August 26, 2020
Topics: KC's Column
Measure Twice, Cut Once
Most are familiar with the phrase, “Measure twice, but cut just once.” The origins of this phrase trace back to the 16th Century and an Italian linguist Giovanni Florio, but its application has been adopted by many trades over the centuries from dressmakers and carpenters to mean “double check before one takes any action.” Whether one is cutting wood, performing surgery, or investing in commercial real estate, it is sage advice to rely on more than one measurement/metric, market source, or perspective before taking action. Not since the 1970s - when our economy was impacted by an oil-shock, unprecedented inflation, stagnant growth, and a Federal Reserve that took the prime lending rate to 21% by 1981 - have we experienced as complex an economy and investment climate as today’s. However, there is one significant exception. That exception is market behavior contrarian to underlying economic conditions. In the 1970s there was nowhere near the contrarian market behavior to the underlying economic conditions that would have driven the stock market to new record highs and housing to boom as both are doing today.
This exception has been weighing on the minds of many in our ACRE community of students, Realtors, support group members, real estate market debt and equity investors, etc. The angst over this disconnect has been the source of most of the recent inquiries to ACRE by our many constituents. The answer to the many inquiries increasingly appears to be that market participants – for whatever reason – are not connecting the dots or “measuring twice” the influence of the coronavirus on all aspects of the economy. On one hand we have record unemployment above 10% (higher than the peak from the Great Recession) and disruption in vital transportation, energy, retail, and L&T (leisure and travel) industry segments; but on the other hand, we have record low interest rates, robust housing demand, and weekly record stock market highs. How does one reconcile this bifurcation and navigate the uncertainty risk with November elections less than 70 days away? The answer is restoration of investor discipline and to “rely on more than one metric, market source, or perspective before taking action.”
To aid in this recommendation to look more broadly at market conditions, ACRE provided a pair of webinars last week by myself and my colleague Stuart Norton. Both these webinars provide updated outlooks on the economy, housing, and commercial real estate. In case you missed them, click on the images below to access the replays:
A Measuring Twice Perspective:
At the beginning of August 2020, Goldman Sachs Global Research and FactSet dissected the stock market returns since December 2019 to ascertain where the record rise was coming from. It was a great example of “measure twice” analytics in action. What they found was: i) most of the gain came from five stocks (Facebook, Amazon, Apple, Microsoft, and Google) who collectively were up 35% YTD; ii) the S&P 500 – while at a new record high of 3,443 at today’s Aug 26, 2020, opening – is up just 2% YTD and was at a record low of 2,237 just 5 months ago when global COVID-19 cases were a mere 5% of today’s level; and iii) the aggregate stock prices for the remaining 495 companies comprising the S&P 500 are actually down 5% January - August 2020. In other words, when you cut the stock market rise twice, one finds that there is not so much breadth in companies whose stock prices are increasing. The following two charts from Yahoo Finance and FactSet/Goldman Sachs are worth noting prior to your next 401(k) reallocation:
A Measuring Twice Perspective for the Economy:
This same perspective from the stock market applies to the economy. Take Jobless Claims as an example. Although they dropped backed below 1.0 million two weeks ago, they are: i) at levels never seen before (695K was the prior peak in 2009 during the Great Recession); and ii) have rebounded back above 1.0 million and continuous claims still hover north of 14 million. That is the bad news from a national view. It is a much different story in some states like Alabama that are not among the 10 states with the most COVID-19 cases (California, Florida, Texas, New York, Georgia, Illinois, Arizona, New Jersey, North Carolina, Louisiana and Tennessee). Alabama ranks 15th among states for COVID-19 cases, has been able to reopen auto, other manufacturing, and even its universities. As a result, jobless claims in Alabama have fallen steadily from their peak of 106,000 the first week of April 2020 to less than 10,000 (first time since outbreak of coronavirus and shelter-in-place orders) the week of August 8, 2020. This measure the macro numbers twice to translate local is critical to understanding why say an Alabama has an unemployment rate well below the 10.2% national level at just 7.5%. And if you measure the unemployment data a third time in Alabama to see where it is highest and lowest, it is revealed that the unemployment rate is lowest in Huntsville (6.4%) and highest in Mobile at 11.5% (Source: ALDOL). The aforementioned was covered on slides 6-10 of the August 2020 Economic Outlook Update webinar by ACRE. The two key “Measure Twice” charts/slides are below:
