Sunday, March 28, 2010

A Shot Across the Bow

Last week's rapid rise in interest rates sent a shot across the bow of the recovering U.S. economy. It was no accident the the rise in 10-year U.S. Treasury yields to 3.85% from 3.69% the week before occurred immediately after Congressional passage of the massive healthcare reform bill. Although the Congressional Budget Office scored it modestly deficit favorable, the real truth is that all of the medicare cuts and tax increases could have been used to reduce the deficit. Instead of cutting the deficit by $1 trillion over ten years, the resources will be used to finance a new entitlement program.

Remember the tax increases on high income earners and the medicare cuts were "low hanging fruit." The hard work lies ahead of us and the bond market now recognizes how difficult the task of deficit reduction will be. Thus interest rates will continue to rise and the nascent recovery will be put at risk.

Friday, March 26, 2010

"The Bipolar Economy," UCLA Anderson Forecast, March 2010

The economy seems to be suffering from a bipolar disorder. For example since 1985 there have been 15 quarters where real GDP expanded by 5% or more including the 5.9% gain in fourth quarter. In every one of them, except for the fourth quarter of 2009, payroll employment typically expanded on the order of a 2-3% annual rate. In contrast employment contracted at an annual rate of 1.3% in the fourth quarter. Unfortunately the closest comparable was during the “jobless” recovery of 2003 where in the third quarter of that year real GDP grew by 6.9% and payroll employment increased at 0.1% crawl. In economics terms “Okun’s Law,” which defines a relationship between GDP growth and unemployment, appears to have broken down as gains in productivity swamped the employment effects of a growing GDP.[i]

Ironically the sluggish growth in payrolls could be an unintended side effect of all of the economic medication coming from fiscal and monetary policy. The stimulus seems to working its effect on GDP and temporary hiring, but make no mistake the follow through to a sustained expansion in employment has been disappointing. After all long term hiring decisions are not generally based on temporary tax and spending programs coupled with a non-sustainable zero interest rate policy. In addition all of the policy uncertainty coming out Washington has made more difficult for businesses to ascertain their long term cost structures. Nevertheless the economy is now on growth path and employment will soon be increasing, albeit modestly.

After a stunning inventory-led 5.9% increase in real GDP in the fourth quarter, we expect the economy to grow at a 3.2% rate in the current quarter and continue to grow at a 2%+ rate for the remainder of the year. (See Figures 1 and 2) Moreover real GDP is forecast to grow at a 2.3% and 3.2% pace in 2011 and 2012, respectively. However, in keeping with our bipolar disorder thesis unemployment will remain high throughout the forecast period. We forecast that the unemployment rate will be 9.6% at the end of 2010, just a tad lower than where it is today and 9.1% at the end of 2011. (See Figure 3) Why? Simply put employment growth will struggle to stay barely ahead of labor force growth. Furthermore, with the modest employment growth we are forecasting, payroll employment will still be two million jobs below its peak in 2007 by the end of 2012! (See Figure 4) Even after creating about 200,000 jobs a month in 2011, the economy will find it very difficult to climb out of the 8.4 million lost job hole it dug for itself.

Figure 1. Real Inventory Change, 2005Q1 – 2012Q4F

Source: Department of Commerce and UCLA Anderson Forecast

Figure 2. Real GDP Growth, 2005Q1 – 2012Q4F

Source: Department of Commerce and UCLA Anderson Forecast

Figure 3. Unemployment Rate, 2005Q1- 2012Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 4. Payroll Employment, 2005Q1 – 2012Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast

The Basis for Recovery

The recovery we envision is based on strength in business equipment and software, exports, and a revival in home construction from its postwar nadir to a more normal level of housing starts. (See Figures 5, 6 and 7) With the exception of housing all of these forces are now in train.

Figure 5. Real Equipment and Software Spending, 2005Q1-2012Q4

Source: Department of Commerce and UCLA Anderson Forecast

Figure 6. Real Exports, 2005Q1 – 2012Q4

Source: Department of Commerce and UCLA Anderson Forecast

Figure 7. Housing Starts, 2005Q1 – 2012Q4

Source: Bureau of the Census and UCLA Anderson Forecast

Growth will be held back by declines in nonresidential construction and the hitherto resistant state and local government sector. (See Figures 8 and 9) Nonresidential construction is suffering from weak demand and the after effects of the credit crisis. As is typical for most cycles nonresidential construction lags the overall economy. Thus we expect to witness a recovery here starting in the second half of 2011.

