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

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