Commercial Real Estate Implosion Is Imminent

Real estate investment trusts (REITs) are leveraged-financed property investments that pervade the commercial real estate market. With the real estate bubble financed by Greenspan's artificially easy credit policies, these REITs witnessed surging revenues as property values soared. With the collapse of the housing bubble, property values are in free-fall, but unlike residential real estate, commercial real estate hasn't witnessed mass defaults yet.

Unlike residential real estate, the collateralized debt obligations (CDOs) pervasive in commercial real estate are isolated to a handful of REITs. Mall operators, retailers, and other commercial properties are developed and run by a select few investment trusts, differing from residential housing, which has millions of mortgage bundles across America, many of them already defaulting. This prevents immediate defaults but also centralizes the pain, because as one REIT faces defaults, the others soon follow.

With the weighted average cost of capital (WACC) set to rise 150-200 basis points in response to the credit crisis, cap rates will also increase, causing property values to fall further. This increases default risk as the collateral backing debt obligations loses value, causing borrowing costs to rise further, and restarting the vicious cycle.

As this occurs, REIT clients will be forced to default in mass waves, as they are unable to sell their properties for a decent price and can't refinance their loans in secured debt markets. About $30 billion of REIT-related debt matures in 2009-2010, and there is very little equity left in REITs to finance the debt.

Some REITs have resorted to suspending cash dividend payments, reverting to stock issuances in their stead. This increases investor exposure to falling property values (expected to be around 30% declines in 2009) and default risks, which could cause more selling as investors flee the overleveraged REITs no longer offering time payments.

The largest REITs are among the most exposed to equity decline, as their growth was financed by the same debt that is causing their downfall. Stocks like Simon Property Group (SPG), Vornado Realty Trust (VNO), Boston Property Group (BXP), Brookfield Properties (BPO), Equity Residential (EQR), Kimco Realty (KIM), HCP (HCP), Public Storage (PSA), and Duke Realty (DRE) are good short candidates for 2009.

Looking at technicals, the Dow Jones Real Estate ETF (URE) shows real estate equities at their November lows, approaching breakdowns. Simon Property Group, Vornadio Realty Trust, and Boston Property Group all show similar charts––massive distribution near their 50 day moving averages, high volume sell offs to near November lows, and approaching breakdowns of significant support levels.

If equity markets continue lower, which the indices currently point to them doing, REITs are at risk for huge selloffs as debt default risk heightens and property values plummet.

For the active trader, the ProShares Ultra Short Real Estate ETF (SRS) is a good way to play a sharp sell-off in REIT equities. This is a fast-moving stock that can net huge gains in quick periods of drastic selloffs in its associated index, but also sells off twice as quick and twice as hard when the sell-offs cease. Short positions in aforementioned CRE equities are a safer, more orthodox way of profiting off of the coming commercial real estate collapse.

Disclosure: Short SPG, VNO, BXP, DRE.

Comments

[Mad Hedge F...:]

Vc Frn In case you missed the business section of the San Francisco Chronicle, there is a fabulous graphic illustrating the hard times for the city’s commercial real estate market. The epicenter of the melt down is Tishman Speyer’s 556,000 sq. ft. 555 Mission Street, which opened in late 2008 during the worst possible market conditions, and remains 70% empty. What is really impressive is how bad the implosion of the legal profession is hitting landlords. The dissolution of Heller Ehrman has emptied 350,000 sq. ft. 333 Bush Street, while 388,000 sq. ft. 101 Second Street has been vacated by the dissolution of Thelen LLP. Conditions will worsen as more new buildings started during better times come on the market.

Mar 02 09:06 AM

[werawc:]

Come on, do some research. Not all apples have worms. On your list of
good shorts you include PSA, a REIT with NO, as in ZERO, bank debt.
How can it face debt rollover problems?

Mar 02 10:10 AM

[Emerald:]

Broad generalizations with little facts. Apartment REIT's are not all the same. Some have minimal debt rollover exposure in the next two years, such as EQR, and have large lines of credit. Do your homework before making these comments..

Mar 02 11:42 AM

[mr freddo:]

I am thinking that one day soon we will tune in to the Daily Show and John Stewart will switch to a reporter on Wall Street who will be reporting on the mood after a 500 point decline day on the Dow. "Why is everyone cheering?" John will ask. "Because John, as it turns out, everyone in America is now short."

I have been bumping into people at social events who say that they cannot get projects refinanced and are being forced to pay default rates on solid, fully leased projects. So the babies are being thrown out with the bath water at this point.

Mar 02 11:51 AM

[brianfoley:]

And what about HCP? They just raised their dividend into all of this. Far different than a mall operator, etc... they run retirement communities and hospital buildings. I picked up some in the 20's and have taken a hit, but I feel they should weather this storm?? (anyone have comments on whether I should be concerned there? - I know they can be impacted by falling property values, but they seem to be in a fairly "safe" sector)

Mar 02 12:20 PM

[jimmy46:]

Commercial RE wasn't overbuilt the way residential RE was,
and the banks didn't lend to deadbeats as they did in residential RE.

This is SA at it's worst, some kid with $300 in the market acting like he knows it all.