In contrast the ongoing restructuring of state and local government represents a fundamental structural adjustment. Something more than the recession is at work. The era of public employment and compensation well exceeding private sector averages is coming to an end. Further exacerbating the situation is the trillion dollar underfunding of state and local pension plans.[ii] A gap that will be closed by a combination of reduced employment, lower pay, lower benefits, higher employee contributions and higher taxes.

Figure 8. Nonresidential Construction, 2005Q1 – 2102Q4F

Source: Department of Commerce and UCLA Anderson Forecast

Figure 9. Real State and Local Government Spending, 2005Q1 -2102Q4

Source: Department of Commerce and UCLA Anderson Forecast

Although the recent data on retail sales have been somewhat better than expected, we continue to believe that balance sheet impaired consumers will reign in their spending. To be sure consumer spending will be growing, but the 2% or so growth that we are forecasting will be far less ebullient than the 2005-7 housing bubble era. (See Figure 10)

Figure 10. Real Consumer Spending, 2005Q1- 2012Q4

Source: Department of Commerce and UCLA Anderson Forecast

Interest Rates and Inflation: The Big Question Marks

Despite the high unemployment rates we forecast, with the economy on the mend, we anticipate that the Federal Reserve will start moving away from its zero interest rate policy this fall. Simply put, the financial emergency of 2007-2009 is over and we believe that the Fed will soon recognize this reality. To be sure interest rates will remain historically low throughout 2011, but the way will be open to more normal interest rates. Concomitantly the yield on 10 year U.S. Treasury notes will gradually rise above 4% later in the year and rise modestly thereafter. (See Figure 11) Indeed the deficits arising from the financial crisis and its hangover will exert upward pressure on interest rates for a long time to come. (See Figure 12)

Figure 11. Federal Funds vs. 10-Year U.S. Treasury Bonds, 2005Q1 – 2012Q4F

Source: Federal Reserve Board and UCLA Anderson Forecast

Figure 12. Federal Deficit, 2005 – 2012F

Source: Office of Management and Budget and UCLA Anderson Forecast

Despite the sluggish growth we are forecasting, we believe that the real risk the economy faces is that of inflation. By way of analogy the Fed’s monetary policy has strewn kindling wood throughout the economy that could ignite into inflation at any time. Presently the kindling is wet and is in no danger of ignition, but in a few years that might not be the case. We believe that the Fed understands this risk and that is why we believe policy will be tightened this year.

Our forecast assumes that inflation will remain under control. Nevertheless core CPI is forecast to be modestly in excess of the Fed’s historic target of 2% in 2012. (See Figure 13) Yes, 2012 is a long way off, but markets have a way of telescoping future events into current market prices with astounding rapidity.

Figure 13. Core CPI, 2005Q1 - 2012Q4F

Source: Bureau of Labor Statistics and UCLA Anderson Forecast


Modest GDP growth will soon translate into job growth, but the unemployment rate will stay above 9% through 2011. After a huge inventory rebound, economic recovery will be led by equipment and software, exports and housing. Offsetting these strong sectors will be weakness in state and local government, nonresidential structures and tepid consumption growth. Although the threat is real, inflation will remain modest throughout the forecast period as the Fed ends its zero interest rate policy and gradually returns interest rates to more normal levels.

[i] See, Daly Mary and Bart Hobijn, “Okun’s Law and the Unemployment Surprise of 2009,” FRBSF Economic Letter, March 8, 2010.
[ii] “The Trillion Dollar Gap,” The Pew Center on the States, February 2010.

