Should Dodd-Frank Be Repealed?

The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama in 2010 is considered the most sweeping change in U.S. financial regulations since the Great Depression.

Many of those regulatory changes will become effective beginning January 1, 2012. If you’ve listened for any length of time to the Republican presidential debates one of the re-occurring themes that is bandied about by several of the candidates is that Dodd-Frank should be repealed. They consider this legislation a quintessential example of government red tape that is crippling our economy. Hmm… Is that really true?

I freely admit I’m no expert on the subject of the Dodd-Frank bill which totaled over 2,300 pages in length and most likely neither are you. So let’s begin by doing a quick overview of what was in the bill and how it impacts commercial real estate.

1. Banks are required to have 5% “skin in the game” for every loan that they approve. No longer can they approve a risky loan and then sell it to some unsuspecting investor by passing it off as a quality investment. This means that lenders are now scrutinizing and documenting real estate loans more carefully. Anyone in the mortgage lending business will tell you that it takes much longer and requires much more paperwork today than it did three years ago. You can thank this 5% rule for the reason why loan processing has become so much more cumbersome.

2. Banks are required to carry more capital reserves. They now have to prove they have the correct amount of reserves, and based on recent default rates and delinquencies, they have had to increase capital reserves significantly over what they were required only a few years ago. This has resulted in decreasing the overall amount of lending capacity in the market in addition to decreasing significantly the number of lenders lending. Pre-2008 lenders were tripping all over themselves competing for loans.

3. Rating agencies now bear more risk and liability under Dodd-Frank. Gone are the days when credit agencies were fearful of losing lucrative business if they came down too conservatively on risky loan pools. As a result CMBS issues today are much more conservative, with lower LTVs and higher debt coverage ratios. It is no surprise that the CMBS market is a shadow of its former self. In 2007 there was $228 billion in the CMBS market compared to a measly $12 billion in 2010. There are several reasons for this downturn but the rating agency reform in the Dodd-Frank bill is certainly one of them.

I would be the first to admit that the Dodd-Frank bill is having a huge adverse impact on the banking system in the short term. But would you prefer to go back to where the banking regulations were prior to the sub-prime loan debacle? I don’t think so. Yes it’s painful and it certainly makes a good sound bite on the campaign trail to rail against the Dodd Frank bill. But all three of these changes are just plain common sense. They are needed in order to slowly repair a battered banking system that has lost all the respect that it once had. If you disagree, I welcome your comments.

Source: Regulatory Reform: What Impact Will It Have On Commercial Real Estate?, CoStar Group Real Estate Information, Randyl Drummer, July 28, 2010.

IREM Forecast Breakfast - Optimism Abounds

The 24th Annual IREM Forecast Breakfast was awash in cautious optimism as the commercial real estate industry is slowly rebounding from the most difficult recession in our lifetimes. For 2012, each of the presenters, whether it be for office, retail, industrial or apartments, forecasted modest but steady improvements in both occupancy and rental rates for the Portland real estate market for the coming year.

But I would prefer to focus my commentary today on the presentation given by Nawad Othman, Chief Executive Officer for Otak, Inc. Mr. Othman, a self-described “optimist” gave a compelling presentation about current world affairs that he described as a time of uncertainty and an age of complexity. It would be easy to focus on all the real and ever pressing issues that confront us, and they are legion! Or we can, as Mr. Othman did, focus on the many things that truly make us the envy of the world. I would like to take the liberty to expand on Mr. Othman’s list.

• We live in a country of laws that protect our civil liberties. We should never take this for granted. Franklin Roosevelt described them as our four fundamental freedoms: freedom of speech and expression; freedom of worship; freedom from want; and freedom from fear. These freedoms are the bedrock upon which our government was founded.

• Our business environment fosters, promotes, and encourages innovation like no other country in the world. It isn’t by accident that Microsoft, Google, Facebook, Amazon.com, to name just a few, are American corporations. China may be able to make things cheaper but they have no ability in creating the next new idea. They, and the rest of the world, look to us to do that.

• Our kindergarten through high school educational system may not be stellar but our universities are the best in the world. Students from all over the world flock to our universities.

• We have a strong commitment to fostering and maintaining a viable middle class. Unlike many countries of the world, we believe in public education. We believe in the American dream where someone who works hard and takes risks can rise to the very top of our society.

• Unlike many countries of the world (Japan, China, Europe) we have a growing population base. People from all over the world want to come to live in our country. Population growth is absolutely vital in order to have a healthy economy. And if you believe in Social Security, Medicare and other social welfare programs that help the most disadvantaged among us, a growing population is absolutely necessary to fund these programs.

Yes, we can focus on all of our problems or we can pause for a moment and see how blessed we are as a nation. So are we willing to view the proverbial cup of water half empty or half full? Even those of us who have gone through tough times (as most of us have during this recession) deep down realize there is no better place to live then where we live right now at this time in history.

Have a Merry Christmas or Happy Hanukkah and a prosperous new year! If this closing offends you, get a life! :)

Source: IREMOregon.com; 2011 Forecast Breakfast Transcript, December 8, 2011. 

What exactiy did The Fed do?

Last week the Dow Jones Industrial Average soared almost 500 points (4.2%) on the news that The Federal Reserve in a coordinated effort with five other central banks of the world came to the rescue of European banks. Specifically, The Fed’s action effectively gives these central banks access to a massive pool of new U.S. dollars that they can borrow at a very low rate of 0.5% to fund their banking sectors. Why should this action be viewed with euphoria by the world's stock markets?

To better understand what is going on you need to know why The Fed took this action. For European banks to lend money they have traditionally borrowed dollars from other banks, money market funds and institutional investors. As the European debt crisis has deepened, these lending sources have slowly pulled back because Europe’s banks are holding ever larger amounts of sovereign debt that is becoming increasingly more likely it will not get paid back.

Since May, U.S. money market funds have reduced their loans to European banks by 42 percent reports the Fitch rating agency. If we could know what the other lending sources for European banks were doing we would likely see the same response. Prudent lending sources seeing the increasing risk of sovereign debt are unwilling to risk their own money by lending it to the European banks. This is just plain common sense. You would do the exact same thing. Therefore the reason The Fed acted as it did last week is because the European banks were starting to experience a liquidity crunch.

It is the equivalent to what happened to Washington Mutual a few years ago. Recall what brought down WaMu was bank customers losing confidence in the long term viability of the bank quietly, but ever so quickly withdrawing their deposits. There was a run on the bank. In the period of a few weeks, WaMu went from being healthy to insolvent. The exact same thing is happening right now to European banks. The only difference is that it is happening across all the major banks in Europe, not just one particular lender like Washington Mutual. So I ask you? Is this something to be euphoric about? Does this justify a 500 point increase in the Dow? Only if you think bad news is good news.

