A Capital Markets Overview

By Mike Myatt, Chief Strategy Officer, N2growth

I am beginning to sense a change in the winds…While I’m certainly not a dooms-dayer, I am starting to show my bearish teeth as the capital markets are definitely starting to slow their momentum. Virtually anywhere I look, I’m seeing markets showing cautionary signals which I believe merit some analysis for those of you looking ahead into 2007.  The good news is that healthy upward trending markets need to rest on a plateau or even suffer a minor retracement in order to sustain long-term growth. The bad news is that I beleive this not to be the case…While I don’t believe current market conditions are reason for panic, I wouldn’t be at all shocked to see the economy move toward slow growth or no growth (can you say recession) over the next 12 months. I hope that the text contained in today’s post will provide a bit of insight as you make your plans for the New Year…

Let’s start with a quick synopsis of the mergers and acquisitions markets. There is an interesting paradox developing in the M&A market in that the capital targeted for new acquisitions is at an all time high, yet both the number of transactions as well as the aggregate transaction volume has fallen for two consecutives quarters. Q3-06 transaction volume fell to 1900 transactions down from 2200 transactions in Q2-06, and total transaction value slipped to $230 billion dollars down from $290 billion dollars during the same period.

The statement that there is too much money chasing too few quality deals has never been more accurate. Private equity firms, hedge funds, as well as corporate and institutional investors have appeared more like sharks in a feeding frenzy than sophisticated investors over the past few years. The voracious appetite of those on acquisition binges has been in large part responsible for driving valuations to ridiculous heights. Many entrepreneurs have been rewarded by holding-out for premium valuations with no lack of suitors knocking at their doors. However things may be changing as it appears that the smart money is starting to wake-up and exercise some discernment if not straight-out caution…Companies will need to fight harder for valuations next year as the frenetic pace of the last few years will slow in 2007.  The times are changing and my advice is to get your capital while it is still available…

Let’s turn our attention the stock market…Even though the Dow Jones Industrial Average has continued its march into record territory in recent weeks, the closing bell yesterday marked the worst day in four months for the Dow with the market falling 158 points. Are yesterday’s closing numbers just indicative of profit-taking or could this be a sign of things to come? You might consider that the New York Stock Exchange recently announced that it took a $28 million dollar charge-off to fund severance payments for more than 500 employees expected to be cut from its payroll by March. A workforce reduction by the NYSE in a heated bull market seems a bit odd doesn’t it? I wonder if perhaps they know something we don’t…

The economy in general is also showing signs of rapid slowing. While many believe the housing market has hit bottom, it still remains very weak which had a dramatic effect in consumer confidence in October. This weakness in consumer confidence has also had an impact on retail sales numbers as holiday sales are off to a much slower start than forecasted. Wal-Mart, the world’s largest retailer reported a 0.1 percent decrease in same store sales over recorded numbers last year at this time. This is Wal-Mart’s first reporting deficit in a decade and may be yet another indicator of a slowing economy. Further confirming this trend is the fact that the US Dollar hit a 20 month low against the Euro yesterday pointing to concerns that foreign investors may be sensing a weakening US economy as well… 

My point in sharing these observations is not to send you rushing to make adjustments to your portfolio. I’m simply attempting to point out that signs of market transitions are starting to show themselves. My advice in that regard is to consider the impact of weaker capital markets in 2007 on your business, and to factor this into your forecasting for next year. An acronym drilled into me from my days in the military is the principle of the 7 P’s: Prior Proper Planning Prevents P*ss Poor Performance…Plan well!  

The Impact of Rising Interest Rates

By Mike Myatt, Chief Strategy Officer, N2growth

I was recently asked how a rising interest rate environment would effect the commercial real estate market. Given that interest rates have been hovering at or near all times lows for quite sometime now, I believe addressing the impact of a changing rate environment would potentially be beneficial to many. Being old enough to have lived through a few different market cycles I have witnessed the carnage that can occur when people get caught flat-footed during market transitions and it is not pretty. The question is not if interest rates will rise, but rather when, how much and for how long they will rise. In today’s post I’ll attempt to provide you with enough information to make an informed decision as to how you will manage interest rate risk into the future…

There has been no shortage of conversation surrounding the topic of rising interest rates in the commercial capital markets over the last two years. The reason for all the column fodder is that interest rate movement has a direct impact on the state of capital markets supply and pricing and can have a very real impact on the overall commercial real estate market. Furthermore, the impact of rising interest rates can spill over into other sectors causing even greater havoc on the overall economy. That being said, the question that was posed addressed the commercial real estate market and so I’ll focus the balance of the text in that area.

