To the Editor:
On the very week the census told us that over the past decade there was a mass migration of Americans out of high-tax states and into low-tax ones, you call for an increase in state taxation. The people you want to tax can and do vote with their feet, rendering higher taxation a far from optimal solution.
Nevertheless I will grant you that taxation should not be off the table when dealing with the fiscal crisis that is enveloping most of the states.
But unless the bottomless pit of public employee pension and post-retirement health benefits is dealt with, no amount of higher taxation will be able to solve the problem.
David Shulman
Full URL:
http://www.nytimes.com/2010/12/31/opinion/l31states.html?_r=1&ref=opinion
Friday, December 31, 2010
Thursday, December 23, 2010
A Reality Check on Congress' Lame Duck Session
The results speak for themselves. Simply put it was not a victory for President Obama or the congressional Republicans, but rather it it was a victory for the popular will. On every major issue the popular will was carried out. Public opinion favored a tax compromise, repeal of 'don't ask don't tell," passage of the Start Treaty, aid for the 9/11 responders and a rethinking of the FY 2011 spending plan. Public opinion was divided on the 'Dream Act" and that failed to pass.
Thus before rushing to conclusions that a new era of commity has descended over Washington, D.C., it more likely that on the controvesial issues that lie ahead there will be all-out street fights. The popular stuff will pass, but the really difficult fights over spending, taxation, environmental regulation and healthcare will be the norm.
Thus before rushing to conclusions that a new era of commity has descended over Washington, D.C., it more likely that on the controvesial issues that lie ahead there will be all-out street fights. The popular stuff will pass, but the really difficult fights over spending, taxation, environmental regulation and healthcare will be the norm.
Thursday, December 9, 2010
Risky Business, UCLA Anderson Forecast, December 2010
"In sum, on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years. As a society, we should find that outcome unacceptable."
- Ben S. Bernanke, "Rebalancing the Global Recovery," November 19, 2010
With short-term interest rates already at zero, the measured inflation rate approaching zero and the unemployment rate stubbornly remaining near 10%, a deflation-haunted Fed decided to experiment with a policy characterized as quantitative easing. (See Figure 1) On November 3rd, the Fed announced that it would expand its balance sheet by $600 billion dollars over the next eight months by buying intermediate-term Treasury bonds. Its purpose was not so much as to increase bank reserves, which it will do, but rather to lower long-term interest rates and as a consequence raise asset prices, thereby stimulating consumption and investment.
The unstated goals of this exercise in money printing are to lower the exchange value of the dollar and to lower real wages by causing inflation to
Figure 1 Federal Funds vs. 10-Year U.S. Treasury Yields, 2005Q1- 2012Q4F
Source: Federal Reserve Board and UCLA Anderson Forecast
increase relative to money wages. The former set off a firestorm of criticism at the G-20 meeting in Seoul, Korea increasing the risk of growth-dampening trade policies and as for the latter, although a theoretically appealing way of lowering the unemployment rate, it’s hard to see how a lower real wage in the construction industry, for example, will stimulate housing construction. Nevertheless, from an aggregate perspective a path to a more fully-employed economy could very well be through the wage adjustment process. That process is well underway in many sectors of the economy with the growing use of two-tier wage contracts and mandatory furloughs.1
The risks associated with the policy are that by monetizing the Federal deficit, it could lead to far more inflation than the Fed forecasts; it could engender a dollar crisis that would make it far more difficult to fund our fiscal deficit and it could negatively impact the dollar as the world’s reserve currency. Obviously, the additions to the Fed balance sheet will make it more difficult to unwind the extraordinarily easy monetary policy of the past few years.
Nevertheless, we must be mindful of the fact that the Fed has a dual mandate from Congress, which in the words of Chairman Bernanke "are to promote a high level of employment and low, stable inflation."2 Simply put, the Fed, as a creature of the Congress, has to try to fulfill its mandate or face the political consequences. To be sure, there are many critics who believe that rather than increase employment, the Fed will increase inflation, but with fiscal policy constrained by high deficits and stalemated politics; the Fed is the only game in town.
