Comments from Dealmakers

Last week I spent three days in La Jolla, CA at Institutional Real Estate, Inc.’s Dealmakers Summit. I was impressed by the number of very high-level speakers and I think everyone can benefit from what they said. Believing such, I am going to attempt to regurgitate some of what I heard along with my own comments and opinions.

I will post my comments in the following segments: (1) General Economic Outlook, (2) State of Real Estate and Outlook, (3) Deal Flow, (4) Debt Outlook, (5) Equity Outlook, and (6) Recommendations on What To Do Next.

Economic Outlook

The overarching message of the conference was that “we are still in a period of macro uncertainty; we are deep in uncharted territory.” Recovery really can’t take place until that clears up. There is sentiment that this is not a sustainable recovery, but rather more of a fragile recovery. Although we are beyond the ‘scary period’, as many called it, there is no market-clearing mechanism as there was in previous recoveries. It seems likely that we will have to work our way out of this one.

Interestingly, there was almost no ‘safe harbor’ in this crash (exception: treasuries earned +/- 15% over the last year). All asset classes seem to be correlated right now. However, markets will decouple and some will recover faster than others. Real estate is not predicted to be a leading indicator.

Going into ‘defense mode’ may have been a large factor in causing the problems, but optimism alone will likely not get us out. Reality is, the credit pullback caused very real problems that can’t be fixed with capital or optimism alone.

A key discussion point for speakers and among participations was the shape of recovery. Will it be a V, Square Root, W, or broken-W (where the second part of the W is a long, slow recovery)?

There was a significant consensus that a sharp recovery is overly optimistic, but this was a crowd of real estate people who are facing declining market fundamentals for the next several quarters. Reading economists outside the industry paints an even muddier picture. As a result, I still have no idea although I tend to fall into the broken-W camp, given that a large percentage of my inner circle are still ‘kicking the can down the road’ and the worst is yet to come. In my opinion, calling it a recovery now is overly optimistic.

Interestingly, one economist calculated the statistical probably of the type of breakdown we recently experienced: 1 in every 20,000 years. So the bright spot is we don’t expect it to happen again any time soon.

One of the speakers pontificated that a big part of the bubble was caused by “too many people managing other people’s money that don’t care.” I tend to agree. The syndicated loan market for commercial real estate loans as well as the lack of fiduciary duty at Fanny / Freddie flushed the markets with irresponsible capital. Of major concern, is that rather than cleaning up FNMA and FHLMC, the government has blessed them and given them mounds of fresh capital. This may lead to prolonging of the recession or a return to financial crisis.

Notwithstanding this recession, the US economy is and has been in a long period of erosion. Other countries will gain ground, both because of their growth and because of our erosion. This isn’t necessarily horrible news, but to the extent we continue to live beyond our means, as individual households and as a country, we will suffer increasingly harsh consequences.

Of particular concern to me was learning that some very savvy and highly respected participants were bearish on financial institutions, to the point of shorting financial stocks. If they are correct, economic recovery will likely resemble the ‘broken W’ model.

Banking System

One speaker reported that the banking systems’ stress is gone, as evidenced by LIBOR rates. The three-month LIBOR that spiked last fall in an unprecedented run up, is now back down around 0.3% (wow, that’s low). Also, the 30-year fixed mortgage rate spread over treasuries has tightened which further indicates reduced systemic stress. Short rates will go higher soon; there is no consensus, however, as to when.

Banks need to ‘earn’ their way out of balance sheet problems. It appears there is a large discrepancy among banks’ ability to earn out of stress. Some may be able to do it in 12-24 months, many will take longer. Those banks that take longer may see the current environment for ‘easy’ earnings dry up, exacerbating their problems.

Consensus among bankers attending the conference was that banks are dealing with their residential inventory, but they are still in workout mode on their commercial portfolios. This may indicate that some banks have not yet come to grips with the state of their commercial loans. Some participants I talked to were of the opinion that the decision to loosen FAS 157 (mark-to-market) has only prolonged the problem.

Recovery

“Capitalism without failure is like Christianity without hell.” – I can’t remember who said it, but it is worth repeating.

Again, the key questions on recovery are when will it happen and what will it look like? Economists at the conference were divided between the broken-W and the square root-symbol models. There was hopefulness that we may have a recovery based on optimism alone, however, it is most likely that this recovery will take real, hard work.

There was consensus, however, that a financial crisis is the hardest to recover from.

A considerable bright spot is the fact that there is still a significant amount of capital on the sidelines. Which, if you buy Dr. Mark Dotzour’s * ‘spotlight’ theory of capital, we know at least one or two sectors will get ‘burned up’ by the spotlight soon. We will probably look back and say treasuries are the benefactors of that right now. I am not convinced that the return of capital will signal true recovery, but in many sectors it will definitely help.

According to one presenter, in the coming decade, the stock market is projected to have a real return of +/- 8%, which is not necessarily compelling. Add to that the fact that Bond values will likely drop as rates rise, and that stocks are being heavily scrutinized then real estate may be seen as an attractive asset class.

Here are some key components to consider: inflation on the horizon plus deteriorating fundamentals, equals low prosperity for a long period of time. Be prepared for 4-plus years of little to no job growth, and thus low demand for commercial real estate over that time.

Summary

The worst appears to be over, but the future is unclear at best. It will undoubtedly be several quarters before we see fundamental growth in commercial real estate.

* Dr. Mark Dotzour, Chief Economist, Texas A&M. HE was not at the conference, but because of his dual understanding of real estate and economics, he is worth following closely.