Welcome to the Future

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Dechert LLP

Long ago, I read a book by a man named Herman Kahn, one of the founders of the Hudson Institute and a well-known public intellectual.  The book was entitled On The Year 2000.  (He was more famous for that truly uplifting missive, On Thermonuclear War.)  I suspect I didn’t understand a lot of it, but I was jazzed by this apparently serious effort to peer into the future.  How cool!  Mr. Kahn was an interesting character; think of a banal-looking, rotund academician, who talked about nuclear annihilation like I discuss box scores.  He was, in fact, an inspiration for Stanley Kubrick’s Dr. Strangelove and for General Jack D. Ripper’s famous line in that wonderfully dark comedy, “Casualties?  50 million…tops!”  A father of US nuclear deterrent strategy and a considerable intellect, he actually got much of what he thought of the Year 2000 wrong, but in a fun way.

Predictions are indeed particularly hard about the future.

But as we have observed in this commentary before, the fact that peering into the future is difficult is no excuse not to try.  Not having a view is, in fact, an uneducated and rather lazy viewpoint.

So with all the noise out there now, let’s play a little thought game and think about the Year 2026.

Speculating about the big picture stuff, the stuff of made-for-TV movies is way more fun than speculating about the state of commercial real estate and capital formation, the shape of the yield curve or the stability of SOFR, so just for giggles, let’s start there.  President Warren is still reveling in her successful re-election and thinking about how she will complete the transformation of our country.  The economy and indeed capitalism is largely now in thrall to her economic vision.  The Senate and House are in her hands and virtually all the levers of power are in her remit.  The regulatory state in full stalks the land and the government is beavering away attempting to provide a solution for… everything.  Business, writ large, is generally the all-purpose villain.

Will the economy be expanding or contracting?  Who knows?  Bad policy can clearly screw up the economy, but nonetheless our economy is durable and our political leaders take way too much credit and get way too much blame for the way the cycle actually turns.  However, if we are envisioning an embrace of European-type policies, then, for our purposes, let’s assume growth, but anemic growth.

Across the pond, some luster is beginning to return to the Square Mile after a half decade-long embrace of Brexit. The Euro experiment?  Mostly toast.  The internal inconsistencies of a monetary union with an obdurate Germany and disparate fiscal policies across 28 different nation states (let’s face it, statelets) has finally killed off this doomed experiment, which had been flirting with zombie status for quite a few years.  As the EU dream fades, London is recrudescent.  Russia remains an economically anemic but revanchist troublemaker along the eastern edge of Europe and China, while somewhat diminished by internal political strife and a loony half capitalist/mercantilist and half Soviet five year plan style economy, remains a powerhouse, the second largest economy in the world and a troublemaker throughout the Pacific.  The Middle East?  Never changes – an ongoing carbuncle on the world polity.

So outside of our borders, it’s Groundhog’s Day.

That’s all fun and it might even in some ways be right.  For our purposes let’s assume it’s at least directionally right, the question is, what does it mean for the commercial real estate markets, lending, the dynamism of our economy?

And the concomitant and equally interesting question is what do you do today if that’s our tomorrow?

First, what’s our 2026 government’s activism actually accomplishing?  An activist federal government and broadened regulatory state is likely to create both winners and losers.  The trick is figuring out which is which.

A Warren administration looks likely to be a place where the government will have great faith in its ability to do good and also to engineer specific outcomes through tax policy, through regulation and the like.  Those outcomes are likely to be wildly different from the outcomes pursued by the Trump administration.  It will engage in targeted initiatives designed to achieve particular outcomes with bespoke, specially focused incentives and penalties.  We’ll see tax exemptions, tax credits and other goodies for socially conscious investments and burdens for those not so blessed.

Let’s start with the banks.  A good guess would be that the prudentially regulated banking sector, or at least the bulge bracket portion of that, will increasingly look like a utility.  Whether the Business Roundtable believes all that they recently said or not, major institutions and certainly major financial institutions now must recognize the political reality of multiple stakeholders and the increasing reality of having political masters.  Rule by regulation and guidance (for those who pine for the good old days of the Obama administration) will be the hallmark of this administration.  This, one would think, would tend to diminish capital formation, economic dynamism and impair at least, to some extent, of the engines of growth in our economy.  That’s bad, but that might not be entirely true.

