Commercial Real Estate: Toxic Asset or Simply Undervalued?

Includes: KRE, VNQ
by: Ray

If you listen to Cramer commercial real estate is the place to be, he mostly points to the increase in certain equity prices in current trading to make his point along with some parallels drawn from the Savings and Loan Crisis. However, rising share prices are not indicative of a stable sector as the beginning of 2008 told us about the banks and the markets in general. Perhaps one reason why these commercial REIT’s are still doing so well is that there is that the shorts cannot short them.

There seems to be a shortage of shares to borrow which is highly unusual and, to my knowledge, this shortage of shares to short has never been a problem up until 2008. Either there are no shares to short because they have already been loaned out, unlikely because short interest in the S&P 500 has decreased 72%, or banks just do not want or are told to not lend shares, which is more likely. Either way, it is highly odd that there is a lack of shares with falling short interest. Regardless, commercial real estate is rife with problems and is a sector I would likely avoid for some time to come.

Here is what I do know about commercial real estate, it is not a good investment right now as the consumer is strapped and stopped spending. Earnings are down some 32% in 2Q09 and that means less expansion or buying within commercial property. Perhaps the biggest data point is on commercial mortgage backed securities have had an 585% increase in default rates rear-over-year totaling some $28 billion so far this year ().

Realpoint CMBS June

All major media outlets and ratings agencies have had countless stories and reports about escalating delinquencies and that defaults will not only increase, but extend into 2011. Not only does this make REIT’s unattractive, but it also makes regional banks unattractive as they have more exposure to commercial real estate than one would think and they do not have the Fed backstopping them with tens of billions of dollars.

As tempting as it might be to short commercial REIT’s I think it best to not take the risk because even with bad news this market just does not want to go down, plus you probably can’t even get the shares. Not only would I not short them, but I would not buy them either since the risk just seems to be too great right now for these types of investments.

While others feel that this recession is no different from any other downturn we have had I must disagree. If other recessions had numerous banks, 2 out of 3 automakers go bankrupt and the government backstopping trillions of assets then I would have to agree that this time is no different.

However, with the exception of the Great Depression, we have had nothing like we have seen over the past 12 months. Therefore, it is different and to think otherwise is ridiculous, although by thinking it is different you might get you a gig on some TV networks.