Redwood Market Commentary, Q2 2011

What a difference two years make.

In the second quarter of 2009 we had extreme market volatility, pervasive fear, and virtually no economic data to base opinions on with regard to market opportunity and pricing. All the data pointed down and no one knew if there was a bottom. The Dow hit below 6,600 the second week of March 2009. Did you remember how low it went?

One year later the Dow crested 10,500 during the second week of March 2010. On the same date in 2011 the market breached 12,200 on the Dow. Yes that was progress – a lot of progress in a short period of time. Normally we do not address events that have occurred after the reporting period (in this case the second quarter of 2011), but in this report we feel the need to make an exception. During the last month we have seen the Dow break 12,700 and then precipitate to fall below 10,600. Now, again, we have extreme market volatility, pervasive fear, but a lot more economic data to base opinions on with regard to market opportunity and pricing. The fear component in the market, as sensationalized in the media, seems equal to 2009. However the market resiliency and the economic data bear out a slightly different story. Here some of the fears are backed up by real data and specific situations rather than the lack of real data or frankly even price discovery for any assets like in 2009. Here are some interesting and some opinions on what they mean:

Fact 1: Standard & Poor’s downgraded US Treasuries to AA+ from AAA.

Meaning: The action occurred on the same day as fears about the financial condition of the European Union resurfaced and that made investors, of course, flee to Treasuries and buy. The only thing I can discern from these events is that the rating agencies still command very little respect and that United States Treasury Bonds still remain the asset of quality that investors flee to for capital preservation. This was further verified when S&P decided to not rate any new commercial mortgage backed securities (CMBS) in the short run until they fixed some problems in their model.

Conclusion: Ratings mean very little and treasuries continue to be a “flight to safety” asset.

 

Fact 2: Bank of New York started charging clients 0.10% annually for keeping balances of $50 million or larger at the bank.

Meaning: This is approximately the amount charged to the banks by the Federal Reserve for cash deposits on hand. The only thing that this indicated to us is that the bank must feel that deposits are not long term, meaning they cannot deploy the deposits into new loans. They may feel that way because of all the excess cash reserves in the economy or because borrowers that need financing are not credit worthy. If they cannot make money on the deposits by making loans because it is “flight to safety” cash then they seem to feel it is reasonable to charge what the Federal Reserve charges for cash deposits on hand.

Conclusion: Cash is also a “flight to safety” asset.

 

Fact 3: Gold and Silver prices have increased to all-time highs.

Meaning: Precious metals are also a “flight to Safety Asset.” However, keep in mind that the dollar has been declining in value so quoting precious metals in dollars may be misleading as, recently, the dollar has declined more than Gold has increased in price.

 

Fact 4: The Economy is faltering and the risk of a double dip recession has increased.

Meaning: Most of the economic data that has come out over the last few months has been negative. Even previously good economic data has been revised to be worse. This recovery has serious risk of faltering and starting a double dip recession. The exogenous events that are causing weakness to be looked on by the market as fear have caused a “flight to safety” as evidenced by the points 1-3. The European Union debt woes, high unemployment with slow job growth, the United States government debt problems (including a congressional impasse or some would say compromise), the earthquake in Japan all have contributed to the fear and pervasive volatility in the market that have caused this “flight to safety.”

 

Fact 5: The market concerns now are different than 2009!

Meaning: We have a market that has been more and more driven by media hype and traders that live by the second. Now even the traders are having trouble making money. Despite all the bad indicators out in the media there are still some points worth focusing on when it comes to being “level headed” and investing diligently and prudently when everyone else is losing their head. All the “flight to safety” assets are driven by a lack of commitment to other assets not fundamental value. Cash earns less than zero; precious metals do not pay you anything so you have to believe it will go up in price or down less than other investments to make it a compelling allocation. Treasuries earn zero to very little on a real basis, again you would only allocate to that investment class if you felt it would go up in price (not very likely as rates can’t go much lower so you have capped upside) or you felt that the class would go down less than other investments. What I am getting at is that the “flight to safety” is of course a fear based allocation. So it would seem that if you believe you should invest when others are fearful and sell when other are certain; it would seem a good time to invest in anything else than the “flight to safety” assets. Now, the question is what to invest in if not cash, precious metals, and treasuries. Of course, this is where the conversation must in our opinion turn to real estate.

What This Means for Us

Notwithstanding the government debt and failure of QE2 addressed in the last quarterly report; what has happened in the capital markets is a retesting of resolve, through fear, on market participants to underwrite value based on fundamentals rather than technical information or emotion. The market participants have responded with a soft thud. The market went down, but not as far as 2009. The allocation of capital to “flight to safety” assets is both a sign of current market weakness and medium to longer term momentum.

Look for signs of optimism to release capital into M2 (money supply) and the general economy; driving new loans, new spending, and ultimately new jobs. Just don’t expect it to happen anytime soon. These signs might look like oil prices declining (from new regimes needing to raise cash), merger and acquisition activity increasing (deploying excess corporate capital), potential tax breaks (just kidding – unlikely), your banker asking if you have any loan needs, etc. These signs and the roll out of this “flight to safety” capital could take several years. The Federal Reserve cannot necessarily do much to increase the money supply on its own as it has lowered interest rates to zero and open market operations seem to just build up more buying of “flight to safety” investments, including by the Federal Reserve itself.

The opportunities in front of us are just starting. As we have said before this could ultimately combine into the “Perfect Storm” for buying opportunities from 2011-2015. Below is mostly repeated from previous market commentaries, but we are consistent in our belief that the market environment we are in and heading into will be very attractive for investment opportunities.

Here is why we are entering the perfect storm. First, as problem assets are held for longer by banks and servicers they become ignored and much harder to lease. Deferred maintenance can become a problem and leasing agents of prospective tenants know the lender does not respond with appropriate urgency and worry about delivery of the space by lender or receiver asset managers. Leasing brokers do not get paid for waiting, but for finding space for their tenant clients or tenants for their landlord clients. The leasing brokers will drive business to decision makers who will get them paid, period. Second, as banks and servicers get busy with new loans that generate new origination income they focus more on redeploying capital and human resources tied up in problems. People get bonuses for originating new loans not working out old ones. Third, everyone is stalling. Banks and servicers, to be rid of troubled assets, could end up with the pressure to all sell at the same time.

 All of this means that as fundamentals of leasing might be improving, the vast majority of problem assets start to become available. That perfect storm is oversupply of investment sale product with improving leasing demand! That means properties could get cheaper and buying them means taking on less risk because there is more demand for space. We are definitely seeing better demand for space at our existing properties and now we are seeing many more properties for sale at much better prices than a year ago. The market really is bifurcated; one market for low risk urban “core” investments that trade at aggressive pricing and another market for everything else. The “everything else” market includes a very large percentage of distressed assets. What that means is that properties that are “everything else” get priced at distressed levels regardless of other circumstances so the properties either do not sell or sell at distressed prices.

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