The Power of the Infrequent Event

As I've stated before, I am wary of economic and financial forecasters. Mainly because they are seldom right, and when they are wrong the social impact is significant. There exists a fallacy in economic and financial forecasting models that most tend to ignore. The fallacy exists because forecasting models rely on assumptions that fall within a predictable realm. The calculation of risk in financial and economic models are based on standard deviations from the norm, therefore most models predict that 95% of possible outcomes will fall within 3 standard deviations. The farther an event falls from the norm, the less statistical significance that event carries. Another term for standard deviation is sigma. In finance, a six sigma event is characterized by a price drop of six times the volatility (or standard deviations) of the asset. On a daily horizon this translates into an event occurring once every 2,500,000 million days, or every 6,849 years. Yet in the past 22 years financial markets have suffered the following six sigma events: the '87 market crash, the Russian devaluation, the Asian crisis, the bursting of the Internet bubble, and the current 2009 recession.

Since my first day in Econ 101, I've been struck by the absurdity of academic rigor. On that day my professor managed to take an intuitive concept and confuse it. Of course if more people demand my product I can charge more, and guess what? If I'm the only one making my product and a lot of people want it, I can charge whatever I want for that product! That led to discussions of elasticity and more classes to include economic modeling. Even then, I was wary, how could any econometric model take every possible variable and interaction into account? The answer is they can't. That's why we've had multiple six sigma events (events that statistically should occur only once every 6,849 years) in the past 22 years. The problem with these models is that they can't predict that terrorists will fly planes into the world trade center, or an outbreak of the flu may cripple consumer spending in the domestic US market, or that some inventor will develop a battery that can safely store energy with 99% efficiency. Heck, they can't even predict events they should, like the over valuation of US residential real estate market, or that someone that makes $40,000.00 per year can't repay a $400,000.00 mortgage.

The point here is that infrequent events shape our history and our future. Its not the predictable that we should concern ourselves with; Its the unpredictable. In investing, the return on placing a winning bet on the infrequent event is far greater than placing a winning bet on the predictable event, especially when placing that bet on the predictable event is negatively impacted by an infrequent event. To do this you must expose yourself the infrequent events and place your bets. Look for that inventor that is developing the battery that stores energy with 99% efficiency. Look for that company that is converting 18 wheelers from diesel to natural gas. Look for the next breakout technology, tablet computing across 4G? What's the next break-out application? Where does social media take us? There are opportunities to bet on infrequent events, whether you bet on business, politics, or social issues. You just need some creativity.

Gold for What?

As of this post, gold is trading at $1049 an ounce. Gold is at an all time high (in nominal terms), while almost everything else is trading sideways. Small gains are made by trading one commodity/asset for another.

The U.S. Economy is in a recession. Depending on who one listens to, the U.S. Economy is either turning around, staying in no growth/slow growth mode, or heading to a double dip recession.

So what does one do? Don't listen to the experts. Forecasters can't forecast. There is no way their models can take into account all known variables that affect the economy, much less anticipate all unknown variables that affect the economy. The forecasters don't even know what they don't know. Yet, they run models, flash their faces on CNBC and tell us what is going to happen in the economy. The investment banks had "risk models" that told them they could leverage 30+:1. How did that work out for you as an investor?

Here is what we do know. The price of oil in relation to the price of gold is at 2003 levels, the price of housing in the U.S. in relation to the price of gold is at 1988 levels, the price of the DOW in relation to the price of gold is at 1994 levels.

The money is flowing into gold. Is it flowing into gold because gold is safe in uncertain economic times? A hedge against inflation? In a deflationary environment? Is it a reflection of the inflation caused by the anti-deflationary policies of world governments to stem a deflationary asset base? Who knows? Ask an expert, I'm sure they'll tell you.

What I do see happening, is that there are asset classes on sale; primarily real assets and stock assets. Alternate asset classes continue to get cheap in relation to gold. At some point the markets will shift. Gold prices have been steadily rising since 2001. Investors will shift when they feel other markets have stabilized enough to come out of gold. Monies will flow from gold to other assets. The question is when and to what assets?

If inflation remains a concern, money should flow to an asset class that benefits from inflation - real assets. Currently real assets are deflationary, with commercial real estate expected to further depreciate, unemployment increasing, little to no growth in GDP. However, the $787BB stimulus package is less 20% distributed. The full distribution of those funds will serve to increase employment, spur consumer spending, and stabilize the asset base. This in turn will lead to growth in the money supply and cause inflationary pressures. Real commercial assets benefit from increased consumer spending, and inflation (asset appreciation). The question remains, is it time to sell gold and buy real estate?

