LRG Capital Report by Larry Goldfarb

Is It Time To Get Back Into Real Estate?

Over the past decade or so, long term investors who have followed the herd, whether it was in high flying internet stocks, or more recently buying homes as an investment in hopes of turning a quick profit have been burned.  The massive amounts of liquidity and cheap rates initiated or overseen by the Federal Reserve fueled not one, but two bubbles, the likes of which have not been seen in generations.  Prudent asset managers were forced to compete with speculators boasting of impressive, yet short term returns.  As we all know now, the dramatic rise and fall of the residential real estate market threatened to take down not only the US financial system, but the global economy as a whole.  We will leave the question of whether or not the government’s response to this crisis was appropriate for another day.  The reality is that the government chose a course of action which includes massive amounts of printing and borrowing of money in an attempt to ease the stress on banks.

In simple terms, an investor can allocate resources to five different asset classes.  These include stocks, bonds, commodities, real estate, and currencies.  As the turmoil in the residential real estate market begins to subside, and the economy as a whole begins to digest the various stimulus packages provided by the government, investors should adjust their portfolios accordingly to benefit from and guard against oncoming inflation.  Despite the negativity surrounding the real estate market in general, we believe that attractive opportunities can be found in certain regional commercial real estate markets for the medium to long term investor.

The ability of real estate to provide a hedge against inflation is one of the primary arguments for including the asset class in a diversified portfolio.  Research on the question of the inflation hedging ability of real estate generally shows that when markets are experiencing equilibrium, the lack of rental space alternatives provides negotiating power for the landlord.  By contrast, during periods of high vacancy rates, the negotiating power transfers to the tenant who will have options available to move and/or lower rental expenses.  Thus, it is important that the investor consider what kind of companies and industries inhabit a given region and will be positioned well for turnaround growth.  For example, since the current downturn has centered on the financial community, major money center metropolitan areas such as New York City will most likely not benefit greatly from inflation unless a new industry quickly emerges to fill the void left by the financial companies who are forced to cut costs and downsize.  It is our view that regions which are not heavily concentrated in finance should only see a temporary weakening of rental demand as the economy works its way through the recession and recovers more quickly.  With a long term view in mind, we believe that the 2009 inflation rate will remain moderate at best while beginning to pick up steam in the latter half of 2010 at which point the Federal Reserve will have a tough decision to make around raising interest rates.  We do not believe that the Fed will be able to raise interest rates in 2010, even with higher inflation, due to fear of damaging the recovery and causing a double dip recession or worse.  Therefore, the next 12-18 month period should provide an excellent window to find value in select commercial real estate markets.

Most analysts agree that technology companies, which spent the last 8 years cutting costs and raising cash due to the bubble burst of 2001, may be one of the strongest sectors to emerge from the current recession.  In addition to tech, well diversified regional economies with access to the global supply chain, including and especially commodity transportation and the global trade network, should stand to benefit from some of the strongest growth as the economy begins to improve.  Finally, regional economies with a high concentration of small business entrepreneurs and professional services should also perform well in a growth scenario.   We are beginning to see parallels between the commercial real estate market today and the values seen after the recession of the early 1990’s.  With interest rates at a 40-year low, massive fiscal spending by the federal government, and unemployment rates now beginning to stabilize we believe the time is right to invest in commercial real estate in well-positioned markets.  However, as value investors, we know that sometimes good prices can turn into outstanding prices with a little patience.  There is no substitute for doing the research and diligence necessary for making a good investment.  That definitely holds true in this market. 

Earlier this month, Paulson and Co., a hedge fund which made billions by correctly anticipating a crumbling housing market, said that it would buy $100 million in stock of commercial real estate services firm, CB Richard Ellis Group.  Additionally, the hedge fund company is in the early stages of raising “a couple of hundred million dollars” for a fund focused on a medium- term property recovery.  The smart money has always known to enter the marketplace when fear is at its highest.  By including commercial with residential real estate, the financial media and misinformed analysts and investors have created an artificially high risk premium for commercial properties.  The big difference that many people aren’t recognizing between commercial and residential real estate is that the hype and annual median price increases seen on the residential side were not seen in commercial real estate.  After almost two years now of monthly declines seen on the residential side, and some overheated markets such as Florida and Nevada falling as much as 40% from their peaks, we believe the downturn in housing has finally begun to stabilize.  And with major commercial operators such as General Growth Properties declaring bankruptcy, the supply of quality properties at good prices are plentiful.  Commercial property investors should not expect a straight ride up, but we do think most of the risk of investing in commercial property is already in the price.  And there are good reasons to believe that today’s opportunity to invest at decent yields won’t last forever.   

