Fearful forecasting - Posted by ray@lcorn
Posted by ray@lcorn on September 04, 2003 at 12:41:34:
There are opportunities in every market. Just depends on which side of the trading you are on. The trick is to see it coming and get ahead of the crowd.
Before I make any lofty forecasts, let me remind everyone of the old adage… “economists have predicted nine of the last five recessions.”
I’m not an economist, and my crystal ball is as murky as they come. I got my ears pinned back about six weeks ago along with the rest of the world with the sudden move in long term bonds. The Wall Street Journal ran an article about the turnabout in prices, and led with the line, “Never have so many, been so wrong, about so much.” Count me among the wrong.
For the near term, meaning the next year or so, I subscribe to the “Muddle Through” theory of writer and money-manager John Maudlin. You can read his entire mid-year review and forecast on his website at http://www.2000wave.com/article.asp?id=mwo070403
It’s a long article, but it is full of insights that I have not seen pulled together into a coherent whole anywhere else.
Employment does have a direct effect on real estate values. But as a predictor, employment levels are actually a lagging indicator in a recovering economy. Companies do not start hiring until they are certain of firm footing.
Preventing that at present are two significant factors, capacity utilization and continued productivity gains. The former, capacity utilization, remains below an anemic 75%, and until that excess capacity can be put to use there is no demand to add additional capacity, hence less capital investment and lower employment levels.
The latter point of the effect of productivity gains is one that Maudlin makes so well. Productivity gains in the US continue to average 2.25% per year. The labor force grows by about 1% per year. Those two numbers add up to the growth it takes in the GDP to stop losing jobs. Therefore, until the economy builds significant steam, i.e. above 3.25% GDP growth, then we’re treading water. From the reports I monitor it seems likely that GDP growth will be between below the optimists at GAO, but above the doomsayers at the forex desks. Maybe 2%-3% for the year. If so, and long term rates stay low to protect the housing market, then we will continue to muddle through the period needed to rebalance production and demand.
But, that assumes nothing untoward happens… anyone making any prediction nowdays must add the caveat of “event shock.” That refers to the effect of another terrorist or other major event that no one can predict the outcome for.
For the real estate business, the most immediate threat comes from instability in the capital markets, hence my eye is on the turmoil surrounding Fannie and Fred. They are the twin 800lb gorillas, with over a trillion dollars in securities between them. Many think they are too big to fail. My fear is that if their elaborate, derivative-based hedging structure begins to unravel, they may be too big to save.
But even then, real estate is market driven, and specifically by local markets. There has never been a time when it is more important to understand the dynamics of the local economy around your real estate. There are some broad trends, but as with using any average, when you see the number remember that 50% of the people you know are below average.
In my area I’m seeing asking prices begin to soften a little across the board, even to NNN retail which has been the stalwart of value through the last two years. I’ve got my eye on a couple of deals, and am anticipating that the sellers market we’ve been in is about to turn. I will acquire when it is most advantageous for me to do so.
However I do not think this is a time to be highly leveraged. Greenspan said it well last week… “Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape.” No one can model uncertainty.
I take that to mean I had better realize that no prediction of future results in an investment should be counted as certain based on past performance, Therefore I need to price the uncertainty into the deal… that means higher entry cap rates, higher debt coverage ratios, and the resulting lower levels of leverage.
Bottom line, its back to doing deals based on fundamentals. That means valuations based on actual operations and local market conditions, and with financing at conservative cash flow levels. You might say it is “buy based on worst-case assumptions from present operations, structure financing for the muddle through scenario, and design the exit plan for either case.” If the deal makes sense with those assumptions, then it is one worth pursuing.