Saturday, March 10, 2012

Credit Growth Rising: Trade Deficit Soaring: Student Loan Bubble Expanding

Our global economy runs on the expansion of credit. Since 1970, the credit markets have doubled in size every decade. This massive expansion of debt/borrowing created one of the biggest booms in history - seen in the DOW running from under 1000 in 1980 to over 14,000 in the year 2000, and the real estate markets soaring in prices worldwide from 1997 to 2008 (some markets are still expanding today).

The economy is now dependent on this growth of credit in order to expand in size. Why?  Because you need a larger economy tomorrow to pay off the debt you accumulated yesterday. Does this sound like a Ponzi scheme?  Well, it is.

This is why central banks and governments around the world are desperate to pump credit into the system through government spending, which has been paid for with central banks printing money.

Up until 2008, this credit expansion was handled through the consumers around the world ready and willing to take on more credit card debt, a new auto loan, or a home equity line.  Then, we ran into a problem. When the subprime mortgage crisis hit in 2008 and home prices began to contract, the American consumer and engine of global growth hit the wall. Government leaders went to work to get the credit machine growing again and it appears, based on the most recent data, that they have accomplished this goal.

Zero Hedge provided the following chart this week showing that in the most recent quarter, for the first time since 2008, credit (debt) across all classes increased. Household debt (consumers borrowing), corporate debt (businesses borrowing), state and local governments, and the federal governments all grew the size of their debt outstanding.  The chart below shows this incredible feat:

This is excellent news for a global economy modeled around the United States borrowing money and purchasing foreign goods using the debt.  The following chart, based on data released this week, shows that the US trade deficit increased to $52.6 billion in the month of January.  This means the United States imported $52.6 billion more goods than they exported in the month.

Let's take a look at one particular portion of the credit markets discussed in the chart above: household debt, also known as consumer debt.  This debt can be broken down into two parts, revolving credit (credit cards) and non-revolving credit (student loans, auto loans, boat loans, etc).  The following chart shows the sequential change in revolving and non-revolving credit.

Revolving credit (credit cards) showed a decline in the month of January, but there was a surge in the non-revolving credit driven higher by a portion of the debt markets that has mushroomed in size over the past few years...student loans.

The following info graph shows how the recessionary conditions in America have affected the younger generation.  While 24% have moved back in with their parents, 35% have decided to go back to school.

Why are they going back to school?  Because they can approach the government and borrow money to pay for tuition, room, board, books, food, and a little extra for discretionary spending money (partying).  It provides a free way to live while they "wait out the recession."

The following chart shows student loan debt growth vs. household debt growth over the past decade.  You can see where consumers hit the wall in 2008 and passed the baton to student loans.  The rise is extraordinary.

The business of college has never been better.  With an endless amount of federal (tax payer) money available for school it has created a surge in demand which has in return created a surge in college tuition pricing (see 2012 Real Estate Outlook: Demand - Ability for an in depth discussion on how credit availability impacts pricing).  The following chart shows the rise in college tuition prices vs. home prices vs. the standard consumer price index (general cost of living).  You can see the bubble rising and falling in the home price index (red line).  It looks like a minor bump in the road compared to the growing student loan bubble.
As these college students leave school with tens (or hundreds) of thousands of dollars in student loan debt and find that there are no jobs available, what are they going to do?  In Greece, the unemployment rate for the youth is now over 50%.  They spend their time in the afternoon setting buildings on fire and throwing rocks at the police. Hopefully the youth in America will spend time doing charity work for the local church, but I doubt it.

Some people believe that a war can help put this youth to work and get us out of our current economic malaise as it did back in the late 1930's when a world war cured the Great Depression (or at least that's how the history books have been written).  Something to think about as you watch the slow moving developments with the United States and Iran.

For a much more in-depth analysis on the need for an exponential growth in credit, I recommend Chris Martensen's excellent book The Crash Course as well as taking an hour of your time to watch his Crash Course video series.

Sources: Zero Hedge, Calculated Risk, Charles Smith at Of Two Minds

Economist Interview: Ray Dalio

Ray Dalio, founder and CIO of Bridgewater Associates, recently spoke with the Economist providing his thoughts on the global economy and financial markets. Bridgewater Associates is the most profitable hedge fund in history, recently passing George Soro's Quantum Fund.  He has a multiple decade track record of incredible success and navigation through the turbulence in the financial markets.  In other words, he walks the walk.


