Markets are a field where dumb things sometimes work. Ignorance can win; and experience can lose. This is just the nature of the game. Best to accept occasional absurdities then to shoulder the distraction of anger over them. Time cures most of these episodes anyway.
~ Ed Borgato
I know everyone has been focused on inflation lately, but this month I want to focus on shrinkage. I am sure you have heard and seen in the stores and eateries, smaller packaging, serving sizes and quantities for the same price. This is still inflationary, but they hope you won’t notice (or care). However, shrinkage isn’t just happening at the retail/consumer level. For instance, San Diego’s unemployment rate dipped (a good thing), but the job growth was largely in leisure and hospitality (lower paying jobs). However, the labor force “shrunk” by more than 15,000 people – that “shrinkage” is people moving elsewhere for jobs. San Diego also lost 12,800 office-using jobs in the last 12 months – now that is “shrinkage”!
There continues to be concern over the future of office properties, especially with large leases nearing expiration. Tenants are expected to “shrink” their space needs, putting pressure on landlords. The peak of defaulted office loans is yet to come. Some are predicting the office market won’t stabilize until around 2030. This is expected to affect larger offices more than smaller office properties. We are currently working on several solutions to this ongoing problem. Condominimizing allows a building to be sold off in pieces. Small business owners who couldn’t ordinarily buy a building can access ownership and all of its benefits.
As mentioned last month, tearing down buildings or converting them for multi-family or single-family (row homes/condos) is gaining momentum. The interesting “shrinkage” story here is that in tearing down or converting a building it comes out of inventory, thereby shrinking the vacancy rate (smaller denominator makes a smaller fraction).
As inventory levels drop and interest rates stay high, fewer properties sell. Fewer transactions mean less income for brokers. It is already a tough industry with 90% of real estate agents not making it. The number of agents will decline but they will rise again when they think there is easy money to be made. It has little to do with transaction volume; when it stops being easy, the part-timers and dreamers “shrink” away. Funny, we’re in the problem-solving business at CDC so we get busier. As John Wooden, the greatest basketball coach of all time would often reference the quote, “when the going gets tough, the tough get going.”
Well, one area not experiencing shrinkage is the minting of cash by our government! They are now printing at $2 million per minute! While we can argue whether the 10-year U.S. bond should yield, say, 4.5% or 4.65% – it is easy to lose sight of the fact that after being held hostage by zero-rate policies for almost two decades, U.S. Treasuries are finally reverting to their traditional role in the economy. It is finally a source of income that investors can look at and rely upon year after year, for years to come. The whole point of owning U.S. bonds is that they aren’t supposed to lose money, are less volatile and provide a fixed rate of return above inflation.
It is no secret that the reason Treasuries are high and back in demand is that after years of yielding next to nothing, holders experience brutal losses (as rates rose from 1% to 4.5%) in the face of rampant inflation and aggressive rate hikes to combat it.
Like the losses experienced by the treasury market over the last two years, I am concerned that commercial real estate (CRE) has not made a similar adjustment. Historically, CRE has a cap rate that runs about 2.5% to 4% above the 10-year Treasury. However, for the last 10 years money has chased yield that couldn’t be found in Treasuries and CDs, driving CRE cap rates lower and lower. As you will see in Nick’s Numbers below, only office has made the adjustment. If (or when) the other property types adjust, there will be a brutal loss in value.
Nick’s Numbers
This month’s numbers are very revealing. The colored lines give you the cap rate over the last 24 years. The gray shaded chart is treasury rate. Below the section title gives you the historic spread (bps *.01=%) and current spread.
If you would like an analysis of your properties’ value or discuss what you should be doing with regard to interest rates or inflation and their impacts on your business, tenants, or property, I’d be happy to talk. (Nick Zech, 858-232-2100, nzech@cdccommerical.com).
I started with a quote from Ed Borgato and I thought I would finish with another of his great gems. “To be a good investor you need to be a good buyer. To succeed as a trader, you need to be a good seller. The right way to trade is to hate yourself for selling, before you hate yourself for not.” Hope you enjoy the story…
Grandma in Court
Lawyers should never ask a Mississippi grandma a question if they aren’t prepared for the answer. In a trial, a Southern small-town prosecuting attorney called his first witness, a grandmotherly, elderly woman to the stand.
He approached her and asked, “Mrs. Jones, do you know me?”
She responded, “Why, yes, I do know you, Mr. Williams. I’ve known you since you were a young boy, and frankly, you’ve been a big disappointment to me. You lie, you cheat on your wife, and you manipulate people and talk about them behind their backs. You think you’re a big shot when you haven’t the brains to realize you never will amount to anything more than a two-bit paper pusher. Yes, I know you.”
The lawyer was stunned! Not knowing what else to do, he pointed across the room and asked, “Mrs. Jones, do you know the defense attorney?”
She again replied, “Why, yes, I do. I’ve known Mr. Bradley since he was a youngster too. He’s lazy, bigoted, and he has a drinking problem. He can’t build a normal relationship with anyone, and his law practice is one of the worst in the entire state. Not to mention he cheated on his wife with three different women. One of them was your wife. Yes, I know him.”
The defense attorney almost died. The judge asked both counselors to approach the bench and, in a very quiet voice, said, “If either of you idiots asks her if she knows me, I’ll send you to the electric chair.”
