Interesting Times

Although the economy has been growing lately, fallout from the recent recession continued to negatively impact commercial real estate sectors in the fourth quarter, but there is hope for some improvement next year, according to the National Association of Realtors®.

Lawrence Yun, NAR chief economist, said commercial real estate almost always lags the economy. “Because of the lingering impact from the deep recession over the past two years, vacancy rates will trend higher and many commercial property owners will need to make rent concessions,” he said.

“With the job market expected to turn for the better later this year, we’ll see rising demand for office and warehouse space, but that isn’t likely before 2011,” Yun said. “At the same time, improved consumer confidence would help sustain the retail sector and encourage more people to enter the rental market.”

Yun notes that commercial vacancy rates remain high in most market areas and are depressing rents.

The Society of Industrial and Office Realtors®, in its SIOR Commercial Real Estate Index, an attitudinal survey of more than 700 local market experts, suggests a flattening level of business activity in upcoming quarters with 55 percent of members expecting the market to improve in the second quarter.

The SIOR index rose 0.2 percentage point to 35.5 in the fourth quarter, compared with a level of 100 that represents a balanced marketplace. This is the first gain following 11 consecutive quarterly declines. Although some indicators show that a decline in commercial property values is beginning to flatten, 86 percent of respondents report prices are below replacement costs.

Nearly nine in 10 survey participants said new commercial development is virtually nonexistent in their market areas, and rent concessions are reported almost everywhere.

An independent survey earlier this month showed a couple dozen banks are willing to expand commercial credit this year, which is critical. The lending expansion is aided by the Federal Reserve's Term Asset-Backed Loan Facility, which is encouraging issuance of commercial mortgage-backed bonds. In addition, regulators are prodding lenders to extend terms for many existing commercial loans.

“We have a long way to go for satisfactory levels of commercial credit, but these are important first steps,” Yun said. “Given that about $1.4 trillion in commercial debt will come due over the next three years, more extensive action is needed and the Fed needs to more actively help resuscitate commercial mortgage-backed securities. The credit improvement will mean more commercial property sales in 2010, even some at deeply discounted prices.”

Looking at the overall market, commercial vacancy rates generally will stay at elevated levels, according to NAR’s latest COMMERCIAL REAL ESTATE OUTLOOK. The NAR forecast for four major commercial sectors analyzes quarterly data in the office, industrial, retail and multifamily markets. Historic data were provided by CBRE Econometric Advisors.

Office Market

With a lot of sublease space currently on the market, vacancy rates in the office sector are forecast to rise from 16.3 percent in the fourth quarter of 2009 to 17.6 percent in the fourth quarter of this year; the longer term outlook is for vacancies to average 17.4 percent in 2011.

Annual office rent is projected to decline 7.2 percent in 2010, following a drop of 12.7 percent last year. In 57 markets tracked, net absorption of office space, which includes the leasing of new space coming on the market as well as space in existing properties, should be a negative 27.3 million square feet in 2010.

Industrial Market

There is proportionately less industrial sublease space on the market than in the office sector, but obsolescence remains a factor. Industrial vacancy rates will probably rise from 13.9 percent in the fourth quarter of last year to 14.9 percent in the closing quarter of 2010; they could average 14.5 percent next year.

Annual industrial rent is likely to fall 9.6 percent this year, after declining 10.9 percent in 2009. Net absorption of industrial space in 58 markets tracked is seen at a negative 93.5 million square feet in 2010.

Retail Market

Retail vacancy rates are expected to edge up from 12.4 percent in the fourth quarter of 2009 to 12.7 percent in the same period of this year, and may hold at that level in 2011.

Average retail rent is forecast to decline 2.4 percent in 2010, following a drop of 4.0 percent in 2009. Net absorption of retail space in 53 tracked markets should be a negative 3.4 million square feet this year.

Multifamily Market

The apartment rental market – multifamily housing – is poised to gain from a rise in household formation. Multifamily vacancy rates are likely to decline from 7.4 percent in the fourth quarter of last year to 6.6 percent in the fourth quarter of 2010, and possibly edge down to 6.1 percent next year.

Average rent is projected to decline 3.4 percent this year, following a decline 3.6 percent in 2009. Multifamily net absorption is expected to be 115,000 units in 59 tracked metro areas this year.

-- Walter Molony, National Association of Realtors Commercial Division

The rate at which home prices are dropping may be slowly coming to a halt across the United States, with analysts at Barclays Capital predicting only a 4 or 5% dip left to go before stabilization. But the rate of appreciation on the back side of that bottoming out is likely to “muddle along for the next few years,” they say in a weekly letter to investors.

This conclusion is based on expected aftershocks of the “smoothed-out” housing supply model, where millions of potential foreclosures are being averted temporarily with government-backed programs or by suppliers slowing the rate in which foreclosures hit the market. On the positive side, they say this effort actually prevented home prices from falling considerably more.

But the smoothed-out method, while successful on the supply side, is coming at a cost: “The overhang of distressed inventory is a huge negative technical – it suggests that any price rise will probably be met by increased distressed sales,” say the securitization analysts in their Residential Credit Strategy report.

“Meanwhile, home prices do seem a little cheap, using fundamental metrics like price/rent and price/income ratios, but not extremely so,” they add. “Thus, a meaningful rise in prices would need big changes on both the technical and fundamental fronts.”

Home prices dipped only slightly in December, according to Standard & Poor’s Case Shiller US National Home Price Index. However, it is the recent drop in new home sales, down 11.2% from December to January, that the analysts find “disappointing.”

And in added response to claims that housing is becoming more and more affordable in the United States, the report adds that “affordability indices are not good predictors of future moves in home prices.”

Jacob Gaffney, Housing Wire, 2-26-2010

Interesting Times is brought to you by Bremner Real Estate (BRE), which specializes in Apartments and Single Tenant NNN Investments.  To learn more about BRE, and to see our listings, click here. 

Last of four parts

There are no silver bullets to solve our looming energy crisis, resource depletion, and environmental pollution.  But, there are surely better courses of action.  Major problems are not solved, but we can create an environment whereby solutions evolve.  The following 12-step program is a beginning to keep us on course as the most prosperous nation in the world.

1. Disabuse the bankrupt economic theories that neglect the importance and limitations of our resources, environment, and quality of life while lionizing economic growth.
   
   The continued devotion to outdated and discredited economic theories result in situations like the reported advice former Fed Chairman Alan Greenspan gave to U.S Treasury Secretary Tim Geithner that the government should simply buy houses and then bulldoze them to solve the housing crisis.
   
2. Throw out the notion that "free markets" will solve our energy and environmental problems.
   
   Businesses have neither the interest nor resources. Market participants are motivated by short-term profits, which are their mandate, not in solving societal problems. I hate to break the Adam Smith myth that there is actually no "invisible hand" that works for the good of all as long as everyone only looks out for their self-interest. The actions necessary to deal with these monumental issues must come, dare I say it, from good government.
   
3. Students must demand that they be taught economics that deal with the real world and that can be substantiated with actual data and analysis. 
   
   They must resist theories that serve special interests, political, and economic doctrine.   Students must lead, because the self-serving, symbiotic relationship that exists between academia, government, and business will resist any approach that threatens their controlling position.  In other words, don’t expect Bernanke or Mankiw to propose a revolutionary, real-world view of economics.
   
4. Young adults must demand and force good government. 
   
   The younger generations have the most to gain and the least to lose by replacing our dysfunctional Congress and state legislators. They also have the energy and power to effect the change.
   
   In addition to Congress, the largest and most prosperous states of California and New York are virtually paralyzed by weak and partisan politics. A Republic, such as ours, is totally dependent on sober, intelligent lawmakers who will devote a portion of their life in public service for the good of the populace and to serve national interests. Those lawmakers that are slaves to special interests, religious and political doctrine, and dogma must be given their walking papers regardless of party.
   
   It is instructive that two of the most thoughtful legislators contributing to intelligent political discourse are Ron Paul and Bernie Sanders.  Though they are at the opposite ends of the political spectrum, they both have fresh and informative views because they are independent thinkers and neither party nor political dogma dictates their views.
   
   In addition, we need political leaders that are intelligent. When long time political pundit, Seymour Hirsh, was asked the difference between members of Congress today and 50 years ago, he said, "Their IQ is 35 points lower today!"  The issues we face today are complex and we need leaders that have intelligence, aptitude and the work ethic to deal with them.
   
5. Demand the fundamental democratic principle of majority rule is re-established.
   
   Do away with the self-imposed 60-vote filibuster process in the Senate. In the 1960s, filibuster entered into an average of six pieces of legislation per year. Last year, there were 120.  This has essentially brought the legislative process to glacial speed while totally distorting the legislation itself.  The filibuster makes us suffer from the tyranny of the minority as we have seen in the so-called "Health Care" bill.
   
   And, overturn the two-thirds vote requirement for tax increases that have paralyzed the governance of California. California can only pass a budget that is filled with so much fiction that makes it essentially useless as a financial plan.  California will go broke without major constitutional changes and its repercussions will be felt throughout our economy.
   
6. Stop the influence of business and other special interest groups in elections and legislation. 
   
   Corporations are not citizens and therefore must not be able to use their unlimited media and financial resources to mold the government to suit their pecuniary interests.  Business lobbyists have no interest in the public good or the national interest, only in the financial advantage or doctrine of their employers. There are currently 10 times as many lobbyists in Washington as there are legislators. The financial industry alone spent $336 million lobbying Congress in the first nine month of 2009. Hundreds of millions of dollars were spent by the drug and insurance interests to sculpt the "Health Care" legislation to their advantage or to kill it entirely.  We have all suffered loss because of their success.
   
   The recent Supreme Court decision which allows unlimited corporate financing of federal offices may destroy the concept of government of the people, by the people, and for the people.
   
7. Demand that all energy production, including food (the source of our energy) disclose the EROEI, resource cost, and environmental impact. 
   
   As it now stands, we have practically no comprehensive information that allows us to determine the efficacy of the various alternative energy programs. Good data would provide the foundation for developing programs which make rational trade-offs between energy, environment, and the economy.  Provide this information before we fund Ford and Tesla Motors.
   
8. Demand a comprehensive long-term, integrated plan for the country that takes into account, and makes trade-offs between energy, the economy, natural resources, and the environment.
   