We should be very concerned with what just happened and here’s why:

1. This did nothing to solve the European debt crisis. All it did was to delay the outcome.

2. The Federal Reserve has now become the lender of last resort. In other words when a European bank defaults, which will happen, we the American public will be picking up the tab.

How does that make you feel?  Euphoric?


Sources: What exactly did the Fed do?, by Robert J. Samuelson, The Oregonian, December 2, 2011; Fed Action in Europe Underscores Dollar Primacy, STRATFOR, November 30, 2011.

Shackleton's Way: Leadership Lessons from the Great Antarctic Explorer

From time to time, I'll read a book that I think my readers would find of value.  Shackleton's Way: Leadership Lessons from the Great Antarctic Explorer by Margo Morrell and Stephanie Capparell is one of those books.

In 1914, Ernest Shackleton and 27 others under his command start on a journey to be the first expedition to cross the Antarctic continent.  Their ship was caught in the ice, eventually crushed and sunk to the bottom of the ocean.  The story of how they all survived has become a classic.  If you haven't read this true story I would recommend The Endurance: Shackleton's Legendary Antarctic Expedition by Caroline Alexander.

In Shackleton's Way, the authors focus on Shackleton's leadership traits and skills in crisis management: self-sacrifice, optimism, perseverance, loyalty, duty, honor, and humor - to name just a few.

As a person who manages his own business and an avid reader of inspirational biographies, I found this book a perfect blend of my two interests.  Each chapter provides a chronological flow of the life of "the Boss" from early childhood, through each of his Antarctic expeditions and finally to his untimely death.  At the end of each chapter is a summary of leadership skills he demonstrated, followed by a contemporary story of an individual who was inspired by Shackleton to follow his example of leadership.

For anyone who has the responsibility to lead others this a must read book.  For those of you who may not want to read the book but would like a quick overview, I've written a 4 page summary for your review.  To access it, click on the link below:

Doug Marshall's Recommended Reading List

This link will take you to the correct page of the MCF website.  Then scoll down under the category "Professional Growth" to the "Leadership" subsection where you will see the name of the book - Shackleton's Way.  Click on the blue ball to the right of the page and open a PDF of the 4 page summary.

John Mitchell's Economic Forecast - Opportunities to Be Seized

I had the opportunity to hear John Mitchell’s economic forecast at the Sterling Savings Bank November 3^rd breakfast meeting.  John always does an excellent job making a boring topic interesting.  There were no surprises in his presentation about the current economic situation, the gist of which was, the U.S. economy is growing, albeit at a slower rate than one would hope.  

But I didn’t go to hear John Mitchell talk about our current economic situation.  I went there to hear what he thinks will happen going forward.  Accurately forecasting future economic trends splits the men from the boys, which reminds me of the Yogi Berra quote: “It’s tough to make predictions especially about the future.”

Not surprisingly, John Mitchell didn’t go out on a limb making any bold predictions about our economic future.  Economists as a rule are not known for being risk takers.  But in fairness to John, he did identify several issues that could influence the economy for good or for ill.  I would like to focus on two of these challenges.  If these issues are handled properly it would have a positive long-term impact on our economy. 

Opportunity #1 – The Housing Crisis

As John Mitchell pointed out, 17% of all homes in Oregon and 22% of all houses in the U.S. are underwater, i.e., homeowners owe more than their houses are worth.  Until this crisis is resolved, house prices will not bottom out, let alone begin to appreciate in value.  And until house prices begin going up most Americans will not have the confidence that the economy has turned the corner regardless of what the economic numbers may say.

One proposal that would go a long way to resolving the housing crisis is writing down some of the principal on these underwater mortgages.  It is estimated that 10 million out of 55 million mortgages are likely to default. The single best indicator of whether a homeowner will default is the size of the imbalance between what is owed and what the house is worth.  Reduce the size of the imbalance and there will be fewer defaults.  Fewer defaults would be a major step in stabilizing house prices.  

Banks hate this idea and would rather continue with the status quo.  The solution: Leaders in Congress should propose legislation that will allow banks to quickly write down mortgages in a manner that doesn’t punish the banks’ long-term viability.  The alternative is continued stagnation in the housing market. 

Opportunity #2 – The Congressional Supercommittee

As you already know, the congressional supercommittee has been given the task of proposing a combination of $1.2 trillion in spending cuts or revenue increases over the next 10 years.  Their deadline to make their proposal before Congress is November 23^rd which is fast approaching.  Most economists believe that anything less than a $3 trillion package will be perceived by the market as little more than putting a band aid on a gaping wound.  Failure to come to some agreement will likely increase our chances of a further downgrading of our nation’s credit rating. 

I hope that those on the committee are closely watching the debt crisis in Europe unfold.  Just in the last week both the Greek and Italian leaders have been forced from office.  Europe is in the throes of a financial crisis.  We could be next.  Compromise, a word that is now considered a pejorative by many, needs to happen between Republicans and Democrats in order to get anything through the supercommittee that has a chance of passing both houses of Congress.   

Both of these issues are at major crossroads.  And both of these are opportunities to be seized or to be squandered. If those in political power show some leadership they could help turn our economic ship around.

Sources: Aftershocks, Oil Shocks and the Long Good-Bye, by John Mitchell, November 3, 2011; A Good Idea in Principal, by Joe Nocera, The Oregonian, November 8, 2011. 

Kicking the Greek Can Down the Road

Stock markets around the world surged dramatically last week with the news of the European Union’s Grand Plan (their name for it) of forgiving 50% of Greece’s sovereign debt. At first blush, it sounds like the sovereign debt crisis in Europe has been solved with this one decisive step. Reality is this will likely keep the euro alive for the next few weeks until the next crisis occurs.

I could bore you by explaining the three main elements of the plan: 1) the bank recapitalization proposal; 2) the Greek write-down of 50 percent of its debt; and 3) the proposed fund and leveraging system that is necessary to make it all work. Most of the details of how this is to be implemented have not yet been decided. It will take weeks to flesh out this plan.

But I can already envision you with a glazed look in your eyes trying to make sense of the preceding paragraph so what’s the point? And quite frankly I don’t blame you. It’s complicated!

So let’s break it down into bite size pieces that we can all understand.

1. The European sovereign debt crisis is not going away anytime soon. It is truly a crisis of epic proportion. There are no easy solutions. All of the possible alternatives to solving this crisis lead to a European banking crisis of varying severity. Shown below is a simplified but accurate version of the choices Europe can make to get through this crisis.

This chart by STRATFOR reminds me of one those convoluted Rube Goldberg-like mouse traps. Unfortunately you’ll notice that all paths lead to the same outcome: European Banking Crisis.

 2. It is going to require someone to step up and boldly lead at a time when statesmen are few and far between. It will also require a good amount of old fashion luck to make the right decisions because the path through this mess is not readily apparent.

