QE2: "No Cure But It Eased Symptoms"

The Wall Street Journal published the results of its monthly survey of economists.  The consensus forecast is for modest growth in GDP, 2.3%, and employment, 2.2 million jobs to lower the unemployment rate to 8.2% by this time next year.  A  number of potential risks are mentioned (spiking oil prices, increase in unemployment), but three potential tornadoes are ignored.  Greece is holding a yard sale to try to hold off foreclosure.  The U.S is reworking its budget (flying coach instead of business, cutting back to basic cable) in hopes increasing the line of credit.  And the Fed has been very clear that there is no plan for QE3. (The economists were decidedly unimpressed with the results of QE2!)

So this is where we stand:  sluggish growth and stubborn unemployment for the next 18 months with no expectation of any policy changes.

Inland Western Valuation

Inland Western filed an 8-K on June 20 announcing management's estimation of a $6.95 per share valuation.  This is an increase of $0.10 per share over the valuation announced last January.  Both of these figures  were developed by management.  No third party appraisals were conducted.

The valuations appear to be on the high side.  While doing a financial analysis earlier this year, I was able to estimate the real estate portfolio's Net Operating Income at $433 million.  Applying a (somewhat arbitrary) 7.5% cap rate (RealtyRates.com reports a national average of about 8.3% for anchored shopping centers), would indicate that the directly held real estate is worth about $5.8 billion, or about $100 million more than carrying value on the December 31, 2010, balance sheet.  Subtracting the liabilities provides shareholders equity of $2.4 billion or approximately $5.00 per share.  On the other hand, I calculated Funds from Operations (FFO) of $153 million or $0.32 per share.  The May issue of REIT Watch, a statistical publication of NAREIT, estimates the Price/ FFO of shopping center REITs at 16.75.  This would indicate a share value of $5.36.  Mind you, neither of these rise to the thoroughness of an appraisal, but at least you have the methodology to assess for yourself.

One very important source of information available to management to which I do not have access is a sense of the actual market acceptance of the shares of Inland Western.  Inland Western announced its IPO filing on February 14, 2011, and named four book-running offering managers.  Surely, these investment banks have been willing to advise management on its share value estimation, so as to avoid disappointment on opening day.  Still, $6.95 seems like a significant premium to just over $5.00 per share.

Special Thanks to the Rational Realist

No More Hybrid Advisors?

Todd J Pack, President and Chief Operating Officer of Financial Advisors of America LLC, has contributed a piece to Investment News on how the regulatory environment is making the hybrid advisor model unwieldy for the advisor and burdensome for the broker-dealer.  It appears that FINRA and state regulators are going to be enforcing "private securities transaction" oversight rules on broker-dealers whose reps who conduct asset management business under their own RIAs.  This outcome has been developing for 15 years, as FINRA has been putting pressure on BDs to assume the oversight responsibility "voluntarily."  Along with a number of related issues, including exorbitant state review fees, the viability of the business model on the broker dealer's part is diminishing.  Advisors should prepare to make the decision on which side of the fence they are going to conduct their business.

Rob Arnott's Inflation Protected Portfolio

Market Watch has an interview with Rob Arnott, founder of Research Affiliates, about his economic outlook and his portfolios allocation.  Arnott says the "3-D Hurricane" - a combination of deficits, debt, and demographics - is setting the U.S. economy up for a slow growth environment that is likely to b e accompanied by the inflation of deliberate debasement of the dollar.  His ideas for portfolio protection:

1. Rethink Asset Allocation - A traditional 60/40 allocation will disappoint.  Diverting some of the equity allocation to inflation hedge is cheap insurance.  Given the specific recommendations, I can understand this suggestion.  However, given that inflation is a covert transfer of wealth from lenders to borrowers, I would be inclined to reduce the fixed income allocation.
2. TIPS - Bonds tied to inflation should perform "decently" in an inflationary environment, and that is what an investor needs.  He cites the 1.8% spread available on the 30-year TIPS as comparable to what has been available to long Treasuries over the past ten years.  What isn't mentioned is that this spread is about the smallest it has been since the Treasury started issuing TIPS.  Purely defensive.
3. Commodities - With a nod to the drawbacks of commodity investments - volatility, prices reflecting expected inflation, speculation-driven prices - Arnott reminds us that commodities are an effective hedge against unexpected inflation.  While this could be argued at the stretched prices we have seen last year and earlier this year, the recent pullback of prices in the agricultural and energy sectors signal that this could again be an effective inflation defense.
4. Emerging Markets - Representing 40% of world GDP and only 10% of world debt,  emerging markets, both debt and equity, emerging markets have three factors in their favor: high growth, low leverage, and commodity exposure.  It could easily be argued that emerging market exposure in the equity portion of a portfolio is sufficient inflation hedge that no other is needed.
5. High Yield Bonds - As a fixed income instrument, junk bonds would not be expected to be a very good inflation hedge.  Arnott makes the argument that inflation improves the nominal performance of the issuer, potentially improving the credit quality of the bond.  On the other hand, this low growth economy that he forecasts could create struggles for companies of dubious credit.  Be wary.

