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Inflation Misconceptions Hide A Downright U-G-L-Y Real Estate Landscape! – Part 1
Here’s a quiz for you. An ages old correlation that has pretty much remained rock solid is now upon us. Real estate has been highly correlated to inflation and has acted as an inflation hedge for a very long time. This makes sense, since hard assets that both throw off income and have an actual demand for physical use (in other words, they have have intrinsic value) that hold when fiat currencies assimilate toilet paper in both value and use as input prices skyrocket. The question du jour is, “What happens when you have a glut of unused real estate supply abound in a tight credit environment, a guaranteed increase in rates AND higher input prices?”. Of course the smart people out there (in other words nearly everyone with the impetus to read BoomBustBlog) are then forced to challenge the thesis, “So is this time different? After all Reggie, you have been bearish on real estate.”
The short answer is, no this time is not different. It rarely ever – if ever – different this time. The key is the terminology. You see, many in the media are throwing around the word “inflation”, and understandably so as they see prices (particularly staples, commodity and input prices) and money injected into the system go up appreciably. The problem is that the core real assets are not only in a deflationary cycle, but in a downright depression – reference In Case You Didn’t Get The Memo, The US Is In a Real Estate Depression That Is About To Get Much Worse. How can you have inflationary input prices and deflationary real asset prices amid stagnant employment? The answer is STAGLFATION! I have been calling for stagflation since 2008, and it definitely seems as if I called it correctly. Keep in mind that this will be one of the corner stone topics discussed in the ING Real Estate Valuation seminar in Amsterdam on April 8th, which has now sold out its capacity of 250 seats -see www.seminar.ingref.com. Amsterdam is a very interesting city to have such a discussion, for the pundits there are calling for a 25% office vacancy rate at a time of increasing inflationary pressures. On top of that, they have actually called in the world’s leading real estate bear as the keynote speaker! It should be fun. I actually have an implementable solution to this mess. I wouldn’t necessarily call it light at the end of the tunnel, but it is a way of pricing, valuing and transacting in these depreciating, illiquid assets correctly. Something that is currently lacking. Let’s dig in, shall we…
Input Prices Skyrocket world wide just as Reggie Warned back in 2008, but the media mistakenly calls it “Inflation” when the word should start with an "S"!
Stagflation is the more accurate term but inflation seems to be on everyone's mind. From an economic livelihood perspective, inflation would be preferable. I will go into this further in my next post, but first let's explore the the inflation argument.
Inflationary aspects abound in the US, Europe, Asia and particularly in China. China is the exception here, for China has true inflation (not merely inflationary aspects) with increasing money supply, increasing input costs, increasing labor costs, increasing commodity prices and increasing (bubble???) real asset prices. Then again, I also believe China is in an inflationary bubble that needs to either burst or be deflated, You don’t get 30 years of growth in 3 years without breaking something. See What Are the Odds That China Will Follow 1920’s US and 1980’s Japan? and Chubble (The Unmistakeable, Yet Thoroughly Argued Chinese Bubble)...Please upgrade your browser
Choice quotes from the retailer with the most pricing power in the whole, wide world!
Inflation is “going to be serious,” Wal-Mart U.S. CEO Bill Simon said during a meeting with USA TODAY’s editorial board. “We’re seeing cost increases starting to come through at a pretty rapid rate.”
“Every single retailer has and is paying more for the items they sell, and retailers will be passing some of these costs along,” Long says. “Except for fuel costs, U.S. consumers haven’t seen much in the way of inflation for almost a decade, so a broad-based increase in prices will be unprecedented in recent memory.”
Wal-Mart, for example, could have “access to any factory in any country around the globe” to mitigate the effect of inflation in the U.S., Long says.
Still, “it’s certainly going to have an impact,” Long says. “No retailer is going to be able to wish this new cost reality away. They’re not going to be able to insulate the consumer 100%.”
We also have the WSJ reporting Euro-Zone Inflation Hits 29-Month High
The euro zone’s inflation rate jumped unexpectedly to its highest level for 29 months in March, strengthening the case for the European Central Bank to raise interest rates.
To add to the above: South African Producer-Price Inflation Accelerates by More Than Expected. How about those input prices???
