As Building Slowdown Goes Commercial, Ultrashort Real Estate Should Speed Up

Another good piece from the Wall Street Journal on one of my long held theories. For those newer to the blog, my top two Ultrashorts since inception have been Ultrashort Financial (SKF) and Ultrashort Real Estate (SRS) - the latter is focused on REITs not homebuilders. While the Financial has been the better performer since October 2007, I think in many ways the Real Estate position will fare better in 2008 [Dec 26: Credit Downturn Hits the Malls].

Reasons for this are multiple (a) much (not all) of the financial mess is becoming known, as more and more cockroaches are discovered (however I still think people understate the economic strains on Americans and how it's going to cause a lot more writedowns in non mortgage areas) and (b) the entire Federal government is here to support the financial system. Commerical real estate on the other hand is more a play, not as much on credit crunch (although it's affected by it) but simply stated a slowing economy. Especially in retail and restaurants which I believe this country has too many of. Especially in areas showing slow population growth or net migration.

We have too many stores based on spending levels that were inflated by the steroids of easy credit and housing ATM. As inflation continues to erode buying power, these stores and restaurants will continue to flounder and begin to close. That will hurt rents. That's why if this were a real fund that I could short individual names, I'd be focusing on those in certain regions and in certain subsectors. But instead I must use the blunt instrument of Ultrashort Real Estate (SRS). Last, unlike financials which the government and all the king's horses (and men) plan on saving by any way possible (read: your tax payer dollars in the end), they won't have such warm hearted spirit for commercial real estate.

So this is a revisit for newer readers of why I've been against this sector and believe it has much more downside as we move from denial to realization of the problems. If you believe in a 6 month recession (or no recession as was popular consensus last fall and early in the winter) my position would make little sense. But by going against the consensus I've made a lot in both positions, and this is why I continue to hold the Real Estate Ultrashort as my top short position. I believe the slowdown will be deeper and longer than people want to admit, simply because this slowdown is based on the consumer, not business. Now that the evidence is finally appearing in front of people's faces, they might finally finally face reality. If you were drinking the Kool Aid, you would simply be saying "it will all be ok in 6 months" back last summer.

• Cracks are starting to show in commercial construction. For the second month in a row, the Commerce Department reported a decline in spending on nonresidential construction -- which includes everything from hospitals to office parks to shopping malls. The report yesterday showed construction spending fell 1.7% in January from December, the steepest drop in 14 years. While residential construction accounted for a big part of the decline, spending on nonresidential construction slid 0.8%.
• Meanwhile, there may be an oversupply of shopping malls and office buildings after a period of intensive construction. It adds up to bad news for employment, the economy and investors.
• While the boom in commercial construction wasn't as dramatic as in home building, the impact of a slowdown on the economy could be significant. Nonresidential construction accounted for 3.6% of gross domestic product in the fourth quarter of 2007, up from 2.5% five years ago and the most since the second quarter of 1988, according to Moody's Economy.com. (but don't worry about it, it is ONLY 3.6% of GDP... just like they said don't worry about this minor housing issue - it is ONLY 4.5% of GDP)
• As home construction got caught in a downward spiral last year, nonresidential construction continued to expand at a healthy clip. Spending on nonresidential structures rose 16% in 2007, the biggest four-quarter increase since 1984, according to Morgan Stanley.
• Signs of trouble cropped up at the end of the year. As credit markets tightened, office space sold in the fourth quarter dropped 42% from a year earlier, and sales of large retail properties declined 31%, says Real Capital Analytics, a New York real-estate research group.
• Nonresidential construction payrolls, down 2.7% in January from their recent peak in March, posted year-over-year declines in December and January, the first such drops since August 2004. A construction slowdown will be especially tough on specialty-trade contractors, such as plumbers, painters and electricians, who account for about two-thirds of overall construction payrolls. This could spell trouble for consumer spending, which accounts for two-thirds of the U.S. economy.
• In the past few years, builders aggressively put up stores and strip malls amid easy financing and resilient consumer spending. Spending on construction of shopping centers leapt 67% in 2007 from 2005 levels.
• Last year, developers built 144 million square feet of retail projects in the top 54 U.S. markets and are slated to build another 131 million square feet this year, according to Property & Portfolio Research Inc., a Boston research company. Property & Portfolio Research calculates that demand justified 36% of the new space built last year and will support 15.7% of the space slated to be completed this year. (take a moment to mull over that, we continue to build stuff that is not justified - sound vaguely familiar?)
• Another problem: Property values of commercial real estate are declining. A Moody's index of commercial real-estate values fell 1.5% in December from the previous month. It was the fourth steepest monthly decline in the seven-year history of the index, which nearly doubled from the end of 2000 through October.
• Moody's expects a peak-to-trough decline of 15% to 20% in commercial real-estate values, returning prices to where they stood about four years ago. Goldman Sachs Group Inc. analysts have projected a drop of as much as 26%.
• Retail is one of the more vulnerable sectors of commercial real estate, tied to the housing market and consumer spending. As the economy lists toward recession, retail property stands to suffer higher vacancy rates, constrained rent growth and declining values. Results for publicly traded retail landlords look healthy. After several years of rapid expansion by retail tenants and strong spending by shoppers, real-estate investment trusts that own and develop retail properties boast occupancy rates in the low- to mid-90% range.

