makes; while the frenzy of deals ratchets up prices and whips up more transactions and higher fees. In the past decade, even lumpy commercial real estate wall streetized and traded like crazy thanks to various securitized structures. Entrepreneurial developers who hadn't turned into REITs, transformed themselves into advisors and managers to get in on the action. You buy real estate with little down, sit on it for a short time, and flip into riches... repeatedly.  And all the other intermediaries get their sliver of the pie too -- appraisers, lawyers, accountants, title companies, even (gasp) rating agencies pile into the pool. Nothing much is created, leaving something for posterity isn't part of the equation. Extracting money through trades is the name of the game. It's genius. 

That was then too. The game has changed for 2008. What will it take to make money next year?

(To be continued)

© Miller Ryan LLC 2007

     

Feeling safe and secure?

Americans worry about terrorists infiltrating our borders from offshore and wreaking havoc. But last week's mall shooting (as well as Church shootings in Colorado)  again reinforces how vulnerable we are to garden variety All-American nut jobs who get their hands on guns and spread easy carnage, making for lurid coverage on CNN and FOX. And as we know in the gun-friendly USA anybody from mental cases to you or me can find or buy an AK47 and ammo clips to do ugly deeds without much trouble. So last March it was Virginia Tech, last week it was Omaha, a few years ago Columbine. No one wants to deal with the gun menace so more indiscriminate mass killings will certainly happen like the West Roads mall tragedy. And if mental cases can spray gun fire around a mall, well how easy would it be for a terrorist or group of terrorists? Forget about dirty bombs. And let's face it, mall owners can do very little to stop people of any stripe who want to commit mayhem. The cars with yellow lights patrolling the parking lots won't stop them. Will shoppers put up with metal detectors at mall entrances?

Now more than six years post 9/11, only a handful of office buildings around the country still undertake airport-like visitor checks, mostly in the handful of global business centers (San Francisco, West LA, Chicago, DC), and predominantly in Manhattan headquarters towers. The x-ray screenings and/or instant picture ids with bar codes are leftover trappings from the 2001 events, and a nice boon for security and rent-a-guard firms.  Class A owners in these prime markets need some semblance of "high tech" security to stay competitive, but I never have figured out who or what they were trying to stop from getting upstairs. I guess the security schemes give some level of comfort to tenants and I bet these buildings report far lower incidences of pocketbook thefts and other petty crimes than lower security buildings. While the riff-raff certainly can't easily get into elevator banks anymore, Bruce Willis or 24-style terrorists most definitely can.  Like the TSA, these systems hardly appear fail safe. Just last week, a security guard in one high-profile bank-branded skyscraper eased me through without a complete check and I got into a reception at a  new "media" tower without much of a review either, although the guard programmed my floor destination into the elevator computer controls. In another building my laptop bag was x-rayed, but I didn't go through a metal detector.

Whether in malls, office buildings, or just walking down a street, I'd be more concerned about all the  "ordinary" Americans toting around guns than the next (inevitable) terrorist sortie. Maybe I should pick up an AK47 or Uzi to protect myself.       

What a difference a year makes

A year ago this week, I concluded a presentation at the annual Bear Stearns real estate "Year Ahead" conference by saying "the next five years of real estate returns will not be as good as the past five years." Audience body language and comments afterwards expressed bemused skepticism. Afterwards, several people took issue with my suggestion that underwriting standards would turn more stringent during 2007. "We haven't seen that yet." Well, it was late 2006, the new year hadn't yet begun and the EOP/Blackstone deal was about to close.  I thought the gist of my comments was pretty grounded -- how could core real estate continue to produce mid-to high teens annualized performance when the historic mean for unlevered core returns lies in the high single digits?  Ross Smotrich, Bear's lead REIT analyst, also signaled that stocks he covered looked way too toppy.  We shrugged over the reaction. And who could argue too stridently -- the markets continued to pump property prices.

I was back at Ross's conference this week. Let's just say the mood was "somber."  Speakers talked about  "defensive" strategies  and operating  from "caution." It was hard to hear mention of the dreaded "R" word, but most attendees seem resigned to at least a "slow growth" economy next year, and wondered how much property cash flows will be impacted. Charts showed how rent growth and demand indicators seem to be moving in the wrong direction. Nobody was showcasing optimistic forecasts, and the housing outlook steadily gets gloomier. Some grumbled about how the "press" was fomenting a downturn with all their negative headlines. On the positive side, speakers talked up the prime global pathway markets along the coasts and Ross suggested that select REIT companies with strong management teams might be prime buy opportunities in coming months after getting beat up.

I'll say it again -- the next five years of real estate performance will not be as good as the past five. Let's just call it -- reversion to the mean.    

The fee for all is over

I traveled coast to coast last week making Emerging Trends presentations and here are some observations:

Real estate pros get increasingly spooked by the economic news.  In particular, execs working in the capital markets show more frustration and angst. It's beginning to dawn on folks that heady transaction volumes enjoyed for most of the past decade won't be repeated next year, and brokers and bankers realize the fee-for-all is over for  a while. The closer people are to the debt markets the higher the gloom quotient -- refi risk jangles nerves. Commercial developers naturally tend to be more optimistic -- they have no choice with projects going up. Skill sets become more valued for leasing, property management and workouts.

Investors in global pathway markets -- New York, Washington, LA and San Fransisco (where I made  speeches last week) -- feel more insulated from the potential downturn. Core style properties in these cities offer downside protection, buoyed by solid occupancies and tenants locked into long-term leases. In tough times, DC investors always gain comfort from seemingly never-ending federal largesse. San Francisco rides momentum from resurgent tech companies and the West LA office market remains tight. Foreign tourists also provide a lift attracted to these prime U.S. destinations by the weak dollar. Amid the cacophony along New York's prime shopping streets, English sounds like a foreign language lately.

But office leasing momentum and upward rent moves have hit the wall for now. Even in the global pathway markets, recent investors who overpaid and over leveraged swallow hard as do their lenders. They know those overly optimistic pro formas won't deliver and the flipping game is over, eliminating easy exits. One San Francisco real estate advisor is knocking on doors of local owners he thinks may be in distress to offer capital resources. And he says he's making attractive deals. Rising cap rates and flagging growth in net operating incomes portend some value erosion.

It's time to accept we're in for a rough ride. The real issue is for how long and at what cost?

© Miller Ryan LLC 2007