Commercial Real Estate and REITs: Ticking Time Bomb?

In keeping with the Monday morning ritual of taking a look at new highs and lows on the NYSE, Barron’s showed 802 for the former and 6 for the latter which gives us a ratio of 134:1. This is a new high both in terms of the outright number of new highs as well as the ratio of highs to lows. Not completely surprising given that we spent 2 days above the 10K mark but also a good way to check on the breadth of things.

The relative strength of the dollar against its trading partners is also a statement on the rate outlook in the U.S. and that is a product of what investors think it will take to have unemployment in this country begin to come down.

The dollar, oil and gold are getting most of the headlines these days and what they don’t garner, the movement of the sub-prime contagion to prime mortgages seems to grab. NAHB Housing Market Index is due out today, Housing Starts and Building Permits tomorrow and MBA Mortgage Applications on the 21st so the residential housing market might move up in the headline league tables this week.

There is, however, another problem lurking behind the scenes which is just beginning what we should all hope is a very short “15 minutes of fame” but could turn out to be a mini-series instead and that is commercial real-estate.

“Banks will be slow to recognize the severity of the loss – just as they were in residential” was how it was worded in a presentation given by the Fed last month and more recently Bill Dudley, New York Fed President, was quoted as saying: “More pain likely lies ahead for this sector and for those banks with heavy commercial real estate exposures.”

The WSJ did some analysis work of its own on 800 banks that reported having more than half of their loans tied up in commercial real estate and found that these institutions reserved $0.38 on the dollar against bad loans vs. the $1.58 for every $1.00 in bad loans set aside since January of 2007.

Patrick Phillips, the new CEO of the Urban Land Institute, a real-estate industry group, describes the methodology currently used by the banks as “an extend-and-pretend philosophy”. Matthew Anderson, a partner at Foresight Analytics said: “It’s like taping paper over a hole in the wall.” Not an encouraging quote from either gentleman.

Exhibit A is Reis Inc. (REIS), a New York real-estate research firm found to which companies returned 19.6MM sq.ft. of commercial space to landlords in 3Q09 which brought the total for returned space to 64.2MM sq.ft. in 2009, the highest “negative absorption” Reis has seen since it began keeping records in 1980. The vacancy rate also hit a new high of 16.5% at the end of September.

Reis’s research director, Victor Calanog, says: “It means more losses for the banks because they will have to write off more bad debt.”

To the extent that TARP and other initiatives have ring-fenced the banks, it is not certain any amount of write-offs will cost anyone but the taxpayers more but there are also the REITs to think about. To the best of my knowledge none of these has been designated TBTF yet so there could be some risk in names among this group.

The CEC Strategy follows 21 REITs and is holding long positions in four: DRE, HCN, HCP and VTR. The sector has been volatile with long positions established in 8 names at the beginning of September which were then sold later that month and early in October. A few names were shorted during the swoon earlier this month but those shorts were covered as the market recovered.

Volatility, such as has been seen in the REITs lately, tends to pretty much make a mess of the CDS/equity combo’s which results in fewer and fewer positions being taken until things settle back down. It is the way in which the CEC Strategy protects itself from continuously being whipsawed. In general, after the second false signal the combos will have to become either much less volatile or the move will have to be outsized to the current volatility such that a position is warranted.

The slight long bias in the REIT sector currently could have as much to do with the general positive trend in the indices as with the particulars of the individual names. Needless to say that 4 out of 21 is not a bold statement by any means.

Enjoy the week.

Comments

[davidbdc:]

While there is certainly more 'pain" to come in commercial real estate overall, the majority of the REIT's should be in good shape (not saying I don't think some are overvalued, but some are also good buys). I think there is much more worry for individual and small owners of a few buildings/developments that are going to fall.

The advantage the REIT's have over private owners is that they can 1. Raise money through equity or debt offerings. 2. They have portfolios that can (for a period of time) allow "good" properties to make up for "weak" properties. and 3. They have the relationships with the stronger retailers.

I wouldn't want to own small strip malls, multi-tenant office space, and new apartments. But I think industrial has seen the worst, Regional Shopping malls seem to have weathered the storm, and older apartments are still cash flow positive. We are at a point where the REIT sector shouldn't trade in lockstep and hopefully we'll see more company specific differentiation in the near future.

Oct 19 11:35 AM

[Tack:]

Current projections for maximum industry default rates are now pegged at 5.4% in 2011. That's no worse than the last commercial-realty slump in 1989-1992.

Also, most commercial REITs have raised capital, paid down debt, extended maturities, sold assets, and added significantly to reserves.

However, unlike the last slump, many REITs and commercial lenders have seen their prices plummet 70-95%, and many remain significantly depressed, even after the recent rally.

Commercial REITs look more like a buying opportunity than a problem.

Oct 19 11:54 AM

[Living4Divi...:]

Good post Tack !!


