Friday, December 31, 2010

Letter to The New York Times, December 31

To the Editor:

On the very week the census told us that over the past decade there was a mass migration of Americans out of high-tax states and into low-tax ones, you call for an increase in state taxation. The people you want to tax can and do vote with their feet, rendering higher taxation a far from optimal solution.

Nevertheless I will grant you that taxation should not be off the table when dealing with the fiscal crisis that is enveloping most of the states.

But unless the bottomless pit of public employee pension and post-retirement health benefits is dealt with, no amount of higher taxation will be able to solve the problem.

David Shulman

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Thursday, December 23, 2010

A Reality Check on Congress' Lame Duck Session

The results speak for themselves. Simply put it was not a victory for President Obama or the congressional Republicans, but rather it it was a victory for the popular will. On every major issue the popular will was carried out. Public opinion favored a tax compromise, repeal of 'don't ask don't tell," passage of the Start Treaty, aid for the 9/11 responders and a rethinking of the FY 2011 spending plan. Public opinion was divided on the 'Dream Act" and that failed to pass.

Thus before rushing to conclusions that a new era of commity has descended over Washington, D.C., it more likely that on the controvesial issues that lie ahead there will be all-out street fights. The popular stuff will pass, but the really difficult fights over spending, taxation, environmental regulation and healthcare will be the norm.

Thursday, December 9, 2010

Risky Business, UCLA Anderson Forecast, December 2010

"In sum, on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years. As a society, we should find that outcome unacceptable."
- Ben S. Bernanke, "Rebalancing the Global Recovery," November 19, 2010

With short-term interest rates already at zero, the measured inflation rate approaching zero and the unemployment rate stubbornly remaining near 10%, a deflation-haunted Fed decided to experiment with a policy characterized as quantitative easing. (See Figure 1) On November 3rd, the Fed announced that it would expand its balance sheet by $600 billion dollars over the next eight months by buying intermediate-term Treasury bonds. Its purpose was not so much as to increase bank reserves, which it will do, but rather to lower long-term interest rates and as a consequence raise asset prices, thereby stimulating consumption and investment.

The unstated goals of this exercise in money printing are to lower the exchange value of the dollar and to lower real wages by causing inflation to

Figure 1 Federal Funds vs. 10-Year U.S. Treasury Yields, 2005Q1- 2012Q4F

Source: Federal Reserve Board and UCLA Anderson Forecast

increase relative to money wages. The former set off a firestorm of criticism at the G-20 meeting in Seoul, Korea increasing the risk of growth-dampening trade policies and as for the latter, although a theoretically appealing way of lowering the unemployment rate, it’s hard to see how a lower real wage in the construction industry, for example, will stimulate housing construction. Nevertheless, from an aggregate perspective a path to a more fully-employed economy could very well be through the wage adjustment process. That process is well underway in many sectors of the economy with the growing use of two-tier wage contracts and mandatory furloughs.1

The risks associated with the policy are that by monetizing the Federal deficit, it could lead to far more inflation than the Fed forecasts; it could engender a dollar crisis that would make it far more difficult to fund our fiscal deficit and it could negatively impact the dollar as the world’s reserve currency. Obviously, the additions to the Fed balance sheet will make it more difficult to unwind the extraordinarily easy monetary policy of the past few years.

Nevertheless, we must be mindful of the fact that the Fed has a dual mandate from Congress, which in the words of Chairman Bernanke "are to promote a high level of employment and low, stable inflation."2 Simply put, the Fed, as a creature of the Congress, has to try to fulfill its mandate or face the political consequences. To be sure, there are many critics who believe that rather than increase employment, the Fed will increase inflation, but with fiscal policy constrained by high deficits and stalemated politics; the Fed is the only game in town.

To us, a real risk is that the policy doesn’t work in reducing unemployment thereby lowering the Fed’s credibility. Indeed, clear signs of the Fed losing some of its credibility where a sell-off in the bond market more than undid the interest rate declines that took place in September and October and a surge in the prices of globally traded commodities that took place in anticipation of the quantitative easing policy. In essence, market fears of future inflation and/or dollar weakness have offset much of the positive effects that were to come from rising bond prices
Although it wasn’t called quantitative easing at the time, the Fed followed a balance sheet expansion policy in the context of near zero short-term interest rates during the 1930s. Then Fed chairman, Mariner Eccles characterized the effectiveness of monetary policy as "pushing on a string."3 All it did was increase bank reserves without transmitting any stimulus to the real economy, much like today.

After all, from late 2007 to the present, bank reserves increased nearly 30-fold with minimal upside effects on the economy. (See Figure 2) That is why Chairman Bernanke is stressing the asset market channel rather than the banking channel to transmit monetary policy. Of course it certainly can be argued that reserve expansion put a floor underneath the economy preventing something far worse. But, we must keep in mind a Fed without credibility is a clear negative for the economy, think the 1970s. While a Fed with credibility certainly aided the 25 year 1982- 2007 boom.

Figure 2 Total Bank Reserves, 2007Q4 – 2012Q4F

Source: Federal Reserve Board UCLA Anderson Forecast

Our Forecast

Our view is that the new Fed policy will be modestly helpful and the most recent economic data have been encouraging. As a result, we have revised up both our real GDP and inflation forecasts from last quarter, but unfortunately even with jobs gains averaging 150,000 a month in 2011 and 200,000 a month in 2012, unemployment will remain above 9% through the third quarter of 2012. (See Figure 3) We expect that real GDP will grow at a 2% plus annual rate through the third quarter of 2011 and then ramp up to a 3% or so growth rate. (See Figure 4) With respect to inflation, we are less fearful of deflation than Chairman Bernanke and we expect consumer price inflation to be at or above the Fed’s informal 2% target by late next year. (See Figure 5) The higher apartment rents now being reported by the publicly traded apartment REITs will soon find their way into the consumer price index.

Figure 4 Real GDP Growth, 2005Q1 -2012Q4F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 3 Unemployment Rate, 2005Q1-2012Q4

Figure 5 Headline vs. Core Inflation,
2005Q1 – 2012Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Why with such high unemployment is economic growth so sluggish? Historically, steep downturns are followed by steep upturns, but not this time. As we argued last quarter and previously, the economy is suffering from a debt hangover that will require many years of deleveraging to recover from.4 Consumption growth, instead of running at an historical 3% rate is now slogging along at a 2% clip as consumers increase their savings rate to repair their tattered balance sheets. (See Figures 6 and 7) Furthermore, with real wages stagnant, debt constrained consumers do not have the wherewithal to go on a consumption binge. (See Figure 8)

In fact, the economy just might be suffering from a new version of Keynes’ paradox of thrift. In the 1930s, Keynes argued that whereas savings for an individual was a virtue, for an economy in recession it is a vice because if every household cuts back on consumption the entire economy remains mired in a slump. Today, however, with very low interest rates, consumers and pension funds have to save more and/ or increase their contributions to achieve their target stock of savings. Moreover, it goes without saying that those consumers who are already retired are being forced to cut back on consumption because of reduced interest income. Thus, one of the challenges facing the Fed’s quantitative easing policy is that lower interest rates could have the perverse effect of lowering consumption rather than increasing it.

Figure 7 Personal Saving Rate,
2000Q1 – 2012Q4F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 8 Employment Cost Index, Real Private Sector Wages and Salaries,
2000Q1 -2012Q4F

Figure 6 Real Consumption Growth,
2000 – 2012F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Furthermore, much of the increase in consumption is going to imports. Where a year ago net exports were contributing to growth, it is now inhibiting growth. (See Figure 9) That is why a weaker dollar is necessary part of the adjustment process in that it would work to reduce imports and increase exports. (See Figure 10) Of course, the adjustment process would be made easier if China moved with greater alacrity with respect to the upward revaluation of its currency. Nevertheless, in order for net exports to structurally improve, the savings rate has to rise. Why? The U.S. now consumes more than it produces and borrows the difference from abroad. If consumption were reduced to equal production the savings rate would rise and the trade deficit would disappear.

Housing continues to be in the doldrums. We had hoped to see a meaningful recovery in 2011, but that has been pushed back into 2012. The near complete breakdown in the foreclosure paperwork process has dramatically slowed the price discovery process and introduced a new element of uncertainty. We are now forecasting housing starts to be 757,000 and 1,196,000 units in 2011 and 2012, respectively, compared to an estimate of 604,000 units for 2010. (See Figure 11)

The Restructuring of State and Local Government

Although most business cycles have similar characteristics, each cycle is different in its own way. In the current one instead of the state and local sector

Figure 9 Net Exports, 2005Q1 – 2012Q4

Figure 11. Housing Starts, 2005 – 2012F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 10 U.S. $ Trade-Weighted Exchange Rate

Sources: Bureau of the Census and UCLA Anderson Forecast
Source: IHS Global Insight and UCLA Anderson Forecast

gradually increasing throughout the business cycle, this time it is in decline. Simply put, the state and local government is now undergoing the same type of restructuring that the private sector has endured over the past two decades. As a result, we do not expect any meaningful growth in state and local spending over the next several years. (See Figure 12) That is to say, the tax base cannot keep up with the growth in public employee pension and Medicaid outlays and as a consequence other sectors of state and local budgets will be squeezed. This phenomenon will be reinforced by the election of a flock of new budget cutting governors last November. Over the long-run, the growth path of Medicaid and pension expenditures, of necessity, will be lowered.

Fiscal Imbalances Remain

As we noted earlier, high deficits are constraining the Federal government to engage in further fiscal stimulus. Indeed, the newly elected Congress might just be in the mood for fiscal consolidation on the spending side of the budget. As for the tax side, we are assuming for modeling purposes a tax compromise where all of the Bush tax cuts get extended for one more year and in 2012 high income taxpayers will see their tax rates rise. However, we caution a highly partisan Congress might fail to compromise on the tax issue leaving the economy vulnerable to a massive tax hit in January.