If You Think Things are Getting Better, Think Again

With the market continuing to move higher in recent weeks, the onus lies squarely on the bulls now to produce evidence of an economic rebound in the coming months.  The powerful rally in global equities has forced the staunchest bears to take notice of, at the very least, rising asset prices and a thawing out of credit conditions.  Throughout this rally, the major theme we have heard from the bulls is that “the pace of the decline is slowing”.  But does a slower rate of decline necessarily warrant a near 40% move off the bottom for the S&P 500, one of the biggest moves in the history of the index?  Are we really starting to see “green shoots” in the economy like the media says and the government would like us to believe?  Unfortunately, due to the massive government intervention in the markets, asset prices may be improving, but the global and domestic economy are still very weak, and don’t look like they can improve anytime soon.  With the astronomical amount of money the Federal Reserve has thrown at the economy, it’s no surprise that asset prices have been moving higher in recent months.  The total amount spent by the government, in addition to all of the loan guarantees, 0% interest rates, and treasury purchases is in now the range of 5 to 6 trillion dollars   To put this into perspective, less than 8 years ago our entire national debt was 3 trillion dollars.  It is my strong view now, that sooner (rather than later) the markets, most likely the currency or bond market or a combination of both, will force the Treasury and Federal Reserve back into the same precarious position of making the tough choice they should have made almost a year and trillions of dollars ago, which was to just let the market work this mess out on its own, so the country and world can truly begin the process of rebuilding.  The unintended consequences of the actions the government has chosen to embark on are just now starting to show in our economy through the troubles seen at the regional banks, or the continued funding and pension crunch in the state and local governments, and of course the daily decline in the dollar that we are all getting used to now.   Not to mention the overwhelming evidence of a credit card implosion that can further derail economic recovery.  While we applaud President Obama’s new efforts on the credit card pandemic, no one wants to really open the Pandora’s Box of the staggering amount of principal credit card debt that will never be repaid.   In my opinion, while the markets may have improved, the improvement was mainly due to the money printing by the Federal Reserve and is not reflective of the real economy which is still very weak and struggling with mountains of debt at the household level.

For those who haven’t read my previous post which refers to a potential currency crisis at home and abroad, please do so.  Already at the time of this writing, Standard and Poors is warning that the United Kingdom may lose its AAA credit rating and rumors abound that the US is next.  Immediately on these rumors, yields on US Treasury debt spiked higher to prices we haven’t seen in almost 6 months.  This is in the face of Mr. Bernanke’s continued bond purchase plan in an attempt to keep rates low.  The cat is now out of the bag.  The entire world knows now that the US and UK will do whatever it takes to save already insolvent banks, including and especially devaluing the currency.  Readers of the LRG Capital Report knew the time would come where US debt would come under pressure but that day has come quicker than anyone has expected.  We are now pushing our forecast for an outright currency crisis to sometime this fall or winter as the world begins to slow its purchases of US Dollar denominated assets that are losing money due to a declining currency.  We would caution investors who believe, like our friends at the Fed and Treasury, that a devalued currency would increase exports and stoke just the right amount of inflation.  The truth is that throughout history governments have NEVER been successful at what the Fed is attempting (reinflate a bubble without causing high inflation in other areas of the economy).  In fact, now the odds are more in favor of higher prices for food and energy and interest rates.  The cross currents the market has shown recently have been extremely negative.  The normal movements we have been used to since 2001, (or about the time the dollar began its secular decline) was on days the dollar falls, stocks would move higher due to higher commodity prices and in turn more profitable energy sector.  Over the past week or so however, we have seen the dollar decline, but at the same time commodity and US stocks falling.  This has mainly been due to the rumors that the US will lose its AAA credit rating (due to excessive debt and money printing by the government) which in turn would make it more difficult for everyone, government and private sector included, to borrow at favorable terms.  I want to personally congratulate Mr. Bernanke for potentially ruining the dollar, and now bonds, and thus the equity markets to save Wall Street. 

As far as the real economy is concerned, we must now wait and see just what kind of recovery we should expect.  We have been told by the Federal Reserve and Treasury that we should not expect to see jobs come back any time soon.  A recovery without jobs is like a birthday party with no cake.  The truth is that over the past year or so it has been the state and local governments that have done most of the new hiring.  Now, as Californians know all too well, some states are facing huge deficits and some face cash shortages.  After delaying state refund checks earlier this year, the Golden State is on the verge of running out of cash again as early as July.   With the resounding defeat of Props 1A and 1E, voters essentially told lawmakers that its time for them to finally take responsibility for their budget and stop the tax increases.  The idea of raising taxes or borrowing more money only to delay the inevitable is complete lunacy.  Three areas where the state needs to address its problems are the overpromises on pensions, union wages and a bloated budget.  The day of reckoning for decades of wasteful spending has arrived for California as well as other state and local governments across the US.  Until these structural problems are addressed by legislators, we are only delaying a worse outcome down the road.

Finally, the free markets seem to be working with respect to the Chrysler bankruptcy and inevitable General Motors bankruptcy.  Maybe the real green shoots are that the bankruptcies of Chrysler and GM (as they are bankrupt) are now showing what markets are supposed to do: stop rewarding failure so smart and productive industries, whatever they may be, can successfully compete on any level.  I applaud the Obama administration, along with the executives and counsel at Chrysler who are moving at warp speed to complete the Chrysler bankruptcy.  It’s hard to imagine that a company with the size and reach of Chrysler could complete a bankruptcy filing within 30 days, but they seem to be pulling it off.  Bankruptcy has always been the best course for both Chrysler and GM.  This will allow the companies to truly restructure labor contracts that don’t make sense and in GM’s case, may even allow it to possibly survive as a functional company.  Without bankruptcy, it will just be the same old, same old and we the taxpayers will be forced to continually fund the company’s shortfalls.