To us, a real risk is that the policy doesn’t work in reducing unemployment thereby lowering the Fed’s credibility. Indeed, clear signs of the Fed losing some of its credibility where a sell-off in the bond market more than undid the interest rate declines that took place in September and October and a surge in the prices of globally traded commodities that took place in anticipation of the quantitative easing policy. In essence, market fears of future inflation and/or dollar weakness have offset much of the positive effects that were to come from rising bond prices
Although it wasn’t called quantitative easing at the time, the Fed followed a balance sheet expansion policy in the context of near zero short-term interest rates during the 1930s. Then Fed chairman, Mariner Eccles characterized the effectiveness of monetary policy as "pushing on a string."3 All it did was increase bank reserves without transmitting any stimulus to the real economy, much like today.
After all, from late 2007 to the present, bank reserves increased nearly 30-fold with minimal upside effects on the economy. (See Figure 2) That is why Chairman Bernanke is stressing the asset market channel rather than the banking channel to transmit monetary policy. Of course it certainly can be argued that reserve expansion put a floor underneath the economy preventing something far worse. But, we must keep in mind a Fed without credibility is a clear negative for the economy, think the 1970s. While a Fed with credibility certainly aided the 25 year 1982- 2007 boom.
Figure 2 Total Bank Reserves, 2007Q4 – 2012Q4F
Source: Federal Reserve Board UCLA Anderson Forecast
Our Forecast
Our view is that the new Fed policy will be modestly helpful and the most recent economic data have been encouraging. As a result, we have revised up both our real GDP and inflation forecasts from last quarter, but unfortunately even with jobs gains averaging 150,000 a month in 2011 and 200,000 a month in 2012, unemployment will remain above 9% through the third quarter of 2012. (See Figure 3) We expect that real GDP will grow at a 2% plus annual rate through the third quarter of 2011 and then ramp up to a 3% or so growth rate. (See Figure 4) With respect to inflation, we are less fearful of deflation than Chairman Bernanke and we expect consumer price inflation to be at or above the Fed’s informal 2% target by late next year. (See Figure 5) The higher apartment rents now being reported by the publicly traded apartment REITs will soon find their way into the consumer price index.
Figure 4 Real GDP Growth, 2005Q1 -2012Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 3 Unemployment Rate, 2005Q1-2012Q4
Figure 5 Headline vs. Core Inflation,
2005Q1 – 2012Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast
Why with such high unemployment is economic growth so sluggish? Historically, steep downturns are followed by steep upturns, but not this time. As we argued last quarter and previously, the economy is suffering from a debt hangover that will require many years of deleveraging to recover from.4 Consumption growth, instead of running at an historical 3% rate is now slogging along at a 2% clip as consumers increase their savings rate to repair their tattered balance sheets. (See Figures 6 and 7) Furthermore, with real wages stagnant, debt constrained consumers do not have the wherewithal to go on a consumption binge. (See Figure 8)
In fact, the economy just might be suffering from a new version of Keynes’ paradox of thrift. In the 1930s, Keynes argued that whereas savings for an individual was a virtue, for an economy in recession it is a vice because if every household cuts back on consumption the entire economy remains mired in a slump. Today, however, with very low interest rates, consumers and pension funds have to save more and/ or increase their contributions to achieve their target stock of savings. Moreover, it goes without saying that those consumers who are already retired are being forced to cut back on consumption because of reduced interest income. Thus, one of the challenges facing the Fed’s quantitative easing policy is that lower interest rates could have the perverse effect of lowering consumption rather than increasing it.
Figure 7 Personal Saving Rate,
2000Q1 – 2012Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 8 Employment Cost Index, Real Private Sector Wages and Salaries,
2000Q1 -2012Q4F
Figure 6 Real Consumption Growth,
2000 – 2012F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast
Furthermore, much of the increase in consumption is going to imports. Where a year ago net exports were contributing to growth, it is now inhibiting growth. (See Figure 9) That is why a weaker dollar is necessary part of the adjustment process in that it would work to reduce imports and increase exports. (See Figure 10) Of course, the adjustment process would be made easier if China moved with greater alacrity with respect to the upward revaluation of its currency. Nevertheless, in order for net exports to structurally improve, the savings rate has to rise. Why? The U.S. now consumes more than it produces and borrows the difference from abroad. If consumption were reduced to equal production the savings rate would rise and the trade deficit would disappear.