Mar 02 02:07 PM

[Eyal:]

Four big mistakes. First, anyone who includes BXP in a list of REITs with too much debt clearly doesn't understand leverage in real estate. Second, the decline in value does not cause default on a loan. It's the payments that matter most. If you make your monthly check you get to keep your building Third, SRS is not a good way to play the sell-off because ultrashort are only good for moves without dead cat bounces, and lord knows this market has seen many dead-cat bounces. Fourth, the indices do not predict their own future.

Mar 02 03:11 PM

[Big K:]

This seems to be a common argument I've seen recently. Because there was massive defaulting in residential real estate, there will be massive defaulting on the commercial side. And by analogy, there will be massive defaulting on everything else. The only answer as to why it will happen, given in the article, is that it hasn't happened yet.

Mar 03 12:36 AM

[2houndz:]

If you had focused on retail and office REIT's this would be very accurate. PSA has little or no debt and the business model is not broken. Not everything that qualifies a a REIT is in the same boat. Maybe there's a timber REIT out there who is upside-down on debt, but the true focus should be on those who see rising CAP rates, big leverage and shrinking demand for their product.

Mar 03 08:21 AM

[PainfullyAware:]

I think you underestimate the power of the frenzy that has now ended.

My career is in distressed real estate and there is no shortage of lunacy in this market.

In 2006 there was almost nothing to review; Now - there is almost too much.

Exaggerations may be presented and must be met with skepticism. However, even if the underwriting was diligent the market conditions are conspiring against the solvent.

The Commercial Real Estate Crash Will Become More Evident As We Progress In This Disaster.


On Mar 02 02:07 PM jimmy46 wrote:

> Commercial RE wasn't overbuilt the way residential RE was,
> and the banks didn't lend to deadbeats as they did in residential
> RE.
>
> This is SA at it's worst, some kid with $300 in the market acting
> like he knows it all.
>

Mar 03 04:14 PM

[Chris B:]

Why will the healthcare REITs like HCP, HCN, HR, and VTR face defaults? Will the nursing home patients on Medicaid be evicted? Will hospitals move into those empty and discounted skyscrapers? Will doctors' offices face a collapse of demand as the recession makes people healthier?

Why will the self-storage REITs go under? Companies like EXR and PSA seem to be holding up well so far, as the foreclosures and churn in the real estate market, as well as the downsizing and roommate-getting trends actually feed their businesses. The 2 examples above seem to have plenty of cash to cover their obligations.

Somebody tell me why these aren't the babies in the bathwater. I can certainly understand why one would want to avoid mortgage, office, mall, industrial, and apartment REITs. But these 2 categories might be bargains at this price. Tell me why not.

Mar 04 01:27 PM

[Eric Winchell:]

capitalcurrents.com/fi...

Mar 05 12:45 AM

[joof:]

drop the hat dude

Mar 05 04:49 PM

[joof:]

ON the operating end refied assets are facing 30-50% value declines and deep reductions in permitted LTV - from 80 to 60-65

If they can get any money to refi

BTW the value decline works out like this

10-20% decine in rent
10-20% decline in occupancy
2% increase in cap - 20-25% decline in multiple

(15+15+20)=50

Mar 05 04:55 PM

[werawc:]

On my earlier comment on PSA I left out an important word: net. PSA has no net debt if you take the $572 million in cash they have and net it out vs their debt. In other words, they have enough cash on hand to extiguish their debt. Thus they dont face any rollover issues.

Mar 06 02:12 AM

[Cardio:]

The market has already anticipated and priced much of what SA has discussed, hence the 80-90% decline in some share values. Why write this article now? It seems more appropriate to last summer.

Mar 09 02:54 PM

[jason_fund:]

Many of these REITS have just rallied 40%-50% in the last few days... Tons of short covering going on (this article's timing turned out to be horrible), however it looks like a good entry point if you still believe your thesis. I'm personally nibbling some more short here. Will nibble more if we get to that 20% overall bear market rally.

Mar 16 09:09 PM

[Delinquent ...:]

Public Storage is shedding itself of its Pickup & Delivery component and Truck Rental component this Spring. Should be one to watch.

Mar 17 06:09 PM

[Joshua Hayes:]

My name is Joshua Hayes and I am a contributor to Seeking Alpha but have not contributed articles for a while due to the poor market conditions. I am ready to start again, as the market is looking much better, but I am disturbed that Naufal is on this site. Naufal subscribed to my site TWICE in 2008 (once in the summer and once in December) and both times executed "charge-backs" saying that BigWaveTrading used his daddy's CC illegally. This was not the case and we have NEVER been paid by him. If he subscribes to your website, be very careful. This kid is the only person out of over 1000 subscribers we have had to do this. WATCH OUT FO THIS GUY. DO NOT LET HIM SUBSCRIBE TO YOUR SITE. HE WILL RIP YOU OFF.

Aloha from Maui,

Joshua Hayes

(where obviously Naufal will never be allowed to be a member of BigWaveTrading.com again)

Apr 11 01:57 PM

[On Going Co...:]

have you done your research on PSA? I dont think you can put them in the same basket as the rest of the REITs you want to short. PSA has very little debt and has the second largest market cap of REITs. I think you are also missing a major highly leveraged REIT that should be included in your list, PLD.

May 21 01:20 PM