How to Profit from the Commercial Real Estate Fallout

On April 17, I wrote about the massive train wreck coming in commercial real estate.

As it turns out, my estimates of the coming devastation - which seemed outlandish to some at the time - have actually turned out to be too conservative.

The problem is far worse than anything that’s been reported so far, particularly when it comes to our icon of consumerism: The shopping mall.

With retail losses continuing to accelerate and vacancy rates skyrocketing, malls are going to be one of the biggest losers from the consumer spending slowdown…

Here’s why our shopping malls, and by extension the commercial real estate market, aren’t going to be moving anywhere but down over the next few months - and what you can do about it in the meantime.

Don’t Be Fooled By Housing Starts Recent Uptick…

Much has been made of the recent uptick in housing starts in May, but don’t be fooled - this is simply seasonal. In the northern half of the country, foundations can’t be dug during the winter months, so there is always a “spring surge” in housing starts.

The Obama administration predicted that without the recovery plan, unemployment would peak around 9% in 2010. With the plan in place, the estimate was 8%, and that we’d hit it this year…

• The official Bureau of Labor Statistics number is at 9.4%. But even though unemployment rates are easing slightly, the overall number of unemployed is still rising.
• And it gets even worse when you throw in the 2.2 million additional people that are so discouraged they’ve quit looking for work. Today’s number then jumps to 10.8%. These individuals haven’t even shown up on the rolls yet.
• With few companies announcing even minimal hiring plans, it’s highly likely that the ranks of the unemployed will continue to swell to 11% to 12% sometime in 2010.

What does this have to do with commercial real estate and shopping malls? Plenty. As I’ve said before, it all starts with the consumer.

• In America, the consumer’s long-term contribution to our Gross Domestic Product (GDP) is around 65%.
• But for the last five years or so, it’s been over 70%.
• That is, until the fourth quarter of 2008, when it dropped off a cliff.

And therein lies the problem: Less employed workers means less discretionary spending, less homes being built, bought and sold, less trips (or none) to the local mall, less warehouses needed, less manufacturing, less transportation… all resulting in a big pullback in GDP.

Consumers are spending less, not more. When they do spend, it’s on staples: food, gas and clothing.

The normally big-spending teenage segment is currently experiencing a 22.7% unemployment rate. So instead of going to their former favorite hangouts - the shopping malls - they’re hanging out at each other's houses. (I know this to be true, as my son is entertaining a group of friends at our house as I write this.)

Are Fears of a Commercial Real Estate Fallout Overblown?

Many so-called “experts” in the commercial real estate field have said the fear of commercial real estate fallout and failures are overblown… that it won’t be nearly as bad as people like myself are predicting.

They’re dead wrong.

They’re ignoring the fact that there’s always a lag between when the economy heads south and when commercial real estate does. Let’s face it: Some stores can coast for a few months - or even a year - while they wait for a pickup in business. But that pickup isn’t coming anytime soon.

The reality is that many mall-based stores haven’t renewed their leases - their lack of income is forcing their hand. Many others are underwater financially, and only months away from closing.

When national chain Ritz Camera filed for Chapter 11 bankruptcy protection, 300 stores in malls all across the country immediately closed. The result isn’t hard to picture.

• A report from the New York-based research firm Reis, Inc. indicates that retail tenants vacated a 10-year high 8.7 million square feet of retail space in the first quarter of 2009 alone.
• This compares to 8.6 million square feet… for all of 2008.
• Kyle McLaughlin, an analyst at Reis, says that vacancy rates at strip malls, neighborhood centers and regional malls are increasing at rates not seen in 30 years. “We’ve never really seen deterioration of this order in occupied space since 1980. We don’t see much in expectations for improvement throughout the rest of this year and next year.”

Reis indicated that their forecast assumes positive job growth and an increase in consumer spending starting in 2010.

Say what?

Here’s the problem with that assessment: It’s ignoring what’s really going on outside their offices - unemployment is still rising, and that means fewer consumers spending less money.

