Real Estate Economics and Finance

Advice to President Obama:

.”..we’re going to unclog the arteries. My banking experts have analyzed each of your balance sheets. You will tell us if we’re right. Those of you who are insolvent, we will nationalize and shut down. We will auction off your viable assets and will hold the toxic ones in a government reconstruction fund and sell them later when the market rebounds. Those of you who are weak will be merged. And those of you who are strong will receive added capital for your balance sheets, after you write down all your remaining toxic waste. I am not going to continue rewarding the losers and dimwits amongst you with handouts.”, Thomas Friedman wrote on Sunday.

With another $350 billion to spend, Barack Obama has a critical decision to make. In this mess of an economy, who is the best allocator of capital (how can we get the most bang for our buck)? There are three broad options:

1. Individuals
2. Government
3. Businesses

As our economy matured over the past several decades, banks (businesses) have been the bearer of this responsibility, but with the failure of so many massive financial institutions, can business be trusted allocate capital efficiently?

Yes, with a caveat. While capitalism has proven government is too susceptible to partisan & special interests, many individuals and businesses have also proven to be too susceptible to human nature, primarily greed. There are however, those that have proven different.

As Friedman points out, we must reward those businesses who have proven responsible and effective, not to the reckless institutions managed by the weak leaders that brought this upon us.

Public works projects are well intentioned and should certainly be pursued where appropriate; however, government has largely proven to be an inefficient allocator of capital. The single greatest tool the government has is the ability to incentivise behavior through fiscal policy rather than mandate it through regulation.

In this spirit, if we want America to thrive again, government should focus its efforts and resources on putting Americans back to work. The key to this strategy is to reduce labor costs for employers.

• Obama has it right with his tax credit for businesses hiring new employees, but this does not go far enough. There is a need for a number of other programs which have been tossed around by the new administration and some they haven’t thought of yet.
• The tax credit certainly lowers costs, but it is an upfront savings which effects will be limited by businesses already struggling to keep who they currently have on staff.
• Healthcare is another crippling cost that keeps employers payrolls smaller than they otherwise would be. This is why passing Obama’s healthcare plan will open up resources for hiring a more robust workforce.
• Offer employers further tax benefits for subsidizing the education of new employees and community college students who will commit to working for the company once they graduate. Not only will this be a boon to educational institutions, it will provide a clear path to employment for underprivileged youth.
• A modified section 8 program can close the gap left by a weakened economy, falling wages and a government which is quickly becoming over-stretched. The impact on struggling families and a faltering real estate market would work by encouraging those under threat of foreclosure to make sure they are working, even if their wages were less than desirable.

Much of our strength as a nation comes from the incentive system embedded in a capitalist economy. Rewards come to those who work harder and smarter than the competition; put in place the right incentives, put America to work and we’ll be on the road to recovery sooner rather than later.

Adapting the Section 8 housing subsidy model, government might just find a way out of the cascading housing crisis. At the root of the problems in our credit markets and financial institutions are falling home prices nationwide; a phenomenon never before seen in America.

A program which subsidizes rents of homes would do two important things helping to abate the current crisis: (1) guarantee investors a baseline rental income –effectively allowing investors to accurately value a property based on cashflows guaranteed by the government– and (2) help individuals in danger of foreclosure by providing them with a stable place to live.

A subsidy plan could also be used to incentivise investors and financially troubled home owners to take actions which might aid our troubled economy in other areas…and god knows we need the help.

UPDATE [12.15.08]
Robert Maniscalco, my real estate law professor, brought up an interesting point today in class. Years ago, income producing property was depreciated over a twenty year life, rather than the current 39
year schedule. What a great compliment this would be to an expansion of the Section 8 rental subsidy program above. It would effectively result in a doubling of the depreciation write off (increasing investment returns) and a decrease in basis (reducing the incentive to sell). Rather than throw money at insolvent lending institutions, ideas like this would do much more to help the housing market find a bottom and save the U.S. tax payers a few bucks.

If 40:1 leverage was responsible for much of the GDP growth over the last decade or so, what does this mean for us going forward?

Here are a couple of questions we should be asking to determine where we are and where we are going (it’s already clear how the housing crises started):

1. Which assets benefited most from this exorbitant leverage environment?
2. What is a “healthy” level of leverage for these assets?
3. Based on the above two answers, what is the legitimate price level for these assets?
4. Did any of the financial engineering of the past decade have a legitimate use in risk reduction, thereby increasing what historical levels of “healthy” leverage are?

To the extent we can answer these questions, one should be able to call a “real” bottom and determine what the true expected returns will be in the long run. I haven’t seen a fair analysis of this anywhere, but if you have, please point to it in the comments below.

Most investors are rational; like most politicians are honest. So, if you fancy yourself one of the rational crowd, shouldn’t you be raking in the returns right now.

Too Smart By Half

“The problem with being smart, is waiting for the rest of the world to catch up with you.” - Jeff Macke (Fast Money on CNBC)

Should we accept this statement as true, we can infer that, to successfully time an investment, we must ask ourselves, “What event(s) will affect market psychology or, in other words, what will cause the tipping point?”


We can also state that the general liquidity of the asset in question should affect our decision.

Repressing Market Sentiment

Our answer to this answer should inform our investment decisions and strategy relative to the event(s).

So, what indicators should we ‘rational’ investors monitor? We’ve all heard of the “Magazine Cover Effect” and the “CNBC Effect“, but what are some other events indicating market psychology has gone askew? Market technicians should have a ball with this question.

I’m hoping to add some facts, figures and non-fiction on topics related to investing, finance, real estate and economics here.

Enjoy!