Trend Czar

Follow the Money (Consumer)

A raft of recent statistical indicators show the recession has ended--housing prices increase in many regions, job losses decline month by month, and today the government announced a shallower contraction in GDP during the second quarter. It's odds on that third quarter GDP numbers will be in the black. In short, there is not much doubt that the economy is headed back in the right direction after its serious decline.
 
But heading in the right direction and recovery are two very different conditions. Banks remain in a fragile state--a big part of their problem is toxic commercial real estate assets. They still need to build up reserves to take eventual losses. Consumers won't rebound into house buying and shopping mode until they work their way out of considerable debt holes. For that to begin to happen companies need to start hiring again and wages must increase for the average American. This won't be a quick process--let's hope that net employment gains begin to register by next spring.
 
For retailers, some economic improvement can't come fast enough with their prime Christmas season approaching. Halloween orange and black now merges into greens and reds sometime in early October. Retail sales have been improving month to month and the ICSC expects better Christmas sales than last year (let's hope so!). But no one can is particularly optimistic--expect more stocking stuffer presents than big boxes under the tree.
 
And retailers appear to have a particularly rocky road ahead. If savings rates restore to more traditional levels (5-10% of income), a big dent will be taken out of consumer buying in any recovery. Of course, during the last 10 years of consumer binging people not only failed to save they were actually borrowing to buy what they really couldn't afford. Retailers just can't expect spending patterns to return to pre 2008 levels. And since the economy has been so dependent on consumer spending (it had been an unsustainable 70% of GDP) how can anyone hope for a robust turnaround?
 
I don't think we can.     

Three Strikes and You're Out

Many investment managers and wannabe investment advisors now put together funds to take advantage of the market distress. There's plenty of talk of mountains of equity capital on the sidelines ready to pounce on deals once there are deals to pounce on. We've heard this talk for several years now and its difficult, no impossible, to quantify just how much money there is. The stock market has already siphoned off capital in its run up this year. Other countries' economies have recovered more quickly than ours---Brazil garners ample attention and capital flows. China rebounds. Investors still like India. Even Europe looks better positioned right now. In short, U.S. commercial real estate is far from the only game in town. Investment managers count on pension funds to be active players, and they will be, but plan sponsors never ramp up in the vanguard--they'll be careful and follow the leaders. And meanwhile U.S. commercial markets list in a suspended animation, offering little action.
 
No doubt, managers and investors will do well with many early cycle U.S. real estate funds investing at market bottom. Once those funds are fully invested, managers will start selling Fund IIs and later Fund IIIs, and they hope the cycle lasts long enough for a Fund IV or even Fund V.
 
Here's my advice to investors. Place capital with cycle-tested managers who have operated successfully at real estate market bottoms before. Their Fund I offerings should do well off buy low gambits--it's hard to mess up as long as you have some level of experience and savvy. Down the road, the Fund IIs may be worth a bet. But investors need to be more choosy about strategies and be clear headed that the market timing won't be as advantageous. When managers start marketing their Fund IIIs, touting the success of Funds I and II--that's the time to turn wary. Remember past success doesn't guarantee future returns. And just turn tail on Fund IV or V offerings. By that time the cycle will be over and it will time to cash out and wait for the next correction to play out.
 
In other words,at three strikes you should be out of the game.         

Public Pension Woes

Public pension funds have been big investors in real estate over the past 25 years, but what’s the future for these pools of capital? Corporate pension plans are steadily getting replaced by 401K alternatives which reduce company expenses and put investment decision making into the hands of employees. Companies spin 401Ks as their pension plan, but let’s face it, they are poor substitute for beneficiaries, who don’t have the expertise to manage their investments and can’t protect themselves against losses when markets tank. The notion of a guaranteed pension for many corporate employees is disappearing.