Don’t look to the emerging markets to bail us out, either. The Chinese, Brazilians, Russians and Indians can’t just run down to our local malls to shop.

The problem is made worse by vacant storefronts, which hurt the few remaining stores. When the stores on either side of a remaining store closes, less traffic comes by and, well, you get the picture.

All this puts shopping mall owners and landlords in a big financial squeeze play: They’re forced to drop rents at a time when less money is coming in due to rising vacancies.

Commercial Real Estate Loans Mature - Bigger Problems Arise

The problem is about to get very, very big: Between now and 2011, as much as $814 billion in commercial real estate loans will mature - and need to be refinanced. The problem is that the credit markets are still too tight for most commercial projects.

Most banks have tightened their lending standards, reduced the amount they are willing to lend and significantly reduced the value of the collateral (malls). This leaves many owners with little choice but to turn to the Fed.

Back in May - and with much fanfare - the Federal government announced it would soon be expanding its Term Asset-Backed Securities Loan Facility (TALF). It now plans to include existing securities backed by loans for apartment buildings, office complexes, shopping centers and other commercial property.

But these programs aren’t an industry panacea. If you read the fine print, they provide backing only if the securities are rated AAA by major rating agencies. This excludes just about all the needy real estate - and the REITs that own it - from participating in the program.

How to Play the Commercial Real Estate Fallout

So, how do we play the commercial real estate fallout? The bottom-line is this: Many shopping malls in this country are simply going to disappear. Supply and demand will ultimately determine how many. All this bodes well for really big operators like Kimco Realty (NYSE: KIM) and Simon Property Group (NYSE: SPG), long-term plays that are large enough to weather the lengthy storm.

But for short-term investors looking to pick up some companies on the bottom, beware of going long just yet: While the market has already baked in a lot of bad news, uncertainties surrounding any additional big chain bankruptcies persist.

That means many REITs still have further to fall.

If you’re looking for an investment option that plays this angle, a dropping real estate market bodes well for ProShares UltraShort Real Estate (NYSE: SRS). It seeks investment results equal to twice the inverse of the daily performance of the Dow Jones U.S. Real Estate Index.

In the coming weeks, I’ll take a look at the office and industrial property side of commercial real estate that, unfortunately, isn’t much better off than the malls.

Good investing.

Comments

[zevach:]

All the shopping malls that were built and bought from 2003-2007 were done under the assumption that the consumer had tons of cash to spend via the great housing inflation and the great bank loan scam. These two things will not repeat. There is no easy credit to spend at the malls anymore and it is not coming back. The CRE establishment is hoping that everything turns around in a year. Consumers flush with cash return to the malls to buy junk. That is not going to happen for a long time. All CRE has is hope, there are no green shoots just hot winds blowing across a dust bowl of overbuilt malls. Hoping for rain does not make it happen.

Jun 18 08:33 AM

[User 433240:]

I just hope that our government rethinks the idea to rescue this sector of the economy. Corporations who built big made a bad bet on a faulty assumption. The taxpayer shouldn't indemnify them for that.

Jun 18 08:58 AM

[MartyT:]

Even if consumer spending increases the retail portion of the commercial real estate market is toast. The monthly cost of a retail location in my area is typically between $2000 and $10,000 a month. Putting up an ecommerce site runs between $50 and $200 a month. Sure there are people that want to buy in stores, but it's a lot cheaper and more convenient to buy online.

Jun 18 09:13 AM

[finmah@yaho...:]

Why save the landlord when every capital market from coast to coast is telling you that they are overcharging. The rental rate is simply vastly overpriced. Retail should survive when their rental rate is reduced by 60%.

Retail will not grow fast but people need to shop. Is our govern going to waste money by propping up comm real estate landlords so that they can charge 70 sq ft? It appears so. There is no way out - they cannot easily change the usage of the facility. Give up - let a judge decide the real rental rate and fill the mall. Shopping goes on in poorer countries - it just needs a much lower base.

Jun 18 10:14 AM

[rabphxaz:]

I don't understand how that, if many shopping malls are going to simply disappear, this "bodes well for really big operators like Kimco...." Please explain.

