Saturday, January 26, 2013

2013 Outlook Part 9: Chapter 2 Of The Sovereign Debt Crisis Begins

After spending a few sections of this outlook looking at the United States and the impact of low interest rates on markets within that country, it is time to now to take the conversation global.

In 2012 there was a critical change in the landscape of the sovereign debt crisis. This important change closed the door of chapter 1 of this crisis and simultaneously opened the door to chapter 2. It was the announcement from the European Central Bank that they would provide "unlimited" money to stand behind sovereign debt. Up until that announcement it was uncertain where the ECB stood and if they were ready to do "whatever it took" to stop rates from rising. By this I mean they were ready to print an unlimited amount of money to push the debt bubble down the road.

Psychology plays an extremely important role in the bond market. This has also been know as "trust" or "faith" in the debt one is purchasing. Up until this point in the sovereign debt crisis, investors have wanted to know that the nominal value of the bonds they purchased would be returned after the term of the bond.

This is why Europe was ground zero for the origins of the crisis. It was obvious to anyone who could handle simple arithmetic that the governments in Europe had no possible way of paying back their debts. What was unknown was whether the ECB would stand behind the bankrupt governments 100% with their printing press. Bond buyers do not like uncertainty. Especially those that are buying government bonds. 

Many of the more experienced investors still remember being on the wrong side of Russian debt in the late 1990's when they defaulted. That event by itself was almost enough to cause a Lehman like chain reaction in the financial system, at a time when the market was just a fraction of the size it is today.

Fast forward to the beginning of 2010 and investors begin to smell trouble around the government bond market in tiny Greece. Greece has been so important over the last 3 years, not because of the risk of their debt to the financial system, but because how that country was handled would create the blue print for the rest of the larger bankrupt countries throughout Europe.

The ultimate resolution was a carefully crafted write down of a significant portion of their debt (investors were forced to take losses), leading to complete chaos throughout the rest of Europe. If Greece debt was written down, then investors believed it could happen in Spain or Italy. Uncertainty leads to fear and fear leads to pressing the sell button. Bond yields began to blow out across both Spain and Italy, and it was rapidly moving to the point of no return; a Greek like moment for these two nations.

This was why the ECB finally threw in the towel and agreed to stand behind all the toxic debt in the system. I have been writing about this moment for years. My ultimate belief was that the central bank would cave and money printing would be the ultimate resolution. I have often discussed not only this event occurring by how that would impact the markets moving forward.

Why is it so important?

The major developed nations around the world, which make up a significant portion of the global economy, also have governments with toxic balance sheets that look just like Greece - only with many more zero's. The key difference, and why you have not heard a peep from them so far during this crisis, is that their central banks began this process with the market understanding that their central banks would do anything to protect their debt markets, aka, unlimited money printing. 

While in years past this was only assumed, it has recently been confirmed from the central banks themselves. In just the past few months the Federal Reserve has announced QE-ternity. They will purchase $85 billion worth of debt every month until the unemployment rate reaches 6.5%. The Bank of Japan has recently announced a similar program of unlimited QE until their inflation rate reaches 2%. The Bank of England has followed suit and agreed to print money until the economy recovers, an economy that has just recently slipped back into recession.

All these countries plan to boost growth through a lower currency which will help their export markets. The problem is that these currencies are valued against each other, which has created a modern day currency war. I will come back to this very important point in a later section of this outlook.

The second reason they have embarked on this process of currency devaluation (the part that is never discussed publicly) is that the central banks are actually GDP targeting. GDP is a number that grows in a nominal fashion - it is not inflation adjusted. Central banks are well aware of this very important fact.

Therefore, if they increase the price of goods, stocks, real estate, etc. across the board, the nominal value of GDP in that country will increase in size. During this nominal boost to GDP, the value of debt simultaneously falls (bonds do not track the rate of inflation which is why they are lethal during inflationary periods). 

If the nominal GDP rises by 20% over 5 years and the debt within the country only rises by 10%, they have still lowered the total debt to GDP rate over that period. This process is known as financial repression. For a more in depth and easy to understand discussion on this topic see: What Is Financial Repression?

Financial repression eases the burden of debt repayments by making that debt less valuable. The key to this process is to do it very quietly. You can think of it like boiling a frog. For 99% of the process the frog does not even realize that the water is getting warmer because it is happening slowly. This is exactly what is taking place in the bond markets today. Investors are putting their money into a fund that yields 1.5%, while the central banks have told them (those that are listening) that it is now their mandate to achieve 2% inflation. That means it is the central banks goal to make those investors lose .5% a year in purchasing power.

This had led us to the crucial point we are at today when the second chapter begins. We are in a transition phase from the point where investors are terrified of losing their investment principle (European government bonds) to where they will ultimately be worried about the value of that principle when it is returned (all government bonds).

The important question now is, what bond market will be the first to experience the impact of this new psychological shift? 

Enter Japan. Ground zero for the second chapter of the sovereign debt crisis.

Tuesday, January 22, 2013

Jim Rickards On German Repatriation Of Gold

Long time favorite of this site, Jim Rickards, speaks with long time favorite of this site, Lauren Lyster (who recently moved to Yahoo! Finance), about the recent German repatriation of gold. If you are unfamiliar with this story you can click here for all the details. This repatriation may be looked back on as the trigger event for all major countries (then individual investors) to demand physical metal in possession instead of a paper promise to deliver in the future. There are hundreds of times more paper metal traded and loaned into the market vs. the actual physical metal available. Ultimately it will end with a very exciting game of musical chairs.

