The “American Realist” Says: Past as Prologue – Re-blown Bubble to Pop Before the Previous Bubble Finishes Popping!!!!

Note: This is a very long post, and would have been longer if I didn’t decide to break it up into pieces. I am presenting plenty of background material in it that regular readers have probably seen before because the subject matter is so pertinent to asset values both today, and tomorrow. I suggest those with interest in the real estate and/or banking arena read it in its entirety. The latter portion of the post is all new material that leads into valuations of real CRE properties that are currently on the market and ties in seemingly unrelated issues such Portugal’s bailout and Greece’s inevitable restructuring.

Last night, I spent an interesting time with the esteemed and world reknown macro economist, entrepreneur, NYU professor and strategist, Dr. Nouriel Roubini. Nouriel is a very, very bright guy. He has to be, he agrees with many of my viewpoints . Dr. Roubini had a client reception at his downtown loft in NYC. It was a delightful affair, plenty of heavy thinkers, a bevy of beautiful women, engaging debate of things geopolitical, macro-economic and financial… and of course at least one trouble maker. That would be that tall handsome fella in the middle who had the nerve, after Roubini literally deadened the room with his proclamations of what could come in the case of China crash, European default or US hard landing, to actually burst out and say the esteemed economist was actually being TOO OPTIMISTIC!

Hmmm, and they have the nerve to call Roubini Dr. Doom. Don’t they know Dr. Doom wears a mask, a suit of armor, and is truly no joke?.

Well, I assume you can guess where my remarks took the topic of conversation on the floor. I had to put my two cents in regarding US housing, European sovereign insolvencies, and China – all of which I happen to pretty much agree with the Doctor on. After all, I told you he was smart. On a more serious note, I fear many may dismiss my viewpoints simply because they may have a bearish tinge to them. Trust me, I am not a pessimist. As a matter of fact, my actions throughout the first half of the first decade of the new millennium would have led many to believe that I was the ultimate real estate bull. Alas, it was not optimism, it was realism, just as what may appear to be pessimism now is nought but realism. To discount realism as pessimism, from a historical perspective, may not be wise. Every since 2006, my views on the asset and credit bubble bursting have been quite contrarian and thought of as pessimistic. All one had to do was fast-forward a year or two and realism easily replaces the term pessimism. Go to the 11:00 mark in this video from the Dutch Station/show VPRO Tegenlicht and listen for at least 45 seconds. It pretty much tells the tale…

As detailed in “Who is Reggie Middleton!!!”, my empirical approach allowed me to see the housing crash, CRE crash, collapse of GGP, Bear Stearns, Lehman, WaMu, Countrywide, municipal finances, regional banks, monoline insurers, the pan-European sovereign debt crisis as well as a whole host of other valuation faux pas, considerably ahead of sell side Wall Street, ratings agencies, most independent shops and the financial media. Hell, I’m quite bullish on mobile and distributed (cloud) computing as I type this, but I insist this bullishness come from realism, not optimism.

There is a lot to discuss that intersects with what was presented last night, but for now I’m going to focus on real estate in order to respond to a reader who emailed a question several weeks back. In my appearance on CNBC’s Fast Money over the winter, the fast moving short clip format proved less than conducive to the communication of the thick, fact heavy style of analysis that is common to BoomBustBlog, and yours truly. Nevertheless I am quite thankful for the opportunity to share my contrarian views in the mainstream media.

In the post that followed said appearance, Reggie Middleton ON CNBC’s Fast Money Discussing Hopium in Real Estate, I ran down what I perceived to be the major risks of real estate in the states today, and that is a departure from the fundamentals and bleak macro outlook. During the Q&A at Roubini’s crib, where I was actually guilty of accusing Nouriel of being too optimistic (I know, that’s probably a first – but if anyone were to do such it would probably end up being me), participants were suggesting in a rather optimistic fashion that if a hard landing or recessionary environment were to come it would presage a time to buy assets at value prices. Of course, that is assuming those assets that you got very cheap didn’t then proceed to get much cheaper. Nouriel replied exactly as I would have (and have in the past, particularly during my Keynote at the ING Valuation Conference in Amsterdam), and that was that it simply cannot taken as a given that assets prices will cyclically snap back in a year or even two. Now, I do have an investment strategy that I plan to pursue in regards to real estate, but it is quite different from what I see being bandied about today and over the last 8 years or so. To wit (as excerpted from the link directly above):

… It is the reporting company’s responsibility to report, not to obfuscate. The big problem with this “hide the market marks” thing is that markets tend to revert to mean. Unless said market values fundamentally catch up with said market prices, you will get a snapback. That is what is happening in residential real estate now. That is what happened in Japan over the last 21 years!!! That’s right, it wasn’t a lost decade in Japan, it was a lost 2.1 decades!

