Don't Buy REITs

If you feel like investing in real estate, you're better off buying cheap lots in Florida rather than REITs. Yes, it is possible to buy a waterfront lot for under $5,000 - a much better investment than the stock market right now. Check out this essay by Dan Amos:

The commercial real estate crisis may be the most anticipated crisis in history. But just because it's widely anticipated doesn't mean that the crisis won't be destructive for REIT shares. Since most REITs are richly valued, the slow-moving commercial real estate crisis will ensure that future returns disappoint.

Consider the valuation of REITs versus the S&P 500, which itself is overvalued. Despite being 25% below its late 2007 peak, the US stock market - measured by the S&P 500 index - is very expensive. The "Shiller P/E ratio," developed by Yale professor Robert Shiller, measures the S&P 500 against the average S&P 500 earnings over the previous 10 years, adjusted for inflation. It's a much more robust measure of valuation, considering the fluctuation of corporate earnings, and the fact that after bubbles, much of the earnings booked during the boom are written off during the bust. Consider that the earnings booked by Citigroup and other big banks near the peak of the bubble were largely written off during the bust. Therefore, a 10-year average of earnings is a better indicator of true earnings.

The Shiller P/E ratio for the S&P 500 Index is now 21 - up dramatically from 13 at the March 2009 lows. This 21 P/E is higher than at almost any point in stock market history, outside of the late 1920s bubble, the late 1990s bubble, and the market peak in 2007. The S&P 500 is overvalued based on the Shiller P/E, but corporate earnings are supposedly going to soar in 2010, right? Well, even if you believe the optimistic 2010 estimates, the market is still more than fully valued on that metric.

Ditto REITs.

Commercial real estate - and the REITs that hold commercial properties - began to deflate rapidly in late 2008. But the Fed stepped in with bailout funds and easy money to halt the deflation...and even pumped the bubble back up a bit. The nearby chart shows the results of the Fed's handwork. REITs of all shapes and sizes more than doubled off the stock market lows of last March, while the Bloomberg Hotel REIT Index more than tripled. (We'll come back to this chart a little later).


This rally has the look and feel of a dead-cat bounce, which means that it provides an attractive short-selling entry point.

REITs soared as the bubble inflated from 2000-2007, then crashed when the bubble popped in 2008 and early 2009, and then launched a dead cat bounce when the Fed flooded the system in mid-2009 with massive injections of liquidity and cheap credit. Now REITs are priced at bubble valuations - valuations that bear little resemblance to economic reality.

This bounce has postponed a healthy purge of assets in which old capital invested by foolish speculators during the bubble would have been wiped out - clearing the way for new owners to assume title to real estate at reasonable prices. When central banks prop up deflating bubbles with super-easy bailout cash, the bubble investors don't liquidate their overly inflated assets. They hang on and hope for a turnaround.

But bubbles always deflate...always. Government intervention merely muffles the hissing sound for a while. This story played out in the Japanese real estate bubble that peaked in 1990, and it's happening with the US commercial real estate bubble that peaked in 2007. Capital becomes trapped in a dead asset class, thereby stretching the bubble's resolution out over decades.

Toward the end of 2009, it became clear that "extend and pretend" had become the official policy at most banks that hold commercial mortgages. We won't see a cleansing flush of hundreds of billions in underwater properties changing hands to new owners. Instead, properties will be dribbled out of the foreclosure pipeline at a slow pace. This measured pace of foreclosures will add to the chronic glut of property that will be quickly listed for sale into any bounce in demand.

Some of the best short-selling opportunities in the REIT sector may be in the hotel REIT sub-sector.

It's not a stretch to expect the hotel business will be ugly for a long time. Corporate and leisure travel is in the midst of a depression. And leveraged hotel owners built or acquired too many hotels near the peak of the commercial real estate bubble.

Now many hotel owners are desperate to generate cash in order to pay down debt and retain titles to properties. Some are slashing nightly room rates below break-even levels. You know from the growth of Internet hotel booking services just how much more competitive and transparent hotel pricing has become over the past decade. Unless competitors are willing to match the pricing of the most desperate hotel owners, healthier competitors will suffer lower occupancy.