Housing continues to be in the doldrums. We had hoped to see a meaningful recovery in 2011, but that has been pushed back into 2012. The near complete breakdown in the foreclosure paperwork process has dramatically slowed the price discovery process and introduced a new element of uncertainty. We are now forecasting housing starts to be 757,000 and 1,196,000 units in 2011 and 2012, respectively, compared to an estimate of 604,000 units for 2010. (See Figure 11)
The Restructuring of State and Local Government
Although most business cycles have similar characteristics, each cycle is different in its own way. In the current one instead of the state and local sector
Figure 9 Net Exports, 2005Q1 – 2012Q4
Figure 11. Housing Starts, 2005 – 2012F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 10 U.S. $ Trade-Weighted Exchange Rate
Sources: Bureau of the Census and UCLA Anderson Forecast
Source: IHS Global Insight and UCLA Anderson Forecast
gradually increasing throughout the business cycle, this time it is in decline. Simply put, the state and local government is now undergoing the same type of restructuring that the private sector has endured over the past two decades. As a result, we do not expect any meaningful growth in state and local spending over the next several years. (See Figure 12) That is to say, the tax base cannot keep up with the growth in public employee pension and Medicaid outlays and as a consequence other sectors of state and local budgets will be squeezed. This phenomenon will be reinforced by the election of a flock of new budget cutting governors last November. Over the long-run, the growth path of Medicaid and pension expenditures, of necessity, will be lowered.
Fiscal Imbalances Remain
As we noted earlier, high deficits are constraining the Federal government to engage in further fiscal stimulus. Indeed, the newly elected Congress might just be in the mood for fiscal consolidation on the spending side of the budget. As for the tax side, we are assuming for modeling purposes a tax compromise where all of the Bush tax cuts get extended for one more year and in 2012 high income taxpayers will see their tax rates rise. However, we caution a highly partisan Congress might fail to compromise on the tax issue leaving the economy vulnerable to a massive tax hit in January.
Figure 12 Real State and Local Government Expenditures, 2000 – 2012F
Figure 13. Federal Surplus/Deficit, FY 2000-FY2020F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Source: Office of Management and Budget and UCLA Anderson ForecastUCLA Anderson Forecast
Until Congress grapples with the long-term nature of our fiscal problems, we will be living a period of ongoing uncertainty with respect to taxation. The chairman’s mark of the Bowles-Simpson Deficit Reduction Commission offers a good start, but the politics don’t seem to be there for a meaningful solution. Congress does not seem to be in the mood to cut entitlements will raise taxes even if taxes are meaningfully reformed with lower rates and fewer deductions.
In the meantime, we forecast mega-fiscal deficits for as far as the eye can see. (See Figure 13) Thus, in our opinion, gridlock is bad. Without the two parties coming together there cannot be any meaningful solution to the long term fiscal imbalances we now face.
Conclusion
Despite all of the issues outlined above, the economy will continue to muddle through with modest growth and distressingly high unemployment. The economy is healing, albeit at too slow of a pace, but we forecast there will be an acceleration of growth in late 2011 that will gradually work to lower the unemployment rate. Inflation will pick up quicker than the Fed now expects and as a consequence the extraordinary policy measures taken will gradually be reversed and a gradual tightening cycle might begin in early 2012.
Endnotes
1. See, Uchitelle, Louis, "Unions Yield on Pay Scales To Keep Jobs," The New York Times, November 20, 2010, p.1
2. Bernanke, Ben S., "What the Fed did and why: supporting the recovery and sustaining price stability," The Washington Post, November 4, 2010.
3. Meltzer, Allan H., "A History of the Federal Reserve Volume 1, 1913-1951," (Chicago: University of Chicago Press, 2003), p. 62.
