Recovery and Reflation

By Michael Douville - Real Estate Market

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First the bad news:

The U.S. is in a recession, and has been since December of 2007, in my view. Furthermore, I expect it will be the worst recession since the Great Depression, and last at least until 2010. It will, however, NOT be a depression. There will be a terrible loss of jobs, with unemployment reaching almost to 10%. I see many business failures as well, particularly in finance and retail. This should drive huge dislocations of families, as workers seek alternative careers in the South and West. Just as necessity is the mother of invention, those who have had the misfortune of losing their jobs will seek new opportunities. Throughout all of 2009, there will likely be upheaval as the economy adjusts to the new reality of restrictive credit and raised underwriting standards of the financial system.

The Federal Reserve and the Treasury Department were late in understanding that fighting inflation was an issue of the past, and that there was a new and different problem before them. The deflating of the real estate bubble, followed swiftly by the bursting of the commodity bubble and the ensuing unwinding of leveraged positions around the U.S. and the world was causing huge destruction of capital. This loss of capital nearly destabilized the financial system.

The freezing of the credit markets in September was the "shot across the bow" that awoke the authorities to the crisis that had developed. Trillions of dollars have been lost over the past year throughout the world. As the unwinding progressed, asset prices sunk lower and lower; further exacerbating the downward spiral. In true emergency crisis mode, the horns blared and the cavalry charged with both the U.S. Treasury and the Federal Reserve swiftly replacing lost liquidity and capital.

The financial markets are still weak and before lending is resumed, each financial institution's own survival and viability will need to be ensured. However, the major governments of the world have taken equity positions in the financial system and guaranteed their viability. I expect that within three months, reserves will have been restored and lending will start to flow. Before today's action, the U.S. had added $4.5 trillion into the system, flooding liquidity throughout the banking body. Other G7 nations have added an equivalent amount. Thus, the replacement of lost capital is reaching the system. I expect the infusion needs 6-9 months to filter to users of credit throughout the world, and so it will be a difficult 6-9 months.

Those who have a job and have exercised restraint in the use of credit may pass through this period without a worry; those who are in debt or live in the more affected regions of the country, or indeed the world, will not be so lucky. Many U.S. citizens have enjoyed the free and easy availability of credit, and have become addicted to borrowing; they will suffer badly, as they potentially lose their homes, their cars and their credit.

Production of everything related to the consumer will slow as credit lines shrink; so will the over-consumption that has been pervasively driving the world economy. Without home equity lines and extended credit card balances, there will be fewer buyers. Those with cash will have their choice of a myriad of bargains, from computers and high definition digital televisions to cruise vacations and hotel accommodations. Valuable assets will likely be liquidated and sold cheaply to those with cash and credit.

Now the good news:

Recovery in both the financial markets and the real estate markets should be evident by mid-2009. In my view, the stock market will have bottomed by the end of March, as the efforts of the FDIC, FHA, and the Treasury will start to stabilize foreclosures across the US. Further, the lack of new construction in the residential and apartment sectors should bring an end to the glut of vacant homes. The demographic population shift from the industrial North to the West and South will see temporary acceleration due to the loss of manufacturing jobs. The troubled MSA's of California's inland empire, Phoenix, Miami and Las Vegas will once again stabilize through the added population of these displaced workers. Rental vacancy factors will start to decline, and due to the lack of additional construction, rental rates will start to rise. By the end of 2009, I believe the population will have risen through normal growth, to begin the process once again. As liquidity permeates the economy, recovery will inexorably reach all sectors and prices will rise again in both the equity and property markets. There will be unintended results.

The Great Depression was a simple recession amplified to an extraordinary degree by the central banks of the world mistakenly restricting money supply. The world suffocated from loss of capital and years of pain were added by not replacing the lost capital. In this recession, the financial institutions are being flooded with money. Trillions of dollars are being added to the money supply; never has there been this much liquidity added by so many global participants in such a short time. The increase in money supply is at historical proportions. The central banks of the world, in a coordinated response to the financial crisis, will attempt to restore asset prices, and as a result, restore solvency to businesses and institutions. I expect they will be extremely successful in restoring value; so successful that not only will they restore the old value, but they will reflate the world. The unintended result should be inflation.

Real estate, gold, and commodities such as oil and grains will again bubble as the money supply disseminates. By the end of 2012, I expect prices will have surpassed the highs of 2005, making all homeowners and lenders whole. By 2015, inflation should be a problem; interest rates will likely be high and money supply decreasing to slow the economy. In my view, this short time frame of seven years will allow fortunes to be made.

The emerging strategy I offer is as follows: buy affordable single family homes from the first time entry level and from the lower end of the move up category of second homes; these should all provide cash flow with growing rent revenues. The accumulation timeframe is from late 2008 through the end of 2009. Efforts of the FDIC and FHA should slow foreclosures coming to market, and so the availability of properties with depressed prices should dwindle. I expect rents will accelerate, due to a tightening of credit standards for new homeowners coupled with the lack of new construction. By late 2009, the aggressive pricing of asset managers should be waning, and stability and equalization occurring.

The years 2010 through 2013 could be excellent years to enjoy appreciation and growing cash flow; acquisitions would be on an opportunity basis. I believe homes purchased in 2008 will have doubled by the end of 2014. Inflation will likely be a problem by 2014, and all properties would then need to be sold prior to the Federal Reserve's inflation fighting efforts and the resulting problems. By the end of 2014, investors need to be back in CASH. Warren Buffet's famous adage "be greedy when everyone is fearful and be fearful when everyone is greedy" is extremely apt.


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