When I was a boy I used to play quite a bit of Monopoly. After quickly getting bored with the liquidity constraints of the game, i.e. the paper money that came with the game, I devised a system to increase liquidity, much like the financial engineering that occurs on Wall Street today. But I didn’t make a corresponding increase in the number of assets, i.e. the properties on the board. I introduced my own form of deregulation, allowing the prices paid for properties to vary.
Not surprisingly, my property values magically increased and I became wealthier. Importantly however, property income levels didn’t go up. As I think back on that financial system I created I can now see a very important lesson: What matters most in a fiat-based economy is materially different than what matters most in a specie-backed economy.
In an economy using a specie-backed currency, such as gold, the income producing capacity of assets is very influential in determining asset values, because it is difficult to increase values through money creation. Conversely, in an economy utilizing fiat currency, the income generated from assets is relatively less important in determining asset values.
What becomes more important in determining asset values in a fiat-based economy? The answer is money supply and liquidity flows. Money supply, because once a currency is no longer tied to gold, you can increase its supply with the same impact as in my boyhood Monopoly games. And liquidity flows because where the increased money supply flows impacts asset values.
Let’s look at an example of how the increased importance of liquidity flows impacts the commercial real estate sector.
Liquidity Affects Values
In March 1999, the Tech Wreck occurred. Enron happened shortly thereafter. Fear over the drop in tech stocks, the shenanigans of Enron and what it could mean for other companies’ books spurred a significant increase in volatility in the equity markets. This combination of volatility and questions about Wall Street playing fair with investors led to an increase in the amount of money flowing into commercial real estate.
CMBS ballooned to an estimated $230 billion of origination in 2007 and private equity funds targeting commercial real estate swelled in the period from 2000 to 2007 as well. Much like the Monopoly economy I created as a boy, the commercial real estate values of 2007 were based far more on the increase in money flowing into commercial real estate than the actual income of the properties.
In 2007, income levels didn’t keep up with the increase in property prices, in the proverbial disconnect of asset prices from fundamentals. Some readers are undoubtedly thinking that the increase in values was justified because 10-year Treasuries also decreased from 2000 to 2007, reducing the cost of capital.
While Treasuries did decrease, the drop did not account for anywhere near the entire increase in values. Rather, the combination of a substantial increase in liquidity and the presence of yield-starved investors drove the spread between cap rates and 10-year Treasuries down. This is what drove values to historically high levels. Investors got paid far less for far greater risk. Why? Because of the increase in liquidity levels and the low yields being offered by alternative investments.
Tax receipts rise
As a result of this increase in property values, the governments of the world, as well as state and local governments in the U.S., experienced significant increases in their tax receipts. Not surprisingly, as with consumers, this led to significant increases in their spending levels as governments felt richer.
Unfortunately the increased tax receipts were not because of proportional increases in income at the properties. Rather, prices increased simply as a result of the excessive liquidity flowing into commercial real estate. And as we have recently seen this process can be reversed, leaving governments with shrinking tax receipts and increasing budget deficits.
Facing The Inevitable
Fast forward to May 10, 2010 when the European Central Bank became the latest central bank to undertake a policy of trying to prop up asset values. In this case the asset was the euro in the face of significantly lower income levels, i.e. tax receipts. Besides the obvious reasons, why is all this important? Because either the central banks of the world are going to be “successful” in propping up asset values across the board, which will likely result in significant inflation, or they will fail in propping up asset values, including their currencies.
That would result at best in a long period of slow growth, as occurred in Japan, or at worst a period of slow growth and high inflation otherwise known as stagflation. Both options will have far reaching implications for commercial real estate. Most importantly, whether we end up with slow growth or significant inflation the net present value of assets will decrease materially. In other words, they will be the mechanism by which assets will revert back to the mean.
In a slow growth environment properties purchased based on the assumption of significant increases in property income levels will not meet those underwriting assumptions and thus fall well short of their targeted returns. Conversely, in an inflationary environment that includes rising capital costs i.e. interest rates, properties underwritten based on historically low capital costs will also fall short of their targeted returns.
Higher capital costs will significantly impact annual cash flows as well as reversionary values. Some may question this because surely real estate can’t perform poorly in both economic scenarios. However, it is very logical when you remember that assets purchased during the last bubble were purchased anywhere from 30-40% above the long term average. Thus, what I have outlined under both options are simply the two likeliest means by which the overpriced assets will revert back to their long-term historical averages.
We Have A Choice
We are all desperately hoping that we can avoid the healing process that needs to occur, i.e. asset values and our currencies need to be reunited with the income producing capacities of the world’s assets and economies. Why hasn’t this happened? Because we all want to avoid the spending constraints that would be associated with the healing process.
This is no different than when a family chooses to accept that new credit card and max it out, accepts the card and pays down some debt, or rejects the card. Whatever the choice, the family’s income levels do not change, only its debt level changes.
And that is our choice today: get real to heal or continue to extend and pretend as a country. If you don’t believe me, break out your old Monopoly games. Double, triple or quadruple the Monopoly money and see what happens to values, regardless of the fixed nature of the underlying properties’ rent levels. Did the properties really become more valuable? Or did all the baseline values just shift up because the money being used wasn’t worth nearly as much?