Real estate is very important for the US economy. There’s comparatively little direct stock market exposure, however. This is in contrast with most other major world stock markets, where real estate development and real estate investment firms have major index weightings. In smaller, but historically important, markets like Tokyo, Hong Kong and Singapore, real estate has overwhelming influence.

Perhaps as a result of this, the US finance literature on real estate that I read in business school and over the first ten or fifteen years of my investing career (after which I stopped) was underwhelming The basic idea was the real estate was the king of asset classes. The reasoning? …real estate produces not only a larger return than other asset classes but much smaller volitility of return (the academic measure of risk) than stocks or bonds.

How embarrassing for the finance PhDs who wrote this–and who presumably never owned a house or an apartment. As any homeowner soon becomes aware, real estate transactions dry up in an economic downturn. There are few potential buyers, because they can’t get financing at a reasonable price. No one wants to sell in a downturn, either, at the steep discount the few active buyers will demand. So there are basically no transactions. The academic world of the 1980s-90s dealt with this lack of liquidity and the resulting dearth of actual price data by ignoring it, and assuming that prices remained at their boom time highs. This false assumption of price strength during downturns is at the root of the academic coronation of real estate as a superior investment.

The real world has always known better.

There are a number of listed homebuilders in the US stock market, as well as hotel companies. And of course there are REITs. But most exposure is indirect–financial institutions that service borrowers with real estate collateral or whose investment arms manage real estate portfolios for others; or building materials, equipment or maintenance providers.

Around the world, prime office space in urban centers has been regarded as the best–highest-return and most secure–type of real estate investment. That’s followed by upscale hotels and resorts (the main drawback here is sensitivity to the business cycle), with commercial real estate and housing bringing up the rear.

The factors favoring prime office space are:

–tenants are typically large, financially sound corporations

–contracts are for large amounts of space and usually extend for five years+

–landlords can mitigate risk by staggering the lease periods for different tenants

–the amount of available class A urban space is usually limited

–moving costs for tenants are high, and alternatives usually limited

–pre-pandemic, overall demand for office space has been rising, making existing projects increasingly valuable.

There is business cycle movement within office space. Typically during expansions, demand for office space expands from the city center into the outskirts of a city, but contracts back toward the center during recessions. And the overall long-term movement has been expansionary.

The peak of a cycle is typically marked by the completion of a mega- project, like Hudson Yards in Manhattan right now, that supplies massive amounts of new office space into a market that is levelling off and just about beginning to contract.

I was listening to a Bloomberg interview of the owners of Hudson Yards over the weekend. Management spoke of huge demand for office space in the complex. The New York Times tells a somewhat different story and points out that NY state is proposing large increases in office space around Penn Station, a few blocks away. What the HY owners didn’t talk about is the other big variable in evaluating real estate, the rental rate. Typically during a downturn, office buildings may keep the official rental rate unchanged. But they either offer deep discounts or other offsets like rent-free periods to lower the effective rental rate to induce tenants in older buildings to trade up.

The overall effect is that while the prime areas may do little more than break even, older buildings, especially in marginal areas, get clobbered. Some may never recover and will need to be repurposed. One issue is that it may be prohibitively expensive to convert bespoke office space into residences (the traditional solution).

The elephant in the room, of course, is the reluctance of remote workers to return to the office.

more tomorrow

what are they?

Public goods are things like roads, bridges, tunnels, schools, police, power generation/transmission…which either would not be provided at all for the average person by private companies or which would only be provided at much greater cost.

The theoretical underpinning of the Reagan/Thatcher revolutions of the 1980s onward in the US/UK is the neoliberal idea that there are no such things as public goods. A further claim is that state involvement in in their provision creates great inefficiencies and that the simple act of shrinking the state will cause lower-cost, more efficient private substitutes to spring up to take their place.

This hasn’t worked out well at all. The UK is the sick man of Europe, potentially nosing out Italy as that continent’s laggard …and, shockingly, in worse shape that Greece! The US is barely growing. Visitors make fun of our antiquated public infrastructure. And, of course, the rural poor left jobless by the modernization of the pre-WWII industrial base during the 1980s are so badly off that they could be persuaded by con men preying on them to try to overthrow the government.

the idea of creative destruction…

…is arguably the culprit. I like the idea itself. The metaphor of the phoenix rising from the ashes is very dramatic. Flames are always good. And if (counterfactually) one ignores the Marshall Plan, it serves as a reasonable description of the rebuilding of Europe and Japan after WWII. Hard to argue that WWII was a big plus because it allowed rebuilding to happen, however. The larger issue is that destroying stuff to make the world better isn’t how economics normally works.