4. See Shulman, David, "The Uncertain Economy," UCLA Anderson Forecast, September 2010.
- Ben S. Bernanke, "Rebalancing the Global Recovery," November 19, 2010
With short-term interest rates already at zero, the measured inflation rate approaching zero and the unemployment rate stubbornly remaining near 10%, a deflation-haunted Fed decided to experiment with a policy characterized as quantitative easing. (See Figure 1) On November 3rd, the Fed announced that it would expand its balance sheet by $600 billion dollars over the next eight months by buying intermediate-term Treasury bonds. Its purpose was not so much as to increase bank reserves, which it will do, but rather to lower long-term interest rates and as a consequence raise asset prices, thereby stimulating consumption and investment.
The unstated goals of this exercise in money printing are to lower the exchange value of the dollar and to lower real wages by causing inflation to
Figure 1 Federal Funds vs. 10-Year U.S. Treasury Yields, 2005Q1- 2012Q4F
Source: Federal Reserve Board and UCLA Anderson Forecast
increase relative to money wages. The former set off a firestorm of criticism at the G-20 meeting in Seoul, Korea increasing the risk of growth-dampening trade policies and as for the latter, although a theoretically appealing way of lowering the unemployment rate, it’s hard to see how a lower real wage in the construction industry, for example, will stimulate housing construction. Nevertheless, from an aggregate perspective a path to a more fully-employed economy could very well be through the wage adjustment process. That process is well underway in many sectors of the economy with the growing use of two-tier wage contracts and mandatory furloughs.1
The risks associated with the policy are that by monetizing the Federal deficit, it could lead to far more inflation than the Fed forecasts; it could engender a dollar crisis that would make it far more difficult to fund our fiscal deficit and it could negatively impact the dollar as the world’s reserve currency. Obviously, the additions to the Fed balance sheet will make it more difficult to unwind the extraordinarily easy monetary policy of the past few years.
Nevertheless, we must be mindful of the fact that the Fed has a dual mandate from Congress, which in the words of Chairman Bernanke "are to promote a high level of employment and low, stable inflation."2 Simply put, the Fed, as a creature of the Congress, has to try to fulfill its mandate or face the political consequences. To be sure, there are many critics who believe that rather than increase employment, the Fed will increase inflation, but with fiscal policy constrained by high deficits and stalemated politics; the Fed is the only game in town.
To us, a real risk is that the policy doesn’t work in reducing unemployment thereby lowering the Fed’s credibility. Indeed, clear signs of the Fed losing some of its credibility where a sell-off in the bond market more than undid the interest rate declines that took place in September and October and a surge in the prices of globally traded commodities that took place in anticipation of the quantitative easing policy. In essence, market fears of future inflation and/or dollar weakness have offset much of the positive effects that were to come from rising bond prices
Although it wasn’t called quantitative easing at the time, the Fed followed a balance sheet expansion policy in the context of near zero short-term interest rates during the 1930s. Then Fed chairman, Mariner Eccles characterized the effectiveness of monetary policy as "pushing on a string."3 All it did was increase bank reserves without transmitting any stimulus to the real economy, much like today.
After all, from late 2007 to the present, bank reserves increased nearly 30-fold with minimal upside effects on the economy. (See Figure 2) That is why Chairman Bernanke is stressing the asset market channel rather than the banking channel to transmit monetary policy. Of course it certainly can be argued that reserve expansion put a floor underneath the economy preventing something far worse. But, we must keep in mind a Fed without credibility is a clear negative for the economy, think the 1970s. While a Fed with credibility certainly aided the 25 year 1982- 2007 boom.
