Harry Newton's In Search of The Perfect Investment
Technology Investor. Harry Newton
9:00 AM EST, Friday, April 3, 2009.
continue to rise. I now believe the present 20% recovery so far has legs.
Latest "legs-adder" has been this week's loosening of the mark-to-market
rule, which now gives financials the freedom to report ebullient (though fake)
it's impressive that G20 leaders quickly agreed on stimulus programs and said
they'd dump $1.1 trillion into the IMF.
big market gains have been among financials. Compare their recent prices to
their one-year lows:
biggest gloom is rising unemployment and the devastation it is doing to the
commercial real estate (CRE) industry. But there is clearly money around and
being "put to work" (to use a ghastly expression). Rising housing
sales and full restaurants attest to that.
column is long. For that I apologize. I wanted to include three articles --
one wonderfully optimistic, two ultra-gloomy. First, the positive one. From
this weekend's Economist:
A faint sound of applause
Some signs suggest that the recession is lifting, but the path to recovery
is fraught with danger
recession has broken many of the rules of business cycles, but not this
one: when something gets cheap enough, buyers emerge.
housing bubble seems mostly deflated. According to the S&P/Case-Shiller
20-city index, house prices through January were down 29% from their all-time
peak. Relative to incomes, houses are now 10% undervalued, and relative
to rents they are fairly valued, thinks Paul Dales of Capital Economics,
This is luring
buyers back. House sales rose unexpectedly in February. The National Association
of Realtors estimates that up to 45% of existing homes sold were distressed
propertiesthose in, or close to, foreclosure. In Nevada, which with
California, Florida and Arizona was the epicentre of the boom and bust,
fourth-quarter sales were more than double their level a year earlier. Keith
Kelley, a Las Vegas estate agent, has an investor interested in offering
about $80,000 for a foreclosed, four-unit apartment building which, fully
let, could bring in over $25,000 a year in gross rent. He has two buyers
interested in paying $220,000 for a five-bedroom house that sold in 2004
for more than triple that. Their monthly mortgage payment would be about
half the rent on a similar property. Even so, he says, I still talk
to buyers waiting to see when we get to the bottom. Indeed, homes
may be fairly valued now but could get dirt cheap if, as commonly happens,
of the housing market is one of several tantalising glimmers that the end
of the recession may be in sight. In March factory purchasing managers were
their least gloomy about new orders since last August. Vehicle sales rose
8% in March from February. New claims for unemployment insurance have stopped
rising. Gross domestic product, which shrank at a 6.3% annual rate in the
fourth quarter, probably shrank at a similar rate in the first, but the
composition of the drop was more encouraging; it was driven not by the collapse
in consumer spending, but by sinking output as businesses sought to bring
inventories into line with lower sales. Second-quarter growth has
a good chance of being positive, according to Ian Morris and Ryan
Wang, economists at HSBC, though the risks
are still huge.
What has brought
this turnabout? In part, the normal corrective powers of the economy. Larry
Summers, Barack Obamas main economic adviser, has noted that current
annualised vehicle sales of about 9m are well below the 14m necessary for
replacement and rising population, while annualised housing starts are about
a quarter of the rate needed to support the forming of new households.
is also the expected response to monetary and fiscal stimulus, both of which
have been exceptionally aggressive. The Federal Reserve, having lowered
short-term interest rates in effect to zero, has intervened in bond markets
to push down long-term mortgage rates as well. On April 1st paycheques were
due to begin reflecting the tax cuts in Barack Obamas $787 billion
have shifted their economic outlook from catastrophic to merely grim, the
stockmarket has shot higher, by 19% on April 1st from its 12-year low on
March 9th. Like houses, stocks look cheap. Strategists at Deutsche Bank
estimate that investors can expect to earn an additional seven percentage
points over the long run from holding stocks instead of Treasury bonds,
the highest such equity risk premium in at least 25 years. Mr.
Summers says it may be the sale of the century.
Yet even if
the bottom in economic activity is in sight, a robust recovery almost certainly
is not. Housing usually leads the way out of recession as falling interest
rates unleash pent-up demand. But easy credit in earlier years has turned
many renters into homeowners already. At the end of last year 67.5% of households
owned their home, down from a peak of 69% in 2006 but still well above the
64% that prevailed from 1965 to 1997. Moreover, many prospective buyers
cannot take advantage of low mortgage rates because higher down-payments
are now required.
of lower interest rates has been dulled by the dysfunctional financial system.