   As we have seen, ad-hoc legislation addressing energy, climate and economy singularly are doomed to failure because any effective legislation would result in costs "somewhere else."  The "somewhere else" will defeat it. President George W. Bush illustrated the problem when he dismissed the Kyoto Treaty by saying, "it would be bad for the economy."
   
   It is a fatuous argument that we have heard for 10 years that we cannot unilaterally move on energy efficiency and carbon pollution because China will not reciprocate. This is not a reason but rather an excuse to do nothing.  China will never have meaningful "talks," agreements or other forms of blah, blah, and blah. They think like George Bush. To get China to move we must institute a carefully crafted "carbon tax" on Chinese imports that makes it more costly to pay the tax than to become efficient and non-polluting. To keep a level playing field, and clean up our industries, we must also put a "carbon tax" on our goods and services starting with transportation, utilities, and agriculture.
   
   Let's look at how we might approach the triage between the environment, economy, and energy.
   
   The deterioration of our environment, particularly "global warming," has gotten well-deserved attention but rather modest action. The discouraging thing about climate change is that our atmosphere will continue to warm, with its adverse consequences, regardless of what we do.  The objective of reducing our emissions to the levels of 2000 is noble but does not solve any problems. It merely reduces the rate of global warming.  As long as the burning of fossil fuels provides the lion-share of our energy, our atmosphere will continue to deteriorate.  Without the development of new energy sources we will continue to use the available fossil fuels until they are gone. 
   
   Although, the slowing of emissions is important, it must be determined at what cost. It is likely that the resources and political capital necessary to accomplish this limited objective might better be directed toward the development on non-polluting energy sources and increased energy that would allow us to combat the problems that will be caused by global warming.  With increased low-cost energy we can create fresh water, increase food production, and protect our population centers from rising oceans.
   
   The economic problem with concentrating on energy and the environment is that it overturns the economic status quo.  In the long run if developing new sources of energy is successful, it will save the economy from collapse.  In the short term it will put people back to work, but it will cost a lot.
   
   The way to pay for the programs will have to come from elimination of our glaring inefficiencies.   We need to have a health care system that costs less than 5% to administer, like Medicare, and eliminates the 30% drain from insurance companies.  Drug costs can be cut through competitive pricing.  Incentives for unnecessary testing and procedures must be eliminated.
   
   The financial industry must be compensated at their value added contribution to the economy, which is less than 5% of GDP rather than its current elephantine share.  Goldman Sachs, alone, charged the economy $45 billion in 2009 for its money conduit services.
   
   We must redirect the costs and energies spent on frivolous defense systems and insure that we do not enter into un-necessary wars.
   
   We must provide incentives to work and not retire. The government must not pay people to stop working at 62, or even worse, workers in their forties, as is the case in some government jobs.
   
   In addition to the restructuring of our economy, the costs need to be primarily paid by those with high incomes. That is where the money is. It will also lead to the elimination of other frivolous economic activity.
   
   The priority is clearly to develop new energy sources.  Environmental emphasis can mitigate some long-term economic problems but cannot generate the energy we need.  The economic status quo will not materially improve our environment or create new energy.  Only new sources of energy can solve our economic problems and gives us the resources necessary to mitigate the climate induced hardships.
   
9. The government must fund big physics R&D. 
   
   We do not have the solution to our energy needs and the deterioration to our environment.  And, in no way, are we on the course to solving these problems. 
   
   It is absolutely necessary to develop new energy sources outside of the sun.  We are already tapping the efficient sources and their availability is declining as the world’s demand for energy continues to increase.
   
   The apparent non-sun source of energy is the energy stored in atoms.  In effect, if we could harness nuclear fusion, we could generate virtually unlimited energy the same way the sun does. Since we do not have the force of gravity of the sun to enable the process we need to develop other techniques. To develop this capability may take up to 40 years and require huge resources spent on R&D.  The government can only champion an effort of this magnitude. 
   
   Our government funding of big physics R&D has been astonishingly effective in the past and can be in the future as well.  Even today, we can take pride in the scientific research and education in two of the most esteemed science oriented universities in the world, MIT and Caltech, which are predominately federally funded.
   
   Nuclear fusion is only one example, but potentially the most rewarding, of big physics R&D that must be implemented now.
   
10. Increase the support of and demands on higher education.
    
    We still have the finest college and universities in the world but they are not meeting the challenges facing us.  Even the finest, like the University of California, are deteriorating because of funding cuts. 
    
    Increased emphasis on the sciences is a must.  We must attract the brightest and best to sciences through grants and scholarships while providing first-rate education.  There must be a long-term commitment to science and R&D to assure students will have professional opportunities throughout their careers.  We must increase the incentives and opportunities so that we are training our own citizens instead of 50% foreigners, which is now the case.
    
    There are even more fundamental changes needed in the nontechnical fields of study such as liberal arts, general studies, economics and business.  Fifty years ago, a full-time student in these fields of study would typically attend about 20 one-hour classes over five days in a typical week. They would spend one or more hours, per class hour, in out of class study.  The result was a 40 plus hours per week in higher education.  If the student did not take a full load or did not get passing grades (students were actually flunked), they would be expelled.  Men would lose their deferment and would soon get a "Greetings" from their draft board.
    
    Today, in most large universities, classes are only held four days a week.  A typical full-load would be 12 classes resulting in about 11 hours of classroom time.  Surveys indicate that students spend a total of only 20-25 hours per week in classroom and studies.
    
    It is ironic that college students spend so little time in education while top high schools require much more than 40 hours per week.  In my experience, students in non-sciences, from rigorous high school curriculums, find college much less challenging.  Upon graduation, if the student is fortunate enough to get further training by their employer, they will typically be required to spend much more than 40 hours per week in their training.
    
    In any event, if educators justify 11 hours a week in class and 20-25 hours of total commitment as optimum, then they are underutilizing their facilities.  With so little going on, they could easily double their enrollments by simply expanding their hours of operation.
    
    As a rule of thumb, a tenured professor spends about half time in research.  This may be worthwhile, but the research should be published on the Internet so everyone can benefit from the insights or realize that they are paying for academic trivia.  It is absurd that research papers are published in non-descript publications that are only available to a narrow slice of academia.
    
    Classes should be open.  With few exceptions, if there are empty seats, students or other interested parties should be allowed to sit in.  In my limited experience with open classroom, I have had siblings, parents, grandparents, and friends of students attend, in addition to members of the administration, other professors and just the curious.  Without exception, guests have enhanced the classroom experience.
    
    Many more classes need be put on the Internet to broaden the education experience.  "Physics for Future Presidents," an introductory class taught at Cal-Berkeley is a marvelous example.  All lectures are broadcast on the Internet.  They are followed by thousands of people around the world.  Try it, and you will agree.
    
    Finally, in areas such as economics and business, bring in people outside of academia with actual experience and success in the real economy to participate in the education of young people.  It would be unthinkable to have professors of medicine with no clinical experience.  The very best in medicine are to be found in our medical schools.  In our military schools, soldiers who have actually been in combat teach tactics.  Yet, in business and economics it is not unusual to find professor who have spent decades in academia with no meaningful experience in the real economy.  Recently, I met the head of the marketing department at a major university that had been in academia continuously for 43 years. It makes you question the credentials of a leader without experience or real world discipline.
    
    In summary, getting back to increasing our understanding of real world economics, we need to demand more of students, we must open up academia to the light of day by publishing research, opening classes, and bringing in outside experts with actual experience to substantiate or refute academic theories. This is how we break the economic nonsense perpetuated by the likes of Greenspan, Bernanke, and Mankiw and their academic acolytes in our leading colleges and universities.
    
11. Raise Taxes. 
    
    Yes, raise taxes!  The ambitious programs to rebuild our infrastructure, emphasize education, develop environmentally friendly technologies, and most importantly developing new sources of energy which will put people back to work will take a large chunk of our production.  It would be a shame to embark on such a program paid for by debt, deficits and other financial chimera whose inevitable collapse would unnecessarily destroy our economy.
    
    The increased taxes must be based on consumption, not on income.  Free markets can work quickly and effectively in allocating resources if given nudges in the right direction.  For example, instead of spending huge political energy and time dealing with mileage standards for automobiles while ignoring trucks, tractors, airplanes and ships, simply increase the price of oil to $200 per barrel. This could be done taking the market price of oil and adding taxes to bring the total price to $200.  As the price of oil increases, taxes would be reduced to maintain the price at $200.  All industries and consumers would adjust quickly by eliminating marginal uses and stimulate the development of more efficient machines.
    
    California has been effective in penalizing heavy electricity consumption while protecting low usage, low-income households.  I recently installed 5 amplifiers which I calculated costs $150 per month for electricity in standby mode.  When in actual operation they use 9-10X the power consumption.  If I would have researched it before I bought them, I may have thought of better alternatives. The effectiveness of the program is demonstrated by the fact that the average Californian uses, on average, 30% less than the rest of the country.  The utilities are continually offering programs and education to cut power consumption. And, increases in California GDP require only 60% of the power used, on average, compared to the rest of the country.
    
    Similarly, cap and trade could be an effective program in reducing emissions if administered effectively.  Effectively administered is the key because this complicated program could be easily corrupted by special interests.
    
    Ironically, the people most adamantly opposed to increased taxes are the ones that have the most to lose in a financial collapse and in an energy-short future.  An energy failure takes no prisoners. There is no protection.  Financial and material wealth is an empty sack in energy-less economy.  But, long before an economy runs out of energy and their environment is destroyed, the hapless people at the bottom of the pyramid, who always feel shortages first, will overturn the society.  As Jared Diamond has explained in his book, "Collapse," advanced societies fail quickly when their standard of living drops significantly because people begin turning on each other.  Again, the CBS documentary "2100" shows how this might happen.
    
    If the rich want to continue enjoying the fruits of their wealth and providing for their children and grandchildren they had best join the movement to developing new, efficient sources of energy while protecting our environment. They must pay for it with a portion of their wealth, which will disappear in any event, if we are not successful in husbanding our resources and environment while developing breakthrough new sources of energy.
    
12. Mobilize and activate the people who have a commitment to address the issues of energy, environment, and resources that we face.
    
    Simply sending a few bucks, attending a rally and voting for Obama to achieve "change" simply doesn’t get the job done.
    
