Since 2008, the Federal Reserve has been buying financial assets, mostly Treasuries, through a program called Quantitative Easing (“QE”) in a bid to shore up the economy from contraction.
When the great recession struck in 2008, the Federal Reserve reduced the overnight interest-rate charged to member banks (I.e. Wells Fargo) almost to zero to boost the economy. When cutting the overnight interest-rate as far as it could go failed to spark recovery; the Federal Reserve went back to the drawing board. The Federal Reserve introduced QE, an expansionary monetary policy, intended to lower interest rates and spur economic growth. Essentially, a tool used to encourage member banks to make more loans.
To embark on QE, the Federal Reserved created dollars electronically to purchase Treasury Notes and mortgaged-backed securities from the member banks. The idea is that member banks take the newly minted money and buy assets to replace the ones they have sold to the Federal Reserve. To understand the enormity of this measure, the Federal Reserve held less than $1 trillion of assets on its balance sheet prior to 2008; as of now the Federal Reserve holds more than $4.5 trillion.
It is my belief that the QE has crated a number of unintended consequences for all types of investors. There is a looming asset price bubble; which can be seen in the nosebleed valuations of technology companies, common equities, and real estate. The S&P 500 stock index is now up 173% from the bottom in March of 2009 all the while corporate profitability has barely nudged the needle over the same period.
The eye-popping valuations of technology companies are mirroring the Internet boom that swept over the tech industry beginning in the late 1990s.
Commercial Real Estate is no exception. The demand for quality investment properties among all major buying populations is currently off the charts. Institutional capital has rebounded robustly and foreign capital continues to pour into the market at near record levels. I do think that the current pricing for commercial real estate is reflective of an imbalance between demand and supply. There are too few quality assets available for purchase versus the strong demand for real restate among the buying populations.
Rental rates have improved modestly from March of 2009, but only by 15 to 20 percent depending on asset class and location; however, values are approaching pre-2008 pricing for Class A office buildings. There is a disconnect between property value increases and the improvement in the underlying fundamentals. We know bubbles are created when investors do not recognize that rising asset prices are detached from the underlying fundamentals.
The gradual removal of quantitative easing by the Federal Reserve since the beginning of the year has generally been regarded as a return to the normality. When purchasing assets, the real money is made at the time of purchase – not the sale. As Warren Buffett stated, “Have the purchase price be so attractive that even a mediocre sale gives good results.” When this tide of Quantitative Easing goes out of this economy, we will truly see who has been swimming naked.