Last week I gave two presentations to individual investors, clients of a financial adviser that offers Grubb & Ellis’ healthcare REIT on its platform of investment alternatives. At the last minute, the adviser asked us to yank some slides specific to real estate and focus more broadly on the economy. That left plenty of time for Q&A, which often ends up being almost an afterthought at many presentations, but this time it was a central part of the event.
My colleague Chad Hunt, a wholesaler who represents Grubb in the Upper Midwest, took notes and had me write up my responses afterward. So here they are — my short answers, sometimes more like opinions, to a wide range of questions on the economy. Take what you like and leave the rest, and be sure to let me know if you disagree. Let’s get some discussion going.
Q: Distinction between public versus non-traded REITs
A: Long-term returns are solid for both types of investments with public REITs holding the edge recently, but that comes at a price of greater risk. Publicly traded REITs are volatile like stocks, which also means they are more liquid than non-traded REITs. Non-traded REITs pay a steady dividend in the range of 6-7% with the anticipation of some upside when the properties are sold.
Q. Easy fix for social security?
A. Solutions include: increasing the age for partial benefits from 62 to 63 and full benefits from 67 to 68 for people currently in their 20s or 30s, giving them plenty of lead time to plan; some form of means-testing, i.e. reducing benefits for wealthier recipients; and eliminating the income cap (currently $106,800) above which workers are not taxed for social security.
Q. What drives prices of gold, commodities & oil?
A. Gold prices are driven almost exclusively by speculation, usually related to fears of economic collapse and/or inflation. Short bursts of speculation play a supporting role in prices of energy and commodities, but underlying demand fundamentals related to economic growth play a bigger role over the longer term.
Q. Are municipal bonds in trouble? Meredith Whitney says there will be dozens of significant defaults in the next year or so, shaking investor confidence in muni bonds.
A. Most analysts think that is overdone. Revenues in many states have bottomed and are beginning to grow again, and the same dynamic is in place for municipalities. The exception will be for jurisdictions that have made unwise investments such as Harrisburg, PA (renovation of city’s trash incinerator) and Orange County, CA (dangerous bets on the direction of interest rates in 1994). That said, states and municipalities still must make tough spending cuts to balance their budgets, and some troubled states such as Illinois are having to pay high interest rates to sell their bonds.
Q. Stimulus package: Was it warranted?
A. Economists are split. Some say there is no such thing as a shovel-ready project, so those expenditures didn’t perform as advertised, while funds given to states and municipalities merely postponed the cuts that are being made now. Others, including me, think the program was worth the cost because it helped restore confidence in the global financial system.
Q. If government eliminates Fannie Mae and Freddie Mac, what effect will that have on the housing market?
A. Impacts will include greater use of variable rate mortgages and less reliance on 30-year loans (shifting interest rate risk to borrowers), fewer subprime loans, and less investment in housing overall, which would shift capital to more productive uses. This is probably warranted as government policies resulted in too much capital being allocated to housing, particularly in the last decade. Some analysts believe private issuers and investors will fill most of the gap left by Fannie and Freddie so that the impact on loan terms would be quite manageable for borrowers.
Q. Which types of REITs are strongest?
A. In terms of underlying market fundamentals, apartments and healthcare properties are strongest followed, in order, by industrial, retail and office. The falling homeownership rate and demographics (the boomers’ kids) are driving demand for apartments. Aging boomers and the steady increase in healthcare spending are driving demand for medical office and other healthcare properties. The strong manufacturing sector, weak dollar, exports, business capital spending and a slow but steady recovery in consumer spending are driving demand for industrial properties. Shopping centers are benefiting from the release of pent-up demand that developed during the recession and also continued weak pricing power by retailers. Office properties are expected to recover last because demand is dependent on job growth, which is lagging.
Q. When will businesses stop expecting the government to bail them out?
A. I would argue that they already are. Governments are broke and have no money for handouts.
Q. Will Republicans & Democrats come to an agreement to cut the budget deficit?
A. Yes! … I hope. When push comes to shove, the parties will compromise.
Q. Is there a point of no return as we increase the debt?
A. Probably, but no one knows for sure. We are in mostly uncharted waters with the exception of the debt spike during World War II. Publicly held debt is projected to increase from 59% of GDP in 2010 to 77% by 2020. There is not a specific threshold above which the debt ratio becomes a threat to the stability of the financial system and the economy, but economists generally seem to prefer ratios below 60% and are made nervous by ratios above 80%. Uncomfortably high levels of debt could undermine faith in the dollar, causing investors to shun U.S. Treasuries. This, in turn, could cause interest rates to spike as the Treasury would be forced to offer higher rates, perhaps uncomfortably high, to attract investors willing to finance its debt, which would hurt the economy. Debt levels rise during recessions as tax collections fall and support payments such as unemployment insurance increase – that is normal and desirable. But the long-term rise in the debt-to-GDP ratio even after the economy recovers could pose danger to the financial system and will likely require increased taxes, reduced entitlement spending or a combination of both to return the ratio to a lower, more sustainable level.
