Treasuring Fine China

In case you’ve been living under a rock the last several years, here’s a news flash:  China’s booming economy is having a big impact on the world, and the U.S. in particular.

And whether you like it or not, or agree or disagree with U.S. policy toward China, it doesn’t really matter.  China matters.  So, we’re learning to pay attention to China.

In case you aren’t convinced, consider that Chinese demand for raw materials (cement, steel, lumber, oil, etc.) create more demand which drives up prices.  So if and when U.S. builders start building again, their costs will be higher.  This means the properties they build will cost more.  Which means that existing properties’ values will be pulled up by rising replacement costs.

What???  How, you ask, can we talk about rising prices when everything’s in the dumper?

It’s easy.  As long as people do what they do, populations grow.  The need for buildings continues in spite of the economy.  And the last time we looked, people will do without a lot of things before they skip having a roof over their head.  So it’s only a matter of time before building begins.  Meanwhile, we sit in a rare window of time where there are low interest rates and lots of properties selling at or below replacement costs.  Just something to think about…

And speaking of interest rates…

Did you hear what Morgan Stanley Asia’s honcho Stephen Roach told CNBC?  He thinks China may decide to stop lending money to Uncle Sam.

In case you’re holding your breath waiting for the super-duper council of 12 deficit reduction committee to balance the U.S. budget, even if Uncle Sam miraculously produced a surplus, he still has lots of short term debt that needs to be refinanced.  So if China doesn’t re-up, then who’s got the horsepower to feed the U.S. debt addiction?  Greece?  Spain?  Italy?

Time out.  Before your mind wanders off, let’s talk about why real estate investors care about all this.

Real estate investors get rich doing leveraged buyouts.  Really!  Just like some corporate raider.  You find an income producing business (a rental property), then go get financing to purchase it.  Then you use the income from the business to pay off the loan.

So, if your goal is to own a lot of these properties, you will have a lot of loans (what we affectionately refer to as “good debt”), and your cash flow will be substantially affected by interest rates.  Right now, in case you’ve been napping, interest rates are REALLY LOW.  And if you lock them in for the long haul, it’s hard to imagine you’ll be regretting it down the road.

But if the Chinese stop buying U.S. debt (Treasurys), then (says Mr. Roach), the U.S. may have to pay (gasp!) higher interest rates to attract buyers.  And if U.S. Treasurys go up, you can bet real estate loans will be right behind them.  See?  Get the connection?

However, as previously posed, this presupposes there is a buyer out there with a big enough checkbook to meet Uncle Sam’s needs.  If not China, then who? And if there isn’t another economy strong enough out there to buy up trillions in U.S. debt, then are there buyers at any interest rate?

So here’s another take:  If China goes away, in part or in whole, our guess is that Big Ben Bernanke will get out his magic checkbook and, either directly or indirectly, will pick up the slack.  In this case, Big Ben isn’t concerned with interest rates (after all, his cost basis for the money is zero), so the issue isn’t rising interest rates, it’s an increasing money supply.  In other words: inflation.

(In case you missed it, we did a series of blogs on this topic when everyone was getting their undies in a bunch over the debt ceiling debate.  If you want to learn more about Big Ben’s magic checkbook, search our site for “The Great Debt Ceiling Debate” or click here for Part 1 of the 5 part series.)

Here’s the bottom line (which is why it’s conveniently located at the bottom):  No one knows what China will do.  But if you understand the mechanics of the money, then you can make a plan A, B, C and D.  And there’s even more letters available if you want to go farther than that.

If China goes away, and Mr. Roach is right and interest rates rise, do you want to be sitting on lots of low interest rate debt locked in for the long haul and being paid for by people who have to rent because home loans are too expensive to buy?  We do.

If China goes away, and Big Ben’s magic checkbook comes into play, and inflation is fueled, do you want to own real assets (like commodities and real estate) that go up in value (over time…be patient) as replacement costs rise?  Check.

If China keeps on buying, but demands higher interest, go to plan A.

If China keeps on buying, and is content with ridiculously low interest rates, even if the Fed doesn’t intervene, won’t low interest rates eventually lead to inflation? (Yes, they do. The whole reason the Fed alleges it keeps interest rates low is to “stimulate” the economy).  Go to plan B.

We’re not saying the current de-leveraging (the U.S. is still suffering from a major sub-prime hangover) won’t suppress prices for the next few years.  But if you’re a buyer, aren’t low prices, low interest rates, and a growing rental population all good things for right now?

 

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