The world is full of people with little or no real estate experience (okay,
like me) who still claim to know the business well enough to predict a crash.
It's also full of real estate industry pros who, deep in denial, seem to expect
a soft landing followed by another long, glorious boom.
So when an actual real estate expert crosses over to the dark side, it's news.
This morning I'm reading through a 31-page report compiled for internal use
by Colorado Santa Fe Real Estate,
a company founded by a serial entrepreneur named Marcel Arsenault, one of the
rising stars of the commercial real estate business.
Back in the late 1980s, Marcel was a hippy/entrepreneur in the Ben & Jerry
mold who had spent the previous decade mixing up vats of Mountain High yogurt,
eventually turning the brand into one of the most popular in the West and selling
it Beatrice Foods for a nice profit. He then started buying up Colorado real
estate. "I couldn't have picked a worse time," he says now. The junk bond implosion
was metastasizing into the S&L collapse, and the value of office buildings
and shopping malls was plunging.
But he held on, and in a couple of years was rewarded with the mother of all
fire sales. The government began liquidating the assets it had acquired from
failed thrifts, and prime properties were suddenly available for pennies on
the dollar. Marcel loaded up on empty office buildings and leased them out
for a fraction of the going rate -- possible because of the low purchase price.
The buildings filled up, their values rose, and he leveraged their cash flow
to buy more offices, shopping malls and condos. As western real estate values
soared, so did Colorado Santa Fe's portfolio. It now manages upwards of $350
million of property and is sitting on well over $100 million of unrealized
capital gains.
In other words, this is a guy who has prospered in both good and bad real
estate markets, which makes his current take worth noting. And right now he's
excited -- about the prospect of another 1990-style crash. Below are some excerpts
from the previously mentioned report. The capitalized headings and italicized
comments are mine, the rest is Marcel's. As your read this, keep in mind that
it's the analysis of someone who for the past fifteen years has been very successfully
LONG real estate.
THE BIG PICTURE
We believe that the apparent 'irrational exuberance' in the real estate market
is, in reality, an asset bubble that has been inflated by a flood of capital
attracted to real estate. The effect of this flood has been to drive down yields
and push up prices. We believe this value trend is unsustainable and that we
are at a crucial inflection point. Based on the analysis detailed below, we
believe that cap rates will inevitably rise back to trend (and possibly overshoot),
thus driving values down dramatically.
HOW WE GOT HERE
Phase I: Stimulus through Monetary Easing. Following the recession
and 9-11, the U.S. Federal Reserve implemented monetary easing to a degree
not seen in almost 50 years. Cheap money and credit flooded the U.S. economy
in an effort to prevent a serious recession (which had the risk of turning
deflationary like Japan's). The lax monetary policy had the intended effect
of stimulating consumer spending (particularly on assets like homes and real
estate).
Phase II: Illusion Becomes Reality. By 2003, prices of real estate
began rising faster than the rate of inflation. In effect, investors began
noticing how "profitable" it was to accumulate real assets. Rising prices created
a "virtuous cycle" whereby more and more buyers participated in the equation
of purchasing real estate. While admittedly rising prices were driving down
yields, few cared about yield because the Fed was not rewarding saving. The
preferred game was appreciation.
Phase III: Lenders "Pile In" (the final period of play). Given a few
years of rising prices, real estate began looking very safe; low rates made
the cost of debt very manageable, justifying higher prices and larger loans.
By 2005 real estate lending was extraordinarily competitive, (after all, default
rates were at historic lows). By 2006, cheap and easy mortgages had grown to
epic proportions throughout the real estate industry. "No money down" became
the way to purchase a home. Foreign and hedge fund capital poured into mortgage
markets chasing yields of the "risky" tranches of mortgage paper (why settle
for the 5% yield of "A tranche" if the risky "B tranche" yielded at 8-10%?)
With rising property values, the "B tranches" were soon re-rated to "A",
rewarding the buyers with phenomenal appreciation in their mortgage paper.
Mortgages become more plentiful and the tide of easy money rises into uncharted
territory, and bringing real estate values even closer to rocky shores hidden
beneath a tidal flood.
Phase IV: Inflection Point Achieved (the cost of money rises). Satisfied
that it had prevented a serious deflationary recession, by June 2004 the
Federal Reserve begins to slowly increase rates. By 2006, the Fed Rate had
increased from 1% to 4.5% (the "neutral rate" - not deemed excessively simulative
by economists). With yields this high, it again makes sense to hold cash
at the bank. By 2006, the cost of mortgage debt is returning to the long
term average.