Figure 12 Real State and Local Government Expenditures, 2000 – 2012F

Figure 13. Federal Surplus/Deficit, FY 2000-FY2020F

Source: U.S. Department of Commerce and UCLA Anderson Forecast
Source: Office of Management and Budget and UCLA Anderson ForecastUCLA Anderson Forecast

Until Congress grapples with the long-term nature of our fiscal problems, we will be living a period of ongoing uncertainty with respect to taxation. The chairman’s mark of the Bowles-Simpson Deficit Reduction Commission offers a good start, but the politics don’t seem to be there for a meaningful solution. Congress does not seem to be in the mood to cut entitlements will raise taxes even if taxes are meaningfully reformed with lower rates and fewer deductions.

In the meantime, we forecast mega-fiscal deficits for as far as the eye can see. (See Figure 13) Thus, in our opinion, gridlock is bad. Without the two parties coming together there cannot be any meaningful solution to the long term fiscal imbalances we now face.


Despite all of the issues outlined above, the economy will continue to muddle through with modest growth and distressingly high unemployment. The economy is healing, albeit at too slow of a pace, but we forecast there will be an acceleration of growth in late 2011 that will gradually work to lower the unemployment rate. Inflation will pick up quicker than the Fed now expects and as a consequence the extraordinary policy measures taken will gradually be reversed and a gradual tightening cycle might begin in early 2012.


1. See, Uchitelle, Louis, "Unions Yield on Pay Scales To Keep Jobs," The New York Times, November 20, 2010, p.1
2. Bernanke, Ben S., "What the Fed did and why: supporting the recovery and sustaining price stability," The Washington Post, November 4, 2010.
3. Meltzer, Allan H., "A History of the Federal Reserve Volume 1, 1913-1951," (Chicago: University of Chicago Press, 2003), p. 62.
4. See Shulman, David, "The Uncertain Economy," UCLA Anderson Forecast, September 2010.

Wednesday, November 24, 2010

Did Vornado go After the Wrong Retailer?

Reprinted by permission from REIT Wrap dated November 15, 2010.

By David Shulman

In early October, Pershing Square Capital Management and Vornado Realty Trust (VNO) announced they acquired beneficial ownership of 16.8% and 9.9%, respectively of JC Penney Co. (JCP) common shares. Both are widely regarded as savvy real estate investors; so, JCP shares spiked 45% on the news and are now trading at around $31 a share.

JCP is loaded with real estate, but much of it is leased and only 49% of their stores are located in malls, -- mostly Class B malls.

JCP operates just over 1100 stores encompassing 112 million square feet. JCP owns 416 of their stores, but 119 are on ground leases yielding a free and clear total of 297 stores. In addition it owns approximately 4.7 million square feet of warehouse/distribution space.

Goldman Sachs has valued JCP’s real estate at between $1 and $1.5 billion based on low in-place lease rates. Based on a per box valuation Newport Beach, California headquartered Green Street Advisors pegs JCP’s real estate value between $3-$4 billion on an equity market cap of just north of $7 billion. The Green Street Estimate, in my opinion, is the more accurate one.

There is no question that as a stock trade, Pershing Square and Vornado have made a lot of money for their investors/shareholders. (Something both have done before previously, albeit separately, when they both bought Sears (SHLD) shares.) That said, at its current valuation, it is hard to make a compelling case for JCP based on its real estate valuation.

First, I am not a believer in the “REITCO/OPCO” strategy of spinning off the real estate assets of a department store into a REIT and keeping the retail in an operating company. Something Pershing Square’s Ackman proposed when he went after Target (TGT). Simply put, all the leasing real estate at market rates would do is weaken JCP’s already below investment grade rating.

Second, though JCP’s most recent earnings provided some hope, JCP has of late been a very weak retailer. Sales have gone nowhere since 2003 and profits have collapsed. In contrast JCP’s major competitor, Kohl’s (KSS) has seen its sales nearly double over the same time period.

Third, unlike interior mall stores, the department store business model is based on paying minimal rents and Goldman Sachs estimated that JCP pays an average rent of $3.55 a square foot. Perhaps a new tenant would be able to pay far more creating the opportunity to create “sandwich” leases.

In addition JCP’s stores sales generate an unimpressive $150 a square foot in sales. Kohl’s, on the other hand, generates just under $200 a square foot in sales. Further, like most department store chains, its store base is relatively old with just over 60% built before 1990. Against that statistic, 20% of their stores are located in the Sunbelt states of California, Texas and Florida.

Neither Pershing Square nor Vornado has tipped its hand on what it views as the “end game” for their JCP investments. One possibility would be to close many department stores (a lot of them) and harvest their value for alternative uses, such as in-line mall stores or possibly residential, in the case of stand-alone stores. Such a strategy, however, would take considerable time and in the case of mall-stores it would involve amending reciprocal easement and operating agreements.

If JCP isn’t a real estate story, what might VNO and Pershing Square have in mind? My guess is that JCP is a retailing turnaround story where capital could be allocated far better than it has been. For instance, pre- recession, JCP earned $4.86 a share and $4.75 a share in 2006 and 2007, respectively. On those earnings JCP sold above $80 a share.

In contrast consensus estimates call for earnings of $1.43 a share in 2010 and the consensus for 2011 is $1.79 per share. Prior to the recent Pershing Square/Vornado announcements , JCP was changing hand in the low 20s.To be sure, JCP earnings are somewhat understated because of noncash GAAP charges ($237 million in 2009) for their now fully funded pension plan. Those charges will go away by 2014.

In order the bring earnings back to anywhere near their prior peaks management would have to, in the words of Goldman Sachs analysts Adrianne Shapira and Jonathan Habermann, improve capital allocation by lowering cap-ex and buying back shares with the $3 billion in cash on their books, rationalize and monetize real estate assets and reinvigorate their basic retailing business.

No question that VNO and Pershing Square can bring skill sets to the table that would enable JCP management to accomplish at least two of those goals. However, given the “poison pill” that JCP just put into place, a meeting of the minds (at least near term) seems unlikely.

Further, at least near-term, Vornado may be handicapped as a result of the recently announced departure of its retail head, Sandeep Mathrani who takes over early next year as CEO General Growth Properties’ (GGP).

Yes, JCP’s earnings appear to be at or nearing a cyclical trough. However, the retailing environment is far from benign. Deleveraging middle-market consumers wracked by substantial losses on their homes, makes for a powerful headwind facing JCP. Which means it will be awhile, at least, before JCP can execute a turnaround.

JCP stock was cheap when Pershing Square bought their shares at 23 and when VNO bought its shares at 26. There is certainly less of a margin of safety today. Nevertheless, with JCP trading at under 7X EBITDA it seems a better investment than VNO stock trading at 18X EBITDA. The larger question, however, is whether investing in JCP was the best use of capital for a REIT acting like a hedge fund.

Given Vornado’s retailing roots I wasn’t surprised to see Steve Roth and Mike Fascitelli go after a retailer. JCP would not have been my first choice, however. From a strategic standpoint, Macys (M) is a far better fit for VNO. M has much better mall-based assets than JCP and its flagship store is adjacent to VNO’s vast holdings in Manhattan’s Penn Station submarket. If the VNO’s Hotel Pennsylvania site is worth X, then under certain circumstances the Macys full block position on 34th Street is worth 2X. Of course, at its current price of roughly $25 a share, M can hardly be called “cheap.”

David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He is now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. He can be contacted

Wednesday, November 3, 2010

Election Rap Up

The Republican Party did somewhat worse than the surge I expected two weeks ago. In the House I was pretty close to the mark with the Republicans picking up about 65 seats compared to the 70 seats I envisioned. The Democrats did better in the Senate than I expected by losing 6 seats for sure and possibly a seventh compared to the nine I expected them to lose. Nevertheless it was a good night for Shulmaven. The voters rightly held the Democrats responsible for the high unemployment we are now suffering from.

The big losers last night were obviously President Obama and the Democrats, but largely unnoticed in the press commentary was a string of defeats for Sarah Palin, who in her own way may have cost the Republicans Senate control. Palin favorites Christine O'Donnell in Delaware, Sharon Engle in Nevada and especially Joe Miller in Alaska all went down to defeat. Her stock has peaked and with that she will be less of player in 2012 than most people now imagine. Further, those defeats will make it easier for Republican regulars to bring the Tea Party into the fold and will, in liklihood, make the Tea Party more realistic with respect to future candidates. They will learn that winning is important.

Also beneath the radar was the silent war going on between Senators Chuck Schumer and Dick Durbin to replace Harry Reid as majority leader. With Reid's win a temporary truce has settled on the battlefield. Too bad, it would have been fun to watch, but for Shumer and Durban it has feel like coitus interruptus.

Monday, November 1, 2010

In the Washington Post, "Federal Reserve's, Bernanke's credibility on line with new move to boost economy"

November 1, 2010, P. 1

"The greatest risk for the Fed in taking this action is that it could extend the economy's funk by giving a sense that either no one is in charge or that the people who are in charge can't get it right," said David Shulman, senior economist at the UCLA Anderson Forecast. "The whole psychology of that could leak back into the economy."

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Saturday, October 30, 2010

The New Republic Picks up Infrastructure Idea (from July 4 Post)

See "Desperate Measures" by Noam Sheiber, October 29, 2010

Shoot the hostage (i.e., kneecap your allies to finagle more government spending). It’s no secret that Democrats are keen to pass a major infrastructure package, which would have the dual benefit of supporting the economy in the short-term while making us more productive over the long-term. Pretty much everyone who studies these things agrees that our infrastructure is either badly outdated, in a state of disrepair, or both. (The American Society of Civil Engineers estimates that the country could use about $2.2 trillion worth of upgrades and repairs over the next five years.) But, of course, Democrats had zero luck passing a major infrastructure package after the initial stimulus in early 2009. It’s hard to believe they’re going to fare much better with a House Republican majority that’s constantly looking over its shoulder at pitchfork-wielding Tea Party activists. Particularly since several of these activists are on the verge of coming to Congress themselves.

