How To Build A Better Investment Model
MyEListings' markets and economics editor and creates content about global macro events and their impact on US commercial real estate.
To see the road, you need light. To know where the road is taking you, you need a map, but you also need to know how to read a map, with its layered meaning and shades of difference. Understanding the landscape of investing in any asset class requires a functional model of how things work; a mental mockup of what barriers, gateways, and probable paths exist for a given set of phenomena. And when the machinery`s movements begin to seem chaotic, those with the most applicable models can seize the opportunity where others are stunned by the shock. In this piece we will postulate a model we can extrapolate for nearly any investment purpose, but contain it to commercial real estate.
The Big Five Inputs
To set the stage, let`s examine the cornerstones of understanding one must have to be able to predict with some accuracy what may be coming soon.
1. Geography. Everything about a country`s people is in some way a product of its geography, down to its national and even individual personalities. As an individual, if you live in a coastal port city you are more likely to be more tolerant, enjoy a wider variety of foods and speak more than one language. If you live in the mountains, you`re more likely to be sequestered, have fewer friends, and be insulated from those outside your region.
On a national level, good natural barriers make good borders. Ease of internal transport means lower costs to get goods to market and people to workplaces. Arable land makes for food security, rich water resources mean plenty of hydration and abundant energy resources equate to cheap power for all endeavors. Geography isn`t quite destiny, but it`s extremely close.
2. Demographics. People live and spend differently as they age. Young adults generally spend, older adults save, and retirees consume.
Today we have the largest generation in history entering mass retirement right this very moment, and this has several implications not just for the US, but the world. When boomers entered the workforce, they decreased wages by their sheer size. Their adaptation was for women to work outside the home, which had the perverse effect of further depressing wages. As the boomers have aged, everything from interest rates to equity valuations has followed along; we`ve been awash in capital since the mid 1990`s, as reflected in the lowest interest rates on record. This is largely a function of boomers doing what they once did to the labor market, in the capital markets – flooding them with sheer size. The good news for the US is that we have a millennial generation that is larger than the boomers right on its heels, and most of the rest of the world does not. In fact, the fertility rate, ie the number of babies born per woman on average in the developed world is around 1.5 currently, well below the replacement rate of 2.1. This is a major impending societal and economic problem in the world, and we are not prepared to confront it.
3. Economics. Few people understand economics in enough depth to really appreciate its intricacies, and this largely stems from its complexity as a subject. Its laboratory is the actual world, and we have few ways of conducting scientifically valid studies or observations therefore – there are simply too many variables able to influence outcomes, so assigning them impact weights can be a matter of statistical derivation if not outright conjecture. Thankfully, the science of complexity has itself been studied in the past two decades to the extent that it now colors other subjects like economics and illuminates new dimensions in their application.
4. Complexity. The study of complexity has allowed social and other sciences to be much better understood. We now understand phenomena, for example, such as inflation and other economic outcomes as emergent products of a complex adaptive system as opposed to a linear, x plus y equals z formula we either get right or wrong. There are several fundamental implications of this idea. One is that randomness exists in every system – from cellular mutations in biological systems to tiny changing differences between similar variables in physical systems, randomness forces change even where sameness is expected. Another is that these tiny random imperfections interact with each other in unexpected ways, and we know their potential as the `butterfly effect,` so named because a butterfly flapping its wings in one location can set off a chain of compounding events that becomes a hurricane halfway around the world. A third implication is that not only is the whole greater than the sum of the parts, but complex outcomes cannot be predicted accurately as a function of time. We still cannot, and never will be able to predict the weather beyond a week or two from today, for these reasons.
5. Technology: Virtually all the technological progress the world has made has been in the past 100 years. Technology compounds on itself, meaning its effect, which is to enable greater output per unit of input, grows in a compound, not a simple way. The balloon, as it were, gets larger in all dimensions, not just one or two, as this happens. It costs less than a penny today to store a gigabyte of data. In 1983, it cost over $180,000. Today the distance we can travel in a day is orders of magnitude greater than 100 years ago. More output, for less input. This singular driver has enabled more economic productivity per unit of time than any other. To envision this, consider what the business world would be like without Microsoft Excel. This one technological innovation represents more work saved than we are capable of counting, and it in turn compounds on itself in ways we can`t necessarily predict, but can see with hindsight.
Putting The Big Five In Context
How does this apply to any one asset class? How do the actions of someone in Russia have any impact on a strip center or mixed use development in the US? If everything is connected yet outcomes are largely unpredictable, how can we forecast anything with confidence?