3. You might be thinking, “Who cares about the Greek debt crisis? How does it affect me in the Pacific Northwest?” It is important to us because how well the Europeans handle this crisis will determine how significant an impact it will have on the world economy. You can already see how the stock markets of the world are reacting to any news good or bad about this crisis. More importantly will be the effect on our European trading partners. If their economies are adversely impacted it will adversely impact our exports, which means our economy will be affected.

Some may accuse me of being Chicken Little shouting, “The sky is falling” when in fact things are improving. Isn’t there evidence of an economic recovery in the U.S., albeit ever so slowly? Yes, thank goodness. But if we ignore the banking crisis in Europe we do so at our own peril. Now’s the time to think through the ramifications of how this crisis could impact you.

In some respects we are quite fortunate being in the commercial real estate industry as we are part of the solution for our clients to this crisis. If things progress over time as I expect, people will continue taking their money out of the stock market because of volatility and possibly because of declining stock prices. And the interest rates on bonds will continue to be meager. What’s left over to invest in? Commercial real estate, that’s what. The next decade could see the return of investors in a big way coming back into our industry.

 Source: Agenda: Issues Remain for the Eurozone Despite Its Grand Plan; STRATFOR, by Peter Zeihan, October 28, 2011.

First 9 Months 2011 Transaction Activity

The first 9 months of 2011 has come and gone!  From a sales standpoint how well did we do compared to previous years?  Shown below is the criteria we used to tabulate the results:

• Sales information from the CoStar database
• Transactions closed between January 1st and September 30th
• Investment properties only (no owner user)
• Property types - apartments, industrial, flex, office, retail, mixed use
• Transactions with sales prices of $1 million or larger
• Arms length transactions
• Transactions located between Kelso, WA and Eugene, OR including Bend

Based on these criteria the chart below compares the sales activity for the first 9 months of 2011 with each of the preceding four years for the same time period.

As you can see, the sales activity for the first 9 months of 2011 has almost doubled from last year and is almost back to the same number of transactions recorded in 2008.  We are definitely on the rebound!

We then analyzed the 205 transactions by property type:

Multi-family and retail properties continue to dominate the property transactions but other property types are beginning to make their presence known.  All other property types represented 35% of the total sales transactions compared to 28% for the first 6 months of this year. 

Of the 205 transactions, 96 had brokers representing both sides of the transaction.  Forty-nine transactions had no broker representation.  The remaining 60 transactions had only one side of the transaction represented.

If you add it all up, there were a total of 156 broker paydays (2 x 96 + 60).  So if you want to know your personal market share of all the broker paydays divide your number of paydays by 156.  Shown below are the first 9 months lending sources for the 178 sales transactions where the lender was identified:

Seventy-three out of the 178 transactions (41%) were either all cash transactions, assumed the existing debt or were seller financed.  Only 105 transactions (59%) used conventional financing.  Of these, the vast majority were financed by banks 67 (64%). 

Thank goodness owners have to refinance their properties from time to time or most of the mortgage brokers would be out of business.

The sales transactions for the first 9 months of this year strongly suggests that commercial real estate is on the rebound.  Let's hope for all of our sakes that this trend continues into the foreseeable future. 

Why Greece Can't Default Just Yet

Greece has been on the verge of defaulting on its debt for more than a year.  Each time the crisis looms its ugly head, European leaders, led by Germany's Chancellor Angela Merkel, come through with another temporary bailout plan that enables the Greeks to survive a little while longer.  But the decision makers about the Greek crisis have to know that Greece at some point is going to default.  So why throw good money after bad with one more bailout? 

The reason is simple: the European market needs to have all its ducks in a row before it allows Greece to default.  If Greece were to default before they are ready, it could potentially have catastrophic financial consequences in Europe and in time to the rest of the world economy.  So while we watch the news showing the Europeans confidently handling the latest debt crisis, behind the scenes they are working as quickly as they can to make the necessary preparations for the eventual default.  It's like watching a duck traveling through water.  Above the surface it looks effortless but below the surface the duck is paddling furiously.  That's what's going on with the European leaders right now.  They are trying to put a "happy face" out to the public to reassure us that they have the crisis under control, but behind the scenes they are all wringing their hands making the hard decisions needed to weather this financial storm.

So what needs to be done to prepare for this eventual default?  Greece has to be kicked out of the eurozone if the euro is to survive, but for that to happen three things must occur: 1) 400 billion euros are needed to firebreak Greece off from the rest of the eurozone; 2) 800 billion euros are needed in order to prevent a wide-scale banking meltdown, because the day that Greece defaults on its debt, there is likely to be banking collapses in Portugal, Spain and France; and 3) the markets will go wild to say the least.  To avoid Italy being dragged down with Greece, it will need 800 billion euros to keep it solvent for the next three years.  So until the Europeans have two trillion euros in funding available for this crisis, they can't kick Greece out of the eurozone. 

So how does this affect commercial real estate in the Pacific Northwest?  For one, interest rates should remain low.  The Europeans will continue to pour their equity into U.S. treasuries (a flight to quality) which will keep treasury rates low.  Secondly, we are fortunate that our trading partners are situated along the Pacific rim.  Most of our exports are shipped to Canada, China, Japan, South Korea and other Asian nations.  If our export volume remains steady the Pacific Northwest should weather this storm without serious consequences.  I am not as bullish about our east coast which trades heavily with Europe.  I believe the Greek crisis will result in slower economic growth in Europe (likely prolonging the European recession) which will have an adverse impact on their buying U.S. exports.  This will eventually affect us on the west coast but not nearly as much as those states who trade significant volumes with Europe.  I still believe that commercial real estate in the Pacific Northwest is a sound long-term investment, and though it may sound like it, I'm not trying to put my own version of a "happy face" on the impact to us of the mounting crisis in Europe.  Stay positive, the world is not coming to an end, we'll get through this. 

Source: Portfolio: Preparing for Greece's Failure, STRATFOR, Peter Zeihan, September 29, 2011.

China to Start Liquidating US Treasuries

Over the past several blog posts, I've focused almost exclusively on the sovereign debt crisis in Europe, and for good reason.  The next jolt to the world economy will likely come from Europe.  How well or should I say how poorly the European Union handles Greece defaulting on its bond obligations will determine the severity of the impact on the world economy.  There are lots of interesting articles on the sovereign debt crisis in Europe that I could write about.  But I'm going to let that situation percolate awhile and instead focus on an obscure article I read recently in the British newspaper, The Telegraph. 

In this article by Ambrose Evans-Pritchard, the head of China's central bank stated that Beijing plans to reduce its portfolio of US bonds as soon as it is safely possible.  At the World Economic Form, Li Daokui, stated that China will in the future be investing more in physical assets.  "We would like to buy stakes in Boeing, Intel, and Apple... Once the US Treasury market stabilizes we can liquidate more of our holdings of Treasuries," he said. 