That is why credit markets have not reflected the optimism of stocks and
are forcing corporations to pay punitive yields on the bonds they issue
may also be depressed for some years to come by the record 18% collapse
in household net worth over the course of last year, a drop of $11 trillion.
That is a chief reason why the OECD on March 31st released an exceptionally
gloomy prognosis, predicting that the American economy would shrink by 4%
this year and not grow at all next year. Deflation, it said, may become
risk of renewed recession or stagnation comes from the banking system. As
long as home prices keep falling and unemployment keeps rising, banks
bad loans will keep mounting. Huge questions hang over the Treasurys
plan to remove those loans, and many economists think it must commit more
public capital than the already authorised $700 billion in TARP money. Perversely,
a continued stockmarket rally could undermine the chances of more aid, lulling
some in Washington to believe enough has been done.
the treasury secretary, understands that. The big mistake governments
make in recessions, he said on March 29th, is
that first glimmer of light, and the impetus to policy fades. Yet
he hurt his own case the same day by saying that more TARP money is not
needed for now because some banks will repay the government capital they
have previously received. That is bad news, not good news: banks are lining
up to repay the money to free themselves from political interference, even
though the loss of capital will constrain their lending. That increases
the odds of a multi-year, Japanese-style credit crunch.
Even if the
administration wants the money, Congress at present is in no mood to grant
it. The Senate and House budget resolutions were silent on the administrations
request for $750 billion in extra funds (with a budgeted cost of $250 billion).
The administration is wisely waiting for tempers to cool before asking for
second article is from today's Wall Street Journal.
The third article
is from Q1
Vacancies Hit 15.2% -- and Rising
Companies, struggling to cut costs, dumped a near-record 25 million
square feet of office space in the first quarter, driving vacancy up and
rents down, according to data to be released today by Reis Inc.
that needed to lease space took advantage of the market weakness to extract
concessions from landlords. But the trends exacerbated financial woes for
owners, especially those who owe more on their mortgages than their properties'
vacancy rate nationwide rose to 15.2% from 14.5% in the previous quarter,
and likely will surpass 19.3% over the next year, according to Reis, a New
York firm that tracks commercial property. That would put the vacancy rate
above the level during the real-estate bust of the early 1990s, the worst
rents, which include free rent and other landlord concessions, fell 2% in
the first quarter to a national average of $24.16, the largest drop since
the first quarter of 2002, according to Reis. Sublet space, on average,
is going for between 10% and 15% less than what landlords are charging.
commercial real-estate market is posing yet another threat to the ailing
economy because it is causing the value of buildings to plummet, often to
less than the amount of their mortgages. In one closely watched transaction
earlier this week, the marquee John Hancock Tower in Boston was valued at
$660.6 million in a foreclosure auction, less than half of its $1.3 billion
price in 2006. Washington policy makers are scrambling to extend bailout
programs to help shore up commercial real estate.
many have expected commercial real estate to fare better than the housing
market, thanks to the lack of rampant overbuilding in the recent cycle.
But supply is being dumped on the market instead from layoffs. With as many
as 1.5 million jobs expected to be cut this year, more than 50 million square
feet of office space is expected to be emptied out for the full year, projects
only at the beginning of a hurricane that may continue for at least the
next 18 to 24 months," said Reis research director Victor Calanog.
Soft Panic of 2009 Has Just Begun
By Andrew Mickey,Chief Investment Strategist
Clarendon Street sits on one of city’s most iconic buildings. It’s also
the symbol of what could kick off what I call the “Soft Panic of 2009.”
know it simply as “The Hancock.” The 60-story frame wrapped in reflective
blue glass makes it look like the tallest mirror in the world. I’m sure
it was an impressive sight when it was built in the 70’s. It still is.
I.M. Pei designed building stood as a symbol of financial strength and ingenuity.
Now, it’s looking a whole lot different.
for those of us looking into this situation now we will be protected. And
for more aggressive folks, we’ll actually be able
to profit from it all. Here’s how.
Sign of the Times
Hancock Tower was purchased by Broadway Partners in 2006. It cost $1.3 billion.