Friday, March 9, 2012

Bomb Triggered: ISDA Determines Greek Restructuring A Credit Event

The most important news for the financial markets in three full years just crossed the tape:

The ISDA has determined that the Greek debt restructuring has been deemed a "Credit Event."  This means that the insurance payments on the debt, known as Credit Default Swaps (CDS), will be paid in full.
For an easy to understand explanation of what all this means please see The Greece Bailout: Do Not Trigger The Bomb.

The bomb has been triggered.  As I discussed in the article linked above, this is important not due to the size of the Greece CDS contracts outstanding, currently around $3 billion in size, but because it sets the precedent for the coming bailouts for Portugal, Ireland, Spain, and Italy.

These countries have a debt crisis, and CDS contracts outstanding, orders of magnitude larger than Greece.

Many of the banks and hedge funds that issued these insurance contracts did so knowing that they did not have the capital to pay them out if they were ever triggered.

American banks, for example, have told us countless times that their exposure to European debt is very low because they are "hedged."  They are hedged because if a bond defaults, they know they have X amount of dollars coming in through insurance payments (CDS contracts).

But what if the bank or hedge fund that sold them the insurance could not make the payment?  This is exactly what happened when Lehman brothers failed and everyone showed up to AIG's office to collect their CDS contract payments.  There was a note on the front door that read:

"We knew that if the bonds defaulted then we would have to pay out $200 billion, but we only kept $2 billion in reserves. We didn't think home prices would fall in value. We're sorry."

Remember what happened then?  The entire financial system collapsed and it took close to $20 trillion in backstops from the Federal Reserve to keep the system alive.

Here is what makes the story even more fun:

CDS contracts are held "off balance sheet," which means no one knows who owns them or how much they own.  The financial system becomes a minefield that you must navigate wearing a blind fold.

So what happens?  No one trusts anyone.  Money stops moving.

This is why after almost $1.4 trillion in money was injected from the European Central Bank over the last three months, almost all of it has moved immediately back onto the balance sheet at the ECB for safe keeping.  The money is not moving because the banks are scared to death.

The implications for this announcement are beyond massive.  Remember that behind Europe we have Japan waiting in the wings - a monster that is larger in scale than both Italy and Spain.  Investors now have the green light to pounce on Japanese debt through insurance contracts knowing that they will be paid out when the collapse arrives.

What happens next is obviously impossible to know.  If a CDS writer can not make a payment, will the central banks step in and make those payments the way they did with AIG?  The size of the contract payouts for the rest of the European contracts will make the 2008 bailout look like a walk in the park.

This process will take a long time to unfold but we received an enormous piece of information today to help us create the road map for what is ahead.  Right now it is time to raise cash and prepare for when assets go on sale.

I will have much much more coming on this news, including in depth analysis on the size of the CDS markets, which banks and hedge funds will be impacted the most, and an estimate of the scope of the coming bailout (printed money) that will be needed to bailout the system.

For an in depth look at the United States credit markets see: Credit Growth Rising: Trade Deficit Soaring: Student Loan Bubble Expanding.

Mark Haines Called The Bottom: Three Years Later

Mark Haines, the brilliant CNBC host, passed away last year.  My favorite memory of him, and one of my favorite moments in CNBC history, was his bottom call in the market to the day three years ago.  While experts came on the show day after day and week after week calling a bottom at every market rally, this was Mark's first time making the call.

It also came at a time when literally everyone thought the market was going lower.  The pessimism in the market that week compared to the optimism in the market today is so incredible that it is almost beyond belief. Erin's comment sums it up best saying that "even if the market bounces for just one day" it would be a great call.  Today any down day is just a blip in the radar for a market "guaranteed" to go higher.


February Jobs Report

Yesterday, I discussed the employment data released by the Gallup Survey and this morning the government employment data was released.  At first blush, as always, it was a strong report showing 227,000 new jobs created in the month.  This left the unemployment rate unchanged at 8.3%.  The following graph shows the steady increase in jobs created, something that will be drilled into your subconscious every day by the media as we approach election time.

A topic I discussed in detail last month regarding the jobs report was the number of Americans not in the labor force.  These are people who are no longer looking for work, either because they have retired or they have given up because there are no jobs available.  See The Jobs Report: Call The Termite Inspector for a full discussion on the labor force participation and its importance.

In February, those "not in the labor force" decreased by 310,000.