It is estimated that China owns $2.2 trillion of US debt, and is second only to The Federal Reserve in the amount of US debt owned.  While China accumulated US bonds over the last three decades, The Fed accumulated its bonds in the last couple of years as a result of the Quantitative Easing program, which ended in June of this year. 

China is clearly worried that about the US debt issue, which now exceeds $14 trillion.  Mr. Li described the debt deals this summer on Capitol Hill as "just trying to buy time," saying it will not be enough to stop the growing debt crisis that is mounting.

It's always interesting to see how the rest of the world looks at us in the United States.  So hearing the comments of a Chinese official in a British newspaper about how the U.S. is handling it's debt crisis is like being the proverbial fly on the wall listening into a conversation about your class behavior between your grade school teacher and your mom.  It's interesting to hear what they're thinking but at the same time you know there's going to be consequences.      

So why is this proposed change in China policy important to those of us in the commercial real estate industry in the Pacific Northwest?  Why should we care whether the Chinese are buying more of our debt or conversely liquidating their holdings of US bonds?  BECAUSE U.S. TREASURY RATES ARE DETERMINED BY SUPPLY AND DEMAND!!! 

We now know that both The Federal Reserve and China are planning to stop buying our debt.  So what happens when the top two buyers of our debt are no longer buying?  To make matters worse China intends to liquidate some or all of their holdings of US debt which will only add to the supply of bonds available on the market to be purchased.  Is it conceivable that the rest of the world can purchase their normal market share of US debt plus China's and The Fed's too?  I don't think so.  Logic tells me it's not possible but smarter people than me who are in the know may disagree. 

Assuming I'm correct, then the rest of the world cannot buy the volume of debt we are currently hemorraghing.  What then?  That means over time treasury yields (interest rates) will have to increase in order to entice enough buyers to buy our debt.  If treasury rates go up, then interest rates of all kinds will follow, including interest rates on commercial real estate.  One offsetting factor are the spreads over treasury rates that lending institutions are charging these days are close to an all time high.  If lenders wanted to absorb some of the rise in treasury rates they could do so by lowering the spreads they are charging.  That is a possibility.  Another possibility is that Congress and the president could pass meaningul legislation to reduce our budget deficits.  I'll let you determine the chances of that happening...

Source: China to 'liquidate' US Treasuries, not dollars; The Telegraph Blogs, by Ambrose Evans-Pritchard, September 15, 2011.

How Bill Gross Got It All Wrong

Earlier this year Bill Gross, the head of bond giant PIMCO, announced in grand fashion that he was getting out of U.S. Treasuries. His reasoning was quite rational: The end of the Fed's quantitative easing program, which ended in June, would be bad for bonds. Prices would fall causing yields (or interest rates) to rise. This would happen because the Fed was the number one buyer of U.S. debt. Without the Fed buying bonds one of two things would have to happen to prevent yields from rising:

1. Some other country would have to step in to buy the Fed's volume of U.S. Treasuries which was highly unlikely, or
2. The U.S. government would have to significantly moderate their borrowing to shrink the volume of U.S. Treasuries being sold on the market. At the present time for every $1 spent by the federal government about 40 cents of that amount is borrowed.

So what do you think are the chances of either #1 or #2 happening? Not likely is it? Looking at it from this perspective, it seemed quite unlikely that another country could purchase the enormous quantity of bonds that the Fed had been buying over the last two years. And it also seemed unlikely that the federal government would reduce its need to borrower.

This past week people were crowing about how Bill Gross got it all wrong and how he lost a lot of money for his bond fund investors. He even admitted sheepishly that it had been a "mistake" to get out of U.S. treasuries. Since Mr. Gross’s announcement in March the 10 year treasury rate has plummeted from 3.46% to 2.02% (Sep 2nd). So how does someone of Mr. Gross's caliber get it wrong? What did he miss?

Back in March when Mr. Gross made his announcement there was no way for anyone to predict:

1. That the sovereign debt crisis in Europe would reach critical mass this year. European leaders had been successful over the years in “kicking the can down the road” and it seemed likely this year would be no different. Wrong!
2. What the impact of the sovereign debt crisis would have on the U.S. treasury market. Fear of a default of sovereign debt by Greece and then by Italy has caused a panic among Europeans. And when panic ensues, investors take their money out of risky investments promising a return on their money and instead invest in less risky investments, in this case U.S. treasuries, where they focus on getting a return of their money.

What has happened is the law of supply and demand has kicked in. Concerned European investors have dramatically increased the demand for U.S. treasuries while the supply has stayed the same. When that happens, yields decline. It’s really that simple.

But the big question is, “How does this affect those of us in the commercial real estate market?” We are currently seeing historically low interest rates.  A lower interest rate means a lower mortgage payment which means better cash flows after debt service. If you own commercial real estate now is the time to lock in long term fixed rate financing.

I know I sound like the boy who cried wolf one too many times but some day we are all going to wake up and the world will be different. Some unpredictable catastrophic event will have occurred (a run on U.S. banks perhaps) causing interest rates to skyrocket and when that happens those who had the foresight to lock in the low rates will be the big winners.

Source: Bill Gross and the Case for Buy Low and Hold, Morgan Housel, The Motley Fool, August 31, 2011.

What Happens if Debt Ceiling is Not Raised?

You may be thinking I'm going to weigh in on the debt ceiling debate.  This reminds me of the old saying, "Fools rush in where angels fear to tread."  I'm not going there.  Not a chance.  I've heard everything from the world is going to end to nothing is going to happen and everything in between.  And likely you have too.  

What I am going to discuss is a bizarre side effect of this fiasco: contrary to everything I've ever read on this subject interest rates on U.S. treasuries are plummeting.  What's going on here???   

Regardless of what happens on the debt ceiling debate the U.S. is likely to lose its triple A bond rating.  The rating agencies have been threatening a down grade of our nation's credit rating not unless $4 trillion is reduced from our spiraling out of control federal deficit.  None of the proposals currently being considered are close to this amount of deficit reduction.  So the likely effect will be a downgrading of our bond rating.  If this happens then logic dictates that interest rates on everything will go up, from credit cards, to auto and home loans to loans on commercial real estate.  But no one really knows for sure the consequences of a down grading of our bonds.  No one.    

So how is it that on Friday last week the 10 year treasury rate plummeted 17 basis points and is now at 2.78% as of this writing?  This is the biggest one-day drop since December 2010.  A drop in interest rates seems so counterintuitive to me.  This is just the opposite of what I would think would happen.  The "experts" believe that investors view the stock market as being more adversely impacted by the debt ceiling debate than the bond market.  As a result investors are selling stocks (notice the Dow Industrials declined 537 points last week, the worst week this year) and are buying bonds.  Go figure!  There is a "flight to quality" - the selling of riskier assets, in this case equities, and the buying of the most secure investment available today - treasuries.

