Credit Crunch?

I'm working on a piece for work about whats going on in the credit markets. I thought I'd post a quick summary of my thoughts to date.

First, the business media is FINALLY starting to notice whats been going on for at least the last month. I noticed this a few weeks ago, and started to wonder. Well, actually in my business world this has been an issue since last year. Pricing has been elevated beyond what fundamentals would dictate, as cap rates were below lending rates on some Class A deals in the coastal markets. 2005 through mid-2006 that deal gets done. Late 2006 through 2007, we are seeing deals fall through because of the credit markets. This has filtered through into the Private Equity market as evidenced by Chrysler and a few other deals (Alliance Boots, Allison Transmission) that have been unable to be sold into the market. This was all quite predictable, as risk has been steadily been underpriced because of the absence of defaults. The subprime issue has reminded bond investors that risk is still around. Hence, investors are no longer shelling out for whatever deal comes to market, thereby reducing liquidity and increasing the risk premium. All of that is healthy. Risk matters and has in my opinion been devalued by market participants in the global chase for yield. That it is returning more to normal, means that the Bernanke Fed is finally squeezing out the excess money that the Greenspan Fed injected into the market in the aftermath of the recession and September 11th. Between October 2001 and January 2005, M1 grew an average of nearly 5.5% year-over-year. Some will dispute the use of M1, but I prefer it as a money measure, because it is the only measure most easily controlled by the Fed and gives an indication of their policy stance. Looking over the last 18 months, M1 has only grown at an average rate of .5%. A far cry from the Greenspan Fed era. The excess money is finally being squeezed out. So what does this mean? For commercial real estate, a return of risk, and a cap rate reversion, especially as it becomes laughable to underwrite continuous 6%+ rent growth in secondary markets over 10 years in light of the housing oversupply. (No kidding, I've seen some deals we've underwritten with that as an assumption). For the rest of the economy, lets hope the Fed doesn't overshoot. And we should see a fall in commodity prices. I am afraid though that a recession may be necessary to put the inflation genie back in the bottle.

Demand vs Supply Side

Just a quick thought, as we were analyzing the Tucson apartment market this morning, it brought on a quick thought. Demand vs Supply. Basic economics right? Even, the non-econ will tell you economics is about supply and demand (they're not correct, but I digress) for changing definitions, see this post from Mike Mandel at Economics Unbound.

Well I think in the apartment industry, the big boys (Equity, Archstone, etc) have focused too much on the supply side of the equation. Their mantra has been "supply constrained" markets, aka high barrier-to-entry markets, places where it is hard to add additional supply. The other focus of which only one big boy (Camden) uses, is demand side. In the supply restricted areas (which incidentally aren't all that restricted, see the multifamily permit boom in SF, Oakland, and LA-all popular supply-constrained markets).

The biggest problem for the supply constrained markets, is their inherent volatility. In a study that I did, we identified the most volatile markets from a rental rate perspective and calculated a beta for them. San Francisco, San Jose, Oakland, New York, Boston were the top-5. The interesting finding from all this research is two things. Supply constrained markets are generally more volatile, and definitely more sensitive to economic conditions. This means that appropriate discount rate applied to these markets should be higher because of the greater degree of risk. Current valuation practices do not take this factor into account. In fact, over time, the high growth regions have generally outperformed (using real $2005) the so-called supply constrained areas.

In conclusion, the supply side focus is trendy, but wrong-headed and will leave certain big guys in the apartment industry with a bad hangover in a downturn. Yield management will help mitigate some of this effect, but that won't avoid the storm. It leaves companies like Camden, well placed to outperform its peers.