Fundamental Tailwinds for Commercial Real Estate Shorts
Sanguine about mark-to-market losses.
Fil Zucchi
Dec 15, 2008 11:45 am
Based on some of the emails I received over the weekend, there seems to be some real angst associated with long positions in the Proshares UltraShort Real Estate (SRS).
Let me revisit the reasons why I’m rather sanguine about my current mark-to-market losses. The data I use below come from the components of the Dow Jones US Real Estate Index (IYR), excluding mortgage and healthcare REITs.
On the fundamentals side, REITs aren’t in a good place:
* The median growth in Funds From Operations (FFO = Net Income + Depreciation + Amortization - Gains on Sales Of Property) is estimated at -1% for this year, -3.5% for next year, and 0% for 2010; the average stands at -3.5%, -6.5% and 1.3%. Against these non-growth rates, the average P/FFO is 13.
* While long-term leases cushion the speed at which FFOs tend to drop year-over-year, as rents get reset lower, pressures on FFOs tend to last for years.
* The 55 companies I considered have a total of $202 billion of debt outstanding at a weighted average cost of debt (WACD) of 5%, against current FFO of $17.4 billion. Every 1% increase in the WACD would eat away $2.0 billion of FFO.
* Even if we reasonably assume that commercial mortgage Backed rates come down from their current moon-shot, given the reduction in lending capacity caused by the de-levering of financial institutions, a best case scenario for super-senior spreads is 4-6%. Assuming 10-year Treasury rates at 3%, WACD for the best credits could easily rise to the 7-9% range.
* The current 8% average yield payout requires distribution of 82% of available FFO. If the WACD increases just 2%, dividends will have to be slashed. Even assuming dividends can be sustained at current levels, who in his right mind would take equity risk for an 8% return, when debt yields for these companies are in the double digits?
* While REITs have yet to recognize any meaningful impairment to their asset values -- and a modest reduction of 15% across the board is something they are hoping and praying for -- the median debt-to-equity ratio already stands at 340%, and the average is 140%.
A November 20th report by Moody conservatively suggests a decline in values of 20-30%. Rising debt-to-equity ratios add pressure to the cost of debt, and/or could force equity raises.
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Cap-rates spreads to Treasuries have been in the double digits for the last couple of years; if those rates return to historical 300-400 bps spread and 10-year Treasuries settle around 4-5% (and I have a bridge to sell you, if you think that’s likely in the next few years), virtually every deal made over the last 3 years will be underwater. Hence, more pressure on debt costs.
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What happens to valuations when (not if) the commercial loans CDO start unraveling?
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What kind of an increase in the unemployment rate (i.e. vacancy rates) is built into the FFO estimates, considering that current vacancy rates are still below the 20-year average and 6% below the 1990-1992 highs?
Commercial real estate peaked in February of 2007, courtesy of Sam Zell unloading his entire portfolio. Since then, transactional volume has plunged as sellers refuse to accept that their properties are worth a fraction of what they think they’re worth; buyers are sitting on the little buying power that’s out there waiting for sellers to abandon ship. It won’t be until that dynamic makes the front page of your newspaper that CRE and REITs will find a bottom.
The technicals:
* Since mid-September, the IYR has been cut in half. That’s enough for anything to bounce, whether that anything be dead or alive.
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The average daily trading range for the SRS over the last 90 days is $19.30, which makes Friday’s ugly $18.60 drop a below-average move.
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I, and many other Minyanville professors, have discussed the fact that many leveraged ETFs correlate poorly to the underlying indices.
Put the last 2 bullet points together, and you know why I keep highlighting my straddle writes against SRS stock, and “diagonal call spreads” (long long-dated calls, short short-dated calls at higher strikes): I don’t mind getting whacked 30%, 40%, or 50% on the stock, if I can collect almost that much in premiums over a 30-day period.
The SRS is not an investment - it’s a great trading vehicle with fundamental tailwinds behind it. I am treating it accordingly.
No positions in stocks mentioned.
Fil Zucchi is the founder and manager of Zebra Investment Advisors LLC, a Virginia registered investment advisor, and Zebra Fund, LLC, a long/short hedge fund. Fil welcomes your feedback at zucchi@minyanville.com.
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