Q. Is the government trying to monetize the debt?
A. Not intentionally. The Federal Reserve is trying to “re-flate” the economy by maintaining rock-bottom short-term interest rates and buying hundreds of billions in Treasury debt and mortgage-backed securities to keep long-term rates low (called quantitative easing). Fed officials would like to see inflation return to the range of 1.5 to 2% but will begin raising interest rates if inflation appears to be gaining momentum.
Q. Is inflation measured the same today as it was several years ago?
A. No. In 1999, the Bureau of Labor Statistics adopted a new methodology estimated to reduce the CPI calculation by 0.2 percentage points per year. Click here to view the explanation from the BLS.
Q. Will Internet sales reduce demand for retail space over the long term?
A. It will cause only a modest reduction in the growth of demand for bricks-and-mortar shopping centers, which is fueled by population growth (see below) and the gradual increase in wages. It won’t actually result in a reduction of shopping center space.
Q. When will the housing market recover?
A. Sales will begin to pick up during the spring selling season of 2012. Prices will not recover to their pre-bubble peak for five years or more.
Q. Is the saving rate impacting retail sales?
A. The personal saving rate, which fell below 1% during the bubble years and shot above 8% during the recession, has leveled off in the range of 5-6% while retail sales have been growing lately at a solid year-over-year rate of 7-8%. Consumers have made a reasonable compromise between reducing debt and spending for necessities.
Q. Why are companies sitting on so much cash?
A. Cash and other liquid assets on the balance sheets of nonfinancial businesses totaled a record $1.93 trillion at the end of the third quarter. This equated to 7.4% of their total assets, the highest share since 1959. Companies are stockpiling cash as a buffer against a potential future disruption to the financial sector that might hinder their ability to borrow. A wait-and-see attitude regarding the strength of the economy also is playing a role. When businesses feel more confident in the stability of the financial system and the durability of the recovery, they will begin to expand their payrolls, but not before.
Q. When will banks start lending again?
A. Banks are actively looking for good credits, but they are being much more cautious (rightfully so) than during the bubble years.
Q. Will lack of population growth in the U.S. restrain economic growth?
A. The annual rate of population growth is expected to decline only gradually from .98% in 2010 to .79% in 2050. In absolute numbers, this equates to a gain of 3.021 million in 2010, rising to 3.450 million in 2050. Even as the percentage growth declines, the absolute growth increases because the base upon which the percentage growth is calculated increases every year. Hence, the country will continue to grow, adding to the labor force, generating demand for housing, etc.
Q. If the budget is slashed, will that hurt the economy?
A. Liberal economists answer an emphatic yes while conservative economists say reduced government spending will take the pressure off interest rates, opening the door for more borrowing, spending and investing by private sector companies. Economists call this “crowding out,” when government borrowing to fund the public debt begins to compete with the needs of private borrowers, driving up interest rates. When the economy was in free fall, increased spending via the stimulus, rising unemployment insurance payments, etc. helped stabilize the economy at a time when there was little or no demand from private borrowers (except those desperate to stave off disaster – not the best credits) and thus little or no crowding out. It could become more of a problem as the recovery accelerates. With the recession in the rear view mirror, government spending cuts are unlikely to derail the recovery and could minimize the crowding out effect.
Q. What happens if gas goes to $5 per gallon?
A. It will raise the potential for stagflation – slowing growth coupled with rising inflation – but only if the price stays high over a sustained period of time, say six months or more.
Q. What is the long-term impact of the government printing money?
A. Printing money is one way to describe the Fed’s purchase of hundreds of billions of dollars in government and mortgage-backed bonds, i.e. quantitative easing. I believe the first round had a stabilizing effect on the financial markets at a time when it was sorely needed – late 2008 and early 2009. The second round (QE2) coincided with an upward run in the stock market, which helped ignite stronger economic growth at the end of last year. Many economists are loathe to admit that the Fed’s actions did any good, but I think they helped. Do we need another round of quantitative easing – QE3? Probably not.