I think of creative destruction as follows:

Department stores emerged as a thing in the 19th century. For the first time, you could do all your shopping in one place, with the assurance of a wide selection and the warrant of a minimum level of product quality. To some degree, department stores replaced the local retailer, but I think in many respects they also filled a vacuum. By the middle of the 20th century these retail palaces were everywhere.

During the 1970s in the US, enterprising retailers had worked out that not all departments were equally profitable. Things like toys, electronics, jewelry and some branded clothing lines made much higher returns than, say, furniture or home appliances. Connecting the dots, entrepreneurs began to mimic these stronger departments in smaller, more focused specialty retail stores that concentrated on only one type of goods. Selection was broader. Rents were lower. The new firms didn’t have the drag on profits of weaker departments. They were more flexible in shaping their offerings. Therefore their prices were lower. They could locate a block away from their department store competitor. And, again in the US, they were easily able to follow population shifts into the suburbs, so they remained closer physically to their middle-income audience.

There has been a further turn of the wheel since, with the emergence of Walmart, Target and Costco as newer, better-managed forms of multi-line retailing.

Luxury goods, once a staple of department stores, is a similar, though slightly different, story. In this case, many luxury goods manufacturers seeking stronger profit growth, and dissatisfied/alarmed by the deterioration of the department store category. have decided to capture the wholesale to retail margin by opening their own stores.

my point

Metaphors are colorful, concise and attention-capturing, but often inexact. In the real world, burning down the local department store is highly unlikely to get the neighborhood a Hermes store, a Starbucks and a Costco to replace it. Probably the opposite. And even in the phoenix legend, the old phoenix imploded by itself and then respawned.

Similarly, defunding Medicare or the VA won’t make people healthier or up enlistments in the military.

PS. Cutting taxes for the wealthiest–who have the lowest marginal propensity to consume–as a vehicle to force change is loony as well. Yes, maybe it generates campaign contributions or lavish vacations or kickbacks to your spouse, but it doesn’t generate econonic progress.

I know a potential domestic political/economic mess is looming over the next few weeks/months. For the first time in a long while, however, I find I have almost no clue about how events will play out.

At issue is the debt ceiling, a Congress-mandated limit on the amount the federal government can borrow to fund its operations. At one time, getting Congressional approval was routine. Over the last couple of decades, though, this has become a contentious issue.

The situation I think is most similar to today’s came during the Obama administration. Republicans demanded reduction of Medicare benefits as their price for lifting the ceiling. There was a small stock market decline just prior to an eleventh-hour compromise. Almost immediately after, however, S&P downgraded its rating on US Treasury bonds, apparently reasoning that for the first time there was a smidgen of doubt that the US would make interest payments on government debt. The stock market dropped by 10%+ on the downgrade.

The government was actually shut down by Trump in late 2018, when he refused to sign a spending bill passed by Congress because it didn’t contain funding for his border wall. What I think is important about this situation is that Trump quickly reversed course when he realized that voters (correctly) blamed him for the resulting reduction in government services, not Congress.

Perhaps learning from the Trump experience, Republicans, who oppose an increase to the debt ceiling without concessions to them, are not 100% about what they want in return for their votes. The general idea seems to be cuts in everything except defense, with special emphasis on programs for low income families. One innocuous-sounding item is a decade-long limit on nominal growth in overall federal government spending to 1% yearly. This, however, amounts to a 20% reduction in real government spending, assuming 3% annual inflation (although the Fed wants 2%, I think this is an aspirational goal rather than a genuine target).

Two other things:

–in the past, most of the negative stock market action around debt ceiling worries seems to have occurred in the few weeks leading up to an ultimate decision

–the leading lights on the Republican side seem to be more cultural performance artists in the Trump mode than actual legislators. So it’s not clear they’ve given much thought to what they’re doing. An analogy would be the DeSantis attack on Disney, his state’s largest taxpayer. Not only do I find the attack itself odd, but if press reports are correct–and I suspect they are–a key part of the evidence against DeSantis in the subsequent DIS lawsuit comes from a book DeSantis recently wrote. And he’s a Yale and Harvard Law graduate.

