Congress is going through its near annual ritual of increasing the official debt ceiling on our national debt, which consists of treasury bonds and bills. The current ceiling is $14.3 trillion, far from trivial at roughly equal to our GDP, but well below the unfunded liabilties of social security and medicare. To be specific the trustees of both programs reported yesterday that social security has an unfunded liability of $17.9 trillion and medicare's unfunded liability is a frightening $38.3 trillion. Thus the two retirement programs have roughly 4X the liability of the official debt.
Thus any real budget solution has to involve radical changes in these two popular programs.(Note: I am a beneficiary of both programs.) Simply put benefits will have to be radically reduced over time and taxes to support both programs will have to be raised. I know that doing both is anathema to both political parties, but sooner or later we will need to have some real adults in the room. Too bad they can't be found.
Saturday, May 14, 2011
Thursday, April 14, 2011
The Great Deficit Debate: Opening Positions or Something More Serious
At their best Congressman Paul Ryan's and President Obama's plans for deficit reduction represent opening positions in a very serious debate. At their worst, they are both political documents highlighting the governing philosophies of each political party. If something serious is to happen taxes are going to have to be increased and the three major entitlement programs of medicare, medicaid and social security have to be radically reformed. But remember in this debate Ryan is more right than Obama because there is no amount of increased taxation that is capable of defusing the debt time bomb our country faces. Simply put the Congress wrote checks that the economy can't cash. Thus if either party is serious there has to be a real conversation about means testing, end of life care( yes, the infamous "death panels") and market oriented reforms. We will soon see how serious serious they are. Remember the Bowles-Simpson Commission proposal has all of the elements needed to make a start at a serious discussion. Unfortunately both Ryan and the president aren't there yet.
Tuesday, March 15, 2011
Crisis of Faith
Although we fancy ourselves to be of the modern world, we, like our ancient ancestors, are idol worshippers. To be sure we do not bow down to golden calves or Baal Peor, notwithstanding the Second Commandment, we have our own modern versions of idol worship. Many of us worship one or more of the false gods of environmentalism, market fundamentalism, secular liberalism, and technology, to name just a few.
With the nuclear meltdown in Japan coming within a year of the BP oil spill in the Gulf of Mexico our faith in large scale technology has been shattered. Moreover the failures of Tokyo Electric, BP and their respective regulators in government hardly gives one confidence in the large bureaucracies that increasingly run our lives. This lack of trust will make for more volatility in our economy and politics.
With the nuclear meltdown in Japan coming within a year of the BP oil spill in the Gulf of Mexico our faith in large scale technology has been shattered. Moreover the failures of Tokyo Electric, BP and their respective regulators in government hardly gives one confidence in the large bureaucracies that increasingly run our lives. This lack of trust will make for more volatility in our economy and politics.
Friday, March 11, 2011
On the Mend, UCLA Anderson Forecast, March 2011
The U.S. economy is getting better. Slowly, in fits and starts, real GDP is growing and employment is increasing. We are forecasting real GDP growth of 3.8% in the current quarter and through 2013 the economy will grow at a 3% clip. In this environment payroll employment will increase at a pace of 1.9 million in 2011, 2.6 million in 2012 and 3.0 million in 2013. Nevertheless, because employment fell so far dsuring the recession, that growth will be insufficient to saurpass the employment peak reach in the first quarter of 2008.
Although the reported unemployment rate dropped to a recent low of 9.0% in January 2011, we believe the data was partially the result of a statistical anomaly caused by an unusually large decline in the labor force. Hence the unemployment rate will rise initially rise modestly in the second quarter before beginning a welcome decline to below 8% by the end of 2013. Implicit in our forecast is that oil supplied won't be disrupted by the turmoil that recently appeared throughout the Middle East.