Some levered hotel owners, like Sunstone Hotel Investors, are abandoning their equity in some properties to salvage others. In the fourth quarter of 2009, Sunstone defaulted on several nonrecourse mortgages held against 13 of its properties and turned the title over to its lenders. Sunstone calls this a "deed-back," but it's really a strategic default.

Sunstone's lenders will probably keep and operate the hotels, rather than dump them at a distressed price. The behavior of Sunstone and its lenders shows how many hotel owners and lenders are putting off the necessary liquidation of underwater properties with bloated cost structures. The industry still needs to make more progress on downsizing, slashing operating costs, shrinking mortgage sizes, and lowering room rates to match demand. Until it does, the industry's returns on capital will not consistently exceed its cost of capital.

Hotel REITs are highly sensitive to perceptions about the near-term health of the hotel business. Trends in occupancy and room rates shape perceptions about earnings. Hotel REITs own portfolios of hotels and outsource the management to companies like Marriott for a fee.

Because of the relatively fixed costs of paying management companies a fee for operating hotels, Hotel REITs operate with high operating leverage: A 20-30% decline in revenues can translate into a 50-75% decline in operating income. Also, unlike offices or retail REITs with sticky long-term leases, the cash flow for hotel REITs adjusts quickly to changing conditions on a day-by-day basis.

Over the past nine months, hotel REITs have soared on the perception that corporate and leisure travel will rebound strongly in 2010 and 2011. Analysts have forecast a sharp rebound in earnings.

But I'm not buying it. In fact, I'm selling it.

Regards,

Dan Amoss
for The Daily Reckoning

Real Estate Market Overview 2009

The Condensed Version: Serious dislocation has resulted in the following challenges:

1. A huge capital gap has been created (most debt has vanished, and all the available equity is not enough to fill the hole).
2. No one expects surviving financial institutions to ramp up lending once they finally stop their own mammoth balance sheet bleeding (even with gargantuan government bailouts).
3. Persistent risk aversion and new regulation could limit debt capital flows for the foreseeable future, muting transaction activity.
4. Many owners needing to roll over mortgages in the coming years can expect to face substantial refinancing hurdles, including higher lending rates, more stringent underwriting, increased equity requirements, and recourse terms.
5. The aftershocks of rampant “over-the-top lending” that batter the entire credit system leave property markets substantially overleveraged and vulnerable to significant depreciation.
a. Real estate value losses will average 15 to 20 percent off mid-2007 peaks, and could be more severe for lesser-quality commercial properties in secondary and tertiary locations.
b. For 2009, U.S. commercial real estate faces its worst year since the wrenching 1991–1992 industry depression:
i. Values will drop substantially
ii. Foreclosures and delinquency rates will increase sharply
iii. The limping economy will likely crimp property cash flows
iv. Lower growth going forward
6. In 2009, expected total real estate private equity investment returns will likely register in negative territory for the first time in nearly two decades.
7. In a classic flight to quality, those interviewed continue to favor familiar coastal global pathway cities as investment outlooks grow bleak—ratings uniformly decline for almost all markets.
8. Only apartments show some enduring strength—increasing numbers of young adults and people pushed out of the housing market keep rent rolls relatively healthy.
9. Always favored, industrial properties may weaken in the consumer downturn—fewer goods are shipped and distributed.
10. Businesses stop expanding or downsize, hurting office.
11. Hotels suffer as business and tourist travel is cut back in the recessionary environment.
12. Retail really hits the skids — cash-strapped Americans struggle with credit card debt, the mortgage mess, and gloomy employment environment.
13. Already savaged, homebuilders see little hope for improvement until mortgage markets come back and the job picture brightens—not in 2009.

Current prognostication: Expect financial and property markets to hit bottom in 2009 and flounder well into 2010.