Public employees, meanwhile, hold onto their defined benefit pensions (read that guaranteed) as long as their unions can bully state and local politicians into keeping them in place. Every time a contract negotiation takes place, the union approach is--You want our members’ support in the next election, don’t mess with our plan. For decades, politicians had been free and easy with giving the store away to unions on pensions since the bills wouldn’t come due until well after they left office. That’s why we have government workers still retiring in their mid 40s on full pensions. 

The only problem with this tactic is time is running out as more baby boomers approach retirement, and the bills are coming due--now. Corporations have been eliminating their defined pension plans because the unfunded liabilities are budget busters. States, counties, and cities are facing the same reality, and taxpayer-voters will eventually come to terms with whether to support candidates who favor public employee pensions or those who call for balancing budgets and keeping taxes in check. The auto workers had to give in when their companies faced going out of business, public employees will relent too.

That doesn’t mean that public funds will stop investing in real estate, and that all public employee pensions will convert to some form of self managed 401Ks. But over time, public funds will become less of an investment force as their source of contributions diminishes.

Besides the unfriendly political realities, public funds have other troubles too—like other plan sponsors, they lost big in the recent market downturn, compounding their unfunded liability dilemma. In several states, “pay-to-play” scandals take down various board members and intermediaries.

The erosion of public fund clout isn’t great news. It points to the decline in the nation’s overall employer pension system, which provides each of us less and less retirement income and security.  Public plans have been overly generous, but few Americans can feel good about the prospects of a 401K getting them through the golden years comfortably.  
      

The Mortgage REIT Gambit

Mortgage REITs have been getting plenty of attention lately. Their proponents--the sponsors and Wall Street bankers--tout them as a solution for providing the real estate debt markets with desperately needed liquidity. And yes, they may provide some funding to refinance borrowers with few other available sources in the parched mortgage markets. But given the $300 billion or so in loans that need refinancing over the next five years or so, the $3 billion in mortgage REIT IPOs won't make too much of a dent. Still, something may be better than almost nothing.

Really, mortgage REITs are a pure and simple opportunistic play. The idea isn't to rescue borrowers, it's to take advantage of them. These vehicles will not only originate new loans at healthy spreads, but also invest in busted CMBS portfolios and pools of failed bank mortgages.The idea is to buy into markets at lows and ride the cycle back up. Doesn't sound too revolutionary or necessarily too benevolent, does it?

Mortgage REITs mark the first foray by Wall Street back into commercial real estate after their drubbing in the CDO/CMBS debacle. The next gambits will be IPOs for equity REITs to bail out failed developers and private real estate owners with large real estate holdings now under water. That's the same playbook dusted off from the early 1990s when some major players were veering into bankruptcy. Presto chango they gave up private control to retain some measure of their fortunes in public companies and lived on to reap large gains in the most recently ended up cycle.

Mortgage REITs historically haven't fared too well. They can do okay early on at cyclical lows, but can get whipsawed by external economic factors like rising interest rates. Early 1970s and mid 1990s iterations eventually were hammered into oblivion.

Like any opportunistic play--investors need to be wary market timers. Mortgage REITs aren't about liquidity or long-term investing. They're about making a quick buck. 
 
      

The graying poor

The healthcare debate points to a growing schism in the U.S. between older people and younger Americans. The economics of Social Security and Medicare (both socialist programs by the way that few if any Americans want to give up) depend on younger working people supporting older retired seniors. The numbers worked at first because the demographics supported the programs--early on there were four times as many working people as seniors. But the numbers are changing. Over the next 30 years, we'll have as many 60 plus Americans as under 20s, and only two times the number of working-age Americans to seniors. You can't support Social Security and Medicare off these numbers.
 
So what does this mean? The conventional wisdom among real estate players has been there will be all sorts of opportunity in senior housing. Arizona, Florida, the Carolinas and the other warmer weather regions expect expanded numbers of retirees to move into these states. Retirees generally mean good business--they've had pensions, savings, and means to live off prosperity.
 
