A Component of our Barbell Investment Strategy: U.S. Commercial Real Estate

Long-time readers will know that I (Henry) have been advocating a consistently bullish position on the U.S. economy, citing the U.S. energy production renaissance, the technology revolution driven by additive manufacturing, cleantech, and finally the general adaptiveness of the U.S. entrepreneurial class and capitalist system. We have been especially bullish on U.S. commercial real estate. While commercial and multi-family real estate prices have risen substantially in prime, “trophy” markets over the last 12 months, we believe there remains numerous investment opportunities in the non-trophy areas–i.e. properties that have not been sought out by international investors.

Specifically, much of the CMBS originated during the bubble period of 2004, 2005, 2006 and 2007 will be maturing over the next four years. As shown in the chart below, approximately $500 billion of CMBS will mature during 2014-17. Given the aggressive underwriting standards during 2004-07, much of these maturing CMBS will not qualify for refinancing. In other words, there will be significant forced selling of U.S. commercial real estate properties over the next four years. We believe such forced selling represent a once-in-a-generation buying opportunity for clients looking for steady cash-flowing properties and as a hedge against future inflation or US$ devaluation.

CMBSmaturitiesSource: AEGON, Trepp

Investing in U.S. commercial real estate or multi-family housing is a sound strategy for a wide variety of investment or economic scenarios, especially in a world experiencing significant social and economic change. The decades surrounding the turns-of-the-century have typically ushered in revolutionary change. e.g. A person who fell into a coma in 1790 and woke up in 1820 would no longer recognize the world. France has lost its dominant position as a European power, while England began its empire-building ambitions. After the War of 1812, the U.S. cemented its position and was no longer a fragile republic dependent on England. Similarly, a person who fell into a coma in 1890 and woke up in 1920 would find himself utterly confused. The U.S. replaced England as the world’s dominant industrial power; Europe’s map had been reorganized and many of the 19th century empires no longer existed (e.g. Austria-Hungary and the 2,000-year old Chinese dynastic system). 37 million perished during WWI, while the terms of the Treaty of Versailles would sow the seeds for WWII. Trust companies, such as Standard Oil and American Tobacco, were busted, while the Federal Reserve sprang up among the ashes of the Panic of 1907.

Fast forward to 1990. A person who has been asleep in the last 23 years would not recognize the world today. The Soviet Union, our greatest enemy, no longer exists. Japan, slated to become the world’s most powerful economy, is no longer (that) relevant. Instead, China is now regarded as America’s greatest competitor. In 1990, India’s economy was close to collapse–today, it is the world’s 9th largest economy–just behind that of Italy and ahead of Russia. Instead of an Indian bailout, the world bailed out Greece, Ireland, Portugal, and Spain. Italy came close to needing a bailout–an unimaginable scenario just a decade ago.

We are also enjoying a new domestic energy revolution, driven by productivity in shale drilling, horizontal drilling, and Lower Tertiary drilling. Solar is already replacing base-load power generation in Germany during a sunny day. By 2020, California will source 33% of the state’s energy from renewables.

On the other hand, there remains significant, new challenges to the U.S. economy and society. Overall debt levels remain high, while unfunded liabilities–in the form of future retirement and healthcare benefits–will bankrupt some developed countries if they are not curtailed (the present value of unfunded U.S. Social Security and Medicaid benefits is more than $60 trillion). Unless we implement more efficient healthcare cures and delivery services, we will inevitably default on these benefits–through more stringent eligibility requirements, inflation of the U.S. dollar, or outright default (Detroit is going through this as we speak).

In other words, both the U.S. economy and society will undergo significant fundamental changes over the next 5-10 years–for good or for ill. We thus recommend a barbell investment strategy over the next 5-10 years, i.e. selective risk-taking while employing a sound capital preservation strategy (contact me for more info). We believe our recommended position in U.S. commercial real estate or multi-family housing is a very attraction option on either end of the investment barbell, i.e. it should do well in the vast majority of different scenarios we could possibly imagine–either significantly higher inflation or a society transformed by clean energy and automation (e.g. self-driving cars). The maturity of approximately $500 billion of CMBS–which will trigger significant selling from motivated sellers during the next several years– is thus a perfect opportunity to purchase commercial real estate or multi-family housing to take advantage of these fundamental, macro trends that we foresee over the next 5-10 years.

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