Skeptical CPI Index vs. "Real" Estate Values

PIMCO's Bill Gross makes an outstanding argument --U.S. CPI Index is understating inflation!

If you haven't heard, Crude Oil futures are on a run-away train headed for a "Super Pike" in price chart formation. Crude Oil Futures even after adjusted for inflation are higher than they were during 1970's Oil embargo. Friday's NYMEX close for the sweet crude hit $129.07/bbl with Boone Picken's (the legenday Guru Oil Trader) predicting crude at $150/bbl before the end of the 2008. I believe just about everyone can feel the effects of higher fuel costs and how inflation is starting to spread into everything we purchase. Higher fuels, foods, metal prices are reacting to the increase costs of production due to higher energy costs. So, as investors we have to take our heads out of the Canadian Oil Sands and consider the effects of energy inflation and what that means for our investments in real estate particularly in low cap rate markets like Las Vegas, Nevada.

First, you must realize that this inflationary cycle will rhyme with those of the past, but will be very different at the same time. You can and will have deflation in some assets while inflation in others which will confuse most investors about their investment allocations. Currently, we have deflation in residential real estate but inflation in commodities like corn, wheat and gold. Both are hard assets and when you listen to comments from CNBC commentators and analyst suggesting to buy hard assets, you might think...well my real estate is a hard asset...it's an inflation hedge...so I'm fine. This is could be a deadly misinterpetation ...for the following reasons.

The Cause....Inflationary Pressures are Growing Fast!

In the June 2008 outlook written by Bill Gross of PIMCO he clearly states an important hypothesis on how the U.S. consumer price index (CPI) is understated, and how the global inflation rate for most of the world is now 7 percent and how our government has manipulated our index to the benefit of themselves and corporations on Wall Street.

(Readers FYI: Bill is being critical of the Federal Reserve and Washington's economic policies ; Emerging economies were partly to blame for America's housing and credit bubble (the Minsky Credit Cycle). As China and Gulf oil exporters purchased American Treasury bonds in order to hold down their own currencies so that they could continue to import to the USA, this demand pushed down U.S. Treasury yields and helped to fuel the housing bubble with negative real interest rates).

"But the number is also critical in any estimation of bond yields, stock prices, and commercial real estate cap rates. If core inflation were really 3% instead of 2%, then nominal bond yields might logically be 1% higher than they are today, because bond investors would require more compensation".

Bill's point is very clear, Bond Yields and Cap Rates are too low for the amount of inflation risks investors are taking due to the government's understatement of the headline inflation. A readjustment is about to occur in our economy and with devastating consequences...many investors will blame our government just like homeowners are blaming their lenders for their dismisses. A readjustment in inflation expectations means a readjustment in asset prices...here's another quote from Bill's June report!

"A readjustment of investor mentality in the valuation of all three of these investment categories – bonds, stocks, and real estate – would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate".

WOW! -- a downward adjustment of 10% in commercial real estate -- 5% in treasury bill/bonds can you imagine the devastation and havoc that would spread throughout the real estate industry -- the national economy? Bill Gross' opinions of headline inflation (CPI) is actually closer to the global 7% rate and he is not alone in his thinking. An article was written in the Wall Street Journal by David Ranson, head of research at H.C. Wainwright & Co. Economics titled "Inflation May Be Worse Than We Think." He too believes the "headline" consumer price index should be viewed with skepticism. The root of the confusion is the fact that the prices consumers actually pay change far more quickly than the CPI. His article goes on to claim, historically, CPI inflation is more closely related to prior changes in the price of gold than most people realize.

"There is a remarkable parallel between annual CPI Inflation and the cumulative change in the price of gold measured from eight years before".

This statement is worth its weight in gold...pardon the pun, but it gives an excellent formula for forecasting future inflation (or, correct inflation for us gold-bugs). Here's David Ranson's formula and calculations:

225% appreciation in gold ('2000-'2008)/80=2.8% + 3% = 5.8% Inflation

This formula above is the rule of thumb used by Ranson to estimate CPI Inflation at any given time: Divide the percentage change in the gold price from eight years in the past by 80, and add three. In the last eight years the price of gold has risen 225%. The rule therefore comes out with an answer that puts inflation a lot closer to 6% than 4% currently quoted. This makes perfect since as the U.S. Dollar has depreciated nearly 30% versus its competitors since the late 90's.