Again, the parallels are striking to residential in many ways. There is also a lot (but not as much as in home mortgages) of securitization in this area. However, it won't be anywhere near as bad as residential in my view, but a lot worse than people have thought the past 6, 3, or 1 months as the economy degrades. As the last paragraph says, shopping is most at risk... while we'll ebb and flow and this Ultrashort will fall when Kool Aid runs rampant and denial is all the rage, I expect the larger trend to be up. So far it's proven to be true, and Ultrashort Real Estate has been the 4th biggest winner for the fund since inception.

Bigger picture for the economy - less construction jobs (if you combine residential and non, 8% of GDP in the US is just "building buildings"), and then we go into the multiplier affect I've been stressing for a long time - each job lost in a service economy means less need for every other service as people can't afford to pay for it. Further, we are going to see a lot of (first) cut backs on expansion plans in retail and (second, after reality hits) closing of stores. We are starting to see the first whiffs of that now... and we are not even "in recession", right Ben?

Disclosure: Long Ultrashort Real Estate, Ultrashort Financial in fund and personal account

Comments

[bhakta]

I agree with all you have written here fully. The tidal wave of collapse in real estate is only starting.

[marcm]

Completely agree with you + technicals are great. Close to a sextuple top break out on the P&F charts. Once this baby breaks out, it's to the moon!

[Jon Doherty]

I also agree. SRS is currently hedging my whole portfolio (plus some)
IYR is just below the 50 day MA. It looks like its about to break.
SRS has been bumping its head on the 50 day MA. When it finally gets above it I think we could see 140 again.

[John Egan]

Nice article. You aren't the first to mention the impact of commercial real-estate, but everyone seems to gloss over it as they muse whether or not the financials "have reached a bottom yet". I feel that commercial R.E. will be the next shoe to drop. And I think the impact will be as substantial as that which we have already seen.

thx jegan ;-P

[TraderMark]

John, I was writing about it last August when I started my blog. Just like I was calling for a recession and that the August writeoffs in financials were not "the kitchen sink quarter" :)

I find it amusing how now its the consensus... from the same people who denied any of the above 4-5 months ago. Most brokerages were not even open to recession until Dec 2007 and once Abu Dhabi invested in Citigroup they were all happy to call the bottom with "smart money" pouring it. Anyhow, this type of exposure on a day like today helps offset the long positions very nicely. Have a good day.

[Tony Soprano]

DON'T BE SO PRIDEFUL ABOUT YOUR PREDICTIONS. HERE IS WHY!

Last summer (while drinking K aid) the commodity bubble was not nearly as pressing for the consumer and you and no one else (except for Jim Rodgers) was predicting crude and wheat at record prices. The high cost of food and gas has changed the equation since last summer.

If we do have a lasting recession and with Europe slowing the bubble in commodities may burst. Meanwhile, our population is growing and I don't see people trying to escape into Mexico and the Fed is cutting. In the end we may well end up with stagflation. Both bears and bulls will suffer unless you are happy with the high dividends. I went through the stagflation of the 70's and the only cure was time. If you are long you can sit on your hands collect those fat dividends and of course if you are short you have to pay them out. I'll be buying long and collecting the dividends just like Warren Buffet did in the 1973 and 1974 recession.

[Purple Cows]

Brilliant article! SRS is hitting a short term low this week after a Fed cut and a quick run up in the stock market in general. Thursday just before close should be a perfect entry point to for a large purchase into this ETF! It's my point.
I'm out of most everything positive by Thursday of close.