The Best Place To Be Born In 2013

The Economist compares and contrasts the former list from 1988. It is startling for many living in the United States that being born in America in 2013 does NOT provide your child the absolute best opportunities in their lifetime. I understand the backlash even whispering a comment like that to many people, but those that will take the time to broadly look at all the information in an non bias manner will come to the same conclusion.

Where to Be Born Infographic Design by

Does that mean that when I have children that I will pack my bags and move to another country? No, because selfishly I want to be close to my friends and family even though it would probably give my children a better environment to succeed. I also think it is possible that America still has the potential to be the greatest country in the world to be born in for my grandchildren. It will take a complete debt collapse and re-organization of the current economic and political structure for that to occur. I hope it comes soon.


2013 Outlook Part 8: Commercial Real Estate Cap & Interest Rates

The commercial real market is composed of the following four sectors:

1. Office
2. Retail
3. Industrial/Storage
4. Multifamily (Apartments with 5 or more units)

Of those four it has been the multifamily sector that has seen the greatest surge in capital inflows since 2009. We will get to that sector in a moment, but I would just like to briefly review some of the other markets that have also become extremely frothy.

For a complete and easy to understand walk through of how commercial real estate prices are calculated and cap rates please see 2012 Commercial Real Estate Outlook: How Prices Are Determined.

The following cap rates come from the CBRE survey in August of last year (their most recent data). I will update the data when their new survey is released. It shows that the hunger for properties has been concentrated significantly in A+ stabilized properties. Investors are willing to pay an enormous price for assets they believe to be the safest and highest quality. How steep a price? The following is just a sampling:

Boston Office - 4.25% cap rate
San Francisco Office - 4.25% cap rate
Atlanta Retail - 5.5% cap rate
Miami Retail - 5.5% cap rate
Los Angeles Industrial - 5% cap rate
Seattle Industrial - 5.25% cap rate

Commercial real estate cap rates have historically trended in the 7% to 15% range with 10% being the historical average for property. Sit back and buckle up because I saved the main event for last. Let's look at the return investors are willing to receive in order to purchase apartments in select cities today:

Baltimore  - 3.8% cap rate
Washington DC - 3.8% cap rate
New York City - 3.5% cap rate
San Diego - 3.75% cap rate
Seattle - 3.75% cap rate
Boston - 4% cap rate

These numbers are staggering. The average cap rate for class A stabilized multifamily housing across the country is 4.6% in urban locations and 5.2% in suburban locations. In many areas, the price of apartments is now greater than it was during the peak of the mania in 2007 and surging higher at a relentless rate.

Let's run through a simple walk through that takes this conversation one step beyond where we went during the in depth 2012 commercial real estate outlook. Lenders look at a tremendous amount of information before deciding whether or not to provide a loan but one of the most important is something called the Debt Coverage Ratio. In simple terms, this means how much cash flow a property generates after all expenses are paid (including the mortgage costs)

Let's say that an investor purchases a class A apartment building in Boston for $30 million. He determined this price using the current market cap rate of 4%.

$2,200,000 (Annual Income)
-$1,000,000 (Annual Expenses)
$1,200,000 (Net Operating Income)

$1,200,000 (NOI) / .04 (cap rate) =$30,000,000 purchase price 

This investor has the ability to finance the property with a 4% interest only loan at today's incredibly low rates. He puts down 20% to purchase the building ($6,000,000), meaning that he will finance the remaining $24,000,000.

$24,000,000 * .04 (interest) = $960,000 annual debt service

This allows us now to see his full annual cash flow.

$1,200,000 (NOI)
-$960,000 (debt service)
$240,000 cash flow 

This also provides him a healthy Debt Service Coverage ratio of 1.25

$1,2000,000 (NOI) / $960,000 (Debt Service) = 1.25

Commercial real estate loans are given on 5 to 10 year terms. We'll say that the bank decided to finance this loan at 5 years. During that time he has done a pretty good job managing the property and the apartment market fundamentals continued to approve. We'll say that he was able to increase his total NOI by 10% bringing the total NOI to $1,320,000 annually. 

He heads back down to the bank to refinance and plans to pull out all the additional equity he added to the building with the increased NOI. He has dreams of buying a new house on the water and maybe a beautiful boat to go with it.

The bank congratulates him on managing the property well but tells him that unfortunately one thing has changed since he purchased his building 5 years ago: interest rates have risen above the 4% level. They are now up to 6% for commercial real estate loans. Just a small 2% rise can't be so bad, right? What does this mean for his refinancing?

For his $24,000,000 loan there is now $1,440,000 in debt service. This means that his $1,320,000 annual net operating income does not even cover the cost of the debt. He quickly understands that there will be no new home on the water and there is no new boat. He will have to pull $6,400,000 from his personal funds just to try and keep the building. If he does not have the funds then the property is gone. The 20% that he sunk into the building, and the 5 years of hard work managing the property have now led him to a potential bankruptcy.

Can you see now why the low interest rate and cap rate environment have created a temporary and artificial surge in the commercial real estate sector? Just as they did back in 2004 - 2007, investors always assume that cap rates and interest rates will continue to fall allowing them to unload the property onto the next buyer. 

When rates rise, the buyers today will be trapped inside these properties. The losses ultimately will once again fall on the lending institutions making the ridiculous loans at the current interest rates and prices.

We will now take the conversation global and look at how the ultimate resolution of the sovereign debt crisis will unfold: