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Economic plans

GEOFF COLVIN: In Washington, America's many economic interests are preparing for an epic battle. Reforming the tax code, repairing Social Security, and fighting the war on terror -- without exploding the budget deficit -- are at the top of President Bush's second-term agenda, and each change will produce winners and losers. Who will they be? We'll talk about that with a Washington insider. And to see those conflicting interests close up, we've begun asking a variety of leaders: If you were Treasury Secretary, what would you make America's top economic priority? This week we asked two of the country's top business leaders, and they gave us decidedly different views. To reduce their positions to a single word each, one said "Grow," the other said "Save."

Hank McKinnell is CEO of Pfizer, the world's largest pharmaceutical company, also chairman of the Business Roundtable, comprising the CEOs of many of America's biggest corporations. He's Mr. Grow -- if he were Treasury Secretary, America's top economic priority would be:

HANK McKINNELL: Growing the economy so more Americans are working and paying taxes.

COLVIN: John Brennan is CEO of Vanguard, America's second-largest mutual fund firm -- and he's Mr. Save.

JOHN BRENNAN: Live below your means, pay yourself first. Simple, trite, but powerful as a concept, and we think it needs to be more of a national concept.

COLVIN: A national concept in part because the federal government isn't saving - it's going deeper into debt, to Brennan a huge problem.

BRENNAN: A high priority is getting the deficit in line, moving forward. There's a lot of debate back and forth about whether deficits matter, we think deficits do matter. We think deficit spending can't on indefinitely, and getting our fiscal house in order for the future is really very important, and that is largely driven by spending and insuring that we reign in the rate of spending growth that's gone on over the last several years to allow revenues and expenses to come into better balance than they are today.

COLVIN: But Hank McKinnell, Mr. Grow, has a different perspective.

McKINNELL: We have a budget deficit, which is not the biggest problem, I believe. It's a problem that needs to be resolved over time, but it's quite natural that the emphasis of the secretary should be economic growth first, which means stimulative fiscal policy, which is what's been accomplished. And over the next five years, we have to turn to balancing the budget and that will be a challenge during the next five years.

COLVIN: But McKinnell's top priority is growth, and he's emphatic about who's standing in the way.

McKINNELL: We need favorable economic policies, which grow the economy. And on that list, the most important thing would be class action reform. The personal injury lawyers are imposing an enormous tax on the American economy, and only 50 percent of those $233 billion in costs every year are going to those who are truly injured. We urgently need civil justice reform.

COLVIN: John Brennan realizes his savings mantra conflicts with McKinnell's growth focus, but he's unwavering.

BRENNAN: We're incredibly committed to the concept of living below your means. You know in a sense, against the short term economic interests in the country to encourage people to save rather than consume, because the consumer has been the engine of continued economic growth. But we think it's a very powerful message. We think it's an important message that, you know, consuming 2 percent or 3 percent less today and saving it is incredibly valuable to you out into the future. The idea that you're going to retire at 55 not 65, or some other age, is one that you just have to talk about overtly because it's a matter of income and out go and how you think about that. It's a discussion that, frankly, the baby boom generation will force on the country. And it will be a good discussion that providers like us, politicians, national people in charge of this whole retirement and fiscal security issue are going to have to have it very overtly. And, again, I think better to have that discussion on a ongoing basis than dealing with it in a crisis mode.

COLVIN: Which everyone would agree with -- but as a matter of political reality, can significant reform happen?

BRENNAN: Well, policy makers always have short-term realities staring them in the face, but I actually think that the political will is there. I know the, at least the members of the administration and, you know, senior legislative leaders that I've come in contact with understand it, and I think it has to be a healthy debate, and recognizing that you are trying to build for the future. Recognizing that polls and short-term pressures are there, but the whole baby boom phenomenon, I think, creates a greater sense of urgency here to get the fiscal house in order as we move forward. And I believe the people in Washington understand that, and I hope they have the willingness to take it on head on.

COLVIN: The other great fiscal problem Washington has avoided taking on is healthcare costs and the CEO of Pfizer wants a completely new approach.