The vacancy rate was a mere 5%. Broadway looked like they had another big
winner on their hands.
Partners was one of the rock stars of the real estate boom. The New York
real estate firm snapped up $15 billion worth of real estate between 2000
and 2007. The firm stuck to red hot real estate markets in places like Boston,
New York City, Washington D.C., and Florida. The strategy paid off too.
Broadway earned an average 35% annualized return from leveraged
real estate deals.
lot has changed since then. The boom has turned to bust. In less than three
years The Hancock Tower has turned from an iconic asset to a top-heavy liability.
Now, Broadway had to sell out.
this week, Broadway defaulted on the Hancock Tower payments. The building
had to be auctioned off. In a two minute auction (using the term “auction”
loosely - there was only one bid) the Hancock sold for a $20.1 million and
the assumption of $640.5 million in debt. That works out to a total price
of about $660 million. That’s almost half of the $1.3 billion paid for the
building back in 2006. More importantly, it shows just how far commercial
real estate (CRE) values have fallen.
thing is, CRE problems won’t be one for Manhattan real estate players. Not
at all. This is a sign of things to come in the CRE market. And when we
look at who owns most of the CRE debt, it’s easy to see it will affect a
lot more people.
go as far to say, the CRE crash could be even more disastrous than the housing
bubble. The costs will run into the hundreds of billions of dollars. Here’s
“Sweetest” Piece of the Pie
long time readers of our Free e-Letter, the Prosperity
Dispatch, the problems of CRE shouldn’t be much of a surprise.
We’ve been expecting this for a while. Back in Kicking
Off the Panic of 2009, we warned of the vicious cycle about to
unemployment rises, consumers spend less, retail sales fall some more,
more shops close down and walk away from their leases, and overleveraged
mall owners collect less revenue eventually defaulting on their loans
and forcing the banks to take the losses. Throughout it all, unemployment
rises even more from the retail stores closing up, manufacturers cutting
back production because the retail outlets buy less from them, banks
cut back staff, and start the cycle all over again.
CRE values are a problem, but it’s not the big problem. The big problem
is the debt.
we’ve seen time and time again, markets do work – when they’re allowed to.
The Hancock Tower is the perfect example. The owners were forced to liquidate.
They lost all of their equity. The property and all the liens against it
(primarily the $640 million mortgage) were sold to a new owner.
the new owners can run the building efficiently enough to make payments,
their equity will build. If not, the lenders will be forced to take the
building, sell it, and write off the loan.
work. And they will continue to do one-time deals like this. However, if
there is a widespread downturn in CRE prices, most CRE transactions won’t
go this smoothly. Sellers will outnumber buyers. And we’ve seen how prices
can fall very quickly when that happens. At that time, the lenders (and
those who bought the securitized loans) will be on the hook for falling
prices. From here, there is no place to go but down.
Soars, CRE Crashes
you think about it, you can practically see the next big round of bailouts
headed for CRE. Another vicious cycle has begun. And it all stems from rising
no secret unemployment is on the climb. At the end of February, the official
unemployment rate in the U.S. was 8.1%. The next unemployment report is
due out tomorrow. The consensus estimates forecast another 650,000 jobs
lost and the unemployment rate to climb to 8.5%.
march to double digit unemployment we predicted last year is continuing.
It’s only a matter of time until we see the real consequences of 10%+ unemployment.
One of the hardest hit sectors will be CRE.
a recession, especially a bad one, commercial rents fall fast. As jobs are
lost, offices shut down, and the office property market reaches significant
points of overcapacity. Inevitably, the cost of leasing an office falls.
Since CRE prices are based on rental prices, CRE prices fall just as fast.
decline stems from the vicious cycle which was started a year and a half
the same vicious cycle we’ve been over before. Businesses cut back on spending,
investing, and hiring. Unemployed people, or those who just fear they will
be unemployed, cut spending. This, in turn, reduces revenues and the downward
is nothing new. We see it every day. The key here is the cycle takes a long
while to hit CRE.
delay comes from many factors. For instance, businesses don’t renew leases
every month. They don’t close up shop quickly. They try to survive until
the last dollar is spent. This results in a long delay. Considering the
recession began in November 2007, right about now is the time when it starts
to hit CRE.