    One of the most cynical political comments of recent history is: “Conservation may be a sign of personal virtue but it is not a sufficient basis for a sound, comprehensive energy policy.”  – Dick Cheney,  April 30, 2001
    
    The most galling thing about this thought is that it is true.  However, threatening and attacking oil-producing countries is also not a sound basis for energy policy.
    
    We have been deluded into thinking that creaky, old, grandmas and grandpas, like my wife and me, when not hiding from "death panels," can actually make difference by driving a Prius, installing twisty light bulbs in out of the way places, and avoiding purchase of avocados from Chile. The reality is, though they make a difference, on the micro-level, they have virtually no impact on the macro level where the problem exists.  Energy is such a value added commodity that it will always be used.  If someone saves energy, it will merely provide the opportunity to light another sign in Las Vegas, fuel a plane to fly flowers from Peru, or power a yacht.
    
    In any event, no amount of conservation can solve the problem.  The overriding problem is upstream.  We are rapidly running out of energy at the source.  We must develop new efficient sources in quantity to meet our needs.
    
    To effect meaningful change, the committed must work to solve the macro problems through education, economic policy, and most importantly, by replacing our dysfunctional political leaders starting with the elections in 2010.
    
    We still have the opportunity to use our still significant resources, unequaled agriculture production, innovative and entrepreneurial aptitude, dominant financial position, military strength and demonstrated resiliency to lead the world in dealing with the issues of environment and resources.  It will not happen on our current course, but we can change that course, through the committed efforts of the people who care.

The answer to our opening question that began this admittedly long series is that we are rich because we consume huge amounts of energy.  If there are not new, abundant, and continued sources of energy, no one will be rich in the future.

Gordon Ringoen, March 05, 2010

Gordon Ringoen, a retired investment adviser, is an entrepreneur and college professor who lives in San Francisco

by Gordon Ringoen, March 04, 2010

Third of four parts

Two years ago, 77% of the United States thought that climate change was a major problem.  Today, only 55% think that to be true.

It is ironic that deniers that fossil fuel burning has caused a major threat to our environment have grown while the Intergovernmental Panel on Climate Change (IPCC) issued their latest report, "Climate Change 2007."  The report was produced by 620 scientists and editors from 40 countries and reviewed by more than 600 experts and governments.  The summary was reviewed line-by-line by representatives from 113 governments.  The summary report said:

"Warming of the climate system is unequivocal."

"Most of the observed increase in global average temperature since the mid-20th century is very likely (between 90-99% probabilities) due to the observed increase in anthropogenic (man-made) greenhouse gas concentrations."

Yet, deniers are winning the public opinion game.  The religious zealots, who believe that God has given "dominion" over the earth to humans and has reportedly promised that He will "provide" – along with the political ideology that claims that climate change is a government plot to take away individual freedoms, and the special-interest utilities and energy companies – have persuaded much of the population. 

For those that are unsure, but are seeking a rationale answer, they could read the IPPC report and the denier's claims and make their own judgment.  For those who wish to be told what to believe, they have numerous preachers, politicians, and Political Action Committees to tell them what to believe.

One thing is undisputable, if the scientists are right, and nothing is done to mitigate greenhouse gasses, the human friendly environment on earth is in for a world of hurt.

Alternative energy

Again, oil is our most important source of energy.  Approximately half of the available oil, and that which is most easily captured, has been consumed. And, half of that consumed has occurred in the last 20 years.  We are already tardy in actively developing new sources of energy.

Our politicians and special interest groups have deceived us about efficient sources of new energy.  In the past 10 years we have been wooed with the promise of hydrogen powered cars, ethanol, "drill baby drill," switch grass, vast solar power, "250 years of coal," and now, battery powered cars.  This demagoguery has spiked intelligent analysis of the issues and the ultimate development of a sound energy and environmental plan.

To begin a rationale discussion of these issues lets go back to simple fundamentals.  With a few exceptions, like nuclear and geo-thermal, nearly all of our energy comes from the sun.  It is the sun's current rays that sculpts our weather, heats the earth, and enables plants to grow. We generally refer to this as "renewable energy" sources.  We also are able to tap the sun's energy from the past in the form of fossil fuels.  These are non-renewable sources of energy and as they burn they alter the composition of our atmosphere and oceans.

As we know, available fossil fuels are limited and are diminishing rapidly.  While fossil supplies are declining, our dependence is increasing from 10% in 1850, to 70% in 1950, to 85% dependence today.

The need for alternative energy sources is clear.  But, how do you evaluate which alternatives are efficient and environmentally friendly?  Currently, our information overwhelmingly comes from special interest groups like the coal industry that wants to increase consumption while lowering environmental restrictions, oil companies that want to drill more, and the car industry that wants to convert major portions of the fleet to battery powered.

Their influence is profound through their use of advertising, media, and politicians acting on behalf of pay to play lobbyists.

Beyond the hype, it is assumed that the market will make the ultimate judgment on the efficacy of an approach to alternate energy by looking at its financial profitability.  Although this view works in many short-term industries, it has major shortcomings in developing a long-term energy policy.

First, much of the pricing in alternative energy is distorted by government action including corn subsidies, mandated ethanol in fuel, tax credits for solar installations, and even indirect subsidies by China in production of solar panels shipped to the U.S.

Secondly, the price of energy in the profit equation is based on the current cost of production, not on the value added benefit, nor on its long-term availability.  Profit, as we view it, is about short-term benefits, not long term.  For example, during the oil shock in the 1970's, we became acutely concerned about our energy supplies.  We spent heavily on Big Physics and actively developed nuclear facilities.  Then, in 1982, with the North Slope oil discoveries, combined with Reagan free market economics, we essentially stopped major efforts to develop new energy sources.  We have not brought a new nuclear plant on line since 1978.  And now, with the North Slope in rapid decline, we have no major alternative sources.

And, finally when you view energy only in terms of money, it is easy to delude yourself and fall back to our recent history, which is to attempt to solve any economic problem by printing money or creating more credit.

Energy supply is our issue, not money.  An illustration of the weakness in evaluating alternative energy sources only in terms of money is the following example:  California law, sensibly, encourages energy efficiency through their rate structure.  Heavy users of electricity, like me, pay $.435 per kilowatt-hour at the incremental unit.  So, when a renewable alternative energy source, like solar, costs substantially less, it seems sensible to exploit it.  The city of San Francisco, despite budget constraints, is proposing to pay up to $7,000 for installation of home solar systems.  The San Francisco Chronicle recently posted the following costs per megawatt of power:

So, from an economic standpoint, it would make sense for large users like me, to install a solar system.  In fact, with the tax benefits and subsidies offered, solar installation proposals indicated that it would be slightly profitable.  And, most importantly, to assuage my embarrassment for using so much power and adding to the pollution, it would provide me with the politically correct opportunity to create pollution free renewable energy!  A win-win situation for all! 

It almost seems too good to be true.  It is.  Even though good data is hard to come by, I was able to estimate that the energy necessary to build, install, and maintain the solar system was probably similar to the energy it would produce over its expected life.  And, since the solar panels were to be manufactured in China, where their energy is predominately high pollution coal, it would likely produce more pollution than simply using electricity produced from natural gas.

Simply using cost and profit for measurement of alternative energy efficacy can be misleading, because energy and pollution are the issues and not money.

So, if profit and money are weak in evaluating the efficacy of alternative energy solutions, how should we evaluate them?  From what we have discussed, we must go back to the fundamental driving force of our economy, energy itself.  Instead of evaluating efficacy in terms of money, measure its efficiency in terms of energy.  In other words, how much energy does it take to create useable alternative energy?  This can be expressed by the simple formulae, EROEI (Energy Returned on Energy Invested).  In the 1930s, when oil was easy to extract, the EROIE was probably near 100.  That is to say, it took only 1% of the oil being pumped to provide the energy necessary to pump and deliver the oil.  By the 1950's the EROEI had dropped to about 30.  Today it's about 20, or it takes about 5% of our energy produced from all sources to get the energy we need. The EROEI continues to drop as we begin to tap more problematic sources.  For example, offshore drilling is energy intense, as indicated by the North Sea deposits with an EROEI of about 5.  The latest offshore discoveries in Brazil at 32,000 feet may have such a low EROEI that they may not be practical to develop.  Oil shale has an EROEI of about 1.7.

Today our energy takes about 4.7% of our GDP.  At an EROEI of 3, it would take 25% of our GDP.  Andy Lees, an astute analyst at UBS, estimates it will take 17% in 10 years.

By looking at energy efficiency through this lens, it becomes obvious that as the efficiency of our energy sources declines, its demands on our total work product begins to increase rapidly or, to put it more bluntly, it lowers our discretionary income.  Also, with declining EROEI, ever-increasing amounts of our precious energy reserves are needed to meet even level energy demands.  And finally, this view tells us which techniques of alternative energy with high EROEI we should pursue.  As EROEI approaches 1 there is no economic point in development.

There are many other considerations. Does it not make sense that any alternative energy strategy, whether it is hydrogen or battery powered cars, ethanol, deep water drilling, or solar power be measured and considered by this EROEI test of energy efficacy?  Yet, they are not.  Any alternative energy proposals must be required to meet this initial hurdle of a favorable EROEI or be eliminated from consideration.  We cannot afford the distraction of frivolous energy programs.

Beyond EROEI we must also weigh the environmental consequences of alternative energy development.  We must not only consider the atmospheric and ocean pollution of our use of energy, which is described in great detail in many studies, but also the decline of other resources such as fresh water.

For example, it takes 787 gallons of water to produce one gallon of ethanol.  Much of this water comes from the Ogallala Aquifer in the mid-west.  It provides 30% of the irrigation in the U.S., and 82% of the drinking water for those who live over the aquifer.  This aquifer has been forming for the last 2 to 6 million years, but it is being depleted at a volume greater than the drainage of the Colorado River. Since it replenishes at about one-half inch per year, some experts forecast that the aquifer will be dry within 25 years.  It is unconscionable that we use this water today for fuel without considering the consequences to our future food supply.

Another limited but important resource is topsoil.  The average depth of topsoil of our agricultural rich mid-west has declined from 18" to 10" in the past 50 years.  It takes 6" to grow crops efficiently.  Any biomass feedstock for alternative energy, or silage (which uses the whole plant rather than just the seed), is simply mining the topsoil.  Comparing the verdant cradle of civilization in Mesopotamia to today's deserts of the Middle East show the effects of the destruction of forests and subsequent loss of topsoil. 

