4C — January 27 - February 9, 2017 — 2017 Forecast — M id A tlantic
Real Estate Journal
www.marejournal.com
E conomy
By David Hansel, Lucern Capital Partners 2017 Economic Outlook
A
s we reflect on 2016, and all of the impos- sibilities that proved to
structurally do not seem to have been impacted as of late. Moving forward, we expect there to be some factors that will constrain these borrowing channels at current profitabil- ity levels. On the heels of 20 years since the famous Greenspan speech, “Irrational Exuberance”, the SP500 Shiller (cyclically ad- justed) Price/Earnings Ratio stands elevated historically speaking, but is still far below levels last seen in the financial crisis. In our opinion, the eq- uity market’s growth more re- cently is driven more by specu- lation of continued growth rather than solid economics and underlying fundamentals. A chilling reminder of this is the significant deceleration of corporate earnings. Earnings per share (EPS) continue to increase in whole dollar prof- its, while earnings sustain- ability is weakening. Increased borrowing costs will weaken corporate balance sheets and increase variable rate corpo- rate borrowings, hurting EPS and making expansion more challenging. Mitigants such as corporate repatriation of profits, tax code changes, and strong economic growth will help offset these challenges moving forward. In our opinion, equity markets will pose volatility risk this upcoming year and investors should proceed with caution. Investing in relatively high valuations in an uncertain market can pose challeng- es, especially with upcoming changes to the economic and legal landscapes. We are of the continual belief that real estate should be an important piece of any investor’s portfolio diversification, but especially in 2017. While Trump’s policies have been partially outlined, his ex- ecution remains uncertain, but inflation that exists currently as a result of an expanding workforce, and contractions in both the unemployment rate and the U6 rate (aka under- employment rate), are driving our economy towards “full em- ployment”, and will continue to do so through 2017. Inflation will continue to drive the costs of goods and services higher propping up the economy and attracting further investment in the US Dollar, which has already and will continue to appreciate. In the mix of this, INFLATION AND DEREGULATION:
rent growth will increase, which traditionally accounts for a material portion of the consumer price index (CPI) which is the measure of infla- tion in the economy. Expect tax cuts through a revamp of the tax brackets and deductions. While the talking points are geared towards the middle class, higher income earners will also benefit from a less restrictive tax code, and small medium business own- ers will see an improvement in their revenues. Driven by a surprise victory for Trump supporters, middle- income earners are very posi- tive on the outlook for America and the economy. This will help reduce caution when given a chance between spend- ing and saving additional (now found) disposable income from tax cuts. The higher income earners and job creators, the “makers”, will invest more into their businesses, hire ad- ditional employees, and spend money on expansion. Deregulation, the corner- stone of any good Republican agenda, is likely to also be a focal point in 2017, led by majorities in both House and Senate. Despite Trump and rank-and-file Republicans not agreeing on a host of issues, de- regulation is one that they both can agree on. While Trump’s promise to “eliminate 2 regula- tions for every 1 passed” may be ambitious, ultimately we will begin to see roll-backs of growth-hampering regulation across industries. Expect energy deregula- tion to be at the forefront of Trump’s agenda as America looks for ways to continue to grow and the Bakken, West Texas, and other shale fields present enormous opportuni- ties for the US to monetize liquefied natural gas (LNG) in the global marketplace. Addi- tionally, lawmakers loosened, and expect them to continue to loosen four-decade old regula- tions that prevent the sale of American oil overseas. This antiquated regulation from the days of the Arab oil em- bargo will allow us to complete more readily in the global marketplace and will solidify America’s position of energy independence, giving us less reliance on current OPEC and Middle-East instability. This will be further bol- stered by Trump’s nominee for Secretary of State, Rex Tillerson - the current CEO of
Exxon Mobil with close ties to oil producing countries across the world and a proponent of energy reform, and of course the Keystone Pipeline. HOUSING FINANCE REFORM Fannie Mae and Freddie Mac, also known as ‘agencies’ or more formally Government Sponsored Enterprises (GSEs), have been under government receivership since shortly after the financial crisis when the United States government agreed to step in to prevent a catastrophic meltdown of the housing finance system in America. Without going into the history of the GSEs, their fundamental purpose is to backstop the single family and multifamily housing market. Between Fannie Mae and Freddie Mac, a staggering 45% of the $10 trillion single family mortgage market is represent- ed. Add in Ginnie Mae, which backstops Veteran’s Adminis- tration (VA) loans, and