As a baseline for a deeper analysis it is useful to have a macro-economic understanding of what happens to property level supply and demand drivers and the resultant impact on Net Operating Income (NOI) in a rising interest rate environment. As a general economic principal when interest rates rise the cost of new construction increases thereby slowing the number of construction starts and depleting new supply of product coming online. This scenario in turn causes an increase in overall market absorption rates and creates a “landlord’s market” environment. The environment which favors the landlord creates an opportunity for property owners to increase rents thereby allowing NOI growth to keep pace with any escalation in interest rates. While this scenario is favorable to existing property owners and making the rise in interest rates less of a concern, the impact to developers and tenants is detrimental and can have a negative overall impact on the economy if a high interest rate environment lasts for any length of time.

At a more micro level some of the major issues surrounding the impact of increasing interest rates on commercial capital markets are addressed below:

Flow of Funds: In a low interest rate environment real estate provides a reasonable investment alternative to other low yielding asset classes. With rising interest rates the supply-side availability of capital marked for commercial real estate will constrict. The aforementioned contraction will be due to a combination of reduced demand for new supply as weaker developers are weeded out of the market and alternate investment opportunities in other asset classes begin providing a better yield while being perceived to have less risk when contrasted to real estate investments.

Loan Pricing, Sizing and Cost of Funds: The overall blended cost of capital will increase dramatically. This dramatic increase will come not only as a result of rising rates across underlying indices but moreover as a result of lower advance rates in the senior position shifting a higher percentage of the capital structure up in the leverage curve. The reduction in LTV and LTC advance rates will cause a borrower to rely more heavily on mezzanine and equity financing resulting in shift from the current “borrower’s market” climate to a “investor’s market” environment.

Investment Sales: Sales of investment grade properties will slow rapidly as many of the buyer’s in today’s low interest rate environment will move to the sidelines. Institutions and REITS will remain active buyers while many of the individual investors will be forced from the market. Default rates will climb and more distressed property will come onto the market as investors who leveraged up on floating rate debt during the low interest rate environment will have a hard time keeping control of property as their debt service obligations increase.

Commercial real estate owners who believe that interest rates will rise substantially and will remain elevated for any period of time should be looking to refinance short-term, floating rate debt with long-term fixed rate debt. Buyers looking to acquire investment property should look for assets with upside potential for NOI growth through improved management and upside pop in leasing opportunities.

A Case Study in Politics

By Mike Myatt, Chief Strategy Officer, N2growth

I rarely opine on political matters, but it was just to tempting to resist on election night…Out of all the House, Senate and Gubernatorial campaigns in this election perhaps the most interesting race in the country was waged in the State of Oregon where Democratic incumbent Ted Kulongoski was in what should have been and wasn’t a hotly contested race with Republican candidate Ron Saxton. Was this the most strategically important race in the nation? No…Was this a race between two political heavy-weights? No…What this race did exemplify is the perfect case study contrasting a well run campaign vs. the worst run campaign in the country. In today’s post I’ll break down this race for your entertainment pleasure…

The backdrop…Oregon is perhaps one of the staunchest “Blue States” in the nation. Even with most of the population centers in the state being very liberal combined with the national shift toward the left (or perhaps more accurately away from the current administration) Oregon was nonetheless ripe for the pickens for the Republicans. Oregon’s economy is weak, the education system is one of the most poorly funded in the country, the state has been in an ongoing budget crisis and there are a whole host of other issues that set the stage for what should have been a Republican victory. If you just don’t believe Republicans can win in Blue States in this current political environment I have three words for you: Schwarzenegger in California…

The Candidates
Ted Kulongoski:  An ex-Marine, former labor attorney and career politician (incumbent Governor, former State Supreme Court Justice, State Attorney General, State Senator, State Representative and State Insurance Commissioner). While in this author’s humble opinion a completely ineffective Governor, he is a man of character and a genuinely nice guy.

Ron Saxton: A corporate attorney and conservative Republican, Saxton’s political experience is limited to chairing the Portland Public Schools Board and serving as a local political commentator. Again, in this author’s opinion Saxton would likely have proved to be a more effective Governor based upon his private sector experience and connections, pro-business philosophy and bias to action had he run a decent campaign.

Where Saxton Went Wrong: Everywhere…Following is a breakdown of what went wrong:

  1. Image: Ron Saxton is a nice guy, but you’d never know it unless you knew him. He went into this election as the lesser known candidate, which should have been to his advantage when running against a career politician with a weak record. He had the opportunity to carefully craft how the public viewed him and completely blew it. His likeability factor was non-existent and his image was rough and unpolished. Moreover, being blunt, brash, opinionated and seemingly arrogant didn’t help matters. Despite huge spending his choice of issue positioning only served to compound his problem and he never really connected with the voters. When are politicians going to learn…winning an election is all about image and the ability to connect with voters…Miss this point, lose the election.
  2. Positive or Negative: Negative campaigns work very well when you opponent is not well liked but they are a complete disaster when your opponent is well thought of. Regardless of Kulongoski’s track-record his likeability factor is huge. Every time Saxton went negative it was akin to the school bully picking on the most popular kid in class.
  3. Spending: Saxton massively outspent Kulongoski with almost $8 million dollars being burnt in his losing effort. Can you say overexposure? One of the big stories in this loss was the horrid choices made by the Saxton campaign when it came to media expenditures. Saxton bombarded Oregonians with negative TV ads, telemarketing and direct mail (the forms of marketing most disliked by voters). From a theoretical perspective his tactics may have looked good on paper, but his handlers obviously didn’t understand the difference between theory and reality. I actually spoke to a registered Republican voter who had their ballot stamped an ready to mail in favor of Saxton, but decided not to send it in simply because they got tired of being bombarded by recorded telephone solicitations.

