Archive for the ‘Finance’ Category
Economic outlook — fundamentals and shocks
I love boating, I really do. To quote from Grahame’s famous The Wind in the Willow, “…there is NOTHING–absolute nothing–half so much worth doing as simply messing about in boats.” However, any experienced sailor has had one of those days when the water was perfect, the wind was with you, but off on the horizon a storm cloud lurked. “Will it head our way, or pass us by?” is the key to whether the fun cruise continues or not.
Today, and for the next few weeks, the economy is like that. The wind is definitely at our backs, and things are generally looking up. That having been said, the fiscal cliff continues to loom on the not-too-distant horizon.
First, the good news, and there’s plenty of it. I’m on the Board of an investment fund (and in fact just got named chairman of the board this month, for a two-year stint). We had a great briefing yesterday from our lead fund manager, and macroeconomic news was as good as I’ve seen it in a while. Corporate profits are at near-record levels as a percentage of GDP, and non-financial interest expense as a percentage of profits is at a near-record low. Lending is back up, although corporate lending isn’t quite as robust as consumer lending, and current stock market price-earnings ratios (measured on a 12-month trailing basis) are at levels usually associated with strong intermediate-term (5-year) market returns. Equity risk premia tell the same story.
On the real estate side, everyone’s seen the news that the S&P Case Shiller index is trending back up, and this morning’s news report puts current housing starts above an 800,000 annualized level (note that we’re hoping for a million, and at the trough of the recession we were at a record low 300,000-ish). Manufacturing has added about a half-million jobs since the trough of the recession (early 2010), and is about 300,000 above where it stood in July, 2009.
The implications for real estate investment are clear, and as I reported earlier this week, the total return on U.S. REITs has exceeded 30% in the past year, besting the S&P 500.
With that in mind, though, the fiscal cliff continues to trouble us all. If you’re not familiar, on January 1, the Bush Tax Cuts will expire and mandated federal spending cuts are scheduled. Together, these two will hit the economy to the tune of about 4% of GDP (yes, driving us into a second recession). Sadly, the solution is political, and this is all coming at a time when Congress and the White House are totally focused on the impending election.
We’ll keep you posted, and we’re preparing some private white papers on this subject for our clients as the season moves forward.
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REITs — good news trumps “iffy” news
The “headline” in Erika Morphy’s piece in GlobeSt.Com this morning was that was that REITs underperformed the S&P 500 for August and September. Specifically, REITs were up 1.85% in the 3rd quarter this year, compared to 6.35% for the S&P 500. You have to dig a little deeper to get to the heart of the matter, though.
First, let’s remember that investors by-and-large buy REITs as an income vehicle with equity up-side. The current average REIT yield is 3.88% — not bad, compared to corporate bonds or preferred stocks, and more targeted income seekers can go after single tenant retail with a yield of 5.9%. (For a great review of this, see a piece by Brad Thomas in Forbes.com from September 10). Couple those sorts of dividend yields with any upside equity potential, and you have a real investment powerhouse in today’s market. For comparison, the current yield on the S&P 500 is 1.97%.
But, the news gets better. For the 12-months ending September 30, the NAREIT index was up 33.81%, compared to 30.2% for the S&P. Do the math — the total return for a portfolio of REIT shares for the past year would have been (33.81% + 3.88% = ) 37.69%. The total yield for the S&P 500 would have been (30.2% + 1.97% = ) 32.17%. Thus, slightly more than a 500 basis point return advantage to REITs.
Of course, (and this goes without saying), past performance doesn’t translate into future returns…..
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Rays of sunshine
Fall isn’t usually the time we talk about rays of sunshine, particularly not here in Seattle where we all “hunker down” this time of year for the long, dark, wet winter. Plus, I just came back from three weeks on the road (nine hotels, 4 time zones, two rental cars with a combined 2,000 miles, and four plane flights). One of the first things to hit my in-box was the periodic Real Estate Investment SmartBrief from the National Association of Real Estate Investment Trusts with the headline “Hopes for U.S. Rebound Fade as Global Trade Slips”. Sigh….. not a really nice headline, eh?