The Effect....Higher Treasury Yields and Cap Rates!

Can you imagine the consequences if investors some day woke up and realized that their compensation for risks were too low?. That the U.S. Government had understated the real rate of inflation? As everyone rushes to the exits...you would have simultaneous bouts of inflation and deflation in real estate. Lenders would adjust mortgage rates abruptly -- Spreads to them would nearly double and entry cap rates would need to increase immediately in order to regain positive leverage in real property values. Here are more possibilities...I bet you can think of others:

• Exporting countries would stop buying U.S. Treasuries increasing yeilds
• Gold prices begin to spike towards $2,500 per oz.
• Increased demand for real estate with short-term leases (Apartments!)
• Slacking demand for real estate with fresh long-term leases (Industrial, Retail)
• Increased demand for real estate with expiring long-term leases
• Difficulties in refinancing as values fall
• The drop in consumer spending would deepen (hurting Retail further)
• The return of creative financing as traditional sources become scarce

I'm sure your imagination can go on and on, or your memory of the early 1980's will flash before your eyes and you have to say...what is this real estate really worth?

Technical Analysis for Real Estate

Technical analysis is no longer just for Stocks and Commodities trading. The S&P/Case-Shiller Home Price Index was created by Robert Shiller of Project Syndicate blogging fame. Not only can you create your own custom index of real estate prices both regionally and nationally, but also chart where housing prices were historically.


For example, the most recent report, released in spring 2008, in home-buying time, says that prices in Las Vegas are down 20.76 percent back to their June 2004 pricing levels. So, if you are looking for real estate timing indicators, visit http://www.macromarkets.com/.

The above chart was created from a free down loadable excel file from macromarkets.com. Here I used, Los Angeles as the S&P/Case-Shiller Index and San Diego, Las Vegas and Phoenix for tier markets. This is an excellent tool to review the past real estate cycle and their correlations.

Las Vegas Apartment Vacancies Rise Again!

Apartment vacancy in Las Vegas rose to 9 percent in January, up from 8.4 percent in December. The breakdown by class shows 7.76 percent for Class A, 9.38 percent for Class B and 9.67 percent for Class C, as reported by CB Richard Ellis.

The Las Vegas Strip Ignors the Slowing Economy

In today's business section of the Review Journal/Wall Street Journal Sunday was an article entitled "The R Word" describing the effects of a slowing economy here in Las Vegas. Of the three page article, I found the comments of Dick Rizzo, the Western Division chairman of Perini Building Co. comments best reflects the anecdotal evidence I use to time the cycle in our economy. Perini is building CityCenter and Cosmopolitan in Las Vegas and has a backlog of two more huge projects on the way, though Rizzo wouldn't identify them.

"We have a unique perspective into the future because we get invited to meetings two and three years in advance of these programs and I can tell you tha the list is significant," Rizzo said from his Las Vegas Office. "People are still able to justify and finance significant new programs in the next three to five years."

Meanwhile, Las Vegas' employment growth has slowed to 1.1 percent with a total work force of roughly 945,000. And unemployment has crept up to 5.6 percent. Roughly 15,000 jobs were lost in the construction industry, which accounts for 11 percent of total employment, twice the national average. Other posts on this blog point out that the recent construction lay-offs are resulting in Class - C apartment vacancies reaching 9 percent.

Rizzo siad it's important to distinguish that most of the job losses came from residential construction, not commercial. He tracks the union employment base monthly and said availble manpower for the mostly union crafts people used for Strip construction has increased.

The sheer size of Strip projects adds thousands of workers at each site. CityCenter has 6,000 to 7,000 workers now on site and will peak at 8,000 in mid-2009, Rizzo said.

Las Vegas Apartment's Increase in Vacancy

CB Richard Ellis reported that Las Vegas apartment vacancy at 8.4 percent in December up from 8.11 percent in Novembers 2007. Vacancies for Class - A is 7.6 percent of the total 26,900 units in this segment; Class - B units were reported at 8.48 percent; and Class - C came in at 9.06 percent.

Take another look at the previous articles labeled "Charts" in the right margin. These reported vacancies substaniates my views regarding higher capitalization rates and vacancies for the Class - C market in 2008.

