By
Michael Douville One of the advantages of being older is the ability to remember past events. Most people in their 40's have not experienced an economic downturn. It used to happen every 4-6 years and the adage was you had to season your investment through 2 cycles to be secure. There is a cycle to the securities markets and there is a cycle to the real estate market. The real estate market is slower to react and takes longer to develop, but usually has a longer duration. The Federal Reserve has adjusted its monetary policy in an attempt to control these ups and downs of the economy with unintended results. Cycle Forecaster Charles Nenner has an interesting perspective relating to cycles in real estate. However, first some historical perspective is helpful.Relative tickers: Nasdaq: ITIC, NYSE: BAC, OTC: FMCC.OB, OTC: FNMA.OB, NYSE: GS, NYSE: MS, NYSE: WFC, NYSE: TD, NYSE: SRS, NYSE: URE, NYSE: IGR, NYSE: XIN, Nasdaq: RYHRX, Nasdaq: TRREX, NYSE: TOL, NYSE: HOV, NYSE: DHI, NYSE: BZH, NYSE: LEN, NYSE: KBH, NYSE: PHM, NYSE: NVR, NYSE: GFA, NYSE: MDC, NYSE: RYL, NYSE: MTH, NYSE: BHS, NYSE: SPF, NYSE: MHO, AMEX: OHB, NYSE: VNQ, NYSE: PNC, NYSE: JPM, Nasdaq: HOFT, NYSE: ETH, NYSE: PIR, NYSE: WSM, NYSE: HD, NYSE: LOW, AMEX: VAZ, AMEX: NKR, AMEX: MZA, AMEX: NXE, AMEX: NFZ, Nasdaq: XNFZX, Nasdaq: FSAZX, Nasdaq: AVTR, NYSE: AIV, NYSE: EQR, NYSE: AVB, NYSE: UDR, NYSE: ESS, NYSE: CPT, NYSE: SNH, NYSE: BRE, NYSE: HME, NYSE: MAA, NYSE: ELS, NYSE: ACC, NYSE: CLP, Nasdaq: AGNC, NYSE: SUI, NYSE: AEC, NYSE: PMT and AMEX: TWO, NYSE: SPG.
A View of Real Estate Cycles with Insight from Charles Nenner
In 1971, Richard Nixon wanted to be re-elected. He fired then Chairman of the Federal Reserve William McChesney Martin who was a monetarist concerned about inflation. Chairman Martin would not overly expand the money supply and would remove liquidity as the economy started to expand, limiting inflation but also limiting business activity and more importantly jobs. Arthur Burns was a Nixon Presidential Financial Advisor; Nixon appointed him Chairman of the Federal Reserve, supposedly a non-political position. In historical writings, contrary to popular perception, the Nixon Administration was in close contact with the Chairman through the President’s Chief of Staff. Bowing to political pressure, Arthur Burns lowered short term interest rates and added liquidity: injecting $21 billion into the economy. The economy responded, business activity picked up, and jobs were created. Nixon was re-elected. The Vietnam War was ending and the economy was shifting from a
war economy to a peace time economy with our troops coming home. The Arab-Israeli War and the Oil Embargo surprised the world and caused a massive disruption; business activity dropped like a rock! The fear of recession and a global slowdown caused the Federal Reserve to again add more liquidity to the economy in 1974, just as the recession was ending. Short-term rates were lowered; the U.S. went off the
gold standard to fiat currency and the US Dollar depreciated drastically; all reminiscent of today’s economic environment.
A new up cycle had started. In 1975 the effect of adding liquidity and the lowering of short-term interest rates started to be felt as employment began to rise. Mortgage rates were low and houses started to sell, and sell, and sell. Home and land prices started to climb along with gold, silver, farmland, wheat, soybeans, and oil. Prices of homes skyrocketed with their commodity driven component prices such as copper, lumber, steel, concrete, oil-based products such as asphalt shingles, plus the cost of fuel to deliver these goods. Virtually everything was going up in price. President Gerald Ford sought re-election with WIN campaign buttons: Whip Inflation Now. Inflation was 4.4%, and within two more years, it had reached 8.8%. Finally by 1979, inflation was running over 10%. The new President, Jimmy Carter, decided to remove Burns in March of 1978 and G. William Miller becomes Chairman, but only until August of 1979 when Inflation was over 12%. Paul Volcker was appointed Chairman of the Federal Reserve with the mandate to wring inflation out of the economy; the Real Estate Cycle had peaked and started to point down. Rates were eventually raised to over 20%, liquidity was drained, and inflation peaked at 14%. Business activity nose dived, the unemployment rate was over 10% and for 2 years the economic situation was grim. Slowly rates were reduced and the economy started to mend, so that by 1982, even without a liquidity push, another up cycle had started.