An Insider's Tip to Real Estate Disposition

My partner and I are actively disposing of commercial real estate assets for our clients. We are doing it successfully: 9 properties in the past 60 days. Property disposition in this market requires creativity.

The first step in disposing of your assets is understanding your real estate. Where in the country is the asset located? What type of property is it? What is the condition of the asset? A good understanding of these factors will shape your disposition strategy.

Most sellers find a local broker, have them do an Opinion of Value, sign a listing agreement, and expect a sale. That method isn't working. Local brokers know local investors. Currently local investors have many investment choices facing them. Opinions of Value are optimistic. Pricing is set above market. Subsequently, investors choose other investments and sellers chase the market down.

To dispose of real estate assets in this market, sellers need to create a micro market for each asset. There are pockets of activity nationally that are active with investors, know those markets. There are investors active for all property types, find those investors and match them with your asset. There are investors with cash or access to cash, find them.

Create a sense of urgency for your asset. Unless you create a sense of urgency for your asset, investors have no motivation to buy the asset. They wait for the price to drop.

Create competition for your asset, more buyers drive up the price. Set your price correctly. If your starting price is too high, you'll crowd out bidders and reduce the competition for the asset.

Auctions are a viable disposition solution. If properly executed, auctions can create a micro market for your asset. If you choose to use an auction to dispose of your real estate assets here are several tips.

Know how the auction and your asset are marketed. Make sure the marketing plan supports selling your asset. Does the marketing plan create a micro market for your asset?

Consider the size of the auction. A micro market for your asset is five to six bidders. To get five to six bidders, 10 to 12 investors must register to bid. Getting 10 to 12 investors registered to bid on your property is a function of the marketing plan. For an auction with 10 properties to be successful the auction will need to have 100 to 120 registered bidders. When it comes to auctions, smaller is better. The more properties in the auction, the harder to create a micro market for your asset.

Most auctions charge a buyer's premium as opposed to a sellers commission, some as high as 10%. 10% is fine if the property sells at auction. If not, and your asset remains tied to the buyer's premium for a period of time post auction, that 10% buyer's premium will destroy the micro market for your property. Negotiate your listing agreement so it supports your goal of disposition.

If your asset doesn't sell at auction, there is no longer a sense of urgency, you have lost your bidders, and lost the competitive environment for your asset. If you use an auction to dispose of your property, manage the process so you'll have success.

Alternatives to auctions, include accelerated marketing programs. Those programs also need to create a micro market for your asset. Understand your asset. Price your asset properly. Find and cultivate 10 to 12 interested investors. Convince 5 to 6 of them to bid on your asset. Create a sense of urgency, and establish rules that allow the investor to quickly close on your asset.

Whether using an accelerated marketing program, auction, or traditional brokerage to dispose of your properties, your chances of a successful disposition increase greatly if you create a micro market for your asset. Creating a micro market for your asset gives you control over the sale of the asset. Otherwise, the buyer will control the disposition of your asset. Never good for a seller.

Chris Pacheco is a full time broker and real estate professional at NAI The Vaughan Company. For more information, or consultation contact call 505 797 1100. Email chris@naivaughan.com.

The 800 Pound Gorilla!

As we progress through this recession, the media talks about a lot of things:  foreclosures, CMBS, lack of credit availability, the price of a barrel of oil, the price of gold, yield spreads, the DOW, the S&P.

CNBC did a superb job explaining how and why the residential real estate market overheated and subsequently collapsed.

Congress passed the TARP, bailed out Freddie Mac and Fannie Mae, AIG, Citibank, and numerous others.  The Obama administration pushed through a stimulus package, and the Fed has expanded its balance sheet to record levels.

Yet few people are explaining to the American Public that our banking system is insolvent and why that system is insolvent (the 800 pound gorilla).  The residential market collapse was bad enough, but given the amounts of money the U.S. Government has printed in the face of this financial crisis, its not that big a problem.  In fact, prior to last September, all the bad residential mortgages could have been paid or guaranteed with $500BB.  Don't get me wrong, that's a huge number, but nowhere near as large as the trillions of dollars being thrown at this recession.  The question is: if the bad mortgages totaled $500BB, then why is the problem trillions of dollars large?  Why is the banking system insolvent?