Or, closer to home, both Haiti and the Dominican Republic on the Island of Hispaniola are poor, but the per capita income of the Dominican Republic is five times that of Haiti.  The Dominican Republic has been more careful with its topsoil and has 28% of their area forested, while Haiti has lost its topsoil and only has 1% forests.  There are also social and political reasons for Haiti's decline from the richest colony in the world to its current sorry state.

Japan, with top down forest management for over four centuries, has the highest forest density of developed countries (74%) while having one of the highest population densities.   Japan demonstrates that good environmentally sensitive government can be effective.

Alternative Energy Silliness

The economic politics has given us a false sense of progress and has resulted in misallocation of our precious resources.  The following are some stupefying examples:

Corn Ethanol:  The EROEI of corn-based ethanol is between .2 and 1.5 depending on whether you include indirect energy costs. It requires huge amounts energy in the form of fertilizer, water pumping, harvesting and the manufacture of the ethanol. Also, it uses extravagant amounts of water and topsoil.  In the refining process, it causes immense pollution.  Its primary political purpose was to provide a subsidy for the politically powerful agro-industry.   And, it is, at best, a marginally effective fuel that has the energy density of only 60% of gasoline.  The ethanol can cause severe damage to some automobile engines. Further, it uses human food for transportation while more than a billion people go hungry every day.  Yet, there is a strong lobbying effort, led by General Wesley Clark, to increase the mandated ethanol content of fuel from 10% to 15%.  Crazy!
 
"Drill Baby Drill":  This and its companion slogan, "Energy Independence," are simply political spin to further the interests of the oil industry by increasing drilling in the U.S.  Seventy per-cent of the world's oil has been nationalized which means that oil companies are paid only for their value added services.  In the U.S., they are compensated by the value of the oil, which is much greater.  In any event, the total remaining reserves in the lower 48 states is about 2/12 years of our consumption.  The environmentally sensitive Anwar oil reserves in Alaska would, at peak production in 20 years, provide about 20% of our consumption before declining.

Switch Grass:  This very low energy density biomass simply mines the topsoil.  It is not a renewable source of energy.  If the scientists were to determine its future as a source of energy, it would have none.  The politically motivated DOE (Department of Energy) forecast that 30% of our transportation fuel will come from biomass by 2030 is absurd, and is in direct conflict with IEA forecasts.

Hydrogen Powered Cars:  Oh, how enticing.  The most common element in the universe, with high energy content, and its residue is water.  The most important problem is that it takes a huge amount of energy to free those pesky atoms so that they can be burned.  It has a serious negative EROEI.

Battery Powered Cars:  This is the latest political and media hype.  Ford has announced that 25% of its cars will be battery powered within the next few years.  GM has splashed their intent for major programs as well.

Toyota, who leads the industry in hybrid technology, has been largely silent.  Hybrid technology has a significant benefit in that its electrical power is "free" from the standpoint the electricity is created without the use of additional energy.  It comes from the otherwise wasted energy from the gasoline engine in braking. Perhaps they think that total electric cars are not energy efficient and not environmentally friendly.

Tesla Motors manufactures battery-powered automobiles exclusively.  The cars use the same, state of the art, Lithium-ion batteries that are used in our lap top computers.  As we know, these batteries, like those in our cell phones and computers are expensive.  They are costly because of the high-energy content and rare earths in their manufacture.  There are few known sources and limited supply of lithium.  Even though the cars sell for more than $100,000, the retail price of the batteries in the car exceeds the cars sales price.  

They claim that the car will get 100,000 miles out of a set of computer batteries.  This is suspect since our experience is that our computer and cell-phone batteries last about 3 years if we are careful with them.

Tesla claims that they are more environmentally friendly by comparing the pollution from natural gas produced electricity to gasoline-powered cars.  Unfortunately, only 15% of our electricity comes from natural gas and 50% comes from heavily polluting coal.

The government has recently granted loans to Ford of $5.9 billion for the development of battery power cars, and $368 million to Tesla Motors as well.

We would know a lot more about the efficacy of electric cars, and the prudence of our loans if we were informed about the EROEI over the projected useful life of these cars.

250 Years of Coal:  This claim by George W. Bush must have assumed a mass human extinction that he neglected to mention.  Although we still have large coal reserves, their quality is rapidly declining.  Most of the anthracite is gone and we are rapidly moving from bituminous to sub-bituminous.  Bituminous coal has 21% more energy density than sub-bituminous and 75% more than low quality lignite.  Because of the deterioration in the quality, the EIA forecasts that we must increase our coal burning capacity by 80% by 2030 to only generate current levels of energy.

Coal causes much pollution.  Low-grade coal causes even greater levels of pollution per unit of energy produced.  To sequester the pollutants would require an additional 40% of coal burning.

Solar Power:  Solar power is not silly, but it is not very helpful in solving our energy needs.  The solar panel production is very energy intense.  The silicon base of the panels need be fired to more than 2,000 C.  Its EROEI is very low.  Currently, despite its hype, it produces .02% of the world's energy needs.  Even Germany, which has 50% of the world's solar capacity, produces only about .5% of its energy consumption. 

Without significant tax credits and subsidizing of solar panels by China, which appears about to end, there is marginal or no energy benefit in solar panels on houses. 

Let us assume that my skepticism of "renewable energy" efficacy is ill founded.  Germany projects that reducing the power produced by fossil fuels from the current 62.5% to 50% through renewable energy (ethanol, wind, solar) would require 11% of the land.  Or, to put it into perspective, it would take nearly all of the land in Germany to meet their total power consumption.  In the U.S., it would take land, the area of Nebraska, to meet our already legislated renewable energy requirements set for 2030.   It is imperative that governments take off their blinders and come up with a rational and achievable energy policy!

Nuclear Energy:  Though we have not brought on stream a new nuclear plant in more than 30 years, nuclear fission power has maintained about 20% of our electricity production because of continuous upgrade programs.  Our existing plants are about at maximum capacity and many are reaching the end of their useful life.  We need to rapidly ramp up development of new plants simply to maintain our current production.  Unfortunately, we do not have the technical skills---engineers, welders, electricians, and plumbers currently available to build these complicated plants even if we had the political will.

The likely ultimate solution to our future energy needs is to generate energy the same way that our sun develops it – through nuclear fusion. We know that it is possible, but we don't have the technology today to implement it.  Incredibly, we are spending practically nothing on R&D on this potential energy silver bullet.

Alternative energy summary

Today, there are no alternative energy techniques or rational plans to replace our declining fossil fuel energy and pollution objectives.

The IEA forecasts that the only economically feasible (i.e. ...energy efficient) renewable energy sources from now through 2030 are hydroelectric and wind. 

The hydroelectric potential lies outside of the developed countries, primarily in Asia and Latin America.

Wind energy is relatively inconsequential and will remain so.  It provides less than 1% of our electricity and will be less than 3% in 2030.  One of the most ambitious programs discussed is a $3 billion program of wind farms and distribution system in Hawaii, which would provide the equivalent power to serve about 400,000 people.  This program would result in power costs much higher than today.

The EIA forecasts that non-fossil and nuclear sources of energy will meet about 8% of the world's energy needs by 2030.

It is irresponsible and detrimental to our understanding for respected publications like "National Geographic" and "Scientific American" to publish "feel good" articles that are not substantiated by analysis on how alternative fuels can solve our energy deficits.
 
In spite of the hype regarding alternative energy, we are ever increasing our dependence on high polluting fossil fuels that are in limited supply.

Tomorrow's conclusion: An action plan

by Gordon Ringoen, March 03, 2010

Second of four parts

First, let's define our GDP as a measurement of our work product in U.S. dollars.

As we learned in elementary physics, it takes energy to create work.  It takes energy to run any machine, to grow plants and it even takes about 20 watts of energy for us to think for an hour.

From this perspective, it would be easy to assume that the economy that consumes the most energy would be the one that had the largest work product or as we call it in economics, GDP.

If you agree with this line of reasoning, you will not be surprised with the following facts:

We are 1st in electricity consumption. 

We are 1st in natural gas consumption.

We are 1st in nuclear energy consumption.

We are 2nd in geothermal power usage.

We are 2nd in coal consumption.

Our most important source of energy is oil. We use nearly 21 million barrels of oil per day of the 82 million barrels of world consumption.   Coincidentally, or maybe not, our 25% of world consumption of oil is a number very similar to our 24% of the world's GDP. 

China and Japan, with a combined GDP of 53% of the U.S., consume about 61% as much oil as we do.  Japan is energy efficient but China is not.

China, the fastest growing large economy in the world over the last three decades, has increased its energy production from coal, equivalent to 34 million barrels of oil per day while increasing their oil production by 4 million barrels per day.  This immense increase in energy production and consumption has fueled its economic growth.

On the other hand, a decline in energy consumption per capita is coincident with failed states.  Zambia, Mozambique, Albania, and Afghanistan have all had significant drops in per capita consumption of energy since 1980.  We consume about 13X the energy per capita of Africa.

Energy is the most important factor of production and not capital, labor, and technology.  And, oil is the most important source of that energy.

Without energy, you not only have no economy, you have no life on earth. Imagine, if you can, what the world would be like after 90 days of no fossil fuel energy.  There would be few lights and little heat.  Water distribution and sewer service would be crippled.  There would be no transportation or goods distribution.  There would be no communications.  Government services would come to a halt.  There would be mass famine and disease.  Public services would disappear, governments would collapse, and perhaps billions of people would perish.
 
Can anyone rationally deny that the fossil fuels of oil, gas and coal, that provide 86% of our energy, are not the most important factors in our economy? 

The Economists View

N. Gregory Mankiw summarizes the popular view of economic priority in "Principles of Economics" p. 250, where he states:

"Long-run economic growth is the single most important determinant of the economic well-being of a nation's citizens.  Everything else that macroeconomists study – unemployment, inflation, trade deficits, and so on – pales in comparison."

Economic growth is of course, our increasing GDP.  Oil that we pump and consume is part of that GDP.  There is no accounting for the fact that it is a diminishing resource.  It is as if simply drilling a hole creates oil.  So, the more oil we burn the better it is for our economy.  A $60,000 Hummer that gets 10 mpg is much more important to our well being than a $30,000 Prius that gets 50 mpg.

