Insanity Reigns in Commercial Real Estate

Let me start by thanking the buyers of the REIT ETF, (IYR), of which I own long-dated puts. On Wednesday, they bid it up, as they also did on Tuesday, in a Pavlovian manner on news that Archstone-Smith (ASN) would be taken private. Hopefully, the buyers will keep bidding up REITs so I can add to my short position.

For, you see, insanity reigns in commercial real estate these days. Prices of commercial real estate are as ridiculous as residential real estate was a year or so ago, and as silly as big cap growth stocks were during The Bubble. It is no different, and the end will also be no different.

But, because of the reckless monetary policies of Easy Al as well as his successor Helicopter Ben - who may differ in style and approach towards inflation targeting but does not differ in attitude towards the asset-driven economy - an ocean of liquidity which has flooded the world has to go somewhere. With the copy-cat pension and endowment funds looking wistfully at the funds which had the foresight to invest in alternative assets such as private equity and real estate a decade ago, money is pouring out of stocks and into alternative asset classes. A decade from now, those piling into alternatives will discover that they were duped. And they will wonder what happened to the asset economy of Easy Al and Helicopter Ben, both of whom should be long gone before the proverbial you-know-what, hits the fan.

Indeed, much of private equity is merely leveraged equity that is not marked to market. Pensions and endowments could get the same effect investing in index funds by either borrowing 5x the amount of equity and investing in an index then turning off its TVs for five years, or investing in futures at 5x the rate to synthetically create an index return, and again turning off the TV for five years. It would then hire a private valuation to firm to tell it what the market should be valued at, all the while not paying the 2 & 20 gravy-train that has the all the ambitious Ivy League MBAs scrambling to jump on to. But we will leave private equity for another time.

Commercial real estate's cousin, residential real estate is dead. Home prices will, at best, move sideways for a decade or, at worst, fall 20-30%. But the Greenspan Bernanke Put is alive and well, as vividly demonstrated by Helicopter Ben when he was madly pumping liquidity into the financial system as the over-leveraged subprime market (a market which we are now assured by the best and brightest was but an afterthought in the mortgage market), was collapsing. Thus, housing prices will not be allowed to fall by those controlling the printing presses of this once mighty currency. But homebuilders stocks have, and will.

Alas, commercial real estate is dead as well, and the REITs will face a similar fate as the homebuilder stocks. It's just that the patient is not yet aware that he is dead.

First, I believe that the IYR ETF has seen its top. Generally, the IYR has been rising when the market has been rising, and selling off or consolidating when the market has been selling off or consolidating. That has not been occurring the past few months. Instead, REITs have been struggling while the Dow and the S&P 500 (SPX) hit new highs. Perhaps the ETF hit $95 or so, but I would then expect it to fail.

Why have the REITs not been following along with the market? This is because spreads have widened. CMBS spreads have gone straight up since the market sell off began at the end of February. However, unlike the market, spreads did not revert back to trend. Instead, spreads on A-rated collateral mortgage backed securities have risen from 100 to 200 bps, whereas spreads on BBB-rated pools have risen from 200 bps to 400 bps. Only recently have the spreads come down a bit. Interest rates on CMBS products are critical for financing deals. Unless spreads come in meaningfully, the game is over.

Next, REITs are expensive. First, ignore this comparison to NAV the analysts use to justify the price of deals. I heard an analyst comment that Archstone was trading below net asset value before it was taken out while the deal price was above NAV. Net asset value is a moving target.

It is based on cash flow projections and discount rates. Because discount rates have, or at least had collapsed to record lows, and cash flow projections are assuming unprecedented rental increases (all while supply is increasing), changing the assumptions can dramatically alter NAVs. I can assure you that five years ago, no analyst, not a single one, was arguing that the net asset values of REITs were as high as they are today.

Instead, let us look at multiples. Using information on 118 REITs in the Russell 3000 (IWV) comprising approximately 95% of the market cap of all REITs in the index, REITs are trading at

25.2x 2006 earnings
28.4x 2007 estimates
26.1x 2008 estimates

compared to S&P 500 (excluding financials) multiples of

20.1x 2006 earnings
17.8x 2007 estimates
15.8x 2008 estimates

Thus, REITs are trading at premiums of 25% on 2006 earnings, 59% on 2007 estimates and 64% on 2008 estimates.

But, the real estate bulls will tell you, that earnings are not a proper metric to value REITs. Instead, one should use something called "Funds from Operations" [FFO]. Why? Because, as the thinking goes, an investor should exclude depreciation since real estate values only go up! Thus, we back out capex and depreciation and amortization (D&A) from free cash flow to obtain FFO. Putting aside the somewhat intellectually vacuous reasoning such as whether you spend any money keeping up your home, and taking the argument at face value, REITs are currently trading at 13.8x trailing FFO. This seems reasonable compared to 20.1x 2006 earnings at which the market's ex-financials is currently valued.

