New York State of Mind
[The Registry June 2011 Issue]
The fortunes of the haves and have-nots have long interested social scientists. Real estate investors, especially Main Street owners, are more recent comers to the action, but their interest is well-founded. At the Zell/Lurie Real Estate Center conference in Philadelphia on April 28, David Simon—a guy who should know—shared some particularly relevant and interesting insights about the have and have-not world of today. Simon is chairman and chief executive of retail behemoth Simon Property Group Inc., the largest real estate company in the country. According to Simon, sales per square foot in his Louis Vuitton stores increased significantly year over year, and the high-end consumer is not being affected by gasoline price hikes. The Wal-Mart shopper, conversely, is a “devastated consumer,” Simon said. Devastated consumers, who greatly outnumber Louis Vuitton shoppers, do not bode well for Main Street commercial real estate.
For those institutional investors who live east of the Hudson River, many of them in attendance at the spring Zell/Lurie event, the commercial real estate recovery is in full swing. The bulk of large distressed loans have been modified, sold or otherwise put to bed; equity is flooding back into the market; CMBS 2.0 is just around the corner; and deal flow is kicking into high gear as ultra-low interest rates drive prices higher, at least for trophy properties. The financial ninjas in NYC know that this period of optimism cannot last and want to cash in while the money spigot from the Federal Reserve is belching currency like water from Brooklyn fire hydrants on a sweltering summer day. Washington politicians are eager to claim credit for this financial recovery, however transient.
Meanwhile, Main Street owners and investors are left to fend for themselves. The phrase: “Let them eat cake” is commonly misattributed to Marie Antoinette, but Jean Jacque Rousseau first wrote those words several years before Antoinette arrived in France. But let’s not split hairs: Misperception by the elite is still misperception. The fact is: There is a stark disconnect between the average investor on Main Street, on one hand, and Wall Street and its hand maidens in Washington on the other. The documentary “The Inside Job” notes that there are five financial services industry lobbyists for every legislator in the U.S. House of Representatives and U.S. Senate. Five pairs of lips whispering in the ears of our lawmakers leave no room for the quavering voice of the average Joe.
According to Joel Kotkin, a Presidential Fellow in Urban Futures at Chapman University, New York tends to represent the most-extreme polarization of income in the nation. Expensive “megacities” with finance-driven economies in particular create high costs and less opportunity for middle and working-class families, he says. In 1980 Manhattan ranked 17 among the nation’s counties for social inequity; by 2007 it ranked first, with the top fifth of wage earners collecting 52 times that of the lowest fifth, a disparity roughly equivalent to Namibia, a post-colonial, African nation with a history of apartheid.
The middle classes in America are under siege. They are wrestling with the rising price of essential commodities without commensurate wage increases; they face higher taxes at the federal, state and municipal levels even as services recede. The political theater in Wisconsin over who should make up governments’ budget shortfalls will soon be coming to a municipality near you. High-income earners, who may think themselves above such petty preoccupations, should not breathe a sigh of relief. Anyone with less than $5 million in net worth is in the same lifeboat as the school teacher and the general contractor looking for work.
Whether you are a Democrat or a Republican in your political outlook, the financial distress of today makes no political distinctions. Inflation will make paupers of millions of Americans, and only investors who position their portfolios to benefit from this very same inflation will ultimately prosper. Inflation is a tax that silently takes money from the pockets of citizens on fixed incomes and savers reliant on their interest earnings. The “stolen” proceeds go directly to the treasuries of sovereign governments in the form of devalued debt. Uncle Sam is the largest borrower in the world. Inflation needs no press conference or policy statement to complete its task, and its complexity provides great political cover. In the short run, it also adds a couple of points to corporate profits as price increases precede cost increases.
But, however much cash that corporations stockpile, the trickle-down effect does not create jobs any more than a politician’s campaign promise. Much of this cash is being used for mergers and acquisitions to quash competition and consolidate market positions in virtually all sectors. This cash is not being used to invest in manufacturing plants or warehouses or new shopping malls.
Still, there is a silver lining. Commercial real estate provides one of the best inflation hedges available to investors if two conditions exist simultaneously. The property must be able to increase rents with inflation, and interest-rate risk must be mitigated to avoid getting clobbered if the loan matures in a high-interest-rate environment. Gross rents need not match inflation percentage point for percentage point but must increase sufficiently to drive net-operating income growth faster than inflation’s rise. Additionally, with the right loan—for example, a fully amortizing loan—the financing becomes inflation hedged in and of itself, with the payments in each successive year being made with and less valuable dollars. Yet, finding a small- to mid-sized commercial property with the pricing power to increase rents that is also attractive to lenders is no small feat in this market.
The recovery in trophy properties will not trickle down to Main Street in short order, giving small investors a feast of their own, despite the emerging euphoria east of the Hudson. If there is one fact we have learned in the last five years, it is that the rules for the smaller real estate investor are not the same as those for the Wall Street elite, and care must be taken not to fall prey to that belief.
In the words of Piano Man Billy Joel in his hit, “New York State of Mind:” “It comes down to reality.” Reality is in short supply these days, and therefore has high value to those who seek it. Reality is also the bedrock of sound investment decisions. If you are as bullish as Wall Street wants you to be, your reality is not real.
