Have you considered that the market may not want a perfect calculation of value?

Thought One:

Money is made in the arbitrage. Why would the capital markets want to screw that up?

It is not difficult to observe this reality. The idea of transparency is easily achieved. Yet everybody keeps their secret sauce. That hidden jewel of information that either gains them advantage in pricing or causes somebody else’s disadvantage.

Thought Two:

Is it not this same arbitrage and its continued reinvestment in the markets that have led to innovation-growth and likewise the collapse and the need for reinvention?

This recurring cycle is unlikely to break because it is natural. We watch the capital markets make a market around the arbitrage until pricing convergence occurs. They then exit the exhausted field (extracting additional value in the retreat through short selling) and begin a new cycle of investment in the next opportunity. Make a market, break a market. This is the natural law of the capital markets. The operation of this cycle is critical to the survival of our species. It is the stimulus to innovate-invent-progress. Without it, there is no drive to improve. Test your models. Remove the returns achieved through arbitrage and tell me what happens to the global economy, social advances and the general welfare of the global population. Explain to me what happens when you socialize pricing and or further achieve a level of predictability that marginalizes the return. The capital markets will withdraw from those opportunities and move to and or make markets that create a spread…new arbitrage.

Human nature causes us to seek a return for our efforts (investments). It is a born desire to survive and succeed. We are also born with the ability to make choices that will dictate what opportunities we are able to pursue and or experience in life. Contrary to the current sentiment in Washington, I believe that individuals are capable of making good decisions. I believe in less government, more decision making and accountability to the individual. When unnatural stimulants and-or controls are introduced into the natural cycles, socioeconomic disaster and punishment (as you say above) occurs. The law of supply and demand are the best regulators. Capital will pursue the arbitrage. Stimulate growth and innovation. Exhaust it. And then do it again somewhere else.

Every so often a unique phenomena occurs where you have a perfect storm. The pricing convergences reaches equilibrium. The capital market has made its exit. The market lacks arbitrage or opportunity. The general population has consumed to a point of excess. The demand cycle and ability to pay is broken (Overleveraged). And surprise you have the great recession (depression).

At this point, correction/re-pricing/resetting/recapitalization or whatever you want to call it begins anew. The excesses needs to run-off. The replacement cycle -consumption demand needs to start anew. The market first needs to deleverage and recapitalize. Arbitrage needs to blossom. The capital markets need to engage. And life will go on. This cycle can only begin in earnest when people chose to pursue it in earnest. It will begin with a few driven leaders that make the decision to pull people up, not down.

Prediction: Still 2011 for a recognizable and consistent return to balanced growth.

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Comment by Anthony M. Graziano on August 11, 2009 at 3:05pm: Mark:
This is an excellent launching point for the discussion "how is value 'calculated'?" I like your thoughts on the "natural cycle" - and I agree with your premise that artificial controls can disrupt the cycle. However - the premise that "arbitrage" creates value is only germaine to how the capital markets make money (ie "how to make money with money"). In traditional capital market cycles, we used global finance differentials and US-backed borrowing to create the arbitrage. In this last cycle, the arbitrage was being delivered using cheap money; and then making it cheaper on the promise of lesser risk through tranching and insuring the debt to "create and extract" the arbitrage. The insurance was not honored; the instruments used to tranche the debt were not adequately tied to the real estate; and ultimately - we have created instruments (RMBS/CMBS) that are very difficult to deleverage. As a result, the taxpayers were forced to effectively pony up the insurance proceeds anyway - for no return; just an unknown future liability.

If I am an equity real estate player (I am and I work for them); you play the game to win the highest returns, but sometimes you also gotta get up from the table and let others get short-stacked on chips. You took the cheap money and you saw prices converging, and you stopped playing 18 months before everyone else. Now you are waiting to see how short-stacked everyone really is - but the transparency is not there; and the government keeps giving the capital markets "re-buys" on chips while equity is waiting. I have a hundred qualified investors lined up; and everyone is saying the same thing - "show me a deal that makes sense if inflation goes to 5%-6% annually!!!"

Over time, you only make money in any market by sticking to two correlated and very simple fundamentals... Buy low, sell high - and exit when you cannot create (or perceive) any more value than whats already been achieved through solid asset management. In real estate, you should not need refinancing to generate your return - it should only be used to amplify already solid returns.

To return to balanced growth - we need to align our capital market and equity market mentality to long-term investment, and growth in value tied to dividends (or in real estate- ie cash flow). Our tax policy must reward low-debt scenarios so equity is rewarded (after tax) for staying equity (not converting to debt). These measures will eliminate volatility; which in itself, helps to stabilize values.

There will never be a "perfect calculation of value". Value is a perception of the anticipated benefits of future income. Values are falling right now (globally) because the majority perception is that future cash flow is uncertain. These "values" were only perceptions in the first place. Is there cash flow after debt and taxes? If so - you have value. If not - you do not have value. "How much" value you have is just a counting game unless you need to exit the property to generate a return. The fundamental problem is that the market engaged itself in an upward pricing spiral that forced annual cash flow yield to nearly zero (in many cases negative) in exchange for the promise and perception that exit values would be higher to make up the difference (by refinancing or sale). You can qualify this as capital market arbitrage, but its equity-market suicide.

Return to fundamentals...by 2011; transactions will be happening at sensible pricing with real cash flow; the economy will have stabilized ;and we will slowly dig out to "balanced" growth. Some big players will be forced to fail in the meantime.

Great article.

The after tax benefits of real estate ownership are superior in every respect to other investments. This will only improve under an increasing US tax burden. Prosperity will return when we stop trying to make money on short-term arbitrage and fees; and return to making money the old fashioned way...by earning it over time; saving some, investing some, and spending some.

Comment by Bowen Wong on August 9, 2009 at 12:47pm: Great article. The market may not want a perfect calculation of value, I believe ... for certain parts of the globe; but not for the markets in some of the countries in Asia. The past is the past, the majority will learn from history but behave the same in time. However, we are making new history...a history of forming a new system and buildng a firewall to prevent a similar cycle. The queston is, have we reached the end of the previous cycle; or it will end on the other side of the globe.

Comment by Jennifer Azzopardi on August 7, 2009 at 8:22pm: Great article Mark, I wish I had your competence in writing skills!

Anyways, so long as all players are revealing the real truth in figures I completely agree with this article. Unfortunately the system encouraged a lot of unscrupulous behaviour that ruined the savings of a huge number of people, basically saying half truths which really is no truth at all, and genuine investors were making decisions based on those half truths, and that in my opinion requires immediate full correction, without creating unnecessary bureaucratic regulations and expenses which will prevent the full prosperity for all concerned