Still, a deal on infrastructure spending may not be entirely out of reach, at least if the White House is ruthless enough. One idea along these lines comes care of David Shulman, a senior economist at UCLA’s Anderson Forecast center. Shulman proposes a several-hundred-billion dollar infrastructure package in which the administration agrees to suspend Davis-Bacon, the law requiring contractors for government-funded construction projects to pay locally prevailing wages, as deemed by the Labor Department. Conservatives complain that the law artificially inflates costs and is a sop to labor. (I have somewhat mixed feelings toward the law but am more sympathetic.)

Shulman would also have the administration fast-track environmental approval of construction projects—under current law, it can take months to assemble the various environmental-impact statements and reports, and there can be costly litigation along the way. Shulman recommends that the White House oversee an accelerated environmental review process and set up some provision for expediting judicial review. (The American Prospect’s Harold Meyerson hinted at some similar ideas back in May.)

Unions and environmentalists would howl, of course—in many cases for good reason. But that’s partly the point. (In fact, the louder the better.) If a spending package has the right opponents, then the conservative media-industrial complex may come around, bringing the GOP leadership along with it.

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Wednesday, October 27, 2010

My History with Santa Monica Place

Reprinted by permission from REIT WRAP Special Report dated October 20, 2010. Editor's Note: David explains that with respect to the design and retailing elements, Macerich (MAC) did a spectacular job rennovating Santa Monica Place. For investors, however, he concludes, the all-in results will likely be less than spectacular.

by David Shulman

Santa Monica Place is a 524,000 square foot regional mall anchored by Nordstrom and Bloomingdale’s. it is located four blocks from the beach in the heart of downtown Santa Monica.

What is striking about the renovation completed in August of this year is that it represents the conversion of a 1970s fortress mall into an open mall fully integrated into the thriving street scene of the very popular 3rd Street Promenade thereby creating a four block long urban retail environment.

Aside from being open, Santa Monica Place differs from suburban malls in that it sits on a very compact 9.9 acre site and instead of having six parking spaces per one thousand square feet it only has four spaces per one thousand square feet.

The 2000 space parking structures are owned by the city and are included in the 9.9 acre site. Given the tight urban environment, it makes for difficult traffic and parking during peak times. This situation is partially mitigated by nearby city parking for the 3rd Street Promenade.

Because the site is so close to the ocean, about half of the trade area is in the water. The other half of the trade area consists of some of the priciest real estate in America.

My own history with the project goes back to the public hearing held by the Santa Monica Redevelopment Agency in 1974. Two competing designs were presented at the hearing: one by The Rouse Company and the other by The Hahn Company. Both firms CEO’s, Jim Rouse and Ernie Hahn, appeared at the hearing.

The project was initially envisioned to be much larger, five more acres, and it included another whole block to the west where hotel, office and residential uses were contemplated.

The Rouse Company, breaking Hahn’s near monopoly on California mall redevelopment projects, won the competition with a Frank Gehry design for the full mixed-use project. Nevertheless, after the project was scaled down to its current size, Rouse brought in Hahn for their construction expertise and made them a 50% joint venture partner.

That was before Frank Gehry became the world famous architect that he now is today. Gehry was not happy how the project turned out. For example in Barbara Isenberg’s, “Conversations with Frank Gehry,” (2009) Gehry said “… we designed it as a mixed-use project, not just a dumb shopping center. Then for reasons beyond my control, the city wouldn’t support it, and so it ended up being just a shopping center.” In Joshua Olsen’s “Better Places Better Lives: A Biography of James Rouse,” (2003) Gehry was more succinct, “It’s not something I go show people.”

What was my role in this saga? In 1974, I was a graduate student at UCLA. I was also a community activist in Santa Monica. The city attorney called us a bunch of long-haired – I wish I still had the hair and my politics have moved to the right -- hippies who dressed up in suits to impress various regulatory bodies.

I was a leader in the opposition to the mall, first before the City, then before the California Coastal Commission and we were allied with a parallel law suit brought on behalf of clients of the Legal Aid Society of Los Angeles. We were opposed to the project on the following grounds:

1. We fundamentally disagreed with the notion that government could take property from a private owner and then turn it over to another private owner. A precursor to the famous Supreme Court case, Kelo v. New London.

2. We argued that the property in question was not blighted. (The city’s newspaper was located in the redevelopment area) and therefore the redevelopment was not lawful.

3. We believed that the $15 million of tax increment bonds issued by the redevelopment agency was a flat out subsidy to the development that expropriated tax dollars that rightfully belonged to the school district and the county. If Santa Monica wanted a shopping center, the private sector should build it. I was quoted in the local newspaper saying, “I don’t believe in subsidizing department stores.”

4. We believed that the mall project was part in parcel with the city’s other redevelopment project in Ocean Park which was designed to remove lower income people from the city. In a word, “gentrification.”

5. Finally, if a mall were to be built, it should be open. Why have an enclosed mall in the most temperate climate in the U.S.? Our design ideas included a “parasol” roof which Gehry was sympathetic to.

We lost and the original mall opened in 1980 at a cost of about $60 million for Rouse/Hahn and $15 million for the taxpayer. The Coastal Commission did require a small open air viewing deck as a condition for a permit and the law suit required the city to come up with about one million dollars for a grab bag of public benefits to fund housing and park projects. That piece was funded by Rouse/Hahn.

Ultimately Rouse bought out Hahn’s 50% interest and then sold the entire project to Macerich in 1999 for $132 million. Analysts at the time estimated the deal was done at a 9% cap rate and to keep the arithmetic simple I am assuming the initial NOI to be $12 million. Just as an aside, in 2000 as Lehman Brothers REIT analyst I conducted a Los Angeles property in 2000 and we toured both Santa Monica Place and the adjoining Promenade. The highlight of that property tour was a cameo appearance of super-model Cindy Crawford.

Macerich knew that Santa Monica Place has issues when it bought it. It was an obsolete fortress mall with middle market stores in a high income area. Meanwhile right next to it was the edgy and newly revitalized 3rd Street Promenade attracting hoards of locals and tourists.

Though the mall was generating about $400 a square foot in sales for its occupied space, its days were numbered. It is likely that the mall’s peak NOI occurred in the first year Macerich bought it.

Now let’s look at the development economics. Macerich stated that it expects Santa Monica Place to generate initial sales of about $800/square foot soon rising to $1,000/square foot - making it a Super-A mall. Net rents are in the $70-$100/square foot range and common area maintenance charges are anticipated to be $27/square foot. MAC is telling investors that it expects to generate a stabilized return of 9- plus percent on its incremental investment of $265 million, or about $25 million a year. Within a few years MAC expects to be generating $27 million a year. A more than successful outcome for a mall headed for the graveyard.

In order to achieve those targets, MAC assumes that it will achieve its leasing targets for the 50,000 square feet on the mall’s third level encompassing the former third floor of the Bloomingdale’s space. Trust me; this represents a leasing challenge because the mall’s third level is devoted to high-end restaurants, a farmer’s market-type retail operation called “The Market” and public open space. If this space were easy to lease, it would have been leased already.

Further, if we start with the original purchase price of $132 million and an initial NOI of $12 million, the returns don’t look so great. All-in MAC now has about $400 million in the project, including some capital expenditures made for the old mall. An initial return of $25 million on that equates to 6.25% and the incremental return on the renovation costs amounts to a low 4.9%. ($25million-$12 million)/$265 million)

If significant value, from the stand point of the 1999 acquisition, is to be created Santa Monica Place would have to be valued a cap rate well south of 6%. This comment should be viewed as a criticism, but it just goes to show how capital intensive the mall business is.

I would be remiss not to point out that MAC will receive a very important intangible benefit from the renovation; it will have a show case asset just a few blocks south of its corporate headquarters.

As for me personally, I feel vindicated that my efforts of over thirty years ago have finally born fruit. A very successful open mall was built and the renovation was accomplished without the contribution of public money.

David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He is now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. He can be contacted

Wednesday, October 20, 2010

Despite Closing Polls, Republican Wave Election Likely

The latest polling data now indicate that this year's competitive Senate races are closing with the leaders of both parties losing ground(e.g. Boxer in California and Toomey in Pennsylvania). Nevertheless because I think this will still be a big Republican year, my best guess is that the GOP will pick up 9 Senate seats, one short of a majority. If I am right, expect to see Senators Lieberman and Nelson holding an auction to determine whether on not they will continue to vote with the Democratic leadership. Net net, Republican Mitch McConnell will be the next majority leader.

As fas as the House goes my best guess is that the Republicans will pick up about 70 seats, far from the 130 seat blow-out of 1894, but way better than the 52 they picked up in 1994. Figure a 250-185 GOP majority. The big questions are what they do with it and can it carry over to 2012. In 1996 the GOP barely hung on and in 1948, the Republican victory of 1946 turned into a debacle. Remember neither party has a magic wand to solve our Nation's deep seated problems and the electorate is, to say the least, very volatile. Thus it would be premature to write-off Democratic prospects for 2012.

This year's election is about two numbers, 9.6% and 17.1%. The former is the official unemployment rate and the latter is the "all-in" unemployment rate that counts involuntary part-time workers and discouraged workers. For whatever reason the Obama Administration and the Democratic majorities in Congress failed to make employment Job One. They will now suffer the consequences.

Wednesday, September 15, 2010

The Uncertain Economy, UCLA Anderson Forecast, September 2010

““Look at the uncertainty,” said one senior Fed official. “Are we facing
deflation or inflation? Are we up or down? Growing or not?””[i]

Against a backdrop of growing policy uncertainty, the economy stalled in the second quarter with real GDP growing at a revised 1.6% annual rate. Indeed we forecast that the economy will continue to crawl at a 1.4% rate in the current quarter and then grow at a very tepid 2% growth rate for the following four quarters. (See Figure 1) Indeed we don’t visualize a return to trend growth to approach 3% or so until late 2011. In this environment the unemployment rate will remain extraordinarily high ending this year at 9.7% and 2011 at 9.5%. (See Figure 2)

Given the huge decline in output that took place in 2008-09, the economy should be growing at 5-6% annual rate, not the 2% rate that we now envision. What normally happens in a recovery is that the proverbial baton is passed from government spending and inventory restocking to housing, consumer spending and investment. In this recovery somewhere along the way the baton was dropped as housing double-dipped and consumer spending stalled. (See Figures 3 and 5) Although it is hard to visualize the double dip in the quarterly housing start data, it is very evident in the collapse of monthly existing home sales after the expiration of the homebuyer’s tax credit. (See Figure 4) To be sure, equipment and software spending has remained strong, but leading indicators of activity and corporate announcements suggest that it too, will fall from its recent heady pace. (See Figure 6)

Figure 1. Real GDP Growth, 2005Q1 -21012Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 2. Unemployment Rate, 2005Q1 – 2012Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 3. Housing Starts, 2005Q1 – 2012Q4

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 4. Existing Home Sales, 2005 – July 2010
Source: National Association of Realtors

Figure 5. Real Consumption Expenditures, 2005Q1 -2012Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 6. Real Spending on Equipment and Software, 2005Q1 – 2012Q4F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

What Ails the Economy?

