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A recovering AOL user, I have long been a lurker on this board in both sites. The migration to the TMF version by the more knowledgeable posters, such as REITnut and Jim Luckett, are truly appreciated. I have a small income portfolio for my mother, who is unburdened by taxable income, that, I presume, will eventually be mine. While I have been investing for some 30 years, I am a scientist, not a businessperson. This board has been invaluable to me in avoiding disastrous speculations. Thank you all.

In my reading last week, I came across a very stimulating column in Forbes by A. Gary Schilling that you can read at

http://www.forbes.com/forbesglobal/99/1129/0224094a.htm

As I recently purchases shares of Mills Corporation (MLS), his column left me with some comfort that my considerations had included such possibilities. I look forward to others' comments.

Ron

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Gary Schilling has done some good work in housing economics, but I think his leap into macro forecasting and futurist pronouncements is unfortunate.

Let me refute his points in order:

1) Productivity enhancements and other positive supply factors result in deflation only if the Fed fails to increase aggregate demand sufficiently to take full advantage of them. The Fed leadership has stated that price stability is its goal, not deflation, while its actions have shown it willing to err slightly on the side of inflation. The Fed responds to politicians. Politicians, and the public, like growth and low interest rates. Therefore, I think the Fed will supply enough stimulus to take full advantage of whatever acceleration in productivity growth and other positive supply shocks come our way.

2) Most people don't want to work at home. Some do, and some will be forced to, I suppose, but if you believe the premise of galloping productivity growth and a benign inflation environment, then you have to also expect a very good economy, which has to be good for office and hotel demand.

3) "Consumers will ease off their borrowing-and-spending binge" -- no evidence of this starting to happen and no evidence is offered by Schilling in this column as to why we should expect this. If it were to happen, I would expect the Fed to offset it with less monetary restraint. This would lower interest rates which would lower the international exchange value of the dollar, stimulating net exports. Lower interest rates would also stimulate investment spending.

4) Building costs will fall? I don't see it. The construction industry will not benefit much from the internet. Trees don't grow in cyberspace. From where I sit, in Boston, construction costs have burst through $100 psf for housing and show no signs of abating. Factory built housing is NOT half as expensive for a comparable finished product. Having built my own house with factory-built modules, and having cost out various developments both ways (factory vs stick) its a marginal difference.

5) Baby-boomers have their houses so housing demand will fall. -- If that's true, why is housing demand rising???????? As he says, the boomers have their houses. But housing demand is still rising!

Bottom-line: Dr. Schilling forgets that the Fed plays last in the game of macroeconomics. Throw in all the price depressing, demand depressing factors you like, the Fed has the power to offset them all, as long as it is not worried about INFLATION.

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JimLucket has beaten me to the punch, but permit me to agree with his views on several of the shortcomings in Mr. Schiller's piece.

Jim notes: "Productivity enhancements and other positive supply factors result in deflation only if the Fed fails to increase aggregate demand sufficiently to take full advantage of them." With a slight twitch to note the limiting effects of the international economy on the US and the Fed, Jim is correct. To the extent that we do differ (and we may not) it seems clear that there is sufficient underlying long-term demand for improving infrastructures here and abroad to ensure that there will be ample demand for many US goods and services.

<< The Fed responds to politicians. Politicians and the public, like growth and low interest rates. Therefore, I think the Fed will supply enough stimuli to take full advantage of whatever acceleration in productivity growth and other positive supply shocks come our way. >>

Yup. In fact, double yup. We are in complete agreement.

<< Most people don't want to work at home. Some do, and some will be forced to. Mt favorite models for this discussion are Microsoft, AOL and the Motley Fool, all three of which are heavily concentrated in large home offices where the opportunities for personal interaction are maximized. They have some home-based employees (I am one) but most are commuting to a campus of cube farms every day. If you doubt me, pick your favorite recent tech or Internet IPO, and go see your company's HQ. Look around the parking lot and count the BMW's.

<< If you believe the premise of galloping productivity growth and a benign inflation environment, then you have to also expect a very good economy, which has to be good for office and hotel demand. >>

Schiller's premise that teleconferencing will cut down on the need for business travel is one of the least supported pieces of conventional wisdom on the net. Is there ANY evidence for this whatsoever? It's an interesting science fiction idea, but then so is the transporter room on Star Trek. That doesn't mean it cannot happen, but no one I know who has actually used teleconferencing believes it. Maybe they will, but so far they don't seem to.

Anyone who differs is of course cordially invited to disagree, but is there any hard evidence to suggest this will occur or is occurring?

