Wednesday, March 9, 2011

Are REIT's the Next Bubble?

The way I see it the answer is a resounding YES!

I thought it was important to discuss this sector because many investors(especially fixed incomers) are desperately chasing these stocks in order to find yield which allows them to avoid eating into their nest eggs. 

Finding yield was much easier 5 years ago when yields were at 5% on bonds. 

Back in those days if you saved $1 million dollars and threw it into treasuries your were guaranteed $50,000 a year in interest.  Throw in an additional $20,000 of social security and it's not a bad living for most folks after they retire.

The problem today is this treasury investment no longer exists thanks to the Fed's zero interest rate policy.  The only treasuries that offer anything close to 5% is the 30 year bond which will give you about 4.5%.  The problem with buying these is you are locked into an investment for 30 years!!!  It's almost like buying a house.

The risk of owning bonds at the longer end of the curve is inflation.  If you buy these bonds and inflation rises above 5% annually(which seems highly likely at this point) then you are losing money in real terms on an investment that yields only 4.5%.  Additionally, the value of these bonds in an inflationary world would drop which means you would also take a huge hit on your principal.  Essentially you get screwed twice!

As a result, many investors and investment advisers are avoiding these long bonds like the plague.  They have decided instead to look elsewhere for yield and one of the areas they ran to was the REIT's.  

This was all well and good early on when these stocks were fairly valued.  The problem is these stocks have become grossly overvalued as investors continue to gobble up anything that offers a decent return.  As these stocks started to rise the speculators got into the game and before you knew it it was "Bubblemania" in the REIT sector.

Of course this is not going to end well.  I mean haven't we seen this game before?  Do the words "triple A mortgage backed securities" yielding 8% ring a bell?  How did that one work out?

Anyways, the best example I could find to show how you insane the "REIT Mania" has gotten was Simon Property Group(SPG).   Simon has essentially risen about 400% from the high $20's up to $106 since the 2009 lows despite the fact that commercial real estate has plummeted in value at the same time.  This puts it near it's all time high of 123 which was seen before the real estate bubble collapsed.

Here is a chart of SPG's amazing performance:

I chose the "best in class" REIT to make my point although I must admit this is similiar to looking for the nicest horse in a glue factory.

The Case

Let's start with their balance sheet.  Simon(SPG) currently has a whopping $17.49 billion in debt on revenues of $3.96 billion.  They currently hold $796 million in cash.

What was first startling to me when I first looked at this was the P/E values.  The trailing P/E on SPG is a whopping 50.  Meanwhile the forward looking P/E for year ending 2012 is only 15. 

Ummm...How do these numbers work?  Are earnings going to rise 400% this year while unemployment remains at 10% and commercial real estate prices continue to fall?    This is a joke right? 

Perhaps they going to make up these losses on their malls that continue losing tenants month after month?  Good luck with that!

It gets better:

Simon's cash level is disturbingly small when you look at how much cash SPG raised in the debt markets the last 2 years:

"The company maintains significant financial flexibility and has demonstrated access to a wide variety of capital sources through cycles. At June 30, 2010, Simon had approximately $2.3 billion of consolidated cash and cash equivalents on its balance sheet as well as approximately $3.35 billion of availability under its unsecured revolving credit facility. Additionally, Simon has raised $3.15 billion of long-term, unsecured bonds year-to-date to fund tenders of bonds due between 2011 and 2014. Simon also raised over $3.5 billion of external capital in 2009 through unsecured bonds, mortgage debt, and common stock during volatile financial market conditions."

My Take:

Where did all this money go?  They only have about $800 million in cash after raising billions in the debt markets.  Did they decide to "double down" and pile it into more worthless commercial real estate or did they need all of this money to pay their 3.2% dividend?

Perhaps the capital was needed to manage the losses they have been forced to take on their commercial properties?  

Let's think about that for a second:  Can you imagine what the total losses are on their massive commercial loan portfolio?

Let's get real here:  SPG would likely not be around if the Fed didn't allow the REIT's to roll over their commercial loans at "fantasy" values.  Remember folks, commercial loans are not like home loans.  They are refinanced ever 2 years or so.  If these companies were forced to eat their commercial loan losses they would have gone the way of Lehman Brothers.

The Bottom Line

Needless to say SPG is not a buy at $106.  In fact if anything it's a darn good short the way I see it. 

REIT's like SPG have more than quadrupled in value for two reasons:  Dividends and specualtion.  These not a sound fundamental reasons to own a stock.   If anything it's a recipe for disaster.

Don't get me wrong on the dividend part, 3% dividends are nice as long as the risk is relative to the return you are receiving.This is clearly not the case anymore when the trailing P/E's on SPG sits at 50!  The earnings growth expected in 2012 is nothing but a fantasy.

Remember folks, there is a reason why SPG continues to suck billions out of the debt markets.  They obviosly need the money in order to survive and pay their dopey dividend.

Bubbles never end and the price action that has recently been seen in the REIT sector is clearly Ponzi style investing.  Buying insolvent companies for a dividend is never a smart approach towards investing.   A 3% yield doesn't work out so well if the stock drops by 30% or more.

There will come a time where all commercial real estate will be forced to mark to market because the banks are going to need the money and they will start to foreclose on these properties in order to get it.   If this doesn't finish off many of the REIT's then the collapsing retail markets most assuredly will.

Disclosure:  No position long or short on SPG.


getyourselfconnected said...

I think as much as 40% of the price of REIT's are based on a bailout backstop guarantee that is implicit, like the GSE one used to be. More FED market manipulation.

Jeff said...

Get Agreed.

The key word there is implied not guaranteed. Big difference

The Fed can walk away without consequences at anytime.

I am hearing a lot of chatter from friends who are in this biz that the REIt's are sitting on boatloads of losses and they don't wanna refi because they can't afford to.

Wall St is trying to find ways to refi these loans but the companies refuse to take the hits because they don't want the losses.

One thing is clear. The Fed is nowhere to be seen in this mess either.

The only help they gave them was allowing them to carry this crap at full value.

This will coem to a head soon and it's not going to be pretty because the Fed doesn't have the political will or funds for another industry bailout.