A Diamond in the Rough

Oh the irony of it all. Consumer spending is way down, and so the retail sector has been hit hard. Unemployment is at 8.1% and climbing by the day on its way to 10%, and so the office sector is hurting. People are traveling less, and have less discretionary income, so the hotel sector has been battered. Portfolios of industrial property that would have traded sub-7 CAPs 18 months ago are now trading at double digit CAP rates. Even multi-family, a sector success by way of comparison, has felt the impact of tenants looking to double up, rent growth beginning to flatten, and has yet to see, in some markets, a wave of supply from condo projects-gone-bust mess with occupancy rates.

The one niche sector that hasn't been touched? Data Centers. That's right, the same sector that fueled the mini recession earlier this decade and is lovingly referred to as the dot-bomb era is currently partying like its 1999. How is that possible, you ask? Several factors are at play.

1. Demand is Different

Back at the turn of the millennium, data center demand was bursting at the seems from seemingly every start up company on Earth. Of course, the ability to grow was fueled mostly by venture capital, and every start up needed, or wanted, data center space. When these low revenue/ridiculously highly leveraged companies failed, data centers emptied out and were sold at bargain basement prices.

Now, instead of poorly capitalized start ups driving demand, heavy hitter companies are leading the charge. There are several reasons for this. First, since 9/11, major corporations are legally required to have backup sites for information to protect against the threat of a terror attack on their main infrastructure. These have to be off site, and since most major corporations are located in urban centers, that means these sites are often in suburban areas at least an hour away from headquarters. Secondly, we have seen the rise in bandwidth sucking websites like Facebook, You Tube and MySpace. These types of social networking sites demand a huge amount of electricity that only data center space can provide.

2. Supply is Constrained

When the data center stock was sold after the fallout, many of the suburban buildings were adaptively reused for other purposes. This constrained supply naturally. Furthermore, as construction costs soared a few years ago, nobody built much of anything on spec, let alone a data center whose bad taste was still in every developer's mouth from 2001.

Furthermore, many of these powerful electricity-sucking facilities need to be strategically located close to a major power source like a substation, or a fiber conduit. Locating further away from these sources makes it more expensive to gain access to the necessary power, which isn't conducive to keeping costs down for landlords or tenants. This is especially the case in urban environments, which makes adaptive reuse of old vacant office buildings or warehouses much more challenging if they aren't in the ideal location.
3. Growth is Organic, not Economic

Unlike most other sectors whose growth is usually tied to economic factors like jobs, consumer spending and housing prices, data centers are not. Demand is outstripping supply by a healthy margin, and demand for this type of space is projected to grow substantially over the next 5 years. One only need to look at the newspaper industry to see why. Newspapers are failing across the country because more people are choosing to get their news either via the television or online. As society as a whole becomes more comfortable with doing things online, and as generations who grew up with computers become the majority of the workforce, it is only logical that more and more of our lives will be connected via the computer. As this happens, there will be ever swelling waves of data that need to be stored somewhere, and data centers are where that will likely be. Corporations will move their file rooms to online servers. Warehouse and stock room inventories will be tracked and managed online. It is a natural progression of the way we will work, and live.

Don't believe the hype? Digital Realty Trust, the biggest REIT of data center space, has an 11-million-square-foot operating portfolio that is 95% leased. Demand appears high and new average rents are three-times higher than expiring rents. Hence its strong fourth quarter earnings report a few weeks ago, which included a 43.4% jump in FFO to $68.9 million ($0.76 per share). For the year, FFO was $230.3 million ($2.62 per share), up 27.8% from 2007, and adjusted FFO was $2.48 per share, a 21.0% jump from 2007.

As Baird analyst Will Marks points out, “We believe that many corporations are likely to look for ways to cut costs in 2009 and one way to cut costs is to outsource data center operations.” “This trend should benefit DLR.”

While there are industries and niches that run cyclical with, and counter cyclical to the economy, the data center market, unlike all of the rest, seems to know no valley no matter what the economy is doing.