But the new world order may be drastically changing the outlook for baby boomer seniors. Company pensions are disappearing. Public employee pensions are next--their payouts cripple state budgets. Can anybody depend on their 401Ks to get them through retirement? Not many people can. Social Security is unsustainable--either benefits will need to cut back or the age for receiving benefits will need to increase from 65 up to 70, and nobody lives very well if they are depending on Social Security in any case. And baby boomer Americans have been woefully poor savers. Many people have depended on home appreciation as a nest egg strategy and then took out home equity lines forgetting the risk of declining house prices. And we all know what's happened since. In other words, many graying Americans will be in the poor house or struggling to get by over the next quarter century. Many seniors will have no choice, but to keep working to get by and others will become even more dependent on government aid.
 
Sure there will be many among the 100 million 60 plus crowd who will be able to afford upscale senior communities along the Palm Coast or in some desert golf community. But many older Americans will be more like wards of the state, depending on what's left of those socialist programs.       

No spin can save you

The inevitable tidal wave of commercial loan busts begins to form--over the next six months more borrower reserves run out and owners come to terms with the harsh reality of rising vacancies and lowering rents. Why should they put good money after bad trying to keep up with debt service when the property is worth less than the loan and the markets won't recover any time soon to rescue them? It's time to bail.

Back in the early nineties, I practiced the spin game for a major institutional investor with a veritable bevy of headline grabbing stinker investments. When a high profile loan or equity deal went bust, we did what some of the big names are doing today--suggesting that our other investments made big returns and we're doing fine otherwise. Don't judge us by this one huge deal or that other huge deal that's going bust too. No judge us by our entire portfolio and no we won't open up the kimono to let you see just how well we're doing for our clients. That's between them and us--proprietary info, advisor-client, el priveeto.

Look if you're invested in commercial real estate today, made big bets late in the game, didn't get into cash two years ago--you're suffering big losses, more if you borrowed heavily (unless you borrowed so much that you didn't have much equity to lose and your lender is stuck). All the spin can't save you. We were geniuses on the way up, and dunderheads now. There's no way around it.

Oh watch out, here comes that wave, and there's no high ground for an escape.          

Not a Good Feeling

It’s a year since the Lehman Brothers collapse and we read in the New York Times over the weekend about investment banks securitizing bonds backing the proceeds from life insurance policies bought from elderly people looking to cash in benefits before they die. Since the CMBS and RMBS markets are dead, the Wall Street houses dream up another fee machine to boost profits and bonuses. This new product gets floated despite unresolved questions about the risk return issues involved, let alone the questionable idea of subverting what life insurance is supposed to provide.

And meanwhile let’s get back to CMBS—everyone in the real estate business is petrified about the consequences of hundreds of billions of dollars in CMBS loans maturing over the next five years. Many of these loans are poorly underwritten (especially later vintage), most at favorable terms and interest rates to borrowers relative to what they would be able to achieve even if markets were more liquid today. And given the broken CMBS engine and ongoing credit crisis, we all know CMBS refinancing is a huge issue which threatens to undermine any real estate market recovery, particularly since nearly everyone expects interest rates to increase over the next several years. Already underwater borrowers and many who are merely struggling with declining property revenues could be toast if they can’t rollover their loans.

But resolving the CMBS market mess is tomorrow’s business given the politicos and bankers are still trying to steady the financial system in the aftermath of last year’s meltdown highlighted by Lehman. You would think new regulation of securities markets must be part of the solution to bring confidence back to the broken system since bond buyers appropriately have near zero confidence in CMBS instruments. Any regulation might be a good first step since self regulation didn’t work, but so far absolutely no action has been taken. And you don’t get a good feeling when you read stories about these new Wall Street securitization forays and realize banking lobbyists pour money into the campaign war chests of congressmen and senators at record rates. It’s like the fix will be in and when markets recover—any regulation will be window dressing, Wall Street will soldier on, and we’ll be on our way to another fiasco.