UltraShort Real Estate ETF: The Only Safe Haven for Commercial REITs

"Your premium brand had better be delivering something special, or it's not going to get the business." - Warren Buffett

Inverse leveraged ETFs provide a great way to maximize returns in a challenging bear market. I would like to call attention to UltraShort Real Estate ProShares (SRS), an ETF which seeks to track twice, or 2x, the inverse of the underlying index of the Dow Jones Real Estate Index.

Among the top holdings which SRS seeks to short is Simon Property Group (NYSE:SPG), an Indiana based retail and mall developer. It currently has lofty valuations of 52x earnings. SPG is listed under the Forutne 500, and does have an admittedly quality management team which has guided SPG through other difficult times, including September 11th.

However, their success must also be attributed to the volumes of cheap credit which was able to fuel their expansion during the last seven years. Look at REITs, and their ability to grow from 1994 to 2001, which were essentially low single digit growth, in line with the rest of the economy and GDP expansion. Home builders follow a similar pattern as well, low, flat growth during the 1990's and a sudden explosion post 2001 with the availability of Greenspanian cheap credit. After soaring to high valuations, the time is ripe for large contraction in commercial real estate, which historically lags residential real estate by one year.

Such growth is clearly unsustainable. Solid mall tenants such as Gap (GPS) and American Eagle (AEO) all posted 10-20% declines in revenue. What about weaker mall tenants such as retail jewelry or Footlocker (FL)? Sharper image did not even make it past the 1st quarter of 2008. Retail is struggling and any plans for expansion will be put aside by retail store managers in exchange for improving existing operating efficiency. This expansionary growth is what fuels the REIT sector; the ability to make new deals upon new deals. What did the Fed estimate the damage to be? They reported that delinquencies on commercial real estate loans surged in the fourth quarter of 2007 to 2.71%. This is the highest level since the fourth quarter of 1996, and more than double the 2006's of 1.32%. I simply do not see retail tenets improving on their default rates in this especially difficult environment.

Even SPG management is decidedly cautious, where there is the "potential for modest increases in store closings and bankruptcies in 2008 over 2007 levels and generally flat retail sales." Analysts are cautious as well, according to Banc of America:

While the fourth-quarter beat is good news and long-term core fundamentals appear intact, we believe that given the current concerns about the consumer and potential for recession, the market could potentially [home in] on the 2008 guidance range.

Options traders are pricing in a large fall too. Large July options activity suggests that SPG can fall by 10%. Not an unreasonable estimate by any means.

Of course, if domestic expansion is slowing, the logical step would be look abroad. This is what SPG has recently done, looking east to Japan, by expanding a 390,000 sq foot premium shopping center, which seeks to cater domestic shoppers as well as international tourists. However, did they take any measure of consumer sentiment which according to the Bank of Japan is at a 5 year low? How are declining export dollars from Japan going to flow back into the Japanese salary men who will in turn buy Gucci or Dolce Gabbana?

Other large holdings of SRS include Vornado Reality Trust (NYSE: VNO), currently at 27x earnings, and Boston Properties Group (NYSE: BXP), at 42x forward earnings. The jury is still out these REITs which have a historically strong exposure to hot markets including New York City and Boston. With large predicted layoffs in the financial sector, these REITs are eventually going to have to write down their prime class A Manhattan properties currently valued anywhere from $60-$100 a sq/ft. balance sheets will take a hit, and their highly leveraged operations will halt in the expansion.

Sound familiar?

Disclosure: Author holds a position in SRS

Comments

[tl:]

While I agree that REITs are likely to drop in price, keep in mind that the preferred metric is Funds From Operations (FFO), not forward earnings. Granted, FFO is a metric created by the REIT industry, so maybe it's not a true measure of a REIT's financial health (anyone remember those late 90's upstart telecoms that were promoting their EBITDA instead of earnings?). But the fact is that FFO is what is used by the investment community to evaluate REITs. So an analysis of forward FFO might be more appropriate.

2008 Apr 13 10:17 AM

[bear9:]

Tl was overly polite, I think. Any REIT analysis that does not use FFO or AFFO (Adjusted Funds from Operations) is flawed from the start. GAAP earnings for REITs are fatally flawed as a metric because they are artificially depressed by the unique, and massive non-cash write-offs associated with depreciation on real estate. Unless you think that the Rockefeller Center is worth zero (all those years of depreciation!), I would suggest that you should use FFO. That simply adds back depreciation to GAAP earnings. A better measure is AFFO, which subtracts necessary cap-ex (i.e. REAL depreciation), but AFFO is hard to come by.

Bluntly, your article is worthless.

2008 Apr 13 10:41 AM

[helplessobs...:]

Yeph, good real estate is depreciated forever and this must be taken in account.

2008 Apr 13 12:01 PM

[Sami:]

The article lacks a closer look at the fundamentals of real estate. Rather it uses non relevant measures of valuation for real esate companies.

Moreover, although retailers have posted weak sales, what does that mean to a retail mall owner? Well, nothing he will still collect rent from the retailer. Retailers are bound by long term leases and they have to pay it as long as they are operational. Tough retail environment means that new space will not be absorbed easily by the market. Then you have to ask yourself have there been overbuilding in the past few years. The numbers suggest there was not any.