The Matrix

The Matrix, the hugely popular movie featuring Keanu Reaves, conceptualized an alternate world disguised as the real world, so that average humans would go on, thinking they are living their lives without drastic change, as machines acted as puppet masters behind the scenes, using us all for our energy in order to survive.

When you think about it, that concept isn't all that dissimilar from what is happening currently in Washington with all of the bailouts. The politicians are the machines, US citizens are the unassuming, comfortable humans, and only a rare few of us are actually "awake" living in the true real world.

Let me enlighten you. I am certain at some point over the last few months, you have heard some variation of a statistic suggesting how much all of these bailouts are costing each man woman and child in the United States. Last time I check, it was approaching a few grand. While to most people that is still a significant sum of money, when you rationalize it that way, it still doesn't seem like its that much.

So I took the time to create a matrix of my own (Microsoft Excel spreadsheet) depicting the twenty-five largest cities in America, their populations, and their average household incomes in order to come up with the annual average income of the cities themselves. Note: Unfortunately due to formatting issues, I am unable to paste the table into this blog, but just trust me...

The real purpose of this exercise was to determine how much each bailout costs an entire city population. That is, I wanted to show how much the bailouts cost U.S. taxpayers as a function of everybody in a major U.S. city forking over every penny they've earned over the course of an entire year. I was hoping my efforts would put some perspective on these bailouts, and the results are astounding. Time for some fun facts.

- If everybody in the city of Philadelphia handed over every penny they earned last year, it would cover the cost of Citigroup's bailouts.

- If everybody in Miami AND Pittsburgh handed over they're paychecks for all of last year, it WOULDN'T be enough to cover just the INITIAL auto bailout.

- To cover the initial auto bailout, AND the subsequent requests to maintain solvency, it would take the dollars and cents of everyone in Miami, Dallas & Seattle.

- Think bailing out AIG was a necessary evil? Ask everybody in Chicago if they'd be willing to spend everything they earned last year to make it happen.

- The cost of bailing out, or to be politically correct, placing in conservatorship, Fannie and Freddie? That would be the entire incomes of Los Angeles, Boston & Phoenix.

- And saving the best for last, what was the total cost of the Bush bailout? Only the equivalent of asking every taxpayer in the three largest American cities (New York, LA, & Chicago) to hand every penny over that they made last year. Oh, and guess what....that STILL would have come up a little short.


When we put it in this context, do you think there is a chance in hell Congress would have approved ANY of these bailouts? A few, maybe, but all of them, certainly not. And at least that would have been one fewer emergency tracheotomy resulting in our economic death.

The Three Kings

On Monday we discussed the game of three card monte. So what are the three cards acting as culprits in this mess? Let's examine:

The King of Spades - Natural Excess of the Cyclical Economy

In every recession, there always seems to be some sector/product of excess, that creates a bubble, or a run up or oversupply of/in that particular sector/product. When demand can't catch up, the recession hits, as there is no longer a need for that sector/product. To briefly explain why oversupply can cause or lead to a recession, we need to understand relationships in the economy. When oversupply occurs of a major economically impacting product, and demand is far behind supply, supply temporarily stops because there is no need for it. This causes roughly a 3% decline in GDP (gross domestic product). Every time there is a 3% decline in GDP, it roughly translates into $2 million lost jobs.

Naturally, over time, the excess is burned off, because production stops, the population continues to grow, and eventually, demand catches up to a healthier balance with supply. When the tech bubble burst, tech startups stopped, datacenters stopped being produced and were converted into alternative uses, and eventually, we recovered. The housing bubble (which was the main culprit for this recession) is, and will be no different. Construction of single family homes has dwindled, but over time the population will continue to grow, demand will catch up with supply, pricing will stabilize, and we will recover.