We have two broad explanations as to what is ailing the economy. The first is the balance sheet recession hypothesis we outlined nearly two years ago which is broadly analogous, with the important exception of the U.S. not experiencing a foreign exchange crisis, to the analysis put forward by Carmen Reinhart and Kenneth Rogoff.[ii] In their historical work, “This Time is Different,” they outline the history of eight centuries of financial collapses and come to the conclusion that recoveries from the bursting of debt fueled financial bubbles are invariably slow and are associated with unusually high unemployment rates and an explosion in government debt. Sounds familiar, doesn’t it? Simply put because the imbalances engendered by the prior boom, it takes a long time for an economy to heal from a financial collapse. It certainly doesn’t have to be as bad as the 1930s or Japan’s lost two decades, but in their view a quick recovery to the semblance of the pre-boom normal is not likely.

The recovery from the balance sheet recession is being exacerbated by an extraordinary increase in policy uncertainty which is amplifying the usual economic uncertainties associated with recessions. . As early as December 2008 and almost continually thereafter in the UCLA Anderson Forecast we noted that fiscal, monetary and regulatory policy uncertainties coming out of Washington, D.C. would limit consumption, investment and hiring.[iii] In a way, policy making has become “iatrogenic” in that instead of curing the economic disease it is making it worse.

Policy makers in Washington D.C. don’t seem to understand that the decision of a firm to hire an employee is an investment decision and therefore subject to all of the budgetary criteria that goes into the buying of equipment. And remember there are no health insurance premiums associated with buying a computer. The investment/hiring decision is subject to forecasts on the future of tax, environmental, energy, financial, labor and healthcare policies.

At the present time, business firms can only make the wildest guesses as to what corporate and individual tax rates will be next year and for that matter three years from now, what the cost of healthcare will be, whether or not there will be a revived cap and trade policy with respect to carbon emissions or whether the Environmental Protection Agency will step in with regulations of their own absent a statute and whether it will be easier or more difficult to hedge risks with financial derivatives. Furthermore, it certainly does not help to have the perception, true or not, that the Administration is at best ignorant of business or at worst, hostile to business.

A Late New Deal Analogue

There is a loose historical analogy to the current environment. In the middle of the 1937-38 recession the term “capital strike” entered the political vernacular as several prominent New Dealers, in particular Secretary of the Interior Harold Ickes and Assistant Attorney General Robert Jackson, attacked the business community for “sabotaging” the New Deal.[iv] Of course left out of their theory was the impact of the full implementation of the Wagner National Labor Relations Act and the adoption of a tax on undistributed corporate profits along with a monetary tightening and the tax increases associated with the beginning of the Social Security payroll tax. In light of this history, it would be fair to say, that today's business community doesn't have a clue as to how hostile government policy can be.

Nevertheless, after two national radio speeches on the subject calling for direct controls on the economy by the previously mentioned New Dealers, the subject was dropped like a hot potato as Roosevelt adopted an all-out Keynesian deficit spending policy. With the likelihood of a European war increasing, President Roosevelt became more conciliatory towards business, the tax on undistributed corporate profits was effectively repealed and the full implications of the Social Security program became more widely understood. As a result the economy began to recover well before the advent of rearmament.

A Tax Compromise

Thus it would certainly help if there were at least a perceived truce between the business community and the Obama Administration. Because the drafting and adopting regulations associated with the healthcare and financial reforms will go on well into 2013, a good start would be to compromise on the contentious tax issue. that can actually be accomplished this month! One example of a bipartisan compromise would include permanently setting the tax on dividends and capital gains at 15% compared to the 20% rate for both proposed by the Administration and 39.6% for dividends should the current law lapse, increasing the top rate on ordinary income to 39.6% as contemplated by the Administration and the lapsing of current law, but have the Bush tax cuts remain in force for incomes up to $400,000 for a joint return instead of $250,000 as proposed by the Administration. Add to that setting the inheritance tax exclusion for a family at $7.5 million as proposed by the Administration or $10 million as proposed by some congressional Republicans. And maybe they could throw in the taxing of carried interest capital gains for private equity and hedge funds at ordinary income tax rates.

There you have it, a reasonable compromise where both parties can declare a victory, but can they actually come together and do it? The Obama Administration would get its higher top rate and a step, albeit smaller, toward deficit reduction and the congressional Republicans would get their low taxes on capital. Above all the economy would achieve at least a vestige of certainty with respect to tax policy. One of the worst things that could happen would be a one year extension of the Bush tax cuts. The uncertainty would remain, incentives would be untouched and the economy would have the increased burden of debt. Remember policy makers are playing with fire with respect to the tax issue. A recent article co-authored by former Council of Economic Advisors Chair Christina Romer noted that exogenous increases in taxation have caused severe shocks to economic activity.[v]

Problems Confounding Policy

The Fed has tried practically everything in its policy toolkit to halt the recession and engender recovery. Short-term interest rates have been cut to zero, its balance sheet has exploded, the open market committee has purchased mortgages and long-term treasury bonds with abandon (quantitative easing) and they announced that short-term interest rates will remain low for “an extended period.” Yet unemployment remains high and the recovery is faltering. At the recent Jackson Hole conference, Chairman Bernanke promised he would do whatever it takes to keep the recovery going.[vi] Whether further quantitative easing will work remains to be seen but to the public it is beginning to look like pushing on the proverbial string. After all, record low mortgage rates are not triggering a housing boom, far from it.

Our view is that monetary policy will work with an unusually long lag. We forecast that the Fed’s zero rate policy will remain in place for at least another year and after that the Fed Funds rate will slowly increase. (See Figure 7) Concomitantly long-term interest rates will likely remain unusually low and we anticipate that the yield on 10-Year U.S. Treasury notes won’t exceed 3% until the third quarter of 2011.

Figure 7. Federal Funds vs. 10-Year U.S. Treasury Yields, 2005Q1 – 2012Q4F,
Source: Federal Reserve Board and UCLA Anderson Forecast

Despite the ongoing policy ease, we expect inflation to remain quiescent during the forecast period. (See Figure 8) Both headline and core inflation will be under control staying below 2% for all of 2011 and the risk of deflation, though nontrivial, remains small. Despite the low rate of inflation, low nominal rates will keep real returns to savers extraordinarily low.

Figure 8. Headline vs. Core Inflation, 2005Q1 – 2012Q4
Source: Bureau of Labor Statistics and UCLA Anderson Forecast

With respect to fiscal policy the Obama Administration is on track to pile up a record decade of deficits. (See Figure 9) Somewhere along the way taxes will have to increase substantially, an inevitable policy uncertainty, and entitlement spending will have to cut radically. In the meantime fiscal policy is not working the way it is supposed to be. Instead of spending with alacrity, consumers are saving and where consumption and investment are rising, a significant portion of it is coming in the form of increased imports. (See Figures 10 and 11) Stimulus in America is turning out to be great news for the exporters of China and Germany.

Figure 9. Federal Surplus/Deficit FY 2000 – FY2010F

Source: Office of Management and Budget and UCLA Anderson Forecast

Figure 10. Personal Saving Rate, 1990Q1 – 2012Q4
Source: Department of Commerce and UCLA Anderson Forecast

Figure 11. Real Imports, 2005Q1 – 2012Q4F, Quarterly Data

Source: Department of Commerce and UCLA Anderson Forecast


In an economy wracked by a post financial bubble environment and living in a theme park of policy uncertainty, we forecast very sluggish growth accompanied by high unemployment. As time passes the economy will naturally heal and the policy uncertainties will resolve themselves to the extent that growth will return to a 3% path and unemployment will begin on its long trajectory downward. We forecast that these more ebullient trends will become noticeable by 2012.

Higher savings and increased imports seem to be one of the key reasons why macroeconomic policy is not working the way the traditional models would have it. Thus if policy is to work it will have to restore the confidence of businesses and consumers to spend and invest in America. A real reduction in policy uncertainty would go a long way toward that end.

[i] Financial Times, August 19, 2010, p.1.
[ii] Reinhart, Carmen M. and Kenneth S. Rogoff, “This Time is Different,” Princeton; Princeton University Press, 2009.
[iii] See Shulman, David, “The Balance Sheet Recession,” UCLA Anderson Forecast, December 2008
[iv] See Brinkley, Alan, “The End of Reform,” New York: Knopf, 1995, pp. 56,57
[v] See Romer, Christina D. and David H. Romer, “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” American Economic Review, 100, June 2010, pp.763-801.
[vi] See Bernanke, Ben S., “The Economic Outlook and Monetary Policy,” August 27, 2010.

Wednesday, August 25, 2010

The Shaky Foundation Supporting Long-Term REIT Performance

Reprinted by permission from REIT WRAP Special Report dated August 16, 2010.

By David Shulman

Though the first decade of the 21st century has been characterized as “lost” for most equity investors, REITs stood out by generating a 9.75% compound annual return as measured by the total return version of the MSCI U.S. REIT Index (RMS) for the 10- year period ending in July 2010.

This performance is truly remarkable when viewed against the backdrop of a small negative total return for the S&P 500. Moreover after undergoing a near death experience in 2008/2009, REIT investors are once again looking forward to high single-digit returns for the new decade.