Now, I have the greatest respect for NAREIT, and out of fairness, they lifted this story from the Wall Street Journal. Nonetheless, when the market opened this morning, it actually darted into positive territory, with the S&P hovering above 1450 as I write this. (I hope I don’t jinx it!). Of course, the stock market has risen for the past three Octobers, and in fact the market had a significant rally in September — a rarity for a month that’s usually fairly flat — with the S&P gaining almost 3% and the Dow picking up about 2% during the month. The “rally” this morning was triggered by two things. First, the ISM report (Institute for Supply Management) came out in positive territory for the first time in four months, confounding analysts who thought it was continuing downward. Second, this caused the short-sellers, who have banking on a negative October, to re-think their positions. Hence, the really great bounce this morning was, in no small part, a lot of short-covering.
No question about it — a shrinkage in global trade is an unsettling thing, for three big reasons. First, it signals that the net importer regions (particularly Europe) are continuing in the doldrums. Second, healthy economies which are heavily trade based (such as the U.S.) depend on trade to stimulate GDP growth. Finally, China is the world’s biggest manufacturing floor right now, and depends on trade to provide full-employment — nothing frightens Chinese officials more than unhappy workers with no jobs. Thus, from both an economic perspective as well as a geopolitical perspective, a shrinkage in trade — or even a shrinkage in the growth of trade — is a bad thing.
Notably, also, while manufacturing is only 20% of the U.S. economy, it is 40% of the profits of the S&P 500. Pundits are already noting that the ISM report is just one data point, but it’s a very important one. In the next few days, we’ll see if the good news from ISM is sustained by other sectors of the economy.
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REIT Research — Real Estate in Volatile Times
The National Association of Real Estate Investment Trusts (NAREIT) recently commissioned Morningstar to study the role of securitized real estate in the well-balanced portfolio, with a particular eye to the investor attitudes regarding risk, as well as the actual performance of markets. Both of these two concepts — risk and investor attitudes — are less well understood than researchers seem to think. In the first, market models assume a degree of normalcy in the distribution of market returns. However, empirical evidence seems to contradict this, and in fact market volatility is significantly greater (and of greater magnitude) than models would predict.
In the second case — investor attitudes — traditional models suggest that rational investors react to “up” markets in the same way as “down” markets. More recent behavioral models recognize the fallacy in this — rational investors relish “up” volatility, but loathe down markets.
The results of the research were published in an excellent new research piece from NAREIT titled “The Role of Real Estate in Weathering the Storm” (click on the title for a copy of the paper). Some high-points from the study:
- Since 1929, the S&P 500 has had 10 months with declines of 15.74% or more — which is eight more than would be predicted by a normal distribution.
- Recent studies by James Xiong of Ibbotson Research show that the log-normal distribution fails to account for this down-side volatility.
- From 2000 – 2009 (often called the “lost decade”), the cumulative return on large-cap stocks was negative 0.95%.
Morningstar then crafted portfolios under the “theoretical” model (normal distribution) versus a more realistic model of volatility, with alternative structures for risk-averse investors and more risk-tolerant investors. Investment returns were measured over the period 1990 – 2009, which notably included the recent market melt-down.
Under normal distribution assumptions, an optimum risk-averse portfolio would allocate about 6% to securitized real estate and theoretically enjoy a return of 7.6%. Under more realistic volatility assumptions, the risk-averse portfolio would allocate 14% to securitized real estate and would have returned 8.2%.
A more risk-tolerant investor would have allocated 18% to 20% in securitized real estate, and would have enjoyed a return of 9.7%, with volatility (standard deviation of portfolio returns) of 10%.
The most striking finding of the study was the consistent role played by securitized real estate in all four of the models (normal versus non-normal, risk-averse versus risk-tolerant) and particularly thru the market melt-down. While this may seem counter-intuitive, given the roller-coaster ride of REIT prices, investors need to realize that REIT shares paid relatively high dividends through this period, thus ameliorating the downward price movements. In short, the gains from real estate holdings pre-meltdown, coupled with the dividends, more than made up for the price bounce over the past few years. Further, REIT prices have rebounded better post-recession than have other S&P shares.