[Tony Soprano]

When published on March 5

the SRS closed at 113.10*

the SKF closed at 125.05*


Today March 18

the SRS closed at 104.00*

the SKF closed at 116.29*

*does not include the cost

Not brilliant for those that got in on March 5th and could not or did not get out in time. What a hard way to make money.

The easy money has been made in this trade. Like many other shorts you are now fighting the FED. It’s not just that the rates are falling. They may buy back the bad debt permanently. Its like they are a trader and what a trader to compete against. They went from holding the bad debt from 28 days to 6 months. We have best Federal Reserve system in the world.

Finally, if you don’t get a big bounce off of 100 or so then watch out. The chart could break down and you will be looking 90. Most of the bad news in ALL the markets is and has been factored in.

[TraderMark]

Tony, this was a great trade
SRS hit 120, 4 of the last 6 days and peaked at 128

SKF is self explanatory, peaking at 150 yesterday

I find it laughable to say it was not a good trade - I am out of both positions as of the good action yesterday due to Fed actions Sunday night but if you have a short term horizon (which I did) these were excellent protection as a hedge in the portfolio. If you are talking a 3 year hold, that's different. I now expect these to rally again, and until the government led bailout to buy mortgage paper direct they should continue to be volatile BUT things did change in the past week as the Fed now is willing to take on bad paper from Bear and backstop the investment banks as of Sunday night. But these were 2 very profitably trades, which I enjoyed!

[TraderMark]

sorry by "Rally" i mean the financials and commercial real estate names to rally. Not these instruments. I'll revisit them once the S&P hits 1360 or so.
I'll probably stop having exposure once the final nail is in the coffin and the US government begins buying mortgage paper direct. But yes the easy money has been made, but I've been trading them since last August. They still provide a nice hedge against long positions, and have been 2 of my biggest winners the past half year.

[Tony Soprano]

TraderMark

I’m glad that these trades have been very profitable for you. Congrats!

You may have been able to get in and out in time. However, some new or inexperienced traders may not. Even experienced traders get squeezed or just caught being short. It’s not easy to execute. You have to stay on top of the market minute by minute and having the right equipment helps as well.

It’s a hard and risky way to make money. Traders cannot go off and play golf or take even a short vacation until they close out their positions. Some traders try to make it look easy. I see a lot of this on the internet. Any trader can say that they got in and out within a certain time. Its misleading for novice traders and not fair for them. During the late nineties we went through a terrible debacle with the day traders. In a way its happening again with ETF’s. ETF’s that double down present new challenges. We cannot take for granted that ever one will understand these types of vehicles let alone where and how to use them.

You said that I said that this was a bad trade. I never said that. You may infer that I said it was a bad trade. But I will let the numbers above speak for themselves. Highly experienced traders need not pay attention.

You made a good argument as to why the commercial real estate market will be hard press as we go into a recession. You laid the groundwork well. Again, it could easy mislead an investor into thinking it would be easy. Especially, if they don’t follow the markets closely. Investors that have a large long stock portfolio should beware, investors that are short beware more, investors that use ETF’s that double down should beware much more.

I have visited your site several times, I have it book marked, and I do find it interesting even though I disagree with some of your data. Good Luck!

[TraderMark]

Thanks Tony

Yes it is not for the faint hearted or those who do not keep up with the market daily. As an aside I am slowly rebuilding exposure to these names as we move in the 1330-1360 level on the S&P :) Eventually this trade will go against me, but with a real recession looming I don't find the Fed to be a salve for everything that is coming down the pike. Thanks for your comments. I do expect continued extreme volatility for the next few months as we work through this credit mess; then we can just focus on the recession

Note: all that changes when the federal govt starts buying mortgage paper direct!

[WantsOut]

I have also been in and out of SRS and SKF since August 07. If you avoided the FED and realized that these were extremely rate\FED sensitive then, well you and I did very well. For what it's worth I got out early before the recent intervention and suffered a bit at first as it kept risng but I have started to accumulate new positions. Recent times have dictated that SRS under 100 is a buy.