Saturday, March 13, 2010

Letter to NY Times(Online Edition), Mar 12

To the Editor:
Re Bob Herbert’s column and “The Emotion of Reform,” by David Brooks (column, March 9):
It was great to see Mr. Herbert and Mr. Brooks agreeing with each other. President Obama’s maniacal obsession with health care shows complete disregard for the jobs crisis facing our country. Moreover, as Mr. Brooks points out, the focus on health care has created so much uncertainty in the small-business community that new hiring has all but ceased. Wake up and connect the dots.
David Shulman

Wednesday, March 10, 2010

An Uneasy Look at Leverage

Reprinted by permsion from REIT Wrap Special Report, March 2, 2010

By David Shulman*

Every REIT CEO and CFO should tattoo on their foreheads the following inscription, “Mike Kirby is right.” Mike Kirby is, of course, Director of Research at Green Street Advisors. He has been a voice in the wilderness calling for REITs to deleverage their balance sheets on the easy to understand grounds that higher leverage is statistically associated with lower long term shareholder returns and that unleveraged commercial real estate, which declined by 30% (likely an under-estimate of the true decline) in the early 1990s and 40% from 2007-2009, simply cannot afford to have leverage ratio in excess of 50% of gross value. Two crashes in 20 years are a bit much for an “asset class” heralded by the pension consultants as “safe.” By the way my UCLA dissertation written in 1975 found no gains to leverage for the few REITS that were in existence from 1963-74.

Moreover there really isn’t any support in financial theory for REITs to be leveraged. Kirby rightly notes the famous leverage indifference theorem of Miller and Modigliani which states that in a world of no personal and corporate taxation there are no gains to be had by leveraging up the balance sheet and in fact there is the risk of the enterprise bearing the costs of bankruptcy. As General Growth is showing us, those costs can be quite substantial.

The real “advantage” from leverage comes from the tax deductibility of interest at the entity level which REITs don’t have. To be sure interest payments at the REIT level can shield income from taxation at the personal level when it is paid out as a dividend, but to the extent that REITs are owned by tax exempt institutions that advantage goes away. Put simply REITs at best receive minimal benefits from leverage, but all of its costs.

If all of what I am saying is true, why do REITs leverage up? My own answer is that leverage has been in the DNA of every real estate professional ever since the first developers in the ancient city of Ur came on the scene. Besides, leverage is made for long-lived assets with relatively stable income streams. That is why institutions usually like to finance income producing real estate, but just because there is a willing lender doesn’t necessarily mean there should is a willing borrower. Nevertheless there are willing borrowers because the empire builder that resides in every real estate professional cannot just say “No” to the crack dealers of Wall Street.

So if theory says “No”, and the evidence says “No”, but existing practice obviously says “Yes” to leverage, where do we end up? What the market might be saying, to state the obvious, is that low leverage is benign and high leverage is malignant. Thus the degree of leverage a REIT takes on should not jeopardize the firm under stress conditions. The questions are where do you draw the line and what is the right measure for leverage.

First we have to dismiss the most widely used measure of leverage, debt/gross asset value. Why? Debt/gross asset value is a poor measure because it is very cap rate dependent. For example, at the height of the recent boom many REITs thought themselves to be conservatively financed with a 60% debt ratio. However when cap rates moved from say 6% to 9% the debt ratio exploded to 90%. In order to avoid the spot cap rate problem a more appropriate ratio to use would be debt/EBITDA which takes into account the ability to service the debt including amortization independent of fluctuating cap rates. Furthermore this metric has the advantage of being widely used in the corporate bond market.

I would argue that 5X EBITDA is the appropriate leverage metric for most REITs. Indeed a ratio of 5X EBITDA gives a great deal of credit for the stability of real estate cash flows. Remember the typical investment grade industrial corporation normally does not exceed 3X EBITDA.

Let’s assume that a REIT owns 10 buildings of equal value and it historically trades at around 12X EBITDA. In the old days a prudent owner would have mortgaged seven of the buildings at 60% and kept three unencumbered for both safety and opportunistic purposes. In this example the leverage ratio for all 10 buildings would be 42% (70% X 60%) or 5X EBITDA (42% X 12).

I would, therefore, argue that 5X EBITDA is a normalized maximum level for leverage for most REITs. If you want to quibble, as long as apartments have access to lower rate Freddie and Fannie financing at 70% of value, you could certainly make a case for 6X EBITDA for apartment REITs. Conversely for the operationally cyclical hotel REITs, debt should not exceed 3X EBITDA. Needless to say that with most REITs trading in excess of 7X EBITDA, the deleveraging process that began last April still has a long way to go.