York is the “canary in the coal mine” when it comes to CRE. A year ago,
vacancy rates in the Big Apple were between 7% and 8%. The rate climbed
to 10.9% at the end of 2008. Now, just three months later, the vacancies
are up to 12%. And they’re still going to go.
vacancy rates have pushed the cost of renting way down. The lease rate on
a square foot of office space went from $74.49 to $65.18 in just the past
three months. That’s a 12.5% decline in just three months. Keep in mind;
this is in New York City where some of the world’s most valuable CRE is.
We can only imagine what is going on across the country.
has its own vicious cycle. Unemployment increases, demand for office space
decreases, rents fall, and then commercial property prices fall. CRE prices
have already fallen and the next leg down could make the subprime crisis
look like a cakewalk.
Biggest Shoe of them All
difference between the impact of the housing bubble bursting and the CRE
bubble is critical to understand. The majority of residential loans were
originated by banks or other lenders, packaged together (securitized), and
then sold off to investors.
mortgage-backed securities paid anywhere from 6% to 10% (depending on which
tranche you bought). Investors were happy to have them. They were especially
happy to buy them if they were buying insurance against a default from AIG
– but that’s a topic for another day.
is a whole different matter. Many of the CRE loans paid higher rates of
interest. More importantly, they were backed by renters with businesses
which generated revenue and profits. In other words, CRE loans were made
to people who could pay them unlike a lot of the residential loans. So the
banks didn’t sell them off to others. They kept them on their books.
loans meant more interest income which would allow them to pay a higher
interest rate to attract more cash from depositors and still make strong
profits. Meanwhile, they could sell the garbage residential loans to someone
why the CRE downturn will create even bigger problems…have a great impact
on balance sheets…and end up in even bigger bailouts.
course, we went over how bad commercial real
estate declines would be for regional banks months ago. At the time
Wall Street was still riding high on hopes the new administration would
provide a plan quickly.
big problem though is not that banks kept the CRE loans on their books.
The Fed, Treasury, and FDIC are making progress. They’re getting bad residential
and credit card loans off banks’ books. CRE loans are a different story.
That will change.
Bigger Shoe to Drop
not the only ones hot on the trail of commercial real estate though. A lot
of people have spotted this storm on the horizon. But only a few have boarded
up their windows and moved to higher ground.
hedge fund investor George Soros sees it coming. He says, “CRE has not yet
fallen in value. It is inevitable, it is written, everybody knows it, there
are already some transactions which reflect and anticipate it, so we know,
they will drop at least 30 percent.”
impact on the value of real estate loans is starting to appear as well.
Wall Street Journal claims “Commercial
Property Faces Crisis.” The financial news service reports:
- The U.S.
banking sector could suffer as much as $250 billion in commercial real-estate
losses in this downturn. More than 700 banks could fail as a result
of their exposure to CRE.
- In 1993,
less than 2% of the nation's banks and savings institutions had commercial
real-estate exposure. In 2008 that had risen to about 12% or about 800
- CRE in
the U.S. is worth $6.5 trillion and financed by about $3.1 trillion
Bank predicts about two-thirds of the $154.5 billion of securitized
commercial mortgages coming due between now and 2012 likely won't qualify
Anderson, partner at Foresight Analytics, expects nearly 50% about $524.5
billion of whole commercial mortgages held by U.S. banks and thrifts
are expected to come due between this year and 2012 as they exceed 90%
of the property's value because, today, lenders generally won't loan
over 65% of a commercial property's value.
CRE crash would require an additional $250 billion (or more) bailout from
the government. That’s another big number that Congress is going to have
to muster up the political will to pass. Or the Fed will just cover it.
Either way, it’s an ugly scenario shaping up. And one industry (insurance
companies) will likely pay a big price.
the past few years, insurance companies bet big on CRE loans. It makes perfect
sense from their perspective.
companies have the same motivation as banks do to seek out a higher return.
They get a great return on the capital they are responsible for managing.
They can charge lower premiums to attract more business. And they can still
maintain healthy profits. It’s great – until real estate prices start to
fall and the CRE loans are at risk.
downturn has already taken a toll on most life insurance stocks. As you
can see in the chart below, the decline of shares of major life insurers
range from 63% to 91%:
Insurance Stocks: Tough Road Ahead
Financial Services (HIG)
this is just the start of it though. Housing has got the headlines, but
it’s CRE that can do just as much damage – if not more.