[TraderMark]

WantsOut - been buying the past 2 days. We'll go down.... The Fed will intervene.... I'll sell. ... Book my profits. And we'll keep repeating this parlor game until some arm of the Federal government buys mortgage paper direct and the US taxpayer pays. :) So I consider these gains to offset my coming purchases of mortgages - money in 1 pocket, and back out to the other to help support the "system" aka a deregulated mess built for and paid for by corporations and the NYC banks.

[WantsOut]

TraderMark - No doubt you are correct. Sidestepping the FED is critical. I expected a bit of end of quarter propping. The FED has overstepped their bounds and many people are questioning them. My thinking is much like January, after year end, there was a selloff. I'm thinking we get a good 2 or 3 weeks of limited intervention and pressure on the markets?

I had been very wary of 116 as it has seemed over time that there was a good level of resistance\profit taking. Your thoughts?

[Noah Painter]

TraderMark - SRS seems to be under a heavy downward trend. If you look at a P&F Chart it hasn't seen a stable uptrend in several months. I know that I'm analyzing this more as an equity than as a hedge/variable short for the REIT index. However, this etf has the liquidity of a typical equity.

I don't think Paulson's plan to regulate the investments and securities industry will gain much traction, and the Fed is losing ground with every instance of lowering the fed funds rate. I presume that in the next six months we will see an increase in vacancy rates thus requiring REIT's to lower their lease rates, driving down their NOI, depending on their inherent leverage they could have to seek operating capital from the markets/shareholders. I know there are a lot of assumptions in this -- do you feel that they are realistic?

[TraderMark]

User, those are exactly the reasons I bought back in Aug 07 but I'm always early :)
SKF is more of a credit contagion play first and recession play 2nd, while SRS is more of a recession play 1st, credit contagion 2nd. At this point the recession has gotten almost no play as the credit crisis dominates all the talk. So I think the effects of a slowdown in the economy are really being missed. We are only just now seeing the press come around to the idea - up to Dec 2007 most investment banks were not even open to an idea of a recession. And even now the only talk is of "short and shallow"

Myself, with the strained consumer, double whammy by food and fuel inflation, on top of asset deflation (homes/stocks) - I think it's going to be an ugly time. I expect malls to really suffer along with many small restaurants going out of business. So rental rates should really get hit. But all in good time. I think this is one worth holding a core position and then trading around the edges.

Bush will come back from Europe with a bailout plan for homeowners, etc - so times like that the market will spike - but eventuality cannot be forestalled forever.

Paulson's plan won't be ready until the next President is in office - its just a lot of huff and fluff for the financial media to talk about for a day. More important for the near term are the competing mortgage bailout plans congressmen (and now president) are falling over themselves to propose.

[Noah Painter]

TraderMark - I think you're dead on. The people on The Hill will not stand by and let a great press-op pass them by.
Specifically focusing on the affects of SRS to this market. Yes, the macro view of Fed intervention and Congressional/Executiv... overzealousness will play a key role as to whether the credit markets will continue to cease operation, or the Fed changes the rules to the game and starts being a player -- instead of a cheerleader.

From the SRS standpoint -- if you look at what REIT's makeup the DJUSRE index there are more than 80+ REIT's that are unequally weighted. Out of 80+ REIT's only 11 comprise 2% or more of the index.

1. VNO
2. VTR
3. SPG
4. PSA
5. PLD
6. PCL
7. KIM
8. HST
9. HCP
10. GGP
11. EQR

When I have some more free time I'd like to put together a dossier of these 11 REIT's and their exposure to the credit markets as well as their sensitivity to the potential increase in vacancy due to the recession.

I was able to pull this from DJ's website explaining how they create the weights for each REIT that is included in the DJUSRE

Weighting Float-adjusted market capitalization -- Component Number Variable

Review Frequency Quarterly -- in March, June, September and December

Calculation/Distributi... Every 15 seconds during U.S. trading hours

Base Value/Base Date 100 as of December 31, 1991

History Back-tested history. Available daily back to December 31, 1991

Date Introduced February 2000

[WantsOut]

User,

Thanks for your input. I'm an amateur investor so please forgive any obvious ignorances.

Regarding your 11 GT 2%. It seems many have not really had a significant hit to date. HST, GGP, and VNO but many of the others don't seem to have had much of a hit given the situation. Curiously VTR has bucked the trend and maintained a lower left to upper right despite the recent (Jan) environment going against it.

Both your and TraderMarks input is greatly appreciated.

I'm gambling the houses money ... I couldn't resist adding some more at 85.

Thanks