Jack Chat | July 2021

Beautiful day in the mountains today and I was moved to write another blog. I hope this finds you making progress on your 2021 plans and initiatives; as you begin to think about strategic planning for 2022, have you considered deflation?

One of my ULI colleagues, Mike Escalante, the CEO of Griffin Realty Trust, asked me to read The Price of Tomorrow by Jeff Booth. Booth is a tech entrepreneur who believes global abundance is found in deflation! And, what if he is actually right?

Mike and I had a robust dialogue this past week about the topic of deflation (yes/no); and, what we should do differently in our businesses (operationally and as investors) given our day jobs are in the real estate industry. My disclaimer, Mike and I are commercial real estate entrepreneurs; we are NOT economists.

First, the book: the general thesis by Booth (a technologist) is that Technology drives business processes (and the creation of products) better, faster, and cheaper. Further, tech eventually drives costs to zero. Given tech is globally pervasive in all regions of the globe, in all industries, and services; technology is the driving force for worldwide deflation. Booth believes that easy credit has driven economic growth and asset value appreciation. A credit driven asset bubble created artificially high LTVs. What then, assuming he is right, does this mean for the CRE Industry? Our industry has been built on the premise of job growth (which tech mitigates) and inflation (which tech deflates).

I ask YOU to consider your thinking about Booth’s thesis and the unintended consequences that could show up in your businesses. As for me and my thinking about a deflationary environment:

  • The concept of “total return” would be no longer of interest or valid.
  • Cash and Cash Flow would be king. Cash flow buys more in a deflationary environment.
  • We should then hoard cash and no longer ever try to be fully invested.
  • The industry then will go back to a ‘hold the asset long term’ context rather than CRE as a ‘trading’ asset class.
  • More cash equity should be invested in each deal.
  • Debt yield becomes more critical than LTV.
  • Lower LTVs are safer. So too is shorter amortization schedules.
  • Underwriting is all about the durability of cash flow. Long term cash flow, durable, is king. Therefore, single tenant credit, multifamily (stabilized), self-storage (stabilized) should remain valuable. (NOTE: I question, given a post-Covid world, whether tenants will want to sign long term leases.)
  • Debt would be a better investment vehicle in a deflationary world than equity. However, will the borrower agree to borrow (versus partner)? “Debt combined with deflation is a toxic combo”. A borrower pays the same constant interest payment while earning less to cover those constant payments.
  • “Value” is a statement about the perception about volatility of future cash streams. There remains ‘value’ in a deflationary world.
  • Is there “network value” in our platforms that all attached to our ecosystem benefit from one another and their growth? Are our platforms valuable as “Origination (of an investment) as a Service” (OaaS) AND as a data company with AI at its core?
  • Yet, before I take the ‘blue pill’ (or is it ‘red’?), I wonder aloud – a growing population creates more jobs. More jobs than tech takes away. Is that enough to eradicate his deflationary pressure and leave us a viable CRE Industry?

This is where Mike comes in; and I am paraphrasing what I learned from Mike:

  • Our world is about jobs, which is about people, and our demographic trends have been moving away from us for decades. Are younger people today thinking of having more or fewer kids than their parents did? If we create fewer people, if population growth flattens or drops by historical standards, then these fewer people are fewer job takers. And, thusly require less CRE. (NOTE: and don’t get me started on the state of the US higher education system and its ability to create professionals ready to be competitive globally for job positions!)
  • We have lived off asset growth since the 70s, driven by the baby boomer bulge and women entering the work force. What if we go back to one wage earners? What if folks retire earlier? Less job takers require less CRE.
  • The inflation we are experiencing currently is temporary – due to pent up demand. (NOTE: remember the “toilet paper rush to hoard” in the early days of covid?).
  • If Tenants will seek shorter term leases. Office buildings will be underwritten like hotels (NOTE: or apartments).

From my colleague John Eisinger at ArrowMark:

  • This has been the case for 20+ years. Japan has been in this situation for a long-time.
  • A few factors this doesn’t address are that declining working populations can be labor inflationary…there are fewer workers for the same # of jobs (so you have to raise wages to attract employees) – unless technology eliminates jobs which has not been the case historically – it has changed the types of jobs available/in demand.
  • Immigration is also another major offset – the total global population is still projected to grow quite a bit.
  • Stagnate economies will have to change their immigration policies to ensure population growth and maintain the ability of working populations to support retired populations.
  • “Let’s say he’s right and deflation is here and not counter-able. Interests rates stay low or go negative so people will borrow even more as hard asset prices keep rising because it doesn’t cost anything to borrow money. The government can sell as many bonds as they want because money is free – so they enact enormous social programs that replace individual consumption (if individuals borrowed less – his comment about how much incremental debt it took to move the growth needle) in the GDP growth driver equation of C+I+G+X…this happens over 15 – 20 years. Then it all ends abruptly 20 years from now as individuals have been taxed at enormous levels to pay for the programs, the dollar is seen as worthless because massive amounts of it have been printed for so long, inflation spirals out of control as the government prints money in a last ditch effort to keep the Ponzi scheme working – boom, massive depression and nation state and individual bankruptcies reset it all.”

It is all about the reset, on so many levels, and when.  I guess Japan really is the canary.

I bet you are thinking I am suffering from hypoxia or heat stroke! Feel free to disagree and bite back! I think it’s fun to take a time out and think about and sprinkle changing backdrops into our thinking.

I do wonder where equilibrium is.

If that isn’t enough, what else?

  • Business is good. A ton of capital is flowing. Our portfolios have bounced back.
  • Not seeing a lot of aftereffects of the pandemic (other than extreme pent up demand).
  • Hiring seems to be an issue. Tough for all of us to find the people we need in our organizations.
  • Everyone will be back in the office soon after Labor Day. Sure, there will be changes, differences, hybrid responses; but (to paraphrase Mark Twain) the demise of the office product is greatly exaggerated.
  • Pensions are underfunded, the enormous US Deficits, political instability in the US, makes me wonder about the fragile underpinnings our economy provides for our industry.
  • Travel is back. Try getting a seat on a plane or a room in a hotel.

God, I love this business. I hope everyone is enjoying their summer. Mike, thanks for priming the pump. John, you as well.