Real Estate Investment (Dis)Trusts

By Dan Amoss | 11 June 2009

I’m confident that the trend for REITs will be down through the end of 2009. That’s why I suggest buying the UltaShort Real Estate ProShares ETF (NYSE: SRS. Current price ~$18) as a way to profit from weakness in the REIT sector. But fasten your seatbelt! SRS will be volatile!

REITs may appear cheap, but they are very dangerous to hold right now. A basic tenet of corporate finance is that a company or a sector is only creating value for shareholders if its return on invested capital (ROIC) exceeds its weighted average cost of capital (WACC). If its WACC exceeds its ROIC, it is destroying value. This describes the situation facing the REIT sector for the next few years. Most REITs cannot float unsecured debt at anything less than 10% or 12%, so their cost of capital is high and rising. At the same time, due to the glut of supply in commercial real estate supply, and waning demand from stressed tenants, the returns on incremental investment in new capacity are very low— possibly negative.

Summing it all up: REITs will be destroying shareholder value until supply and demand for commercial real estate reaches equilibrium. The free market is screaming as loudly as it can that millions of square feet of capacity need to be absorbed or eliminated over the next several years in order for the surviving REITs to have a chance at generating respectable returns on capital.

This process has barely even begun, after the biggest lending binge in the history of commercial real estate. It will last a long time. The lending binge ensured that a large swathe of REITs will not make it to see the next commercial real estate up-cycle, which is still several years away at minimum. The title to many properties will go back to creditors in bankruptcy, and auctions will bring down asset values across the sector until they are cheap enough to earn respectable returns in a weak rental environment.

Another example of stress surfaced earlier this week. The auction to settle credit default swaps related to the General Growth Properties bankruptcy indicates serious pain to come for mall REIT owners: GGP’s senior loans effectively liquidated for 44 cents on the dollar! This means that lenders are demanding extreme discounts and high yields to hold debts secured by mall collateral. This isn’t good news for peers like Kimco (NYSE: KIM) and Simon Property Group (NYSE: SPG). Another argument I’ve seen lately is that REITs will be a good inflation hedge if you buy them at these prices. This is an overly simplistic view of Fed-created inflation and its ultimate symptoms.

Fed Chairman Bernanke can debase the dollar all he wants, but most of the new dollars will act to push up the prices of goods and services in sectors with relatively tight capacity. Mostly, this translates into lower living standards for the average American— an echo of the 1970s, only without the real estate appreciation. The Fed’s inflation will find its way into tangible assets like gold and silver, oil and gas, uranium ore, farmland, potash mines, and any other commodity China needs to import. Conversely, the fed’s inflation will NOT find its way into the pricing of American shopping malls, which arre in a condition of extreme oversupply.

Over time, the capacity to supply light, sweet oil to the global economy will be far tighter than the capacity to supply American retailers with real estate in malls. Demand for oil will be far more resilient than the U.S.-centric consensus expects, while demand for discretionary items— like "Color Fiend Neon Green Hair Spray" at Hot Topic (this product actually exists)— will fluctuate up and down, but generally head lower. Rising prices for several necessary goods and services will crowd out discretionary spending in many family budgets.

Inflation does not re-inflate old bubbles— especially in the case of residential and commercial real estate. It will only slow the previously violent deleveraging process. On a related note, it was a breath of fresh air to hear Howard Davidowitz of Davidowitz & Associates interviewed on Bloomberg Radio recently. (You can find a link to download an mp3 of the 17-minute interview here). Davidowitz has decades of in-the-trenches experience in retail consulting and analysis. Rarely do you find an industry analyst express an informed opinion so forcefully in the mainstream financial media. I highly recommend listening to the interview for an overview of how the retail and commercial real estate business will evolve in the coming quarters.

A preview: It ain’t good.

[Editor Joel’s Note: Faithful readers may remember Dan for being way out front on calling the implosion of Lehman Bros. last year. That play handed his Strategic Short Report readers a chance at bagging over 400%… and that was in the face of everyone who said "the worst is over" after Bear Stearns’ collapse a few months earlier.

Now, those same people are shouting "green shoots" and telling you that the worst is over (again). Meanwhile, the guy who actually got it right is warning of more trouble to come. Hmm…what’s an investor to do?