This has been the first balance sheet recession that the US has ever had, but there is precedence to follow. Japan had a balance sheet recession following their gigantic real asset bust. They made a slew of fiscal and policy errors, which essentially prolonged their real asset recession (now officially a depression) for T-W-E-N-T-Y O-N-E long years! For those that may have a problem reading that, it is 21 long years. What did the Japanese do wrong?

• They refused to mark assets to market
• They attempted to prop up zombie banks
• They failed to promptly clean up NPAs in the banking system
• They looked the other way in regards to real estate value shenanigans

I then attempted to present my perspective in a simple manner. You see, I look at real estate as simply a risk adjusted spread over the (“alleged”) risk free rate. It’s really as simple as that from a valuation perspective. Your two major variables are the delta in said rate (risk free or otherwise) and the delta in said spread. Alas, I digress, back to the article excerpts:

The retail investment banker Davidowitz had similar choice comments on this space: Davidowitz On Overt Optimism In The Retail Space And Mall REITs, Stuff Which We Have Detailed Often In The Past.

Listen up people, HERE ARE THE NASTY FACTS!!!

Real estate is a highly rate sensitive asset class. Capitalization rates (the popular method of pricing real estate) is explained in Wikipedia as:

Capitalization rate (or “cap rate”) is the ratio between the net operating income produced by an asset and its capital cost (the original price paid to buy the asset) or alternatively its current market value.^[1] The rate is calculated in a simple fashion as follows:

Without going into a CRE class, when interest rates go up, cap rates generally go up as well and the value (or cost to purchase) of the property goes down in sympathy unless the rise in interest rates is offset by a commensurate or greater rise in net operating income. Now, either everybody believes that unemployment is going to drop towards zero in an era of US austerity (reference Are the Effects of Unemployment About To Shoot Through the Roof? then see Budget Austerity: Goldman Sees Danger in US Budget Cuts – CNBC) at the same time that historically low interest rates that actually went negative are going to get lower (see the Pan-European Sovereign Debt Crisis) —- or cap rates are about to skyrocket. I’ll let you decide!

As you can see above, CRE drops in value whenever yields spike more than the + delta in NOI. Looking below, you can see that US CRE actually runs to the inverse of the 30 year Treasury.

That visual relationship is corroborated by running the statistical correlations…

The relationship is obvious and evident! In addition, we have been in a Goldilocks fantasy land for both interest rates and CRE for about 30 years. CRE culminated in the 2007 bubble pop, but was reblown by .gov policies and machinations. The same with rates. Ever hear of NEGATIVE interest rates where YOU have to PAY someone to LEND THEM MONEY!!!

So, BoomBustBloggers, where do YOU think rates are going to go from here? Up of Down??? Let’s ask Portugal or any of the other PIIGS group. I have shown, very meticulously, how Portugal can not only afford the path that they are on (record high interest rates) but the losses that will come when they restructure (default) – for all to see. I have done the same with Spain, Ireland and Greece (for subscribers only). See The Truth Behind Portugal’s Inevitable Default – Arithmetic Evidence Available Only Through BoomBustBlog followed by The Anatomy of a Portugal Default: A Graphical Step by Step Guide to the Beginning of the Largest String of Sovereign Defaults in Recent History (December 6th & 7th, 2010). Be sure to carefully and very thoroughly peruse the spreadsheet below to see the many scenarios present that show the NPV of investor losses due to haircuts and restructurings…

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Property EU, one of the leading European real estate rags got it right by quoting me as the “American realist”:

Those who wish to download the full article in PDF format can do so here: Reggie Middleton on Stagflation, Sovereign Debt and the Potential for bank Failure at the ING ACADEMY-v2.