The credit derivatives written on mortgage backed securities may very well destroy the Capitalist system the United States was built upon.  Let me explain, if I owned a mortgage backed security, or a piece of a mortgage backed security, I could hedge my risk by buying insurance from the investment banks on my mortgage backed security.  This was good for me and good for the bank selling the insurance.  This insurance is called a credit derivative and is good for the insurer because they can generate a revenue stream without putting out any cash, and as I explained in an earlier blog represents an infinite return.  The investment banks decided this was a great thing, and hey since all these securities had AAA ratings they had to be safe, right?  What the Investment banks did next is criminal.  They sold multiple insurance policies per security.  In other words they took bets that the securities would not fail.  While the purchasers of those derivatives were in turn betting those securities would fail.  Looks like the investment banks were wrong.  For the life of me, I can't figure out how - they had risk models based on quantum physics.  The fact that someone earning $40,000 per year was buying a $400,000 asset on credit failed to sound an alarm.

If I insure your $100.00 security once, my liability is $100.00  If I insure it 50 times my liability is $5000.00.  I used a multiplier of 50 because that's the leverage ratio carried by some of the investment banks before they merged, or became regulated banks.  With a leverage ratio of 50, what was a $500BB problem has become a $25 Trillion dollar problem.  That's why the U.S. Government has not bought the Troubled Assets.  They aren't assets.  They are liabilities on steroids and would break the US Government if they were purchased by the Government.  This is also why the credit market is locked up.  The banking system is insolvent, and hopelessly under capitalized.  

So how does the Government solve this problem?  The solution to bank insolvency due to credit derivatives is possible on either end of the problem.  On the originating end, the Government simply has to guarantee securitized mortgages.  On the other end, a more complicated solution is Nationalizing the banks, taking them through a bankruptcy process, wiping out the shareholders, the debt holders, and most importantly the derivative holders.  Any other solution drags down the U.S. Economy for as long as a generation.  Yet, neither solution is under consideration.  Instead, the solution seems to be a slow bleeding of the U.S Treasury.

The question is why?  Who benefits from this solution?  Who owns these derivatives and why are we protecting them?  I'm a Keynesian, so I really don't have a problem with the Government stepping in when necessary to stabilize the system.  In this case, I do have a problem with the solution, or lack of solution.  Tax dollars are flowing to derivative holders, and in turn those derivative holders are waiting for the system to collapse with dollars that increase in value in a deflationary environment to buy up the assets.  In a Capitalist environment, they should be considered shrewd investors taking advantage of an opportunity.  The problem with that scenario is that the derivative market was never open to the public.  Most of the readers of this column, including me, never had access to these investments.  The derivatives were available to a select group of individuals only and were never publicly traded.  This group now exclusively benefits from U.S. Taxpayer dollars.

The chosen solution seems to be transferring wealth from the Treasury to the derivative holders, through the banking system, while simultaneously stimulating the economy with demand side policies.  In closing, I repeat my question:  Why don't we acknowledge the 800 pound gorilla?  What is the end game and why have our leaders chosen a solution that benefits a select few to the detriment of a vast majority of others?

The Commercial Real Estate Market in 2009

The general consensus from economists is that our economy won't return to strong growth until 2010.  There are a lot of factors that lead to this conclusion, but the overriding reason is that the residential real estate market is overbuilt.  As per one economist at a seminar I attended last week, the U.S. population won't catch up to the current residential inventory until 2010.  With this being said, there are some markets that are more overbuilt than others.  Which means there are still pockets of growth and residential real estate appreciation.

The question is how does this affect the commercial real estate market?  Commercial real estate activity is down 75% year over year as of the end of the 3rd Quarter of 2008.  The number is slightly misleading, because prior to 2008 the amount of real estate transactions was inflated.  The overall real estate market had heated up to the point where commercial real estate was being traded instead of invested.

As we are aware real estate asset values are depreciating.  The extent of which remains to be seen.  As a nation, we risk a negative asset bubble.  The reason for this is that the short term financing on many commercial real estate projects start coming due in 2009, and most will reset through 2012.  With the credit markets locked up we face the potential of systematic maturity defaults in the commercial real estate market.  There is a lot of money sitting on the sidelines waiting for just that occurrence.

Another reason these loans will face trouble refinancing is because as the economy gets worse there is a widening gap between the pro-forma predictions on which these mortgages were underwritten and the actual performance of the property.  Occupancy upon completion of commercial real estate projects has dropped from 85% at the peak of the market to 62% as of the end of the 3rd quarter 2008.

Looking at specific asset classes, the positive is office and industrial properties were not overbuilt during this last boom, so although vacancies will rise based on the economy; the vacancies are manageable and projects that are complete can continue to cash flow, on slim to little margins, but well managed projects in these sectors will service their debt.  Project developers and owners, however, can expect strong competition for tenants.  As per a large lending institution that focuses on commercial real estate, they are seeing rent decreases as much as 20% in some markets.