Los Angeles Summary: Holding up the best in housing-ravaged southern California, L.A. benefits from a well-diversified economy and dense infill environment with higher barriers to entry than in nearby suburban markets like Orange County and the Inland Empire. An office building wave could weaken the market into 2010 after a falloff in demand—the financial services crash hurts prime west Los Angeles in particular. Downtown continues to benefit from condominium and apartment projects, which help nurture a more 24-hour environment amid hulking office towers, but Pasadena, Glendale, and west L.A. commercial centers still retain an upper hand closer to premier family-friendly executive neighborhoods. Driving to downtown gets more challenging every year and gas prices increase commuting angst. Overall, multifamily has legs: “It’s almost
impossible to lose money on apartment investments, if you have a five- to ten-year investment horizon.” Hotels benefit from the city’s global pathway location. But housing woes devastate homebuilders in previously high-flying San Bernardino and Riverside, where foreclosures spiral and home values drop like rocks. The once white-hot Inland Empire industrial market
cools temporarily—as nationwide consumer contraction hits warehouse demand near the nation’s largest port, L.A./Long Beach. “Bigbox warehouse developers pushed too far,” “building to the horizon.” Upscale Orange County—“ground zero for the mortgage collapse”—gets nailed by its exposure to home lenders, some of which go belly up. Absorbing shadow office
space “could take three to four years.” The O.C. housing picture looks even worse—prices dive. Weak household credit dampens shopping center outlooks throughout southern California.

DETAILED BREAKDOWN
1. Capital Deficiencies: For 2009, the multibillion-dollar questions become: When will money return to the suddenly strangled real estate markets, and who will be investing and at what levels? As markets deleverage and correct, the length and severity of the repricing process will influence the resumption and intensity of capital flows.

Markets went from inundated in capital to drastically undersupplied, especially for precious debt:
2. Credit Gridlock: The nation’s economic prospects and credit markets remained completely gridlocked with no signs of imminent recovery.
Most wish that financial institutions would “take their inevitable writedowns and clear the market,” but understand that the potential severity of losses in a sudden reaccounting could undermine more companies and crater confidence in a suddenly fragile banking system. Instead, lenders grasp for government handouts and buy time—letting buyers quietly cherry-pick
nonperforming loans and making allowances to many borrowers.

