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The End of Extend and Pretend |
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"Zombie Buildings" to create a squeeze on commercial real estate,
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America's Economy: From glory days to "survival of the weakest,"
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Plus, Bill Bonner on the government's $65 million-per-job plan and
more...
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Joel Bowman, reporting from Taipei, Taiwan...
When one considers the state of the modern American economy, the phrase
"survival of the fittest" hardly springs to mind. Instead, we think of
idioms like "too big to fail" and "zombie bank." We think of Band-Aid fixes,
public make-work schemes/scams, of borrowing demand and earnings from the
future and assorted other conjuring tricks used by economists and
politicians, all designed to ensure the survival of the weakest...at the
expense of the fittest.
The nation's largest insurer, for instance, remains but a coddled mass of
inefficiency, even after hundreds of billions in taxpayer-funded cash
infusions; and its flagship automotive companies still suckle desperately on
Washington DC's nanny-state teat. Ol' Fannie and Freddie were gifted - on
Christmas eve, no less - enough taxpayer juice to guarantee they will waste
at least that much...and probably many times more...before all is said and
done.
It seems that all a company needs to do to "earn" somebody else's bailout
cash is to display an unrivaled aptitude for first loosing their own. The
more bereft of any real world capabilities an institution is, the more
likely it will find itself the recipient of your tax dollars.
Thankfully, not all acts of corporate stupidity are noticed by Big Brother.
Some reckless companies are actually, GULP, "allowed" to fail. Here at
The Daily Reckoning, we like to pay homage to those institutions kind
enough to remove themselves from the corporate gene pool. We are all better
off without bankers who can't count and automakers that can't compete. It's
time to stand by the tar pit to cheer their timely demise.
With that in mind, we recently opened nominations for this year's Daily
Reckoning Financial Darwin Awards. In short, the Financial Darwin Awards
recognizes the efforts of companies that, through unwavering dedication to
idiocy, rendered themselves either financially castrated or entirely
extinct.
Readers were quick to nominate the US Congress, the education system, the
Federal Reserve (with separate nominations aplenty for its
Helicopter-in-Chief), the "entire middle class of America" and even "the
state of California." There were also a few nominations for individual
companies, among them Circuit City and the creatively named Linens 'N
Things.
"Circuit City was a damn good electronics chain that was too stupid and slow
to adapt to Wal-Mart's entry into electronics," observed one reader.
Chimed another: "I would give the award to Circuit City's corporate managers
for deciding that the best way to save money and ensure business survival
was to get rid of their best salespeople. Aside from depriving the business
of those people themselves, the decision also sent a message to the
survivors: Stay mediocre or lose your job. (Well, they lost their jobs
anyway, but it probably took a few months longer.)"
A reader from Down Under was kind enough to send through a small list of
ill-fated morons...
"ABC Learning - ended up being bought out by welfare groups with Rudd
federal government financial assistance... Storm Financial - the case of
this company reads like a frenzy of stupidity and greed, combining into a
black comedy... Timbercorp - the model of this business growing trees proved
to be an abject failure... Opes Prime - another failed financial
advisory..."
And still more...
"Don't forget Washington Mutual," writes another, "for forgetting the good
banking activities that made them as large and well liked as they [once]
were."
Now, as much as we enjoy laughing at others' stupidity, we enjoy profiting
from it even more.
So, in today's guest essay, we decided to bring you some thoughts from a man
who makes a career out of spotting the extinct companies of tomorrow. In
fact, when Washington Mutual crashed to the ground back in September of
2008, readers of Dan Amoss' Strategic Short Report were laughing
all the way to the (obviously different) bank. And, according to Dan, 2010
is shaping up to be a great year for more short selling
opportunities...especially in the commercial real estate sector. Details
below...
P.S. Nominations are still open for this year's Daily
Reckoning Financial Darwin Awards. If you'd like to cast a vote, please drop
us a line at:
2009darwinawards@gmail.com
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|
The Daily Reckoning
Presents: |
For many Americans, the subprime meltdown must
have felt like a complete economic collapse. Tens of thousands lost
their homes in the ensuing mess and a growing number face, even now,
threats of foreclosure and badly underwater loans. But subprime real
estate loans were only part of the problem. Dan Amoss, editor of the
Strategic Short Report, explains...
The End of Extend and Pretend
By Dan Amoss
Jacobus, Pennsylvania
Attention REIT investors! The commercial real estate is a disaster-in-
the-making - both for property investors and for the thousands of
American banks that are carrying outsized exposure to commercial
borrowers.