Then there are those that are working temporary ("temp") jobs.  Professional business services added 82,000 jobs in February, and 45,000 of those jobs were temp jobs.

On top of the temp jobs we have Americans working part time.  I know what you are thinking. Many of these people would probably prefer part time or temporary jobs which is why they have taken them, right?  The following chart shows the number of people working part time for economic reasons, meaning their hours have been cut or they are unable to find a full time job.  

The famous and often discussed "Birth Death Model," where the government conjures up a number of jobs they think were created by small business formation was +91,000 in February.

When you remove the fluff, the true underemployment in our country is much closer to Gallup's 19.1% reported yesterday.  Business owners do not believe in this "stock market" recovery, which has created the surge in temporary and part time workers.

h/t MISH, Zero Hedge, Calculated Risk

Thursday, March 8, 2012

Gerald Celente Discussing The Hawks Circling Over Iran

For a complete analysis on the Greece default and credit event see:

Part One: The Greece Bailout: Do Not Trigger The Bomb

Part Two: Bomb Triggered: ISDA Determines Greek Restructuring A Credit Event

Part Three: Credit Default Swaps: How Large Is The Exposure?

Gallup Unemployment Rate Rising

Gallup released their unemployment data for the month of February this morning (the government BLS data will be released tomorrow morning) showing the unemployment rate rising to 9.1%.

Gallup also measures those that have taken a part time job to survive while they continue to look for full time work.  When removing these workers from the population rate they have a total unemployment rate of 19.1%.  The unemployment rate during the great depression reached 25% at its peak.

Fed Sterilization Program: Walking The Tight Rope

Yesterday the Fed leaked news of a new Quantitative Easing program they are considering.  It is called "sterilization."  I know, I know, another weird term to keep everyone confused.

I posted an excellent video interview yesterday with Jim Grant discussing the program, but I'll explain it here in more easy to understand terms.

The Fed will print money to purchase longer dated bonds (such as 30 year treasury bonds or 30 year mortgage bonds).  The Fed then goes into the financial system and removes shorter term bonds, placing them on their balance sheet.  The result is a net - net no increase in total money supply available in the system, which helps guard against inflation.  The Wall Street journal posted an excellent graphic this morning showing this process:

The goal is to keep long term rates down (help homeowners refinance and let our government continue recklessly spending) without any increases in food or energy prices.

The Fed believes that they someone have some sort of magic wand over the economy.  Up until know, because the markets have behaved orderly, they have created the illusion that this is correct.

If we get either a major sell off in the stock market (say due to a Greece default that I will be discussing in great detail this week) or a spike in the price of energy (Iran) or food, then their aura of invincibility will instantly fade.

Everything is magnified because we are in an election year.  The Fed must walk a tight rope to keep their master (Obama) happy on the throne but not push too hard and create an inflation shock.

Up until now (it has appeared) they have been able to walk this rope with ease.  This will change with the first gust of wind brought on by the markets.

Wednesday, March 7, 2012

CNBC Interview: Jim Grant

Europe Debt: US Home Prices: Remembering The Past

The following map, courtesy of the Wall Street Journal, shows the coming maturity schedule for leveraged buyout loans in Europe from 2012 - 2016 as well as which countries have the largest exposure.  A leveraged buyout is when a buyer takes control of a company's equity using a significant amount of debt to make the purchase.  This massive debt rollover, added to the already massive European government debt rollover, will only add to the problems Europe faces in the years ahead.

CoreLogic released their pricing for the month of January this morning showing a 1% decline month over month.  Prices have once again reached a new post bubble low.

To begin the year I discussed the overvaluation of the stock market in terms of pricing and fundamentals in 2012 Real Estate Outlook: United States Stock Market.  Back in the middle of February I discussed the euphoria surrounding the market in Stock Market Sentiment: We Can Only Go Higher.  Since then the market has continued its day in and day out upward tear higher.  It had its first slow down yesterday, falling by over 200 points.  It is always good to go back in history and see what the sentiment was like just before major market downturns (people always were euphoric and believed there was no trouble ahead).  The following excellent video from PBS provides a review of the year 1929 just before the crash that led to the great depression.

Watch The Crash of 1929 on PBS. See more from American Experience.

Sunday, March 4, 2012

2012 Commercial Real Estate Outlook: Introduction

The following outlook is the final piece to the 2012 Real Estate Outlook, released in February.  It is dedicated exclusively to the commercial real estate sector.