McKINNELL: We are on the wrong track. As long as we focus on the high cost of care, we are on the road to rationing, price controls and less innovation. If we focus on the cost of disease, out of this fog some different solutions start to emerge. It's the realization that it's much better and less costly to prevent heart attacks and strokes than it is to wait and treat heart attacks and strokes. So that thinking leads you to an emphasis on wellness, personal responsibility, prevention, early treatment. It leads to quite a different place than where we're headed at the present time. So I think early in this new administration or in the second term, we need to start reaching a national consensus around just what systems of healthcare we want in this country. Clearly what we have now is not working.

Valliere interview

COLVIN: Well, that is several huge issues now on the table, but what's really likely to happen and who wins and who loses? Greg Valliere stays on top of it all as chief political strategist at the Stanford Washington Research Group. He joins us from Washington. Greg, for starters, if you were Treasury Secretary, what would you do?

GREG VALLIERE: I think first, Geoff, I would focus on the budget deficit. And I do believe in January we're going to get a new budget from the Bush White House for the upcoming fiscal year, FY '06, that will be very, very tight-fisted. I think for domestic discretionary spending, there's going to be virtually no growth.

COLVIN: Well, now that would be progress for sure. Is a budget of that kind likely to get through against all the competing interests?

VALLIERE: I think so. I think that with 55 Republicans in the Senate, that's quite a number. It's not quite 60, which is the magical number, but 55 is pretty impressive, and I think on spending restraint, the President will largely get what he wants. That, in my opinion, will lay the groundwork for the next big fight, I mean the two big fights, which is reform of taxes and something on retirement policy. Those are longer-term battles, but first and foremost, I think the President will show the bond market that he's serious about spending restraint.

COLVIN: Well, let's talk about the two battles you mentioned. The first one, tax reform, top of the President's agenda or very close to it. We don't know exactly what he's going to propose, but we seem to know that he wants the tax code to incentivize people to save more, going straight to Jack Brennan's point in those pieces earlier. How do we think the President wants the tax code to incentivize people to save more?

VALLIERE: Well, frankly I'm not sure he's positive either, and I think when you have a situation like that, you form a commission. And there probably will be a blue ribbon commission formed in the next few months to look at all of the options, flat tax, consumption tax, VAT (Value Added Tax) type of tax. I think in the short run the President has a good chance to get the 15 percent dividend tax and the 15 percent capital gains rate both made permanent.

COLVIN: Is there any chance do you think of the dividend tax being eliminated? We've heard some talk of that.

VALLIERE: I doubt that, because there is a problem with revenues, and I do think the deficit is going to be a, it's a factor in all the debates. And I think whatever they come up with on taxes probably will be, as we say inside the Beltway, revenue neutral. One other thing very quickly. It has to address the AMT. The alternative minimum tax is the biggest issue of all. That has to be in the mix of any kind of a compromise.

COLVIN: Let's talk about something that Hank McKinnell mentioned there at the end, which was healthcare costs and going after them. Because it was notable that the President in outlining his agenda for the second term didn't say anything about it. Medicare was not a word that he even mentioned, and some people think that is a bigger issue, a bigger problem than Social Security or anything else. What are the odds of significant action on that in the next four years?

VALLIERE: I think there will be some action next year to constrain costs. Nobody wanted to talk about that during the election because it's painful. Everyone wants to talk about goodies during the election. But I do think that in the new Bush budget, our healthcare team is telling our clients that a lot of areas could get a haircut, whether it's reimbursement for hospitals or nursing homes. I think the Medicare program will be much less generous in reimbursement rates in an effort to control costs.

COLVIN: And is the idea that as a political matter sort of right now the early part of a second term is the best time to try to make cuts like that?

VALLIERE: Absolutely, when he's got capital on a wide range of areas, whether it's saying we favor a Palestinian state, whether it's talking about retirement accounts, this is the time where I think the President has capital that he can spend.

COLVIN: Now who is lined up to fight these changes, and who is lined up to support them? One thinks immediately, for example, of the senior lobby led by AARP, an extremely powerful lobby.