However, REIT performance over the last decade did not come from rising earnings and dividends; rather, it came from the tailwind of multiple expansion that is hardly sustainable. Add to that the “meltdown’s” impact (e.g. dilution resulting from massive stock issuance and significant dividend cuts, which helped right-size balance sheets) and the future appears guarded.

Where in 2000 REITs typically traded at FFO multiples in the 6-9 X range, today they trade in the 15-20+ X range. Moreover in 2000, according to data provided by Green Street Advisors, REIT forward AFFO yields were about 700 basis points above the forward earnings yield for the S&P 500; today, REIT forward AFFO yields are nearly 400 basis points below the S&P 500.

In other words, from a valuation perspective REITs are trading at the mirror image of their levels in early 2000 and it is more than likely going forward REIT performance will suffer from the headwind of multiple contraction.


Beneath this stellar REIT performance is a very troubling record with respect to earnings and dividend growth. I dare say that few analysts in 2000 would have forecast the flat to down earnings that most REITs experienced over the past decade. To be sure 2000 represented a cyclical peak in REIT earnings and 2010 represents results around a cyclical trough, but the fact remains that 10 years is a long time.

Let’s get into the data. I examined the earnings and dividend performance for almost all (20) of the equity REITs that are covered by the Value Line Investment Survey. The data excluded those REITs who were bought out during the decade. Nevertheless, I believe it to be a good, though far from perfect sample, in that it leaves out a few of the major mall companies that did well.

I used Value Line because the data is readily available and it presents long term results on a consistent basis. However to be more current, I am using current IBES estimates for 2010 and Zachs Investment Research for future growth rates. The 10 year record for FFO and dividends are presented in a table at the end of this column.

Several of the “blue chip” REITs did well over the decade. The best FFO growth was reported by Public Storage (PSA) where FFO almost doubled and dividends more than doubled. Simon Property Group (SPG), Vornado (VNO), Federal Real Estate Investment Trust (FRT) and HCP (HCP) all reported credible increases in FFO and dividends. Boston Properties (BXP) reported higher FFO but a slightly lower dividend and AvalonBay (AVB) and Washington REIT (WRI) reported modest increases in FFO, but significantly higher dividends. (NOTE: In 2000 FRT, PSA, HCP and for that matter SPG weren’t as highly regarded as they are today. Moreover with respect to BXP and VNO the data ignore the impact of very substantial capital gain distributions made by those two REITs.

On the hand there were many REITs in 2000 that were perceived to be of high quality that faltered during the past decade. Apartment Investment and Management (AIV), Duke Realty’s (DRE), Prologis (PLD) and Developers Diversified (DDR) had their FFO and dividends decline by more than 50%. Such highly regarded REITs as Kimco Realty (KIM) and Equity Residential (EQR) will earn less and pay smaller dividends in 2010 than they did in 2000. The same is true for Weingarten Realty Trust (WRI), UDR (UDR), and BRE Properties (BRE). The mid-Atlantic office companies, Mack-Cali (CLI) and Liberty Property Trust (LRY) are also earning less and paying out less to their shareholders. The same holds true for Healthcare Realty Trust (HR).

In contrast to their short-run low-balling of earnings estimates, sell-side analysts are ever optimistic with respect to long term growth. Going forward analysts believe that REIT FFO growth rates will be in the range of 4-7% for most REITs, save for a few outliers. It may turn out that way, but history is on the side of the skeptics.

To be sure real estate fundamentals might drive REIT earnings higher, but where most analysts miss the mark it is with respect to capital expenditures and adverse changes in capital structure which are inherently difficult to forecast. Remember that the fastest growing REIT in the sample was PSA with a historic growth rate of 6.1%. Among the better performing REITs the growth rates ranged from 5.1% at SPG to 0.7% for AVB. Against the backdrop of the past decade, a seemingly modest 4% growth rate is stellar.

Similarly dividend growth left much to write home about. AVB, FRT, PSA, VNO and WRE reported solid dividend growth -- in the range of 32%-106%. On the other hand dividend payouts were crushed at AIV, DDR, HR, and PLD. This is hardly a record that inspires confidence for the coming decade.

Said differently, for REITs to work in the coming decade, multiples have to remain high and historically optimistic analyst forecasts have to be realized. We do not have the luxury of low multiples to protect us from untoward events.

Figure 1. REIT FFO and Dividend Growth Per Share, 2000 – 2010E

REIT '00 '10 CAGR Est.CAGR '00 '10 %Ch
FFO Dividend

AIV $4.81 $1.28 -12.4% 6.3% $2.80 $ .40 -86%
AVB 3.70 3.97 0.7 6.6 2.24 3.57 59
BRE 2.38 1.87 -2.4 6.1 1.70 1.50 -12
BXP 3.46 4.23 2.0 5.2 2.04 2.00 - 2
DDR 2.19 .86 -8.6 N/A 1.44 .08 -94
DRE 2.46 1.08 -7.9 26 1.64 .68 -59
EQR 2.50 2.16 -1.5 4.9 1.58 1.35 -15
FRT 2.56 3.88 4.2 7.1 1.82 2.64 45
HCP 1.66 2.15 2.6 6.4 1.47 1.86 27
HR 2.62 1.32 -6.6 5.3 2.23 1.20 -46
KIM 1.35 1.11 -1.9 3.0 .91 .64 -30
LRY 3.17 2.65 -1.8 8.7 2.13 1.90 -11
CLI 3.79* 2.79 -3.0* 5.0 2.38 1.80 -24
PLD 2.21 .59 -12.4 34 1.35 .60 -56
PSA 2.59 4.70 6.1 19 1.48 3.05 106
SPG 3.28 5.40 5.1 7.9 2.02 2.40 19
UDR 1.47 1.11 -2.8 4.4 1.07 .73 -32
VNO 3.86 5.17 3.0 10.3 1.97 2.60 32
WRE 1.79 1.97 1.0 1.0 1.23 1.73 41
WRI 1.93 1.66 -1.5 4.6 1.33 1.04 -22


David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. Heis now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. He can be contacted

Saturday, August 14, 2010

Dividend Yields, Bond Yields and Macroeconomic Policy

Last week Aaa rated Johnson & Johnson (JNJ) sold 10 year bonds at a 3.15% yield, well below the 3.71% dividend yield on its common stock. Old codgers like myself remember that stocks in general, with the exception of 1929, invariably yielded more than bonds until mid-1958. After that bonds always yielded more than stocks. As I wrote in my "Paradigm Shift" paper for Salomon Brothers in 1995 the reason for the revaluation of share prices then, in the view of Benjamin Graham, was that macroeconomic policy had the ability to prevent depressions. That view was logically based on policy successes that worked to end the recessions of 1948-9, 1953-4 and 1957-8 with the last one being particularly deep.

What the capital markets are now signalling is that stocks are especially cheap in the light of the past 50 or so years of history or perhaps, more ominously, the markets no longer believe that macroeconomic policy can work in preventing either a depression or a long period of Japanese-like stagnation. In a nutshell, at least for now, it is a vote of no confidence in the Obama Administration and the Fed.

In my own view its a little of both. Stocks are cheap, but the macro environment is extremely troubling. By way of disclosure, my family owns shares in JNJ.

Saturday, July 31, 2010

In the Washington Post, "GDP report: Economic growth slows with 2.4 percent rate in second quarter", p. a1

"The problem is it looks like the consumer was really weakening in June, so you're starting the third quarter in a position of weakness," said David Shulman, senior economist at the UCLA Anderson Forecast. "The components of this report are ugly."

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Wednesday, July 28, 2010

Is the U.S. Headed for a Double-Dip Recession?

Reprinted by permission from Reitwrap special report dated July 19, 2010.

By David Shulman

Double-dip recessions are rare. The last one occurred from 1979-82 when a renewed round of Fed tightening triggered back-to-back declines in output. That hasn’t (isn’t) impacted discussions of whether the U.S. is headed (imminently, some argue) for a double-dip recession, however.

And last Friday’s nearly 3% drop in the broad market won’t do anything to diminish fears of a dreaded double-dip is looming. Reinforcing that concern was a decline in 10-year U.S Treasury bonds to nearly 2.9%.

Remember, of late, the bond market has been a much better forecaster of future economic activity than the stock market. Nevertheless, my own view is that the economy will not experience a double-dip recession. Instead I believe we are in for a sustained period of very slow growth. Over the next four quarters I would not be surprised to at least one quarter with real GDP growth less than 2% and no quarter with growth above 3%.

What accounts for my skepticism that the U.S. will experience a double-dip recession? Because, in the words of my UCLA colleague Ed Leamer, it usually takes a coordinating mechanism, to trigger a recession and absent an even worse crisis emanating from a collapse in the Euro, I don’t see it. Absent that trigger, there seems to be just enough impetus in capital spending, exports, inventory accumulation and modest increases in consumer spending to offset the weakness coming from deleveraging, policy uncertainty, state and local government spending and higher income taxes next year.

REITs were only beginning to reflect the coming sluggish growth reality with the late June to early July decline in share prices. How so? If my view about the future course of the economy is close to the mark, investors were beginning to realize that FFO estimates for later this year and all of 2011 are way too high. My guess is that the already optimistic analysts got sucked into much of the happy talk that was present at NAREIT’s recent REIT/WORLD confab in Chicago. If I am correct on that score -- they will likely be disappointed.

To be sure much of the optimism was grounded in a very real improvement in the real estate operating environment that took place over much of the first half. And second quarter results should be fine. However, my interpretation of what happened earlier this year is consistent with the inventory cycle the broader economy experienced. From the point of view of the tenant, leased real estate is much akin to business inventory that expands and contracts over the business cycle.

What happened earlier in the year is that enough tenants realized that they had excessively cut back on their space needs and either ceased cutting back or made modest additions to space. That showed up as improved, or, at least, less negative, absorption. Let’s make this concept a bit more specific by using apartment demand, which analysts and companies alike are most bullish about, as an example.