<< "Consumers will ease off their borrowing-and-spending binge" -- no evidence of this starting to happen and no evidence is offered by Schilling in this column as to why we should expect this. If it were to happen, I would expect the Fed to offset it with less monetary restraint. This would lower interest rates, which would lower the international exchange value of the dollar, stimulating net exports. Lower interest rates would also stimulate investment spending. >>

Yup.

<< Building costs will fall? I don't see it… Trees don't grow in cyberspace. From where I sit, in Boston, construction costs have burst through $100 psf for housing and show no signs of abating. Factory built housing is NOT half as expensive for a comparable finished product. Having built my own house with factory-built modules, and having cost out various developments both ways (factory vs stick) it's a marginal difference. >>

Having worked in housing finance for three decades, I have been hearing about the "advantage" of modular housing for three decades. In the 0s, when George Romney was at HUD, they had a program called “Operation Breakthrough” whose intent was to pay extra money to builders of modular units so they could prove they could build cheaper.. Only two problems:

1) They were more expensive.
2) They tended to leak at the seams.
Jim is right again.

Then add in the fact that there is less remaining prime land unbuilt upon, zoning is getting tougher, environmental issues are tougher, etc., etc. it becomes clear that land values will rapidly increase to absorb construction cost savings in most good markets.

<< Baby-boomers have their houses so housing demand will fall. -- If that's true, why is housing demand rising???????? As he says, the boomers have their houses. But housing demand is still rising! >>

Well, of course Jim is right. The point Schiller seems to miss is that the RATE of increase in housing demand will fall, but absolutely no one forecasts that there will be fewer US citizens in the year 2010 than there are today. They may want different things in housing. They may choose to live in different places. But fewer people or fewer households? Bullfeathers.

Do note one interesting dynamic. Recent data indicate that, the Internet is markedly aiding small town, main street retail. Clearly, just as with the coming of the railroads, trolleys, and highways, the net will give many people much more latitude on where they live, work and shop. It will provoke changes. Foe example, in the case of hotels a more efficient auction market will depress room rates a bit. But deeply cut into demand for office, hotel or apartments nationwide?

I really doubt it.
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I read A. Gary Shilling's article, "Real Estate Hazards" and was a little puzzled by his evidence and his conclusions.

Doctor Shilling sees a real estate future in which we have lower interest rates, higher savings (investment) rates, and lower building costs. As a real estate investor, I would find all of those factors to be a positive envirnoment in which to invest, build, and finance real estate. Futher, my tenants would find it an enviroment in which expand their businesses.

Doctor Shilling also has the peak housing formation behind us as we baby boomers move on into retirement and death: "fewer people in the next age cohort". No, Dr. Shilling, there are more- a lot more and housing demand is still growing, albeit at a lower rate of growth. The population is not declining, only the rate of growth is declining.

There is no evidence that building costs are going down or that the cost of available building lots is declining. The current evidence for building costs, material and labor, show both are rising.

Building costs for modular housing and site built housing are approximately the same in this area when the costs of the lot and set-up are included. However, the resale value of site built housing is higher.

While there is talk of labor costs going up as we reach full employment, labor costs in construction have already gone up. Drywall and insulation contracts are being being pushed out 6 weeks and up 10%, if one can get them at all, since we can't find installers.

We are looking forward to Dr. Schilling's reduction in building costs; but, we're not counting on it.

His vision also includes cost-cutting by businesses and shrinking office space, but strong demand for class A buildings. I would think that under his scenario class B buildings would do better.

I think it's very difficult for anyone can get their hands or mind around the real estate industry completely. The land is under all and is valued by its utility. We can only report what we see in our own little sector of the market. In that sense, it's much like the blind men describing the elephant. Each description is valid from the impression of each of the reporters. In this case, Dr. Shilling and I are looking at different real estate markets and have unavoidably come to very different conclusions.


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While I was posting, two very good responses were posted by TMF Yorick and JimLuckett. Needless to say, I'm slow to post and I agree with both.
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I think I can probably speak with Jim Luckett's agreement, though I am not sure. I would note that most all of my favorite subcontractors are stretched to the max. They cannot find enough good laborers to do the work, and their present response has been to over-book just like an airline.

The best architects and builders I know are making it a priority to find new good subcontractors to do their work.

In view of all that, it is highly unlikely (IMNEHO) that we are looking at a decline in construction labor costs in my market any short time soon. Absent that, and absent a decline in the price of zoned, permitted land, where will we lok for this great decline in building costs? I am willing to listen to a much longer-term argument but I would like there to be more than a simple reiteration of "conventional wisdom" behind it.

Best,

TMFYorick
(Resident Curmudgeon)
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I do agree with your observations on the Boston construction market.