Growth Drivers - Equipment and Software, Exports and Autos
The economy is being propelled higher by strong increases in corporate spending on equipment and software. The fuel for this spending is coming from extraordinarily low interest rates, a rapidly recovering stock market and investment incentives coming out of Washington D.C.. Indeed independent of policy, investment is being spurred by technological innovation in wireless and cloud computing along with new natural gas drilling technologies that are reshaping the Nation's energy map. As a result the real business investment share of GDP will increase from 12.8% in 2010 to 15.4% in 2013.
The capital spending surge is being reinforced by a much imporved export picture. The newly emerging economies of Asia are not only exporting to the United States, but are also importing American made airliners, machinery, medical devices and farm products, for example. Adding impetus to the export boom has been the weaker dollar which makes American exports more competitive in international markets. As a result real exports are on track to grow at an 8.5-9% pace over the next three years.
After suffering its worst collapse since the Great Depression, the motor vehicle industry is on the mend. Recall that automobile sales declined by 38% from 16.9 million units in 2005 to 10.4 million units in 2009. Sales rebounded to 11.5 million units in 2010 and now appear to be on the road to near 16 million units by late 2013. For the Detroit portion of the industry that appeared to be near death, this is a remarkable recovery. A key factor driving the automobile recovery is the fact that cars wear out and have to be replaced and with normalized replacement demand to be reckoned to be on the order of 13 million units a year,meeting pent-up demand has become a decisive factor. Just as in the case of corporate investment, automobile demand is being spurred by low interest rates and imporved stock prices along with a much imporved product line.
The Laggards: Housing (for now) and State and Local Government
Unlike automobiles, it takes a long time for housing to wear out. Housing continues to wallow in its modern day depression as low interest rates are being more than canceled out by the glut of new product created during the bubble years of 2004-2007, the tidal wave of foreclosures and increased credit standards being imposed by lenders. Moreover hte reemergence of real cash down payments in the housing finance system has offset the 30% decline in prices. Indeed fears of a further ratcheting down in prices along with the shock of witnessing an unprecedented collapse in the price structure have kept buyers out of the market. Put simply the investment value of home ownership has declined. Furthermore the usual factors associated with housing weakness of tepid job growth and high unemployment are suppressing demand.
As a result we are forecasting only a modest recovery in housing starts this year to 658,000 units up from 586,000 units in 2010. Thereafter, as the employment situation improves, we forecast that housing starts will exceed one million units in 2012 and approach 1.5 million units in 2013 as pent-up demand offsets rising interest rates. Remember as strongas this recovery appears, a run-rate of 1.5 million units represents demographic demand and no more. As an aside, we anticipate that multi-family construction will recover more rapidly as the glut of housing in fringe areas supresses new single-family construction in the exurbs.
As w have noted many times in the past, state and local government is undergoing a fundamental restructuring analagous to what happened in the manufacturing sector over the past 40 years. Simply put, promises were made with respect to public employee pension and post-retirement health benefits that have become financially infeasible. With state and local budgets being drained by employee benefits and the ever-growing Medicaid program, there are insufficient funds available to fund the remainder of government such as education, environmental, public safety and recreation programs. Thus even as tax receipts improve, state and local budgets will continue to be squeezed triggering new rounds of employee cutbacks, furloughs and pay cuts. As we have seen in other sectors of the economy, this process will take a long time and it will be accompanied by highly publicized "flashpoints" such as last month's dispute in Wisconsin over pensions and union bargaining issues.
A Whiff of Inflation
Although inflation has been quiescent and as recenmtly as November the Fed seemed to be more worried about deflation, there is now a whiff of inflation in the air. Commodity prices have rocketed higher with corn and wheat up about 60% from a year ago levels and with even greater advances for for iron ore, up 78% and cotton up 130%. Oil prices- up until the Libyan crisis spike- were still up 20% from the year ago level and for no apparent reason the European Brent market has consistently traded at an unpcredented $15 premium over the U.S. West Texas benchmark. It appears that aside from fueling the stock market, the Fed's quantitative easing policy has lit a fire under commodity prices.