Just like most businesses apartment renters were shocked by the speed of the economic decline in late 2008 and early 2009. It seemed that we were headed for The Great Depression 2.0. Renters responded by staying put or moving in with friends and/or parents. As a consequence vacancy rates rose and apartment rents dropped. No surprise here. Then in late 2009 and in early 2010 without any meaningful employment growth, apartment demand picked up as tenants realized that the world wasn’t as bad as previously thought. With demand rising without employment growth, company managements and analysts began to mark-up their future outlooks, figuring logically that if things are getting better without employment growth, demand would really explode once jobs were being created in any meaningful amount.

It can certainly turn out that way, but if the increase in apartment demand was just a temporary inventory adjustment by tenants who recognized that a depression was off the table, then the future outlook for apartment rents and occupancies would be far more tepid. Obviously if the economy double-dips we would be in a whole new ball game, but the sluggish outlook I envision would mean that there would very little follow through to the demand increases experienced earlier in the year.

Similarly the demand for retail space will continue to remain depressed. Witness the very sluggish growth in June same-store sales reported last week. For whatever reason it seems that the economy really down-shifted in June. Furthermore the consumer continues to retrench from the leverage bubble of a few years ago. For example total consumer credit outstanding has been declining almost continuously since July 2008. As of May 2010 it was down $167 billion, or 6.5%. This decline is unprecedented since the start of the series in the early 1940s. More forward looking, the recent strength in high-end retailing waned in June, perhaps in response to a transitory fall stock prices. Note: There will be substantial and permanent tax increases for high-end consumers taking place next January with further rounds to come in 2012 and 2013. Analysts who expect high-end retailing to save them are whistling passed the graveyard.

In the case of the office sector, the weakest of the major real estate food groups -- with the notable exceptions of Manhattan and Washington D.C., the recovery in demand will have wait until the second half of 2012. Although private sector employment has been growing modestly, the all important financial sector continues to exhibit monthly declines. The recent blip up in Manhattan investment banking employment is the exception, not the rule.

Warehouse demand has reflected the swing in inventories from huge declines to modest accumulation. This recovery process still some legs in it, but it will likely wane by the end of the year as the inventory adjustment is completed.

All told my main point is that although I don’t think the economy will experience a double-dip, a sustained period of tepid growth will not bring with it any meaningful recovery in REIT earnings. Tepid growth when starting from a fully or near fully employed (occupied) economy can and does generate significant earnings growth, but that is not the case when vacancy rates are high.

Simply put, there is too much downward pressure on rents. This is especially true in a very low inflation environment. Going back to the sub- 3% yield on the 10-year Treasury bond, a yield that low implies there will be an insufficient dollar flow in the economy to ratify rent increases.

David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. Heis now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. He can be contacted

Tuesday, July 6, 2010

"Spending controls are key," Letter to the Star Ledger, July 6

I wish Paul Mulshine would get off his Proposition 13 fixation. (“California dreaming on property taxes,” July 4). To be sure, New Jersey’s property taxes are way too high, but a Proposition 13-like solution is not the answer. I lived in California in 1978, the year Proposition 13 passed, and authored two academic articles (National Tax Journal and Southern California Law Review) on the subject.

Mulshine neglects two fatal flaws in Proposition 13. First, two identical houses standing side-by-side can and are taxed at substantially different levels. For example, it is not unusual to have one house taxed at $3,000 and another at $10,000 depending on the initial purchase price. Second, with property taxes cut back, California over-relies on volatile income taxes to fund public services. That is why the state is subject to periodic budget crises as flush times bring with them runaway spending that has to be cut back when an economic downturn causes a collapse in income tax receipts. Sounds familiar, doesn’t it?

The real solution is spending control at all levels of government. The compromise agreement announced over the weekend is a good start, but no real reform is possible without significant reductions in pension and health care benefits for public employees.

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Sunday, July 4, 2010

Democrats Adjourn, while Unemployed Suffer

The Democrats control the White House and both Houses of Congress. They certainly have the power and, yet they don’t really seem to care about our nation’s most pressing problem, mass unemployment. On this July 4th nearly 15 million Americans are counted as unemployed and another 9 million are too discouraged to look for work or are under-employed. Indeed nearly one million workers dropped out of the workforce over the past two months. Given this crisis, what does the Congress do? It adjourns for the holiday. Meantime an extension of unemployment benefits and Pentagon funding await action.

Where is the concern for job creation as the officially unemployed and new entrants to the labor force wait and wait and wait? Although I have few ideas on the subject (see below), it is not all that clear what Congress can really do. Nevertheless it is hardly helpful to pass and propose new legislation that increases business uncertainty and feeds into the reluctance to hire. It seems that the Obama Administration has a giant checklist, stimulus-passed, healthcare-passed, financial reform-almost passed, cap and trade –in deep trouble, immigration reform-going nowhere. The checklist is the priority meanwhile the plight of the American worker falls by the wayside. If the Administration were serious about the economy creating jobs it would put a time-out on new regulations and cut business and payroll taxes. The deficit hawks would respond, how do you pay for it? Answer: redirect unspent stimulus money and cut out year spending on entitlements. And if Congress really had the nerve it would borrow $500 billion at 4%(current 30 year rate) to fund infrastucture projects with limited, meaning fast track, environmental review and without the prevailing wage provisions of the Davis-Bacon Act.

The Administration would not as it did a week ago hold up a loan guarantee from the Export-Import Bank for coal mining machinery to an Indian utility on global warming grounds. Only because of an outcry from the Wisconsin delegation where the machinery is made and the potential for embarrassment at an Obama event there did the Administration relent. It is chicken-shit stuff like this that drives businesses crazy.

Of course the Republicans are offering no solutions either, but they do not have the burden of being in control. The Democrats have the burden and they are royally blowing it. So much so that they may soon give the Republicans the opportunity to show that they are serious.

Saturday, July 3, 2010

Are REITs Pricey? You Betcha!

Reprinted by permission from REIT Wrap Special Report, June 24, 2010

By David Shulman

This month’s column won’t win me the “Mr. Congeniality” award. As those who have followed my work over the years will attest—this is nothing new.

What I will outline below is my view that relative to stocks, REITs and for that matter real estate, look very over-priced. This cannot persist long-term!

History suggests that in recoveries from structural bear markets, the previous bull market leaders tend to significantly lag after an initial rally. For instance, the tepid performance of technology stocks, the bull market leadership of the 1990s, over the past decade. As a result, today, tech stocks look cheap compared to real estate.

At this month’s NAREIT meeting in Chicago Sam Zell told the audience that “a REIT is a stock, first last and always.” Like stocks in general REITs respond to broad macroeconomic and industry specific fundamentals and are valued by stock market metrics.

Try as NAREIT would like to compare REITs with real estate, every trading day the shares are evaluated by stock investors in general not just investors seeking a real estate proxy. As a matter of fact this behavior is exactly what many of the pioneers of the modern REIT era had hoped for.

Because, REITs do not trade in their own real estate-centric cul-de-sac, they are continuously compared to other sectors of the stock market and by the normal metrics of stock market valuation REITs appear to be especially over-priced.

According to data compiled by Michael Bilerman’s team at Citigroup REITs are trading at a weighted average FFO multiple of 15.3X on 2010 estimates. As we all know, FFO is not a normal stock market metric, in fact it an alien measure so here we will use some common equity valuation measures that are also suitable for REITs.

Two appropriate measures would be free cash flow yields to equity (net income per share plus depreciation minus capital expenditures and incremental working capital requirements/equity market capitalization which is analogous to Reitland’s AFFO yield) and EBITDA multiples (Enterprise Value/EBITDA). By these metrics REITs are currently trading at an estimated 5.1% free cash flow yield based on 2010 estimates and 16.6X latest quarter EBITDA run rate.

By comparison the broader market, according to Goldman Sachs, is trading at a 7.0% free cash flow yield 7.9X EBITDA based on consensus estimates for 2010. On average, then, corporate equity returns about 40% more free cash per dollar invested than REITs and trades at half the EBITDA multiple.Further free cash flow in the corporate sector is after research and growth capital expenditures, while the estimate of AFFO only subtracts maintenance capital expenditures.

In order to better make my point let’s compare the valuation metrics for several of the leading REITs and compare them with well known industrial companies. Put bluntly the valuation differences are stark. By way of reference I have included an estimate for unleveraged physical real estate assuming a 7% cap rate, 50 basis points of management fees and 100 basis points for capital expenditures.

Below are the estimated 2010 free cash flow yields and EBITDA multiples for the selected REITs followed by an estimate for physical real estate and then the data for the selected industrial companies. Notice that my list of industrials includes such premier growth companies as Apple Computer (AAPL) and Google (GOOG). The data for the REITs are from Citi. The data for the industrial companies come from multiple sources, largely Factset and my own calculations.

AvalonBay (AVB) 3.2%, 24.8X
Equity Residential (EQR) 4.0%, 19.9X

Simon Property Group (SPG) 4.9%, 16.4X
Regency Centers (REG) 4.7%, 15.4X

Boston Properties (BXP) 3.5%, 16.7X
Vornado (VNO) 4.2%, 17.0X

AMB Property (AMB) 3.7%, 18.6X
Public Storage (PSA) 5.1%, 16.2X
Ventas (VTR) 5.4%, 16.5X

Physical Real Estate @7% cap rate 5.5%, 15.4X


Apple Computer (AAPL) 4.7%, 14.3X
Google (GOOG) 5.6%, 12.8X
Microsoft (MSFT) 8.2%, 7.9X

Abbott Laboratories (ABT) 9.0%, 9.4X
Johnson & Johnson (JNJ) 8.2%, 8.0X

Emerson Electric (EMR) 5.1%, 10.4X
Illinois Tool Works ( 8.2%, 11.3X
3M (MMM) 7.0%, 8.8X

Coca Cola (KO) 6.0%, 12.3X
Procter & Gamble (PG) 6.1%, 10.2X

Exxon Mobil (XOM) 5.5%, 7.2X
Chevron (CVX) 6.2%, 4.9X

The data clearly suggest that investors value one dollar of real estate cash flow far more than one dollar of corporate cash flow. In fact AvalonBay is way more expensive than Apple Computer and Google looks real cheap relative to all of the REITs!!! Furthermore Abbott Laboratories, Johnson & Johnson and Microsoft have free cash flow yields in excess of 8%, 60% higher than the average REIT. From a valuation perspective either both real estate and REITs are extraordinarily expensive or that stocks, in general, are a super bargain.

