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Where Is The Opportunity?

By Joel Ross

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While the world escaped the immediate crisis in Greece and Italy with the selection of excellent technocrats as prime ministers, they have a very long way to go. As experienced as they are as technicians, they are not able to change decades of cultural and political attitudes which badly hamstring business and which have trained the population to become entitled instead of productive workers. Terrible labor laws and all sorts of regulations have built up a network of corruption, tax avoidance and coddling of workers. You don’t change that over night without social and political disruption. Spain is only somewhat better. Ireland is far better, and seems to be headed back onto the road of a semblance of a functioning economy. What all of these countries should have taught the private equity world in the US is that when you go to foreign lands, there are massively different rules and cultures which make investing very different than in the US. Many private equity firms here proved they really did not fully understand fundamental investing in the US, and especially the housing market, in mid decade, so it is clear there are big gaps in fully understanding the real estate markets of the European countries.

The incredible lack of coherent leadership in Europe and the White House is not going to change at least until January 2013. As a result we cannot expect anything much to change in the economies of the western world before then. The Obama administration continues to churn out rhetoric and stop gap useless programs to try to fix the economy. Obama’s latest bit was last evening to claim the problem with America is we are lazy about attracting foreign business to come here. That is not only wrong, but surely not helpful. Whatever the debt committee does it will not even be a start to fix the problems of the deficit. Regulations continue to pour out and Dodd Frank is not even half way to being implemented with Carl Levin claiming nothing about it should be changed. Carl Levin could not even qualify to be a bank teller, but he is claiming to know how to regulate the banking system. The various politically motivated attorneys general at the federal and state level continue to attack the banks. Europe is no longer available to buy the CMBS paper we dumped on them in mid decade. CDO’s are toast for the most part. In short there is going to be a long way to go before CMBS issuance can come close to meeting the demand for refinancing. Banks are being pressed to built their capital ratios to 9% or more. That means a lot less real estate lending and surely a lot less construction lending which carries a higher risk adjustment for capital purposes. All of these issues combined will keep volatility in the bond markets at a higher level than is efficient for refinancing of the $1.4 trillion of real estate debt which needs to get funded over the next few years.

So here is the very likely result. The economy remains sluggish, but improving slowly. Europe and the damage already done here by this administration will not go away quickly even if Obama is replaced. Unemployment remains very high for several years. Consumers remain careful and cost conscious. Digital shopping grows very rapidly and brick stores become smaller and less important. The housing market takes several more years to settle and readjust. Unless the courts and the AG’s let banks rapidly clear the foreclosure backlog, home prices will remain weak or even decline in some markets like Phoenix. There is little chance the avalanche of litigation against the banks and servicers set loose by Elizabeth Warren is going to subside anytime soon.  Travel by corporations will remain constrained as they seek areas of their budgets to control costs during this sluggish period. Hiring will remain constrained so office space needs will not grow quickly. The digital revolution will also mean a lessening need for everyone to be in expensive downtown buildings for all functions. It will increasingly be at home or in satellite locations at much lower space costs. Law firms will continue to use less and less space. The good news is far less new buildings of any food group will get built over the next five years, helping to better rationalize space usage.

The result of all of this is many owners who got an extend and pretend deal will now be out of options.  They are not going to get bailed out by a booming economy, especially in secondary cities. At best they will see rents and hotel rates move up slowly for the next two or three years. The refinance markets remain will very constrained and underwriting remains careful. CMBS comes back, but with limited capacity for several years. Maybe it gets to $100 billion in 2013,  but that is just a dent in the need.  Several of the large houses that were starting back into CMBS and stopped, will not be rushing to restart again anytime soon. Commercial banks will continue to be spending billions on lawyers and fines and the foreclosure problem will continue to drain away capital and costs in people and cash. Both the federal government and local governments will remain essentially broke for years and unable to tap the capital markets sufficiently to provide the sorts of building programs and subsidies we had seen over the last decade. The teachers unions and other government worker unions will now be emboldened by the Ohio recall vote. Pensions will not earn anywhere the returns their actuaries project and so pensions and healthcare will continue to drain any ability of municipalities and states to undertake the massive infrastructure building that is needed.

So where is the opportunity. If you have cash over the next 3 years you will be king. Despite all of the above, the world is not ending. There will be economic growth, and if we have a new president, there will be a greatly renewed sense of optimism in business. It will also mean a major pullback in the effort to crush the banks and the capital markets. Many owners will be forced to sell or just give up their assets in deed in lieu over the next two years. Asset prices will remain constrained, providing great opportunities for cash buyers. The key is to have a long term view. This bad period will pass,AC and in five years the world will be a very different and much better place. There will be no choice but for the politicians to deal with many of these issues in a much better way.

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