As an asset class, retail properties will struggle through 2009 into 2010.  Vacancy rates are climbing steeply and the vacancy trends are structural.  Retail is more closely linked to residential than are office and industrial.  Big box developments in overbuilt residential neighborhoods are especially susceptible to vacancies.  There are structural factors that adversely impact retail.  Consumer access to home equity loans is greatly restricted, which restricts consumer spending.  Retailers are over inventoried, however, the impact of inventories will clear up by the end of the 1st quarter 2009.

The outlook for multi family varies greatly by market throughout the U.S.  In markets that had many condo and conversion projects, vacancy rates are increasing.  That's because many of the condo and condo conversion projects are reverting to apartment use and causing an overbuilt scenario.  In markets that did not have many condo and condo conversion projects vacancy rates are low, and rents are increasing.  As a rule of thumb, most Tier 2 markets are good for multi family real estate.

For office, industrial, and retail properties; the current real estate market creates good buying opportunities for well financed, well informed investors, that are not dependant on debt financing.

In the right markets, multi-family is a good investment.  In those markets, properties are maintaining their value, and rents are increasing.  Also, this is the one asset class that still has a secondary mortgage market.  Fannie Mae and Freddie Mac are buying multi-family mortgages, albeit the equity requirements have increased; but multi-family purchases can still be debt financed.

In summary; for office, industrial, and retail look for buying opportunities starting in early 2009.  Debt financing is scarce for these projects, which creates strong opportunities for cash buyers.  Expect more seller financing and syndications to fill the financing void.

For multi-family, study the market.  There is good value in this environment in markets that are not over inventoried.  Buyers that have strong credit, and can afford equity payments of 25% to 30% have an advantage.

Over the next 18 months there will be many "good buys."  This is a market for sophisticated investors, study the project, study the market (growth, demographics, underlying local economies), know the tenants, and study the leases.  There are some excellent buys, and fortunes are made in these markets; but this is a sophisticated investor's market.  If you are new to real estate, you can still get in, but find a good, knowledgeable professional to guide you.  A reasonable investment in professional guidance can lead to large future returns.

What Leads the Recovery?

It looks like the the stock market found a bottom. The massive capital injections, loan guarantees, and rate cuts seem to have stemmed the crisis. The price of a barrel of oil is in the manageable range, and credit is slowly starting to flow. What's important to remember is that Main Street is not in trouble; Wall Street is.

On Main Street, we are in a recession, but not a 40% decline that was reflected in the stock market. In the past the market was a rough reflection of the future economy, that connection is broken – perhaps forever. A recessionary market should have reflected losses of no more than 15%.

Where will we see the recovery? Last week I wrote that we wouldn't see supply side growth for at least two years. I regret that statement. I usually look for the positive and opportunities prevalent in all situations. I allowed myself to get caught up in the panic I was watching on CNBC. The fact is; there are supply side drivers developing to push increases in productivity and efficiencies in technology and energy.

The technology driver is loosely termed cloud computing. Cloud computing as a concept is not really new. When I learned programming in college, I learned on a terminal attached to a central processor. Cloud computing is the use of Internet- based applications that incorporates software as a service (SaaS). We all use the early cloud computing applications – mapping services, gmail, and yahoo mail for example. Google has fielded Google Aps, which include applications that compete with Microsoft's Office package. Although still buggy, the productivity and efficiencies offered by SaaS are apparent. As an example, there are studies that show for every dollar spent on Microsoft products there is up to seventy three dollars spent in support of those products. Cloud computing will not eliminate those costs, but will greatly reduce those costs. In terms of bottom line dollars, that's a large productivity impact, as some of those dollars are redistributed to revenue generating use.

Additionally, anything that has access to the cloud – wireless devices – have access to Internet-based applications. Admittedly, many of those applications still have a way to go, but most of us have the ability to receive and send email on the road, review documents, and complete simple tasks like get directions, get news and information, or get that all important Southwest Airlines A boarding pass while on the road. Our ability to complete these tasks from almost anywhere with a wireless device make us productive 24 hours a day and essentially triples the work day. Our efficiencies will increase as more robust applications are fielded for wireless devices using SaaS.