What Kulongoski Did Right: Everything…Following is a breakdown of what he did right:

  1. Image: Regardless of what you think of his politics or effectiveness he is well liked. He’s a patriotic ex-Marine who has attended virtually every funeral of Oregon soldiers who lost their lives in the Middle East. He spends a great deal of time in the community and is well thought of for doing so. He is also very adept at knowing when to lay low (in my opinion he is too good at this such that he has been labeled by many as the “no-show” governor) and avoiding conflicts…the benefits of being an experienced career politician.
  2. Positive or Negative: Kulongoski is a feel good campaigner…He knows that the majority of voters in the state are democratic and he is definitely in touch with his constituency. He spent less money and effectively painted a picture of a friendly, honest man attempting to do right which resonated with voters. Rarely did he go negative, but when he did he picked his shots and they were well received as his opponent was not well liked.
  3. Spending: Two words…well managed. Kulongoski had less money and did more with it…Most importantly he didn’t alienate voters that were party-liners or voters that were on the fence. Rather he actually capitalized on the ineptness of his opponent by getting some Republicans to not cast a ballot out of disgust and pulled other moderate Republicans over to his side of the fence.

I’m quite convinced that with a fraction of Saxton’s budget I could have crafted an image and a campaign to support said image which would have resulted in a Republican victory…Hey Ron, give me a call next time around! 

Amtrak…Doesn’t Get It

By Mike Myatt, Chief Strategy Officer, N2growth

Having spent much of my life working with successful companies I appreciate all that it takes to create one. Developing world class organizations is not an easy task however settling for mediocrity (or worse) doesn’t require much effort at all. Quite frankly I have developed a bit of disdain for organizations that won’t do what it takes to get things right because virtually all business issues can be resolved with focus, effort and commitment. Therefore I’ve decided to add a new category on the N2growth Blog: Rants. Within this category I’ll take the liberty of venting on topics, issues, current events and companies that just miss the mark. First up…Amtrak. 

I’m not sure whether it’s a luxury or a curse but I end up doing quite a bit of traveling on behalf of my clients. In that love-hate relationship that I have with travel there are fond memories and pleasant experiences as well as equally memorable but horrific experiences. I had a relatively short trip to take last week and decided to try something different…rather than fly, drive or be driven I opted to travel by rail. Big Mistake…

OK, the scenery was gorgeous and the company was great (my wife was traveling with me), but there ends the positive sentiments with regard to my Amtrak experience. We arrived at the train station only to find it outdated, dirty and unkempt. It is my humble opinion that amenities at the train station should closely resemble those of an airport, but what we experienced was regrettably nowhere near the modern environment of an airport, rather it was a mirror of a Greyhound station. Strike number one…

We chose not to travel coach opting for business class tickets, expecting a business class experience…we were disappointed yet again as the car was old and dank. Once we found our seats and got settled I practiced my quick-draw and reached for my BlackBerry only to have the conductor inform me that I can’t use my cell phone in the car and that I would need to step out into the vestibule so as not to bother the other passengers. Hmmm…business class seats presumably occupied largely by business travelers and all prohibited from using their cell phones. Strike number two…

At this point we decided the only reasonable thing left to do was to feed our frustration. As my wife and I went in search of the dining car with our hunger and our anticipation building we walked through the door only to find out that it was “not active” which meant that you could sit in the dining car but that they wouldn’t serve any food to you. Yet another disconnect and strike number three…

I could comment on other flaws regarding what I now refer to as the “great train robbery” but I think you get the point. It is no secret that Amtrak has been in financial trouble for sometime, but as I’ve said many times cost-cutting does not constitute a viable long-term business strategy. I’m fine with temporary cost-cutting as part of a transitionary tactical plan but Amtrak seems to be forever stuck in transition land. Deferred maintenance, poor customer service, flawed business logic, no competitive value propositions and a lack of vision will not turn the Amtrak brand around.

The leadership at Amtrak should be embarrassed about their product. Rather than over promise and under deliver they need to embrace innovation and creativity to regain customer loyalty. If anyone at Amtrak wants to comment I’d be happy to give you some airtime in an attempt to let you justify how you treat your customers. However rather than have your PR firm try and spin me I would suggest that you start working on your business model…