Commercial real estate borrowers and their lenders face a mountain of
debt maturities over the next few years. And re-financing this debt will
be next to impossible, thanks to soaring vacancy rates and plummeting
property values. "Zombie buildings" are popping up all over the place,
according to Crain's New York Business.
"Virtually all the assets bought between '05 and '07 cannot be
refinanced today without a significant capital infusion," says Shawn
Mobley, executive vice-president at real estate firm Grubb & Ellis Co.
"These buildings need to be recapitalized to get back in the business of
being active real estate."
Unfortunately, these "zombie buildings" can't compete for new tenants
because they lack the money to cover brokers' commissions and interior
office reconstruction. The number of zombie buildings in the Chicago
area is likely to grow in 2010, according to a forecast by Grubb &
Ellis. For landlords, the trend means even top-quality office properties
are likely to divide themselves into "haves" and "have- nots," with the
latter seeing their vacancy rates worsen because of the lack of
financing.
We'll see many more zombie buildings emerge in 2010.
Many REIT investors seem to have grown complacent about the risks in the
commercial real estate market. These investors seem to believe that
banks will simply roll over underwater loans once they reach maturity,
in the hopes that a future rebound in property values will catapult
these loans back into solvency. This phenomenon is known as "extend and
pretend."
The "extend and pretend" strategy did not work for Japan's banking
system, and it won't work for the US either. It won't work because it
will lead to a two-tiered commercial property market. In one tier, we'll
see property owners with affordable mortgages cut rents to fill their
vacancies. In the other tier, we'll see property owners and lenders
hoping for a return to bubble values, and maintaining a high- mortgage,
high-rent strategy.
Property owners in the high-rent tier may be making payments on their
underwater mortgage for now. But once the low-rent tier starts winning
all of the scarce leasing activity, vacancies in the high-rent, high-
mortgage tier will accelerate and property-level cash flow will fall
dramatically.
In other words, just because a mortgage happens to be performing now
does not mean it will be viable in the long run. As commercial landlords
with negative mark-to-market equity watch their tenants flee, they will
stop making mortgage payments and surrender their properties to the
lenders. Thus, sooner or later, commercial real estate will find its way
down to the prices that would attract new investors and speculators.
This process is known as "price discovery."
By rolling over the maturing bubble-vintage loans made to underwater,
but cash-flowing properties, the banking system (if allowed to do so by
its regulators) would establish an artificially high price floor. Such
industry-wide collusion would slow - but not prevent - the slide toward
real-world pricing - the kind that would attract new investment.
But even if the process of price discovery in real estate is delayed by
"extend and pretend" at banks, some measure of price discovery will come
from the liquidation of properties that collateralize commercial
mortgage-backed securities (CMBS). In these securities, when the
underlying properties default on mortgages, the holders of the senior
CMBS tranches usually push for liquidation. This means that junior
tranche holders get wiped out, but losses to the senior tranches are
minimized. The senior tranche holders have neither the patience nor the
risk tolerance to hope for a rebound in property values. They just want
their principal back as soon as possible.
One way or another, commercial real estate prices will fall toward their
real-world prices...which are clearly below the "pretend" prices that
most banks are using today.
Therefore, my outlook for REITs remains very bearish. Many REIT
investors seem to believe that "extend and pretend" is a viable strategy
for the over-levered commercial real estate sector. I do not.
REITs, despite facing the toughest fundamental outlook in the history of
the asset class, are trading at valuations typical of market peaks.
Citigroup's REIT team, in a recent research note, estimates that the
REITs it follows are trading for 18 times estimated 2010 cash flow and a
7.2% implied cap rate. This is expensive in ANY market environment.
Investors speculating in REITs at today's high valuations give
themselves no margin of safety.
Citigroup's estimated 2010 cash flow for its REIT coverage universe
assumes a strong rebound in demand for commercial space, which I do not
expect. Demand will remain below supply for years, forcing REIT
landlords to cut the asking price for rents on vacant space.
The REIT sector has already "priced in" the typical sharp post-WWII
inventory-led economic recovery. But I expect a very tepid, narrow
recovery with a "double dip" recession by late 2010. The current
"recovery" is not typical. It is merely a stimulus-induced bounce in the
midst of what will likely wind up as a decade-long deleveraging,
downscaling economy.