On Oct 19 11:54 AM Tack wrote:

> Current projections for maximum industry default rates are now pegged
> at 5.4% in 2011. That's no worse than the last commercial-realty
> slump in 1989-1992.
>
> Also, most commercial REITs have raised capital, paid down debt,
> extended maturities, sold assets, and added significantly to reserves.
>
>
> However, unlike the last slump, many REITs and commercial lenders
> have seen their prices plummet 70-95%, and many remain significantly
> depressed, even after the recent rally.
>
> Commercial REITs look more like a buying opportunity than a problem.

Oct 19 02:43 PM

[John Gault:]

@Tack

You left the same post on seekingalpha.com/artic...

No illumination? Just the blanket "buying opportunity"?

Oct 19 08:26 PM

[Tack:]

What "illumination" would you like?

Yes, I think the best approach, as I usually follow, is to make a diversified portfolio of selections in the sector, rather than trying to cherrypick one or two. That prevents a serious "uh-oh" and still provides a nice upside if the sector, as a whole, is undervalued, as I believe.

I'd also consider buying some of the preferred shares of some of these names, as they have nice yields and are virtually immune to seeing dividends reduced, suspended or paid in kind.


On Oct 19 08:26 PM John Gault wrote:

> @Tack
>
> You left the same post on seekingalpha.com/artic...
>
>
> No illumination? Just the blanket "buying opportunity"?

Oct 19 09:24 PM

[John Gault:]

The kind of illumination I would prefer is that they are undervalued based on...historical book value, net operating income/cap rate, replacement value, rental demand, historical occupancy, historical vacancy, growth, future tenancy demand, declining costs, management efficiencies, price to earnings, price to ffo, lack of available developable land, employment/population growth, consumer spending, ......

Gold is "undervalued" because there are only 4.5 billion ounces worldwide, and most everyone wants an ounce (although I don't).

How many square feet per person is the right number for retail real estate to be "undervalued"?

Do you feel that being diluted every quarter on your common dividend is a positive?

How about office space in Southern California going from $4psf to $2.40? Is that good for valuation?

That's the "scratch the surface" illumination I'm looking for when someone makes general statements like gold/oil/dollars/hambu... estate is/are undervalued.

Oct 20 01:27 AM

[Tack:]

I have found that getting oneself tangled up in myriad stats in an attempt to discover value usually just obfuscates simple realities. But, yes, prices are out of alignment with book values and FFO's, just to focus on a couple key ones.

The simple reality is that the default rate for this recession isn't looking a whole lot different than the default rate for the last recession, or many others, despite the incessant, world-is-ending, shoe's-going-to-drop media ranting. It's precisely these histrionics that create such an exquisite opportunity.

While default rates are projected to be in a typical range, the prices of commercial REITs and commercial developers have been decimated, far beyond any previous pullbacks and disproportionate with the projected default rates. There's a complete pricing disconnect between the current and projected data.

Now, if you're in the "this-time-it's-differ... camp and want to suggest that the future behavior of retail and commercial space demand is and will be radically different, then, of course, none of these declines will seem disproportionate. Having invested for a very long time, I've learned it's rarely, if ever, different.

P.S. I failed to understand your "dilution" comment. Many commercial entities are still paying their dividends in cash, not shares, and even those paying in shares are seeing their prices rise, so "dilution" is merely an abstract construct, which has little bearing on actual investment performance. Also, preferred dividends are completely immune from common dilution, even if it were a factor.


On Oct 20 01:27 AM John Gault wrote:

> The kind of illumination I would prefer is that they are undervalued
> based on...historical book value, net operating income/cap rate,
> replacement value, rental demand, historical occupancy, historical
> vacancy, growth, future tenancy demand, declining costs, management
> efficiencies, price to earnings, price to ffo, lack of available
> developable land, employment/population growth, consumer spending,
> ......
>
> Gold is "undervalued" because there are only 4.5 billion ounces worldwide,
> and most everyone wants an ounce (although I don't).
>
> How many square feet per person is the right number for retail real
> estate to be "undervalued"?
>
> Do you feel that being diluted every quarter on your common dividend
> is a positive?
>
> How about office space in Southern California going from $4psf to
> $2.40? Is that good for valuation?
>
> That's the "scratch the surface" illumination I'm looking for when
> someone makes general statements like gold/oil/dollars/hambu... estate
> is/are undervalued.

Oct 20 05:54 AM

[tresspass:]

Two of the REIT's specifically mentioned were in the health care sector. This is a sector that differentiates. Retail and office, admittedly, are sub-sectors I'm not terribly familiar with so I cannot comment with any authority, only anecdotally.

Driving down 2 routes I travel by every day, all I see is " for lease "
or " for sale " signs---some of which seemed to be thriving businesses merely a few months ago. So there's my " analysis."

Also anecdotally, I am in the health care business as well as several friends and acquaintances. The skinny is that skilled nursing homes, medical facilities of all kinds, nursing homes, stop in clinics are all busy and will be so in the foreseeable future.

We are living longer and the demographics are much too compelling not to view this sub-sector, i.e. HCP, HR, MPW, CRE going forward while consolidating while paying substantial dividends, not one which has been cut or modified in the last half year.

A distinction with a difference, here.

tresspass.

Oct 20 10:09 AM