Other so-called safe havens will also benefit from this uncertainty caused by the debt ceiling crisis.  But gold, top-rated corporate debt or the bonds of other countries with triple A ratings are miniscual markets in comparison to the almost $10 trillion U.S. treasury market.  Investors are also confident that the U.S. Treasury will continue to pay the principal and interest owed on existing bonds, even in the case of a prolonged deadlock.      

In addition it is in China's best interest, as the largest holder of U.S. debt, to come to our rescue if things got out of hand with a gridlocked Congress in order to prevent serious harm to their huge existing holdings of U.S. treasuries.  

So for these reasons we are seeing treasury rates declining.  At least for now.  This is a great time to be locking in long term fixed rate financing.  If you are on the sidelines wondering when I should refinance, what are you waiting for?   

Sources: Debt Ceiling Deadlock Could Lower Interest Rates, CNNMoney.com, July 28, 2011; and Treasury Yields Fall By the Most This Year, Market Watch, July 29, 2011. 

First Half 2011 Transaction Activity

The first half of 2011 has come and gone!  From a sales standpoint how well did we do compared to previous years?  Shown below is the criteria we used to tabulate the results:

• Sales information from the CoStar database
• Transactions closed between January 1st and June 30th
• Investment properties only (no owner user)
• Property types - apartments, office, flex, industrial, retail, mixed use & specialty use
• Transactions with sales prices of $1 million or larger
• Arms length transactions only
• Transactions located between Kelso, WA and Eugene, OR including Bend

Based on these criteria the chart below compares the sales activity for the first half of 2011 for each of the last five years:

As you can see, the sales activity for the first half of 2011 increased significantly over the same time period for the last two years: up 17% over 2009 and a whopping 54% over 2010.  We are still well below the transaction activity that we achieved in previous years but the trend is going in the right direction.  Hey that's encouraging!

We then analyzed the 91 transactions for 2011, starting by property type:

Multifamily and retail sales comprise 72 percent of all the sales transactions which is similar to what we've seen in the past couple of years.

Of the 91 sales transactions, 75 of them identified the broker representation and 77 of them identified the lending source that was used.  The remaining transactions did not identify broker representation or lending source.  Shown below is a summary of broker representation fo these 75 transactions:

Assuming that the trend for the 75 sales held true for all 91 sales transactions, then there were about 73 paydays for all of the real estate brokers in our area in the first half of this year (91 x 53% x 2 + 91 x 15% + 91 x 12%).  So if you want to know your personal market share of all the broker paydays divide your number of paydays by 73.

Shown below are the first half lending sources for the 77 sales transactions that a lender was identified:

Thirty out of the 77 transactions (39%) were either all cash buyers, assumed the existing debt or were seller financed.  Only 47 transactions (61%) used conventional financing.  Both regional and national banks made up the majority of these loans.  Insurance companies only made 2 acquisition loans in the first half of this year.

Thank goodness owners have to refinance their properties from time to time.  Refinancing properties is not included in the figures above.  If we had to live solely off acquistion financing many of us on the lending side would be out of business.

Let's hope for all of our sakes that the upward trend in commercial real estate activity continues to improve so there are more paydays for all of us in the industry. 

Fed Scorecard: Where QE Worked and Where It Failed

Quantitative Easing, which ended last Thursday, has had its successes and failures.  But before we look at the outcomes of QE let's quickly review what it is.

The term Quantitative Easing (QE) describes a form of monetary policy used by The Federal Reserve to increase the supply of money in an economy where interest rates are at or close to zero.  The Fed does this by first crediting its own account with money it has created ex nihilo ("out of nothing") or some would say, by "printing money."  It then purchases financial assets, including government bonds, from banks and other financial institutions.  The purchases give banks the excess reserves required for them to create new money.  The increase in the money supply thus stimulates the economy.  That's the theory at least.  Let's see how well it worked.

Where it Worked

1. The stock market benefitted.  Since last August when Fed Chairman Ben Bernanke announced QE2 the major stock indexes have increased between 20 to 29 percent.
2. Commodity prices climbed.  When a currency is debased, it takes more dollars to buy the same product.  Commodities such as oil, precious metals, farm products, etc have benefitted.
3. U.S. exports rose.  Cheap dollars when compared to other world currencies makes our exports that much cheaper, increasing the demand for our exports.
4. It reduced our chances for deflation.  By pumping enough liquidity into the markets we have for the time being avoided the harmful effects of deflation (far worse than inflation). 
5. It created a "Wealth Effect" for some.  If you invested in the stock market, or commodities during this time chances are you did quite well.

Where It Failed

1. Housing is broken.  Bernanke assumed that lower mortgage rates would have a positive influence on the housing market.  That has not happened.
2. Jobs market is broken too.  QE2 was supposed to spur spending, which would increase demand resulting in more jobs.  This hasn't happened.
3. Inflation may not be temporary.  Bernanke called food and energy prices "transitory" and will likely reverse.  This doesn't appear to be happening.  Inflation is currently 3.6% and trending upward.
4. Dollar's potential destruction.  There is a fine line, which may have been crossed, between stimulating the economy with cheaper dollars and ruining the currency.  This is my greatest concern.
5. Interest rates will eventually go higher.  They have to.  Rates are unnaturally low.  If the U.S. continues to borrow debt at the current pace, who will buy it once The Fed is no longer purchasing it?  In order to get sell our debt, rates will have to rise, maybe dramatically in order to attract a new buyer.  

In hindsight, it's easy to see that Quantitative Easing did not accomplish the two most important things it was supposed to do: 1) correct our housing crisis; and 2) get our economy moving in any substantial fashion.  

So where do we go from here?  What other means will be employed to get our economy going again?  Is there anything that can be done?  From my perspective, neither political party has had the political will to outline a realistic plan to get our economy moving in the right direction.  Leadership is the key but no one has yet to act like a statesmen instead of just another politician pointing fingers.  No one has yet shown a willingness to yield a little on one of their pet positions in order to achieve a benefit for the greater good.  Until that happens we will have more of the same. 

Sources: Yahoo.com, CNBC, Fed Scorecard: Five Ways QE2 Worked-And Where It Failed, June 30, 2011; Quantitative Easing by Wikipedia.

Why a Greek Default is Important to Us

I know that if I emphasize too strongly what is happening in Greece I will be accused of being another Chicken Little proclaiming that “the sky is falling.” But reality is that a default by Greece on its debt obligations will likely have a serious adverse impact on us in the United States. But before I explain why let me back up a bit and give you a brief overview of what’s going on.