Or is it? Why compare earnings to FFO? Is it not consistent to compare the FFO of REITs to the market? When backing out capex and D&A from free cash flow, the S&P 500's ex-financials are currently trading at 9.2x FFO. Thus, REITs are trading at a 50% premium to stocks based on FFO! Considering that REITs used to trade at 7x-9x FFO a few years back before everyone went ga-ga over real estate, I would guess that this spread is as wide as it has ever been.

This astonishes me as REITs must distribute the most of their cash flow as dividends to qualify for tax-exempt status whereas corporations retain earnings to grow. Corporations have a source of capital to fund organic growth whereas REITs have no (or little) source of retained capital to grow cash flow. Growth must come from increases in rents. Thus, corporations should trade at a premium to REITs, not at a discount.

The bulls may then retort that the dividend is higher. True. The market-weighted dividend on the 118 REITs is currently 4.3%. (It is 2.9% trailing for the IYR and 3.1% forward.) However, REIT dividend yields used to trade within a range of 6%-10%. Also, since REITs pay out about 80% of its cash flow in dividends, the quick thumbnail calculation for cash available for dividends is 5.3% (4.3%/0.8) whereas this same calculation for the market (this time including financials) given a 30% payout ratio yields 6.0%. So REITs, which have an inherently lower rate of organic growth than stocks, and it also yields less when using cash available for distribution.

Lastly on valuation, complexes such as apartments and strip malls in suburbs are being purchased with an assumed cap rate - that is "capitalization" rate, similar to an internal rate of return - of 4%-5%, below the cost of financing. The free cash flow yield usually is even lower. For prime properties, the rate is lower still. Thus, rents are going to have to go way up in order to just break even. Frankly, as an investment, I think that's nuts. I'll take a 5.25% T-bill rate, thank you very much.

Finally, I began receiving a magazine called Real Estate Portfolio in the mail. It is published by NAREIT. It has nice pictures of buildings and cityscape vistas, and is printed on heavy, glossy paper. Although the articles are somewhat lacking in depth, it is a nice magazine. However, I have no idea why it began showing up on my desk. I never asked for it, I did not subscribe to it, I didn't even know it existed, and apart from my own home, I don't invest in real estate. Is it being sent to anyone who looks like an investment professional? The address box has my CFA designation attached at the end of my name. Perhaps the CFA Institute sold them the list, I don't know. I just figure that when the likes of me start receiving unsolicited magazines about really hot markets of which I am more interested in shorting than investing, I know the end is near.

And the end will come. For that I am certain.

So please keep bidding up my ETF. I really appreciate you doing so.

Comments

[Paul Meisel:]

A thorough analysis..... perhaps Sam Zell agrees.

2007 May 31 08:59 AM

[Augustus:]

So, for a review,
You own Puts on REITs,
The price is going up,
Your position is worth less as a result,
And you are Thankful.

Who is nuts?

2007 May 31 04:48 PM

[john960bell:]

I think you are right about fundamentals, but too early on timing. Inventory of properties for sale is low, and buyer demand is strong. Pension funds are planning to increase their allocations. A new real estate fund is announced almost every week. Good listings get 15+ offers. Think housing 2003-2004.

2007 Jun 01 10:55 PM

[malcom128:]

Timing is key to the deflation of the REIT bubble. Either buyers must recede or supply must surge to end the mania. The supply of REITs is shrinking as private equity takes it out to increase the leverage. The buyers are the same private equity buyers, plus the dedicated REIT investors who have to reinvest in a shrinking universe. Until CMBS spreads widen sufficiently to make the private equity take out math unattractive, or private equity loses access to capital for some other reason, there is no reason to expect the buyers to recede.

2007 Jun 02 12:58 PM

[k_denninger:]

I was playing the SRS (ultra-short) a bit ago but saw some technical indicators I didn't like and dumped the position. Good thing, as it has since sold off by 12% from where I exited! Aieee!

Anyway, I'll be back on that one, but not yet. The deal breaker, by the way, may well be the 10y bond yield. Watch that sucker - REAL interest rates are what will eventually kill the liquidity party, as all that debt that gets issued to fund the game has to go SOMEWHERE, and SOMEONE has to pay interest on the money.

The game is getting long in the tooth both here and in the general equity markets.

Check out market-ticker.denninge... if you'd like - another blog analyzing the broader markets on this stuff (mine)

2007 Jun 04 12:24 AM