Wholesaling Apartment Buildings In A Volatile Economy

Eisenhower Balanced BudgetThe current debt ceiling debate, and now government shutdown, though currently on a 3 month hold, may be the first crack in what is shaping up to be an unpredictable and ugly phase in the life of the U.S Economy.

There is the persistent and “annoying” fact that, since the Clinton second term, and before that, the Eisenhower administration, the U.S. Government has been spending more than it collects in taxes and other revenue. That is, every budget passed by Congress and signed into law by the President (excepting for the two periods mentioned) have been funded by borrowed money.

In 2012 the IRS collected $2.469 Trillion in tax revenues, and the Budget allowed $3.796 Trillion in spending. That’s a difference of $1.327 Trillion.

Where did the $1.327 Trillion shortfall come from?

Well, the Government raises funds by having the U.S. Treasury issue bonds; T Bills. When investors buy the T Bills, the proceeds go into the U.S. Treasury coffers and are available to the Government for spending..

Who buys T Bills? More to the point, who buys the T Bills that fund the $1.327 Trillion (and rising) Budget shortfall each year?

Mainly countries, like Saudi Arabia, China, Japan, and quite a few other countries with shaky economies who want to bolster their sovereign wealth funds with the perceived certainty and stability of U.S. Debt, along with individual investors. But the volume of these investors doesn’t account for the entire $1.327 Trillion. The T Bills that are not bought at auction are vacuumed up by the Federal Reserve.

Apart from the fact of Government deficit spending in the first place, the Federal Reserve involving itself into the situation causes even more problems. Like the bottomless cup of coffee you find in some cafes, the ceilingless credit card the Federal Reserve is making available to the U.S. Government to draw from, skews and distorts what should be the processes of responsible government.

With the President, all Senators and Congresspeople knowing the money is ever flowing, and there are  no real limits preventing more borrowing (although they put on a good show every year with the debt ceiling negotiations), seeing the Fed is there to print money for any Budget shortfall, all kinds of self righteous, absolutist, ideological, self indulgent, finger pointing childishness is enabled in the behavior of the country’s political leaders. Democrats have their bloated welfare state, Republicans have their unaffordable low taxes. And when it comes time to negotiate something with real immediate consequences, like the debt ceiling, responsible negotiation gives way to a game of Chicken with the U.S. Economy.

The U.S. Leadership is so caught up in itself and it’s self created drama, it scarcely seems aware it is driving the country off an economic cliff.

It is exactly this kind of wild-eyed political craziness that spooks foreign investment in T Bills. It may take a few years, but T Bill investment will wane as foreign investors lose faith in the U.S. political process. That leaves the Fed as the only buyer at T bill auctions, and when that happens, the inflation tiger is unleashed and economic carnage can only follow.

If you care about your country, visit your Congressman/woman and give him/her an earful.

But there is also the fact of the U.S. national debt. The U.S. Government has not had a balanced budget since 1998 to 2000, and before that, the Eisenhower Administration in the 1950’s. It’s worth noting what Eisenhower said about his budgetary and fiscal policy, as this was the Supreme Allied Commander in World War II, a man who understood the military, war, and its costs. These are his words as President to a reporter:

“… the annual Federal deficit must be eliminated before tax reductions can begin. So I spend my life trying to cut expenditures, balance the budget, and then get at the popular business of lowering taxes.”

Eisenhower presided over D Day, Operation Market Garden, and the Allied advance that eventually ended the war in Europe. It’s clear the clarity of thinking and courage required to overcome his relentless opponent carried over into his economic policies as President. There were no games, just an honest effort to do what made the country strong; cut expenditures, balance the budget, then lower taxes.

It is striking to see how far the Government has strayed since then. Deficit spending (spending more than the country collects in taxes and funding the difference with T Bill sale proceeds) started with Kennedy, and save for a brief respite in the second Clinton term, and has gone full speed ahead ever since.

Today, the U.S. National Debt exceeds sixteen trillion dollars.

Do you see the pickle the country is in? Due to the Government running a budget deficit every year, the interest on the T Bills already issued ($224.8 Billion in 2012) is being paid for by proceeds of new T Bills being bought at current and future auctions.

I know you know how this ends. In your 20’s, were you so thrilled with your first credit card that you went ahead and took all new credit card offers that came cascading in to you through the mail? I did. I also still vividly remember the feeling of unreality and denial as I told myself everything was going to be fine as I placed my signature on the pre-approval for another card. Predictably, it got to the point where my income plus all the borrowed cash on hand I had wasn’t enough to pay the minimum monthly payment, and I defaulted on all of them, bar one. It took me years to pay it all off. (How about you?)

But sixteen trillion dollars is a bit of a different matter. Even if the U.S. Government stopped borrowing today, balanced the budget and started retiring the debt, it would take a few millennia to pay off entirely.