Anyway, I find this all hard to handicap.

What am I doing? Combing through my holdings, kicking out clunkers and (very unusual for me) not putting the money back to work right away. Experience tells me this is a bad idea. But experience is also not giving me much of a guide to what comes next.

What were they thinking?

I still can’t get over the “strategy” devised by the managements of these two failed banks.

A typical bank takes in deposits, which can be withdrawn relatively quickly, in savings or checking accounts or CDs. It makes much longer-term (meaning at least several years) loans to individuals (mortgages, car loans…) and businesses. Larger and longer-term loans loans may be variable rate and typically have protective covenants that allow the bank to change the rate or call the loan under specified conditions–usually if the borrower’s financial condition deteriorates.

For many loans, the bank chooses either to keep them on its own books or charge an origination fee and quickly resell them to another institution that includes them in an aggregate for sale to, say, a pension fund.

From what I’ve read, neither Silicon Valley or First Republic did much of this. Instead, at the most basic level, their specialty was to collect deposits from wealthy individuals, for whom they provided investment or concierge services. The banks avoided the expense of having an extensive loan department by investing these funds in long-dated US government securities. They also decided to pick up a little extra potential return by buying highly illiquid mortgage-backed aggregates created by other financial institutions. The downside of such securities is that their price tends to shift down a lot at the first whiff of selling pressure.

The banks “maximized” their returns in three ways:

–they didn’t have the expense of having big loan departments

–they picked up a few extra basis points in yield by buying illiquid bonds

–they had a very low cost of funds by relying on wealthy individuals (who were exposed to the risks of having deposits only partly insured by the FDIC).

Looked at slightly differently, the two banks seem to have made an all-or-nothing bet that interest rates would remain stable for a long time and that customers would be happy earning next to nothing on their deposits. In other words, both bet that customers would never withdraw their money, so they would never face the daunting prospect of trying to sell illiquid bonds in an unfriendly market.

The two banks put much of this structure in place while rates were at pandemic-induced lows. To put what they did in context, for a good portion of 2020, the 10-year Treasury yield fell considerably below 1%. 2021 wasn’t much better. The 10-year yield didn’t rise above the 2% level until well into 2022. Overnight money was yielding less than 20 basis points.

So the banks were paying out, say, 20 bp to depositors while collecting 2%- from their bonds. What could go wrong?

What did go wrong is this: if we assume the US economy can grow about 1.5% yearly in real terms and we have 2.5% inflation, then nominal yield on the 10-year should be around 4%. Overnight deposits should provide protection against inflation but no real yield. This implies bank deposits should yield 2.5%.

Two big negatives for our two banks:

–a bond yielding 2% has to be trading a lot below par in a 4% world, so they had enormous unrealized losses on their balance sheets, and

–20bp isn’t enough to prevent even the most loyal customers from shifting deposits to higher-earning vehicles like money market funds. These banks couldn’t pay competitive yields because they were getting 2%- (before their administrative costs) in. They also couldn’t meet requests by depositors for their money both because they couldn’t sell their investments and the proceeds wouldn’t be enough to pay all depositors.

What I still can’t wrap my head around is why the two would risk valuable franchises by making this transparently lunatic bet.

Another thing: During the Trump administration, banks like Silicon Valley and First Republic were exempted from the more rigorous federal supervision maintained for larger banks. Some have blamed this legislation for the subsequent failure of smaller banks. I think this is right, but not for the reasons I’ve read given. My (cynical) take is that the path of least resistance for managements and boards of directors of poorly-managed companies is to collect a salary, look the other way and hope for the best. This is much easier to do if there’s no regulator’s stress test that documents the parlous internal state of affairs–and the culpability of management for it.

the state of play, as I understand it

Don’t Say Gay

In an attempt to burnish his credentials as a 2024 presidential candidate, Governor Ron DeSantis orchestrated the passage of a bill in Florida that limits the ability of the state’s schools to permit discussion of LGBTQ issues. Pressured by its Florida employees after saying nothing about the bill, DIS–the state’s largest taxpayer and one of its largest employers–issued a statement in opposition to it.

a new tourist board

DeSantis and the state legislature responded with a new law that unilaterally terminated the operating agreement that induced DIS to open a theme park in Orlando a half-century ago. The governor also threatened to harm Disneyworld financially (presumably thereby lowering tax revenue and increasing unemployment in the state) through higher taxes, new tolls on roads leading to Disneyworld, more frequent safety inspections, building a prison nearby and encouraging competing theme parks to locate in Orlando…

While this was happening, the Disney-friendly supervisory board–which the new law replaced–reacted essentially transferring operating control of Disneyworld public infrastructure away from the state to DIS before the new law went into effect.

lawsuit

DIS is also suing DeSantis, on two grounds: the DIS press release in question is Constitutionally-protected free speech, so Florida’s punitive actions after/because DIS made it violate the fifth amendment of the Constitution; the state’s unilateral ending of the Disneyworld operating agreement, in essence a contract with DIS, violates the company’s property rights under the first amendment

looking at DIS

The company has four main businesses:

–ESPN + ABC. ABC is a publicity outlet for DIS that doesn’t make much money. ESPN has long been a cash cow, a valuable source of cash flow but not of earnings growth

–movies/streaming. The acquisition and revitalization of Marvel (which made me a DIS shareholder) and Lucasfilm over the last decade or so turned DIS into a motion picture powerhouse. The company had great hopes for streaming as the next source of video profit growth, but for now at least the market share any one entity can grab seems to be much smaller than generally anticipated

–merchandise sales. I think this aspect of DIS is mostly overlooked. But the company is a brilliant seller of themed merchandise. Also underappreciated, I think, is that the additions of Marvel and Star Wars lines gave DIS merchandise to sell to boys as well as girls. Before this, Jack Sparrow was its #1.

–theme parks. Yes, there is a DIS park in France plus one in Japan and two in China. But the serious money comes from the US. Here by far the most important is Disneyworld in Florida. Domestic parks made a bit over $5 billion in operating income for DIS last fiscal year (ended October 1st). Let’s say Disneyworld made $4 billion of that.

(One other thing: Hulu. DIS is a majority owner; Comcast (CMCSA) holds the rest. Starting on 1/1/24, DIS has the right to buy this minority interest for about $25 billion. CMCSA will also have the right to compel DIS to buy the minority interest for the same price. Not so important for this post but still a lot of money.)

Yes, income from the theme parks ebbs and lows with the ups and downs of the domestic economy. So this has typically been a low PE business. But the maturity of the other DIS businesses + the boost to income potential from Marvel/Star Wars characters means that the theme parks are much more important to the company than previously and the main potential for its growth comes from Disneyworld in Florida.

DIS vs DeSantis

Given that DIS is the largest taxpayer in Florida and one of the bigger employers, one would think that DeSantis is well-aware of the composition of DIS businesses and the crucial importance of Disneyworld in its plans. But maybe not. He most likely reasoned that DIS has such a gigantic investment in not-easy-to-move land and plant and equipment, plus intangible equity built up over a half century, that the company would be compelled to meekly accept whatever harm to its property that DeSantis decided to dish out.

What I find really strange is that DeSantis doesn’t seem to have been able to do what players in any game (checkers, for instance) automatically considers–what’s my opponent’s net move.

DIS’s preferred position would have been to say nothing about Florida’s anti-LGBTQ legislative actions. But its Disneyworld employees wouldn’t allow that. They demanded a pro-children, pro-schooling statement. So the company made one.

DeSantis’s counter was, in essence, to punish DIS by trying to turn Disneyworld from a $4 billion yearly business to, say, $3 billion…and shrinking. No apparent thought about how this would harm the state financially, or how other businesses might have second thoughts about investing in a place with such touchy and vindictive lawmakers.

DIS’s response? Yes, it can’t move. But it doesn’t have to continue to expand in Florida. Maybe it breaks out its contingency plans and begins to look for another state to build a new theme park in. My guess is that it also has to reassess its neutral political stance in Florida. I can’t imagine that this would involve further support for DeSantis. No way it wants him to be anywhere near the nuclear codes.