Bulldozers and electric power tools did a lot for labor productivity in construction. But those gains are long behind us. There's not much in the computer/internet/cell phone revolution that let's a man or woman dig holes, hang drywall or sweat pipes faster. But, as productivity and wages in other fields advance, construction wages have to keep pace in order for the industry to hold onto its labor force. The land is not going to get cheaper. The labor is not going to get cheaper. Productivity is not going to advance that much. Wood is not getting cheaper, as forests are either cut down or increasingly protected. Plastics are petroleum based and not going to get cheaper. Steel? Don't think so. Codes get more stringent all the time. Osha and environmental rules keep getting tighter. Litigation costs keep rising (litigation seems to be a major input to the construction process, which many theorists would overlook). Disposal costs (another major input)keep soaring.

I must say, a secular decline in construction costs is one of the more puzzling predictions I have come across.
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I forgot one more consideration, or, call it two:

1) Uncle Sam has signed more IOUs than any other entity in the history of the planet. Around $3.7 trillion worth is outstanding. Lots of it long term, noncallable, fixed-rate paper. Does this sound like an entity that would let deflation happen?

2) Consumers owe about $1.3 trillion. Will voter sentiment favor deflation?

Yes, for every dollar borrowed, there is a lender who stands to gain from deflation, but the borrowers are more numerous than the lenders.

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I also agree with JimLuckett & TMF Yorick's refutations of Mr Shillings predictions.

I have one more disagreement which is an often overlooked fact in the office sector.

Shilling states <Cost-cutting businesses will curtail demand by shrinking office space>

Recent trends disprove this theory. It seems that contrary to popular wisdom, the per capita use of office space is actually RISING. The major reason for this rise is the tremendous growth of small businesses. As we all know, the major growth in jobs in the 90's has been primarily fueled by smaller businesses. These entrepeneurs are consuming more office space than the Fortune 500 companies. Thats because these users all need conference rooms, reception areas, storage rooms, etc. which consume a much larger percentage of a small user's space.

In addition, as high tech jobs accelerate, the competition for labor has increased, and employers are being forced to offer better working environments, including day care centers, work-out rooms, etc.

These facts bode very well for the office sector and are partly responsible for the massive absorbtion we have seen in the 90's.

PS: Message 1578 by Ralph was a masterpiece!

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Very Long Term notes <<In addition, as high tech jobs accelerate, the competition for labor has increased, and employers are being forced to offer better working environments, including day care centers, work-out rooms, etc.>>

Excellent observation. Based on various discussions I've had with the management at Spieker Properties, which owns lots of office buildings in the Silicon Valley, this is certainly a true statement. There is no industy that feels the need to cut costs more than most sectors in high tech, given the fact that "ASPs" (average sale prices) are constantly declining; yet, the companies who lease from SPK find themselves compelled to lease additional (and expensive) office space in order to attract and retain scarce and highly qualified employees. Of course, the configuration of that space is constantly changing; right now, low-rise "campus" type buildings are very much in demand.

Ralph
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<<In addition, as high tech jobs accelerate, the competition for labor has increased, and employers are being forced to offer better working environments, including day care centers, work-out rooms, etc.>>

Thanks for your compliment on the above post.

Your conversations with SPK and their success in Silicon Valley does prove the point.

There are literally thousands of small start-up companies that are all hoping to be the next Amazon.com. These smaller users tend to be inefficient users of space because they all need conference rooms, reception, sales and showroom space, extensive computer banks, etc. These facilities are only servicing a relatively small population of workers in a typical start-up company, so the per capita use of office is actually rising.

This trend is not only unique to high tech users. The strong job growth from smaller businesses, as opposed to the relatively weaker job production from the Fortune 500 companies, is also contributing to higher per capita use of space. Landauer has done research on this and have stats that prove the increase in per capita use.

In Manahattan for example, space users under 30,000 Sqaure Feet make up over 55% of the total market

This trend bodes well for the office sector and is one of the big reasons that despite considerable new construction in certain markets, space continures to be rapidly absobed.
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Deflation? Yes, for manufactured goods, much of which will be concealed by quality improvements in the arms race most product producers find themselves in. Yes, for services, as human capabilities are increasingly expanded by silicon. But real estate? That's much less likely as long as U.S. economic growth continues. Immigration is clearly growing, and the U.S. population is one of the few among those of developed countries with substantial growth. (There was a recent article in the Economist? indicating that illegal immigration was one of the key reasons wages weren't exploding despite the U.S. low jobless rate.) That indicates to me that even in an overall slightly deflationary climate, real estate might well be the exception, most specifically in hot clusters of development, such as Silicon Valley, etc. The important thing to keep in mind that deflation and inflation are overall trends, and that individual sectors often depart from the average.
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Rashoman, interesting points.

