Very Interesting
[The Registry September 2010 Issue]
The consensus, or perhaps fear, among real estate investors with whom I talk is that interest rates must, must, must go up. At current levels, it is difficult to conceive that rates could possibly fall further. In addition, macroeconomic theory dictates that interest rates are under pressure based on our gaping federal deficits and the extraordinary level of our national debt.
However, we are likely to discover that this belief will prove inaccurate in the short and medium terms. Interest rates are not likely to rise for a long time. Why? The causes stem from the fiscal irresponsibility of other sovereign governments, the desires of our Asian trading partners to continue to sell to our consumers and Federal Reserve hopes of coaxing banks into renewed lending to support economic recovery and to rebuild their balance sheets.
Yet, we dare not imagine an extended period of low rates for fear we will make overly aggressive acquisitions that will come back to haunt us. If investors predict interest rates will stay low for too long, they will be tempted to put the pedal to the metal and go on an acquisition burn, scooping up all those beckoning distressed deals. But the thoughtful will tread much more carefully. The risk remains of underestimating the future cost of borrowed money and its inexorable effects on capitalization rates. Ignoring that risk could be devastating to valuations and investor returns.
The question then becomes not if rates will rise, but when. The answer lies in the relative strength of the dollar compared to other currencies and the time it will take for commercial banks to rebuild their balance sheets.
Domestically, reviving bank lending is so important that the Federal Reserve is flirting uncomfortably with the phenomenon of a liquidity trap. That happens when central banks lower their overnight lending rate to zero but even this radical move is insufficient to stimulate renewed lending. The Fed must keep interest rates low to avoid deflation and support the tenuous economic recovery, but as the chart shows, our money supply is still shrinking, so we know that banks are not taking the Fed bait. Bank capital is so impaired that sustained lending has not taken hold. My guess is that it will take a long time to resume. We have seen the phenomenon in Japan, where it continues to be the case.
The scale of the distress is much larger than reflected in the popular press. Most maturing commercial real estate loans could be described as “distressed,” whether or not they technically comply with special servicer or federal banking regulators’ definition of the term. Refinancing loans these days is grueling, even for seemingly safe, some might even say “trophy” assets. The enormity of the challenge before us, as the chart below illustrates, is enough to stagger even the most optimistic of souls.
For the moment, banks are advocates of a low interest rate environment to avoid exacerbating loan defaults and falling asset prices and also because they are making money hand over fist borrowing from the Fed at zero interest while investing in U.S. Treasuries, which are paying much higher rates. The approach appears risk-free—it is not, but that is the subject of another column.
After their loan portfolios are modified, written down or repaid—perhaps as early as 2013 or perhaps as late as 2018, depending on how robust our economic recovery will be and how bad defaults and losses become—then banks and other lenders will be decidedly in opposition to hyperinflation. By then, of course, it may very well be too late. Thus we all have to live with the risk of hyperinflation to climb from the hole that we have dug.
The chart above clearly shows that the next three years in the least pose significant risk to banks and that financial markets as a whole will struggle with maturities until 2017. The inevitable conclusion is that commercial markets are going to be severely debt constrained through at least 2013 and probably longer.
Little on the international horizon appears to mitigate this analysis. When stressors alarm global investors, they consistently flee to U.S. Treasuries, despite our national debt, continued out-of-control public spending and impossible-to-keep entitlement promises. For all intents and purposes, the Federal Reserve has become the world's central bank. When the Fed reopened its credit facility on May 9 (a Sunday) to the European Central Bank (which loaned U.S. dollars to the ECB to provide euro zone liquidity), the dollar strengthened. This reopened credit facility helped seal the deal with the International Monetary Fund and created the $955 billion EU bailout that gave the PIIGS (Portugal, Italy, Ireland, Greece and Spain) some time to get their houses in order. In the immediate aftermath of the ECB announcement, U.S. Treasuries traded higher, clearly indicating that global investors believed the United States still provides the safest haven to park excess cash.
Longer term, the European Union itself is at risk, and thus the euro. Forecasting survival of the union is binary: It will survive, or it won't. I believe it won’t. However strongly German politicians defend the EU, eventually German citizens will reject continued subsidy of their spendthrift union partners, and without continued subsidy the union cannot hold. Modifying and extending sovereign debt simply delays the inevitable currency devaluation, collapse and/or hyperinflation, according to an exhaustive study of hundreds of sovereign financial crises over 800 years and particularly since the year 1800 by Carmen M. Reinhart and Kenneth Rogoff in the book “This Time is Different.” But there will likely be a long period of unraveling in which individual governments default, or teeter on default, then go hat-in-hand to the IMF for debt relief, probably supported by liquidity provided by the Federal Reserve. That process appears inevitably to support the notion that U.S. Treasuries are the safest haven for short-term liquidity.
For commercial property investors borrowing in dollars, the important question then becomes: How long will this continue? Will each successive member of the EU that falters drive more and more global investors toward U.S. Treasuries? For as long as it does, and I would argue it will for a good long time, the U.S. dollar hegemony is safe, and the dollar will remain steady relative to the Euro, thus keeping interest rates low.
Our Asian trading partners also have a vested interest in a strong U.S. dollar. Their unwavering desire to support full employment at home by remaining net exporters to the United States will push them to devalue their currencies against the dollar and continue to buy U.S. Treasuries as long as their current accounts continue to grow. An international banking friend of mine recently returned from a trip to Asia and remarked that many, if not most, of the smaller economies there are locked in fierce competition to keep their currency competitive with each other and China to ensure that they remain net exporters to the United States. If this tendency unfolds as he describes, their determination to remain a net exporter by devaluing their currency will strengthen the dollar for the foreseeable future. A strong dollar will make it difficult for the United States to become a net exporter itself, but it will support continued low interest rates.
Also, let us not forget that if interest rates rise too much, the United States itself will choke on the payments associated with servicing our national debt, so we as citizens have an enormous stake in keeping the U.S. dollar strong even if it tends to dampen our economic recovery.
Thus, for the commercial property investor the calculus becomes: What is the cost of debt when buying, and more importantly, what will it be when selling a property? The question is even more important if the majority of your return depends on appreciation, rather than cash flow. Low interest rates are an answer to many a commercial real estate participant’s prayers, but they are not a cure-all. Predicting the emergence of high inflation will likely be synonymous with predicting a rise in interest rates. My bet, based on the maturity horizons in the chart above, is that it will take until 2015 to rebuild bank capital and set the stage for monetary inflation. To mitigate risk, acquisitions between now and then should focus on the pricing power of the individual property and estimating the cost of interest payments when the acquisition loan matures.
