matisse capital management

US Commercial Real Estate Declines (Again) in March

A 0.5% drop for the month.  Moody's publishes an index known as the REAL Commercial Property Price Index (CPPI).  It is calculated using data from apartment, industrial, office and retail sales over $2.5 million, and can be found here.  The biggest decline over the last quarter was in retail, which was down 4.7%.  The commercial property index hit a low in October 2009, and then prices increased in November, December and January, rising 6.3%.  In February, prices were down 2.6% for the month, now followed by March with -0.5%.  Does this mark the beginning of a double dip, like we are seeing in housing?  The trough for commercial prices was October 2007, when they were down 43.7% from the October 2007 peak.  Per Moody's,they are now down 42.1% from the peak.

 

 

Commercial Real Estate Data from Moody's

Another month of declining prices.  The Moody’s Commercial Property Price Index was released yesterday.  The index purports to measure the performance of all property types nationwide (office, retail, industrial and apartments).  As reported in Retail Traffic, commercial prices dropped 1.5% in October.  Moody's has compiled this data since the fourth quarter 2000, when the index was set at 100.  The peak occurred in October 2007, when the index reached 192.  Currently, it is at 108, down 43.7% from the peak, and 36.4% from one year ago.

A Turnaround? What About Commercial Property?

The recession may have turned the corner, according to a recent New York Times article.  This is conclusion is based on the index of leading indicators which has "has accurately indicated the end of every recession since the index began to be compiled in 1959."  The index has risen each of the last three months, and is now up over 12%; this number has historically been a signal for the end of a recession.  The New York Times produced a  chart, illustrating the index of leading indicators at the turnaround point for every recession since 1959.  This chart is presented below (click to enlarge):

Commercial real estate might defy this indicator rule, however, and prolong this recession.  According to Moody's, commercial property prices across the nation have declined 35% since October 2007 and CNN recently published an article titled: "The commercial real estate time bomb" (story here).  Meanwhile the delinquency rate on commercial mortgages that were sold as bonds has more than doubled since its 2007 low.  As with residential real estate, the problem is inflated valuations.  For income producing properties, one way to determine the value is net operating income (before taxes) divided by the capitalization rate (known as the "cap rate").  For a couple decades, these rates hovered around 9.0%, in the most general sense.  In the boom of 2004-2007, however, as the federal funds rate hit new lows, cap rates dropped to 6-7% for many property types.  If cap rates now revert to their historic norms, properties acquired or built during the boom could be overvalued by 30-50%, and therein lies the problem for commercial real estate.

The Top Dividend Growing REITs

Many income investors have looked to REITs (Real Estate Investment Trusts) as a source of dividends.  REITs are pass-through entities and to qualify for this status, they must pay dividends equal to 90% or more of their taxable income.  Because many REITs are now trading far below their 2007 highs, their yields appear very attractive.  For example, National Retail Properties (NNN) currently pays a 6.6% dividend, while Realty Income Corporation (O) is paying 6.1% (the author is long O).

REITs, the Next Financial Problem

   While the US Markets have been focused on Citigroup and Merrill Lynch, a major Australian REIT has quietly become a victim of the credit crisis.  Centro Properties owns retail developments in Australia, New Zealand and the US.  In the US, the company owns over 650 shopping centers and is one of the largest retail REITs.  American bondholders now claim that Centro has defaulted on $450 million in debt.  The company first ran into trouble two months ago when it could not find a lender to refinance $3.9 billion in debt.  It had previously borrowed from JP Morgan as discussed in this story.  Additional information on the Centro debacle can be found here and here.

   In Australia, the company's share price has dropped from $2.09 per share to $0.32, and shareholders have been enraged by the CEO's golden parachute, which is tiny by US standards. The following quotes about Centro are from the Sydney Morning Herald.  They have to make you wonder, is this problem company specific, country specific or across the board?

   "It is understood the "package" of assets that Centro has offered to lenders as collateral for its $1.3 billion debt refinancing is now worth as little as $750-800 million, due to huge overvaluations on its assets and a scarcity of buyers in the current market."

   "In these boom times all the major (property) groups have been borrowing money against property using friendly valuers, and several banks have been happy to accept those friendly valuations," one senior banker said. "But now it's all come to a screaming halt and everyone's holding these valuations and they don't know what to do with them."

Is This the Time to Buy REITS?