Business was good for the next few years, deflation reigned with the S&L Crisis, Congress changed the Accelerated Depreciation Tax rules that had fueled the investment scheme of losing money in complicated investments to reduce Income Tax, and finally in 1991 the RTC had been created which liquidated all the troubled properties. Things were good for 10 years. Uh-Oh! Y2K, the computer digital clocks were not going to change from 1999 to a new units place on January 1, 2000 and THE WHOLE WORLD was going to crash!! Computers would no longer work; payments would not be made; and security transactions would fail... The missile system was in danger; there would be war and pestilence. Software companies were created to rush new software to the world's computers to soften the inevitable catastrophe. Chairman Greenspan lowered interest rates and added liquidity to the system to cushion the coming economic storm, but ultimately nothing happened! However, there were unintended consequences.
The stock market exploded! Home prices and the real estate market were still in an up-cycle, though remaining decoupled from Wall Street, as the land-rooted assets were still considered homes not investment vehicles. Still, manic money was entering the securities markets to change all that. The new interest in software as the savior of the world led to start-up companies in the new phenomena called the INTERNET – dotcoms were born.
The NASDAQ soared to over 5000…money was chasing anything internet related...a huge bubble had been created and now needed to be deflated - the NASDAQ (Nasdaq: NDAQ) peaked in March 2000. The Federal Reserve reacted and continued to raise rates until May of 2000, and did not start to reduce short-term rates until January of 2001, when it was very evident the economy was in trouble and the bubble had collapsed; the economy faltered. Then more trouble: terrorists attacked the U.S. on September 11, 2001 and the stock market declined precipitously. Again, the Federal Reserve reacted and reduced rates aggressively, added more liquidity, and by the end of 2002 the Discount Rate was 0.75%. Chairman Greenspan allowed the discount rate to remain low for all of 2003. Further, Wall Street had discovered the securitization of Mortgage Backed Securities (MBS), and learned it could leverage these bundles, grade them AAA, and with very little of their own capital, sell portions to conservative investors throughout the world. Interest rates were at historic lows and yield starved pension funds and insurance companies acquired these MBSs adding more liquidity which flooded the markets with easy money. The Adjustable Rate Mortgage was quoted at 3.5% fixed for 3-5 years. Underwriting standards were loosened to allow more Americans to achieve the American Dream. Typical Tenants were able to use very low-down mortgage products and historically low short-term rates to purchase homes with monthly payments much lower than their rent. In 2004, true value was still available within the market; GRM, rent-to-own, and affordability all pointed to higher prices. The Real Estate Bubble was underway and the Housing Cycle was maturing.
The liquidity injected into the system in 2001-2003 found its way into the Real Estate Market. The economy created jobs in all construction related industries, real estate related financing, and everything connected to furnishing and decorating properties. Business activity exploded and the Federal Reserve reacted by raising rates from 0.75% to the high of 6.25% on June 29th, 2006. The economy started to slow, and slow severely; by December of 2007, not only the US, but the globe was in recession. The Federal Reserve responded. The Real Estate up-cycle had ended and had started down.
The Fed hiked rates to 6.25% on June 29th, 2006; 18 months later, in early 2009, the stock market had declined over 54% from the peak to under 6700. Lehman Brothers and Merrill Lynch (NYSE: BAC) were no longer in business, and giants like GM (NYSE: GM) and AIG (NYSE: AIG) were begging for money. Prices of everything had declined; deflation was evident. The Federal Reserve injected liquidity; the St Louis Adjusted Monetary Base skyrocketed from
$905 Billion to $2.3 Trillion; an unprecedented re-liquefaction of the economy. The greatest expansion of the monetary base in history was currently underway. The Real Estate Bubble had deflated, however, similar to the early 70’s, commodity prices exploded and inflation was evident in China and India with simmering underlying inflation in Europe.
Today, destruction of credit may be masking core inflation. Many major Banks and Financial Institutions have huge reserves on deposit with the Federal Reserve, parked safely earning interest. The recession officially ended in June of 2009, gross domestic products as well as the major stock indices have finally all recovered to their former levels. Unemployment has peaked and job creation is starting to form. Even with the economy clearly recovering, the Fed is injecting another $600 billion dollars. The cycle has started again. Capital will go somewhere, and the unintended result will eventually be a new bubble in another asset market, probably not in real estate; perhaps it will expand the commodity markets, where prices have already recovered to their former level and are projecting higher. However, real estate will benefit and an astute investor should realize that properties have not participated yet in the price recovery, but as their components of lumber, steel, concrete, drywall, and copper start to rise significantly, housing will also participate and may be a less risky investment starting from a depressed level and having a strong yield component. The down-cycle in housing may have already ended and the excess liquidity will benefit real estate.
Charles Nenner, one of the world’s foremost cycle researchers, has had a terrific record of forecasting liquid markets. The Charles Nenner Research Center has steadfastly forecast no inflation, and indeed deflation has been a concern. One economic definition of deflation is the contraction of credit and the unavailability of new loans. This has been extremely evident in the Real Estate Market. Credit destruction has been massive as the Real Estate Correction unfolds and “underwater” properties are liquidated, resulting in huge losses to the lenders and loss of capital to the economy. Properties sold in 2005-2007 are currently available to the market in the “Sand States” of California, Arizona, Nevada, and Florida at huge discounts. The existing loans have “deflated”; conversely, gold, silver, copper, iron ore, corn, wheat, cotton, etc. have all “inflated”. Further, banks have been reluctant to lend, requiring higher underwriting standards than before the boom and preferring to
park the liquidity with the Federal Reserve and earn safe interest rather than earning more return and taking market risk - another example of the definition of credit contraction and deflation. However, the distressed properties will eventually be absorbed and conservative capital will eventually seek higher returns.
Charles Nenner has forecast the Consumer Price Index (CPI) monthly cycle to bottom in April 2012 and the Producer Price Index (PPI) to bottom 6 months later in October 2012. Dr. Nenner’s research has had stunning clarity and should be reviewed. The charts depict the ending of deflation, and the CPI and PPI indices sharply rising into 2018 and beyond. This would coincide with the projected absorption of the distressed housing inventory and the end of the credit destruction brought about by the distressed properties - the re-entering of the former home owners into the housing market, the quantum effects of QE1 and QE2 finally surfacing and affecting monetary velocity, and the bank reserves, some estimates of as high as $1 trillion, entering the market in search of better returns. The
$1.5 trillion expansion of the Federal Reserve’s balance sheet will eventually be felt throughout the economy; possibly in 70’s style inflation. The “Black Hole” in the Sand States will eventually stop destroying Fed added capital and money will spill over. The charts, courtesy of
charlesnenner.com, show rising inflation; accompanying rising inflation will be rising interest rates which will eventually negatively impact the economy. Charles Nenner also warns of the economy faltering.
The stage is set. The simple indicators of housing value have all turned positive, similarly to the 2002-2003 time frames. The Federal Reserve has added substantial new liquidity into an economy already recovering as it did in 2002-2003. Interest rates are lower than 2002-2003 and have been down for a longer time. What is needed is the catalyst to spark renewed buying. If history is a guide, then the potential for price appreciation is enormous. Currently, excellent properties are available 10-40% below insurance industry replacement costs which exclude the value of the land the property is built on, causing enormous competition and trouble for new construction. However, this disparity points to possible rapid price appreciation when absorption of the distressed properties occurs. This disparity may disappear as the price of properties rise to reach equilibrium.
The potential is also enormous for a BOOM/BUST event which would deflate the next bubble. An investor should consider an exit strategy. Properties today are depressed partly because of the job market and economy, but also there are fewer move up buyers to fuel the housing market due to the penalty period enforced against former distressed and displaced homeowners. Sellers that use the short sale process to sell their underwater property, or if they are unlucky enough to have allowed a foreclosure, are prohibited in most instances from obtaining a new loan to finance a housing purchase for at least 24 months for a short sale involving Fannie Mae (OTC: FNMA.OB) for a new purchase involving a penalized buyer requesting an 80% LTV; 48 months for a 90% LTV; and in foreclosure cases, penalized buyers are prohibited for up to 7 years unless there exists special circumstances. This penalty period will fuel a pent-up demand scenario, whereby a portion of the portfolio can be sold as former homeowners become eligible to buy; profits can be taken; and capital allocated to better investments or used to mitigate risk by reducing debt perhaps to an entire portfolio of free and clear properties. The ending of the Penalty Period for the initial “Short Sellers” of 2008, coincides with the Nenner forecast for PPI bottoming.