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Sustainability — Follow the Money
Sustainability seems to be the real estate buzz word du jour. A “google” of “sustainable real estate” brings me slightly over 56 million hits. Number two on the list is the Journal of Sustainable Real Estate, (a more-or-less joint presentation of the American Real Estate Society and CoStar) of which I’m apparently on the editorial committee. Go figure.
I don’t want to sound too cynical here, but as a “finance guy” in the real estate field, I tend to follow the money. A lot of what’s going on in real estate, particularly at the individual building-level, has a lot to do with sustainable energy (e.g. — LEED Certification, Energy Star) or sustainable architecture. There was a nice paper out of Clemson University by David Heuber and Elaine Worzala recently on sustainable golf course development (click here for a link) which begins with the irony that no one is building golf courses today. Scott Muldavin has a great book on underwriting and evaluation sustainable financing (reviewed here) which gets close to the heart of the matter.
However, Ben Johnson, writing for the current issue of Real Estate Forum, seems to have caught the scent, to use a hunting dog analogy. In his article, “When CalPERS Talks, People Listen”, he notes that this mega-pension fund n($228 billion) has about 8% of its total invested in real estate. (My own estimate is a bit higher and more current than that — see here for details.) The noteworthy thing, however, is that CalPERS just made a $100 million stake in Bentall Kennedy outt of Toronto. B-K is one of North America’s largest real estate investment advisors, resulting from the 2010 merger of the Canadian firm Bentall with Seattle’s own Kennedy Associates.
Two things make this all very interesting. First, B-K earned the top spot this year on the Global Real Estate Sustainability Benchmark Foundation’s ranking of fund managers in the Americas. This ranking, covering 340 of the world’s largest funds, measures social and environmental performance. (Given B-K’s Pacific Northwest and Canadian pedegrees, this doesn’t surprise me at all.)
Second — and this may be the biggie — as CalPERS goes, so goes the industry. The focus of Mr. Johnson’s article was to note that now every pension fund in the known universe will need to consider using an advisor like B-K. Johnson notes that this deal “gives the largest public institutional player in the US a deeper investment in understanding real estate as an asset class and a unique insider’s view of the industry’s dynamics.” More interestingly, I would posit, it puts a leader in sustainable real estate front-and-center in the view of the sorts of pension managers who, until now, have very little cross-pollination with the real estate industry. In short, as institutions look to find good real estate partners, sustainability will be a key element of consideration.
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The right number of new homes?
Much has been said in recent days about the Census Bureau’s August 23rd announcement about new residential home sales in July. To summarize, 372,000 new homes were sold last month, which is 25.3% above the July, 2011. This is good news for a lot of reasons — construction workers get jobs, banks get new loans, etc., etc.
Naturally, it begs the question, “what’s the right number of homes?”. Here at Greenfield, we’ve posited that the U.S. housing price “bubble” was really a demand bubble, fueled by easy money, which led to an artificial inflation of the nation’s home ownership rate. (Housing bubbles in other countries were fueled by similar problems.) We’ve also suggested that the market won’t get healthy again until several things happen, including a stabilization of the homeownership rate at long-term equilibrium levels, a restoration of “normal” conventional lending (both for home mortgages as well as for development financing) and a restoration of the housing infrastructure (development lots in the pipeline, local regulatory department staffing, hiring & training skilled construction workers, etc.) . It is highly doubtful that we’ll see housing starts and new home sales “bounce back” to normal levels anytime soon, and our own projections suggest several years before we get back to “normal”.
But this begs the question: What’s normal? (A great t-shirt from the Broadway play, “Adams Family” simply said, “Define Normal”.) Anyway, as new home sales go, it’s helpful to glance at the experience over time. It may surprise you.
One might actually expect the graph to be less erratic, but there are good explanations for the “bobbing and weaving” you see from year to year. During recessions, new home sales decline, and then bounce-back afterwards. During periods of economic overheating, the FED tightens the money supply, thus causing home starts/sales to decline. (In practice, this is a major tool in the FED’s toolkit, simply because it has a great multiplier effect on the economy.) Of course, the bubble is quite apparent, and following it the inevitable decline.
With all that in mind, though, we can see that there is a decided upward trend in the chart — that makes sense, since a growing population, coupled with a fairly consistent homeownership rate, will generally demand more new homes each year than it did the year before.