Over the past year, REIT prices and multiples have come down considerably.  Many stocks are now paying very attractive yields based on their current valuations: ProLogis (PLD) at 2.7%, Simon Property Group (SPG) at 3.5%, Macerich (MAC) at 4.0%, and SL Green Realty (SLG) at 2.5%.  But will prices go even lower, giving buyers a better entry point?  There are two places to look for the answer to this question: commercial building vacancy rates and capitalization (cap) rates.  Cap Rates are used in commercial real estate to value properties - the net operating income from a commercial building is divided by the cap rate to determine a value, so the lower the rate the higher the value.  Cap rates are the inverse of the P/E ratio used in valuing stocks, except they are applied the net income before taxes. (Chart, above left of Simon Property Group over the last year).

Time to Buy REITs?

Over the past year, REIT prices and multiples have come down considerably.  Many stocks are now paying very attractive yields based on their current valuations: ProLogis (PLD) at 3.2%, Simon Property Group (SPG) at 3.7%, Macerich (MAC) at 3.6%, and SL Green Realty (SLG) at 2.5%.  But will prices go lower?  Cap rates may be the best place to look to answer this question.  Cap Rates are used in commercial real estate to value properties - the net operating income is divided by the cap rate, so the lower the rate the higher the value.  Over the last few years, buildings have sold at rates of 6.0 and 7.0 percent, and even as low as 5.0 percent in the best locations.  Over the last 20 years, however, cap rates have been a lot higher, averaging probably closer to 8.0 or 9.0 percent.  In historic terms, this may mean that values will adjust downward if rates return to more "normal" levels.  Although P/E ratios for REITs are at there lowest levels in five years, it is probably still to early to buy as there may be some balance sheet adjustments yet to come.  Above, chart of SPG and PLD over the last six months.

UK REITS on Sale: BXTOF.PK, HMSNF.PK

The UK REIT system was introduced on January 1, 2007, but share prices are down at present, creating a buying opportunity. The Bank of England recently raised its base lending rate to 5.5% to slow the current 2.8% inflation rate to its target 2.0%.  The next inflation report is due in mid-August, and REIT prices are already down in anticipation, with some REITs selling below book value at the present time.

Two interesting REITs are Brixton PLC (BXTOF.PK) and Hammerson PLC (HMSNF.PK).  Brixton owns and leases warehouse-distribution space in the UK, focusing on the Heathrow and West London markets. Hammerson owns prime retail properties in England and France, including WestQuay in Southampton.  Many of Hammerson's properties are fully leased.  The company's performance is illustrated in the chart after the jump, below.  Expect REIT share prices to drop over the course of the next month, before the Bank of England's August announcement.  Despite the high interest rates, demand for space remains strong, and new construction continues.  Above, on the left is The Shard, a 72-story office and retail tower under construction in London, on the south bank of the Thames.  The project is scheduled for completion in 2010.  Directly to the right, is a glass and light installation on Plantation Lane, a narrow street in London's city center, between two office towers. 

The web sites for Hammerson and Brixton are as follows:

http://www.hammerson.com/pages/1/Home.stm

http://www.brixton.plc.uk/

Also of interest is the site: http://www.newlondonarchitecture.org/

Friday, May 18 REIT Fire Sale

The dramatic drop in REIT prices seemed to attract little attention today in the media.  Here are ProLogis (PLD) and Simon Property Group (SPG) plotted against the Dow.  PLD was down 3% at one point today and fell below its 200 day moving average of $64.40. The causes are the sense that the Fed may not lower rates at all this year (two year treasuries yields climbed to their highest since February and, of course, the weak housing market.  Fed fund futures now show only a 37% chance of a rate cut this year.  See: http://www.bloomberg.com/apps/news?pid=20601087&sid=aWbrcz8Bp8Mk&refer=home)

I used the drop to buy shares of PLD, and will hold long.  The P/E at the current price is 15.3 X.  Other REITs today: VNO down 1.8%; BXP down 2.2%; AMB down 1.7%; GGP down 1.8%.

REITs on the Radar: O, MAC, PLD

To the left are three REITS that I am currently following, with their performance charted over the last five years.  The first, O, Realty Income Corporation, I already own shares in.  The others are the primary performing stocks in the real estate funds of Goldman and T. Rowe Price.  MAC is Macerich Company, which owns shopping centers around the country.  PLD is ProLogis, a REIT that focuses on industrial warehouse and distribution space.  The plus to PLD is that it has operations in many countries around the world, including Eastern Europe and China.  This exposes the company to greater growth possibilities in the near term.  The dividend yields for these stocks are as follows:

O: 5.5%; MAC: 3.0%; PLD: 2.8%.

REIT prices have stalled recently, based on the Fed's unwillingness to lower rates.  I believe this makes the above three, in particular PLD with its international exposure, attractive buys, as I expect the Fed to lower rates later this year, if for no other reason than to salvage the housing market.