The dilemma comes into play when said “realism” shows that things are probably going to get worse instead of better. Apparently, human nature looks for the purported “upside” of things versus how things actually are. Well, I try my best to keep my human nature in check – at least long enough to accurately peruse and analyze the facts. The result will probably sour the puss of your typical long-only optimist:

• The True Cause Of The 2008 Market Crash Looks Like Its About To Rear Its Ugly Head Again, With A Vengeance Friday, March 11th, 2011
• Inflation Misconceptions Hide A Downright U-G-L-Y Real Estate Landscape! – Part 1 Friday, April 1st, 2011
• There’s Stinky Gas Inside Of This Mini-Housing Bubble, You Don’t Want To Be Around When It Pops! Wednesday, May 4th, 2011
• Bubble, Bubble, Real Estate Toil and Trouble: Macro Climate for Real Estate Still Sucks, Despite New Bubbles Tuesday, May 3rd, 2011

As excerpted from Inflation + Deflation = Stagflation ~ Lower Real Estate Values! Friday, April 15th, 2011

Keep in mind the macro environment surrounding this issue.

Those of use who actually use math to make decisions are concerned that the Fed’s intervention has made true price discovery impossible as risk no longer has a cost!

A reader responded to this video and posed the following scenario a few weeks ago…

Reggie, FANTASTIC presentation. I have been following your website for a while and I feel you are one of the few individuals that sees things clearly…very clearly. I hope you have a few minutes to help clarify a few issues from your ING PPT.

CONUNDRUM: Single Family is deflationary at the moment but Multifamily pricing is in a bubble thanks to Fed’s flooding of liquidity (Greenspan on steroids); and the impact of artificial demand from single family foreclosures.

Quick History:

My company bought apartment units (c. $550M)

during the last boom cycle. We sold a material portion of our portfolio in 2007 for an outrageous price, but the remaining properties in the portfolio were whacked when the market turned.

I have been sitting on the sidelines waiting to jump back into the market. I have not bought any properties to date.

Observations:

Single Family foreclosures have been extremely high in the midwest states; some of which are the highest rates in the country. We are running 50k foreclosures per year minimum; there are 75-100k VACANT SF homes sitting in limbo that the banks won’t address due to ROBO signing issues and/or fear of selling at such a loss that they will cripple their puffed/fictitious balance sheets. SF homes built in the 2000 era are selling for $40/sf…..

Certain midwest states are unique whereby there is a significant supply/demand imbalance of housing inventory. We built way to many homes in the 2004-2008 period. Not that many MF units but a ton of SF units.

The apartment market was on its ass until SF foreclosures took off.

In Arizona in partiular, there have only been 700 new net jobs created year over year and our population has slowed to a trickle due to lack of jobs and people not being able to sell their homes in the states they typically migrate from. We lost 250k jobs between 2007 and 2010.

Apartment Net Effective Rents (NERs) are accelerating at parabolic rates now, thanks to the SF foreclosures. It is not job growth or population growth, statistically speaking. Foreclosed home owners are renting like crazy due to lack of credit.

By this time in the NER recovery, I would have bought at least 2k units. However, I have not pulled the trigger because of prices being paid.

My belief is that you only make big profits contrary to liquidity flows; meaning, during the last cycle, we purchased properties at 8% cap rates when debt was slightly higher and there were fewer buyers and on very depressed NOIs. We sold our properties after growing NOIs, and when cap rates compressed to 4%.

Right now it is very reminiscent of 2006 and 2007 [the top of the boom cycle] when liquidity was running rampant. Buyers are posting non-refundable earnest money deposits at the signing of the contracts and closing for all cash in 20 days…$20-plus million properties.

Currently, I believe the buyers who are buying on 4.5-6% cap rates may be shocked when the bond markets get rocked and interest rates are forced up. The increase in interest rates (cap rates following interest rates up) will have a much greater impact on value of these properties than NOI growth.

Questions/Conclusions:

Based on your presentation, how are NERs effected by SF foreclosures on a short term and long term basis? I understand your inflation, deflation and stagflation points, but there are other large factors effecting the supply/demand fundamentatls; albeit, artificial demand from single family foreclosures.

Properties are transacting like crazy and at extremely high prices.

Liquidity is running rampant.

My partners are wanting me to buy properties because NERs continue to recover rapidly.