The second graphic adds a simple linear trend line for simplicity sake, which is not far removed from the actual household formation trend line during that same period. Note that from the beginning of the chart until about 2001, we had a nice cycle going, and in fact around 2001, the blue line should have turned negative to account for the recessionary impacts. However, money got very loose during the early part of the last decade, and rather than housing starts serving its normal “pressure relief” role, it was driven into a counter-cyclical path. This created the oversupply we are now trying to work through (often referred to as the “shadow inventory”) and we won’t see a healthy market until this inventory is mopped up.
Good news, though — if you glance quickly at the second chart, it becomes clear — albeit from a very simple visual perspective — that we must be close to a spot where an up-turn in the chart would give us as much negative area red line as we had during the previous cycle above the red line. In short, we’re not at the end of the tunnel yet, but this simple way of looking at things suggests we may be able to SEE the end of the tunnel in the not-too-distant future.
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REIT Fundraising on the Rise
According to SNL Financial, U.S. Equity REITs have raised $35.27 Billion through August 10th, over 10% more than was raised during the similar period last year. Continuing with the debt/equity theme we noted in a recent post, senior debt only constituted about 38% of this total ($13.53 B) with the remainder coming from common equity ($14.72 B) and preferred equity ($7.02 B).
Interestingly enough, Health Care REIT had the largest stock offering at $810.8 million, followed by Kilroy at $230.5 million and Taubman Centers at $281.5. All three of these are notable, as none of them are in the “hot” apartment sector. Indeed, of all of the sectors, health care raised the most at $7.7 Billion, followed by retail at $7.61 B.
The bigger question, of course, is what does this say about the real estate market? REITs buy cash flow, not capital growth, and respond to investor demand for something to take the place of flat-lined bonds. Given the risk of holding long-term bonds in an up-ticking interest rate market, compared to the yield margin and inflation hedge of REITs, this may be less a commentary on the quality of the property market and more a comment on the demand for REIT shares.
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REIT Valuations — Looking Forward
We’re still picking thru the immense amount of information that came out of REIT week back in June. Paul Whyte, a managing director at Credit Suisse in charge of their investment banking sector, is looking for “continued growth in valuations and operating income in the commercial real estate industry during the second half of 2012,: according to an article posted by REIT.com writer Matt Bechard last week.
Whyte says investors will continue the “flight to quality” in terms targeting trophy assets, noting that “In uncertain times, capital tends to go where they see long-term opportunity.” Whyte singled out two sectors, retail and data centers, for particular attention. In the retail arena, investors appear to be looking for higher-quality class-A mall properties rather than suburban investments. He suggested that data centers are “intriguing,” and that with continued movement to cloud computing and social media, “there’s just enormous demand there.”
Reflecting our own sentiments here at Greenfield, Whyte has deep concerns about property investments in the Eurozone. “I think that what Europe lacks is a comprehensive, long-range plan for fiscal unity,” Whyte said. “Without it, we’re just really putting Band-Aids on the patient.” He also noted, “From a headline perspective, Europe is influencing the markets more so than I think anybody had ever imagined,” he said.
As for the U.S., he concurs that we are in a recovery mode, and projects investment interest in energy, health care and technology sectors.
REITWeek was held June 12 – 14 at the New York Hilton. It is the annual investor forum sponsored by the National Association of Real Estate Investment Trusts.
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Appraisal Institute meeting in San Diego
I had the pleasure of being invited to speak at the Appraisal Institute’s annual meeting in San Diego last week, which brought together many of the top minds in the valuation field for three days of seminars and business meetings. While AI is fairly small (only about 23,000 members globally), its influence in the real estate field cannot be understated. In the U.S., appraisal license law and standards (the Uniform Standards of Professional Appraisal Practice, commonly known as USPAP) owe their genesis to work done by AI back in the 1980’s during the Savings and Loan Crisis, and possession of an AI designation (either MAI or SRA) is frequently cited in real estate contracts as required for establishing lease renewal rates or other contractual matters. Courts throughout the land routinely accept testimony from AI members without question. Real estate regulatory bodies throughout the U.S. are populated by AI members, and rare is the state legislature that will make changes to real estate law without the consultation of AI members. The AI’s government affairs team in D.C. has influence throughout the real estate arena, which of course today transcends traditional boundaries and includes regulatory efforts of the GAO and SEC, among others.