Perhaps more important, under the radar apartment rents are rising as would be homeowners remain renters. Several of the larger apartment owning real estate investment trusts(REITs) are reporting year-over-year rent increases on the order of 2-3%, compared to the 1% reported in the official consumer price index. Historically REITs lead the official data by about six months. To be sure, renters represent only 36% of thepopulation, cash rents statistically enter into the owners' equivilent rent calculation that reflects the cost of homeownership. As a result, despite continued high unemployment, the core consumer price index on a sequential basis will hit the Fed's informal 2% target by mid-2012 and exceed it in 2013.
Higher Interest Rates Ahead
Since 2009 the Federal Reserve has been running an "emergency" Zero Interest Rate Policy (ZIRP). We anticipate that policy will be with us thoughout 2011 as the Fed remains more concerned about its employment madnate that its inflation mandate. However as the employment situation begins to improve and the inflation rate approaches their informal 2% target, the ZIRP policy will come to an end in early 2012. Before that eventuality the Fed will start unwinding its $600 billion quantitative easing program that is scheduled to end in May.
However, longer term interest rates will begin to antipate the change in policy. Perhaps as early as next quarter the 10-Year U.S. Treasury Bond will reach 4% and be on the road to a 5% yield by the end of 2013. Of course interest rates move far more violently that what are anticipated in econometric models, wo we won't be surprised to see a more dramatic move sooner. We note that from early November to early December 2010 the yield on the 10-year Treasury spiked from 2.5% to 3.5%.
The interest rate outlook is being exacerbated by the mega-Federal deficits as far as the eye can see. The Bowles-Simpson Deficit Reduction Commission offered a rough outline to partially alleviate the problem last December, but neither the President's budget nor the recent proposed cuts in discretionary nondefense spending bythe House Republicans come close to getting to the core of the issue. The big "elepahnts" in the room are the entitlement programs of Medicare and Social Security and until those programs are dealt with, the long run deficit outlook will be problematic. Remeber entitlements are the Federal equivilent of the state and local pension issue. Just to note our forecast assumes modest cuts in domestic discretionary outlays and defense along with increased taxation on high income earners in 2013. We have not, however, modeled in any significant entitlement reform.
Conclusion
Assuming the rolling crisis in the Middle East does not disrupt oil supplies, the economy is on the mend. Real GDP will be growing at a 3% clip over the next three years along with accelerating gains in empoyment. By the end of the forecast period in 2013, the unemployment rate will be below 8% and payroll employment will approach the prior peak. Along the way inflationary pressure will increase with both headline and core consumer price indicies exceeding 2% by mid-2012. That eventuality will bring with it an end to the ZIRP policy and 10-Year U.S. Treasury Bond yields will be at more nromal 4+% range.
Although the reported unemployment rate dropped to a recent low of 9.0% in January 2011, we believe the data was partially the result of a statistical anomaly caused by an unusually large decline in the labor force. Hence the unemployment rate will rise initially rise modestly in the second quarter before beginning a welcome decline to below 8% by the end of 2013. Implicit in our forecast is that oil supplied won't be disrupted by the turmoil that recently appeared throughout the Middle East.
Growth Drivers - Equipment and Software, Exports and Autos
The economy is being propelled higher by strong increases in corporate spending on equipment and software. The fuel for this spending is coming from extraordinarily low interest rates, a rapidly recovering stock market and investment incentives coming out of Washington D.C.. Indeed independent of policy, investment is being spurred by technological innovation in wireless and cloud computing along with new natural gas drilling technologies that are reshaping the Nation's energy map. As a result the real business investment share of GDP will increase from 12.8% in 2010 to 15.4% in 2013.
The capital spending surge is being reinforced by a much imporved export picture. The newly emerging economies of Asia are not only exporting to the United States, but are also importing American made airliners, machinery, medical devices and farm products, for example. Adding impetus to the export boom has been the weaker dollar which makes American exports more competitive in international markets. As a result real exports are on track to grow at an 8.5-9% pace over the next three years.