Not surprisingly in light of the credit cataclysm, it appears certain that capital availability for both debt and equity will be constrained in 2009 and investment will be “rather muted.” (See Exhibit 2-3.) In fact, overall capital availability ratings (on a one-to-nine scale) are the lowest in the survey’s history. Only opportunity funds and mezzanine lenders will have more
money to invest than in 2008, according to the surveys. Significantly, expectations sink for financing from commercial banks and CMBS. Many previously active private syndicates and tax exchange buyers without leverage leave the scene.
3. Transactions:
(A) Risk Adversion: Some wonder how they ever embraced the alluring notion that secular change in the capital markets had eliminated most cyclical investment risk. In hindsight, “there was never any structural change, just a temporary surge of capital into the markets.”
(B) Muted Transaction Activity: There is a vast bid-ask chasm separating buyers and sellers. 2008 deal volumes are 20 percent of those of 2007, and 2009 may not be much better. “It’s a terrible time for transaction people” after “some incredible years.” Most agree that sellers will blink first—“they need to get reality.” Underwater owners will almost certainly cave toward buyer expectations, hoping enough dollars come off the sidelines to buffer pricing in bidding for
distressed assets. Unlike in recent years, cash buyers will have the advantage—leveraged buyers and financial engineers “are gone.”
4. Refinancing Issues – Buy, Hold, or Sell:
(A) Significant Depreciation: “As long as you can sit with what you have you’ll be fine.” Taking all the bad news in stride, most real estate players, including homeowners, should uncomfortably ride out the storm. Owners who locked in debt on a long-term basis or shied away from heavy leverage—like pension funds and real estate investment trusts (REITs) — should have the staying power and cash flows to cover obligations to lenders and stomach paper losses.
For private equity real estate owners, “It’s too late to sell.” In fact, Emerging Trends surveys register the lowest sell signal in the report’s 30-year history (see Exhibit 1-1). Survey buy ratings continue to rebound off 2006 lows (when players should have retreated) as investors hopefully expect seller capitulation to meet their increased yield expectations. Many real estate owners just focus on holding on through the “rough sledding,” comprehending that
transactions are beside the point until the market takes its bitter medicine and suffers pain. “The best bet at this point is to ride out the cycle.”
5. Value Depreciation
(A) Cap Rates Readjusting: An interviewee consensus calculates that cap rates need to increase about 150 to 200 basis points on average from their recent lows to more normal 7.5 to 8.5 percent territory depending on property sector, market, and asset quality. That translates into a possible 15 to 20 percent value haircut. Trophy, 24-hour city properties should have less exposure—with their cap rates rising 50 to 75 basis points—while B and C product could
see increases of 200 to 300 points. Inflation and rising interest rates pose additional downside risk. Through 2008, Fed policy makers continued to keep interest rates well below historic norms to stave off economic turmoil despite energy cost–driven inflation and blame on low rates for creating baleful asset bubbles. Over the longer term, interest rates should rise, putting more upward pressure on cap rates.
(B) Buyers and Sellers can’t agree: “Sellers want prices available a year ago, while buyers want prices anticipated a year from now.” While lenders dithered and sidestepped marking down their convoluted portfolios, appraisers and private equity fund managers also avoided taking significant writedowns through most of 2008 despite the handwriting on the wall. They
pointed to the lack of meaningful transactions to gauge value declines and the yawning gap between buyers’ and sellers’ expectations, reminiscent of the housing markets circa 2006. Various opportunity funds have raised “a ton” of money—rumored at upwards of $300 billion—but managers don’t want to start acquiring anything before the market has finished sliding, and some commitments may not stick after the downturn. The dearth of transactions, however,
stymies devaluations. Owners won’t sell at “liquidation prices” if not forced, and lenders haven’t pushed troubled borrowers for fear of exacerbating recognition of their own problems. This circle will likely only be broken when banks and special servicers ramp up foreclosures. From the trickle of transactions, interviewees suggest that pricing levels had declined at least 10 percent off 2007 highs by midyear 2008.
(C) Limping Economy: Optimists had been hoping for offsets from rising property net operating incomes to help counter depreciation from rising cap rates. But the lackluster economy compromises their projections. Instead of rents rising or at least holding steady, owners resign themselves to a deteriorating leasing environment where concessions and tenant inducements proliferate. Higher energy costs and inflationary pressures ramp up operating costs, shrinking
bottom lines further. Total returns cannot escape negative territory—the depth and severity of the recession will determine the extent of losses. This downturn “looks like a long doubleheader,” bemoans an interviewee. “The first game is the credit crisis and we’re only in the middle innings. And now we have another game to play and that’s the poor economy.” “Every day that goes by without economic improvement increases the risk for real estate.”
(D) Lower Growth: Without as much leverage in the market, any pricing increases over time will be more “moderate.”
“The impact of lower debt levels and more expensive debt is lower growth assumptions.” Underwriting will be based on 12-month trailing cash flows, not dreamy forward projections. “
6. Private Equity Model: Opportunity funds need to reorient their formulas and expectations—returns and promotes won’t be as high without a boost from debt. Money will be made on riding markets back to recovery and releasing properties, not on cap rate compression and financing structures.
• Cash and low-leverage buyers will be king;
• Surviving banks will impose strict lending guidelines, requiring more recourse and equity;
• Left-for-dead commercial mortgage–backed securities (CMBS) markets will revive, but in a more regulated form;
• Opportunity funds will need new investment models that can’t rely on massive leverage and cap rate compression to boost returns and promotes.
7. Global Pathway: The favored 24-hour coastal cities—D.C., San Francisco, New York, L.A., Boston, and Seattle—will hold value better and bounce back more quickly. Core players and offshore investors gravitate to these elite business and cultural centers linked directly to Asia and Europe commercial capitals. Hot-growth Texas markets—Houston and Dallas—show temporary strength as long as oil prices stay high.
8. Buy or Hold Multifamily: Apartment investments get a boost from a host of significant trends: increasing numbers of young adults who leave their parents’ homes, more aging baby boomers looking to downsize from suburban lifestyles, and stiffer mortgage costs/requirements that make homeownership too expensive for some prospective buyers. Increasing renter demand helps blunt ongoing recessionary impacts and ensures solid cash flow increases when the economy improves.
9. Buy or Hold Industrial: Despite near-term softness in availability rates, coastal gateways and primary international airport hubs will consolidate their positions as prime warehouse markets operating along global pathways. Watch for distressed owners and pick off bargains in top markets.
10. Hold Office: Long-term leases can bridge the downturn.
11. Hold Hotels: Occupancies decline and room rates suffer—it’s no time to sell.
12. Pray for Retail: Mall owners hope consumers haven’t collectively shopped till they dropped. Neighborhood centers with stronger grocery anchors and chain drugstores should fare best: people still need to eat and purchase more Advil for all their headaches.
13. Buy Residential Building Lots: The market collapse mauls homebuilders—increasingly, they capitulate and give up inventoried land tracts in bankruptcies and foreclosures. Prices are cents on the dollar from market peaks. But investors must be prepared to hold for a while.
Purchase Distressed Condos: At the right prices, these projects can be transformed into profitable rentals. Properties in urban areas near transit hubs make the best bets. Once markets recover, units can be converted back for sales.
Dire Effect of Jobs Market: The dreary jobs picture stirs particular apprehension about the country’s ability to bounce back from its current slump. Although overall U.S. employment had been healthy from 2002 to 2007, job creation and wage growth trailed other economic expansions. High-paying manufacturing jobs continued to migrate overseas, replaced
by lower-wage/lesser-benefit service sector “discount store” jobs. At the margins, many white-collar companies steadily transferred more “knowledge-based” work overseas to lower-cost markets thanks to telecommunications and Internet technologies. While high-tech jobs have rebounded off 2001 lows, the important financial services industry “is a train wreck” and its prodigious Wall Street bonus machine in shambles. To make matters worse, the government sector will scale back in 2009, as state and local agencies face severe declines in tax revenues. Slashed budgets translate into reduced government hiring and layoffs as well as reductions in contracts to private firms and funding for nonprofits. For the short term, rising unemployment and additional consumer distress appear unavoidable. Interviewees, meanwhile, continue to
scratch their heads about new job growth engines; most mention energy, health care, and education. Initiatives to recast the country’s increasingly obsolete infrastructure (roads, rails, transit, airports, electric grid, water/sewage systems) as well as securing greater energy independence through new technologies may key an eventual resurgence. But such programs have no chance to gain immediate traction, given various political, business, and financing roadblocks — certainly not in time to help in 2009.
Check out deals on Commercial real , single-family homes and even cheap hunting land.