Single-Family Home Foreclosure Data

Financial Advisor magazine has a May 26 article based on a press release from RealtyTrac.  It details the market share of home sales represented by distressed (bank owned, scheduled for auction, or in default) properties during the first quarter of 2011.  Just over a quarter of the properties that were sold to third parties were in a distressed situation, and sold at an average price about a quarter lower than the average non-distressed property.  Distressed sales have slowed since the previous quarter and the year earlier period, while the pricing is stable.  Current inventory of 1.9 million homes represents a three year supply at current sales rates.

Two factors are likely driving the slow liquidation.  First, foreclosure sales are being closed for all cash.  Selling banks are unwilling to close a sale except for all cash, because they are working to improve the asset quality pf their balance sheets.  Second, mortgage money is not scarce, especially for purchases of bank REO.  The dearth of financing reduces the number of potential buyers and the capital available.

The second factor is a regulatory environment that is encouraging the slow liquidation of the distressed properties.  Default periods are extended to allow for investigation of restructuring the mortgage.  Foreclosure periods are extended to ensure the proper procedures are followed.  REO is held on the books long to avoid taking the writedown of capital.  It is an intricate dance of Extend and Pretend, meant to give banks time to work through their asset quality issues that arose in the real estate bubble.

Three years of supply suggests at least two more years of soft home prices.  There is no telling ow much overhang remains just this side of default.  Until this inventory has been paired to something closer to six months, the economic engine of home building will remain moribund.

Are You Ready For QE3?

The Wall Street Journal hosted a video debate between Brad DeLong, an economics professor at University of California Berkeley, and Jim  Grant of Grant's Interest Rate Observer.  The subject was the prudence of another round of monetary easing, or QE3.

Jim Grant bases his recommendation on the ineffectiveness of the first two rounds of monetary easing, and the observation that interventions and manipulations are often met with unintended consequences.  He notes that large cash balances have been amassed, but that these balances are not purchasing goods.  He notes a fear of inflation in general and asset bubbles in particular

Professor DeLong's argument begins with a appeal to the Milton Friedman's reputation.  He claims that QE3 is what Dr. Friedman would prescribe, based on Friedman's work relative to the Great Depression and the lost decade in Japan.  DeLong sees no asset bubbles, and expects "NEGATIVE headline inflation" (my emphasis) before the end of the year.

My take is that QE3 would be more detrimental than helpful.  We are seeing signs of bubble pricing in certain ares: gold, Treasury Notes, oil.  The inflationary effects of these bubbles are being masked by the deflationary forces working in other sectors: housing, industrial capacity.  There is a sea of liquidity waiting to be unleashed when the economic, regulatory, and taxation conditions are favorable.  It's probably better for the country to go ahead and take its medicine, get labor and capital reallocated, and then move forward.

The Impact of the National Debt

The Wall Street Journal published this quote from Lawrence B. Lindsey:

"Right now, thanks in large part to Federal Reserve policy, Uncle Sam can borrow at an average cost of just 2.5 percent. The average borrowing cost over the last three decades was 5.7 percent. Our debt is now $14 trillion and scheduled to grow to $25 trillion by the end of the decade. If interest rates normalize over that period the added interest costs in 2021 alone will be $800 billion—more than 20 times the mere $37 billion in budget cuts that tore up Congress in March. It would take virtually all of the cuts in the Ryan budget just to cover that added interest, much less to start bringing down the national debt. Unfortunately, the Fed is now in a fiscal box. A normalization of interest rates would break the Treasury. Hence, a normalization of rates really can't happen—we're stuck in a world in which the Fed must keep rates artificially low in order to prevent a budget disaster."

 How terrifying! Either normalizing monetary policy will swamp the federal budget with interest payments, or the country will look to the Fed to debase our currency sufficiently that we don't default on our debt.  Neither scenario allows for economic growth, but the growth we have experienced over the past three years is less than the average cost of the federal debt.  This underscores how important it is to address our federal budget deficit.

Is Rob Arnott a Mad Genius, or Just Mad?

So Rob Arnott took the advice of John Bogle and started his own firm and developed a new product.  Bogle comes back and dismisses the product as "witchcraft" and a marketing gimmick.  Arnott's product outperforms Bogle's by over two percentage points per year over the 5 1/2-year lifetime of Arnott's product.  An Investment News article shares this and additional stories about Rob Arnott and his firm, Research Affiliates.