After suffering its worst collapse since the Great Depression, the motor vehicle industry is on the mend. Recall that automobile sales declined by 38% from 16.9 million units in 2005 to 10.4 million units in 2009. Sales rebounded to 11.5 million units in 2010 and now appear to be on the road to near 16 million units by late 2013. For the Detroit portion of the industry that appeared to be near death, this is a remarkable recovery. A key factor driving the automobile recovery is the fact that cars wear out and have to be replaced and with normalized replacement demand to be reckoned to be on the order of 13 million units a year,meeting pent-up demand has become a decisive factor. Just as in the case of corporate investment, automobile demand is being spurred by low interest rates and imporved stock prices along with a much imporved product line.
The Laggards: Housing (for now) and State and Local Government
Unlike automobiles, it takes a long time for housing to wear out. Housing continues to wallow in its modern day depression as low interest rates are being more than canceled out by the glut of new product created during the bubble years of 2004-2007, the tidal wave of foreclosures and increased credit standards being imposed by lenders. Moreover hte reemergence of real cash down payments in the housing finance system has offset the 30% decline in prices. Indeed fears of a further ratcheting down in prices along with the shock of witnessing an unprecedented collapse in the price structure have kept buyers out of the market. Put simply the investment value of home ownership has declined. Furthermore the usual factors associated with housing weakness of tepid job growth and high unemployment are suppressing demand.
As a result we are forecasting only a modest recovery in housing starts this year to 658,000 units up from 586,000 units in 2010. Thereafter, as the employment situation improves, we forecast that housing starts will exceed one million units in 2012 and approach 1.5 million units in 2013 as pent-up demand offsets rising interest rates. Remember as strongas this recovery appears, a run-rate of 1.5 million units represents demographic demand and no more. As an aside, we anticipate that multi-family construction will recover more rapidly as the glut of housing in fringe areas supresses new single-family construction in the exurbs.
As w have noted many times in the past, state and local government is undergoing a fundamental restructuring analagous to what happened in the manufacturing sector over the past 40 years. Simply put, promises were made with respect to public employee pension and post-retirement health benefits that have become financially infeasible. With state and local budgets being drained by employee benefits and the ever-growing Medicaid program, there are insufficient funds available to fund the remainder of government such as education, environmental, public safety and recreation programs. Thus even as tax receipts improve, state and local budgets will continue to be squeezed triggering new rounds of employee cutbacks, furloughs and pay cuts. As we have seen in other sectors of the economy, this process will take a long time and it will be accompanied by highly publicized "flashpoints" such as last month's dispute in Wisconsin over pensions and union bargaining issues.
A Whiff of Inflation
Although inflation has been quiescent and as recenmtly as November the Fed seemed to be more worried about deflation, there is now a whiff of inflation in the air. Commodity prices have rocketed higher with corn and wheat up about 60% from a year ago levels and with even greater advances for for iron ore, up 78% and cotton up 130%. Oil prices- up until the Libyan crisis spike- were still up 20% from the year ago level and for no apparent reason the European Brent market has consistently traded at an unpcredented $15 premium over the U.S. West Texas benchmark. It appears that aside from fueling the stock market, the Fed's quantitative easing policy has lit a fire under commodity prices.
Perhaps more important, under the radar apartment rents are rising as would be homeowners remain renters. Several of the larger apartment owning real estate investment trusts(REITs) are reporting year-over-year rent increases on the order of 2-3%, compared to the 1% reported in the official consumer price index. Historically REITs lead the official data by about six months. To be sure, renters represent only 36% of thepopulation, cash rents statistically enter into the owners' equivilent rent calculation that reflects the cost of homeownership. As a result, despite continued high unemployment, the core consumer price index on a sequential basis will hit the Fed's informal 2% target by mid-2012 and exceed it in 2013.
Higher Interest Rates Ahead
Since 2009 the Federal Reserve has been running an "emergency" Zero Interest Rate Policy (ZIRP). We anticipate that policy will be with us thoughout 2011 as the Fed remains more concerned about its employment madnate that its inflation mandate. However as the employment situation begins to improve and the inflation rate approaches their informal 2% target, the ZIRP policy will come to an end in early 2012. Before that eventuality the Fed will start unwinding its $600 billion quantitative easing program that is scheduled to end in May.