This discrepancy in valuation may not mean all that much to a dedicated REIT manager who is required to invest in the real estate space, but to a diversified manager of equities and to an asset allocator the valuation differences have to be troubling.

To be fair the markets could be signaling that in the years to come real estate cash flows will be far more durable than corporate cash flows. That certainly is possible, but as we have seen over the past few years the real estate economy seems to be inexorably linked to the overall economy. It is, therefore, hard to imagine a weak corporate profit environment being a good thing for real estate demand. Moreover should the current monetary and fiscal policies lead to a significant inflation later in the decade, the extraordinarily low interest rates we are now experiencing will become a thing of the past. In that environment the low 5%-7% cap rates of recent years could very well revert to the more normal 8% to 10% range.

Yes, real estate cash flows could very well outperform corporate cash flows in a more inflationary environment as depreciation allowances prove to be inadequate to replace equipment. During the inflationary 1970s corporate cash flow lagged well behind net income as the cost of replacing inventory and equipment at higher and higher levels became a very real drain on cash flow. It was in that environment where real estate cash flows proved themselves to the broad investing community. Are we going back to that world? Not likely in my opinion.

Alternatively most investors believe that the real growth in the global economy over the next decade will take place outside of the United States. It is, therefore, improbable that domestic real estate cash flows will outperform the cash flows being derived from the global corporations listed above which leaves me hard pressed to explain the valuation differences.

Simply put at current prices, non-REITs appear much more attractive than domestic real estate and REITs and because REITs are generally trading at premiums to their underlying real estate value, look even more expensive.

David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. Heis now affiliated with Baruch College, the University of Wisconsin and theUCLA Anderson Forecast. He can be contacted

Thursday, June 17, 2010

The Outlook for Commercial Real Estate: The Rocky Road Ahead, UCLA Anderson Forecast, June 2010

When I started writing this section in early May my tentative title was “Party Like its 2006.” Despite all of the well publicized problems facing the commercial real estate industry, asset prices for both buildings (up 20%) and publicly traded real estate investment trusts (nearly triple) were recovering rapidly, bidding wars for individual properties were breaking out and credit spreads for commercial mortgages were in steep decline. (See Figures 1, 2, and 3) Indeed the improved environment was reflected in the rising optimism of Southern California office developers. (See Figure 4) Simply put the Fed’s zero rate policy was working its wonders and investors were willing to look past the current problems of high and rising vacancy and mortgage default rates. Remember with very low interest rates the banking strategies with respect to commercial mortgages of “delay and pray” and “extend and pretend” can and actually are working.

Figure 1. Green Street Advisors Commercial Property Index, Dec 97 –April 10

Source: Green Street Advisors
Figure 2. Dow Jones Real Estate Index, I-Shares, June 2006 – May 2010, Weekly Data


Figure 3.Super-Senior AAA CMBS Spreads to Swaps, Jan 07 –May 10, Monthly Data

Source: Bloomberg

Figure 4. UCLA-Allan Matkins Office Developer Sentiment Survey

Source: UCLA Anderson Forecast and Allan Matkins

For a short time it seemed that the combination of very low interest rates and slow, but sure economic growth were more than enabling the industry to work its way out of rising defaults in its $3 trillion dollar debt load. However the “Euro Crisis” brought with it rising credit spreads and fears that an aftershock from the 2007-09 credit crisis would make it far more difficult to restructure the industry’s debt burden. Our view is that the improvement in real estate capital market sentiment was way over done. To be sure there will be a recovery, but that recovery will likely occur in fits and starts. In a word it will be rocky. There is just too much debt that has to be worked through and it will take time to re-characterize a significant fraction of it as equity. After all Fitch Ratings has forecast that loans 60 days or more past due in the $536 billion CMBS market will rise from the current 7% to 11% by yearend.

The Collapse in Supply

From a fundamental point view vacancy rates are peaking. (See Figure 5 for office vacancy rates) New starts came to a screeching halt at the end of 2007 and with modest growth vacancy rates will gradually decline. Real commercial construction spending will suffer a peak-to-trough decline by early 2011 of 51% since the 2007 high. (See Figure 6) Similarly multi-family starts declined by 80% from 378,000 in the first quarter of 2006 to 77,000 units in the fourth quarter of 2009 and only a gradual rebound is forecast. (See Figure 7) Thus new supply will not be problem for the next several years.

Figure 5. National Office Vacancy Rate, 1991Q1-2010Q1

Source: REIS

Figure 6. Real Commercial Construction Spending

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 7. Multifamily Housing Starts, 2000Q1 -2012Q4

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Structural Weakness in Demand

The real problem, however, is on the demand side. Put bluntly, the modest economic growth we a forecasting means that it will take several years to bring the supply and demand for commercial real estate into some semblance of balance. Why? The economy is in such a deep hole that total employment in early 2010 was back to where it was in late 1999. (See Figure 8) After peaking in December 2007, total payroll employment dropped by 8.4 million jobs making the recession, in term of employment, 3-4 times worse than prior postwar recessions If employment growth is a rough proxy for commercial real estate demand, than every project built in the first decade of the 21st century can be viewed as superfluous. To be sure there is a more than a little hyperbole involved with the prior sentence, but you get the picture. That is why even in a limited construction environment, excess capacity will weigh on commercial real estate for many years to come.

Figure 8. Nonagricultural Employment, 2000Q1 – 2012Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

A skeptic might argue that total employment, which includes manufacturing and construction jobs, might have little to do with office, high end retailing and apartment demand. A fair point so let’s look at financial activities employment. As of the first quarter financial activities employment was off by 730,000 jobs since its fourth quarter of 2006 peak, a decline of 8.7%. (See Figure 9) An industry that was once viewed in secular growth category has proved itself to be highly cyclical, not a good omen for the stability of future office demand. More importantly financial activities employment is now back to where it was in mid- 1999! Indeed employment in this sector is forecast to be well below its peak level at the end of 2012.

Figure 9. Financial Activities Employment, 2000Q1 -2012Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

In a related vein even the law business, a core tenant for pricey CBD office space, is now under extreme stress. Employment in legal firms over the past year declined by 28,000 jobs, or 2.5%. Now here is a business, which was once thought to be recession-resistant, now suffering through the pains of a fundamental restructuring of its business model, the billable hour.

In terms of the office demand I am hard pressed to come up with a scenario where demand recovers quickly and because the employment declines have been so severe it is reasonable to assume that many office using firms a carrying excess space relative to their needs. Thus as leases roll over tenants will just as likely reduce their space demands as increase them.

In the case of retail demand, the consumer has been chastened by the bear market in homes and stocks and a significant fall in the rate of pay increases. Where earlier in the decade and in the late 1990s private sector compensation was growing in the 3-4% range, of late it has been increasing at a 1-1.5% rate. From 1991-2007 consumers financed part of their consumption out gains accruing from rising stock and home prices. As a consequence the savings rate collapsed from an historic 7-10% down to a low 1-2%. It has subsequently popped to 4-5% and in all likelihood it is on the road back to 7% after an intermediate decline from 2011-2013, caused by increased taxation on high income taxpayers, to the 2-3% range. (See Figure 10) Along the way consumers have started to pay down debt in an unprecedented manner. After rising inexorably for decades total consumer credit outstanding dropped by an unprecedented $130 billion or 5% from September 2008 to March 2010.

Figure 10. Personal Savings Rate, 2000Q1- 2012Q4F

Source: U.S. Department of Commerce and UCLA Anderson Forecast

Thus it does not take rocket science to explain that the combined effects of falling asset values, slowed compensation growth, high unemployment and debt pay downs have made for a very disappointing retail environment. To be sure retail sales have bounced off the bottom, but remember total retail sales in April were still 3.7% below their November 2007 peak. (See Figure 11) This data certainly smells like there is quite a bit of excess capacity in retailing.

Figure 11. Retail Sales, 2005 –April 2010, Monthly Data

Source; U.S. Department of Commerce

Because so much of what is sold by retailers is imported, the demand for coastal warehouse space will be less than ebullient. After collapsing during the recession imports are now growing, but at a rate far slower than during the import boom of 2003-2007. (See Figure 12) Furthermore west coast ports will face increased competition from the Panama Canal where a major widening project is scheduled to be completed in 2014. Simply put the ship-to-rail link to the Midwest and east coast will be facing new competition through an all ship link to the Atlantic and Gulf coasts via the Panama Canal. To be sure the Panama Canal alternative is not without issues, but it does offer shippers the opportunity to limit their dependence on west coast ports.

Figure 12. Real Imports, 2000Q1 -2012Q4F, Quarterly data, In $2005.

Source: Department of Commerce and UCLA Anderson Forecast

Trust me, this not a forecast I want to be right about, but it is hard to visualize anything but a long hard slog ahead for the real estate economy that will be eased by limited new supply. Indeed much of the recent strength in the overall economy has come from massive doses of fiscal and monetary stimulus. In a nutshell, the economy is highly medicated. Thus we won’t really understand the underlying strength of the economy until the Fed ends its zero interest rate policy and the federal deficit drops from 11% of GDP to an optimistic 3% of GDP. Nevertheless it is a far cry from all of the gloom and doom we heard about commercial real estate in 2009.

I would like to think we have learned a lot over the past few years. One of the lessons that I have taken away from the experience is that the Great Moderation of 1982-2007 is over and we are about to enter a new world that is beyond the working experience of most real estate professionals now in the field. My guess is that going forward commercial real estate demand will be growing more slowly and that it will be more cyclical. As a result investors could very well find it difficult to exceed the long run 7-9% total returns for unleveraged real estate reported by the National Conference of Real Estate Investment Fiduciaries.