Of course, if the ECB raises rates, its game over for that European CRE that looks towards a 25% vacancy rate in the upcoming year according to ABN Amro. Reference the Dutch financial rag Financieel Dagblad with a rough translation courtesy of Ernst’s blog:
The number of vacant commercial and office buildings in The Netherlands will only increase the coming years. Influenced by the “new working” trend, the need for office space will drop by 10%. [New working is working at home instead of at the office, using modern communication tools, like computers, smartphones and mobile internet. The countrywide coverage of broadband (mobile) internet enables people to stay at home and do their normal day job – EL]
At this moment already 14% of the office buildings in The Netherlands is abandoned. This is stated by a report of ABN AMRO. The bank fears that in 2015 this number will be about 25%. Also a diminishing civil service is one of the causes. “These factors have a sturdy negative impact on the appraisal of Commercial Real Estate (CRE). Especially in the eyes of the large banks”, according to Erik Steinmaier, manager of Research at the CRE branch of ABN AMRO.
The increasingly serious vacancy of CRE is a millstone for financial companies and pension funds. Steinmaier estimates that banks financed in average 60% of the office buildings. This would mean that banks have for about €30 bln in CRE loans on their balance sheet. A lot of these office building are currently appraised at a too high value. It is unclear how much has to be written off in the bleak scenario of ABN AMRO. Since 2007 the value of investments of institutional investors in CRE has diminished by 15%. And according to Steinmaier the financial crisis in CRE hits silently like an assassin. “The worst has yet to come”.
Consultancy firm Twynstra Gudde that assisted in writing the ABN AMRO report states that one third of the large users of office space is planning to fit up flexible working spaces. Working at home should eventually lead to a decrease in demand for office space of 3 mln sqr meter (32.2 mln sqr feet), according to ABN AMRO. The government, using about 21% of total office space in The Netherlands, will have cutbacks up to 2.75% of the civil service labor force. Civil service currently uses 6 mln sqr meter (64.4 mln sqr feet) of office space. Especially The Hague, The Netherland’s own Washington, is hit disproportionately by these cutbacks. Vacancy of CRE in The Hague could hit the 30% mark.[…]
I am on record saying the same thing on BNR Dutch News Radio just a few months ago. That very same radio station broadcasted an interview with Maarten van Poelgeest, alderman of the city of Amsterdam, who states (summarized, again translation courtesy of Ernst’s blog):
In some areas of Amsterdam the vacancy of CRE hits the 40% mark.Of this about 60% is structural vacancy. These office buildings need a different purpose of usage, as they will probably never be rented anymore. The local government needs to change the zoning schemes for these office buildings and should turn them into homes for students or tennants that have no access to public housing, as their income is too high. A lot depends on the owner of the building, i.e. the large banks, big realtors and pension funds. They should take their losses on CRE.
I called this as far back as 2008 and just did a lecture on the issue a couple of months ago.
As we all know, the US is not one to gloat on the CRE issue. The derivatives based on CRE have actually outperformed, and if you looked at the performance of MBS and REITs, one would have thought that the US was in a real estate bull market, pre-2007. Alas, that is the nigh fraudulent representations of derivative paper traded between insiders. The truth lies in the streets, where you see bricks, mortar and dirt falling in prospective value – particularly if you have your eyes open and just look a few quarters towards the future. I have went over this in detail in Reggie Middleton ON CNBC’s Fast Money Discussing Hopium in Real Estate. It should be read by anybody who is bullish on CRE. Keep in mind that the difference between Dutch CRE and US CRE is that our central bank is much, much more adept at the extend and pretend game, while the Dutch are more on the delay and pray side of things. Look at it from an interest rate increase perspective, which is bound to happen in an inflationary environment:
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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Yesterday’s post takes the Portugal risk situation to the next level: Portugal Is On The Verge Of Tapping Out, UFC Style – You Knew It Was Coming, Here’s The Analysis!
Since this has turned out to be quite the lengthy post, I have chopped it up into parts. Part 2 will be forthcoming. In the mean time, anyone who wants to find out more about me can follow this link – Who is Reggie Middleton!!! and/or follow me on Twitter.