If you are right, and if (as you say) <<U.S. economic growth continues>>, this would bode well for the real rate of return from investments in real estate and REITs (assuming REITs come back to achieving some sort of correlation to real estate over time).

Regards
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I agree completely with Rashoman.

Also:

Milton Friedman argued convincingly: "Inflation is always and everywhere a monetary phenomenon." By which he meant that the general price level can rise on a sustained basis only if the managers of monetary policy allow aggregate demand in nominal dollar terms to expand faster than the growth of real potential output. There can be shocks that momentarily increase the price level without the participation of monetary policy, but their effect can only be lasting if nominal demand is expanded to accomodate the higher prices.

The same is true of deflation. It too is always and everywhere a monetary phenomenon, with the possible limitation of the so-called "liquidity trap" -- once you get to zero interest rates, you've reached the limits of monetary policy's ability to influence domestic demand, as in modern Japan. But, we're a long way from zero interest rates.

And, there is also the power of the Fed to influence demand through international exchange rates -- sell dollars on the international exchange markets, drive down the value of the dollar relative to foreign currencies, resulting in rising import prices and falling export prices, resulting in more demand for US output due to import substitution and export promotion.

For someone to convince me we face a deflationary future, he/she has to explain why the Fed would want or allow that to occur. Why not have higher demand and higher output instead? I e-mailed that question to Prof. Schiller (who sees declining construction costs in our economy) and got a reply from an assistant that Prof. Schiller had dealt with that in a recent issue of his newsletter, which would be sent to me if I would supply my postal address. I eagerly hit the reply key and sent off my address. My e-mail was returned as undeliverable. So, I remain in the dark.
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Okay, it's now 4 years since Dr. Schilling predicted deflation "soon", including falling construction costs and therefore falling real estate values, consumers switching to saving instead of spending at the mall, and lenders reluctant to lend on real estate. He counseled "watch out for real estate investment trusts, especially those with leverage." I emailed him at the time, asking why he thought the Fed would not stimulate aggregate demand sufficiently to prevent deflation. I never got an answer.

It's 4 years and a few months later, and so far only the opposite of his forecasted deflation and real estate price crash has happened. Is it time to declare it didn't happen "soon?"

Forbes article with his prediction:

http://www.forbes.com/global/1999/1129/0224094a.html

Click the "whole thread" button to see what we said about this prediction at the time. And kudos to the Fool for making old posts searchable so I could find this. (Old posts are searchable thru the beta version of the archives).
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Jim,

I rememember this discussion--how I miss Yorick--well. A. Gary Shilling, not The Gary Shilling, remains on message:


JANUARY 2001
2000 Long Term Forecast
"Part I - The Case For Recession And The Shape Of The Downturn":
The bear market and the recession we've been forecasting are both now upon us. Five recessionary forces are currently at work, and stocks in general were down—significantly, in many cases—last year....Real estate will struggle in deflation, as will commodities. On the other hand, bonds, especially Treasurys, will thrive in the deflationary climate. And the coming era of deflation will have effects on overseas economies as well.

JANUARY 2002
"2001 Long Term Forecast: Looming Deflation":
We've long held that deflation would commence with the next recession. The downturn is here and deflation looms as our 14 deflationary forces are all now operating........Real estate investment will be difficult as property prices fall in deflation.



JANUARY 2003
“Long Term Forecast: A Deflationary Decade”:
In the next decade, deflation will likely be the dominant force. The deflationary forces first discussed in our 1998 Deflation book and in its 1999 sequel are hard at work, although some of them in unexpected ways. The return to federal deficits suggests inflation and rising interest rates to some, but will be easily offset in the years ahead by slack corporate borrowing and big consumer saving. The Fed and other central banks are moving from fighting inflation to battling deflation, and plan to flood the banks with money, if necessary. Still, as we see in deflationary Japan, that money will probably be impotent as lenders fear to lend and borrowers concentrate on reducing, not expanding, debt. Bereft of stock appreciation, older people plan to work longer, adding to the supply of goods and services—another deflationary force.


JANUARY 2004
“Long Term Outlook--Still Deflationary”:
Most believe that a surge in inflation is imminent. They look at recent strong economic growth and normal inflation harbingers such as the gold price spike. We disagree and continue to foresee mild deflation of 1% to 2% in the years ahead.



http://www.agaryshilling.com/insight.html

An oversimplification for this already long post:

For reasons I don't understand, he wants us to believe the Feds can "flood the banks with money", weaken the dollar, and have deflation in the prices of the things the dollar can be exchanged for all at the same time.

Thanks for digging that discusion up.

Gear





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