The Greek sovereign debt crisis has grown to the point that it is no longer a question of if Greece will default on its debt it’s now only a matter of when. It’s going to happen. Last week Standard & Poors lowered the country’s debt rating to triple C – its worst rating for any country in the world. The Greek government is teetering on collapse as massive demonstrations express their rage and frustration in the streets.

A survey indicated that 85 percent of all Greeks would rather default on their country’s debt than institute the severe austerity measures that are being proposed for a temporary bailout. And make no mistake it is a temporary bailout. Barring an absolute miracle any bailout will only delay the inevitable. They have already tried “kicking the can down the road” too many times and at some point they will have to pay the piper.

There are three ways a default by Greece on their debt will affect us:

1. A small portion of their debt is borrowed from U.S. banks – $10 billion or about 5% of their total debt. It’s not pocket change but that amount is not a serious exposure to their debt. That can be absorbed by our banks.

2. However, U.S. banks through credit defaults swaps have indirect exposure to 56% of the total Greek debt. This represents $116 billion of the total $206 billion that Greece owes. That’s huge! Simply put, a credit default swap is default insurance. What has happened is European banks have lent money to Greece but insured their Greek loans with default insurance from U.S. banks.

So the big question is, which no one has an answer for, “Will the Greeks be able to restructure their debt (negotiate a lower interest rate, maybe a forgiveness on some of the debt, etc.) or will it be a complete default?” If it is a restructuring of debt (kind of a “soft landing”) the European banks will absorb the losses. It will not likely trigger the default insurance.  If it is a complete default, then it is likely that the American banks’ credit default swaps will take the hit. And because most of those American banks who issued the credit default swaps are “too big to fail” guess who will be footing the bill?

3. As tight as credit has been over the past three years, it’s going to get even tighter if $100+ billion is taken out of U.S. banks to pay off the credit default swaps on the defaulting European bank loans to Greece.  That money would better served lending to worthy businesses and individuals in the U.S.  That’s the real killer concern.

Here’s my thinking on this situation:

1. Banks are hoarding cash. They are reluctant to lend to businesses, to consumers and on commercial real estate which would help get this economy going again. The potential default by Greece and others – Portugal, Ireland, and Italy are next in line – will only make matters worse if American banks are picking up the tab through credit default swaps.

2. Congress needs to enact legislation regarding credit default swaps that either bans this financial product or greatly reduces the American taxpayers’ risk if something goes horribly wrong.

3. Finally, it’s time to get tough on banks that make stupid investment decisions. The federal government should not have to provide bailout money to keep these banks solvent. Let them fail!

Sources: Time to Get Outraged, Thoughts from the Frontline by John Mauldin, June 10, 2011; Greek Debt Tsunami Could Reach U.S. Shores, MSNBC.com by John W. Schoen, June 16, 2011; Greek Crisis May Put California Bank in Play, The Street, by Dan Freed, June 16, 2011; Global Markets Shaken by Greek Debt Crisis, AlJazeera.net, June 16, 2011.

Oregon Economy Shows Impressive Growth

Tom Potiowsky, the Oregon State Economist, revealed the latest economic news at the June 1st Oregon/SW Washington CCIM Chapter meeting, most of which was quite positive.  Shown below are the highlights:

• Oregon job growth surged in the first quarter of 2011 rising at an annualized growth rate of 5.2 percent.  This is the third strongest quarterly job growth since 1990.  On a year-over-year basis, job growth is up 1.8 percent, the best since the first quarter of 2007.
• The unemployment rate has slowly edged down to 9.6 percent.  This is a full two percentage points below the May 2009 unemployment rate peak of 11.6 percent.
• For the last six months, job gains have been averaging over 4,500 jobs per month.  Oregon has the 7th fastest job growth year-over-year for March among the 50 states.
• Job gains in the first quarter were broad based with virtually all sectors seeing strong growth.  The exceptions to this trend were the wood products industry, and state and local governments.
• Personal income growth increased 3.3 percent in the 4th quarter of 2010.
• The declining value of the U.S. dollar is helping those businesses dependent on exporting their products overseas.  Oregon exports are up a whopping 18.6 percent over the previous year but much of this increase has to do with the abysmal performance from the previous year more than a spectacular increase in 2011.

Some potential concerns or "economic headwinds" as Mr. Potiowsky called them are:

• The federal government needs to get its financial house in order but it can't do it cold turkey.  Substantial cuts in spending could result in weakening an already fragile recovery.
• State and local governments are also in bad shape and represent between 10 and 15 percent of the overall economy.  Forty four states and the District of Columbia are projecting combined budget shortfalls of $125 billion for fiscal year 2012.  How they muddle through will need to be handled carefully to avoid harming the recovery.
• The housing sector continues to languish.  The recent Case-Shiller report indicated a 7.6 percent decline in year-over-year house prices in the Portland metropolitan area.  This will likely continue until the majority of foreclosures have worked their way through the system.
• If the credit crunch does not continue easing, commercial real estate may be even slower to recover than anticipated.  Credit markets are easing, but consumers and businesses still have difficulty getting loans.
• If gasoline prices continue taking up a greater portion of household budgets this will inevitably reduce consumer spending for other goods and services.

Even so, the job growth among a number of employment sectors in the first quarter of 2011 is nothing short of impressive.  The recovery is happening but with a few cautionary signals.  All in all, the economy is certainly looking better than it has for the past 3 years.  Let's hope it continues well into the future.

Exposing the Soft Underbelly of the Beast

For those of us who believe the Federal Reserve, Wall Street and the major financial institutions in this country wield too much power, something recently happened that has me baffled. 

In March the US Securities and Exchange Commission requested a few of the regional banks to clarify their loan modification policies, what we call in the business "extend and pretend."  Last month the Financial Accounting Standards Board (better known as FASB) also got into the act by issuing new accounting guidelines for "troubled debt restructurings" (TDRs).

On the surface the new accounting guidelines for troubled assets seems quite reasonable.  FASB wants to standardize the definition of what constitutes a TDR so all financial institutions are operating under the same rules.  Right now that isn't happening.  In order to determine if the restructuring is a TDR, a lender must separately conclude that both the borrower is experiencing financial difficulties and the restructuring constitutes a concession.

Beginning June 15th lenders must re-examine their restructured debt to determine how much of it qualifies to be a TDR.  If so, the lender must classify it as such.  The end result is that for the very first time we will see how much of a lender's loan portfolio is deemed "troubled."  At the present time, lending institutions have been able to hide their TDRs with the hope that one day the market will turn around and the loans will be refinanced at market rates and terms, or better yet paid off in full. 

The new accounting rules could have enormous implications, most of which fall in the range between bad and catastrophic.  At the very least the number of loans classified as troubled debt will rise dramatically throughout the banking industry.  But the big question is, "Will the general public's confidence in a bank's solvency be adversely affected?"  Once the cat is out of the bag will the stronger financial institutions be reluctant to transact business with their weaker brothers?

