February 1 – Following is my first guest post. Bruce Cumming, Jr. is the author. He can be reached at 941.926.0800 or bcumming@hettemasaba.com.
We would like to note that from an academic-business perspective real estate is viewed as a sub-discipline of finance, finance as a sub-discipline of economics and the classical economist such as Adam Smith and David Ricardo referred to their discipline as “political-economy” linking economies with the political mode of a country, state, county, or municipality. The following is some economic theory and emerging issue that could impact real estate values.
According to the Austrian business cycle theory, central banks (such as the US Federal Reserve System and specifically its Federal Open Markets Committee) can set interest rates too low for too long, which can create an artificial boom and distort the accuracy of data on a trend line basis, often causing what is termed “malinvestment.” According to an article by Mauldin Economics, based upon a graph of the US 10-Year Treasury Rates going back to 1790, 10-Year Treasury Rates over the long-term averaged just less than 6% and the average over the last 50 years was 6.58%. The current 10-Year Treasury rate according to the US Department of the Treasury is 2.06%, or about 394 basis points below the 200-plus year average rate and 452 basis points below the 50-plus year average rate. The Federal Open Markets Committee just increased its rate for the first time since December 16, 2008, on December 17, 2015. The Federal Funds Rate has been between 0% and 0.25% for 7 years. The Federal Funds Rate is now between 0.25% and 0.50%. The US stock market has been in rapid decline so far in January of 2016.
The McKinsey Global Institute’s report, Debt and (Not Much) Deleveraging, dated February 2015, reports that between 2007:Q7 and 2014 worldwide debt have increased from $142 trillion to $199 trillion, an increase of $57 trillion, or 40.14%. Debt has not been liquidated during the so called Great Recession, but has been increased, thereby potentially distorting asset values.
It should be noted that the Green Street CPPI: All-Property Index (which was started in December of 1997) was 22.7% higher in December of 2015 than in December of 2007, its previous peak. Green Street tends to focus on investment grade real estate and is tightly tied to the capital markets. The Moody’s/RCA CPPI, which focuses on repeat sales of properties greater than $2,500,000 in value, saw its last peak in 2007:Q3 (165) and reached that same level in 2015:Q3 (165). The trough reported by this index was in 2009:Q4/2010:Q1 (96), so the index has increased 71.88% from trough to peak.
Austrian economists theorize that the artificial monetary boom ends when bank credit expansion finally stops, which is when no further investments can be found which provide adequate returns for speculative, or “Ponzi” borrowers. The Austrian business cycle theory asserts that the longer the artificial monetary boom goes on, the more speculative and “Ponzi” the borrowing occurs, the more errors and waste committed, the longer and more severe the workout period (e.g., bankruptcies, foreclosures, and short-sales) until equilibrium is achieved through market-based price discovery.
The Austrian business cycle theory is one of the precursors to the modern credit cycle theory, which is emphasized by Post-Keynesian economists at the Bank for International Settlements and by mainstream academic economists such as the late Hyman Minsky (PhD/economics, Harvard). Post-Keynesian Minsky taught at Brown University and the University of California at Berkeley among others. Minsky’s financial instability hypothesis is translated to real estate markets by borrower type.
Minsky theorized that a key mechanism that pushes an economy toward a financial crisis is debt accumulation by the private sector. He identified three types of borrowers: hedge borrowers, speculative borrowers, and “Ponzi” borrowers.
„ Hedge borrowers: can pay both interest and principal loan payments from current cash flows (e.g., traditional mortgage).
„ Speculative borrowers: can pay interest only loan payments, but must regularly roll over the principal (e.g., interest-only loan).
„ “Ponzi” borrowers: cannot pay interest or principal, and depend upon asset price appreciation sufficient to refinance the debt (e.g., negative-amortization loan), only asset price appreciation keeps the “Ponzi” borrower afloat.
If “Ponzi” borrowing is widespread enough during a credit boom when asset prices stop raising rapidly the “Ponzi” borrower can no longer operate profitably (or at all) and once asset prices start to decline the speculative borrower may not be able to roll over their loan principal and could face a technical, if not a real default. The final financial domino is the hedge borrowers who are unable to find loans despite the apparent soundness of the underlying assets. The market begins to unravel, that is to say, a “Minsky Moment” occurs.
Former PIMCO managing director Paul McCulley (MBA, Columbia) is credited with coining the phrase, “Minsky Moment,” when referring to the point in any credit cycle, or business cycle when investors begin having cash flow problems due to the spiraling debt incurred in financing speculative assets. At this point, a major sell off begins because no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden and precipitous collapse in prices driving market clearing asset prices down as well as a sharp drop in market liquidity. The “Minsky Moment” comes after a long period of prosperity and increasing asset values, which has encouraged increasing amounts of speculation using borrowed money.
Austrian economist Ludwig von Mises (PhD, University of Vienna) who taught at New York University theorized that a financial crisis emerges when consumers seek to reestablish their desired allocation of saving and consumption at the prevailing interest rate. The ensuing recession or depression is the process by which the economy adjusts to the errors and wastes (malinvestment) of the boom, or bubble.
It remains too early in the current cycle to confirm that a “Minsky Moment” has occupied, or if the current stock market activity is a short-term correction that will rebound in a few weeks, or months.
It should also be noted that during that during the last downturn vacant land decreased in value at a far greater rate than improved properties that could be income generating. A paired repeat sales analysis study that we conducted indicated that vacant land was declining at a rate of about 1.35% per month (rounded) versus improved sales that were declining at a rate of about 0.75% per month (rounded). Land was declining in price at an 80% greater rate than improved property.
Generally, entitlements are only worth about what they cost during a normal market and are “usually worthless” during a downturn, such as we recently experienced.
The current macro-level economic activities have not yet impacted real estate values, they may and they may not. Time will tell…