Or, as Bernanke says in his "Macroeconomics'' text, "Ideally, for purposes of economic and environmental planning, the use and misuse of natural resources and the environment should be appropriately measure in the national income accounts.  Unfortunately, they are not."

Temporary shortages of oil are dubbed "oil shocks" and are deemed to be temporary in nature.  As Bernanke explains, "To illustrate, suppose that war abroad disrupts oil imports.  This drop in supply will drive up the price of oil. A higher price will induce domestic consumers to conserve oil and to switch to alternative sources of energy."

Mankiw also argues that oil shocks are only temporary and that the "free market" corrects any disruptions as long as government does not interfere.

In summary, energy is not an essential factor of production; it is merely a product of our labor, capital, and technology.  If we want more energy we simply produce it. Oh, how sweet it would be if it were only true.

The real world

Perhaps it is worthwhile to view the economic world from a fresh perspective.  Instead of the egocentric view that humans are the center of the universe and what matters most is what we do, i.e., … labor, what we build, i.e., … capital, and what we know i.e., … technology, we think of all living things, including ourselves, and all that we build, as instruments which harness energy to serve the purposes of sustaining life.

It takes energy to affect photosynthesis; it takes energy to fly a plane, to pound a nail, and even to think.  Nearly all of our useable energy has come from the sun either currently or stored in the form of fossil fuels.  The effective tapping into the sun's initiated energy has allowed the human population of the world to increase from 10's of millions to nearly 7 billion in the past few thousand years.  Energy is not an afterthought to our existence but is our lifeblood.

To put the importance of energy consumption into perspective, it is as if all 6.8 billion people on earth had the equivalent of 50 human slaves that work 24 hours a day, 365 days per year and require no upkeep.  On the other hand, a simple power outage like we experienced in August 2004 paralyzes our economy.

Hopefully, having established the importance of fossil fuel energy as the driving force of economies, it is elemental that we examine the continued availability of these resources, and whether their extensive use causes unintended negative consequences. And, we must examine other sources of energy available to fill our future needs while limiting the negative effects. 
 
Oil is the most important fossil fuel.  Let's look at its availability.   There can be no rational view that oil is not a limited resource.   Oil reached maximum production in the U.S. in 1970 and in 1988 in Alaska.  It has also peaked or will peak at sometime in the future in the rest of the world.  The question is when and how much is really available and at what economic cost.

First let's test our economic theories regarding oil to see if it gives any clue about its availability.  We recall that that the theory states that if prices rise, it will automatically bring on new production.  The price of oil rose dramatically from the mid $20 per barrel in 2003 to $120 average per barrel in 2008 and $70 per barrel in 2009.  Yet, world production has been flat to slightly down during this period.  Our recent experience clearly shows that this theory is wrong; otherwise production would have increased as prices rose dramatically.  An obvious explanation would be that the prices went up because demand outstripped supply and there was no additional supply that could be brought on stream.

The price of oil futures contracts also gives us some insight as to production capacity.  Historically, while we had excess oil production capacity, the "spot price" (current price of oil per barrel) of oil exceeded the futures price in what is called "backwardization" (future price lower than spot price).  In the early part of this decade futures prices for two years into the future were consistently about 80% of the "spot price."  This indicated that there was excess oil supply as compared to demand.  It discouraged bringing on new production.  Importantly, this "backwardization" of oil futures prices reversed in 2007 to "cantango" (futures prices higher than spot price) as the futures prices began selling at a 20% premium to the "spot price."

The "cantango" of futures pricing, combined with rising "spot prices," and no increase in production would indicate to an oil investor, that there is a shortage of capacity at least in the short to intermediate term and it raises questions about the longer term. 

Let's put aside market anecdotal evidence for now and look at the actual oil forecasts.  The U.S. Energy Information Administration (EIA) forecasts that oil consumption will increase from the current 82 million barrels per day to 110 million barrels per day in 2030.  Their forecast is basically a demand forecast tied to increased population and economic growth.  They essentially follow the economists theory that if there is demand at a favorable price, the supply will follow.  More specifically, any supply increases necessary to meet demand will come from OPEC countries, particularly Saudi Arabia.  This is a convenient place to plug any shortfall because we have no verifiable data on oil reserves in Saudi Arabia.  They claim that they have all of the oil necessary for a thirsty world but it would seem prudent for them to claim that to be so, even if it weren't true.  Any admission by them that their 40-60 year old fields are on the downward slope of production might invite oil hungry powers to invade them.

In any event, we know that in the rest of the world, there is verifiable data that production is declining at a rate of about 6.7% per year.  Our own North Slope fields are declining at about 4% per year.  The production has slowed to the point that it now takes about two weeks for oil to travel the pipeline from Prudhoe Bay to Valdez while it used to take only four days.  The North Sea fields are declining at an even faster rate. 

At current rates of decline of existing fields, it would take new discoveries equivalent to Saudi Arabia every two or three years to meet our needs.  New discovery rates have been in decline since 1964.  There has not been a major discovery in the world in more than 30 years.  Twenty years ago there were 14 fields that produced more than 1 million barrels per day; today there are two.  There has been only one discovery with production capacity greater than 500 thousand barrels per day since 1980.

Although Saudi Arabia has not produced data about its oil production since 1982, there have been more than 200 independent reports by Saudi's petroleum engineers which would indicate that their fields are moving toward the terminal stage.  Moreover, they may have crippled their overall production potential by over-production in the past.  Many of the reports by experts in the field are in conflict with the claims of the Saudi government.  In any event, whenever peak production is reached, it can be expected that there will be rapid decline thereafter.  Saudi overall production declined from 20005-08 while well production dropped 25%.  An excellent analysis of the Saudi oil capacity is to be found in "Twilight in the Desert" by respected petroleum analyst Matt Simmons.

Looking at the larger picture, many geologists think that we have already consumed about 50% of the available oil.  And, we have exploited a much higher proportion of the low cost oil.  Some think that the world reached "peak oil" (maximum world production) production in 2005; others think it is now peaking, and the most optimistic is that it will not peak for another 20 years.  While the EIA predicts production to be 110 million barrels per day by 2031, the American Society of Petroleum Engineers newsletter predicts 58 million barrels per day.  Other analysts forecast as little as 40 million barrels per day for world production. 

In December 2009, the IEA, in its carefully watched annual report, for the first time, made their forecast for "peak oil."  In a business as usual environment, with no major discoveries, they forecast "peak oil" in 2020.

On the other hand, British Petroleum scoffs at these forecasts as too pessimistic.  Instead of total availability of 2-2.4 trillion barrels of oil remaining, they forecast that there might be 4 trillion barrels remaining to be tapped.  If BP were right, it would add about 20 years till we reach peak production.

There are optimists like Cambridge Energy Research Associates (CERCA), which think we can squeeze out an additional decade or two before we reach "peak oil."  They follow the economic theory that higher prices will result in new technology that will increase our oil production.  Again, they concentrate on the machines (capital, labor, and technology) and not on the energy necessary to drive them, which will be discussed shortly.

Though we hope that the more optimistic projections will be more accurate, they all show that there is a critical shortage of oil in the not too distant future.  In the sweep of history, a 20-year window is insignificant.

There is one more reason to be concerned about our dependence on oil.  The world's major economies are slowly but surely on a course to make us pay for our profligate consumption.  Because the U.S. dollar is the world's primary reserve currency and all oil has been traded in dollars, we have been able to pay for our oil by simply creating credit.  We have been getting oil, in effect, by giving the world Treasurys in return.  As the position of the dollar diminishes as the world's reserve currency, our dollar is depreciated because of huge federal and trade deficits, and oil being traded in other currencies; our purveyors will begin requiring valuable goods and services in return.   Unfortunately, we don't produce enough of what they want at competitive prices.  In short we are going to have to begin paying for oil in current production instead of it being financed by foreigners.  This will be painful for our economy.

Let us summarize for a moment, the leading economists and the government view that labor, capital and technology are the principle factors of production. This theory not only lacks logical sense, it does not stand up to even casual observations of the real world economy.  The presumption that the non-renewable resource of oil has no supply constraints as long as the price is allowed to rise is simply absurd.  And, finally, rather than supporting their claims with reason and data, they simply dismiss the real world situation and justify their position by relying on the dubious political claims of Saudi Arabia that there is plenty of oil for everyone for as long as necessary.  So, this in summary is The U.S.'s Plan A for energy, supported by toady economists.  There is no Plan B.  This farcical situation would be comical if it were not so tragic.

Tomorrow: We're running out of fossil fuels

First of four parts

by Gordon Ringoen, March 02, 2010

The question of the day is how we get out of our economic morass? Is it through financial bailouts, stimulus packages, foreclosure forbearance, tax cuts, or cash for clunkers and caulkers?

Second, who can we blame, greedy Wall Street, incompetent government or the over consuming, foolish public?

The presumption is that if we can just restore our economy to our recent prosperity and punish the miscreants, all will be well.

However, it might be prudent to step back and look at how our economy actually works and create a vision as to what we want it to look like in the future.  If we don't, we might find that the cure for our immediate ills causes more economic chaos in the future.  Our current financial debacle resulted from extrapolation of past trends with little thought about the fundamentals.  The CBS documentary, "2100," gave us a grim view of our future with a business as usual approach.

To view our economy in the broadest perspective is not to answer the question why it is so bad, but rather to ask why it has been so good.  We have a GDP of approximately $12 trillion out of a total world GDP of $52 trillion.  How is it that we produce approximately 24% of the world's GDP with less than 5% of the world's population?

In my experience, few people seem to know.  I recently asked the question to a college Business class. Some students were able to explain our economic strength through the principles they had learned in their Macro-Economic classes.