However, longer term interest rates will begin to antipate the change in policy. Perhaps as early as next quarter the 10-Year U.S. Treasury Bond will reach 4% and be on the road to a 5% yield by the end of 2013. Of course interest rates move far more violently that what are anticipated in econometric models, wo we won't be surprised to see a more dramatic move sooner. We note that from early November to early December 2010 the yield on the 10-year Treasury spiked from 2.5% to 3.5%.
The interest rate outlook is being exacerbated by the mega-Federal deficits as far as the eye can see. The Bowles-Simpson Deficit Reduction Commission offered a rough outline to partially alleviate the problem last December, but neither the President's budget nor the recent proposed cuts in discretionary nondefense spending bythe House Republicans come close to getting to the core of the issue. The big "elepahnts" in the room are the entitlement programs of Medicare and Social Security and until those programs are dealt with, the long run deficit outlook will be problematic. Remeber entitlements are the Federal equivilent of the state and local pension issue. Just to note our forecast assumes modest cuts in domestic discretionary outlays and defense along with increased taxation on high income earners in 2013. We have not, however, modeled in any significant entitlement reform.
Conclusion
Assuming the rolling crisis in the Middle East does not disrupt oil supplies, the economy is on the mend. Real GDP will be growing at a 3% clip over the next three years along with accelerating gains in empoyment. By the end of the forecast period in 2013, the unemployment rate will be below 8% and payroll employment will approach the prior peak. Along the way inflationary pressure will increase with both headline and core consumer price indicies exceeding 2% by mid-2012. That eventuality will bring with it an end to the ZIRP policy and 10-Year U.S. Treasury Bond yields will be at more nromal 4+% range.
Thursday, March 3, 2011
Gates Echoes Shulmaven
Today's Wall Street Journal is running story saying that Bill Gates will charge public spending on healthcare and public employee pensions is crowding out needed spending on public education. This position is in keeping with the longstanding position of Shulmaven where we argue that curbing healthcare costs and public employee pension benefits is a "liberal issue." See the lede below.
"Billionaire philanthropist Bill Gates will step into the national debate over state budgets Thursday with a call for states to rethink their healthcare and pension sytems, which he says stifle funding for public schools."
"Billionaire philanthropist Bill Gates will step into the national debate over state budgets Thursday with a call for states to rethink their healthcare and pension sytems, which he says stifle funding for public schools."
Saturday, February 19, 2011
The Battle of Madison
Governor Scott Walker's epic showdown with Wisconsin's public employee unions is being played out on the Madison streets I know so well. Walker is rightfully seeking to reign in runaway public employee health and pension benefits to help bring the state's $3.6 billion projected deficit into balance. To be sure he may have over-reached in seeking to rollback a host of collective bargaining perquisites that the unions have long enjoyed, but as Barack Obama taught us so well, "elections have consequences."
Walker is fighting the good fight against one of the most reactionary elements of our society, the public employee union leadership. Pure and simple they represent "producer" over "consumer" interests. Where the 21st Century calls for flexibility the union leadership clings to obsolete work and retention rules making it all but impossible to fire incompetent workers and to organize work in a cost effective way.
Perhaps what is surprising is that the so called "liberals" are standing with these hidebound reactionaries. Simply put if public employee pension and health (current and post retirement) spending along with Medicaid remain on their current tracks, the will be no money left for "the liberal project." All of the wonderful education and environmental programs that the liberal community desires will fall by the wayside as employee benefits and Medicaid gobble up state budgets.
So I salute Governor Walker and wish him luck in rounding up the the recalcitrant Democrats who fled the state to avoid a vote on his proposals.