The Best Place To Buy Investment Real Estate

I've been an avid real estate investor in the past and I still keep abreast of the market and good places to invest. Here's an interesting email I received recently.

The Cheapest "Nice" Country in the World Right Now
By Doug Casey, editor, The Casey Report

I've been to about 175 countries, and lived in 12. All the while, I've felt the U.S. and Western Europe in particular (but also Canada, to a somewhat lesser degree) are on a slippery slope. So I've always had an eye open for a real second home.

My longtime subscribers will recall my enthusiasm for New Zealand back in the late '90s. Since then, its currency has risen about 75% against the dollar, and well-selected property has roughly doubled or tripled in addition.

New Zealand is still a great place to hang out. I bought a bunch of property and still go there about three months of the year, mainly to play polo and just enjoy the mellow lifestyle. But New Zealand is no longer the bargain it once was; far from it.

I think it's imperative to have a crib outside your home country in today's world. I don't want to get into a detailed discussion of all the possibilities here; that would take a book. But my bottom line is that Argentina is simply the best place in the world right now, all things considered.

It's certainly the cheapest "nice" country in the world. Indeed, Buenos Aires is absolutely one of the world's greatest and most livable cities. The country is running a massive balance of trade surplus. The government (most surprising of all) is running a big fiscal surplus. Rich Europeans are piling in, since Argentina is now ethnically and culturally the most European country in the world. And it should be fairly insulated from WW3. All the stars are aligned for this place. Even as stupid as Argentina's government has traditionally been since the days of Peron, the bull market has a long way to run.

So I'm looking to spend around half the year there. Along with a partner, I bought a ranch in Patagonia 10 years ago, and it's been a spectacular investment.