The goal with this analysis, just as with the residential real estate outlook, is to look at the basic fundamentals of the market and open your mind to areas of the market that are normally not considered in a regular discussion/analysis on future price direction.

The commercial real estate market has the ability to provide investors with a tremendous amount of leverage (borrowed money). When the asset class is moving up in price, leverage is considered one of the investment's greatest attributes. When the asset moves down in price, an investor feels the other side of the double-edged sword.  For example, if you put $100,000 down on a $1,000,000 commercial building and the value of the building rises by 10% in one year, what is your cash on cash return (return on the capital you invested)?  The answer is 100%, even though the value of the underlying asset only rose by 10%.

Investors looking to find that kind of leverage in stocks, bonds, or commodities will come up well short (an investor would need to move into the derivatives to find that leverage power).  For this reason, real estate will always be an attractive investment for those that know how to play with and respect the power of leverage.

Making a few well timed and well managed moves in commercial real estate has the potential to set someone free for life financially.  Making one major mistake could take every asset that person has accumulated, along with their credit.

I will take time over the next few pages to explain and paint a picture of why the commercial real estate market is facing another leg down in prices over the next 3 - 5 years.  I will explain why this downturn will provide one of the greatest investment opportunities of our lifetime and why investors should begin to prepare for the coming buying opportunities today.

Let's begin with an overview on how commercial estate is valued and where those valuations will be moving in the years ahead.

Next: Commercial Real Estate Outlook: How Prices Are Determined

2012 Commercial Real Estate Outlook: How Prices Are Determined

The price of a single family home is determined through comps, what other similar homes in the area are selling for.  Commercial real estate is different in that properties are priced exclusively on the income stream they generate.  We are now going to discuss both how commercial real estate is valued and what is actually taking place in the market using a simple example told through a story.

Meet Bob.  He is a 58 year old real estate investor/owner living in Charlotte, NC.

Bob owns a retail strip with five stores.  The year is 2007.  Business is great and all five of his stores are occupied.  His five tenants are Harry's Hardware, Nancy's Nails, Tina's Tanning, Carl's Cuts, and Arnold's ABC.

Bob charges each retail store $3,333 per month or $40,000 per year in rent.  That means he collects $200,000 per year in total income.  His annual expenses to run the retail strip are $100,000 per year (average retail expenses run about 30% of total revenue, but we'll say Bob is not an efficient manager to keep the numbers simple).

$200,000 Annual Income
$100,000 Annual Expenses
$100,000 Net Operating Income

The net operating income includes all expenses other than his monthly mortgage payments on the building.  The NOI is the basis point used to determine every commercial building price in the country.

If Bob decides to sell the retail strip, the final price will be determined based on how much an investor is willing to pay to receive this annual income stream. 

Meet Mike.  He is a 45 year old successful business owner that is looking to make an investment in a commercial property building.

Mike calls his real estate agent and says he is tired of the low interest rates he receives holding money in cash or bonds, and the stock market makes him nervous. He is interested in purchasing a building but he wants to make sure he is paid well for the risk he takes buying a property.  He wants a 10% return on his money every year.

Okay, so how much will Mike be willing to offer Bob for his $100,000 annual income stream (Net Operating Income)?

$100,000 / .10 = $1,000,000

Mike would offer Bob $1 million for his building to receive his 10% return. You can use this formula to determine either the cap rate or purchase price once you know a building's NOI.

Cap rates are what an investor is willing to pay for an income stream.  They are determined based on the collective sentiment in the market.  If investors feel that commercial real estate prices are risky, they will demand a higher return to purchase the property.  What if Mike was demanding a 15% return on his investment because he was worried about the retail sector moving forward?  What happens to the purchase price?

$100,000 / .15 = $666,667 Purchase Price  

What if Mike felt that the worst of the economy was behind us and that the retail sector was going to be extremely strong in the future? He may be willing to purchase the building with only a 7% return on his money.  After all, he is getting less than 1% holding his cash in a bank CD.  What happens to the purchase price now?

$100,000 / .07 = $1,428,571

There are two ways that properties can increase or decrease in value.  The first we just discussed which is the sentiment (cap rates) toward properties rising or falling.  The second would be the increase (or decrease) of the Net Operating Income.  The NOI can be raised by either increasing income (raising rents) or decreasing expenses (better management).