I have advised my partners to be patient and wait for the interest rates to pop up and values to decline.

I don’t believe we have felt the full impact of the vacant SF homes because the banks are sitting on them and it is a matter of time before they will have to sell even though Fed policy has been designed to inflate SF housing when actually it is deflating.

I have been waiting for the bond market to back up (I believe that is very close now that Gross pulled out of T’s along with many other bond investors) and interest rates to spike.

In short, I have to believe we will be seeing a huge adjustment in pricing soon.

Reggie, if you have the time, just curious to see your thoughts. I have held off buying apts for all the reasons you have explained, BUT, prices are jumping $20-$30k/unit this year. NERs and NOIs are growing modestly, BUT prices are jumping like crazy. Bidding frenzy. Guys buying and trying to flip properties within a year or two. 2006/07 all over again. Scary times!!!

Past as Prologue – Bubble as Burst, Again!

Yes, “ NERs and NOIs are growing modestly, BUT prices are jumping like crazy. Bidding frenzy. Guys buying and trying to flip properties within a year or two. 2006/07 all over again. Scary times!!!” We have seen this movie before, and it’s not even that old. As excerpted from “Doesn’t Morgan Stanley Read My Blog?” pertaining to matters from just FOUR years ago:

In September of 2007, in the very first post on my blog, I announced that the CRE market would crash. I made the announcement again in December of that year and even created a schedule of who would be crashing with their CRE sales. See “Will the commercial real estate market fall? Of course it will” 09 December 2007.

Thus far, quite a few guys on that list have gone bust. How was I able to do that you ask? Well, they paid too much money using too much leverage at the top of what was an obvious bubble. In addition, things were so frenetic that they were literally (well almost) day trading assets that took 3 month or so to transfer at a roughly 7% transaction cost. Last time I looked (okay, maybe time before last), real estate was an income investment, not a trading vehicle for instant capital gains. Sure you can improve the property and extract value elsewhere, but come on… Flipping entire mutli-billion dollar portfolios in a matter of days or weeks??? If that wasn’t a sign of the top, I wouldn’t know what was.

This is an excerpt from that post in December. Notice, half of the companies on this list either have, or will soon cough up those properties that they bought (read the entire article for context):

If you think these numbers might look just a little hairy, just wait and see the numbers of the companies that I am actually shorting. The one’s above were actually cut off of the short’s short list, so to say. Once you see, you will be a believer just like me – commercial real estate is on its way down. See comments below for more on the accuracy of the book calculations I use in my analysis vs. used in this story.

Details of transactions for sale of properties by Blackstone Group

Date	Particulars of transaction	Purchaser	Amount
12th June, 2007	Sold Extended Stay Hotels	The Lightstone Group LLC	$8 billion
9th August, 2007	Sold 38 assets comprised of 106 office buildings and 5.9 million square feet in San Diego, Orange County, San Francisco, Seattle, Portland and Salt Lake City. The properties are from the CarrAmerica West Coast Collection that Blackstone Group purchased last year as part of a national portfolio.	GE Real Estate-owned Arden Realty	NA
17th July, 2007	Merlin Entertainments Group, the leisure park operator owned by Blackstone, sold its property assets to London property firm Prestbury Group plc owned by real estate investor Nick Leslau.	Prestbury Group plc	$1.27 billion
27th August, 2007	Sold 9 suburban Chicago office complexes to GE Real Estate. Blackstone acquired these properties when it bought Equity Office Properties Trust.	GE Real Estate	$1.05 billion
27th August, 2007	Sold a portfolio of downtown Chicago properties to Tishman Speyer. Blackstone acquired these properties when it bought Equity Office Properties Trust	Tishman Speyer	$1.72 billion
9th February, 2007	Sold 6.5 million square feet of Manhattan office space Macklowe Properties. Blackstone acquired these properties when it bought Equity Office Properties Trust.	Macklowe Properties	$7 billion

Let’s fastforward to today, where we may learn the fate of another one those guys who bought that CRE flip from Blackrock. From Crain’s Chicago Business, “Zombie fears stalk Tishman in the Loop”:

A venture led by Tishman Speyer Properties L.P. has defaulted on part of a package of loans used to finance the $1.72-billion purchase of six prime downtown office towers during the frenzied real estate market of 2007, sources familiar with the deal say. The New York developer bought the 5.7-million-square-foot portfolio from Blackstone Group, which flipped them as part of the New York private-equity firm’s $39-billion leveraged buyout earlier that year of Sam Zell’s Equity Office Properties Trust. [Anybody reading my blog in 2007 or even knew me in 2006 could have seen this coming a mile away!]