Jun 18 11:16 AM

[Mad Hedge F...:]

The shoe is falling. The Dana Point, California St. Regis Monarch Beach Hotel has defaulted on a $70 million loan, while lenders have repossessed the “W” Hotel in San Diego. Thus, the spotlight is again refocused on the next phase of the financial crisis, where an army of shoes are falling. A torrent of tenant bankruptcies is creating “see through” buildings in cities throughout the country, which are becoming as abundant as Priuses at an Obama rally. Some players see a further three year bleed that could take property prices down another 40% from here. Large, publically traded REITS have used the three month stock market rally to raise $11.5 billion in new equity that will enable to reduce debt and leverage, as well as buy up of weak competitors and distressed property. Look at Simon Properties Group (SPG), up 128% from the March lows. The saving grace here is that the recent bubble was nowhere as inflated as the S&L crisis in the early nineties. But cap rates may have to climb to the double digit levels we saw then before this period of punishment ends. Cash rich hedge funds are circling.

Jun 18 11:34 AM

[ezee:]

David, very good insights. Maybe you could write another piece to elaborate on SRS and its performance in the last 3, 6 12 months?
I am searching for some ETF that can execute on that vision but run into difficulties.

Jun 18 01:43 PM

[Danny Newton:]

When the malls begin to go, the people who lust after visiting total and effective taxation on the Internet will finally have their proof that untaxed or poorly taxed commerce is an evil visitation on the children, public safety and the stability of government retirement plans.

Jun 18 01:55 PM

[Kristjan Ve...:]

ezee,
You can always purchase put options if you don't want to mess around with the inverted and triple leveraged SRS. SRS is only good during violent falls in real estate companies. If you hold it for the long term, it's going to get eaten away by the triple leveraged nature of the ETF.


On Jun 18 01:43 PM ezee wrote:

> David, very good insights. Maybe you could write another piece to
> elaborate on SRS and its performance in the last 3, 6 12 months?
>
> I am searching for some ETF that can execute on that vision but run
> into difficulties.

Jun 18 03:24 PM

[seekingnothing:]

David, I second Ezee's comments. The SRS has been a poor way to short CRE. the SRS is the double inverse of the IYR. SPG is one of the major holdings in the IYR. You point out the SPG should be a beneficiary of the fall out. Any better plays?

Jun 18 03:29 PM

[REITBull:]

I agree with seeking and Ezee. It's also important to note that SRS's underlying index, IYR, is constantly being rebalanced in favor of long positions and it's current holdings are some of the stronger REITs. The time for SRS was last year before your average Joe was talking about the coming crisis in CRE.

I am just starting some research on this, but I think the next play may be to short Residential Apartment REITs (that hold B and C class properties) using long dated puts.

Disclosure: Long IYR

On Jun 18 03:29 PM seekingnothing wrote:

> David, I second Ezee's comments. The SRS has been a poor way to short
> CRE. the SRS is the double inverse of the IYR. SPG is one of the
> major holdings in the IYR. You point out the SPG should be a beneficiary
> of the fall out. Any better plays?

Jun 18 04:47 PM

[Griller:]

I think the idea is the remaining mall operators will be able to profit from the lack of competition when the field is cleared of weaker businesses in the same sector. Well, given the state of the economy (and the likely decades of stagnation to follow in my opinion), this could be a very long play involving many years of patience.

On Jun 18 11:16 AM rabphxaz wrote:

> I don't understand how that, if many shopping malls are going to
> simply disappear, this "bodes well for really big operators like
> Kimco...." Please explain.

Jun 18 05:19 PM

[jhartz:]

I'm not sure any of these empty malls will need to disappear. what is far more likely, IMO, is there will be a big proliferation of "Outlet malls" and super discount malls taking advantage of all the newly de-leveraged (by bankruptcy) shopping centers.

In California, during the 1980's, that happened a lot. This produced new competitive pricing pressures on the malls that hadn't succumbed.

Too many people want to open their own businesses, often without so much a a written business plan to work from.