THE NEXT FEW YEARS
Phase V: - The Future: Look Out Below. The problem becomes obvious
and virulent when real estate values begin to fall. With debt service costs
rising, real estate begins to flounder, and more risky real estate ends up
on the rocks. As default rates rise, mortgages slowly become more expensive
and difficult to obtain ("real estate becomes a four letter word" in the parlance
of an old banker). Only brave and knowledgeable entrepreneurs venture onto
the scene of real estate wreckage at the lowest tide. Only a "foolhardy lender" would
venture between the rocks of the now quiet ebb tide.
The "virtuous cycle" has completed its turn into the "vicious cycle."
HOUSING AND CONSUMER SPENDING
It is our view that the "irrational exuberance" has transferred from stocks
to housing, setting up conditions for a "housing deflation." We expect a serious
fall-off of home construction, sales and values, starting in 2006, and becoming
very pronounced by 2007. A glut of new houses will accumulate in the next 12-24
months, causing a drop in price and construction of new units, and setting
up a serious risk of price decline (similar to the "tech wreck" in the stock
market).
With the costs of debt service so low, buyers have been able to pay ever
higher prices while maintaining low monthly mortgage payments. In a "virtuous cycle," this
has helped continue to push up housing demand beyond supply for several years
(2002 through 2005). As a result, prices surged higher, and contributed to
a pervasive "wealth effect." Booming housing prices (and sales) have created
a boom in allied industries, including mortgage brokerage, retail sales for
furniture, appliances and home improvements, magnifying the boom throughout
the economy. This spending, in turn, has put off any serious recession. More
importantly, the cocktail of low interest rates and rising home values has
dramatically stimulated retail consumer spending. However, with interest
rates now rising, households are left with an almost unprecedented negative
savings rate, and dangerously high debt levels and debt service costs. The
economy hinges on housing.
Implication: Based on the speculative excess we have observed, we believe
this housing boom will almost certainly be followed by a long and painful
housing bust. We expect that a continued rise in interest rate spreads and
decline in housing sales and prices will push the U.S. in recession by late
2006, and this recession will deepen in 2007, as the housing "wealth effect" turns into
a "poverty effect." As defaults accelerate, lenders' underwriting will tighten
significantly, leading to a precipitous drop in new home sales.
Builders have slowly accumulated large positions in land (2-5 years of inventory),
and will be anxious to turn land into cash (even at a loss). Earnings for the
home builder industry will go negative, along with earnings in many allied
industries (mortgage brokers, title companies, lenders, construction companies,
etc.) This housing downturn will ripple through the economy, creating a loss
of 2-4 million jobs (10-20% of the employment in construction and housing-related
industries).
On the heels of the housing downturn will come a downturn in consumer spending,
particularly in housing-related retail sectors (home improvement items, furniture
and appliances, etc.). This will happen because variable mortgage rates are
rising, fuel costs stay high, and the "wealth effect" of the last 10 years
quickly turns into a "poverty effect," forcing the personal savings rate quickly
back up to at least the U.S. long term trend of 7.1%. With stocks and housing
giving back the "asset bubble" appreciation, the consumer has no choice but
to resort to savings (as they have in the past and as they do in all other
countries once the "asset bubble" turns into an "asset bust").
As savings returns to trendline, our projections show a drop of 3.7% in consumer
spending by the end of 2007 in real dollars. The US economy will, along with
the drop in residential investment, shrink real GDP by 3.1% (a fairly serious
recession). With housing and consumer spending both going down, business investment
spending may also contract, causing declines in the stock market, possibly
driving the economy deeper into recession (until the imbalances are corrected).
The resulting recession will be longer and deeper than most, likely lasting
3 years.
The rising federal deficit, economic recession, lower interest rates, and
declines in real estate will all lead to substantial downward pressure on the
US dollar. Falling U.S interest rates will chase out investors, weakening relative
demand for the dollar. If the economy experiences an asset deflation recession,
the dollar could sink for a period of 3-5 years, reaching new lows year after
year.
COLORADO SANTA FE'S ACTION PLAN
There is virtually no upside left, and instead, tremendous downside risk.
There will be a significant "flight to quality" by lenders and investors.
The risk of remaining heavily invested in real estate is extremely high.
Values are far more likely to fall precipitously than to rise modestly. Most
real estate should therefore be sold and the extraordinary profits harvested.
If our projections are wrong, we have avoided risk and locked in small returns
from holding cash. If our projections are correct, we will need cash in 2007
and 2008 for the considerable buying opportunities that may be available
at the bottom of the cycle.
2006 and 2007: Sell most existing properties:
• Quickly liquidate condo conversions ($75 million)
• Liquidate most retail and industrial properties ($200 million)
• Short stocks of retail REITs, homebuilders, real estate companies,
mortgage insurance companies, and suppliers (construction, copper).
2008-2010: Return to Real Estate (at Cycle Bottom):
• Raise equity pool of $250 million and buy distressed property on a
massive scale ($1 billion).
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