Those in power are aware of this, so faced with the impossibility of climbing sixteen Mt Everest’s, they have chosen instead the path of Quantitative Easing; increasing the stock of U.S. Dollars in the economy. The idea is to make the dollar amount of the debt less, relative to the overall amount of currency in circulation.

It’s a sneaky monetary trick, and not too different to trying to lose weight by having liposuction. Like liposuction though, QE addresses only the symptoms (high debt levels) and ignores the underlying problem (lack of discipline in Government fiscal management), so whatever benefits do come, it will only be short term before the before the underlying problem reasserts itself, and the country once again is unable to pay it’s bills.

But there is more. Like all desperate attempts to avoid facing reality, there are side effects.

In the case of Quantitative Easing, the side effects are asset bubbles in the short term, and inflation in the medium to long term.

The asset bubble is what we are experiencing right now. As the Federal Reserve adds $85 Billion of new currency to the overall stock of Dollars in circulation every month, assets, physical things with tangible value, like real estate, precious metals, go up in value as the dollar amount of their value corrects relative to the increased number of Dollars circulating in the economy.

This is where we are now. Look in your local market. Sales activity more than likely is heating up. In markets like L.A., things are already getting a little crazy.

The inflation is what will come later, as it must. Asset values will self correct, but if all you have is cash in the bank, it is going to be worth less. One dollar in a total stock of $900 Billion (where we were in the late 90’s) buys more than one dollar in a total stock of $1.21 Trillion (where we are today), which buys more than one dollar in a total stock of $1.5 Trillion (where we will soon be). The price of commodities will start increasing soon as well, and the dollar will buy less and less.

In 1970 Nixon went off the Gold Standard and instructed then Fed Chairman Arthur Burns to loosen the money supply so the incumbent President could point to a booming economy and get re-elected. It worked. Nixon won re-election. However, the entire 1970’s was plagued with inflation as a consequence, and only ended when Fed Chairman Paul Volcker raised the Fed funds rate up from 11.2% in 1979 to 20% in mid 1981, which made money tight and choked off inflation.

All this from lowering the Fed Funds rate from 7.23% in July 1970, to 4.05% in Jan 1972. Current Fed Chairman Bernanke has had the Fed Funds interest rate at 0.25% (effectively zero) since December 2008 (5 years), with no indication of ending it any time soon.

As a thought experiment, think about the inflation of the 1970’s. If you experienced it, go back there in your memory. If you didn’t, go to YouTube search “1970’s inflation”. Get a sense of the times. Then multiply that situation by ten (roughly the multiple of the amount of QE that has been done today compared to then).

This is what awaits the U.S. Economy.

Government and Fed officials talk about inflation today as though it is something they can control, like it is a dial on an economic control panel. Nothing could be further from the truth. The U.S. Economy, like all economies, is a dynamic system that seeks equilibrium. Once it is pushed far in one direction, as it is being made to do today with zero percent interest rates and endless money printing, it must correct an an almost equal amount in the other direction.

A pendulum swings back and forth, as it dissipates the energy of its initial swing. The delusion of Government and Fed officials is they can avoid economic cycles as though they don’t exist; stimulate it here and there and make everything OK. Well, economic cycles do exist, and we are all going to find out just how much they exist, soon, as the consequences of years of zero interest Fed funds and QE  play out.

What does all this mean to Apartment Entrepreneurs?

While the money printing and zero interest rates continue another bubble is already inflating, this time blowing real estate prices up to levels that have nothing to do with organic economic growth. We may have 18 to 24 months before it pops, possibly longer. If you are brave, organize a syndicate and buy a Class A apartment building in Los Angeles or San Diego, hold it for a year, then sell. Apart from that, just wholesale properties and build up you cash reserves and lines of credit.

When the current bubble pops, there will once again be masses of cheap deals available from banks, and a long period of austerity to follow. A bond market meltdown will probably bring a halt to the QE, but that is another story. Eventually inflation will rear it’s head, and given inflation is a pernicious tax on consumers, real wages will decrease in the years to come and the demand for affordable apartment units will go up.

Where I will be, and suggest you be too, is in Class C apartment buildings in the Sun Belt. Class C because this is where the demand will be from an overall affordability standpoint (real wages falling and the buying power of the dollar reduced), and the Sun Belt due to the migration of Baby Boomers to warmer climates. For the really industrious, you can also convert your property to solar power, eliminating Electricity as a line item expense and giving you a serious cashflow bump (plus it helps the environment). Cities with high annual days of sunshine are the markets for the Solar play.

Napoleon Hill said in Think And Grow Rich, “every failure brings with it the seed of an equivalent success”. U.S. Monetary Policy appears to be failing, and there are dark times ahead, though this is the United States Of America; who knows what bright new future it will usher in?