The market will indicate in advance of most downturns: rates will start to rise to combat inflation; prices will rise, perhaps very quickly; business will be brisk; and the simple indicators: GRM, rent-to own, and affordability will shift from positive-to-neutral to slightly negative. These indicators will go to the extreme; the cycle will rise to the top and it will start down. The investor needs to have executed the exit strategy and taken profits for a portion of their portfolio. Investing in real estate is a long term commitment; but an opportunity to reap quick capital gains may allow for mitigating of risk by reducing portfolio debt. Currently fixed long-term rates are available that will probably not be available just a few years from now. If rents rise precipitously, another long-term strategy that may unfold will be to hold through any downturn as higher lending rates may make re-entry of buyers into housing prohibitive, creating a huge pool of lifelong tenants. Rents are rising and good cash flows will get better. Exploit the market, as the time to acquire residential properties is now. If the simple indicators of Gross Rent Multiplier, Own vs. Rent, and Affordability as well as Dr. Nenner’s forecast for future PPI and CPI gains are correct, the timing is exquisite. This is the Year of Acquisition.
I would like to thank Dr. Charles Nenner for his time and the valuable insight provided by his ongoing research.
Editor's Note: Article should interest investors in Investors Title (Nasdaq: ITIC), Bank of America (NYSE: BAC), Freddie Mac (OTC: FMCC.OB), Fannie Mae (OTC: FNMA.OB), Goldman Sachs (NYSE: GS), Morgan Stanley (NYSE: MS), Wells Fargo (NYSE: WFC), Toronto Dominion (NYSE: TD), UltraShort Real Estate ProShares (NYSE: SRS), Ultra Real Estate ProShares (NYSE: URE), ING Clarion Global Real Estate Income Fund (NYSE: IGR), Xinyuan Real Estate Co. (NYSE: XIN), Rydex Real Estate Fund H (Nasdaq: RYHRX), T. Rowe Price Real Estate Fund (Nasdaq: TRREX), Toll Brothers (NYSE: TOL), Hovnanian (NYSE: HOV), D.R. Horton (NYSE: DHI), Beazer Homes (NYSE: BZH), Lennar (NYSE: LEN), K.B. Homes (NYSE: KBH), Pulte Homes (NYSE: PHM), NVR Inc. (NYSE: NVR), Gafisa SA (NYSE: GFA), MDC Holdings (NYSE: MDC), Ryland Group (NYSE: RYL), Meritage Homes (NYSE: MTH), Brookfield Homes (NYSE: BHS), Standard Pacific (NYSE: SPF), M/I Homes (NYSE: MHO), Orleans Homebuilders (AMEX: OHB), Vanguard REIT Index ETF (NYSE: VNQ), PNC Bank (NYSE: PNC), J.P. Morgan Chase (NYSE: JPM), Hooker Furniture (Nasdaq: HOFT), Ethan Allen (NYSE: ETH), Pier 1 Imports (NYSE: PIR), Williams Sonoma (NYSE: WSM), Home Depot (NYSE: HD), Lowes (NYSE: LOW), Nasdaq: XNFZX, Nasdaq: FSAZX, Avatar Holdings (Nasdaq: AVTR), Apartment Investment & Management (NYSE: AIV), Equity Residential (NYSE: EQR), Avalonbay Communities (NYSE: AVB), UDR Inc. (NYSE: UDR), Essex Property Trust (NYSE: ESS), Camden Property Trust (NYSE: CPT), Senior Housing Properties (NYSE: SNH), BRE Properties (NYSE: BRE), Home Properties (NYSE: HME), Mid-America Apartment (NYSE: MAA), Equity Lifestyle Properties (NYSE: ELS), American Campus Communities (NYSE: ACC), Colonial Properties (NYSE: CLP), American Capital Agency (Nasdaq: AGNC), Sun Communities (NYSE: SUI), Associated Estates (NYSE: AEC), PennyMac Mortgage (NYSE: PMT), Two Harbors (AMEX: TWO), Simon Property Group (NYSE: SPG).
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No alarm goes off when the economy enters a recession; there is no bell or bright flashing red light. Rather, it is stealthy and silent; activity slows imperceptibly at first and then gathers momentum at which point it is generally too late to make portfolio changes and preparations. As a point, the “Great Recession' is believed to have started in December of 2007, two months before the Dow hit its all-time high of 14,164 on October 9th, 2007. In my opinion, a recession is coming; a deep, nasty, global recession that will affect all corners of the business globe. It may already have started. 
If, as I suspect, a recession has indeed started, it will be the first in memory that was not induced and controlled by the Federal Reserve. Typically, the Federal Reserve would monitor business activity and would raise interest rates to dampen an economic expansion and prevent an outbreak of inflation; money supply was withdrawn, and eventually the combination of increasingly higher rates and reduced money supply would contract the economy; the result was a recession. When the economy had cooled, rates were lowered, liquidity restored, and the economy successfully recovered.
