CIO Letter

LETTER FROM THE CHIEF INVESTMENT OFFICER TIMOTHY J. BALLARD President, Chief Investment Officer Buchanan Street Partners MAY 2011

Debt Ceilings and Senate Floors

The past few months have been consumed with the national discussion over the potential default by the U.S. Government on its debt.  Let’s be clear, this crisis is not a financial crisis but a political one. The U.S. continues to have massive access to the capital markets, even with the political nonsense that continues in the halls of government.  This has been proven out as treasury yields have dropped over 1% on the 10-year treasury in the last month as buyers continue to demonstrate that they don’t see a lot of better alternatives in this time of crisis.  

Clearly we need to get our budget deficit and entitlement spending under control, and the sooner the better.  However, our biggest issue is the system itself and the motives of the human beings charged with making decisions. Politicians by nature are designed to perpetuate their existence, and the best way for them to accomplish this is to take care of those who can get them elected.  This has been proven time and time again, for example:

• Alaska’s bridge to nowhere: a $320 million bridge designed to connect less than 9,000 people to an airport that is already served by ferry access that has worked just fine for the past 35 years - more than $35,000 per person for an unnecessary bridge. 
• $2.4 billion spent for 10 jets that the Pentagon insisted they didn’t want.
• $2 billion given annually to farmers who are paid not to farm their land.
• This year, Washington will spend $2.6 million training Chinese prostitutes to drink more responsibly on the job.
• A GAO audit found that 95 Pentagon weapons systems suffered from a combined $295 billion in cost overruns.

The second major issue is that once government decides to take money from the private sector, they do so in a highly inefficient way, essentially dumping molasses into the gears of our economy. Unlike the private sector where those that don’t provide value must quickly adapt or go out of business, there is no such mechanism for Darwin’s rules of the road within the government sector. This then results in a poor allocation of resources that are diverted to a sector that executes inefficiently and without repercussion.  Again, some examples include:

• Government auditors completed a 5-year study of federal programs and concluded 22% of them fail to show any positive impact on the population they serve - at an annual cost of $123 billion.
• A GAO audit classified nearly half of all purchases on government credit cards as improper, fraudulent or embezzled.
• 20% of government employee travel cards are paid late resulting in millions of unnecessary finance charges.
• Health care fraud is estimated at $60 billion annually.

If any one of us operated our companies this poorly, we would quickly find ourselves unemployed. Not so in government.  While the average tenure of a U.S. CEO is a little over 6 years, the average Senator stays in Washington for over twice that long.  This might in fact be government’s formula to take twice as long, costing the taxpayers twice as much. 

There are further variables for us to analyze:

• Average federal debt per capita is about $117,000 per household. 
• When including unfunded Medicare, Medicaid and Social Security liabilities, average government liabilities per household grow to over $600,000 - $750,000 per household, depending on whose estimate you use.  That level of debt is hard to pay for when the average household earns about $50,000 annually. 
• Primary debt (mortgage, credit cards, etc.) is about $113,000 for the average household.
• The private sector, with all of its faults, including subprime debt, has limited its debt to less than 20% of what the government has incurred. 

In summary, politicians, regardless of party, seem incapable of disciplining themselves when it comes to spending and when they do spend, the inefficiencies and misdirection of capital further slows our economy.  This is not surprising if you look at the average resume of our legislators.  Their predominant professions are politics and law with 226 of the house and senate members having earned legal degrees. Twenty-seven members of the house and senate have no degree beyond high school.  We have charged this group with deciphering the world’s largest and most complicated economy while running the single largest enterprise in the world.  This is kind of like going to Jesse “the Bod” Ventura for tax advice.

So how does this affect our commercial real estate business?

As a real estate investor I have learned that you can’t fight the tide, and government policy can have a significant impact on investment outcomes.  The current federal policy has dramatically impacted the investment environment and the potential trimming of future budget deficits will have a different impact. On the positive side, the government’s assertiveness over the past three years has resulted in a number of benefits to our economy including:

• Saving large banks who have started to lend again.
• Driving interest rates to historic lows allowing some borrowers to significantly reduce interest costs.
• Causing investors to seek risk assets due to low returns in treasuries, pushing pricing for prime real estate assets up aggressively.