Figure 2 Total Bank Reserves, 2007Q4 – 2012Q4F
Source: Federal Reserve Board UCLA Anderson Forecast
Our Forecast
Our view is that the new Fed policy will be modestly helpful and the most recent economic data have been encouraging. As a result, we have revised up both our real GDP and inflation forecasts from last quarter, but unfortunately even with jobs gains averaging 150,000 a month in 2011 and 200,000 a month in 2012, unemployment will remain above 9% through the third quarter of 2012. (See Figure 3) We expect that real GDP will grow at a 2% plus annual rate through the third quarter of 2011 and then ramp up to a 3% or so growth rate. (See Figure 4) With respect to inflation, we are less fearful of deflation than Chairman Bernanke and we expect consumer price inflation to be at or above the Fed’s informal 2% target by late next year. (See Figure 5) The higher apartment rents now being reported by the publicly traded apartment REITs will soon find their way into the consumer price index.
Figure 4 Real GDP Growth, 2005Q1 -2012Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 3 Unemployment Rate, 2005Q1-2012Q4
Figure 5 Headline vs. Core Inflation,
2005Q1 – 2012Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast
Why with such high unemployment is economic growth so sluggish? Historically, steep downturns are followed by steep upturns, but not this time. As we argued last quarter and previously, the economy is suffering from a debt hangover that will require many years of deleveraging to recover from.4 Consumption growth, instead of running at an historical 3% rate is now slogging along at a 2% clip as consumers increase their savings rate to repair their tattered balance sheets. (See Figures 6 and 7) Furthermore, with real wages stagnant, debt constrained consumers do not have the wherewithal to go on a consumption binge. (See Figure 8)
In fact, the economy just might be suffering from a new version of Keynes’ paradox of thrift. In the 1930s, Keynes argued that whereas savings for an individual was a virtue, for an economy in recession it is a vice because if every household cuts back on consumption the entire economy remains mired in a slump. Today, however, with very low interest rates, consumers and pension funds have to save more and/ or increase their contributions to achieve their target stock of savings. Moreover, it goes without saying that those consumers who are already retired are being forced to cut back on consumption because of reduced interest income. Thus, one of the challenges facing the Fed’s quantitative easing policy is that lower interest rates could have the perverse effect of lowering consumption rather than increasing it.
Figure 7 Personal Saving Rate,
2000Q1 – 2012Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 8 Employment Cost Index, Real Private Sector Wages and Salaries,
2000Q1 -2012Q4F
Figure 6 Real Consumption Growth,
2000 – 2012F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast
Furthermore, much of the increase in consumption is going to imports. Where a year ago net exports were contributing to growth, it is now inhibiting growth. (See Figure 9) That is why a weaker dollar is necessary part of the adjustment process in that it would work to reduce imports and increase exports. (See Figure 10) Of course, the adjustment process would be made easier if China moved with greater alacrity with respect to the upward revaluation of its currency. Nevertheless, in order for net exports to structurally improve, the savings rate has to rise. Why? The U.S. now consumes more than it produces and borrows the difference from abroad. If consumption were reduced to equal production the savings rate would rise and the trade deficit would disappear.
Housing continues to be in the doldrums. We had hoped to see a meaningful recovery in 2011, but that has been pushed back into 2012. The near complete breakdown in the foreclosure paperwork process has dramatically slowed the price discovery process and introduced a new element of uncertainty. We are now forecasting housing starts to be 757,000 and 1,196,000 units in 2011 and 2012, respectively, compared to an estimate of 604,000 units for 2010. (See Figure 11)
The Restructuring of State and Local Government
Although most business cycles have similar characteristics, each cycle is different in its own way. In the current one instead of the state and local sector
Figure 9 Net Exports, 2005Q1 – 2012Q4
Figure 11. Housing Starts, 2005 – 2012F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 10 U.S. $ Trade-Weighted Exchange Rate
Sources: Bureau of the Census and UCLA Anderson Forecast
Source: IHS Global Insight and UCLA Anderson Forecast
gradually increasing throughout the business cycle, this time it is in decline. Simply put, the state and local government is now undergoing the same type of restructuring that the private sector has endured over the past two decades. As a result, we do not expect any meaningful growth in state and local spending over the next several years. (See Figure 12) That is to say, the tax base cannot keep up with the growth in public employee pension and Medicaid outlays and as a consequence other sectors of state and local budgets will be squeezed. This phenomenon will be reinforced by the election of a flock of new budget cutting governors last November. Over the long-run, the growth path of Medicaid and pension expenditures, of necessity, will be lowered.
Fiscal Imbalances Remain
As we noted earlier, high deficits are constraining the Federal government to engage in further fiscal stimulus. Indeed, the newly elected Congress might just be in the mood for fiscal consolidation on the spending side of the budget. As for the tax side, we are assuming for modeling purposes a tax compromise where all of the Bush tax cuts get extended for one more year and in 2012 high income taxpayers will see their tax rates rise. However, we caution a highly partisan Congress might fail to compromise on the tax issue leaving the economy vulnerable to a massive tax hit in January.
Figure 12 Real State and Local Government Expenditures, 2000 – 2012F
Figure 13. Federal Surplus/Deficit, FY 2000-FY2020F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Source: Office of Management and Budget and UCLA Anderson ForecastUCLA Anderson Forecast
Until Congress grapples with the long-term nature of our fiscal problems, we will be living a period of ongoing uncertainty with respect to taxation. The chairman’s mark of the Bowles-Simpson Deficit Reduction Commission offers a good start, but the politics don’t seem to be there for a meaningful solution. Congress does not seem to be in the mood to cut entitlements will raise taxes even if taxes are meaningfully reformed with lower rates and fewer deductions.
In the meantime, we forecast mega-fiscal deficits for as far as the eye can see. (See Figure 13) Thus, in our opinion, gridlock is bad. Without the two parties coming together there cannot be any meaningful solution to the long term fiscal imbalances we now face.
Conclusion
Despite all of the issues outlined above, the economy will continue to muddle through with modest growth and distressingly high unemployment. The economy is healing, albeit at too slow of a pace, but we forecast there will be an acceleration of growth in late 2011 that will gradually work to lower the unemployment rate. Inflation will pick up quicker than the Fed now expects and as a consequence the extraordinary policy measures taken will gradually be reversed and a gradual tightening cycle might begin in early 2012.
Endnotes
1. See, Uchitelle, Louis, "Unions Yield on Pay Scales To Keep Jobs," The New York Times, November 20, 2010, p.1
2. Bernanke, Ben S., "What the Fed did and why: supporting the recovery and sustaining price stability," The Washington Post, November 4, 2010.
3. Meltzer, Allan H., "A History of the Federal Reserve Volume 1, 1913-1951," (Chicago: University of Chicago Press, 2003), p. 62.
4. See Shulman, David, "The Uncertain Economy," UCLA Anderson Forecast, September 2010.
Wednesday, November 24, 2010
Did Vornado go After the Wrong Retailer?
Reprinted by permission from REIT Wrap dated November 15, 2010.
By David Shulman
In early October, Pershing Square Capital Management and Vornado Realty Trust (VNO) announced they acquired beneficial ownership of 16.8% and 9.9%, respectively of JC Penney Co. (JCP) common shares. Both are widely regarded as savvy real estate investors; so, JCP shares spiked 45% on the news and are now trading at around $31 a share.
JCP is loaded with real estate, but much of it is leased and only 49% of their stores are located in malls, -- mostly Class B malls.
JCP operates just over 1100 stores encompassing 112 million square feet. JCP owns 416 of their stores, but 119 are on ground leases yielding a free and clear total of 297 stores. In addition it owns approximately 4.7 million square feet of warehouse/distribution space.
Goldman Sachs has valued JCP’s real estate at between $1 and $1.5 billion based on low in-place lease rates. Based on a per box valuation Newport Beach, California headquartered Green Street Advisors pegs JCP’s real estate value between $3-$4 billion on an equity market cap of just north of $7 billion. The Green Street Estimate, in my opinion, is the more accurate one.
There is no question that as a stock trade, Pershing Square and Vornado have made a lot of money for their investors/shareholders. (Something both have done before previously, albeit separately, when they both bought Sears (SHLD) shares.) That said, at its current valuation, it is hard to make a compelling case for JCP based on its real estate valuation.