Which leads me back to my original thought: Why did the SEC and the FASB do this?  If you believe like I do (most days) that the Federal Reserve, Wall Street and the major financial institutions wield way too much power, why would they allow these new TDR accounting guidelines to be implemented?  This is not in their best interests.  The change in these accounting rules has the potential of exposing the truth that they desperately want to keep hidden from the public - most banks are hopelessly insolvent.  This only helps to expose their true predicament.

The huge bank bailouts by both the Bush and Obama administrations, the extend and pretend lending policies of the banks, and the historically low interest rates by the Federal Reserve have all been implemented to directly benefit the financial institutions of this country.  So why are they now exposing the soft underbelly of the beast?  If you have an explanation, I'd like to hear it.

Sources: The Extend and Pretend Expose' - coming to a bank near you, ft.com/alphaville by Tracy Halloway, May 20, 2011; More Transparency Coming to Hidden Costs of 'Extend and Pretend' Strategies, CoStar Group by Mark Heschmeyer, May 18, 2011. 

Retail Is Coming Back Nicely

In my last post I showed the first quarter sales results by property type for our region.  Not surprisingly, 42% of all sales for the quarter were apartments.  What was surprising was the strong showing from retail: 29% of all sales in the first quarter.  So I thought this deserved additional investigating.

The CoStar Group recently had a webinar on the U.S. retail market.  The bottom line of their presentation - retail is coming back nicely.  Shown below are two charts that support their thinking:

As you can see from the chart retail has had 9 consecutive months of positive sales volume (people are buying more) and has been averaging about 6% annual growth since September of 2010. 

Absorption of retail space is also improving nationally as shown in the chart below:

After two negative quarters of negative absorption, we've now experienced 7 consecutive quarters of positive net absorption.  During this time period 80 million SF of retail space has been absorbed. 

Other interesting tidbits from the CoStar webinar were:

• Job creation, which spurs retail sales, has been positive for the past 5 consecutive quarters.
• Construction of new retail space has been almost nothing for 2010 and is projected to continue that way through 2011, which bodes well for further net absorption of retail space through the rest of this year.
• Sales of distressed retails sales is moderating.  Distressed retail sales peaked at 21% of all sales during the 2nd quarter of 2010.  During the first quarter of this year, distressed retail sales were estimated at 17% of all sales.
• Cap rates for retail properties have compressed significantly.  Retail cap rates peaked at 8.5% in the 2nd quarter of 2009 and are now averaging 6.5% nationally.

All of these statistics bode well for further improvement in the retail sector.  Let's hope this trend continues and that other property types can follow in the footsteps of apartments and now retail. 

1st Quarter 2011 Transaction Activity

The first quarter of 2011 is over.  From a sales standpoint how well did we do compared to previous years?  Shown below is the criteria we used to tabulate the results:

• Sales information from the CoStar Group database
• Transactions closed between January 1st and March 31st
• Investment transactions only (no owner occupied)
• Property types - apartments, office, flex, industrial, retail, mixed use & specialty use
• Transactions with sales prices of $1 million or larger
• Arms length transactions only
• Transactions located between Kelso, WA and Eugene, OR including Bend

Based on this criteria the chart shown below compares the sales activity for the 1st quarter for each of the last five years:

 
As you can see, the sale activity for the first quarter of 2011 increased significantly over 2010 but fell well below previous years.  The good news is that if this trend continues for the rest of this year, 2010 will have been the bottom of the market with a good possibility of improving sales activity going forward.   


We then analyzed the 45 sales transactions for the first quarter by property type.

As you can see apartments still are the most favored property type with 42 percent of the sales in the first quarter followed by retail.  Most of the retail sales were fast food franchises or single tenant buildings. 

Of the 45 sales transactions, only 35 identified the broker representation and only 38 identified the lending source used.  The remaining transactions did not provide sufficient information to determine the lender or if brokers were involved in the transactions.

Another way of looking at it, there were 45 paydays for all of the real estate brokers in the first quarter (17 x 2 = 34 + 7 +4 = 45).  So if you know how many of these transactions you were involved in, you can determine your market share. 

Shown below are the first quarter lending sources for the 38 sales transactions that a lender was identified.

Almost half of all sales transactions in the first quarter did not need new financing.  These results also explode the myth that life companies are back in the market.   After you take away the all cash buyers and assumed loans only 20 loans were placed in the first quarter, most of these from banks.  This paltry number of loans for the first quarter does not bode well for the mortgage brokerage community but hopefully we are on an improving trend.  I look forward to seeing how this quarter turns out.  Keep your fingers crossed.

What Impact Will Inflation Have on Commercial Real Estate?

After decades of little or no inflation there is mounting evidence that the Federal Reserve's Quantatitive Easing program is beginning to take its toll on the value of the dollar.  Shown below are some of these indicators:

• The Producer Price Index (PPI), which measures average changes in prices received by domestic producers for their output, is up 5.6% for the twelve months ending February 2011.
• Commodity prices are rising in relation to the dollar.  The price of gold hit an all time high earlier this week before settling down a bit.  Silver prices continue to soar hitting a 31 year high.  So far this year silver has gained 33% in value.
• A recent Deloitte Consulting poll indicated that 74% of those polled believe their spending will slow due to rising prices they are currently experiencing.

So what impact will inflation have on commercial real estate?  In the short-term the real question is what impact will the threat of inflation have on the Federal Reserve raising interest rates?  An increase in the federal funds rate would ease the concerns of those who fear inflation but it would likely have a detrimental impact on the fragile U.S. economy which is just beginning to show signs of recovery.  It's a delicate balance between these two policy positions.

In the long run, modest inflation would be a great benefit to commercial real estate, as long as it happens gradually so that the market can make the necessary adjustments along the way.  Real estate over the long run has been an excellent inflation hedge and it should be the same this time around too.  Over time, with modest inflation those commercial real estate investors who are currently upside down on their investment portfolio could gradually become whole again. 

My greatest fear is what happens in June when the Federal Reserve ends its own bond purchase program known as quantitative easing.  Who will fill the gap in buying U.S. Treasuries?  If no one steps in to the fill the void what will happen to interest rates?  Doesn't the law of supply and demand require that interest rates have to increase?  And more importantly how quickly will they rise and how dramatically?

Those are the questions that are currently being debated.  Surprisingly there is no clear consensus among the pundits.  We'll have to watch and see.  Stay tuned.  It's going to be fascinating to watch! 