I was asked asked to deliver an address on advanced statistical methods. I’ll leave that discussion for another day, and focus on what I learned there — which was significant — rather than what I said. Other sessions dealt with meaty topics like the attorney/appraiser interface and the complexity of real estate valuation in the financial reporting arena. Not unexpectedly, there was a tremendous amount of attention paid to technology, which is really leading to an interface between “automated valuation model”-type tools and the individual appraiser. In short, we may be very close to a day, thanks to technology, when the individual home appraiser is tapping into a more robust set of analytical tools in order to produce collateral valuations with strong statistical support. Anyone who has been following the mortgage meltdown news for the past few years will understand the significance.
The keynote speaker was Dylan Taylor, CEO/USA of Colliers International. He riffed off of the title of the book “The Earth is Flat”, and talked about barriers to globalization in the real estate biz which he called “rounders”. The two principle ones for our field are regulatory barriers (licensure problems, even across 50 states, much less across countries) and capital needed to grow businesses (technology, etc.) He notes that in most professions, there is a tipping point to consolidation, and uses CPA firms as examples. The total billings of U.S. CPA firms last year was about $120 Billion, and the big 4 accounted for $80 Billion of that. The need for technology, increased specialization, etc., will probably stimulate that in appraisal firms (which currently have world-wide billings on the order of $3 Billion, but the top few only account for a small fraction of that). He says that in the future, there will be a handful of very large appraisal firms plus “boutiques”. In his view, the boutiques will do quite nicely, but the middle-market appraisal firms will die on the vine.
Taylor notes that USPAP will be generally moving toward International Valuation Standards (“IVS”) in the same way Generally Accepted Accounting Practice (“GAAP”) is moving toward International Financial Reporting Standards (“IFRS”). The latter sets of standards provide much more “client defined” reporting standards. He notes, for example, that several aspects of IFRS will cause “disruptive change” in American real estate, such as the way the two different paradigms treat carried interest.
As noted, a separate session dealt with the interface between appraisal and financial reporting. Earlier this year, the SEC “kicked the can” toward 2013 for U.S. adoption of IFRS. It was noted that while 90% of GAAP and IFRS are functionally identical, the changes needed to adopt the remaining standards could be so costly and disruptive as to dwarf the problems following adoption of Sarbanes-Oxley. Nonetheless, some movement in that direction is inevitable. From a real estate perspective, this may include the elimination of depreciation for financial reporting, substituting annual “mark-to-market” valuations instead. That is a very different paradigm for property valuation in the U.S.
Other sessions included a presentation from the FDIC’s General Counsel’s office, a presentation on standards and practices for Federal land acquisition, and a VERY informative presentation on “getting published”.
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REIS reports on the office market
Got an early peek this morning at the forthcoming office market report from ReisReports. Like everything else in the economy today (except apartments), the operative word is “sluggish”. Indeed, even in the bullish apartment market, the core driver is the sluggish economy turning “owners” into “renters”.
On the surface, the facts aren’t all that bad. Office vacancy rates topped out above 17.5% in mid-2010, and have been on a slow trend downward. However, for the last two quarters, the rate has stalled at 17.2%. Quarterly absorptions have been in positive territory since early 2011, totalling about 4 millions square feet nationally in the 2nd quarter 2012, even in the face of the lowest office completions level since REIS began tracking data in 1999. Rents remain at 2007 levels, with 0.3% gains in both asking and effective averages.
The reasons are obvious — continued fears from Europe (which may be abating, given very recent pronouncements from European central bankers), the close presidential election, and the very real fear of of the “fiscal cliff” in early 2013 contribute to an anemic jobs recovery. Without new jobs, there is no demand for office space. You do the math.
In most American cities, the stark reality on the skyline is the absence of high-rise cranes. Given the very long pipeline for office construction, coupled with the difficulty financing in this sector, and it may be many years before we see this market turn fully around.
From a small northwestern observatory... 