Back in April, I wrote a column detailing the looming train wreck in the commercial real estate market. It turned out to be a rather controversial piece. How controversial? You can judge for yourself here in my April column: The Commercial Real Estate Sector: As The Other Shoe Drops – Be Wary of Bank Stocks. It was groundbreaking enough to land me a spot on Glenn Beck’s show on Fox News.
Virtually nobody else was talking about the topic and a number of readers e-mailed to tell me how daft I was for even mentioning it. But I sensed the mess coming a mile away.
Right now, commercial real estate is in the gutter. It’s where the banks were last March. No one wants to touch the sector in any form.
But I think it’s time to jump back in. And before you think I’ve sucked down a little too much holiday eggnog, hear me out…
A Contrarian Bet Worth $9.5 Billion
I’m in good company with my projection here. During last February and March, a hedge fund called Appaloosa Management was busy buying up shares of Bank of America (NYSE: BAC) and Citigroup (NYSE: C). The guy calling the shots was a man named David Tepper, who runs the fund.
At the time, investors, colleagues and even his friends thought he was nuts – a move akin to lounging on the deck of the Titanic while everyone else abandons ship.
But in yet another example of how it’s often wise to take a contrarian investment stance, the bet not only paid off handsomely for Tepper’s firm, but for Tepper personally. Appaloosa is up nearly $7 billion on the trade, while Tepper stands to pocket a very cool $2.5 billion in profit for himself.
Tepper’s no one-hit wonder either…His track record includes huge payouts for his investors in Korean stocks, Russian debt, junk bonds and commodities over the last decade. We should all be so astute…Perhaps we can be, because there’s still time to get in on his next big idea…
A Lonely Voice in a Sea of Pessimism
Tepper is quietly purchasing commercial mortgage-backed securities [CMBS]. His purchases include large chunks of real-estate debt – mostly in the form of bonds, according to the Wall Street Journal.
Most notable among them are huge portions of the debt of two New York City developments – Peter Cooper Village and 666 Fifth Avenue, both high-profile real estate development deals. Tepper believes both are significantly undervalued.
Once again, many of his peers disagree, noting that the current tepid market for commercial properties – and their associated debt refinancing problems – portents nothing but more gloom and doom for the sector.
Take Sam Zell, for example. Speaking at an exclusive investment conference in Chicago, he said: “Everybody is waiting for the Grave Dancer to come in, but at this point property owners won’t tango.” Zell feels it’s still too early, as commercial property owners and their lenders have deluded themselves into believing prices will recover and vacancies will begin to drop. He feels we still have another 30% drop ahead before any prices start to firm.
So who’s right?
Where’s the Tipping Point for Commercial Real Estate?
Take a trip to your local mall, and your first instinct could be to side with Zell. By simply counting empty stores, even rookie investors would get the sense that the retail side of commercial real estate is still in big trouble. But other commercial properties aren’t faring any better, as many office and small warehousing facilities sit vacant. So if Zell and others believe things will get worse, how can we identify the real bottom in commercial real estate? Unfortunately, nobody can pinpoint it with 100% accuracy. But we can take a look at history and come up with a very good guess. And the results may surprise you…
The Three Stages of All Economic Downturns
If you haven’t read Ken Rogoff’s book, called This Time is Different: Eight Centuries of Financial Folly, do yourself a favor and check it out. It’s a definitive work, describing how the long history of financial cycles fits in with the current banking crash. According to Rogoff, “the worm is turning” and if what he believes is history repeating itself for the ninth time, perhaps Tepper’s timing is perfect.
In his book, Rogoff talks about the “Crisis Effect,” which says you can separate all economic downturns into three components: housing, equities and unemployment. He notes that housing can take five to six years to return to pre-downturn levels, equities can take two to three years, and unemployment can take four to five years. From peak levels, housing can fall about 30% and equities by as much as 50%. Employment, however, can actually rise by 5-10% by the time the downturn ends.
But, it’s the order in which these events happen that’s important, particularly when making the case for a rebound in commercial real estate. According to Rogoff’s research, equities rebound first, then unemployment and finally, real estate. Let’s take a look at each one…
Three Reason’s Why Tepper’s Timing Could Be Perfect Again
- Stocks: The common consensus among most economists and Wall Street analysts is that equities put in a firm bottom back in March 2009.
- Unemployment: Recent data and the forecast for 2010 are both positive. According to CareerBuilder.com’s 2010 job forecast, 20% of all employers plan to add full-time positions in 2010 – a rise of nearly 43% from 2009 levels.
- Real Estate: The housing market collapse started back in June 2006, right around the time home prices peaked, according to the Case-Shiller Home Price Index.
As you can see, that leaves us just over three-and-a-half years into the real estate correction, making it seem like David Tepper is nearly two years too early.
But if you believe – like I do – that this correction is really a severe over-correction (at least in terms of price) and that prices are likely to head up from here, then Tepper’s timing is perfect.
You see, there’s no construction happening in commercial real estate at the moment. None. This will cause vacancy rates to slowly drop and steadily increasing demand will fill a lot of the current empty space. As the Wall Street Journal recently quoted Tepper: “If you think the economy will be fine, as we do, then we’re going to do very well.”
So how can you take advantage of this when it comes to commercial real estate?
Three Stocks to Capture the Real Estate Rebound
The best (and easiest) way to invest is through ETFs that specialize in commercial real estate holdings. Here are three commercial REIT plays to consider for long plays:
- iShares FTSE Industrial/Office Index (NYSE: FIO) – up 29% in 2009.
- Vanguard REIT Index (NYSE: VNQ) - up 27% in 2009.
- SPDR Dow Jones REIT (NYSE: RWR) – up 26% in 2009.
You could also consider ProShares Ultra Real Estate (NYSE: URE), which aims to pocket gains that are twice that of the Dow Jones U.S. Real Estate Index.
Disclosure: No position