Could Immigration Trends Hurt Las Vegas Apartments?

During a recent market study I noticed an alarming new trend. A trend that was confirmed by a recent phone conversation I had with a client, a substantial apartment owner here in Las Vegas and Phoenix. The trend of a slowing economy coupled by new immigration laws that are beginning spreading throughout the southwestern U.S., (i.e. Arizona & Texas) has suddenly caused properties with Hispanic demographics to increase in vacancies.This dilemma was brought further to light recently with the decision from Framers Branch, a suburb of Dallas Texas in their recent Ordinance 2952. Farmers Branch City Council unanimously approved the ordinance which would require all renters to pay $5 fee and claim US citizenship or legal immigration status to obtain an occupancy license from the city.

This new ordinance will bar illegal immigrants from renting homes and apartments in Farmer Branch. Key provisions:

*Prospective tenants would have to apply for an occupancy license.
*The application form will ask whether the person is in the U.S. legally.
*Anyone who completes the form and pays $5 will get a license and be allowed to move in.
*The city will verify noncitizens’ legal status through a federal database.
*Anyone identified as being in the U.S. illegally will get 60 days to prove otherwise.Violators – tenants or landlords – will face fines of $500 a day.

http://www.dallasnews.com/sharedcontent/dws/dn/latestnews/stories/012308dnmetfbrentals.2c1fcca.html

The State of Arizona as well, has a new law that went into effect January 1st, with strong penalties for employers hiring workers without legal status. Today, Arizona Employers hiring these workers could suffer a suspension of their business license for 10-days on the first offense plus fines; revocation of their business license on the second occurrence. Many hardworking Latino workers have begun leaving the Sun Devil State in the past few weeks, seeking employment elsewhere.

There are no such laws that I'm aware of in Las Vegas....Yet...but the word on the street is many employers are cracking-down on documentation for employment. When combining the slow-down in local housing construction where a great many Latino workers where employed and this budding trend against immigration. It is easy to build a hypothesis for higher vacancies going forward for Class - B/C apartments in Las Vegas. In today's apartment investment environment, investors demand purchasing buildings on actual operating income and expenses. Gone are the days of acquisitions based upon Pro Forma (a method of betting on the future) and higher vacancies equate to higher risks. 2008 could experience a widening spread in capitalization rates between Class - B/C apartments and their Class - A counterparts.

As reported by the RERC/CCIM report, surveyed institutional investors responses found the required going in capitalization rate for Las Vegas apartments is 6.0% as of 3Q2007. The terminal (exit) capitalization rate is 6.8%. The required pre-tax yield for Las Vegas apartment properties is 8.5%, a 20 percent increase from 2Q2007. I would suspect in 2008 Class – B/C properties should see an increase in spread of 130 basis points beyond a typical Class – A property. That would equate to approximately 7.3% capitalization rates for 2008 transactions. Guess what?...we’re already there and beyond!

Look for Cap Rates to Head Higher

Click on Graphic to enlarge


With strong local fundamentals for apartment investment and healthy prospects for employment growth supporting apartment values. Cap rates were averaging in the mid-5 percent to low-6 percent range for most of 2007. The accompanied chart reflects data collected through 3Q2007 and primarily Class-A assets. Investor demand is strong for A product in A locations, and for B product in B locations of the valley. Only in the past few months of 2007 have I noticed that Class-C rates have begun to compress - in the high-7 percent range...I think they may head even higher.


I predict investors going forward will require higher yields on their investments...(cap rates), and acquisitions based upon pro forma is basically a non-starter. Especially for Class B/C properties under poor management or locations. If the property can't show a cash flow at acquisition it will be difficult for the investor to finance these deal, thus causing cap rates to increase in order to clear the market.


Cap Rates may rise across-the-board but the gap between Class-A and B/C may widen further. For the past few years B and sometimes C properties have been trading at the same cap rates as prime Class-A. For well located, well managed deals, I've been successful in selling those deals that are true value-add with prospects for redevelopment. That should continue for 2008 as well. But, owners in off-locations may need to buckle-up, their ride may get rough.


In summary, Class A in A locations - expect their cap rates to increase 25 to 50 basis points and Class C in challenging markets may reach 130 basis points higher.