VALLIERE: Sure. The senior lobby would not want to see these cuts. Many Democrats would not want to see too much cut. But I think an awful lot of Democrats are troubled by the example of Tom Daschle, who was viewed, fairly or unfairly, as an obstructionist, and we all know what happened to him in South Dakota. So I think the Democrats, who already are looking at '06 -- they've got another half a dozen senators who could be vulnerable -- I think the Democrats may be pretty cooperative on spending.

COLVIN: Now another issue is the tax reform we were talking about, if there's some kind of reform that tends to flatten tax rates while eliminating a lot of deductions. You could see the governors weighing in heavily, because one large possibility is that the deduction for state and local taxes might be eliminated.

VALLIERE: Isn't that the truth? The lobbying is going to be intense on that issue, Geoff. On the whole issue of mortgage deductions, do we want to eliminate that? That's like motherhood and apple pie. So there are a lot of deductions that have to be addressed. My personal feeling is that we will begin a national debate on tax policy, but it would be I think unrealistic to expect any kind of breakthrough in '05. It might take a little longer than that.

COLVIN: One of the things Hank McKinnell said that was striking is he thinks the top issue in restoring economic growth or getting it better is civil justice reform, the plaintiffs' lawyers. How do you see it? First of all, is it that big an issue, and second, what are the odds of anything significant happening?

VALLIERE: Well, first of all, yes, it is a big issue. Some people say as much as 10 percent of healthcare costs are driven by excessive lawsuits. That number may be high. There's a lot of spin obviously around that story, but it is a factor in health costs. Secondly, I do think we'll get action. There are several bills that have been stalled, an energy bill, tort reform, asbestos reform. I think these bills could move in early '05.

COLVIN: Well, that would be something to see, because it's been almost impossible to get tort reform anywhere over the past, what, 10 or 20 years.

VALLIERE: Well, that's right, and I think that a bill, which already would sail through the House, has a much better chance in the Senate. Again, on some of the big, big issues, like fundamental tax reform or Social Security reform, I have my doubts, because you need 60 votes to really get those types of bills enacted. But something like torte reform I think has a chance next year.

COLVIN: What about new faces in Washington, the leaders that we are going to see emerging in the Congress or coming out of the administration?

VALLIERE: Well, I think the new face that everyone is going to focus on, he's been around for awhile, but he's now prominent, is Harry Reid, the new Senate Minority Leader. He of course replaces Sen. Daschle. From all indications, Sen. Reid (D-Nevada) may be a little more conciliatory. He could be a really key player if we get any legislation moving.

COLVIN: The stock market certainly seemed to like the Bush victory. Why do you think that was?

VALLIERE: Two or three things very quickly. Number one, I think the regulatory climate will not be quite as confrontational as it could have been had Sen. Kerry won. Secondly, predictability on taxes is really important. I think everybody now in the markets knows the 15 percent dividend tax, the 15 percent cap gains rate stay for at least the next four years, maybe even longer. And I think third, just the fact that we got through an election without any debacle like we had in Florida, that we didn't have any terrorism, I think predictability is important and the market likes to see that.

COLVIN: So they say. What the market likes better than either candidate is simply certainty.

VALLIERE: That's right.

COLVIN: Greg Valliere, thanks so much for your insights.

VALLIERE: Great to see you.

REIT risks

» Housing boom over?

KAREN GIBBS: Any way you look at it, real estate continues to confound the experts. After years of torrid growth, higher interest rates would certainly bring prices back down to earth in 2004, or so they said. But so far this year the index for REITs is up nearly 21 percent -- compared with a piddling 3 percent rise for stocks. So it's no wonder that billions of dollars are pouring into real estate funds this year, money that contributor Michael Farr says looks a lot like a sucker's bet. Wow, those are pretty strong words, Mike. Why would investing in real estate investment trusts now be considered a sucker's bet?