We can all wonder how Macklowe is doing???

BlackRock loses millions on Macklowe loans | The Real Deal | New …

Apr 7, 2009 … BlackRock pegged the potential loss at $53.2 million from two mezzanine loans on current and former Macklowe Properties office buildings, …

I don’t know if these loans are associated with the Zell/Blackstone flip, but at this point, does it really matter? Practically everything touced during that 2 to 3 year period is blowing up, particularly the 2007 vintage. Ahh, what a fine taste. Other posts of interest from that 30 day period of four years or so ago…

• Do you remember when I said Commercial Real Estate was sure to fall? 20 December, 2007
• The Commercial Real Estate Crash Cometh, and I know who is leading the way! 06 January, 2008

I’m in the process of creating a real world valuation scenario that shows what will happen today, if investors (again) tend towards overt optimism and speculation in lieu of employing common sense and spreadsheets. There are three scenarios being run. We are using the model we built for the commercial real estate protection program described in the ING video in order to demonstrate how we can assist those who wish to either access risk or hedge it without actually purchasing properties. First off, we will perform the valuation, then we will use an option to illustrate the transfer of risk.

Here are the scenarios being ran…

Scenario 1: Multifamily demand outrunning the deflationary pressures of single family residential price collapse and oversupply, stagflation, and interest rate spike

• 3.5% increase in expenses (high)
• 4.5 increase in NER (higher) – stemming from increased rental demand of displaced homeowners due to single family home collapse.

Scenario 2: Assumes reality is a bit more harsh than scenario 1

• Cost inputs rise to 4%, fuel costs rise 6.5% (actually much milder than we have already seen, as in the spike in oil!),
• rates rise 100 bp, but rental demand continues to rise as in scenario 1 due to flight form single family housing.

Scenario 3: Same as scenario one except interest rates increase – this would cause c300bps increase in cap rate

This is the building in question that will be used as a base for each scenario. It is a real property that is currently for sale and being marketed through the NY CRE firm Massey Knakal, who has no connection whatsoever with this particular intellectual exercise.

The analysis will come in two parts, with a substantial amount for subscribers only, but plenty available for free on BoomBustBlog to illustrate to all the perils of allowing such a big bubble to be blown (and reblown) in the first place – something that I believe to be an egregious policy error. Interest parties may follow me on Twitter.

Scenario A
4.5% annual increase in NER	Value of Property	xxy
3.0% annual increase in expenses	Implied cap rate	4.58%
Stable Govt Bond Yield
4% spread over treasury	NPV if purchased at 5.23m	xxx
Property Purchased at 5.23m	IRR if purchased at 5.23m	x.x%
LTV of 75% at 6.0%
2.4% vacancy rate (1 unit)
Scenario B
4.5% annual increase in NER	Value of Property	xxx
5.0% annual increase in expenses, 6% increase in fuel costs	Implied cap rate	6.62%
Modest increase in Govt yield (25bps pa for next 3 yrs and then stable)
4.5% spread over treasury	NPV if purchased at 5.23m	xxx
Property Purchased at 5.23m	IRR if purchased at 5.23m	x.x%
LTV of 75% at 6.0%
2.4% vacancy rate (1 unit)
Scenario C (same as scenario one except interest rates increase – this would cause c300bps increase in cap rate
4.5% annual increase in NER	Value of Property	xxx
3.0% annual increase in expenses	Implied cap rate	7.69%
75bps increase in Govt yiled for next 3 yrs and then stable
5% spread over treasury	NPV if purchased at 5.23m	xxx
Property Purchased at 5.23m	IRR if purchased at 5.23m	xx.00%
LTV of 75% at 7.2%
2.4% vacancy rate (1 unit)

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Comments

[Zero Govt]

the most important chart for me is the US and Japan real estate values... it shows just how ineffective the Japs Keynsian efforts were and also the Feds at blowing Fiat bubbles to counter the deflating property sector (result: failure)