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I spend enough time in Spain to know that the legally mandated "inflation raises for everyone" is one of their more disastrous problems. In the US it is simply a reflection of political power and vote-getting requirements that Social Security and government salaries automatically rise with inflation. Since we print our own money, such a system can survive for a time. However the power of others to fend off tax increases leads to debt hell. Those who pay in the end are those who have neither the automatic inflation increases nor the ability to move their assets offshore (directly or through equities in companies who do so).
Sorry, that paradigm only works when your gov't doesn't rig the numbers. It doesn't work when the gov states that inflation is at 1% when it is actually running at 8%. Also, and the gov't know it, the system you present is an exponential system and is not sustainable. Nuff said.
Love reading your posts Debt man. But to point out the unpleasant.
If inflation is tame and not sustained, you may well laugh at us Mericans. If however, this is the real deal, those protections will send you 'all straight to hell on a rocketship as the vicious cycle starts. and individual EU countries don't own their own printing presses. your businesses will collapse at blinding speed.
there is no free ride. just trade offs.
Guaranteed wage increases are themselves inflationary and frankly stupid. Inflation is never the same everywhere and yet governments who really don't and can't (and don't want to) measure it precisely mandate wage increases...starting with government workers and entitlement recipients. It's dumb. Wages should always be tied to a company's(or government's) revenue and free cash flow. A company may fight inflation itself with lower margins which is what is happening now. Many companies are NOT passing on the commodity increases. So how would you calculate inflation and mandatory wage increases? You cannot. Free people make their own deals and deal with their own situations in their own industries.
We need a revolution, but not the type you advocate. We should stop being craven cowards and throw off the collectivist state. Socialism is and always will be for cowards, the lazy and aspiring autocrats. I say this with passion and conviction.
Unions are no match vs globalization's 401k carrots on a stick.. the promise that corporate profits will spread to all so labor be damned
NAFTA & tarrif killing was all it took to open the flood gates
What rogerwilco and Manthong are saying about unions would be true if the U.S. wasn't flush with crony capitalism and a complete lack of enforcing the law other than when it punishes the individual and the household.
The U.S. is a unique mixture of free market conservatives and entitlement liberals with variations sprinkled in between.
It is Nirvana for corporations and government.
The wild-eyed Tea Party Republicrats rail against government and entitlements while the Demicans rail against corporations and profit.
We see-saw back and forth in elections; all the while Governments and Corporations work hand-in-hand to charge more for less, to renege on promises made 30 years ago to teachers, cops, pilots, any employee or constituent.
The foolish populace beleives that elections mean anything.
The two-headed hydra of the Government/Corporate Kleptoligarchy meanwhile bleeds the middle class dry, sucking up any assets of value, leeching itself onto every paycheck, every dollar earned, taxing and feeing and pricing and reducing income to bring them to the brink of insolvency.
The elites will chirp and squawk about hard work and free markets and individualism as the banks are bailed out and the FED buys stocks and CDS's and MBS's and none of the malfeasant are jailed or even charged as the law and ethics are flayed.
The entiltement crowd will bray and whinnie about the common good, the downtrodden, the rights of the worker as they shop at WalMart and buy cheap plastic crap from enslaved Chinese workers while spitting out babies from different fathers and support politicians foisted upon them by corporate interests and corrupt electoral systems.
Insanity.
In a failing state nothing makes sense. Insanity is everywhere. Perversion is called art. Immorality is morality. Money is printed, not earned. Lies satisfy and the truth is ridiculed as farcical. Entitlement supercedes work and feelings overpower honesty.
Look for a return to the mean.
i WISH i could get that whole thing on a bumper sticker !
+ 1000 Well said. The overwhelming and potentially fatal economic problem before us is the absurb growth of inequality exacerbated by a government that refuses to enforce laws and ensure a level playing field.
yeeeesssssss.
More union power?
If we get it here it will be like "unions" got more power in 1930's Germany.
"Union" as arm of the government.
Government and unions are not the solution, they are the problem.
I hope there are enough pieces left to cobble something together after the governments and unions get through with us.
Read the history of a fellow named Allende and what he tried in a little country called Chile. Allende guaranteed wage increases for workers to offset rising prices, but the companies forced to pay the higher wages collapsed. It was an economic death spiral that ended in a military coup.
Europeans in 2011 are much more sophisticated and would never commit acts of stupidity like that. No, Europeans are a peaceful bunch with no inclinations to extreme nationality, or wars with casualties numbering in the millions.
