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 at:david.shulman@baruch.cuny.edu
Wednesday, November 24, 2010
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.
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."
Full URL - http://www.washingtonpost.com/wp-dyn/content/article/2010/10/31/AR2010103103818_pf.html
"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."
Full URL - http://www.washingtonpost.com/wp-dyn/content/article/2010/10/31/AR2010103103818_pf.html
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.
Full URL - http://www.tnr.com/article/economy/78762/desperate-obama-economy-republican-congress
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.
Full URL - http://www.tnr.com/article/economy/78762/desperate-obama-economy-republican-congress
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 at:david.shulman@baruch.cuny.edu
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 at:david.shulman@baruch.cuny.edu
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.
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
Conclusion
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.
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
Conclusion
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.
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