Let's say that in Bob’s retail center, Harry's Hardware has a lease that is expiring this year (2007).  This allows Bob the opportunity to negotiate new lease terms.  Harry's business has been doing excellent and he has no desire to leave the location.  Bob tells Harry that he needs to raise his rent up to $5,000 per month, or an increase of $20,000 per year.  Harry agrees.

In addition, Bob has found a way to cut out $30,000 per year in annual expenses. So what does his NOI look like now?

$220,000 Annual Income
$70,000 Annual Expenses
$150,000 NOI

If Mike now approaches Bob’s building looking for a 10% return (cap rate), what is his new purchase price?

$150,000 / .10 = $1,500,000

Bob’s property has increased in value by $500,000 with a simple rent increase and better property management with no increase in cap rates in his area.

This simple example shows you the incredible opportunity commercial real estate offers as an investment vehicle.  Before we discuss further how and when we can take advantage of this opportunity, we must first look at where we are in the current market cycle and where we are going in the future. 

We will do this though the eyes of our friend, Bob.

2012 Commercial Real Estate Outlook: Income Loss & Debt Payments

In our story, it's 2007 and Bob has just renegotiated the lease with Harry’s Hardware.  He has reduced his expenses and the value of the building has soared. He even spends his weekends looking at vacation homes to purchase for his upcoming retirement.  What could possibly go wrong?

In December of 2007, a recession hits America. Consumers, who were recently pulling out endless cash through their real estate ATMs (refinancing), have stopped spending.  People are now losing their jobs as an economy tied tightly to the real estate boom continues to contract.  Instead of opening new credit cards, Americans begin to do something new - pay down debt (or default on current debt). 

Two of Bob’s stores, Nancy’s Nails and Tina’s Tanning, have been crushed by the recession.  With consumers now unable or unwilling to spend discretionary money at their stores, business has dried up.  They both call Bob to tell him that they must close their business and move out.

Bob is now entering the summer of 2008.  With two less tenants, he must pay to heat and cool those two spots, increasing his expenses $10,000 per year. What does his balance sheet look like now?

Suite 1: Harry’s Hardware - $5,000 per month rent
Suite 2: Vacant - $0 per month rent
Suite 3: Vacant - $0 per month rent
Suite 4: Carl’s Cuts - $3,333 per month rent
Suite 5: Arnold’s ABC - $3,333 per month

$139,992 Annual Income
$80,000 Annual Expenses
$59,992 NOI

New building value at a 10% cap rate?  $699,920

Bob took out a loan in 2003 to purchase the building.  He put down $200,000 of his own money and borrowed $800,000 from the bank ($1 million purchase price).  Bob’s loan has a balloon payment due after 5 years (2008) and this year he must refinance his loan.  Back in late 2007 Bob was planning on refinancing his building for $1.2 million (it was worth $1.5 million) and purchasing his vacation home with the extra $500,000.

Bob goes to his bank’s office and shows him that he currently has a $59,992 NOI.  The bank tells him that they require a 1.4 Debt Coverage Ratio (DCR).  This means that using his current NOI, he must be able to pay out the monthly mortgage and have a 40% buffer.

The bank can give Bob a new loan at 6% interest (interest only) for $700,000.  Let’s look at the numbers to show how they got there:

$700,000 * .06 = $42,000 Annual Interest Payment On New Loan

$42,000 *1.4 Debt Coverage Ratio = $54,600 (under his $59,992 buffer)

Bob’s loan currently has a balance of $800,000.  The bank can now only lend him $700,000 to refinance.  This means that Bob has to come out of pocket for $100,000 just to keep his building.

Most commercial real estate loans have a balloon payment due 5 to 7 years after the loan was issued.  In 2008, thousands of owners across the country were facing the same exact scenario Bob found himself in.

On the other side of the transaction, the bank was just as terrified.  They knew that if Bob walked away from the building they would have to take at least a $100,000 loss on their balance sheet.  They had 40 other buildings in their portfolio facing the same exact situation.

In 2008, our financial system collapsed following the failure of Lehman Brothers.  The large banks, pension funds, and insurance companies had hundreds of billions in Commercial Mortgage Backed Securities (CMBS) on their balance sheets.  On top of this, the local banks were home to hundreds of billions of dollars of individual commercial real estate loans.  

In early 2009, an already fragile financial system was poised for the knock out blow and it appeared that commercial real estate was going to provide the final devastating punch.  Both the owners of the properties and the banks needed a way to hold on for just a little bit longer to wait for the economy and real estate prices to recover.  They found the solution in a process called Extend and Pretend.  