For instance, it’s entirely possible that a heavy regulatory hand on our prudentially regulated banking sector may further invigorate our non-banking sector (shadow banking anyone?).  This is what we had actually expected when the presidency of Mrs. Clinton was widely anticipated and then the market had to reset for the Trump administration (or lack thereof).

On the other hand private equity and all private capital formation (including the non-banking sector) is likely to be a target of some administrative hostility and significant pressure may be brought to bear on investment structures through changes in tax policy.  Moreover, will EU type capital and disclosure regulation for the non-prudentially regulated banking and investment sector be off the table?  I think not.

But don’t count these private investment sectors out.  I’m not going to the cockroaches after thermonuclear war thing, but private capital has shown a remarkable ability to pivot and thrive in any political environment.  Net/net, I expect that there will be an increasingly robust alternate lending marketplace to take up the slack resulting from the diminished prudentially regulated banking sector.

Will this make a difference to the users of capital in the commercial real estate market?  It surely will.  Say what you want, but non-bank lenders and banks operate by different rules with different risk management regimes and return hurdles, and this will change the lending environment for commercial real estate.  More co-investment?  A willingness to go down the capital stack?  More securitizations surely.  What happens if warehouse and repo markets dry up?  How about if fund finance is in trouble?  SASB loan capacity?  What happens if the banks won’t use their balance sheet to provide liquidity in general?  Don’t know, but it will be different and perhaps harder. Users of capital will just have to adapt.

What about the real estate market in general?  Is it a winner or a loser?  A Warren presidency efforts to improve the outcomes for labor over capital, surely the leitmotif of that administration, will not help the real estate market to thrive and hence real estate values may be under pressure.  However, this is an industry, like private capital, that knows how to thrive amongst the Rs and the Ds.  So maybe it’s not all bad.

Infrastructure looks like a winner.  Both parties have made noises about infrastructure, but a Republican administration still has some limited amount of scruples and some discipline around the budgeting process which is likely to be pretty well history in the next administration.  And hey, the Ph.ds behind Modern Economic Theory, now in ascendancy, are pretty clear that deficits don’t really matter and the government can simply print more money.  While that may have certain negative externalities, it’s going to be good for commercial real estate and risk assets.

Multifamily, and particularly tax advantaged multifamily, should be a hot place to invest and the commercial real estate market has shown a magnificently nuanced capacity to pivot from one sector to another when the regulatory environment winds blow a new way.  Green energy; what a great place to invest!  Worry less about earning an economic return, the government will be there with a green safety net!

Public/private partnerships?  Also, bound to be a winner.  Nothing like socializing losses and privatizing gains to fire up the entrepreneurial class, and that’s pretty much what happens when our polity once again falls in love with public/private partnerships. It’ll be a fun and complicated part of the commercial real estate marketplace.

Globalization would appear to be in continuous retreat.  However, that’s unlikely to stop the flow of capital into dollar denominated assets and into the United States and on balance, it’s actually likely to bring more investable dollars into the United States and a great deal of those dollars will end up in commercial real estate.  Not bad.

And then there’s always the unknowns that result from any significant changes in governmental policy.  When the next administration embraces a series of plans to make the country fairer, making income distributions flatter, to improve outcomes for labor over capital, to punish excess asset accumulation and to enhance the role of stakeholders in corporate America, the outcomes might be something which neither the administration nor its opposition would embrace.  Our economy is more complicated than the mind of man (or woman) and just because government policy steers an entirely new course, it doesn’t mean that what was intended will be achieved.

What is certain is when government policy pivots violently, a certain amount of chaos will ensue and with chaos there is risk but also opportunity.

Sounds fun, doesn’t it?  What to do about it now?  That’s a really good question.  Sounds to me that it’s time to be nimble.  Time to be on the balls of our feet.  Time not to get over invested.  Time to not treat projections (beware of geeks bearing formulas, as Mr. Buffet said), as actual reality.  Not a good time to assume that next year will look a lot like this.  Don’t expect the out years in your model to produce the sort of returns to meet your investment hurdles.  Have dry powder when the rules of the game change violently.  Don’t simply assume current levels of liquidity will be available.

If all this is illusory, my phantasmagorical dream, and it’s business as usual in 2021 after the next election, then it’ll be back to business and it’ll be time to reread this commentary four years on.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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