On the energy side, the global increase in demand for fossil fuels and the corresponding increase in the cost of those fuels have driven the refinement of alternative energy technologies – solar, wind, and geothermal. Wind for example, as per the Department of Energy, can supply up to 20% of America's electricity needs by the year 2030. Wind currently supplies 1% of America's electricity. Extracting oil from the ground is becoming increasingly more expensive, this with the continued global increase in demand for fossil fuels causes a drag on productivity. Putting the positive environmental impact aside of alternative energy, harvesting alternative energy is now becoming less expensive than harvesting fossil fuels. Two things will happen based on this fact: 1. employment and wealth is created as the industry and wealth shifts to the development of alternative energy, and 2. as energy harvesting costs decrease, some of those monies are shifted to revenue producing uses spurring further macro-economic growth.

These are two prominent growth opportunities in the near term, this doesn't include the growth provided by the peripheral markets that will get created by enterprising entrepreneurs around these industries. I'm looking forward to see what ingenious markets are created as result of the shifts in technology and energy.

For my part, I plan on continuing to look for the economic opportunities of the future, and ignore the “CNBC” effect. As I continue to say, there is always opportunity in every situation, we just need to look harder sometimes.

The Bail Out Passed. What Next?

What a dramatic week for investors.  Correction, what a dramatic week for Americans.  We hear a lot about Wall Street and Main Street, and how this bill was necessary for both.  Time will tell who benefits more - Main Street or Wall Street.

There are some key provisions in this bill which will have immediate impact on Main Street and Wall Street.  FDIC deposit insurance is increased from $100,000.00 to $250,000.00.  More importantly this bill suspended mark-to-market accounting rules.  What that means is that financial institutions can subjectively value their asset base instead of valuing assets at what the current market will bring for the asset.  Bank balance sheets will improve immediately, and this alone should "unfreeze" the credit markets.  Increasing the value of assets reduces the need for banks to raise capital by selling those assets to the Government.  In fact, the need to sell those assets to the Government is decreased.  What the $700,000,000,000.00 bail out does is recapitalize the banking system through a vehicle other than the Fed.

What does all this mean to Main Street?  What it should mean over the next quarter is that credit worthy borrowers should get access to capital at reasonable rates.  Remember the Federal Funds target rate is still 2%, as credit tensions ease within the financial system lower rates should flow to consumers - although expect banks to take advantage of the tight market and maximize the spread between what they pay for money, and what they charge consumers for money.

A rapid recovery from this recession is unlikely.  Sub prime mortgage holders did not get any relief, and the housing market still needs to work through excess inventory.  From a demand side, consumers have little impetus to spend.  Asset values are down, and will take several quarters to recover - in Main Street terms, your house is worth less, your portfolio is worth less, and your business has less value.  Slow consumer spending adversely affects manufacturing, wholesale, and retail, which in turn continues to put downward pressure on asset values.  

On the positive side, the price of oil is continuing to decrease, and may very well drop to $70.00 per bbl before recovering.   More than driving down prices at the pump, oil is a basic manufacturing ingredient, its continuing price decrease leads to decreases in production costs.  The recovery effect of lower prices should become evident in the 2nd quarter of 2009.

Also, the next administration whether Democratic or Republican will probably enact an economic stimulus package.  This will contribute to a demand side - consumer - economic recovery.

On the supply side, the most immediate positive impact is the relative low price of raw materials. This allows manufacturing costs to stay down, and should contribute to an increase in production - more jobs.  However, inventories will grow slowly in response to demand.  In the short and medium term, out to two years, there is little to spur supply side growth.  Productivity is steady, and there is little in immediate technology to contribute to supply side economic expansion.

Assuming a slow recovery and slow, steady growth over the next year, where should investors put their money?  As in previous posts I'll stick to my mantra, think long.  Good assets are on sale now.  

If you're a stock investor, bet on Buffet.  Look where he put his money, and follow suit.  His track record speaks for itself.  Your probability of success is even greater when you take the time to study and learn how much control Warren Buffet has on both his investments and the investment environment.  When betting Buffet as an individual investor, remember, he has more staying power than you do.  Be careful if your portfolio is sensitive to volatility or you'll need short term liquidity. 

In terms of hard assets, specifically Real Estate, now is the time to look at land.  If you have some staying power, you can find some incredible bargains - in real terms, land prices haven't been this low in a generation.  Look for good land, study growth patterns, study community development plans, study infrastructure plans, buy some dirt and hold it.  If you don't like land, buy investment properties.  If you work with sellers, you can get into properties for 10% to 20% down.  If you finance your purchase through a bank, expect to have at least a 30% equity requirement.

In short, now is the time to get back in.  The full impact of the bail out will take up to ten years to play out, and that's the subject of another post.  The most immediate impact of the bail out is that it has probably defined the bottom of this recession.  There are some good deals on the market, take advantage.