MICHAEL FARR: Karen, not all real estate is a sucker's bet, but some of it is. Interest rates have been very low, and there have been a lot of dollars chasing a limited amount of supply. Take a look at this apartment building in Washington, D.C. It looks like a regular apartment building, but in actuality this is a gold mine.

Professional real estate investor and expert Bob Davis from a very prominent Washington, D.C. real estate firm and his partners bought this building four or five years ago for $1.9 million. They just sold that building for $4.6 million. That's my kind of deal, and if those sorts of deals are available and out there with that sort of money to be made in that short period, it might just be a sign that this market in real estate is nearing a top.

(video clip begins)

FARR: You made $2.7 million in five years. How can I go out and do that and how can our viewers go out and invest in real estate now and make that sort of money?

BOB DAVIS: We're so late in the cycle, we're not buying. We can't afford, we can't duplicate that again today. If we could, we'd be buying like crazy.

FARR: Why aren't you buying? What's wrong with this market?

DAVIS: Prices are too high. We don't think that this building will be worth this for a long, long time. We think there is a time ahead when real estate values are actually going to soften, and that would be a time we think that it might be to reenter the market, but at this moment it's too hot.

FARR: Are you saying there's sort of a bubble now?

DAVIS: Yes. We've been riding in a bubble, and we think we're at the end of it. I've noticed that a lot of people who have been in this market for the past five years have withdrawn. And so the people who have any savvy have also got the same sort of sensations that we have. It's gone too long. It's too late.

FARR: So if savvy developers like Bob Davis are selling, who's buying? It's REITs, with a sea of cash they have to spend. And this time they're reeling in older investors seeking income. Legg Mason's David Fick says investors have to be smart about which REITs are safe.

DAVID FICK: It's the older investor who tends to dominate the REIT investment universe. I like to tell my wife that the REITs we hold in our portfolio are going to be settled out of our estate some day. They are permanent holds because you have that growth in the dividend, which gives you an inflation hedge. You are able to get a higher dividend level than you are able to get from bonds at this point.

In a market where you have Warren Buffett or Legg Mason's Bill Miller saying you have an 8 or 9 percent total return expectation for the next 10 years.

Where here I have a sector where if you are selective you can get 6 percent in cash and you only need a little earnings growth to beat a little return expectation for the S&P 500. And so we still think it's a place where investors ought to have a piece of their portfolio. Ten, 15 percent for the individual investor to us seems to make sense in terms of portfolio allocation. We like retail REITs first.

And mall REITs and shopping center REITs are a favorite area. We like malls as a business. It is one of the businesses that has outperformed during this business cycle compared to all other property types.

When we look at the office marketplace, when we look at the apartment marketplace we don't see the kind of earnings growth we are seeing out of the mall guys. The biggest part of that is that the American consumer, despite concerns about jobs and the rest of the economy, has remained extremely robust. And the other part of it is that we are not building a lot of malls in the United States right now and demand for space on the part of retailers has remained very high. So the rent spreads have been huge.

(video clip ends)

GIBBS: Michael, fund managers have to put money to work, and REIT managers are no different. Is there some similarity between what you're seeing now in the real estate market and the Internet bubble where managers were forced to buy at excessively high prices?

FARR: I think that there is. I think that there's a huge supply of money out there. We've had tax cuts, we've had monetary policy easing for years now. There are enormous amounts of cash out there. Pension plans hold them, unions hold them, and they have to be put to work. Everybody likes real estate now. Remember when everybody liked the tech stocks? And so you mention buying real estate to somebody, and they say, great, yeah, I ought to have some of that. That sort of exuberance is dangerous because it makes, people have stopped being cautious because they feel they have a real asset, there's going to be some income associated with it when they can't get income anywhere else. And there's a trap that sort of forms that lulls the investor into a sort of confidence that shouldn't be there.

GIBBS: But not being an advocate, just looking at arithmetic, over the past five years, real estate has returned 17 percent annually. It was the best performer even while the stock market was in the clutch of the bear. What's different about it this time?