Research Affiliates developed its product, Fundamental Indexing, to address what appeared to Arnott a conundrum: traditional cap-weighted indexes tended to be overweight stocks whose prices had risen faster than their fundamentals would indicate.  At the very least, it did not make sense to invest more money in the most expensive stocks available in a market.  So Arnott and Jason Hsu, Research Affiliates' CIO, set out to devise an alternative weighting strategy.  They settled on a scheme that uses four metrics, each weighted equally: cash flow, dividends, sales, and book value.  The testing indicated that the weighting scheme works to improve performance.

The objective was to give less weight to stocks that may be overvalued relative to their fundamentals.  What emerges is a portfolio that has a distinct value tilt.  So Eugene Fama's quote in the article above is correct, that fundamental indexing captures the value effect.  The approach is definitely passive though, using variables that related to the company for weighting all of the stocks in a traditional index.  (Research Affiliates has applied it techniques to the FTSE indexes to date.)

Now, Research Associates is turning its attention to bonds, intending to use the 3 Ds for weighting purposes, deficits, debt, and demographics.  Of course these are the primary inputs into credit analysis for corporate bonds.  They can also be applied to sovereign debt.  It again provides a disciplined framework for avoiding a excessive allocation to to an issuer who has already borrowed a large amount relative to its ability to service that debt.

The equity strategy is available in an open-end mutual fund format from Schwab and in an ETF from PowerShares.  I use the RAFI funds in my Clarity Portfolios to provide a bit of alpha to overcome fund expenses.

Fixed Income Strategy?

Peter Fisher of BlackRock, Inc., contributed an article to Investment News on positioning fixed income portfolios now that the secular decline in interest rates has ended.  His ultimate advice is to invest in a well managed bond fund that has wide latitude in allocating among bond sectors.  Actually not such bad advice, considering BlackRock has been among the best bond managers across varying market conditions.

I was disappointed , though, in the discussion that Fisher used to back up his recommendations.  On the one hand, he advocates "holding some exposure to non-government spread sectors," because they are "less linked to the direction of interest rates."  On the other hand, he encourages investors to "move higher in quality within spread sectors in order to protect their portfolio if growth should slow down."  In other words, accept some credit risk but not very much.  Which means you will still be heavily exposed to interest rate risk.  Mr. Fisher also states that "rates are likely to go higher over the next year or so. But we don't know when."

And then there is this:

"Now is still the time to capture spread income while shifting up in quality within sectors and getting more flexibility in managing duration risks in anticipation of the volatility that eventually will come when the rate environment shifts."

I've read the passage several times and I'm still not sure that I understood what he was trying to say.

So here we are in a low interest rate environment, with weak economic fundamentals, in which the next major move in interest rates is expected to be up.  What to do?  Shorten duration by shortening maturities and increasing coupons.  Get exposure to high quality, adjustable rate debt.  (Bank Loan funds do not count.)  Since AAA-rated municipal bonds yield about the same as treasuries, they are ideal for taxable accounts.  Try matching specific maturities to cash outlay events (tuition payment, wedding gift).  You might even consider an excellent bond manager like BlackRock.

Office Buildings For Sale

The Wall Street Journal has an article today about trophy office buildings being put up for sale.  Owners are attempting to take advantage of rising prices (read: falling cap rates) in these properties. The story references two completed transactions and a couple of buildings that are on the market to make the point that high profile Central Business District (CBD) office towers are experiencing some liquidity as capital is willing to commit to these properties.

Hines is noted for having sold one (750 Seventh Avenue, NYC) and offering a participation in another (One North Wacker Drive). Beacon Capital Partners has sold Market Square in Washing DC and is considering selling the 1211 Avenue of the Americas property.  These are significant to advisors because: a) the North Wacker Drive property is currently owned by Hines REIT, b) Market Place was purchased by Well REIT II, and c) certain REITs may be able to if benefit hey are prepared.  Hines is obviously trying to take some small advantage with its marketing of the Wacker Drive building.  W.P. Carey's portfolios also tend to have a significant portion of the portfolio in Class A, CBD properties.

The Wells REITs also tend to have this type of property represented in their portfolios.  Wells REIT II has eight properties that are readily identifiable as likely to participate in this strengthening market. However, this portfolio is very immature, so the properties are likely not ready to be marketed.  As if to illustrate the point, one of the recently acquired properties, Market Square, is one of the properties highlighted in the article as a fortuitous sale.  The $615 price tag for the 680,000 square foot building represented a $900 per square foot purchase.  The cap rate has been estimated at 4.5%.

Wells current offering, Wells Core Office Income REIT, is just starting its acquisition program.  Just as in the REIT II portfolio, a significant portion of the Core portfolio can be expected to go into this type of property.  As the Market Square acquisition illustrates, these buildings are becoming very expensive.  This may put the Core REIT at a disadvantage.