RW, you appear to be yet another victim of US propaganda, are you one of the sheeple?
The reason Allende was overthrown was because, "The government of President Richard M. Nixon launched an economic blockade conjunction with U.S. multinationals (ITT, Kennecott, Anaconda) and banks (Inter-American Development Bank, World Bank). The US squeezed the Chilean economy by terminating financial assistance and blocking loans from multilateral organizations."
LOL -- propaganda?
The people of Chile are not fools or pawns, and the coup would have occurred without Nixon's blessing. Read some history outside of the sanitized bullshit propagated by leftist academics who equate Allende with Mother Teresa.
If you are capable of citing facts and sources the repudiate my statement, regarding Nixon and the CIA, I would enjoy reviewing them and encourage you to do so!
My mind is very open to learning new FACTS!!!!
And to clarify my point I have never implied or stated that the people of Chile are fools or pawns!!!
edit, At no time did I equate or imply that Allende had the stature or creditability of Mother Teresa.
Yeah a military coup alright. But who aided or closed their eyes on the coup? Good ole Unca Sammie. It is the same in many countries- DON'T DIS THE SYSTEM OR WE WILL TAKE CARE OF YOU. Translation- if you don't go along to get along the odds of you and your family avoiding catastrophe are slim.
ALL IN THE NAME OF DEMOCRACY AND FREEDOM Nothing to see here just a little accident. Just move along and stop gawking or your TV dinner will burn.
Getting rid of Allende and his leftist buffoons was good for Chile. Unlike most SA countries, today they have a real, dynamic economy.
General Pinochet was a bastard in his own right and ruled with an iron fist, there is no sugar coating that fact. But his reforms made sense and rather than continue his dictatorship, he was honorable enough to call for a new constitution and step aside..
"...his reforms made sense.."
The economic policies espoused by the Chicago Boys and implemented by the junta initially caused several economic indicators to decline for Chile's lower classes.[47] Wages decreased by 8%.[48] Family allowances in 1989 were 28% of what they had been in 1970 and the budgets for education, health and housing had dropped by over 20% on average[48] The junta relied on the middle class, the oligarchy, huge foreign corporations, and foreign loans to maintain itself.[49] The oligarchy recovered most of its lost industrial and agricultural holdings, for the junta sold to private buyers most of the industries expropriated by Allende's Popular Unity government. This period saw the expansion of monopolies and widespread speculation.
Sounds like the USA today!!!!!
Reggie should post the names of the CRE REITs here in the US other than those with significant assets in DC (teehee). I personally know 2 owners of office property in Boston and SanFran and they have already done extend and pretend rollovers with their lenders.
I remember the lickin' RE took 79 - 83 when rates shot up. Only this time the demographics are going Japanese to boot.
Nice work Reggie. Currently divesting some golden RE so count me a believer.
what about rents going up with inflation?
Rents go up with supply and demand. High vacancy rates will let renters pick and choose locations and rents. I don't expect rents to keep pace with inflation but in all but the most devastating scenarios investments that are cash positive now will stay that way. Pick your locations well. Marginal locations will take the hardest hits income wise while the costs will remain fixed. While I don't see real estate keeping pace with inflation what other inflation hedges actually produce income? Real question. Any answers?
" what other inflation hedges actually produce income?"
Buy gold mining shares such as GG, NEM, or mid-tier producers that are liquid and have high cash flow. Then write calls against your shares. Just make sure you keep the strikes high enough to minimize the likelihood of the options being exercised against you.
The worst case scenario is that you have to sell your shares at a profit and you keep the option premiums.
"...what other inflation hedges actually produce income? Real question. Any answers?"
Off the cuff I would say a trustworthy significant other with an income and true friends.
I'd say precious metals, but I fear that the FED and the Government may do anything to crush alternate stores of value, including confiscation.
As you mention, good rental real estate. If real estate gets worse and more are foreclosed on and finally evicted I would say a rental property that is paid for would be a good source of income. I'm thinking condos or townhouses in good areas that are conservatively run.
There will be a lot of former homeowners who don't want to rent an apartment but will be looking for a larger condo or townhouse to rent, especially with a garage.
