Courting Disaster

Published by at under Real Estate Market

Last Wednesday night, the Congress reached an agreement to reopen the Federal Government and avert a U.S. debt default. This agreement was reached just 24-hours before the deadline where U.S. debt obligations would have been considered in default for the first time in our country’s 237 year history. In the last few days, I’ve been asked several times what impact did the Federal government shutdown have on the real estate industry; and what impact a Federal government default would have on real estate values? The answer to the first question is relatively easy. Other than the reported $24 billion in lost economic activity, it’s unlikely the Federal government shutdown had any more than a ripple effect on the real estate industry. The answer to the second question is a far more complicated.

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The agreement reached last Wednesday night in Washington was only a temporary fix. The parties involved agreed to reopen the Federal government for another 90 days and delayed a decision on the debt ceiling, and the potential government debt default, through February 7th, but little else was resolved. In the past, increasing the borrowing power of the Federal government by increasing the debt ceiling was generally a non-partisan issue and passed routinely without controversy. However, lately the issue has become an opportunity for a minority in Congress to try to obtain concessions on a host of issues by holding the country hostage to a potential Federal debt default.

Certain members of Congress have openly advocated that a debt default is the way to deal with the Federal governments growing deficit. That position was countered by the likes of Warren Buffet, one of the most respected investors and financial minds in the country, who said last week that a Federal debt default would be “a pure act of idiocy – the equivalent of financial mass destruction”. Buffett went on to say that “creditworthiness is like virginity; it can be preserved but not restored easily.”

Since the U.S. has never defaulted on its debt, no one can be absolutely sure of the consequences such an event would have on the national and international economies; and more specifically on the real estate industry. However, two recent examples exist of countries that defaulted on their national debt within the past fifteen years. In 1998, the Russian government defaulted on its debt; and in 2001, the Argentine government did the same thing. Neither country fared well after their respective defaults.

In Russia, the financial crisis and subsequent default was precipitated by a political wing of Russia’s parliament the State Duma. That group within the parliament blocked efforts to enact economic reforms that would have averted the financial crisis and government debt default that followed. The Russian government was forced to devalue the country’s currency and cease payments on the government’s debt instruments. Long-term government bond rates swelled to 47 percent; and interest rates on short-term government obligations increased to over 200 percent. Inflation quickly rose to over 10 percent. These series of events precipitated an investor panic followed by dumping of Russian currency and assets, a collapse of the stock and bond markets with stocks losing over 75% of their value, and numerous bank failures wiping out large portions of the public’s wealth. In December 2001, Argentina, following a three year recession, also defaulted on $93 billion of government debt. Foreign investment fled the country, and capital flowing into the country ceased for two years. The Argentine currency lost 75 percent of its value, inflation rose to over 40 percent, and in the year following the default, the national GDP dropped 11 percent.

Although the U.S. might not experience as severe a scenario as either Russia or Argentina, a default on America’s national debt for the first time in history could not possibly be good for the economy and the real estate industry. Based on the experience of Russia and Argentina, it’s safe to say that U.S. interest rates would likely go up substantially, perhaps as much as they did in the early 80’s when the prime rate hit 18 percent. The U.S. government might also for a period of time lose its ability to borrow money. This could lead to a sudden and significant downsizing of the Federal government as the Federal budget is 26 percent funded by borrowed money. If the government had to cut its budget by 26 percent if could likely lead to another significant recession. It might be the perfect storm of negative economic events, high interest rates, high inflation and significantly reduced economic activity. Even a modest increase in interest rates could reverse the current real estate recovery and reduce the value of all types of real estate. In short, it’s not a scenario that would be healthy for real estate values.

Whether you’re a single home owner, or a large real estate investor, you share one thing in common; you’re a member of the real estate owners’ party. As a real estate owner, it’s probably not in your best interest to have the political leaders in this country flirting with the possibility of a U.S. debt default. If the members of Congress that voted against the bill to resolve the impasse last Wednesday night had gotten their way, the economy and the real estate world might be looking very different today. The next round is only 90 days away.

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William Small, JD, CCIM is managing director of Frias Commercial Real Estate, a division of Frias Properties of Aspen that specializes in advising investors and owners of investment real estate. You can reach him at (970) 429-2419 or email him at bill@friasproperties.com.

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