First, I am not a believer in the “REITCO/OPCO” strategy of spinning off the real estate assets of a department store into a REIT and keeping the retail in an operating company. Something Pershing Square’s Ackman proposed when he went after Target (TGT). Simply put, all the leasing real estate at market rates would do is weaken JCP’s already below investment grade rating.
Second, though JCP’s most recent earnings provided some hope, JCP has of late been a very weak retailer. Sales have gone nowhere since 2003 and profits have collapsed. In contrast JCP’s major competitor, Kohl’s (KSS) has seen its sales nearly double over the same time period.
Third, unlike interior mall stores, the department store business model is based on paying minimal rents and Goldman Sachs estimated that JCP pays an average rent of $3.55 a square foot. Perhaps a new tenant would be able to pay far more creating the opportunity to create “sandwich” leases.
In addition JCP’s stores sales generate an unimpressive $150 a square foot in sales. Kohl’s, on the other hand, generates just under $200 a square foot in sales. Further, like most department store chains, its store base is relatively old with just over 60% built before 1990. Against that statistic, 20% of their stores are located in the Sunbelt states of California, Texas and Florida.
Neither Pershing Square nor Vornado has tipped its hand on what it views as the “end game” for their JCP investments. One possibility would be to close many department stores (a lot of them) and harvest their value for alternative uses, such as in-line mall stores or possibly residential, in the case of stand-alone stores. Such a strategy, however, would take considerable time and in the case of mall-stores it would involve amending reciprocal easement and operating agreements.
If JCP isn’t a real estate story, what might VNO and Pershing Square have in mind? My guess is that JCP is a retailing turnaround story where capital could be allocated far better than it has been. For instance, pre- recession, JCP earned $4.86 a share and $4.75 a share in 2006 and 2007, respectively. On those earnings JCP sold above $80 a share.
In contrast consensus estimates call for earnings of $1.43 a share in 2010 and the consensus for 2011 is $1.79 per share. Prior to the recent Pershing Square/Vornado announcements , JCP was changing hand in the low 20s.To be sure, JCP earnings are somewhat understated because of noncash GAAP charges ($237 million in 2009) for their now fully funded pension plan. Those charges will go away by 2014.
In order the bring earnings back to anywhere near their prior peaks management would have to, in the words of Goldman Sachs analysts Adrianne Shapira and Jonathan Habermann, improve capital allocation by lowering cap-ex and buying back shares with the $3 billion in cash on their books, rationalize and monetize real estate assets and reinvigorate their basic retailing business.
No question that VNO and Pershing Square can bring skill sets to the table that would enable JCP management to accomplish at least two of those goals. However, given the “poison pill” that JCP just put into place, a meeting of the minds (at least near term) seems unlikely.
Further, at least near-term, Vornado may be handicapped as a result of the recently announced departure of its retail head, Sandeep Mathrani who takes over early next year as CEO General Growth Properties’ (GGP).
Yes, JCP’s earnings appear to be at or nearing a cyclical trough. However, the retailing environment is far from benign. Deleveraging middle-market consumers wracked by substantial losses on their homes, makes for a powerful headwind facing JCP. Which means it will be awhile, at least, before JCP can execute a turnaround.
JCP stock was cheap when Pershing Square bought their shares at 23 and when VNO bought its shares at 26. There is certainly less of a margin of safety today. Nevertheless, with JCP trading at under 7X EBITDA it seems a better investment than VNO stock trading at 18X EBITDA. The larger question, however, is whether investing in JCP was the best use of capital for a REIT acting like a hedge fund.
Given Vornado’s retailing roots I wasn’t surprised to see Steve Roth and Mike Fascitelli go after a retailer. JCP would not have been my first choice, however. From a strategic standpoint, Macys (M) is a far better fit for VNO. M has much better mall-based assets than JCP and its flagship store is adjacent to VNO’s vast holdings in Manhattan’s Penn Station submarket. If the VNO’s Hotel Pennsylvania site is worth X, then under certain circumstances the Macys full block position on 34th Street is worth 2X. Of course, at its current price of roughly $25 a share, M can hardly be called “cheap.”
David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He is now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. He can be contacted at:david.shulman@baruch.cuny.edu
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 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
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