Spring Task #3: An overview of Dr. Gaines' Presentation. Inflation vs Deflation and the effect in the Real Estate Market.

"The  definition of economics is the science of taking common sense and making it unintelligent." - Dr. Gaines' quote about how every relation and effect in the economy is just disguised common sense.

The newest guess to our class this time was Dr. James P. Gaines and he made a presentation which he entitled as Real Estate Markets, Investments and Risk Analysis. A very enlightening presentation. Why was it enlightening and not just interesting or any random adjective that could pop in my head? Glad you asked. 

So as it is common knowledge, U.S.A. went into a big recession in 2008-2009  and as Dr. Gaines explained, generally after every recession, U.S. economy has gone up within the next year or two, in other words, the economy has been able to rebound pretty quickly. But, it hasn't happened that way this time. So, what is different? That this was not a business cycle recession, this was a debt deflation recession. 

Everybody (Businesses, Government, Households, etc) got over levered. There was too easy  and cheap credit, so everyone borrowed a lot of money. The consequence: Price bubbles. At some time it will go up, and at anytime it would burst in our faces, just like it did.

Generally, since World War II,  the responsible factors for the recessions were interest rates, inflation and inventory adjustments by businesses. For this reason, when there was a down cycle it was corrected. But this can't be done in a debt deflation cycle. Since the worst period in Peru was by the years 1988 to 1990 due to Inflation, my skin crawls when I hear the word Inflation. Apart from Justin Biebber and Joffrey Baratheon, I thought that a High Inflation (like the one that happened in my country) was the worst thing that could happen in a country. 

Deflation, just the opposite of inflation when the prices go up, is more troublesome than the inflation itself according to Dr. Gaines. The last deflation that happened in the United States was in the 1930's, great depression. 

Great Depression.

There's been only 4 debt deflation recessions in the history of United States. What is interesting is that economists figured out that when you have that kind of market collapse, there is no cure. The government has tried everything in these situations: Monitored the market, lowered interests, etc, but that does not guarantee a cure. The only cure is time. Generate productivity by putting people to work. The consumer confidence is very important.  Nobody was confident about anything during the last recession. People would work and was careful in saving money and did not want to spend. Now consumers are slowly gaining confidence and starting to spend more, and thus the prices are slowly inflating.

Now, what is the effect on the Real Estate Market?

As we know, the Capitalization Rate is the ratio from the relationship between income and overall value (price). Deflation and Cap Rates also have a relationship: When Prices go down, Cap rates go up. Dr. Gaines explained that this inverse relationship  is always true. Now, prices in Real Estate are inflating. Prices are slowly coming up now and Cap Rates are slowly coming down.

Well, to illustrate the problem, Dr. Gaines told us that not so long ago he talked with someone who was buying apartments in Houston for 4.5% Cap Rate, which is a pretty low cap rate. You as buyer do not want a low Cap Rate, you want a high cap rate because then the price will be cheap. But as a seller, of course you want a low cap rate, because then you will make good profit out of it.

The situation here is that due to the last recession, Cap Rates are too low right now. Cap rates have the same principle as the P Ratio in the Stock Market. If it is too high, you start thinking: How am I going to make any money?

Then Dr. Gaines explained a fact that I found really interesting: In Real estate one of the first things you think about is: What am I going to get when I sell the property?  As a investor in real estate you are not only concerned on the rent income that you are going to make. You know that after a holding period you are going to sell and of course you expect to make a profit. Well if you are paying such a high price at the beginning,  how are you going to sell it (the property) for more than that high price somewhere in the future if the Cap Rates are going up (And thus, the prices are going down) due to the slow recovery of the economy?

Colophon:  Dr. Gaines also talked about something I found very interesting and I wanted to share it here. Two of the biggest commercial developments in the world are going on in Houston, just outside The Woodlands. One of them is Exxon Mobil Campus. Yes, Exxon is constructing its corporate world headquarters, which has a size of about 386-acres. I looked up some more information about it and here is a photo. Looks pretty awesome and I heard they want to make it better than any of the Google Campuses. 

Will they achieve their goal?