But if I'd been familiar with Salta province – in the northwest – at the time, I'd never have bothered. The province averages about 5,000 feet in altitude, but is at about the same latitude south as Cuba is north. As a consequence, the climate is perpetually mild. And it's dry. Most of it is indistinguishable from Northern Arizona, New Mexico, or Colorado.

It's possible to buy huge parcels of land very cheaply (e.g. 100,000 acres for US$1,000,000), but that's literally in the middle of nowhere and of very little practical value. You're a feudal lord for the people living there. But if you want a latte and an International Herald Tribune, or anything to eat besides an animal some of the peons have butchered, forget about it.

It's a long-standing tradition at Casey Research that we eat our own cooking, so we've bought a lot of property in Argentina in the last few years. But frankly, I wasn't looking for a bunch more trading sardines; that's what stock certificates are for. I really wanted something I could personally use and enjoy. What we did, therefore, was buy 1,200 acres on the edge of the town of Cafayate, in the south of Salta.

Like San Martin de los Andes in Patagonia, Cafayate is going to become another Aspen. Or maybe the resort town of Taos, New Mexico, is a better analog. Located in a huge bowl, surrounded by the high Andes, it's quaint and picturesque. Especially since it's the center of a large wine region. So the area is really more like a "Taos meets Napa."

What we're doing on this land is putting in a world-class golf course, spa, health club, vineyard, equestrian facilities, and, in fact, lifestyle amenities of all types. A library, billiard room, cigar bar – you get the idea. Since good workers go for $200 a month, costs will be low, and services will be excellent. My personal vision is to take the best features from developments I know all over the world and put them together here.

I think we've got the right place, the right idea, and the right time. I also think the cost will be right. I expect it will, initially, go for something like 10%-20% of what something similar – but not even close to as nice – would go for in the U.S.

I hope early buyers will be successful people of a libertarian character; no jerks need apply. Then, as soon as possible, we're going to raise prices as high as possible to keep out the riff-raff.

So that's the story right now. For traveling or an outright real estate purchase, Argentina, all things considered, is my favorite place in the world.

Regards,

Doug Casey

Of course, if you'd like to buy cheap real estate in the US, there are a lot of places to chose from. Make sure you check out this site that aggregates cheap residential and commercial properties for sale.

Investing In Japanese REITs

Here' a few good reasons why Japanese real estate is a great place for our money:

• Japanese real estate investment trusts (REITs) are a great bargain, down 29% since June 1.

• Dividend yields are the highest income plays in Japan, in the 4% range.

• There's a huge incentive to borrow and buy real estate, as "cap rates" (essentially the rent minus the costs of upkeep) are 4%-6%, while the cost of borrowing money is only 1.5%.

• Rents in Tokyo are up 30% in the past two years.

• The city is crawling with investment bankers looking to buy properties... companies like Goldman Sachs, which has already spent billions investing in Tokyo real estate.

• There is no supply... vacancy rates in Tokyo real estate are tight at 2.6% and there isn't much new building taking place.

The opportunity is enormous. Japanese real estate is literally selling at 1980s prices which leads many people to belive that its a really safe investment.

Time To Buy Taiwan Real Estate?

According the Wall Street Journal,

Anticipation that a wave of cash from mainland China will eventually reach Taiwan is helping to turn its real estate into a hot property.

Markets in Taiwan, one of Asia's worst laggards as an investment destination in recent years, were livened up by the Nationalist Party's victory in the March 22 presidential election. On May 20, winner Ma Ying-jeou will be inaugurated, succeeding Chen Shui-bian of the Democratic Progressive Party.

Billy Yen, general manager for property brokerage DTZ Taiwan, estimates that home prices have risen as much as 30% since the voting. And he thinks that by the end of 2008, prices could be 60% higher than they were March 22.

The sharp change in sentiment is rooted in Mr. Ma's pledge to open Taiwan's property market to Chinese investors as part of a broader effort to more closely tie the economies of the mainland and Taiwan.

I guess Morgan Stanley missed it, else they would've jumped up with a newly created Taiwan Property ETF. Looks like it worth looking into.