You see, there were never any runs on banks over the past few months.
The public had confidence in the FDIC. So there was never any need to
run and withdraw all your money – which you can’t really do anyway without
a week’s notice. Insurance companies are a completely different matter.
no government backstop guaranteeing your life insurance. Maybe the AIG
deal is an example of what will come, but you can bet there won’t be much
public support for it. AIG, an insurance company, has done everything
so poorly the public might just not be willing to allow Congress to foot
the bill for the CRE downturn. That’s the real risk here. If there’s a
bailout – ok. Insurance stocks will be worth a tiny fraction of what they
are worth today (I don’t think they can’t fall another 70, 80, or 90%).
firms have already started preparing. Earlier this week Principal
Financial Group (NYSE:PFG) announced it was going to do everything
necessary to cut expenses. It stopped hiring. It slashed pay across the
board up to 10%. It also cut back employee vacation time. These are not
actions taken by a company expecting the good times to return during the
anticipated recovery in the “second half of 2009.”
Crisis and Rational Opportunity
In the end
(yes the end is near – this was a bit long, but it’s not a simple topic
and the risks posed warrant the time), the CRE debt issues are a ticking
time bomb. With unemployment on the rise, vacancy rates rising, rents
dropping, and CRE loans on the brink of default, this is shaping up to
be a big problem.
The deal to unload the iconic Hancock Tower is just a sign of what’s to
come. There are buyers now. But when liquidations increase, you’ll see
prices fall much faster than the three year near-50% decline in the price
of the Hancock Tower.
More importantly, spotting problems like this early enough allows us to
make the moves necessary to protect ourselves from the very real risks
posed to the major insurance companies. You don’t have to short commercial
real estate REITs or insurance stocks to take advantage here.
By focusing on the reality of what’s on the horizon, we have the chance
to adjust our plans accordingly. We’ll have the chance to prepare psychologically,
get prepared for some more bad news, and we’ll be able to make the right
moves when this does become a problem.
And it is that, getting prepared to act rationally when others will be
surprised and act irrationally, that will allow us to turn this potential
crisis into a genuine
This is really interesting. New York Times readers are sending
in their photos and captions from around the world. How do you see the recession
playing out in your community? What signs of hardship or resilience stand
out? How are you or your family personally affected? There are five categories
-- business, family, home, sacrifice, transportation and work. To see the
photos along with their stories, click here.
most tasteless, but wonderful video. If you don't like four-letter
words, don't watch it. The video tells the story of the failed marriage via
a horse race. Use Windows Media Player or equivalent to play it. Click here.
your PC of the Conficker virus. Four percent of
PCs have it. For how to get rid of it, click here.
driving -- Part 1
A senior citizen was driving down the freeway, his car phone rang. Answering,
he heard his wife's voice urgently warning him, 'Herman, I just heard on the
news that there's a car going the wrong way on Interstate 77. Please be careful!'
said Herman, 'It's not just one car. It's hundreds of them!'
driving -- Part 2
Two elderly women were out driving in a large car - both could barely see
over the dashboard. As they were cruising along, they came to an intersection..
The stoplight was red, but they just went on through. The woman in the passenger
seat thought to herself 'I must be losing it. I could have sworn we just went
through a red light.' After a few more minutes, they came to another intersection
and the light was red again.
they went right through. The woman in the passenger seat was almost sure that
the light had been red but was really concerned that she was losing it She
was getting nervous at the next intersection, sure enough, the light was red
and they went on through. So, she turned to the other woman and said, 'Mildred,
did you know that we just ran through three red lights in a row? You could
have killed us both!'
turned to her and said, 'Oh! Am I driving?'
This column is about my personal search for the perfect
investment. I don't give investment advice. For that you have to be registered
with regulatory authorities, which I am not. I am a reporter and an investor.
I make my daily column -- Monday through Friday -- freely available for three
reasons: Writing is good for sorting things out in my brain. Second, the column
is research for a book I'm writing called "In Search of the Perfect
Investment." Third, I encourage my readers to send me their ideas,
concerns and experiences. That way we can all learn together. My email address
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