Paying Attention to the Risk from Deleveraging in Commercial Real Estate

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Lost in the developing cap-and-trade industrial train wreck (with the Rudd government trying to shame the rest of the country into following America’s foolhardy lead), no one is paying attention to the risk posed to asset values by deleveraging in the commercial real estate sector. Be warned!

Standard & Poor’s is preparing to downgrade some $235.2 billion of commercial mortgage-backed securities (CMBS), according to our friend Dan Ferris. When these downgrades occur, the banks and insurance companies that own this paper are going to have a big problem,” Dan says. “Prices are already down around 25% in the past year.”

Hmm. How do you think Australia’s banks and insurance companies would fare if a larger downturn hurt commercial real estate values? Do you think the bad loan cycle Cameron Clyne referred to yesterday might be even more vicious?

We do. Banks want to survive, of course. And they’ll do so by being more prudent about their lending. We’d also expect them to retain more earnings rather than paying them out as dividends. This means if you’re looking for dividend paying stocks, you may have to look harder.

But it’s all a process of repairing the corporate balance sheet to correct the lending excesses of the bubble. It’s happening at the household level too, with savings rates rising. This, by the way, is an ominous sign for economies that are based on consumption, like Australia, the U.K. and America. De-industrialising political policies seem to exacerbate the weakness of these economies (which are structurally vulnerable to begin with, but no one ever said politicians had the people’s best interests at heart. The political class has become a modern-day oligarchy, concerned only about its re-election and wealth preservation (often at the public expense).

Economist and Nobel laureate Edmund Phelps told Bloomberg this weekend that it may take as long as 15 years for households to rebuild what they lost in the recession. In America, that’s the $14 trillion in wealth (via shares and real estate) that’s been wiped off net worth since the bursting of the credit bubble. “The only way we’re going to get a healthy, full recovery is over a long period of time, involving households rebuilding their balance sheets…There’s no silver bullet that’s going to get us into good shape quickly.”

Check out the chart below, courtesy of our old friend Chris Weber. We are often asked how the Aussie dollar price of gold can go up when the Aussie dollar itself is getting stronger relative to the U.S. dollar. Chris shows that all currencies have been declining against real money since 2000. It’s a case of competitive devaluation.

In the case of the Aussie dollar, what’s good for Aussies touring abroad (a stronger currency) is not as good for manufacturers, who desire a weaker currency. “Since about 2001,” Chris writes, “whenever any currency rises too much, the local manufacturers or farmers – or anyone who lives by exporting – start to scream about it. Their local governments respond by doing all they can to lower the value of that currency, having it fall in value and thus making exports cheaper, all this in the hope that the domestic economy will become better.”

“Pick any period so far this young century and you’ll see how this is true. For instance, right now you see it in those countries whose currencies have soared the most in the last few months….As all the countries with unwanted strong currencies move to cheapen them by printing more money, slashing interest rates, or just ‘talking’ it down, the question remains, just what are those high currencies declining against?”

“If you answer, ‘against the currencies of their main trading partners,’ well, yes, this is true. But it is only temporary. If they are successful in this, then the trading partners don’t want their own currencies to go too high, so at some point they try to cheapen them.

“It has become an endless round-robin game, except to call it a ‘game’ is a little perverse. All holders of currencies suffer in the decline of the purchasing power of their money. You go lower, but then your partners go even lower, and then you have to cheapen your money yet more… It’s an endless cycle that really doesn’t help the world economy in the long run.”

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. I’m getting really sick and tired of the DR/Money Morning etc just bagging anything to do with any program seeking to reduce our reliance on fossil fuels where we don’t need them, or reducing pollution etc etc

    Waxman Markey was needed.
    Carbon taxes or ETS’s (or whatever), to cap emissions are needed.

    You guys are NOT, as far as I can tell, climate scientists, so stick to finance please – you show your utter ignorance apropos the need to act on climate change by your continued snide references to anything climate change related.

    The free markets and ability to run businesses and make money (as I do) won’t even be relevant if we don’t have a sustainable economy (sustainable environmentally and energy wise)

    Cheers
    Tim

    Reply
  2. Gotta agree with Tim, above. You guys are starting to sound like Denninger on climate change.

    I’m a fan of sound-money, suspicious about fractional reserve banking, aware of the egregious theft that Fed-bailouts (overtly) and inflation (by stealth) represent, but save me the swaggering red-neck “guns, foon ‘n ammo” climate change denialism, ok?

    Right-wing republicans deny climate change (despite significant-not complete – but, *SIGNIFICANT*) evidence to the contrary for ONE reason: it affects the fortunes of the incumbents whose interests they most frequently serve.

    On this issue, DR runs the risk of endorsing positions that are going to look as awkward in 10 years from now as all those people who defended Phillip Morris back in the 70’s/80’s and claimed smoking didn’t cause cancer.

    Oh, PUH-LEESE.

    Reply
  3. Tim and DH,
    So what about the risk from de-leveraging in commercial real estate?