Saturday, June 5, 2010

Obama's Return to Earth

One of the political by-products of the horrible oil spill in the Gulf of Mexico is that it has ended, once for all, the image of President Obama as "messiah" or as "The One." During the campaign all too many of my liberal friends were in a state of rapture over Obama's then candidacy. In their view he would truly be the miracle worker who would right all of the wrongs of the Bush Administration.

Unfortunately he is a mere mortal. No parting of the Gulf waters here so the crews could cap the leaking well a mile below the surface of the sea. Had this incident happened under George Bush the long knives of impeachment would have been unsheathed, but the well would still be leaking just as it is now.

What this return earth means is that come 2012, the near idolotrous zeal the white liberal community exhibited for Obama will be a shadow of its former self.

Saturday, May 29, 2010

What's Wrong With ATM Deals? Plenty!

Reprinted by permission from REIT Wrap Special Report, May 20, 2010

by David Shulman

When the history of the next REIT bear market is written, one of its causes almost certainly will be the widespread uses of at-the-market, or ATM, offerings.

Simply put an ATM is a “slow motion” stock offering that enables an issuer to dribble out shares over an extended period of time based on a defined percentage of trading volume. The total amount of stock involved can be substantial; typically, it runs around 10%, but sometimes as high as 25%, of the shares outstanding at the time of registration with the Securities and Exchange Commission. A REIT with an ATM can issue shares at will; except during “black-out” periods (e.g., surrounding earnings releases).

Roughly a third of the equity REIT universe has an ATM on file with the SEC currently. The list includes some blue-chip REITs [e.g., Avalon Bay (AVB), Boston Properties (BXP), Equity Residential (EQR), and Essex Property Trust (ESS)]. That so many REITs have jumped on the ATM bandwagon is hardly an argument for ATM deals. The case against ATMs was recently (April 20) put forth (convincingly, I’d add) in a piece posted to NAREIT’s website ( by Joe Harvey, president and Chief Investment Officer for Cohen & Steers (CNS), one of the largest buy-side REIT shops. Over roughly two decades, Cohen & Steers and I have occasionally differed on issues; on this one, however, we’re on the same page!

Yes, companies announce when they have signed agreements to offer shares via an ATM. But it is difficult, especially for “retail investors,” to know who is doing the selling. Is it the company (a dilutive sale) or another shareholder? In that way investors large and small alike have an equal opportunity to be “arbed” by the issuer. It is a conundrum that is at odds with the transparency that REITs talk about so frequently. That’s not the only issue, however.

Something more insidious is going on. ATMs create the illusion that equity is cheap and can be sold at will. It is just too easy! Plus, because the costs associated with issuing shares via an ATM offering are well below those associated with a conventional follow-on deal, the sales pitch to REITs by investment bankers is straightforward. Unfortunately, issuing equity is far more serious than a stop at the local ATM to pick up some cash. Specifically, REIT managements that use ATMs don’t have to answer investor questions about the use of proceeds, or the outlook for their businesses. And, investors don’t learn how many shares have been sold via the ATM offering until the REIT issues an announcement; typically, when it announces earnings. Is this the sort of full disclosure and good corporate governance that investors expect from REITs?

It is not surprising that Cohen & Steers along with other dedicated buy-side REIT shops might take issue with the widespread use of ATMs. After all, it is the institutions that get first crack at conventional follow-ons. An advantage they don’t have in the case of ATMs. However, because they are acting in their own self-interest doesn’t put them at odds with the interests of individual investors. Nor does it diminish the validity of the points made by Cohen & Steers’ Harvey.

Personally, I believe the fairest and most transparent way to issue stock is through a rights offering, which gives shareholders in the REIT a pro rata right to maintain their proportionate interest in the company. Though widely used in Europe, Japan and Australia, rights offerings haven’t been used (generally) in the U.S. for decades. Why? It is a long story (grist, perhaps, for a future column).

Thus far, the REIT bull market has papered over the potential negative side-effects of these “stealth equity offerings.” Oftentimes, what feels good at the moment may leave investors with a serious hangover down the road. Consider the rush to embrace forward equity deals, roughly a decade ago. Admittedly, forward equity deals were far more toxic than ATMs. Nevertheless, the law of unintended consequences is ignored at our peril. And there’s no way around the fact that whatever their perceived benefits, ATMs debase the value of the shares outstanding prior to issuing shares via an ATM offering.


David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He
is now affiliated with Baruch College, the University of Wisconsin and the
UCLA Anderson Forecast. He can be contacted at:

Friday, May 28, 2010

Where Was Corzine's Ax a Few Years Ago? Letter to The Wall Street Journal, May 28

I read with great interest that Jon Corzine is taking the ax to 10% to 15% of MF Global Holdings Ltd.'s workforce ("Corzine Takes Ax to MF Global," Deals & Deal Makers, May 21).
New Jersey would have avoided the fiscal crisis it is now facing if only former Gov. Corzine had acted with such alacrity and applied the same results-oriented standards to the state's business.
David Shulman

Saturday, April 24, 2010

REIT Merger Wave: Don't Hold Your Breath

Reprinted by permsion from REIT Wrap Special Report, April 14, 2010.

David Shulman*

The heated battle for General Growth Properties and the general increase in merger activity across corporate America has increased speculation that a new wave of REIT mergers will soon be upon us. Although certainly possible, don’t hold your breath. Simply put, with REITs trading at 130% of net asset value, according to Green Street Advisors, a Newport Beach, California-based buy-side boutique, it makes little sense for a REIT to pay 130 cents plus an acquisition premium and merger costs for 100 cents of assets. The more obvious play is to acquire assets in the private market for 100 cents which is now happening, albeit slowly.

Of course all of my investment banker friends, yes I do have friends in the banking community, would argue that an acquiring REIT can easily get around this issue by using their high-priced stock as an acquisition currency. In that case the acquirer would be paying with their own newly minted 130 cent dollars. It is not as simple, however. In order for a merger to be successful there has to be value creation for the acquiring company and merely purchasing assets does not create value unless the shares of the acquirer are truly over-valued (issuing what Warren Buffet has called “counterfeit currency”). In either case in order to create value the acquiring shareholders have to end up with more value at the end of the deal than at the start.

For instance if REIT A issues 25% of its stock to acquire REIT B, then upon completion of the transaction REIT A’s shareholders would own 80% of the newly combined company. Thus for the merger to work for REIT A’s shareholders 80% of A+B has to be worth more than 100% of A. This metric is a very high hurdle because, aside from the mall sector, there are no real economies of scale in REITland. Said differently it is very difficult for a REIT to create value though public-to-public mergers in the current environment. Yes there are savings to be had by “vaporizing” the G&A costs of the acquired company, but over time as firms grow larger the initial G&A savings wither away in the form of higher executive compensation and a larger bureaucracy. Indeed, the absence of economies of scale and the tendency for G&A to drift higher with firm size make it so difficult to point to successful public-to-public REIT mergers.

Nevertheless, the lure of using high priced stock for acquisitions is too hard for many REIT executives to resist. An easy way of disabusing them of this notion is to restructure the merger as a cash transaction. Would the buyer pay cash for an acquisition and fund it by a public offering of stock? From the point of view of the buyer this is no different than issuing stock directly to the seller. However, the fig leaf of directly using high-priced stock to pay for the acquisition would disappear and shareholders would be forced to look at the transaction’s true cost.

The discussion thus far has been generic so let’s focus in on the more micro issues as to who would be the buyers and sellers if there were to be a merger wave. It has been long known that there are too many small REITs trading in the marketplace that have no real reason to be public. Many of these companies would probably like to be acquired, but for too many obvious reasons there are no real bidders, especially at a significant premium to net asset value. If these companies weren’t taken over during the great privatization wave of 2004-07, when will they be taken over?

Moreover if you look at the larger companies in each sector it unlikely that a Vornado (VNO), Boston Properties (BXP) or a Brookfield (BPO) would buy a suburban office company. Any one of them might want to do a “strategic” deal in buying Los Angeles oriented Douglas Emmett (DEI), for example, but I doubt it would be for sale and if it were, it certainly wouldn’t come cheap. Remember in M&A parlance the word “strategic” is a synonym for overpay. It is also unlikely that an Equity Residential (EQR) or an Avalon Bay (AVB) would buy any of the smaller apartment REITs operating in the southeast or southwest.

In the case of the mall sector, there’s lots of speculation that once the General Growth saga is settled that “the loser” might be on the prowl for Macerich (MAC) or Taubman (TCO). We remember Simon (SPG)/Westfield’s (WDC) failed attempt to buy Taubman. But can you visualize Simon or Brookfield going after CBL & Associates (CBL) or Penn REIT (PEI) for example? Very unlikely.

That leaves the possibility of small- or medium- sized REITs buying each other. It is possible to visualize, for example, Camden (CPT) acquiring Post Properties (PPS) or Duke Realty (DRE) merging with Highwoods Properties (HIW) as well as M&A activity in the healthcare sector. Again all of these hypotheticals still have to overcome the merger issues I raised earlier.
For those reasons, it is my sense is that the “real M&A activity” will take place with public companies buying private assets. Although it is unlikely there will be the feeding frenzy that many though would emerge a year ago, many private assets will have to trade because they cannot support the capital structures they are burdened with. Some of these transactions will come in the form of purchasing whole companies that were privatized only a few years ago, but most will be in the form of one- off transactions such as the recent purchases of busted condominium projects by Equity Residential and Essex Property Trust (ESS). The economics of these one-off transactions are far preferable to buying an existing REIT at a 130%+ premium to net asset value.

Yes, the money spigots have opened to real estate investing and there are few bargains available in the private market for core real estate. Nevertheless, core assets might still be available at a “fair price” and non-core assets or core assets with leasing risk might offer significant opportunities for REITs with the appropriate skill sets. If I am close to the mark, then it looks like AMB Property Corp. (AMB) did exactly the right thing when it recently sold roughly $425 million in stock to make “…equity investments in co-investment funds, acquisitions of properties, portfolios of properties or interests in property-owning or real estate-related entities.”

*-David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. Heis now affiliated with Baruch College, the University of Wisconsin and theUCLA Anderson Forecast. He can be contacted