The King of Diamonds (aka the King of the Middle East) - Gas Prices

This is probably the card that fools everybody. For months, all anybody wanted to talk about as the culprit for all this mess was the housing bubble. While it certainly was a major culprit, as we analyzed above, it certainly was not the only one. From mid 2006 to the fourth quarter of 2007, the price of a barrel of oil rose $100 per barrel. This was a $100 RISE in oil prices, after the price of a barrel of oil had only previously topped $100 per barrel for four months in the history of commodities trading. Suffice it to say this was unprecedented. The massively booming rise of the populations, and economies, of India and China were a significant cause of demand for oil, which helped push the price up, up more, and up higher still.

Yet, nobody talked about that as a cause of potential recession. No matter how you slice it, every one of us paying more at the pump led to one of two things. Either we spent less as consumers, or we saved/invested less of our money. Both of these have a negative impact on the economy. In fact, this phenomenon alone also caused about a 3% decline in GDP, or another $2 million jobs lost. The good news here is that since then, as the global economy crashed, oil prices have gone DOWN by about $100 per barrel, which should help lead us out of a recession over time. That is of course, if it weren't for card number three...

The King of Hearts - Emergency Tracheotomies

In the notoriously awful film Anaconda, featuring J. Lo and Ice Cube, Eric Stoltz gets a nasty bug lodged in his throat while swimming in the dangerous Amazon River. Jon Voight, who plays a shifty snake hunter (and also has one of the worst accents of any actor trying to portray an indigenous foreign national ever) sees he can no longer breathe. So Voight's character, trying to help, stabs a pen in his trachea, below the blockage, and puts a plastic stint in it, creating another passageway for oxygen to reach his lungs, thus saving his life. We are led to believe Voight's character has done this before, and is somewhat of an expert at Amazon first aid.

Well this is precisely what Secretaries of the Treasury Paulson and Geither have done to the asphyxiating US economy (in the form of ridiculously expensive and often unnecessary bailouts), only they don't have the medical training, and are more likely to kill the patient (the economy) than save its life.

On Friday, we will examine the impact of these bailouts, and what they really mean. Stay tuned.

Three Card Monte

The game of three card monte, is a confidence game in which the victim, or mark, is tricked into betting a sum of money that they can find the money card, for example the king of hearts, among three face-down playing cards.

In a bastardization of the traditional game, say I were to give 3 players a card, and if they won, I'd give them five more cards, and if they won that, I'd give them double the amount of money they bet. Then I asked each how much they wanted to bet. Suppose the first player elects to bet $100, the second player elects to bet $50, and the third player elects to bet $0. Traditionally, logic might tell you the guy betting zero cannot possibly win because he didn't bet anything, and as any avid poker player knows, you can't win what you don't put in the middle. However, we would argue the opposite, because how could anyone ever possibly win a game in which the rules are not clear AND they change as you go?

Of course that question is rhetorical, but its exactly the situation U.S. citizens, and investors alike, find themselves currently in. The U.S. government, both under the Bush & Obama administrations, or to be more direct, under Treasury Secretaries Paulson and Geithner, are the hustlers and we, the public, are the collective "mark." How else can you explain the hilariously sad hearings for the big three auto companies a few months ago? After weeks of hearings in which executives were ridiculed for asking for billions in bailout funds while travelling in corporate jets to the meetings, Congress all but denied Ford, Chrysler and GM their request...until Paulson changed the rules 12 hours later. This blog will not speculate as to the photos Mr. Paulson may or may not have of Harry Reid and Nancy Pelosi, or whether he passed them on as a rite of passage to Tim Geithner.

That being said, the supposed bailout monies have changed intended recipients more times than Sarah Palin has shot moose from a helicopter with a high powered rifle (a lot). First, it was supposed to go to the failing investment banks, then to AIG, then to commercial banks with regulations, then to commercial banks with little regulation, then to the auto industry, then to homeowners (even though nobody has identified which homeowners), and now maybe back to the auto industry again. Its dizzying.