Walker is fighting the good fight against one of the most reactionary elements of our society, the public employee union leadership. Pure and simple they represent "producer" over "consumer" interests. Where the 21st Century calls for flexibility the union leadership clings to obsolete work and retention rules making it all but impossible to fire incompetent workers and to organize work in a cost effective way.
Perhaps what is surprising is that the so called "liberals" are standing with these hidebound reactionaries. Simply put if public employee pension and health (current and post retirement) spending along with Medicaid remain on their current tracks, the will be no money left for "the liberal project." All of the wonderful education and environmental programs that the liberal community desires will fall by the wayside as employee benefits and Medicaid gobble up state budgets.
So I salute Governor Walker and wish him luck in rounding up the the recalcitrant Democrats who fled the state to avoid a vote on his proposals.
Sunday, January 30, 2011
David Shulman's Crystal Ball
Reprinted by permission from REIT Wrap dated January 19,2011.
Editor’s Note: REIT Wrap contributor David Shulman writes that he’s not
especially bullish on REITs this year. Neither, however, is he bearish.
REITs, Shulman says, are likely to be little changed from year-end 2010 in
2011. Why does Shulman see REITs treading water this year? He lays out his
case and the reasons for it, below. As always, your feedback is
encouraged. And best wishes for a profitable 2011!
After plunging 41.51% in 2008, the price-only version of the MSCI U.S.
REIT Index (RMZ) jumped 20.97% in 2009 and another 23.53% last year.
Yes, the closely followed benchmark remains well below – nearly 40% -- its
February 7, 2007 all-time high of 1,233.66. Before you get carried away
with how far away the index is from its 2007 peak; I should tell you that
I view the RMZ 2007 high as the equivalent of the Nasdaq peak of 5,132.52
in March 2000. Said differently, I don’t expect the RMZ to test its
all-time high anytime soon!
What lies ahead for REITs this year? My best guess is that the RMZ will
trade in a broad range -- between 680 to 820 – and end 2011 roughly where
it began the year, at 760-ish. Why am I not as bullish as others?
Simply put, in terms of equity valuation, REITs are way ahead of
themselves trading at 17X 2011 estimated FFO and trailing EBITDA. Frankly,
REITs are quite expensive. Remember the Standard & Poor’s 500-stock index
is currently trading at roughly 8X 2010 EBITDA and 13X 2011 estimated
earnings. And, to top it off, REITs are still trading at a roughly 15%
premium to net asset value. Of course this state of affairs has been with
us for quite a while. So, why should it be different this year?
The answer is not complicated. The great bond bull market of 2007 to 2010
appears to be over. Ten-year Treasury yields have surged from 2.5% in
early-November to approximately 3.3% as of this writing.
Whether the bond market sell-off resulted from concern over the Fed’s
quantitative easing policies, higher deficits coming from the recent tax
deal, or higher growth in 2011 coming from the same tax deal is really
irrelevant. The fact remains that yields have dramatically backed up
causing the recent huge underperformance by REITs versus the broad market.
Rising rates and still tepid earnings growth for REITs are not a formula
for strong gains in share prices. This will be especially true against a
back drop of double-digit earnings gains expected for the S&P 500 in both
2011 and 2012. Said differently, the headwinds coming from the bond market
will more than offset the modest earnings gains of about 6% that most
REITs will report in 2011 even if those earnings exceed current estimates,
which I think they will.
Wearing my UCLA hat, I recently forecast 2+% GDP growth in 2011 and
just above 3% growth in 2012. Though those numbers are low compared to the
4% GDP growth forecasts coming from several of the major investment banks
following the recent tax deal; the UCLA forecast was put to bed prior to
the deal. It also only included a one full year extension of the Bush-era
tax cuts and it did not include the very important payroll tax cuts that
were added to the compromise. If I had to do a new forecast today, I would
mark it up to 3+% in 2011 and 2012;, still below where the Wall Street bulls currently are.
The economic environment will be improving going forward. Even the more
modest UCLA forecast calls for 150,000 jobs a month in 2011 and just above
200,000 jobs a month in 2012. That kind of labor market improvement will
certainly help real estate absorption going forward. Contrast that data
with the very tepid 100,000 a month job gains reported for 2010.