a mas- sive 61% of the single family mortgage market in America is backstopped implicitly and explicitly, by the United States government. Fannie Mae and Freddie Mac also control north of 95% of all new residential mortgage backed securities offerings in the United States. This means that the share of the residen- tial mortgage market that both agencies control will continue to outpace private lenders over time, an unsustainable path for the long-term health of the single-family housing market. By comparison, the multi- family side of both businesses (which sustained average de- faults during the financial crisis - not outsized like the residential business), have balance sheet loan portfolios of approximately $200 billion. Between 2015 and 2016, total multifamily originations for both Fannie Mae and Freddie Mac exceeded $200 billion. The disconnect between origina- tions and balance sheet loan portfolios is due to Fannie Mae and Freddie Mac securitizing the majority of their deals and selling them in to the market, therefore transferring them off balance sheet. The only re- minder of what was originated being the guarantee position that is recorded on their re- spective balance sheets. The call for privatization of the GSEs has never been louder. While the Treasury Department draws (exchanged
for preferred stock) have not le- gally been reduced by the divi- dend payments that the GSEs have swept to the Treasury De- partment, to date, Freddie Mac has remitted $101.4 billion in dividend payments, far eclips- ing their initial drawdown of $71.3 billion. Fannie Mae is in a similar situation, having distributed $148.5 billion in dividends, while only borrow- ing $116.1 billion. While the call by shareholders of both GSEs (the government pre- empts shareholder profitabil- ity through the preferred stock sweep), has been happening for some time, Steve Mnuchin, Trump’s nominee for Treasury Secretary has championed this call. It’s generally unclear how quickly Fannie Mae and Fred- die Mac could be unwound, but the Treasury department still holds approximately $80 bil- lion in warrants for ownership. There are several suggestions on the table to tackle this is- sue, but there is still a signifi- cant amount of uncertainty on which route will ultimately be selected. Rest assured that any change would likely preserve the ability of Fannie Mae and Freddie Mac to do what they do best - provide financing for housing in America, while pre- serving the depth and breadth of the single and multifamily market, thereby keeping rates in check (relatively speaking), and providing security for those investors who purchase Fannie Mae and Freddie Mac securities. COMMERCIAL REAL ES- TATE (CRE) and LENDING Dodd-Frank, the sweeping bill of financial regulation signed into law in 2010, will likely be weakened, however not entirely eliminated. Struc- tural changes to financial regu- lation and the agencies that enforce this regulation would be too costly and challenging to entirely unwind. Provisions related to high velocity commercial real estate (HVCRE), a new classification introduced by Basel III which focuses on construction lending and higher leverage riskier products, will also remain as lawmakers will not be eager to scale back financial crisis era reforms. Treasury Department regu- lated institutions will likely scale lending activity back on real estate as CRE concentrations reach the highest levels since continued on page 18C
be possible, we wanted to provide some of our com- mentary and insight into some of what we have been focusing on as we move
David Hansel
into 2017. It goes without saying that we are bullish on real estate, but from our team to you, we wanted to share our general outlook and mus- ings to (hopefully!) ease any uncertainty this upcoming year. From all of us at Lucern Capital Partners, we wish you a happy, healthy, and prosper- ous New Year! THE FED AND EQUITY MARKETS The Federal Funds rate hike was expected with 96% probability based on trading patterns and futures, and was therefore already priced into the market. The December rate hike was symbolic - the Federal OpenMarket Commit- tee, colloquially known as ‘The Fed’, needed to convey to the markets that they understand where the economy is headed, and that inflation was on the rise. More recently, trust and ac- ceptance of Fed commentary has waned to lows amongst market participants. After repeatedly misleading the economy on Federal Funds rate hikes earlier in 2016, and the “easing” tool chest grow- ing thin, the Fed needed a step in the right direction to avoid being “behind the curve” on tightening in an upwardly mobile economy, while saving face with the global markets and attempting to restore some degree of trust and a “say what we do, do what we say” method of operation. The world is looking to the US now more than ever, as Trump takes the Presidency with plans of infrastructure, employment, production, and GDP growth. The focus of the markets moving forward will be the additional hikes through 2017 which will so- lidify the rate hike cycle. While markets have expected the last two Federal Funds rate hikes for some time, conven- tional lender borrowing costs, indexed off Federal Home Loan Bank (FHLB) and other Federal Funds based indexes
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