2012 Commercial Real Estate Outlook: Extend & Pretend

The following graph shows the collapse in commercial real estate prices since 2007.  Prices are now down 42% from the peak.

The following chart shows the loan maturity schedule from 2011 through 2018 (when loans are coming due and need to be refinanced).

In 2009, our leaders were looking out at the tsunami of commercial real estate loans ready to rollover in the years ahead.  Between 2010 and 2013, $1.2 trillion in loans were set to mature.  They came up with a plan with a catchy phrase that, so far, has postponed the crisis out into the future.  It is called "Extend and Pretend."

Facing extreme pressure on their balance sheets, regulations were relaxed to allow (and encourage) banks to approach property owners and extend their loan at the current terms.

For example, Bob’s hypothetical loan that was due to refinance in 2008 was given a 5 year extension through 2013.  Everyone’s hope was that over that 5 year period the economy would begin to recover, unemployment would fall, incomes would rise, and Americans would go back to borrowing and spending.

This would create demand for Bob’s vacancy allowing him to fill the building with two new tenants (maybe Nancy’s Nails and Tina’s Tans would return).

The problem?  This has not happened.

The following shows total credit card accounts falling from $500 million at the peak in 2008 down to just $385 million today.  Americans continue to pay down (or default) on credit cards month after month.  The discretionary income from credit cards that was once used to purchase tanning sessions (Tina's Tans) or a pedicure (Nancy's Nails) is now going to paying for food and gasoline – also known as survival.

The next chart shows the total household de-leveraging (consumers paying down/defaulting on debt and not taking on more) process currently taking place.  In June of 2009, Americans had borrowed a total of 114.76% of personal income. At the end of 2011, this number has fallen down to just 101.1% - still extremely high with a long way to fall.  This means Americans will continue to pay down debt instead of borrowing more to consume as they did during the early 2000’s.

The extend and pretend program was created on the hope that consumers would re-leverage, not de-leverage.  Real unemployment has stayed high, with many Americans taking part time jobs or significant pay reductions.  The cost of living in terms of food, gasoline, medical costs, and monthly rent continues to rise, cutting further into discretionary spending.

Office vacancies are at 17.3%, strip mall vacancies are at 11%, and regional mall vacancies are at 9.2%.  All these are at or above 20 year highs.

Banks and property owners have continued to “delay and pray” that the economy will recover and property values will rise.  This has concealed the problem (similar to the shadow inventory in the housing market) making many believe that there is a “shortage" of product available.

Default rates “peaked” in 2009 and have fallen for the past two years.  This is because banks stopped sending default notices.  In many cases banks are not even requiring monthly payments in order to push back the day of reckoning.

Due to this supply being held off the market, prices have begun to stabilize and in some areas even begun to recover.  Investors, starving for any form of yield on their capital, have begun to bid up the prices on the few office and retail buildings that have entered the market (more on that coming).

There is even new construction supply entering the market. 12.3 million square feet of office space and 4.9 million square feet of retail opened in 2011. There is now 46 square feet of retail space for every man, woman, and child in our country.

Banks and building owners continue to race against time.  They are underwater hoping that the economy and building prices recover before they run out of air. They will not. As the economy begins its next leg down, more banks and owners will give up. The built up supply of properties that should have hit the market in 2010, 2011 and 2012 will begin to hit the market in force during 2013 – 2015.

This will occur at a time when our economy and stock market will be in the next leg downward.  Consumers will continue to retract, the cost of living will continue to rise, and our government will find it more difficult to support the entire economy through stimulus.

Investors that have been patiently waiting, like a hungry lion perched in the shadows, will reap the rewards of a market that will soon be at its most vulnerable point. 

This is obviously bad news for Bob, but great news for Mike if he has been patiently waiting out Bob’s refinancing reckoning day

2012 Commercial Real Estate Outlook: Apartments

The new darling in the investment community has been the apartment market. Prices began to fall, along with residential single family homes, when the crisis hit back in 2007 – 2008.  Prices for apartments began to stabilize in mid 2009 and have since been on a tear upward.

The fundamentals are sound.  Home owners losing their homes will need to move back into apartments. The younger generation, facing high unemployment, does not yet feel comfortable making a home purchase and can't afford a down payment.  The baby boomers have found apartments are an attractive alternative to home ownership that provides them maintenance free living (and an asset that does not depreciate in value). I covered this discussion in great detail in the 2012 Real Estate Outlook: Demand - Willingness.