More important, sometime this year, real estate and REIT investors will
conclude that the era of extraordinarily low interest rates has ended.
Interest rates will start to normalize and that means instead of sub-3%
10-Year U.S. Treasury yields, 4+% though still low, will become the norm.
As a result, the scramble for yield that we witnessed over the past few
years will abate making REIT yields relatively less attractive. Put
bluntly, REITs, in my opinion, are not priced for a more normalized yield
world and it will take a year or two of rising dividends to help them
catch up.
Over the longer-term REIT investors should keep a keen eye on several of
the tax proposals made by the Bowles-Simpson Deficit Reduction Commission.
Their proposals to lower income tax rates and tax dividends and capital
gains at the new lower ordinary rates (23% to 29%) would be a boon to REIT
investors as REIT dividend taxation declines and corporate dividend
taxation increases.
On the other hand, the commission’s proposal to lower the corporate income
tax rate to 23% to 29% makes the REIT corporate tax exemption far less
valuable. When coupled with longer depreciation schedules for REITs
compared to C-Corps more than a few real estate companies might decide
that the REIT structure might not be as suitable to their needs as they
once thought.
Although the commission’s proposals are now out of the “new”
news, the long-term fiscal deficit faced by the United States makes it
almost inevitable that its ideas will be soon be revisited.
In terms of sectors: an improvement in economic growth will likely benefit
the hitherto lagging regions of the economy as the expansion broadens. It
won’t only be New York and Washington D.C., so I suspect that the much
maligned suburban office sector might surprise to the upside in 2011.
Moreover, the really new thing in the tax compromise, the payroll tax cut,
will help the Wal-Mart customer far more than the Nordstrom customer in
2011. With improving employment and a much needed pay raise coming from
the payroll tax cut, strip and power centers might outperform malls
this year. That’s a tough call, because the high-end consumer will benefit
from a continuation of the Bush-era tax cuts.
In sum, it is hard for me to be bullish about REITs in 2011. (No surprise,
I’m sure, to those who know me.) On the other hand, it is also hard for me
to be really bearish, despite high valuations. The economic environment of
modest growth and still low, albeit rising interest rates, makes it hard
to be outright bearish. There is still way too much money out there that
is looking for a home in real estate!
-----------
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.
Editor’s Note: REIT Wrap contributor David Shulman writes that he’s not
especially bullish on REITs this year. Neither, however, is he bearish.
REITs, Shulman says, are likely to be little changed from year-end 2010 in
2011. Why does Shulman see REITs treading water this year? He lays out his
case and the reasons for it, below. As always, your feedback is
encouraged. And best wishes for a profitable 2011!
After plunging 41.51% in 2008, the price-only version of the MSCI U.S.
REIT Index (RMZ) jumped 20.97% in 2009 and another 23.53% last year.
Yes, the closely followed benchmark remains well below – nearly 40% -- its
February 7, 2007 all-time high of 1,233.66. Before you get carried away
with how far away the index is from its 2007 peak; I should tell you that
I view the RMZ 2007 high as the equivalent of the Nasdaq peak of 5,132.52
in March 2000. Said differently, I don’t expect the RMZ to test its
all-time high anytime soon!
What lies ahead for REITs this year? My best guess is that the RMZ will
trade in a broad range -- between 680 to 820 – and end 2011 roughly where
it began the year, at 760-ish. Why am I not as bullish as others?
Simply put, in terms of equity valuation, REITs are way ahead of
themselves trading at 17X 2011 estimated FFO and trailing EBITDA. Frankly,
REITs are quite expensive. Remember the Standard & Poor’s 500-stock index
is currently trading at roughly 8X 2010 EBITDA and 13X 2011 estimated
earnings. And, to top it off, REITs are still trading at a roughly 15%
premium to net asset value. Of course this state of affairs has been with
us for quite a while. So, why should it be different this year?