So all that's necessary for a 40% decline in the REIT index is for net
operating income to fall 20% to 30% (through a combination of falling
rents, rising tenant defaults, and higher interest rates on new CRE
mortgages), and cap rates to increase by 200 to 300 basis points - just
slightly above the long-term average. A slow economy could easily
produce such an outcome...if not much worse.
The UltraShort Real Estate ProShares (NYSE:SRS)
is an aggressive way to bet against the REIT sector. This stock has
performed very poorly during the last several months, as REIT shares
have soared to the heavens. But I think it makes sense to be holding SRS
now, because REIT valuations are high, and fundamentals will remain
terrible, no matter how successfully real estate lenders manage to
"extend and pretend."
Sell REITs.
Until next time,
Dan Amoss
for The Daily Reckoning
Joel's Note: To commemorate the Daily Reckoning
Financial Darwin Awards, we're working on securing a very special deal
for readers interested in trialing Dan's Strategic Short Report.
We should have the details ironed out in a few days...so stay tuned...
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And now over to Bill Bonner, who has today's reckoning from
Baltimore, Maryland...
Hey ho...what goes?
The stock market registered a gain of 53 points on the Dow yesterday.
Gold saw a modest gain too.
And the White House came right out and with a straight face said it had
saved 2 million jobs. How do you like that? More than 7 million jobs
have disappeared in the correction so far. But the total would have been
more than 9 million, had it not been for the feds.
Let's see, $700 billion worth of stimulus spending...hey, that's
$350,000 per job. But every dollar of deficit is actually 'stimulus
spending.' At that rate, each job cost about $800,000. And what about
all the Fed's pump priming? What about all the loan guarantees and toxic
asset purchases...and bailouts of the auto industry, AIG, the banks,
mortgage holders, Fannie and Freddie...etc. etc? That's all stimulating
too, isn't it? The total is said to be around $13 trillion, putting the
cost at $65 million for each job saved.
Of course, it's all hooey...all nonsense...all balderdash.
It makes sense to 'save' a job if and only if the job didn't need
saving. In other words, the jobs that are worth doing are worth
saving...but they don't need saving. Why? Because a job that is worth
doing is a job people will pay for. And if they won't...or can't...it's
NOT worth doing.
Otherwise, the feds could have 100% employment...just as they did in the
Soviet Union. Give everybody a job. What the heck, give everybody two
jobs! But it only really does any good if the jobs are productive. And
how can you know if they're productive or not? You have to wait for Mr.
Market to tell you. If a job is productive, people will pay for it. If
not, well...the job is cut and/or the business goes bust.
Mr. Market never gets a say on government jobs, however. That's why the
feds can say any fool thing they want.
Washington, DC is full of government bureaucrats who earn 30% to 50%
more than people in the private sector. In the private sector Mr. Market
puts his thumb up or his thumb down. The job is saved. Or the job is
cut. But here in the federal city his thumbs are in his pockets.
For example, every day, we drive by the NIH - National Institute of
Health. Thousands of cars go in and out every day. The NIH was set up in
1930. It had 140 employees, which seems like more than enough. Today, it
has 18,442. The same sort of employee inflation happens at every
government level on practically every government project. You set up an
agency or a commission. Then, you can't get rid of it. As the saying
goes, 'nothing is more eternal than a temporary government agency.'
But are Americans any healthier thanks to the NIH's 18,000 + employees?
No one knows.
And that's just the NIH...where employees might conceivably be doing
something worthwhile. Just for fun we went to the
A-Z Index of US Government Departments and Agencies
and copied some of the list. This is just the beginning of the As:
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Administration for Children and Families (ACF)
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Administration for Native Americans
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Administration on Aging (AoA)
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Administration on Developmental Disabilities
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Administrative Committee of the Federal
Register
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Administrative Office of the US Courts
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Advisory Council on Historic Preservation
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African Development Foundation
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Agency for Healthcare Research and Quality (AHRQ)
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Agency for International Development
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Agency for Toxic Substances and Disease
Registry
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Agricultural Marketing Service
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Agricultural Research Service
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Agriculture Department (USDA)
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Air Force
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Alabama Home Page
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Alabama State, County, and City Websites
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Alaska Home Page
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Alaska State, County, and City Websites
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Alcohol, Tobacco, Firearms, and Explosives
Bureau (Justice)
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Alcohol and Tobacco Tax and Trade Bureau
(Treasury)
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American Battle Monuments Commission
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American Samoa Home Page
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AMTRAK (National Railroad Passenger
Corporation)
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Animal and Plant Health Inspection Service
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Appalachian Regional Commission
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Architect of the Capitol
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Architectural and Transportation Barriers
Compliance Board (Access Board)
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Archives (National Archives and Records
Administration)
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Arctic Research Commission
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Arthritis and Musculoskeletal Interagency
Coordinating Committee
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Atlantic Fleet Forces Command
Would we be worse off if half of these people
were sent home? Probably not.