There were eight other “Measure Twice” metrics detailed in the webinar that included: i) tracking COVID-19 cases by state – know what has been happening in neighboring states as it is likely headed your way and could foretell re-implementation of Occupancy Restrictions; ii) Job Cuts by Challenger-Gray – this is your forward guidance on employment; iii) State Budgets – with no new CARES Bill 2.0 emminent, states will have to shoulder more of the burden from higher unemployment, Medicaid, etc. costs that will likely result in larger budget shortfalls and spending cuts in 2H 2020; iv) Small Business Closings – Yelp is tracking it and detailed 80,000 casualties March through July 2020. The loss of small business is likely much higher as the “silent failures” detailed in August 12, 2020 WIN - Small Business Update are not being counted; v) Transportation metrics like TSA Passenger Count – if the business traveler doesn’t return, the economy can’t recover to pre-Covid levels; vi) CRE Credit metrics like LTSS and delinquency rates – not an issue in MF and Industrial property types, but a big-deal in anything tied to Leisure & Travel; vii) CRE Transaction Activity – it is actually rebounding according to NAIOP and CBRE, but not-so-much accroding to Real Capital Analytics (RCA); viii) Corporate Earnings – it’s a tale of two economies. Zoom is a boom and that is not good for office CRE, but expansion of e-Commerce is driving industrial warehouse demand. Whether you opt to utilize one, two, or more of these measures in your CRE investing strategies in 2H 2020, use of more than one will enable you to begin adopting a “Measure Twice” mindset.
A Measuring Twice Perspective for CRE Investing:
Also included in the ACRE Economic Update webinar were nine “Measure Twice” topics dissecting the most noteworthy commercial real estate risks ahead in 2H 2020. These commenced with understanding the CRE Debt Pie and which lender types are likely to be hurt the most (banks with >50% of the CRE debt pie) and by property type. It concluded with a reminder about ESG. It did not die with COVID-19. It will come back with a vengeance post COVID-19. And in between those CRE topics were measurements on bankruptcy filings (Alabama ranks #8 behind #1 California, #2 Florida, #3 Illinois, #4 Georgia, and near time for #5 (Ohio and Texas); property valuations (hard to estimate with a dearth of transactions); MF, office and hotel property types (How does rent forbearance play out in 2021? Will anyone return to work in the dense urban cities? What hotel property will not go through a work-out in 2021 with more than 35% of hotel loans on a watch list for default, one in four loans already delinquent, and another one in four already transferred to a special servicer?) Industry groups and brokerage companies are being as encouraging as possible to sustain tractional activity in the CRE industry, but before you cut debt or equity capital lose in 2H 2020, measure the risks from multiple dimensions. There are good opportunities, such as in MF and industrial and the suburbs; but there are also risks where the bottom has yet to be defined, such as Leisure & Travel and dense urban cities like New York City, Chicago, and Seattle. Below are three graphics most worth your attention as part of your “Measure Twice” thinking are: i) CRE Debt Pie; ii) Office Issues –who will return to work in an office; and iii) Trepp’s just published Hotel CRE Debt report.
In summary, one-dimensional thinking before “cutting” will likely make for missed opportunities (best case) and/or losses (worst case) in 2H 2020. Adopt a “measure twice” – maybe three times or more to capture all the dimensions of risk – CRE investing strategy in 2H 2020. The uncertainty risks are elevated more than any point during the Great Recession and include: i) the rapid rise in COVID-19 cases to more than 20 times the level from April 2020; ii) expectation for more job cuts as CARES Bill obligations to retain workforce end in September 2020; iii) rising small business failures; and iv) the November 2020 elections.
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