The answer is not complicated. The great bond bull market of 2007 to 2010
appears to be over. Ten-year Treasury yields have surged from 2.5% in
early-November to approximately 3.3% as of this writing.
Whether the bond market sell-off resulted from concern over the Fed’s
quantitative easing policies, higher deficits coming from the recent tax
deal, or higher growth in 2011 coming from the same tax deal is really
irrelevant. The fact remains that yields have dramatically backed up
causing the recent huge underperformance by REITs versus the broad market.
Rising rates and still tepid earnings growth for REITs are not a formula
for strong gains in share prices. This will be especially true against a
back drop of double-digit earnings gains expected for the S&P 500 in both
2011 and 2012. Said differently, the headwinds coming from the bond market
will more than offset the modest earnings gains of about 6% that most
REITs will report in 2011 even if those earnings exceed current estimates,
which I think they will.
Wearing my UCLA hat, I recently forecast 2+% GDP growth in 2011 and
just above 3% growth in 2012. Though those numbers are low compared to the
4% GDP growth forecasts coming from several of the major investment banks
following the recent tax deal; the UCLA forecast was put to bed prior to
the deal. It also only included a one full year extension of the Bush-era
tax cuts and it did not include the very important payroll tax cuts that
were added to the compromise. If I had to do a new forecast today, I would
mark it up to 3+% in 2011 and 2012;, still below where the Wall Street bulls currently are.
The economic environment will be improving going forward. Even the more
modest UCLA forecast calls for 150,000 jobs a month in 2011 and just above
200,000 jobs a month in 2012. That kind of labor market improvement will
certainly help real estate absorption going forward. Contrast that data
with the very tepid 100,000 a month job gains reported for 2010.
More important, sometime this year, real estate and REIT investors will
conclude that the era of extraordinarily low interest rates has ended.
Interest rates will start to normalize and that means instead of sub-3%
10-Year U.S. Treasury yields, 4+% though still low, will become the norm.
As a result, the scramble for yield that we witnessed over the past few
years will abate making REIT yields relatively less attractive. Put
bluntly, REITs, in my opinion, are not priced for a more normalized yield
world and it will take a year or two of rising dividends to help them
catch up.
Over the longer-term REIT investors should keep a keen eye on several of
the tax proposals made by the Bowles-Simpson Deficit Reduction Commission.
Their proposals to lower income tax rates and tax dividends and capital
gains at the new lower ordinary rates (23% to 29%) would be a boon to REIT
investors as REIT dividend taxation declines and corporate dividend
taxation increases.
On the other hand, the commission’s proposal to lower the corporate income
tax rate to 23% to 29% makes the REIT corporate tax exemption far less
valuable. When coupled with longer depreciation schedules for REITs
compared to C-Corps more than a few real estate companies might decide
that the REIT structure might not be as suitable to their needs as they
once thought.
Although the commission’s proposals are now out of the “new”
news, the long-term fiscal deficit faced by the United States makes it
almost inevitable that its ideas will be soon be revisited.
In terms of sectors: an improvement in economic growth will likely benefit
the hitherto lagging regions of the economy as the expansion broadens. It
won’t only be New York and Washington D.C., so I suspect that the much
maligned suburban office sector might surprise to the upside in 2011.
Moreover, the really new thing in the tax compromise, the payroll tax cut,
will help the Wal-Mart customer far more than the Nordstrom customer in
2011. With improving employment and a much needed pay raise coming from
the payroll tax cut, strip and power centers might outperform malls
this year. That’s a tough call, because the high-end consumer will benefit
from a continuation of the Bush-era tax cuts.
In sum, it is hard for me to be bullish about REITs in 2011. (No surprise,
I’m sure, to those who know me.) On the other hand, it is also hard for me
to be really bearish, despite high valuations. The economic environment of
modest growth and still low, albeit rising interest rates, makes it hard
to be outright bearish. There is still way too much money out there that
is looking for a home in real estate!
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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.
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