On Jun 18 05:19 PM User 343789 wrote:

>
> I think the idea is the remaining mall operators will be able to
> profit from the lack of competition when the field is cleared of
> weaker businesses in the same sector. Well, given the state of the
> economy (and the likely decades of stagnation to follow in my opinion),
> this could be a very long play involving many years of patience.
>
>
> On Jun 18 11:16 AM rabphxaz wrote:

Jun 18 08:11 PM

[Fighting Yoda:]

NEVER NEVER NEVER buy double shorts they are a complete disaster - they track only on a daily basis over one other duration they are a complete disaster. the index could go one way the double short could go any which way.

Again NEVER NEVER NEVER buy double shorts, they should be banned.

However comml. and residential both will continue to perform poorly, form these elevated levels considerable drops are reasonable.

Jun 19 01:44 AM

[Sovestor:]

Deferring consumptions and building savings are the trends that will stay for quite a long-time now in the US.

Jun 19 10:52 AM

[Booba:]

SRS perfomance sucks big time! This is my own experience, not "statistics"!
I was lucky: I didn't loose too much on stocks, and I even won something on reverse ETFs.
Bot SRS proved top be terrible terrible idea! SRS was my number 1 money looser, way ahead of other ETFs.
I learned one lesson: stay away form it!


On Jun 18 01:43 PM ezee wrote:

> David, very good insights. Maybe you could write another piece to
> elaborate on SRS and its performance in the last 3, 6 12 months?
>
> I am searching for some ETF that can execute on that vision but run
> into difficulties.

Jun 19 12:50 PM

[IT'$ OVER!:]

I think that a good question to consider in your scenario is who is going to produce the low priced goods in these "Outlet Malls"? The retail environment of the 80's benefited from the outsourcing and subsequent destruction of our own manufacturing base.
Once our domestic retail inventories run out/low, and without the ability to finance new inventory or a place to sell it, or produce it, where are these discount goods going to come from?

BRIC nations may even reject the dollar further, and we will have a more difficult time paying for their imports, or the oil to get them here. Supply and demand will ultimately kick in and the price of manufactured goods will not be sold at "discount" or "outlet" prices.

I support your vision of malls taken over by the entrepreneurial, but they will be much more like bartering flee markets than the outlet malls of the 80's



On Jun 18 08:11 PM jhartz wrote:

> I'm not sure any of these empty malls will need to disappear. what
> is far more likely, IMO, is there will be a big proliferation of
> "Outlet malls" and super discount malls taking advantage of all the
> newly de-leveraged (by bankruptcy) shopping centers.
>
> In California, during the 1980's, that happened a lot. This produced
> new competitive pricing pressures on the malls that hadn't succumbed.
>
>
> Too many people want to open their own businesses, often without
> so much a a written business plan to work from.

Jun 19 08:37 PM

[User 150084:]

I'm sure that the poster above is the only successful investor in America today.

What a pompous remark!

Jun 21 03:29 PM

[TruthSayer:]

SPG a good buy? I dont understand the logic. SPG earnings based on expected mall rental rates, continued tenants, and low financing. With vacancies rising, rental rates falling, and underlying finance cost rising how do those supporting a long position in SPG?

SPG is showing P/E of 26. Forward P/E of 8 - using $6 earnings est. - which is good assuming the underlying included the issues above....how ever I doubt that. If you read their guidance and outlook in the Q's they continue to tout growth...where there is no growth. The competition of vacant retail space and the lower consumer spending will lower rents for everyone including SPG.

Jun 24 09:38 AM

[moneyma:]

Try 3X leveraged REIT ETF : Take a look here for ETF symbols list

www.moneyma.com/market.../

Jul 16 11:52 PM

[Gunslinger:]

SRS is a terrible way to play this. As stated, IYR actually has some good holdings in there (like NLY); better way is to play puts on the most leveraged REITs with massive upcoming debt due - especially with the really cheap IV these days.

Having said that, SGP is a bad long play here, and KIM is horrendous.

Jul 17 10:35 AM