I would start with a place I could live in myself if things got really bad and go from there.
"I'd say precious metals, but I fear that the FED and the Government may do anything to crush alternate stores of value, including confiscation."
There is -0- chance they would successfully confiscate Au or Ag or any other precious metal at this point. People are too fed up with the BS and there is no way to explain it other than direct robbery of citizen wealth. Too many in the US are well armed and would treat confiscation just like if someone broke into their house. Besides, how do you enforce it?! Treat it like a drug possession crime to have Au or Ag coins ?!
The more the gov't tries to increase taxes and regulation the more vast the underground economy will become. We needed to move away from credit anyway seeing the mess it got us into. The barter system has worked well for 1,000s of years. It can work again and PMs are just one medium of exchange. Pick something you are good at doing or creating, make sure it's something other people want or need, and then you have a way to live a basic life if SHTF.
We don't all have to prepare 100% for every possible outcome.. but you do have to have the basics and a way to add value to those around you.
Good luck all!
(I'm buying real estate as my "best case" scenario plan and PMs (and other stuff) as my "worst case" scenario plan.)
yeah, I'm with you - and long physical pm--- but in terms of confiscation, I think you underestimate the power of the state. Does your firepower exceed that of US Corp.? I doubt it.
My Grandfather owned thirty pieces of commercial property in Los Angeles going into the depression. Many went vacant but he just managed to hang on to them okay. Then the city decided that it needed more money and raised taxes. The city then decided it needed to make civic improvements and raised special assessments. In no time my Grandfather lost most of his property and so did thousands of other property owners.
The moral: If you think property is safe in hard times consider what those fine folks in city hall can do to you.
See Marx Brothers' Cocoanuts, a movie in 1929 that reprised a 1925 musical. The RE bust in Florida preceded the Crash of '29 by several years. Given that history rhymes more often than it repeats, the current bust in housing and CRE is still a preview of the big event.
by the way reggie... our criminals here in the states are much more proficient than those in the piigs.
iyr is kissing 52 week high.
Thanks, Reggie. You do purty charts!
BTW, the past participle of your particular irregular verb would yield "have gone" as opposed to "have went". But that's just the grammar nazi in me speaking.
Sigh! If only school teachers knew the rules of grammar......
Sigh! If only school teachers knew the rules of grammar......
Good analysis. TPTB have created the worst of all possible scenarios and outside of government, TBTF banking, and academia, we proles have to live and deal in this mess. At my little company, our sales are off 30%, COGS and overhead are up, yet customers expect us to sell at prices last quoted in 2006!
Expenses have been slashed as much as possible, no trade shows, no conferences, minimal travel. We're not doing any major capital investments, only equipment replacements as-needed. We have no pricing power and there is little room to raise wages. A couple of years like this and we're toast.
Something tells me that the likes of GE, GM, and PBoC don't have a problem with my plight.
Commercial needs to have differentiation as to types of properties. Strip malls and big boxes are tripe, along with general office.
However, heavy industry with outside equipment/vehicle storage are doing quite well in many areas, as the NIMBY pub employee zoners don't want to add (and most likely are detracting) to this.
As the $ falls, look for this sector to stay stable or rebound as mfg returns.
Eliminate these F'n Financial KAWKSUCKERS!
That would get rid of the issues. Then the honest people of the planet can live life like they want to. Straight up with no B.S. and Financial Ruin.
These punks aren't "geniuses" they just checked their morality at the door.
Stand up and don't take any SHEEEEET from this A'Holes.
That's been the trend among my small biz friends since 06. Only health care and gov. are unaffected, so far.
Screw it my fellow small business owners, I did. Shut down, sell your assets (while people are out there still able and ignorant enough to buy them) and buy physical AU and AG. Look at a place outside this U.S. purgatory, like Peru, Uruguay, etc.
If you do not have access to the discount window, have a product or service that is useful to the government, have access to credit, have real capital with some semblance of liquidity, compete in ANY way to a large multinational or politically connected public company, are sure you can make it until peak energy sends the manufacturing back to our shores, you ARE going to be toast!
No doubt about it. There's an exit door if you're willing to take it. You may step in some dung on your way out, but at least you'll be left with feet.
If worse comes to worse, they will get a bailout with your tax dollars at work