Japan
The answer has more to do with the time frame than anything else. The big pieces move slowly, and only in so many ways. There are limits to what a country can do. Japan, for example, cannot afford to raise interest rates, because its population uses more adult diapers than children`s diapers. When that`s the case, the population can`t afford to consume what its economy produces – so it must export, and must issue bonds to cover much of the costs involved. Who then will buy Japanese government bonds in a market where other countries pay considerably more in interest? Might it be advantageous to borrow in Japan, in yen, for investment into your dollar-denominated project so you create an advantage for yourself of being able to repay in yen, which are all but guaranteed to be cheaper in the future?
Japan`s prescient solution has been to co-locate its manufacturing centers alongside its biggest consumer base – in the US. This increases demand for industrial manufacturing, office, and retail space in the US – not today`s issue making waves, but something to note.
China
What about China? If we zoom out and look at China over the longer term, several observations are inescapable: First, the only reason China`s economy has grown as it has is due to its having joined the US-led world economic order in 1971. The US Navy under this agreement guarantees shipping security for client countries. This has enabled complex trade networks that have made it possible to source raw materials in one country, send them to China, and metabolize them into finished goods for re-export to the broader world, all at a profit. This only happens with very cheap labor. China`s labor costs have increased by a factor of 20 since the 70s, as they have systematically moved people from rural locations to cities, and their birth rate has at the same time plummeted. People have far fewer children when they live stacked on top of one another in urban locations, and arguably misguided policies like the one-child dictum have simply exacerbated what was already likely to be a regime killer at some point. Couple this with a paranoid cult of personality as the one-party government and we have a potent economic, if not kinetic flashpoint developing as the forces of supply, demand and geography converge powered by the exponent of complexity.
China has never been able to sustain trade with the wider world in 3000 years – for largely geographic reasons. All the US need do to reimpose this reality is stop protecting Chinese shipping and/or deny said shipping access to geo choke points. Chinese capital entering the US typically does so disguised as something it isn`t, due to China`s capital controls – the CCP limits citizens to taking $50,000 US per year out of the country, which goes completely against the counter-incentive in place to get that capital as far from China as humanly possible – often to Canadian and US residential real estate, an effect we can observe being deflated at present in British Columbia, and one we can see several US entities signaling they`ve made errors in entering, to wit: Zillow, Redfin, etc. On the margin, this affects the US commercial real estate market because residential real estate helps drive locations, zoning, and therefore values for some commercial real estate in the US.
Russia and the EU
And lastly, what about Russia and Europe? Russia has once again committed one of its now-legendary miscalculations in invading Ukraine, and in doing so has put unyielding pressure on the EU – pressure that it is all too easy to apply thanks to the EU`s erroneous incentive structure. Political union cannot be achieved outside monetary union, but monetary union requires shared interests and policy adoption. The policies that work in southern Europe, where geography and demographics dictate a wholly different monetary policy than in northern Europe, cannot be shared sustainably. Russia knows this and is using very hard leverage to attempt to pry certain countries, namely Germany and Turkey, away from the EU and/or NATO. In doing this, they are affecting the prices of various commodities such as crude oil, natural gas, chemical fertilizers and the crops to be grown with their input. Higher commodity prices are reluctantly absorbed in the US but can be devastating to other parts of the world. The luxury of paying higher prices is replaced with outright product shortages, and all that implies, including higher values for US farmland.
Conclusions
As the US continues its digestive processes regarding the world`s shifting economy, several forces give the US economy an advantage. For one, the US has a millennial generation that is larger than the retiring Boomer generation, which gives it a 20-30 year window to observe how other nations with poor demographics cope with the problem and make their own adjustments in time.
Second, the US possesses the single most valuable set of geographic advantages anywhere on earth – deserts and mountains on the southern border, forests and lakes and ice to the north, and oceans east and west, plus more miles of navigable inland waterways than the rest of the world combined. This means we are isolated and protected from invasion without the required expense of fielding a standing army on our borders. This enables the US to project power outwardly – we keep conflict far from our shores, an incredible luxury, but this geographic blessing also means the US creates net amounts of capital without really trying, thanks to cheap transportation costs.
Transport over water, as most agricultural goods are shipped, is a small fraction of the cost as over land. This implies that by having more navigable inland waterways than the rest of the world combined, the US can get goods to market much more easily and cheaply than anywhere else on earth, and this advantage backstops the US` economic and geopolitical position in the world. In fact, it is fair to say that whoever occupies the north American core is destined to dominate the rest of the world in most respects, for this set of reasons.
In subsequent installments of this series, we`ll explore in greater detail how various aspects of the commercial real estate market are affected by macro events not just in the US but elsewhere, and how CRE investors can digest this information to gain advantages for their portfolio.
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