The effect? Investors don't know the rules of the game, and so money continues to sit on the sidelines and wait. Have you put money in an S&P index fund lately? Didn't think so. Point proven. In fact the only people investing these days seem to be hedge funds, and thats only because they have to do something by their very nature. They are the equivalent of a gamble-a-holic in this sheisty casino we are all in.

But if we are all playing a game of three card monte, exactly what are the three cards being used against us?

On Wednesday, we will examine what the three cards being used in this game are in detail. Stay tuned...

Dis-Qualified Intermediaries

When I was a young commercial investment sales broker, I wasn't quite sure how 1031 Exchange Qualified Intermediaries made money, and didn't really care so long as they helped me make money. All I knew was that the IRS required these "qualified" intermediaries to handle the proceeds from an investment sale until a like-kind property was identified by the seller to buy, lest their capital gains on the sale of their property be subject to the tax code. The purpose was to prevent the individual sellers from making money on proceeds from the sale without paying taxes on them (even thought these intermediaries generally paid investors between 0.5-1% in exchange for holding the money).

As it turns out, I wasn't the only one who didn't get it. In the last several months, some of the biggest 1031 intermediaries were either sued, or filed for bankruptcy, placing investors who used them to facilitate their 1031 exchanges in a very precarious position.

Now, before we delve into this mess, let us first step back to the broader picture. 1031 exchanges are facilitated of course by the velocity of sales transactions of property. Simply put, if there are fewer properties being sold, there are going to be fewer 1031 exchanges. Almost a self fulfilling prophecy, the reason velocity is down contributes to an entirely different, but substantial reason for the decline in 1031 exchanges. With property values plummeting, even those property owners who have found a legitimate reason to sell are finding that the "gain" on their property has dwindled to a point where doing a tax-deferred exchange is seemingly pointless, because there isn't a ton of increased value (if any), from the time they bought the asset, to protect from the IRS. I digress....

Back in 2006 during the heyday of the boom in commercial real estate, there were 1031 exchanges happening left and right. The irony of the term "Qualified Intermediary" is that there is nothing "qualified" about them. They are not regulated in any way, nor are the ways in which they invest their clients' funds in the interim until it is time to fund the new property they are buying. No licenses are required, and Nevada (of all states, given whats legal there) is the only state that imposes any regulations.

Intermediaries make money in several ways. Most charge transaction fees, while others earn the spreads between interest they gain on investors' proceeds and the interest paid out to investors.

In 2007, three big intermediaries were charged federally with misappropriating clients funds. One ran a Ponzi scheme (Southwest Exchange, Inc. and Qualified Exchange Services), and another (1031 Tax Group) used monies to fund private real estate transactions, of all things.

One would think investors would have wised up and only invested their funds with bank or securities related intermediaries, or those that are part of the Federation of Exchange Accomodators, a trade organization that performs background checks of all its members looking for previous illegal or fraudulent activity.

Unfortunately, even those "safe" intermediaries investing appropriately, and in some cases, only in securities considered very liquid, were not immune from losing their investors money.

The most public of which was Land America, at the time the third largest title insurance company in the nation, as well as a busy 1031 exchange qualified intermediary. The investors, from retirees to a public company, had $400 million on deposit with the LandAmerica subsidiary, who has sold their title insurance company to competitor Fidelity National Title Insurance Co., and will likely be liquidation their 1031 Exchange arm.

In the filing, the company said it had put much of the money it was holding for real-estate investors into commingled accounts that invested in auction-rate securities that have become illiquid. LandAmerica had guaranteed the money. The auction-rate securities market seized earlier in 2008.

Investors, who thought their exchange and their money were safe, have been put in the precarious position of having to sit through bankruptcy proceedings just in order to get their money back. The biggest problem, again due to lack of regulation, is that there was no transparency for investors to see how these intermediaries were investing their money.

While this isn't necessarily an instance of robbing Peter to pay Paul, rest assured that Jesus was consulted by furious investors on more than one occasion.