This means that demand is strong. Currently, the only hindrance for apartment demand is the younger generation whowx has moved back in with their parents.  It has provided the market an additional form of shadow demand.

The problem with the apartment market is obviously not in terms of demand.  It is also not a problem in terms of general supply (or shadow supply) on the market as real estate has not faced the same issues that office and retail have. 

The hidden supply for the market comes from the single family residential shadow inventory.  Millions and millions of homes currently being held off the market will eventually be purchased and rented out to compete with apartments.  See the 2012 Real Estate Outlook: Supply - Shadow Inventory for the magnitude of this market. 

Based on the prices (cap rates) investors are currently paying for apartment communities (in many areas the sentiment is higher than it was at the peak in 2007) they have not factored in this coming supply.

If the rents are both $1000/month, would a family of three rather rent out a single family home or an apartment?  In a home, you have a back yard for children and no attached walls echoing noise from your surrounding neighbors.

Fannie and Freddie have both begun the early stages of a foreclosure rental program - where they will bundle thousands of single family homes together for investors who will then rent them out.

I believe the fundamentals of the apartment sector are very strong and will continue to improve in the short term as more demand comes into the market based on the reasons just discussed.  However, I believe that investors are currently overpaying for buildings based on three key and often overlooked factors:

1.     1. Shadow Housing supply coming to the market
2.     2. The Availability & Cost Of Financing
3.     3. The Future Direction Of Cap Rates

The second and third extremely important factors are what we will look at in detail now.

2012 Commercial Real Estate Outlook: Financing

We have discussed the implications for the supply/demand dynamics for the commercial real estate market in terms of the coming maturity cliff approaching for office, retail, and industrial space, as well as the coming shadow inventory approaching for the multi-family sector.

There are two other major components that will determine future price direction.  The first is the availability of financing and the second is the sentiment in the market (the price investors are willing to pay for the income stream known as the cap rate).

The availability of financing has diminished considerably since the peak in 2007.  The following chart shows all commercial loans at all commercial banks.  As you can see the loan issuance skyrocketed year after year reaching a peak of $1.6 trillion in 2008.

It since has collapsed downward along with prices.  A major portion for this rise in demand came from the securitization market: Commercial Mortgage Backed Securities (CMBS).  This market essentially disappeared following the financial crash of 2008.  Small local banks, who also had an enormous appetite for commercial loans during the boom, have seen their balance sheets impaired with the extend and pretend program.  This has hindered their ability to take on new loans.

The big buyers of new commercial loans after the financial crisis have been pension funds, insurance companies, and the government sponsored entities; Fannie Mae and Freddie Mac.   Fannie Mae and Freddie Mac purchase only multi-family loans.  They are lending to top quality buyers with significant down payments.

Pension funds and insurance companies have begun to lend to all commercial products.  Just as with Fannie/Freddie, they are only lending to A+ properties and top quality buyers with significant down payments.

This had put liquidity into the highest property tiers (A+ buildings) in strong markets such as Washington DC and New York.  This high grade product has seen the largest recovery in pricing because the capital is available to purchase.

However, the gaping hold left from the CMBS and local bank lending market has severely impacted the availability of loans available.  The increased scrutiny on who money is lent to and the significant down payments have lowered the supply of willing buyers who are able to purchase.  The concept of stricter loan requirements on financing and its impact on pricing was discussed in detail in the 2012 Real Estate Outlook.

The following provides a snapshot of where we are today in terms of financing availability and cost.  The information comes from Click for larger view:

The current spread over the 10 year treasury (I will explain all of these in a moment) is at 3.10%.  The current average debt coverage ratio is 2.00 and the average interest rate on a loan is 5.11%.  The average loan to value ratio is 67.5%.

Let’s begin with the spread.  Most banks determine the rate they will lend at based on the 10 year government bond yield.  The 10 year is currently hovering around 2%.  This means that if the banks want to keep a “spread” of 3% they will give out a commercial real estate loan with an interest rate of 5%.  This provides an example of why Ben Bernanke and our Federal Reserve desperately want to keep rates low.  It has eased the financing cost for commercial loans (lower rates allow buyers to pay a higher price).