As we look forward, the impact of short-term stimulus and loose monetary policy will fade and create both new opportunities and challenges.   Things to be mindful of include:

• Investing in locations with a heavy concentration of state and government employment, i.e., Washington D.C., where federal spending as a percent of Gross Metropolitan Product (GMP) is in excess of 40%.  Sacramento and San Diego both have high concentrations of GMP derived from government spending at 25% and 20% respectively.
• Entitlement programs that have not contributed materially will cause unavoidable future tax hikes. It is likely that tax increases will be more heavily allocated to the wealthy impacting higher income coastal locations as disposable income is shifted to government.  In turn, cities like Houston, Seattle and Dallas will be relative benefactors. 

• Core assets purchased at low cap rates will struggle to achieve investment return as cap rates and interest rates rise.
• As soon as predictable, public policy is put into place, the massive trove of cash on corporate balance sheets will start to be invested, creating jobs.
• Overall the banking sector will heal and banks will start to lend their record level reserves, providing further needed liquidity to non-core assets, resulting in price appreciation.
• The dollar will continue to weaken, strengthening markets with concentrations of export driven business, i.e., Los Angeles, Seattle and the mid-west (passenger cars are one of our largest export products).

Investment Period Moral Hazard

Lastly, let’s talk about investment time periods. Like politicians who are in the business of getting re-elected, real estate investment managers are in the business of collecting income by buying real estate.  If they don’t buy real estate, their investment allocations are returned and deployed elsewhere. As you can see from the graph, investment managers had banner years in 2007- 08 raising about $175 billion in new commitments.  Assuming 65% leverage, managers had $500 billion in buying power from just those two years of fundraising. 

Generally speaking, most funds have a period of 3-4 years to invest before having to return the uncommitted funds to investors.  As of the first quarter of this year, Prequin estimated that there was approximately $120 billion of unfunded equity commitments outstanding, allowing for $350 billion of new investments on a leveraged basis. 

Given that much of this capital was raised in 2007 and 2008, investment periods are about to expire for many funds, providing significant incentive for managers to invest the capital now.  There is anecdotal evidence from the brokerage community that fund managers are pushing to invest their capital before it goes away.  But as managers look to invest in assets that are targeted by these funds, they are challenged with the underwriting assumptions necessary to win in today’s environment.  We often see these managers assuming 30-50% rent growth over 4-5 years and by utilizing all time low exit cap rates.  Given the lackluster performance of our economy and a likely continuance of the same for the next 12-24 months, we don’t see how fundamentals will improve quickly.

 If managers are giving in to this economic pressure to deploy capital, then it is no wonder that we have seen prices move back to the 2007 high watermark. This price rise then is unrelated to projections of economic soundness of our financial system, but simply based on capital market momentum. Today’s private equity fund managers have enormous buying power compared with the potential of actual transactional activity. Total U.S. commercial property sales for the period 2009-2010, was about $165 billion - or only about half of the buying power of these funds.     

The balance to this is that raising capital during the last two years has been almost nonexistent.  Investors have allocated less to commercial real estate funds in the last 30 months - less than they did in 2008 alone. As investment periods expire and are not replaced with similar allocations of capital, I expect that competition for assets will lessen.  Furthermore, as we look into 2012 more properties will continue to come to market as lenders appropriately address their problem loans.  This will allow the disciplined investor a better opportunity to buy quality assets without having to force underwriting assumptions to unreasonable levels.  This can be achieved in markets like Houston and Phoenix, where we see less capital competition, the assets are better priced and where we believe underwriting assumptions can be more realistic.

Best Regards,

Timothy J. Ballard

President and Chief Investment Officer

This publication is for information purposes only. Past performance is no guarantee of future results. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision.   Any opinions expressed are current only as of the time made and are subject to change without notice. Buchanan assumes no duty to update any such statements. The views expressed herein are solely those of the author and do not represent the views of Buchanan as a firm or of any other portfolio manager or employee of Buchanan.  This report may include estimates, projections and other "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. Buchanan assumes no duty to update any such statements.  This publication is not to be used or considered as an offer to sell, or a solicitation to an offer to buy, any security. Nothing contained herein should be considered a recommendation or advice to purchase or sell any security. Buchanan, its officers, its directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice.