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Here's a Block Party that was posted a few weeks ago...


Perhaps it’s because the World Series has recently concluded, but it seems that there have been a number of baseball analogies floating around the investment world these days. One recent comment that struck me as interesting was made by the guy who we know as the “Grave Dancer” – Sam Zell. He opined that real estate is expensive, and that the current real estate cycle is in its 8th inning. We REIT investors are, of course, familiar with Mr. Zell. He certainly has a well-deserved reputation in the world of commercial real estate; however, it’s important to note that, like other human beings, he isn’t right 100% of the time.

I am never comfortable disagreeing with Mr. Zell, of course, but it seems to me that commercial real estate is “expensive” today only if one is looking to steal it, as Mr. Zell did in the late 1980s – but wasn’t able to do so in the aftermath of the late Credit Crunch and Great Recession. The bargain hunters began competing with one another, and prices firmed up quickly. Commercial real estate is more known and more liquid today, and is priced accordingly. Huge returns are not consistently available anywhere in today’s investment world, as evidenced by the troubles of many hedge funds. If you must have double-digit investment returns when investing in high quality commercial real estate, then you’ve got to lever up and play the yield curve – which can be like playing on an LA. freeway at 5:30 am. Otherwise, you just don’t play at all.

I will try to explain in this Block Party post why I respectfully disagree with Mr. Zell’s eighth-inning analogy. But, first, a few thoughts about the Fed and short-term interest rates. I don’t know whether the pending decision to raise interest rates is the cause of today’s extreme market volatility – but it certainly gets the blame on down days. If “investors” (and I use the term loosely) are selling their stocks because the Fed is now likely to boost rates by 25 bps, well, that tells us quite a bit about investors’ convictions these days – and it ain’t pretty. It should be obvious that the US economy isn’t about to break into a major growth mode, despite the strong employment numbers 10 days ago (as I will argue below). I think the Fed will emulate top-notch college basketball players: “one and done.” Those who are dumping stocks these days should have a better reason for exiting than a 25 bps bump. They might just as well base their investment decisions on what the Pope has for breakfast tomorrow.

I believe that this cycle will be longer than prior cycles with respect to both the US economy and commercial real estate. This is not just another of my half-baked opinions. According to a Barron’s article, dated November 9, the widely-respected economist and head of research for Evercore, Ed Hyman, stated that interest rates are likely “to remain modest by historical standards” for quite some time. He concluded that we could enjoy “slow but steady” economic gains for a period of three, five or even seven years. I would also suggest that the flipside of a weak economic recovery is a lack of animal spirits; for example, new supply of commercial real estate is being built pretty much only to meet modestly increasing demand.

Commercial real estate prices, and returns, are – more than ever – determined by what’s available on bonds and likely to be obtained on stocks. With Moody’s Baa-rated investment grade bond index yielding 5.5%, and stocks trading at 23x trailing 12-month earnings (and no revenue growth), today’s expected unlevered 6% IRR on quality commercial real estate looks reasonable, i.e., there is no reason to expect a price decline unless bond yields spike or stock prices collapse. Investment returns are low everywhere, relative to historic levels, and whether or not one invests at today’s prices should depend heavily on whether he or she expects “New Normal” to continue for several more years. As a parenthetical note, two widely respected investment veterans, David Kostin, chief US stock strategist at Goldman Sachs, and John Bogle, founder of Vanguard Group, are expecting stocks to return, on average, only about 4-5% per year over the next 10 years, according to a November 9 Wall Street Journal story.

And bond yields won’t necessarily spike despite the Fed’s expected move to increase very short-term interest rates. Bond yields do not always march in lock-step with short-term interest rates, as we’ve seen during many prior time periods. But if short-term rates do rise substantially while other central bankers continue to ease, the US dollar is likely to soar, and exports will get clobbered while US manufacturing will shrink. And guess what happens if long-term yields increase by, say, 100 bps? Mortgage rates will jump, and the housing market will stall out. Bond yields will then drop back down.

The world is awash in commodities, and prices from iron ore to copper to oil have been plummeting. This is not consistent with a global economy on the brink of brisk recovery.

And a one-month boost in payroll figures doesn’t presage a willingness of employers to goose wages substantially. Investors are always fighting the last war, expecting the return of old scenarios. But this is a new world – lightning quick improvements in technology change the way we do business, and allow even start-ups to compete globally. Increasing competition reduces pricing power, and so inflation will be subdued – perhaps hovering around 2% for quite a few years.

Capitalism is now a dirty word throughout much of the Western world and there is less interest in wealth creation and more in “social justice” and income inequality. Regardless of one’s political or social views, I wonder how this will affect economic growth. It probably won’t be positive.
Conservatives object to increasing regulation of business, but it seems that they are a voice crying in the wilderness. Government regulation increases the cost of both doing business and employing more people, so there is slower economic growth – there is no free lunch. Meanwhile, bank lending remains subdued. Populations are aging, stoking demand for more government assistance, which must be paid for via higher taxes or more debt – both of which also slow economic growth. And if you really want to get scared, look at today’s very low labor participation rates and consider what that means for future economic growth.

The bottom line, I believe, is that unless governments are allowed to print money at will, we will have very modest inflation and slow economic growth for at least several more years – regardless of which party controls the government. Non-government bonds will continue to yield 4-6%, stocks will return 5-7% annually, at best (and with a lot of volatility), and quality commercial real estate will provide 6% IRRs – for quite some time. REITs, using modest debt, may be able to lever investment returns to as much as 7%+. And that should be good enough for most of us, especially when returns on cash are nil.

I will fall on my sword if real estate cap rates soon rise meaningfully and property prices (and REIT shares) implode. Eventually that will happen – I don’t believe that cycles have been repealed. But I do think we are closer to the 4th inning than the 8th and that we are going to be playing in a very long ball game.

Ralph Block
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