FARR: Well, I think that's what's different about it. I mean it's up 17 percent per year over the past five years. This thing has really rallied. This is a stock that's gone up, a market that has appreciated dramatically. In the past 24 months, the Dow Jones (Equity Total Return) REIT Index is up 70 percent. Now if you're supposed to, those old rules where you're supposed to buy low and sell high, I don't know if we're at the highest point yet, but I know we're not low.

GIBBS: Well, you know, Mike, real estate investment trusts are very, very popular with investors because by law they have to pay out 90 percent of their profits as dividends, so it's like an income stream here. So where's the bad news there?

FARR: The bad news, Karen, is that interest rates have been very low, so as real estate prices have moved higher and higher, REITs and other investors have been able to afford more property because their borrowing costs have dropped. Some REITs have borrowed money at these very low rates but for very short periods, or some of them have even taken adjustable loans, just like adjustable floating rate mortgages. If rates rise, not only will property values fall as David Fick mentioned, but those dividends could be cut dramatically if these people have to refinance at higher costs. So if you're one of those senior investors who are looking to REITs to give you a constant flow of income, your income might be pretty risky. So take a look at your portfolio. All REITs are not the same. David Fick has somewhere he believes the dividends are going to be a lot safer than in others.

GIBBS: When you do have higher interest rates, it means that the economy is growing. Jobs are going to be created, so offices are going to need lots more office space, and employees are going to need someplace to live, and if they can't afford, they're going to rent. Doesn't that offer a little bit of a safety net under certain types of REITs?

FARR: Yes, and no. Yes in that unlike the Internet bubble, there is a real piece of dirt there that's worth something to someone. It's not going to go from $90 a share down to zero, as many of those stocks did. But because prices have been going so high and demand has been there for them, needless to say the supply is coming on. In the Washington market, there's a huge supply of apartment buildings and apartments coming online into the marketplace. So more supply means that if the rental pool starts to dry up, a lot of those rents are going to come down, the incomes of those buildings are going to come down, and the REITs could end up holding the bag.

GIBBS: What REITs do look good? We saw Mr. Fick talking a little bit about it. Tell us where there is value.

FARR: Mr. Fick likes two REITs in particular. He recommends Simon Properties. This is the largest REIT in the country. They own malls, they own regional malls from Las Vegas to Topeka, Kansas. They're very well diversified, and he believes that the dividend's relatively safe.

Another that he likes a great deal is Pennsylvania REIT. They like them very much on the valuation side. They just bought two portfolios last year, Crown American and another group of assets from Rouse Company that they felt were basically under-managed. So with their management skills, they'll be able to add some tenants, they'll be able to get some cost efficiencies, and Pennsylvania REIT pays a dividend of close to 6 percent.

GIBBS: Well, okay, I'm still going to push this because I'm going to play devil's advocate. We've got that spread between say Treasuries and REITs, what they're yielding. You've got the performance between the real estate market and the stock market. How about that Treasuries and the stock market are finally going to find some legs and rally to perform like the real estate market is?

FARR: That could be, but if those interest rates go higher, I don't see the bond market rallying anywhere from these levels. I mean the bond market has rallied right along with the real estate market. So if we see stocks go up, that will be great. I don't see REITs appreciating. And what I really want to tell investors is some REITs have taken on risk that is not immediately evident in order to maintain a dividend which won't last should those interest rates rise. Be careful and look at which REITs you own. That's all. This isn't a market that's going to crash. There are some parts in it that represent hidden risk.

GIBBS: Just be very careful, do your homework, especially if you're relying on income.

FARR: Do your research. Go to the brokerage firm, call your broker, because there's a trap here. There's more risk in a REIT portfolio than may meet the eye. You need to be careful. And this is an investment that when it goes wrong, you don't want to find out too late, because the value drops and the dividend drops at the same time.

GIBBS: And that's not a good thing. You lose on both ends of the curve.

FARR: That's not a good thing.

GIBBS: Michael Farr, always a pleasure.

FARR: Thank you.

NEXT WEEK: Why some investors repeat the same mistakes over and over. We will also check in with all-around investor and funnyman Ben Stein.