By Tom Wight
On Tuesday the Fisher Center held its 41st Annual Real Estate and Economics Symposium. In one of the most highly anticipated presentations of the year, Fisher Center Chairman and Haas Professor Emeritus Ken Rosen provided an audience of 350+ with unique insights into the current state of the economy and real estate market followed by his economic forecast.
Dr. Rosen covered a broad range of topics and I have done my best to distill them down into three big takeaways. Please note that I am paraphrasing unless directly quoting. I’ve also included a few of his slides with brief explanations below.
Takeaway #1: A Sugar High for the Economy
A memorable takeaway for me was Rosen’s characterization of the current administration’s financial stimulus package as an unnecessary “sugar high” for the economy. Consumer confidence is at its highest level in over a decade, and we are experiencing a “red hot economy today – too hot.” When the economy is firing on all cylinders with full employment we should be collecting higher tax revenue to offset spending and moving toward a balanced budget, or as Rosen calls it, “macroeconomics 101.” Instead we are running a huge deficit. Compounding the issue is a “monetary policy has been the easiest in the history of mankind.” We now have a “business-minded” Fed which is working to normalize (i.e. reduce) the Fed balance sheet. As Rosen succinctly puts it, “Unfunded tax cuts and increased spending in a full employment economy leads to higher inflation and faster normalization of monetary policy.” We could see violent swings in the markets and can expect inflation to accelerate. And when there is a recession the Fed will not be able to cut taxes further. Not to mention potential political headwinds caused by legislative gridlock, investigative hearings, and possible government shutdown.
Takeaway #2: Several Global Concerns
Rosen says we shouldn’t blame China for our trade deficit since it really stems from American companies sourcing cheap goods abroad. “Walmart and Target are Chinese outlet centers.” He believes that imposing tariffs on China is an overreaction with consequences, like “using a sledgehammer to crack a walnut.”
Rosen was concerned with a potential economic meltdown in emerging markets. This is because as USD strengthens and interest rates rise, external trade deficits and debt service repayment could be unsustainable for these countries that borrow in USD. Chinese developers who have borrowed in USD would also be affected.
Rosen believes that the current administration’s restrictive immigration policy is just plain dumb. Economic growth is largely driven by population growth, and 45% of our population growth can be attributed to legal immigration. By reducing this number we are only hindering the growth of our economy.
Takeaway #3: A Tech Bubble in the Bay
Everyone knows that the Bay Area economy is driven largely by the booming tech industry, which in turn drives our real estate market. This means we face unique challenges at this stage in the economic cycle. For example, while the national unemployment rate is 3.7%, the Bay Area unemployment rate is a miniscule 2.2%. This labor shortage is a result of rapidly expanding tech companies competing to hire the best talent from a labor pool that increasingly cannot afford to live here. The high cost of living, along with high state taxes and lower federal tax deductions means that job applicants have no choice but to look elsewhere.
To make matters worse, Rosen believes there currently exists a technology valuation bubble. Tech company valuations are very dependent on capital markets, where Rosen believes we are experiencing a bond bubble. If there is a correction in values then tech companies will no longer be able to hire in advance of profits. As it relates to commercial real estate, expansion-minded tech companies that advance lease 2x – 4x as much space as they currently need would pump the breaks. For these reasons, Rosen believes that the Bay Area and other MSAs that are most dependent on this sector will see the biggest corrections.
Conclusion: Rosen’s Economic Forecast
In short, Rosen believes we have 12-18 more months of runway before a possible recession. Why? He believes long-term bond interest rates will rise in the next 3 years due to inflation and monetary policy. With the value of real estate dependent on cap rates, and cap rates dependent on long term interest rates, it is likely that cap rates will rise and values will fall. He thinks cap rates will rise 50-100 bp, with the biggest move being in the retail sector. He believes that real estate investors focused on value-add strategies will be best equipped to ride out the storm by offsetting higher cap rates with increased cash flow and therefore maintaining values.
Rosen also mentioned senior housing, industrial, and self-storage as product types that should continue to do well over the next two decades. Finally he thinks that borrowers should “Harvest” gains now though selling or refinancing.
I found the following sides particularly helpful in understanding these topics (please click link for slides):
Risks to Economic Outlook
A summary of topics discussed at length during Rosen’s presentation.
10-Year Treasury Spread to 2-Year Treasury
Rosen mentioned that when the spread between the 10 year treasury and 2 year treasury inverts, it always predicts a recession. If that dynamic holds true we could be getting close.
Why Long Term Bond Interest Rates Will Rise in 2018-2020
Global inflation, Fed raising short term rate target, increased deficit and reduced balance sheet, and extreme monetary expansion by ECB and bank of Japan.
10-Year T-Bond Forecast
This graph shows the 10-year bond forecast with three possible scenarios. The top curve in green is the implied curve if the Fed’s guidance is taken at face value. The middle curve is the market’s prediction (the forward curve). The bottom dotted curve is Rosen’s prediction if there is a global recession and investors rush to safety.
Economic Outlook for 2018-2021
Rosen predicts stable GDP and job growth for the next 12-18 months although with a continual rise in bond rates and inflation. He believes that we are likely to experience a recession sometime in 2020.
Cap Rates by Product Type
Nationally Cap Rates appear to have bottomed out in 2016.
Late Cycle Investment Implications
Advice for Lenders, Investors, and Developers at this late stage in the cycle.
Tom Wight is a Vice President at NorthMarq Capital in San Francisco. He can be reached at twight /at/ northmarq.com.
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