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