Sources: PIMCO bets against U.S. government debt, Reuters, April 11, 2011; Don't Believe the Inflation Fear-Mongers, The Mark, April 12, 2011; Inflation Not a Threat? Most Consumers Aren't So Sure; CNBC.com, April 12, 2011; Gold Price Sinks After Hitting Ne High at $1,478, Gold Alert, April 11, 2011; Producer Price Indexes - February 2011, Bureau of Labor Statistics, March 16, 2011.

The Six Immutable Laws of Real Estate Investing

James Montier, the well known author of "The Little Book of Behavioral Investing" recently wrote an article called "The Seven Immutable Laws of Investing."  In this article he identifies seven principles for sensible investing in the stock or bond markets.  I was intrigued by the title so I read the article and somewhere along the way I realized that 6 of these 7 "immutable laws of investing" also apply to investing in commercial real estate.  So I thought what the heck, maybe I should take a stab at writing an article on the "Six Immutable Laws of Real Estate Investing."  So here goes:

1. Always insist on a margin of safety.  In other words the goal is not to buy at fair market value but to purchase with a margin of safety as property performance, market conditions, etc. may not live up to expectations.  In our world of real estate this means finding properties that are under performing the market but with a change in ownership will turn the property's performance around. 
2. This time is never different.  The four most dangerous words in investing - "this time is different."  The dot.com bubble that occurred about ten years ago is a perfect example.  Investors were buying stock in companies that hadn't turned a profit on the expectation that they would be the next Google, or Amazon.com.  Stock prices soared and even though it made no logical sense the argument that was bandied about was, "this time is different."  The same was true of real estate.  How many believed that house prices could never go down?  In both examples a speculative fever resulted in a bubble causing stocks and house prices to plummet in value.  Whenever someone starts saying this time its different, get out of that investment as quickly as you can.
3. Be Patient and Wait for the Fat Pitch.  As Mr. Montier states in his article, "Patience is integral to any value-based approach on many levels... However patience is in rare supply."  In commercial real estate there is a time to wait and there is a time to act.  When things go bad, like they have for the last three years the tendency is to dump our real estate holdings as quickly as we can when the prudent thing to do is wait.  Most investors suffer from an "action bias" - a desire to do something.  But often times the best thing to do is to stand at the plate and wait for the fat pitch.     
4. Be Contrarian.  Humans are prone to the herd instinct.  When everyone is buying they buy; when everyone is selling they sell.  Last year the value of BP's stock plummeted due to the gulf oil crisis.  BP stockholders were dumping their stock and only a few contrarians were buying.  Less than a year later those that fought the urge to follow the herd have made a handsome profit while those who sold lost money.  Now's the time to be buying commercial real estate, especially those that have been hardest hit - office, retail and industrial.  Years from now we will realize that that there were bargains to be purchased in 2011.  Or we can go along with the herd and sit on the sidelines.
5. Be Leery of Leverage.  I really shouldn't have to say much of anything on this topic.  In many instances those owners with properties that were over leaveraged have paid the ultimate price - the loss of their properties.  Those homeowners who used their homes as ATM machines learned the hard way too.  Three years after the the collapse of the housing bubble about 1 in 4 homeowners have no equity in their homes.
6. Never Invest In Something You Don't Understand.  This is just plain old common sense.  It's not uncommon for for me to talk with real estate investors that are clueless about their real estate holdings which puts them at the mercy of their real estate advisors.  Many times these advisors have a different agenda than the owner but the owner not knowing the fundamentals of commercial real estate is unaware of the conflict of interest.  It's a simple truth: If you don't understand the investment concept, then you shouldn't be investing in it.

I personally believe that now is the time to be investing in commercial real estate as long as you follow these six fundamental principles.  Cap rates have risen significantly, the frothiness of the market has long since disappeared and  interest rates are low... at least for the time being.  Or you can be a part of the herd that sits on the sidelines waiting for a better day, a day that will likely never come.  

Bill Gross Thumbs Nose at Bond Market

Last week Bill Gross, who runs the world's largest bond fund at Pacific Investment Management Co., sold all government related U.S. debt from PIMCO's $237 billion Total Return Fund.  You may be thinking, "Why is this tidbit of news important to us?"  Good question.  When someone who is as knowledgeable about the bond market as Mr. Gross decides to get out of U.S. bonds there's a good chance that something signficant is about to happen.  Gross is betting that the discontinuation of the Federal Reserve's Quantitative Easing program (QE2) in June will have a negative overall impact on the bond market. 

Let's back up for a minute and explain some things.  QE2 is the Federal Reserve program of buying U.S. government debt instruments for the purpose of stimulating the economy.  In a period of only 28 months the Federal Reserve has become the largest owner of U.S. Treasury Bonds ($972 billion as of December) surpassing both China and Japan who took decades to accumulate their bond holdings.  Yesterday, Mr. Bernanke, Chairman of the Federal Reserve confirmed that the Fed will discontinue QE2 as planned by the end of June.

Bill Gross wonders when the Fed stops buying bonds who will take their place?  The Federal Reserve is currently buying $75 billion in U.S. bonds a month.  That's a huge amount.  So what will be the impact when the Fed stops buying?  It all goes back to the law of supply and demand.  If the supply of U.S. treasuries remains the same but the #1 buyer of bonds is no longer buying, in order to get others to absorb the excess supply the market will demand a higher rate of return.  It's as simple as that.  Gross believes that the current interest rate on 10 year treasuries is at least 100 basis points below the historical average.

If Mr. Gross is correct the logical result will be a significant rise in interest rates and it should happen before the end of this year.  If true this could have a dramatic impact on the commercial real estate market.  Rising rates would require a re-adjustment in cap rates upward to offset the decline in investment returns due to higher interest rates.   

Years ago there was a TV ad by investment banking firm E.F. Hutton.  The ad shows an E.F. Hutton fiancial advisor about to give confidential investment advice to his client in a crowded, noisy room.  Before the advisor speaks the crowd stops talking and leans their ear to hear what he has to say.  The ad ends with the slogan, "When E.F. Hutton speaks people listen."  Mr. Gross has just spoken and his actions speak loud and clear.  Are we wise enough to follow his lead is the only question?  
_________________________________________________

On a totally different note, treasury rates have plunged in the last few days.  The 10 Year Treasury rate at this moment is 3.20%, down 55 basis points since January.  On the surface this flies in the face of what is being predicted by Mr. Gross.  In reality this substantial dip in rates is being caused by the crisis in Japan.  Japan's stock market, has plunged 16% in the last couple of days and investors are taking their money out of their stock market and putting it into the safest investment they know: U.S. Treasurys.  How ironic.   

Sources: Gross Sees Trouble Ahead for Treasurys, The Oregonian, March 15, 2011; Pimco's Bet Against Treasurys Not Working (So Far), Wall Street Journal, March 15, 2011; Federal Reserve Enters Final Lap of Easing Policy, National Journal by Clifford Marks, March 15, 2011.