Bens "wealth effect" in the Russell 2000 (who gives a monkies about this minor Index anyway!) misses (deliberately no doubt) the poverty effect of watching their property prices plummet... Mystic Ben selects what he wants you to watch like a magician in the vein hope you take your eye off the ball of the real economy tanking and all his policy failures to shore up housing prices

[michaelj007]

Great article Reggie.  The GSEs are the lynchpin holding the false bottom to CRE values. This, the shadow inventory, employment woes, trashed consumer credit, low rates, etc. are ALL participating in the current bullrun of the institutional MF asset class.  I think the biggest mistake investors are making right now is that they are using short and mid term debt!  spreads to TSYs are pretty competitive right now.  YOU KNOW rates and spreads will be higher in 5 yrs and likely 7 yrs too!  why they aren't taking advantage of cheap long term debt makes no sense.  I think the best strategy is to buy class B assets that the GSEs won't lend on, lock in long term and/or fully amortizing debt, pref with a 1yr fwd (pricing is cheap for fwds too!), WITH assumption/transfer rights- Yield Mtc won't be an issue.  These less desirable/non-institutional assets aren't as sensitive to price shocks.  When rates hit 7% or higher 5 yrs from now you will be able to dispose of you asset much easier and at a higher price with below market, long term, assumable debt.  Please correct me if I'm out of my element.

[chumbawamba]

Hey, who's the hottie in the top photo (and I'm not talking about Nouriel, nor you, Reggie ;)

Another tour de force of exposing financial prestidigitation.

I am Chumbawamba.

[SilverBaron]

What happens to NER's if the government quits paying poor people's rents?

[Tramp Stamper]

Reggie,

You are by far the best analyst I have seen in a long time.  The compilation of your articles and the amount of info really shows how much homework you do on something before you write about it and how you can see through all of the bs and msm spin.  Great article please keep up the good work in disecting the real data and providing it for all to see.

[cocoablini]

Reggie- another outstanding piece. Thanks for the work.
I can't wait for short rates to go negative- thats going to be really bad for the economy. Paying the bank to store your money and then they lose it again.
At thesame time as asset prices CRASH again( real estate)
And negative short rates looking at a wall called the 30 year yield- where no one borrows.
Great work Bernanke- Greenspan. Administrating the death of an economy and doing a great job.

[FEDbuster]

Dittos on the great work.  I have become a big fan of Charles Hugh Smith's blog, Of Two Minds.  He has done some great articles on real estate, everyone should take a minute to read "Phase Shift: The Next Leg Down in House Prices"

http://www.oftwominds.com/blogmar11/phase-shift-housing3-11.html

Since we are also talking about the crash of China, any thoughts on the 65 million vacant housing units there?  Seems like a "super bubble" to me.

[tired1]

Reggie,

Perhaps you can explain the endgame, as I gather that more and more postings on this site deal with the mechanisms of collapse rather than the likelyhood. I can see scenarios by which the US defaults on payment to China and the rest, what about the Fed? Is the plan to simply hyper-inflate? Are those folks running the show oblivous to the polical implications of currency destruction?

BTW, I enjoy your insights. Thanks

[Careless Whisper]

if investors view a spike in interests as "transitory" hehe, then the cap rate won't change that much.  a more lasting change in rates will spike the cap rate for sure. a change from a cap rate of 4.5% to 7.5% would translate to about a 35% drop in CRE values.  brilliant as usual, reggie.

and reggie, where do you buy your ties?

[Zero Govt]

Tie Rack

[doomandbloom]

i dont like Roubini....i see him as a part of the establishment...

[Mec-sick-o]

I don't like the establishment either, but I prefer too keep playing and not see and wait until the rules change to my liking (probably never in my lifetime!).

Unless you end going to Capitol Hill and pass laws that you like (good luck with that), we have to move on.

You may have other options, but that's your choice.  If you can't beat them, join them.

[LawsofPhysics]

Spot on Reggie, true price discovery is only available in the black market.  So Here I sit in some revenue-bearing assets (rentals and leased farmland), stable muni bonds, bluechips, some physical PMs and various fiat cash.  What market is willing to prosecute the fraud and police itself?  When I find that market, my capital will be deployed. Please stand by...