The media have linked commercial real estate and residential real estate in one big lot. However the realty is the economics between the two is vastly different.

I would not suggest shorting an entire sector. You have to look at the ones that have a lot of development projects in the pipeline in b and c markets and depend on a lot of leverage. Those are good candidates for a short.

2008 Apr 13 12:52 PM

[Yonaton Dolgin:]

Still, I say I would be wildly surprised if SRS is not over 100 by the end of this week, if not pushing 110. No matter how you view the fundamentals, scared profits will be taken after the pullback on Friday, especially when you consider that those who tapped into REITs at the Bear Bottom are looking at healthy returns which they want to protect.

2008 Apr 13 05:47 PM

[zimmyzee:]

T-bills yield 1% while Reits yield 4%. Anyone long SRS is going to get boned.

2008 Apr 13 05:53 PM

[Richo:]

Thank you for your analysis.

2008 Apr 14 05:16 PM

[johnthebear:]

The last week of April will be most interesting as most REITs report earnings. Those reports will follow a series of negative reports from financials et al. The thing that worries me is the FAS 159 accounting rule that allows the REIT to write down both asset and liability, as if it did not exist!

I don't understand this! I have looked at RAS and read the transcript of their last conference call on "Alpha" and they reported how a book value of $10.52 could increase to $16.50 and $22.32/share based on "economic" or "tangible" book values?

Who can help explain this mess? I take heart in the fact that the share price of RAS did not increased after the call, still trading low at $6.29, and the yahoo finance book value is reported at $9.49! The 52 week price range is $4.82 to $30.55! So all the accounting noise did nothing to improve the stock price. I figure that earnings will be awful when the interest only loans and super leverage comes back to roost! While the analyst look at FFO to value REITs, Capitalization rates are how you value the property which make up the REITs and I think they will double over the next 6 to 12 months! As you may guess I am betting heavy against IYR using SRS! I believe we will see a big move up during the next two weeks to all time highs for SRS. Anyone agree with me?

2008 Apr 15 03:21 AM

[outersquare:]

playing REITs for yield, yeah that worked out well for TMA

2008 Apr 15 10:25 AM

[tl:]

John the Bear,

Mortgage REITs like RAS make up a small portion of IYR and SRS. For SRS to really move up, equity REITs need to show weakness.

2008 Apr 15 11:41 AM

[johnthebear:]

I agree, small potatos in the big scene, but the conference call transcript and affect on book/stock price made an interesting study. I have more confidence in my short position using SRS at the end of the month.

2008 Apr 15 08:33 PM

[SJC:]

Well I believe there are oversupply issues, that the market has not confronted yet. Look at the graphs, who is building? At what prices will they sell? www.costar.com/News/Ar...


And well earnings games can be hard to interpret, depreciation has to be considered at some point. Perhaps a comprimise between GAAP and FFO's ( around 14-15), for these reits needs to be reached.


www.costar.com/News/Ar...

2008 Apr 19 03:19 PM

[Nomadd:]

Many of you might not remember but following the Vietnam debacle, and the political decision to wage it on credit (i.e. increase the national debt) Jimmy Carter walked into a meat grinder of skyrocketing interest rates. I was personally on prime +2 points with my banks and all too painfully recall making 21%-22% interest payments - before having to finally relinquish my properties and begin litigation. Consequently, high interest rates oblitereaed the REIT industry in the 70s. Flash back to the present: as the acknowledged present War costs, again on credit, near $1 trillion dollars - with Stiglitz and others predicting that they could be $3 trillions - what do you suppose the Post-Bush president and economy is about to experience - and the REIT industry?

Another factor: the primary investor in commercial real estate has been insurance companies and (ironically) large retirement funds. Again in the late 60s, early to mid-70s, I was involved in major commercial (office/retail) development in prime Florida Central Business District locations. At the time, those properties were pro-forma $20 sq foot, with the tenant resposible for taxes, maintenance, utilities, insurance etc. In the more than 30 years since, not a single property has operated fully leased (90%-95%) at the full pro-forma lease price - and, vacancy rates are 14% or greater, with declining vacancies. Anecdotally, my attorney has just re-leased on the top floor in a "trophy" downtown property (that I co-developed) at $16 per foot full service. Today, major domestic and foreign insurance companies and retirement trusts own these properties and I would be willing to wager that their book value is pure fantasy.

Now comes a seminal event in human history, the retiring U.S. baby boomers - and all of those retirees demands against their whole life insurance policies,annuities, retirement accounts etc.. It seems to me that someone is going to have to dump properties - which could be unrealistically valued on the books - to create liquidity to meet these unprecedented cash demands. I will greatly appreciate hearing some of you obviously bright guys response...

2008 May 04 03:35 PM

[MarcV:]

I am going to have to do some research into what insiders of these reits are doing especially commercial reits as that is the next logical shoe to drop. I wish there was an ETF that followed commercial reits, particularly malls and office buildings. Anyone know of anything?

Marc

May 19 01:14 PM