The debt coverage ratio was discussed in a previous section but we’ll go back to Bob our retail owner to explain.  If Bob’s building currently has $60,000 per year in NOI then the bank will lend him a maximum of $30,000 per year in interest payments.  This provides the bank a 2.0 DCR.

The average loan to value ratio is 67.5%.  This means that lenders are currently requiring a 32.5% down payment (lenders were providing 80% loans at the peak of the bubble).

The question is where are these lending restrictions moving in the future?

I believe that a 32.5% down payment and 2.0 DCR are healthy requirement for lenders.  Eventually the DCR will move back down to its more standard 1.3 range and the down payments will eventually move closer to 25%.

The trouble I see is in the interest rates.  Right now Bob is purchasing a building financed at 5% interest.  This provides him a great opportunity for current cash flow today.  What he is not considered is what the interest rates will be when he is selling his property. Or to think of it another way, what will be the monthly interest payments his buyers will use to determine the price they will pay for his building?

As previously mentioned interest rates are bench marked off the 10 year treasury yield.  This means an investor's future outlook for real estate values should be heavily weighted on where you believe the 10 year treasury yield will be in the future.

For reasons discussed on this site in great detail over the past few years, I believe that government bonds are currently at the end of a 32 year bull market.  I believe they are close to or have already entered the bubble/mania phase of this bull market.

Investors purchasing buildings today have priced in low interest rates forever.  Where else has this been applied in the commercial real estate market?

2012 Commercial Real Estate Outlook: Cap Rates

Since the financial crisis began back in the summer of 2007, the Federal Reserve has lowered interest rates to zero and embarked on multiple rounds of Quantitative Easing programs.  A QE program is when they print money and enter the market to purchase assets. Their two assets of choice during QE 1 & 2 have been mortgage bonds and treasury bonds.  By purchasing these bonds and adding trillions of new liquidity into the market, yields have been driven down to artificially low levels.

This has many benefits to the economy. Home buyers can purchase homes with lower monthly interest payments. Businesses can borrow at a lower cost. Our government has the ability to finance multi-trillion dollar deficits annually, which allows tax cuts and stimulus programs to flow into the economy.

It also has other “side effects.”  By driving interest rates lower, it punishes investors who hold money in cash (save money) or live on fixed income payments. It pushes Americans who are retired into riskier assets in order to try and generate a return on their money that they can live on.  For example, there has been a recent rush back into junk bonds, blue chip stocks, and municipal bonds - which all generate a higher return than short term government bonds or cash.

The same effect has been seen in the commercial real estate market. Investors look across the spectrum at their asset class options and see that commercial real estate provides the opportunity to generate somewhere between 4% and 10% on their money depending on type of property and location they choose to buy. The following table from shows the current average cap rates for the major commercial real estate property sectors. Click for larger view:

Remember Mike, our potential investor from the previous example?  With interest rates at 0%, Mike is willing to pay a higher price (purchase with a lower cap rate or return on his money) than he otherwise normally would.  If more investors begin to enter the market, they will begin to compete for these yields.  This is what has happened over the past few years in the apartment industry and the A+ property sectors in top markets.

Investors are starving for yield. They have entered back into the market with force, seeing low interest rates and watching the stock market rise. What they are not seeing is the shadow inventory lingering over the market.

Let's say that Bob the investor buys an A+ property at a 4% cap rate (this is happening every day in some of the strongest markets).  The ten year treasury bond rises from 2% to 4% (still very low in historical terms).  Bob has raised his rents, reduced expenses and put his building back on the market because he reads that the economy is doing very well in his area and investment capital is continuing to come back into the real estate market.

Mike the investor comes to town and is looking to put money to work.  Mike has the option of purchasing Bob’s building at a 4% cap rate (which he must then manage), or he can purchase a 10 year treasury bond and collect 4% per year with absolutely no work (the 10 year treasury bond is considered a risk free investment because it is very unlikely our government will default on the debt).

Mike and other potential investors who could've purchased Bob’s building decide they would rather purchase treasury bonds.  Bob is shocked that his building is sitting with no activity.  He must now lower his offering price (to provide a 5% or 6% cap rate) in order to compete with treasury bonds.

Even with an increase in rents and a reduction in expenses, Bob may still be underwater on his investment.  To repeat, investors are purchasing commercial real estate today with no consideration on the future direction of rates.  These rising rates will provide the next leg down in pricing just as the first round of extend and pretend assets begin to hit the market.