Friday, 01 April 2011 11:01

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 . 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 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"!

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)...

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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.

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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 . 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:

 \mbox{Capitalization Rate} = \frac{\mbox{annual net operating income}}{\mbox{cost (or value)}}

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 AusterityGoldman 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...

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.

Last modified on Thursday, 14 July 2011 08:43