Another offering that may find these developments a hindrance is CNL Macquarie Income REIT (CMIR).  Intended as a core income real estate fund, CBD office could be expected to be a part of the portfolio.  While the REIT has not acquired any CBD properties to date, any such acquisition could be a drag on performance.

10K Season - Wells

Financial reviews continue.  I have run a basic financial statement analysis on the most recent Wells offerings – Wells REIT II, Wells Timberland REIT, Wells Hid-Horizon Value-Added REIT, and Wells Core Office Income REIT.

In  Thousands	Wells REIT II	Wells Mid-Horizon Value-Added	Wells Timberland	Wells Core Office Income
Total Assets	$5,371,685	$63,242	$360,491	$35,421
Total Liabilities	$1,754,452	$20,974	$199,931	$18,877
Equity Raised	$3,455,697	$51,854	$240,000	$20,548
Net Real Estate	$4,230,039	$50,178	$340,504	$27,994
Direct Debt	$886,939	$19,000	$168,841	$17,275
Leverage Ratio	21.0%	37.9%	49.2%	61.7%
Revenue	$567,967	$5,570	$47,582	$755
Net Income	$23,266	$3,420	($19,518)	($1,544)
FFO	$243,176	($16)	($5,180)	($1,203)
Mod Cash Flow[1]	$254,116	($16)	($1,471)	($534)
Dividends	$300,719	$0	$0	$127
Yield ($10 share, $1,000 unit WMHVA, $25 share Core Office)	5.7%	0.0%	0.0%	1.0%

Wells Real Estate Trust II closed its offering in June 2010.  At December 31, 2010, the REIT had $5.4 billion of assets including $4.2 billion of real estate owned directly.  Wells REIT II realized $568 million total revenue and a $23 million net income.  The shareholder 5.7% dividend is 80% covered by Funds from Operations and 85% by Modified Cash Flow.  The company realized a $161,000 loss on the sale of New Manchester One during 2010.  The REIT appears to be managing its cash flow prudently, covering distributions at a 90% rate.  Property operations in 2010 capitalized at a 7.5% rate suggest net real estate value of $5.9 billion, approximately 40% higher than the book value of the real estate.  Such a value would be consistent with a value of about $9.50 per share, very close to the DRIP price.

Wells Mid-Horizon Value-Added Fund, LLC, opened its initial offering in September 2005 and closed it September 2008.  At December 31, 2010, Timberland had $63.2 million of assets including $50.2 million of real estate owned directly.  Wells Value-Added Fund realized $5.57 million total revenue and $3.4 million net income after recognizing a $6.7 million gain on the disposition of the Park Lane Building in Pittsburgh, PA.  The REIT’s book value per share was $812.85 as of December 31, 2010, which reflects a decline from the original $1000 offering price per unit equal to the offerings costs and deprecation recognized on the real estate holdings.  The REIT originally had an objective of liquidation of the portfolio within eight years of the start of the offering of units.  This would suggest a termination in 2013.  However, the 10-K appears to be preparing investors for an extended holding period: “(W)e do acknowledge that the current economic conditions and their impact on office market conditions may require that we hold individual assets longer than originally projected in order to achieve the best disposition pricing for our investor members.”

Wells Timberland REIT opened its initial offering in August 2006 and its follow on offering ion August 2009.  At December 31, 2010, Timberland had $360 million of assets including $341 million of timberland owned directly.  Wells Timberland realized $47.6 million total revenue and a $19.5 million net loss after provision for $3.7 million of preferred dividends, which were deferred.  Shareholders currently receive no distributions.  The REIT’s book value per share was $4.16 as of December 31, 2010, which represents a significant dilution from the $10 offering price.  As of the publication of the REIT’s 10-K, the share offering is scheduled to close August 6, 2011.

Wells Core Office income REIT opened its offering in June 2010 and is raising funds at a reasonable pace.  At December 31, 2010, the REIT had $35.4 million of assets including $28 million of real estate owned directly.  The company generated $755,389 total revenue and a $1.5 million net loss.  The shareholder 1.0% dividend is not covered by Funds from Operations or Modified Cash Flow.  The subsidy of dividends at this early phase of the capital raising is common.  As the REIT has less than a year of operations, it is too early to draw any conclusions on the effectiveness of management.

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[1] Modified Cash Flow is a Clarity Finance measure which equals (1) net income plus (2) depreciation and amortization, plus (3) acquisition fees and expenses, less (plus) (4) any realized or provisions for capital gains (losses) on the income statement, less (plus) (5) income (losses) from unconsolidated entities, plus (6) distributions from unconsolidated entities.