Are REITs Cracking?

As I mentioned in a recent post, I am short REITs. It is my biggest exposure by far. I own puts on a REIT ETF, (IYR). If the price happens to move against me before they expire, I will merely reload.

I will be right, for that I am as certain as one can be in investing. (Which is not 100% certain. That is known as "hubris." Or "insider trading.")

On Friday, The Fox Street Journal reported about the deteriorating credit market for commercial real estate transactions, which is something that Running of the Bulls noted a few weeks ago, and which we will update shortly.

The falling Archstone-Smith price underscores growing concern in the commercial real-estate world that higher interest rates are killing deals or causing prices to be renegotiated lower. Banks are renegotiating terms of tentative deals that haven't closed, and buyers and sellers are haggling over already agreed-upon prices.

"Lenders are becoming a lot more careful about the borrower," says Phil Feder, a real-estate attorney at New York law firm Paul, Hastings, Janofsky & Walker LLP. "Lenders aren't reneging on their commitments, but I have seen approval for new loans slowing and it's generally becoming more difficult for real-estate funds and other investors to get financing for their projects."

The change in borrowing costs was triggered April 11, when Moody's Investors Service fired a warning flare about Commercial Mortgage Backed Securities, or pools of real-estate loans that are sold to investors as bonds. Moody's said lenders' underwriting standards had become too lax during the real-estate frenzy. That warning scared investors and forced bankers to raise yields on CMBS offerings to attract investors, sending shock waves through the real-estate lending world.

The situation got worse last week when Treasury bond yields, on which the loans are based, shot up.

"It's going to bring the price of real estate down," says Gary Mozer, principal with George Smith Partners, a Los Angeles-based commercial real-estate finance firm. The "meltdown" in the CMBS market, as Mr. Mozer calls it, has caused a "sea change" in the amount that real-estate investors can borrow. "People can't pay as much for property because they can't get as much positive leverage," he says.

Mr. Mozer estimates borrowers can get 20% to 30% less than they could have eight weeks ago.

William Hughes, a managing director at Marcus & Millichap Real Estate Investment Services in Encino, Calif., says "a lot of CMBS issuers are running for their lives. Investors are rejecting transactions from CMBS pools that have significant interest-only components or little to no cash flow."

Loan terms are becoming more stringent despite the promise of strong rent growth. "We're seeing lenders underwriting more conservatively against future increases in rent," Mr. Hughes says. In the past, "we might be able to utilize rent increases that are 18 months to two years out [for the basis of a loan], but we're now down to one year."

Please note that, according to Bloomberg, the dividend yield on the IYR has grown on average 2% per year the past five years, whereas the price more than doubled.

Tick, tick, tick...