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Are Real Estate Appraisers Former Internet Analysts?

On Tuesday, Challenger, Gray & Christmas announced job cuts increased 11.5% in June from May. Not surprisingly, telecom and computers accounted for the majority of the announcements. John Challenger, CEO of the placement firm which conducted the survey, commented that the stock market decline, which is resulting from the loss of confidence in corporate America is "likely to ripple through many industries, starting with the financial sector."

The lack of corporate governance is retarding the mergers and acquisitions cycle. Stephen Schwarzman, president and CEO of The Blackstone Group, was interviewed by John Crudele of the New York Post this week regarding the current M&A activity, or lack of it to be more precise. The mood of corporate America is summed up nicely by Schwarzman, "Directors [are] saying ,'Why don't we take some time out, and let's make sure everything is fine at home before we start expanding. The M&A cycle is retarded a bit this time by the Enron/Worldcom 'Are your numbers any good?' fallout." Global M&A activity was down 35% to $528 billion in the first half of 2002, which is the lowest level in at least five years according to Bloomberg News. In the U.S., there were just over $200 billion worth of announced deals in the first six months of the year. This compares to $369 billion announced in the first half of last year and a bubbling $887 billion in the first part of 2000. "There are companies facing financial pressure. They don't have to be distressed companies per se, but companies that are concerned about refinancing bank lines, even if they are healthy companies," warns the investment company president. Schwarzman foresees more restructurings that will cut "across industries" and many of these will result in debt-to-equity conversions.

In our opinion, the current outlook for the rest of the year is to optimistic. As companies continue to evaluate the business climate, it will be inevitable that corporations will have to scale back operations further. We would not be surprised if these announcements occur when companies release second quarter results or soon after.

In Denver, the 40,000 layoffs during the past year helped fuel a 54% increase in home foreclosures. Another contributing factor is the increased role of refinancing mortgages. Homeowners have increasingly used refinancings as a method to "manage" personal finances, which has left a lot of homeowners with out any equity in their home. Little equity combined with a historically low savings rate creates a delicate situation when the family experiences an emergency or job loss. There are a significant number of homeowners that do not have any cushion or means to maintain their standard of living should this occur. Real estate agent David Binikowski, explained "I've had some clients who lost their jobs, who had sucked all of the equity out of their homes, and when they went to the closing they were lucky to break even. You have to beware of those 120 percent loans. Be wary of loans that take out all of the equity in your home. That's financial suicide." Unfortunately, this advice has not been widely followed during the past five years, and especially this past year.

There is an increasing debate on whether or not a bubble exists in residential real estate. The argument against the bubble is entrenched behind the notion that real estate only goes up. This was the same mentality that investors had while buying Yahoo at $150 per share. Sunday's Philadelphia Inquirer carried a story titled, "Home buyers' mad scrambles." Everyone is familiar with the frenzy in California, but this story exemplifies just how widespread the frenzy is. As with all stories of this nature, it contained several examples of buyers getting multiple bids over their asking price and offers being accepted the day after listing. But more interestingly, there were several quotes that were reminiscent of the internet bubble. One realtor lamented about "having trouble with appraisers because [houses] are selling $20,000 over price." The solution is "to find appraisers who are more aggressive." Another realtor warned that "if you see a house you like, you're not going to have time to go back a few times. You have to make a very quick decision in today's world." That almost sounds like a line out of the movie Boiler Room. This is from a city that is experiencing a declining population. Especially troubling is the idea that some appraisers are currently acting like Internet analysts a few years ago. When banks lend money based on inflated housing prices and the economy takes a turn for the worse, it usually does not have a happy ending.

Just as the telecom / technology boom created a surplus of engineers and programmers, the real estate boom is adding to the number of licensed brokers. In Texas, the Real Estate Commission issued almost 10,000 new licenses in the seven months ending in April. Almost twice the number issued last year. The growth is nationwide. According to the Association of Real Estate License Law Officials, about 2.3 million agents held licenses at the end of 2001, up 10% from 2000.

The employment situation has not helped the commercial real estate market. Here in Dallas, which has one of the highest vacancy rates in the country, the situation is getting worse. The most recent Worldcom layoffs will trim 700 workers from the Dallas area. Rents have only dropped about 3.5% this year, but that does not include incentives. According to Tracy Fults, a director for Cushman & Wakefield, "Free rent is abundant - they will quote you $20 per square foot and will give you a year's free rent. A year ago, if you got six months' free rent for your clients, you thought you were doing swell." Along with free rent, landlords are also throwing in free parking and helping to pay for office space finish-out. Putting more pressure on landlords is the amount of sublease space that will be coming on the market in the near future.

Over the past several weeks the market has started discounting stocks of big ticket consumer items. After out performing in the first quarter, stocks like: Best Buy, Harley-Davidson, Polaris, Brunswick, and even auto related companies like General Motors and Sonic Automotive have started coming under selling pressure. GM's announcement of zero-percent financing didn't help the stock at all. Either the market is expecting a substantial drop off in consumer spending in the second half of the year, or there are problems brewing in the credit markets. Almost all these type of companies are dependant on the credit markets, which they use to securitize a portion of their receivables. This ability to sell off receivables and receive cash has dramatically increased their ability to extend credit. If there are concerns that companies will not be able to sell receivables to the credit markets, these companies' ability to extend credit to customers will be severely diminished. This might be what ultimately causes consumers to slow their spending - the loss of easy money.

Debt laden media companies have also come under extreme pressure lately. It started with the Wall Street Journal story questioning Omicom's accounting and was magnified after Worldcom announced its fraudulent accounting. These companies also have high borrowing needs and have been previously valued on EBITDA.

The mad rush into small cap stocks is unwinding. Unfortunately, investors are learning that liquidity is more of a concern when selling instead of buying. Even on Wednesday, the Russell 2000 index lagged the rest of the market.

Investors have quickly started acknowledging all the concerns we have raised over the past several years. It is likely these newfound concerns will continue. Worldcom was a much bigger psychological blow to investors than Enron. During the late 90s the investment rules were suspended. Only market share mattered. Profits would flow later. This logic has changed over the past two years and has taken a dramatic move during the past six months. Now investors just need to remember what is a fair multiple to assign to earnings. The S&P 500 is valued at 21 times forecasted 2002 earnings, which in the words of FirstCall's director of research are "unrealistic". This is still higher than every other market peak. Earnings multiples usually fall to around 10 during market troughs. Needless to say, significant risk remains in the market. And just think, how much of those earnings are real!

David Tice & Associates wishes everyone a safe and enjoyable Fourth of July.

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