But what are we ranting about? The Daily Reckoning is about
money, right? It's not about politics...
But...whoa...now politics and economics are mighty cozy with one another.
A growing part of GDP comes directly from the federal government. Already,
there is now more government spending than there is private investment.
And many mainstream economists are calling on the government to spend more
money to fight the downturn...and 'save jobs.' They don't bother to think
about whether the jobs are worth saving or not. And they don't seem to
care that government spending is not the same as private spending. As the
feds take over, the economy changes shape. It becomes less and less a
free-market, productive, wealth enhancing economy. Instead, it becomes
more and more of a centrally-planned, unproductive, wealth destroying one.
It becomes Sovietized, in other words...like Venezuela...more below...
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And back to our thoughts...
The poor Venezuelans. But that's the problem with democracy. Everyone gets
what the majority of voters deserve. They voted for Chavez. Now, they have
to pay for it.
The lawfully elected (insofar as these things are ever lawful) government
of Venezuela cut the value of its currency in half. That was only a week
or so ago. Then, there was "chaos" in the streets, according to press
reports. "Inflation fear grips nation," says The Washington Post
story.
In response, Venezuelans are on a buying spree.
"What can the citizen do, but conclude that his money is best spent on a
toaster [that] he really doesn't need," said the mayor of Caracas.
Señor Chavez has only done what Señor Bernanke and Señor Geithner have
done, too. They have all so confused the situation that ordinary people
have no way of knowing what to think...and no way of protecting
themselves, other than by doing something stupid.
But wait...there's more...
Now, the press is reporting that Caracas faces "rolling blackouts."
Well, isn't that just like dunderheaded government? Energy rich Venezuela
is running out of juice. Good work, central planners!
How long will it be before New York runs out of power, too? Or Los
Angeles? We don't know...but give the feds a chance. They'll make a mess
of things; count on it.
"How come Mexicans are doing all the work?" asked Edward innocently.
Edward was raised in France. He was only 2 years old when we left to live
in Europe. He is now discovering his homeland. So are we.
"All the people who clean up at the school are Mexicans. So are the
guards. And look at the guys working on the roads. They all look like
Mexicans...or Latin Americans."
Yesterday, we were late picking him up. We went into the school building
and asked one of the cleaning ladies if she had seen him waiting
somewhere.
"No hablo ingles," she replied.
She was then delighted when your editor was able to respond in flawless
Spanish - albeit heavily accented. Not for nothing has he been taking
Spanish lessons for the last 3 years!
The woman who cleans our office in Baltimore is from Nicaragua. The woman
who serves coffee at The Diner in Bethesda is from El Salvador. Guys
operating backhoes, trucks, shovels - all of them look like they are from
Latin America.
"I don't know Edward," we replied. "They were all black when we left."
Regards,
Bill Bonner,
for The Daily Reckoning
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Joel's Endnote: Finally today, a quick mention to save
the date for the 2010 Agora Financial Investment Symposium. The buzz is
already creeping in around the office as tentative lists of speakers are
passed around.
We expect to hear from a 2010 US congressional candidate...a well regarded
Moscow fund manager...and a leading petroleum analyst, speaking on "one of
the largest oil discoveries in the last 40 years."
If you've been to one of our previous events in picturesque Vancouver,
you'll know how valuable (and fun) this event is. One attendee this editor
spoke with last year called it his "must see" financial event of the year.
So here's a very early "Save the Date" heads up to get in early. The
conference gets bigger and better each year...but the venue remains the
same size. We've had people standing in the aisles in the past so, if you
want in, don't tarry.
Here's some preliminary info for your calendar.
Until next time...
Cheers,
Joel Bowman
Managing Editor for The Daily Reckoning
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Here at The Daily Reckoning, we value your questions and
comments. If you would like to send us a few thoughts of your own, please
address them to your managing editor at
joel@dailyreckoning.com
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