    Tony Hansen
    July 1, 2009
    Reply
  4. DD: “This, by the way, is an ominous sign for economies that are based on consumption, like Australia, the UK… ” To compare the UK and Australian economies may be a tad simplistic, Dan, doncha think? Our resource base may point to some subtle differences, surely? Your quote: “… it may take as long as 15 years for (US) households to rebuild what they lost in the recession….” is more to the point. Youngest son (24) is currently featured in a reality show set in a Las Vegas mansion with two swimming pools, valued at $7 mil, but currently for sale at $2 mil. He’s awed by property values there. Owning Australian properties himself, his perception is the Australian and US property scenes are incomparable… much I guess in the same way as comparing the Aussie economy with that of the UK.

    Biker Pete
    July 1, 2009
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  5. @Biker Pete, your view is fine within it’s boundaries but it is oft repeated. Concentrating on proving that you’ll be right even as all burns around you eventually wears thin. There are few cashed up enough to hop on your strategy. If your res investments are more toward the top end of the market as you have indicated you may even need to turn your places into boarding houses at some point and the vista of some of your locations may not produce income at all in a deep trough. But you do have horsepower so why not add some value here.

    Deep current account deficit countries (the anglo’s+Spain+Eastern Europe) have to fund their debts. Debt was too cheap, risk wasn’t priced, and asset prices rose exponentially. If debt is not cheap any more, or the debt-income paradigm changes like in the US where you could buy a house without having half an average income, there are issues. Just because Australia doesn’t have anywhere near as much in the mortgage book in the latter category doesn’t mean the former gets diminished.

    Look at Spain, the Euro gives them shelter just like commodities gives Australia shelter, but then have a look at the recent spike in the unemployment rate and the tax receipt collapse. In Australia we have maintained and increased residential real estate lending (see APRA monthly figures) which is not the case in any other country in the world. This has been achieved at the expense of sharply reduced lending to the business community and the banks failing to fill the hole left after the collapse of direct borrowing for business from the offshore bond markets and foreign bank subsidiaries.

    So the govt has chosen to avoid a consumer sentiment crash resulting from a residential real estate asset crash but is driving the real economy toward a wreck and the tail whip will just hit the phony asset prices harder when unemployment meets among the worst household debt-income ratios in the world. The prospects for commodities and the dollar and our new service economy are now the centre of our economic world. Household debt-income ratios will normalise because the bubble has burst on the govt and bankers and if nothing else Basel III will get them and knock down their phoney balance sheets with raw leverage limits.

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  6. Tony

    Everyone who is in a so called “balanced” super fund allocation is at high risk as the deleveraging continues over the next 2 or three years.

    Dan is also trying to say that there is significant excess capacity in the sector as the type of world such real estate was built to support no longer exists. Yeah its a bit of a blanket statement but the intention of the article is not to provide specific investment advice. Clearly, some types of commercial property and locations will be in more demand than others.

    In saying this, Gen Xers and Gen Y’s may still do well out of commercial property IF they tick it as an investment allocation AFTER the deleveraging finishes. I recall people in my grandparents generation talking obout how they or others picked up quality property during the Great Depression for a hundred quid or so (ie. nothing!).

    cheers

    Coffee Addict
    July 1, 2009
    Reply
  7. Sorry Tony. I now realise that you were pointing to responses that should be on another thread.

    Coffee Addict
    July 1, 2009
    Reply
  8. The central banks of the world have engineered this economic collapse. It will be way worse soon.

    Central Banks = Most successful crooks ever!

    Reply
  9. Horsepower, Ross? Or do you mean Whorespower? I should rent out beachside homes to madams, perhaps? Seriously, I take your point about the discomfort at level of risk it would take to do it all again, now; but I think we could. I enjoy working outside, as an unskilled or semi-skilled labourer, adding tens of thousands in value to each new house we build. (My days as CA are over… but I can still enjoy a thermos on my self-appointed breaks.) The future scenario you paint is a little amusing. I’m able to enjoy summers in the NH annually… four to six months at a time. The flights are all free, too. Pete puts it all down to age, yet I know very few BBs who have our options, flexibility and mobility. Yes, I’m a Very Tiny Tiddler, who enjoys the horsepower of classic motorcycles, content to let the rentals motor along quietly… . :)

    Biker Pete
    July 1, 2009
    Reply
  10. Had a chat to a feelance madam about setting up a business when the heat went off the industry a few years ago in Qld Biker – The advice: Staff management issues are a BIG hassle. And the best ones go private anyway. Nah, stick to more conventional investments unless one has found a niche market … Madam Lash and her ideas re members of the judiciary were thought provoking though … And could potentially help keep a smile on a bloke’s face if he ever did have to front a shoulder length horse hair wig wearing representative of the Old Bailey? Cheers!

    Reply
  11. Ha, ha… enjoyed that, Ned. I had a free lance, once!

    Biker Pete
    July 1, 2009
    Reply
  12. End of conversation I think Biker? We are supposed to be making money – Not having fun??? I’ll just have to take your missus word for the fact you have a point!

    Reply
  13. Enough punishment! Was having so much fun in the Parkside’s garden reticulating, I forgot to eat. Off to find a pizza. I’ll be off to find the missus, Tamara. Feel a little like a fly-in/fly-out mineworker these days, Ned.

    Biker Pete
    July 1, 2009
    Reply

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