Where do pension funds come in? It is no secret that many large pension funds and endowments with leveraged real estate investments got clobbered in the recent downturn. In my view it was an inevitability brought on by a complete misperception of risk. Put bluntly leveraged real estate is different from unleveraged real estate. It is much riskier. The higher risk can be categorized in two ways.

First whenever a pension fund engages in a leveraged transaction, it is, in effect, shorting it own bond portfolio. How so? All a pension fund has to do to understand this concept is to “gross-up” its leveraged asset and fully consolidate it on its books. For example take a hypothetical pension fund with the following asset allocation: $600 million equities, $300 million bonds and $100 million leveraged real estate/private equity.

In this example a $100 million real estate/private equity investment with $300 million of debt on it would be booked as a $400 million asset with a concomitant $300 million liability. In reality by booking only the equity, the pension fund is under-stating its investment in real estate and over-stating its investment in fixed income securities as the real estate debt cancels out the bond assets. Distilled down the pension fund portfolio is holding $600 million in equities and $400 million in real estate/private equity -- not exactly what you would call a “conservative” asset allocation. When looked at this way is not a surprise that a seemingly small allocation to real estate had such a drastic effect on pension fund performance.

If you prefer a different approach, the second way to look at leveraged real estate in a portfolio is to view it as a warrant. People tend to forget that in the original options pricing paper by Black and Scholes common equity was viewed as an option to buy back the firm from its bondholders. When leverage is low this notion is of minimal significance, but when leverage is high it becomes very obvious and it is this insight that theoretically underpins much of what goes on in capital structure arbitrage.

If a pension plan fully understood that its leveraged real estate investments were really long term options (warrants) and classified them as such they would have had a far better understanding of the risks embedded in their portfolios. It, therefore follows that, leveraged real estate certainly does not belong in the plain vanilla real estate bucket.

There is, of course, an agency argument for high leverage in REITs and private equity. Briefly stated leverage is required to increase the return on equity that is so necessary to compensate the best talent. That certainly was the argument from 2004-2007. However, many of the most talented real estate professionals crashed and burned with everyone else in 2008. It seems to me that the agency argument is better suited for bull markets than bear markets. All told, then, the evidence suggests that less leverage is preferable to more.

*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

Monday, March 1, 2010

Time to Pull the Plug on Obamacare

Being a glutton for punishment, I watched nearly all of last Thursday's Blair House forum on Obamacare. I expected very little to come out of the meeting and I was not disappointed. Simply put, the Democrats want to expand coverage, but don't really want to pay for it, and the Republicans don't want anything to pass. Unfortunately doing nothing keeps us on the road to perdition and passing Obamacare only makes things worse.

What both parties understand, but are unwilling to admit, is that the current system is bankrupting the Nation. Medicare has a $38 trillion unfunded liability and yet the Democrats want to exacerbate the situation by expanding coverage and the Republicans are now positioning themselves as the saviors of Medicare. Give me a break.

Obama and his cohorts, sucking up to their paymasters in organized labor, punted on the one big measure that would have a chance in bending the cost curve, the excise tax on "Cadillac" plans. If the Republicans really cared about costs, they would have pushed Obama on this issue. But no, in fear of anti-tax Grover Norquist, they can't come out in public in favor of any tax.

At the end of the day, if we are to break not bend the healthcare cost curve, sterner measures will be needed. A few suggestions, a stiffer tax on "Cadillac" plans, real cuts in medicare, ending the middle-class entitlement of nursing home care under Medicaid, ending fee for service medicine, triage with "end of life" panels, and a payroll tax to fund expansion of care to let all of the particpants know that healthcare is not a free good. Remember both Social Security and Medicare are funded with payroll taxes. If the Democrats want healthcare so bad, they should be willing to tax their own constituencies. After all this is how it works in social democratic Europe. Thus we should put the horse before the cart and cut costs first and generate real savings and then we should rightfully expand coverage.