Let's look at what is being taught by our most esteemed Economic professors. N. Gregory Mankiw, Harvard economics professor and previous chairman of the Economic Advisors for President George W. Bush, in his textbook, "Macroeconomics'' Sixth edition, had this to say about the determinates of GDP:

"Factors of production are the inputs used to produce goods and services.  The two most important are capital and labor.  Capital is the set of tools that workers use:  the construction worker's crane, the accountant's calculator, and the author's personal computer.  Labor is the time people spend working."  p. 46

"The available production technology determines how much output is produced from given amounts of capital and labor."  p. 47

"These theories hold that high wages make workers more productive."  p. 170

Per the Solow model, "If the savings rate is high, the economy will have a large capital stock and a high level of output in the steady state.  If the saving rate is low, the economy will have a small capital stock and a low level of output in the steady state."  p. 195

"In the long run GDP depends on the factors of production – capital and labor – and on the technology for turning capital and labor into output."  p. 548

"The economy's natural level of output depends on the amount of capital, the amount of labor, and the level of technology.  Any policy designed to raise output in the long run must aim to increase the amount of capital, improve the use of labor, or enhance available technology."  p. 550

Some argue that policymakers should not encourage generations to make sacrifice, because technological progress will ensure that future generations are better off than current generations.  (One waggish economist asked, ‘What has posterity ever done for me?)"  p. 550

Ben Bernanke, the Federal Reserve chairman, previous chairman of the Economic Advisors to the President and Princeton economics professor, had this to say in his textbook, "Macroeconomics'' Fourth edition:

"What determines the quantity of goods and services that an economy can produce?  A key factor is the quantity of inputs – such as capital goods, labor raw materials, land and energy – that producers in the economy use."  p. 61

"Of the various factors of production, the two most important are capital (factories and machines) and labor (workers)."  p. 61

"Much of any country's economic well-being flows from natural, rather than human-made assets – land, rivers, and oceans, natural resources(such as oil and timber),and indeed the air that everyone breathes.  Ideally, for the purpose of economic and environmental planning, the use and misuse of natural resources and the environment should be appropriately measured in the national income accounts.  Unfortunately they are not."  p. 31   

In summary, it is quite clear that according to established economic theory, our GDP is determined by capital and labor with an overlying umbrella of technology and a few incidentals.

If this sounds familiar, it should.  More than 200 economic professors in the leading universities in the country, including their home bases of Harvard and Princeton, use Bernanke and Mankiw texts.  Most importantly, their theories are bedrock principles for our economic policies.

The veracity of any theory is that it stands up to real world tests.  If these theories are valid, we should be able explain why our GDP is three times greater than our nearest competitor, Japan, by analyzing our capital, labor, and technology.

Capital

As we know, the most important source of capital is our domestic savings.  In 1990, our net savings was $255 billion.  In 2008, our net savings was negative $249 billion.  That is right, we consumed more that we produced.  The only net investment came from investments and loans from abroad.

Over the last 20 years the U.S. has the lowest rate of savings and investment among Organization for Economic Cooperation and Development (OECD) nations.  It has averaged approximately 62% of the average OECD rate.

In the period 2001-2008, the U.S. had the smallest growth in capital stock since the troubled economic times of 1970-1973.

In terms of our capital stock, in 1990 we had gross savings of $940 billion and consumption of fixed capital (depreciation and wear and tear) of $608 billion, which resulted in an increase of our capital stock of $332 billion.  In 2008, we had gross savings of $1,650 billion while we had consumption of fixed capital of $1,900 billion, which means that our capital stock actually declined by $350 billion.  We are not even maintaining our capital base.  The U.S. Civil Engineers estimate that we need to invest $2.5 trillion to get our infrastructure back to "good."

Finally, to our humiliation, in 2008, our gross investment as a percent of GDP placed us in 135th place of 145 nations in the world!  Our rate was 1/3 of that of the leaders!

It is unreasonable to think that our capital investment is the reason for our outsized GDP.

Labor

Well, if the accepted economic theory is correct, and it is not capital that makes us rich, it must be labor.  Let's look.

As we know, our current unemployment rate is around 10% and the underemployed and part-time raises the rate to approximately 18%.  The average work week has declined to 33 hours per week.  A full 56% of layoffs are claimed to be permanent, an historic high.  Yet, the story of this sorry state of employment is still to be written.   Since the decline in employment has largely been felt in the last 2 years, it has not much yet affected reported GDP.

So, we will look at our labor from the recent past, when we were more prosperous.

Approximately 51% of our population is gainfully employed, which places us 57th in the world.  We have, until recently, worked longer than most at 1,792 hours worked per year, which ranked us 3rd.

It might be argued that our work force is better educated and therefore more competitive.  The numbers don't seem to bear this out.  Our education spending as a percentage of GDP is 5.7%, ranking us 37th in the world. 

Our reading literacy places us 15th, near the bottom for developed nations.
 
The educational areas where we seem to excel are most regrettable.  We rank 5th among developed nations in students who dislike school, and 2nd among nations with students who find school boring.

It is hard to argue that we produce more because we are healthier.  The World Health Organization rates us 37th in health care systems, ranking us just ahead of Slovenia but behind Costa Rica.  Or life expectancy from birth places us at 46th.  Unbelievably, our maternal mortality places us 121st!  We are 37th in hospital beds per thousand and 31st in physicians per 1,000.

However, we are 1st in plastic surgeries.  Also, we lead the world in obesity, teenage pregnancy, and teenage births per capita.

And, of course we lead the nearest competitor by nearly double in the amount of money spent on health care per capita.

Socially, we lead the world in incarcerations per 100,000 and beat 2nd place Russia by 20%.  We rate 19th in safety and security, governance at 16th, and corruption at 19th.

We are ranked 1st in entrepreneurship and innovation, and 2nd in Democratic institutions.

Technology

Although capital and labor do not seem to explain our outsized GDP maybe it is the third leg of our economic theory stool which is technology. 

In the world's global economy, technology tends to be available to everyone, whether it is GPS, prescription drugs, Internet, cell phones, or the latest hybrid automobile technology.

Yet, there is certainly an advantage to those who lead in R&D, science education, and patents.

In the 1960-70s, we spent 3% of our GDP on R&D.  Today we spend about 2.6%.

In big physics R&D, funded by the federal government, our investment has dropped by three-quarters from 2% of GDP to 0.5%.

The U.S. ranks 16th in broadband access per person.

Japan has now passed us in patent applications.

Measuring greater than 12th grade advanced students in science, we place last among the developed economies.  Currently, India has three times, and China four times, the engineering graduates per year. 

Although we clearly lead in innovation, China has far outdistanced us in the production cycle, getting from prototypes to full production. 

So, when you combine capital, labor, and technology you find that only 13% of our GDP actually goes to producing value added manufacturing, which places us 75th in the world and far behind Estonia, El Salvador, Bangladesh, and even Afghanistan.

On the other hand, the finance industry accounts for 40% of corporate profits and 30% of the market value of stocks while providing the relatively minor economic value-added function of moving money from A to B. 

Yet, with all of this, how do we explain that we have three times GDP of Japan, which is in 2nd place?  If the leading economists and government policymakers have other ideas than capital, labor and technology, they are not sharing them with us. But, assuming they are giving us their best shot, it is safe to say that their economic theories don't stand up to the simplest real world examination.  In short, their theory must be flat wrong. 

Tomorrow: A theory that does make sense

Will 2010 be the year that distressed assets get sprung from limbo, or will lenders still be kicking the can down the road?

BY JERRY ASCIERTO and Les Shaver, Apartment Finance Today

(Photo: Richard Clark)

There was blood in the streets last year. More than 130 banks failed in 2009. Fundamentals, from effective rents to occupancy levels, declined to record lows. There were fewer sources of debt all around. A number of large multifamily owners—including Fairfi eld Residential, Babcock and Brown, and Bethany Holding Group—went under. And a wave of loan defaults had vulture funds salivating as they hunted for easy prey at wholesale discounts.

Yet, while a new opportunity fund seemed to close every week in ’09, the pace of distressed acquisitions was slow, to say the least. Distressed sales only accounted for about 15 percent to 20 percent of the overall multifamily sales volume through December 2009, according to New Yorkbased market research firm Real Capital Analytics (RCA). This is despite the fact that the volume of distressed apartments reached $30.8 billion in December, according to RCA.

Although the pace of distressed acquisitions is expected to pick up in the coming years, “it won’t be the bloodbath that a lot of people expect,” says Linwood Thompson, managing director of Encino, Calif.-based broker Marcus & Millichap. “The amount of money being raised for distressed asset purchases is going to be a lot harder to place than most people think.”

Take Alliance Residential. From the start of 2008 to November 2009, the Phoenix-based company had underwritten more than $4 billion of potential distressed transactions—but only closed on $100 million. “The level of distress is certainly as much if not greater than we ever thought it would be,” says Jay Hiemenz, CFO of Alliance. “But the level of dispositions are not.”

That’s a common refrain. Most of the opportunity funds were expecting returns of around 25 percent. But as more buyers enter the market chasing the same few opportunities, those return expectations are falling fast.

As the industry enters 2010, the question is: When will all of those distressed assets emerge from limbo? Better yet, when will the peak of opportunity (or the pit of despair, depending on your point of view) reach its zenith?

“You can’t time an absolute bottom, and people who try are going to miss the opportunities,” says Dan Fasulo, managing director of RCA. “We’re still in the early innings of the distress cycle—a lot of opportunity-focused investors will be disappointed.”

For the past year, several factors have kept the floodgates of distress closed. The availability of agency capital has helped to prop up values. The London Interbank Offered Rate, the benchmark upon which most construction loans are based, was low throughout 2009, which has also been a boon. But the willingness of lenders to modify loans is the biggest factor staving off distress.

HOW BAD IS IT?

Through the fourth quarter of 2009, the volume of distressed multifamily properties was more than three times greater than reported at the end of 2008.

“The issue right now is one of valuation. There are a lot of properties that continue to cash flow, but if you value it today, there would be a substantial discount,” says Craig Butchenhart, president of Minneapolisbased Northmarq Capital. “As long as a property continues to cash flow, the lenders will extend a year or two and hope that things get better.”

But how long can lenders continue to amend and extend? Several investors believe that the peak of opportunity is right around the corner. It’s just a question of simple math, they say. Five-year, aggressively-underwritten CMBS loans done at the height of the market—from 2005 to 2007—should come due starting in 2010. “The next three years are going to be great,” says Eric Silverman, managing director of Boston-based investor Eastham Capital, which is raising a $50 million opportunity fund. “Many loans coming due in 2010 and 2011 will have difficulty refinancing and will have to re-trade.”

A Different Floodgate

Where will all of these maturing CMBS deals find refinancing capital? Fannie Mae and Freddie Mac obviously continue to be active lenders in the space, but they’re generally only doing 70 percent loan-to-value (LTV) loans on higher-quality deals. And regional banks aren’t big on nonrecourse long-term loans. “Ultimately, there isn’t enough regional bank capacity to bail those guys out,” says Mike Kelly, president and co-founder of Greenwood Village, Colo.- based Caldera Asset Management. “If you look at the maturity schedules, there’s only so much time that people can delay the inevitable.”

Indeed, these are boom times for special servicers. For instance, CWCapital Asset Management has been inundated with business—its portfolio of assets grew from $3 billion a year ago to $11 billion now. The division nearly doubled its staff in the first half of 2009, mostly for the distressed debt and REO groups. “I haven’t seen any kind of financing source enter the market on a broad basis to finance a lot of these properties,” says Brian Hanson, managing director of Washington, D.C.-based CWCapital Asset Management.

But just as lenders are extending loans based on sunny projections, many special servicers are now opting to asset-manage their way through the downturn, trying to stabilize or increase the NOI of an REO and wait a couple of years before selling.

“I don’t think the wave is coming. I don’t believe that the maturity defaults are nearly as scary as we thought six months ago,” says David Rifk ind, principal and managing director of Los Angeles-based George Smith Partners. “If the fundamentals and underwriting are there, extensions are granted fairly easily. The headlines we saw six months ago about the maturity tsunami—that’s all bullshit.”

Rifk ind’s firm offers a lender services group, which advises lenders on maximizing the value of their distressed assets. And based on what he’s seen, the majority of lender sales are going to be driven by measured strategic decisions, not the panic dumping that investors assumed would occur. The quality assets will generate serious bids at a pretty high level, he says.

Sandy Pockets

Not all markets are created equal, though. Caldera’s Kelly points to the large number of units that recently came online in some markets as further proof that a wave of distress is coming. Consider Phoenix, where builders delivered about 5,000 units in 2009, adding 2 percent to the existing stock. That doesn’t bode well for a market that ended 2009 with a vacancy rate above 12 percent, according to Marcus & Millichap.

“From a global view, the supply-anddemand balance of the apartment market looks good,” Kelly says. “But it’s all about submarkets: You start going down from 30,000 feet, and it’s a different story.”

In hard-hit states such as Florida, there’s no denying that more distress deals will take place in 2010. More than half of the deals that NAI Tampa Bay has processed since the beginning of 2009 have been distressed—a trend they see increasing this year.

“We’re seeing a dramatic slowdown in the pace of transactions,” says T. Sean Lance, president of the Troubled Asset Optimization Team of NAI Tampa Bay. “But the banks are starting to get comfortable with where some of the values lie, and they’ll start disposing. The drip might turn into a faster drip, but it’s not going to be the tidal wave everyone is talking about.”

Big Fish in a Small Pool

The size of deals currently at play has also changed. The vast majority of the distressed acquisitions closed in 2009 were smaller (less than $20 million), but larger deals emerged in the fourth quarter. For instance, Chicago-based Apartment Realty Advisors (ARA) marketed an ING portfolio of 10 assets located mostly in Texas and received more than 200 offers. The assets were mostly Class B- and C-quality.

“We are seeing people coming off the sidelines who were quiet six months ago; there’s been a real change in the number of offers we get on transactions now,” says Debbie Corson, who heads ARA’s Distressed Asset Solution Group. “These larger guys with equity are really coming out of the woodwork.”

Opportunity funds that hoarded cash for much of 2009 are starting to realize that the discounts won’t be as jaw dropping as they once believed and are starting to engage the market. Addison, Texas-based Behringer Harvard has been the most active buyer, closing deals in the $80 million to $90 million range. Chicago-based Equity Residential has also been active, recently paying $100 million for a 326-unit property in Arlington, Va. These acquisitions signal that it’s not just older assets that are hitting the distress auction block—larger deals constructed in the past 10 years are also at play, many of which have solid occupancy rates.

NAI Tampa Bay marketed a Class A REO asset of less than 100 units recently and received several full-price offers. “Six months ago, it wouldn’t have been the case, but now people are starting to realize they’re missing the boat,” Lance says. “They’re willing to pay a little premium now as opposed to having to compete for deals when prices go up.”

The 12-property Bethany portfolio deal in Phoenix attracted 50-plus offers, though deals of that size were few and far between at the end of 2009.

“There are only a handful of deals out there that the entire buying community is looking at, so it’s sort of an artificial feeding frenzy,” Kelly says. “There’s not a giant, deep bench of qualified buyers. You’ve got a couple of REITs and a handful of highnet- worth guys who can close deals.”

The distressed assets Caldera sees generally fit into two categories. The majority are Class C assets, but on the flip side is a growing number of construction loans going south. “We know the quality assets are there; it just takes time for them to come through the snake,” Kelly says. “It’s like what happened in ’07 and ’08 when it took so long for single-family homes to roll through the foreclosure process.”

RTC Redux?

When the Great Recession began, many expected a second coming of the Resolution Trust Corp., the government program of the 1990s that sold off troubled properties after the Savings & Loan scandal. Back then, the pace of dispositions was swift and orderly. But this cycle won’t behave like the last one. Why? For one, the assets of 20 years ago were facing severely-overbuilt markets. Throughout the 1980s, developers delivered about 4 percent of the existing apartment stock annually. But from 2000 to 2009, only 1 percent of existing stock came online annually, according to Marcus & Millichap.

Today’s culprit is unemployment. “This is not caused by overbuilding; it’s not a problem with the industry,” says Thompson of Marcus & Millichap. “As the economy strengthens, then the problems will go away rather quickly.”

Another major difference is the owners themselves: In the late ’80s, the industry was highly fragmented. Today, a larger percentage of units are owned by well-capitalized firms.

Additionally, the type of loans backing these properties is different today as well: Twenty years ago, unwinding a balance-sheet loan was easy. But CMBSbacked loans pose a much more difficult knot to untangle. “It’s like taking a building down floor by floor,” Thompson says. “You’ve got a mezz lender, a CMBS loan with four stacks in it, some [of which] has been syndicated across 15 different investors. It’s more time consuming because nobody wants to get out of the way.”

Kicking the Can to 2012

By 2012, the multifamily sector should be in full-recovery mode, but getting there is the hard part.

Most economists don’t see a return to significant job growth until the end of 2010. The 10-year Treasury rate is expected to rise in 2010, pushing up prices on fixedrate debt. And rising concessions and vacancies will produce more negative NOI growth in most of 2010.

“It’s going to be a slow, tough climb out of the recession,” Thompson says. “We’re still going to be bouncing around the bottom for another 12 to 18 months. But attitudes have already started to shift; people are less concerned about it getting substantially worse.”

Several factors complicate this forecast. Congress plans to debate the future of Fannie Mae and Freddie Mac in the spring, and any disruption in the flow of GSE funds could have serious ripple effects on the level of distress.

“It’s a false sense of security that there’s an efficient market for multifamily,” says Rifk ind of George Smith Partners. “How the GSEs operate could upset the fragile efficiency of multifamily finance, which is holding the market together.”

The Competition

As more distressed assets shake loose, transaction velocity will accelerate. “I think the competition will be intense once things start hitting the street,” says Robert E. Hart , CEO and president of KW Multifamily Management Group , a Beverly Hills, Calif.- based apartment owner with 10,000 units in the U.S. “There will be a few players to take it down. There’s a huge desire on the sidelines to get stuff.”

In fact, if you have been selling apartment properties during the past five years, you may not recognize the people bidding on assets today. On distressed deals, Bill Shippen, principal of the Atlanta office of ARA, says only about 50 percent of the current bidders were active in the last real estate cycle. The other half either hasn’t been bidding for deals in awhile or has stuck with retail and office investments.

“It’s a lot of new people. A lot of those people were players back in the early ’90s,” Shippen says. “They’re coming back in. They bought in 1992 to 1995, hung out, sold in 2001 and 2004, and have been sitting on the sidelines. Now they’re ready to do it again.”

The other new faces that Shippen sees come from the remaining commercial real estate sectors. They actually see more potential in multifamily distress than the battered retail and hospitality markets. And not only are they new to the multifamily sector, these groups also share a common thread—they’re private.

“There are a lot of private funds out there; it seems that everybody has got a joint venture these days,” says Eric Bolton , CEO of Mid- America Apartment Communities , a Memphis, Tenn.-based REIT with 42,252 units.

WHAT’S DUE?

The amount of multifamily loan maturities across all investor types will nearly double in five years’ time.

The reason for the private interest is easier to understand. High-net-worth individuals don’t have to get an investment board to sign off on their deals. They can take chances pursuing risky distressed deals. “Private capital and high-net-worth individuals are the most active,” says Joe Leon , a partner at Hendricks & Partners , a broker based in Phoenix. “Family trusts and high-net-worth buyers are nimble and can be more aggressive. That’s a big issue with a bank or a seller that’s motivated to get a transaction closed.”

And the smaller, private buyers also often have significant local market knowledge. “Every city has buyers who will buy more challenged deals with all cash,” says Caldera’s Kelly. “They know they can manage this rough clientele for x per door. That will be a local guy who has local management [expertise] and is not afraid of the submarket and economic risk.”

Waiting on the REITs

While the private buyers are often the first to bid on distress assets, many people predict they won’t be alone for much longer. “Generally, the private buyers are the first to buy and sell,” says Lili F. Dunn, senior vice president of investments at AvalonBay Communities, a REIT based in Alexandria, Va. “They also represent the majority of the buyers. They usually have more of a tolerance for risk. Until recently, most of the buyers have been small, private buyers or regional companies.”

Pat Barber, president and CEO of Encore Enterprises, a Dallas-based commercial real estate firm with 436 units, knows the institutions will eventually be players in the distressed (or, at least, discounted) space. That’s why he’s trying to make his move now.

“In the early stages, there’s always a lot of private money,” Barber says. “Then the institutional capital will come in when there’s a lot of money transacted on the private side.”

What’s more, the REITs seem to be focused on bigger moves than just buying one-off deals. “We could see the acquisition of entire companies,” says Nicholas Michael Ingle , director of capital markets for Hendricks & Partners. “Developers get bought. There’s an opportunity for deal making, but people haven’t gotten their head around it yet. That’s where I would see the institutions get an upper hand on the private guys.”

But Ingle doesn’t expect all institutions to become suitors for distressed apartments or their notes. Right now, both life companies and pension funds are more focused on selling.

“They’re pretty scared and burnt from losing so much money over the past five years,” Ingle says.

One thing is certain: People are anxious on both sides of the coin—hungry investors on offense and struggling owners playing defense—to just get it over with, to find a resolution. And nobody really disputes whether things will get worse before they get better. The falling knife is a foregone conclusion. The question on everybody’s mind is, how deep will it cut?

Interesting Times is brought to you by Bremner Real Estate (BRE), which specializes in Apartments and Single Tenant NNN Investments.  To learn more about BRE, and to see our listings, click here. 

“Within a year or so, residential housing problems should largely be behind us,” Buffett wrote Feb. 27 in his annual letter to shareholders of his Berkshire Hathaway Inc. “Prices will remain far below ‘bubble’ levels, of course, but for every seller or lender hurt by this there will be a buyer who benefits.”

The worst housing decline since the Great Depression has left one in five U.S. mortgage holders owing more than their houses are worth. Record foreclosures last year flooded a real estate market already glutted with unsold property, causing new construction to fall to the lowest in at least 50 years. The fall in homebuilding is the only fix unless the U.S. decides to “blow up a lot of houses,” Buffett joked.

“People thought it was good news a few years back when housing starts -- the supply side of the picture -- were running about two million annually,” said Buffett, the chairman and chief executive officer of Omaha, Nebraska-based Berkshire. “But household formations -- the demand side --only amounted to about 1.2 million.”

Berkshire, which owns a real-estate brokerage, a business that constructs pre-fabricated houses and units that make products used in homebuilding, has suffered amid the slump. Profit at Clayton Homes, the pre-fab housing business, fell about 9 percent to $187 million before taxes, while earnings at carpet manufacturer Shaw Industries fell 30 percent.

‘Deeply Invested’

“High-value houses and those in certain localities where overbuilding was particularly egregious” will take longer to recover, he wrote.

“He’s very deeply invested in this,” said Tom Russo, partner at Gardner Russo & Gardner, which holds Berkshire stock. “Across his industrial companies, he’s massively poised to gain” from a housing recovery, Russo said.

Buffett joked that curbing home construction was the best of three ways to reduce supply. The other two, he said, would be to explode homes in a “tactic similar to the destruction of autos that occurred with the ‘cash-for-clunkers’ program” or “speed up householder formations by, say, encouraging teenagers to cohabitate, a program not likely to suffer from a lack of volunteers.”

Baseball, Wall Street

Buffett’s annual communications with shareholders have won him a following of professional money managers and the moniker “the Oracle of Omaha.” He’s written passages in past years that compare investing to baseball, derivatives to venereal disease, and Wall Street bankers to Pied Pipers. The letters have been compiled into a book for those who want to study his pronouncements.

Buffett, 79, built Berkshire into a $198 billion company through investments in firms he believes have superior management and lasting competitive advantages. His deals transformed Berkshire from a failing textile mill into an enterprise that makes candy, produces power and sells flight time on private jets. The shares traded at about $15 when he took control in 1965; the Class A stock last closed at $119,800.

Still, he and Vice Chairman Charlie Munger passed up opportunities when they weren’t able to evaluate the future of a business, even in a compelling industry, he said. That strategy has allowed the company to perform better than the benchmark Standard & Poor’s 500 in every year when both Berkshire and the index have fallen.

Playing Defense

“In other words, our defense has been better than our offense,” Buffett wrote. Last year, he said, Berkshire should have made more purchases of corporate and municipal bonds because they were “ridiculously cheap” when compared with U.S. Treasuries.

“When it’s raining gold, reach for a bucket, not a thimble,” he said. Corporate bonds returned 26 percent in 2009, compared with negative 11 percent in 2008, according to data compiled by Bank of America Corp. Merrill Lynch. State and local government bonds yielded 14 percent last year, compared with negative 4 percent in 2008.

Berkshire did extend financing to companies including Goldman Sachs Group Inc., General Electric Co. and Dow Chemical Co. during the credit crisis as other investors were withholding funds. The private deals pay dividends and interest of $2.1 billion annually, Berkshire said in a filing disclosing 2009 results. Berkshire’s net income of $8.06 billion rose 61 percent from 2008.

‘Climate of Fear’

“We’ve put a lot of money to work during the chaos of the last two years,” Buffett wrote. “It’s been an ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance.”

Buffett has used past letters to discuss plans for his successor, praise Berkshire managers and confess his failings. He admitted this year to a “very expensive business fiasco” with his move to issue credit cards to policyholders at his company’s Geico Corp. auto-insurance subsidiary. Last year, he said the U.S. economy was “in shambles” after reckless lending caused the worst financial “freefall” he ever saw.

He chastised the media in the new letter for “terrible journalism” in seizing on that comment from the prior year without also reporting that he made no predictions about the direction of the stock market.

CEO Responsibility

Buffett said this year that the CEOs and boards of companies that failed during the credit crisis shouldn’t be allowed to pass blame to underlings. Boards should insist on CEOs taking full responsibility for the risk of collapse, he said. “If he’s incapable of handling that job, he should look for other employment,” Buffett wrote.

Shareholders weren’t responsible for the botched operations at some of the country’s largest financial institutions, Buffett said, “yet they have borne the burden with 90 percent or more” of their holdings wiped out in cases of failure.

Still, he said, using year-to-year stock prices to evaluate a company’s progress can be an “extraordinarily erratic” measure. Even a decade can fail to give the proper picture, as Microsoft Corp. CEO Steve Ballmer and GE’s Jeffrey Immelt found when they took over with their shares at “nosebleed” prices.

Immelt, Ballmer

GE shares have dropped about 60 percent since Immelt took over in September 2001; Microsoft has fallen about 47 percent under Ballmer’s tenure. Berkshire shares have risen more than 160 percent in the past decade, compared with the 17 percent decline in the S&P 500. Buffett’s company joined that index last month when it completed the largest deal of his 40-year tenure, the $27 billion takeover of railroad Burlington Northern Santa Fe Corp.

Berkshire owned about 23 percent of the railroad’s stock before the acquisition, and will book a first-quarter gain of about $1.1 billion tied to the increase in the value of those shares on the takeover, the company said.

Berkshire had $30.6 billion in cash and so-called near cash like U.S. Treasuries as of Dec. 31, compared with $26.9 billion three months earlier, after Buffett sold stock to add to the company’s cash cushion in advance of the rail deal. Buffett used about $8 billion of that cash to help fund the acquisition.

“We pay a steep price to maintain our premier financial strength,” Buffett wrote. “The $20 billion-plus of cash- equivalent assets that we customarily hold is earning a pittance at present. But we sleep well.”

By Andrew Frye, Bloomberg, 3-1-2010

A new report on global commercial property sales $10 million and above shows that quarterly transaction volume has surged for the first time in two years, a clear indication that the market is recovering from a deep recession.

In the fourth quarter of 2009, volume rose to $147 billion, up 85% from the same period of 2008, according to New York-based research firm Real Capital Analytics (RCA). It was the first quarterly increase on a year-over-year basis in seven quarters, according to the report.

From apartments and offices to retail deals, all property types except hotels showed an increase. Office, retail and industrial transactions together registered a 29% gain in the fourth quarter from the same period a year earlier.

Asia led the fourth-quarter surge, with China, Hong Kong and Taiwan providing most of the momentum, while the U.S. and Canada experienced a decline in sales.

“The U.S. is lagging counterpart regions in Europe and Asia. But we fell into the down cycle arguably later as well,” says Dan Fasulo, managing director of RCA. “We like to think that the U.S. will start to recover rapidly over the next six months, basically following in the same path of the recovery we’ve seen in Western Europe and in Asia.”

In the Asia Pacific region, volume rose 240% year-over-year in the fourth quarter, with China showing the strongest gains. And for all of 2009, only China registered a significant increase in sales, with volume rising 139% to $156 billion.

Although European and U.S. governments initiated stimulus programs, they were outdone by China, says Fasulo. “When Beijing told the banks to lend, they went out and lent the money. A lot of that excess debt capital went toward the acquisition of real estate, mainly large development sites.” A number of mixed-use projects were initiated at those sites and projects are under way.

Values begin to rise

The strengthening sales show that the market has bottomed out and begun its recovery, says Fasulo. “I think it’s very easy to say that as far as transaction activity goes, we’re well off the bottom, which as we look back, probably occurred in the first half of 2009.”

Anecdotal and some statistical evidence show that values have also begun to rise, says Fasulo. “In early 2009, you could barely get a quote to buy an office building in Manhattan. And if you did get a quote from a lender, you would be at extraordinarily low loan-to-values and a high interest rate. Now there’s more than a dozen lenders that would give you an honest quote today, at pricing that’s much more attractive.”

In one example signaling an improved market, the iconic, 160-unit Helmsley Carlton House hotel on Madison Avenue in Manhattan drew a flurry of offers after it was put up for auction in January. “There were over 35 bidders — over 100 interested parties and 35 firm bids,” says Fasulo. “Those are greater numbers than we saw at the height of the market.”

Bidding war in Boston

Another sign of an improving commercial property market is the bidding war that erupted over One Brigham Circle, a 200,000 sq. ft. office complex in Boston. Less than a week ago, AEW Real Estate Investment Management, based in Boston, won the competition with a bid reported at nearly $99 million.

Although the fourth quarter saw a dramatic increase in sales activity, transactions for the entire year of 2009 reflected the severe losses of the economic downturn. The global volume of commercial property sales dropped 30% to $381 billion, while the number of transactions fell 40%, RCA reports.

“We got pushed to the brink in late ‘08 and early ‘09, and saw almost the disappearance of the debt capital markets for commercial property,” explains Fasulo. But little by little, the marketplace has improved and property values are in the initial phases of climbing back from the abyss.

Still, not all properties are rising in value and desirability at the same pace. Class-A properties in highly desirable markets will recover their values more quickly, says Fasulo, particularly those with long-term leases in place and strong tenants.

“It’s almost a two-tiered market that’s developing. One is the prime assets that have more bond-like qualities, and the other part is assets that have near-term exposure to the economy — retail centers that have lost major tenants, broken development projects, raw land, a secondary market hotel. Those are the types of assets that are not going to see values recover anytime soon.”

A Class-A office building that stands mostly empty also is unlikely to share in the rebounding market, says Fasulo. But a building net-leased to a major institution such as a pension fund is a different story. “You’d better believe we’re going to see values increase for that type of product this year.”

As for the timing of recovery, Fasulo says he may be more bullish than many analysts. “I would argue that it’s already happening now.”

Denise Kalette, National Real Estate Investor, 2-23-2010