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Four Short Ideas for the Coming Commercial Real Estate Crash
by David White March 29/2010
We have been hearing about the coming commercial real estate crash for the last two years. Judging by the increasing amount of fretting by economists and the Fed, it may arrive in force this year. The current equities rally is long in the tooth. “Trash” stocks have been bid up beyond reality. Excessive optimism about the health of real estate and the health of the economy has led to the bid up of commercial real estate stocks. Almost all indicators on real estate have been negative since the first of the year. The recent rise in long term Treasury bond yields has made those negative indicators seem even more worrisome.
Most commercial real estate loans are much shorter than residential loans. The typical length is 7 to 10 years, but they may be as short as 3 to 5 years. Normally new loans will replace the expiring loans. Prices of commercial real estate are already below 2004 levels. The peak in most areas was 2006. All of this means that a slew of commercial real estate loans will have to be replaced in the next 2 to 3 years. Many of those loans will be underwater. It will be nearly impossible to get new loans. Many companies may walk away from underwater properties. Even major banks such as Morgan Stanley (MS) may go this route. It may hand its creditors the keys to its $2.4B investment in Japanese hotels (poor Citigroup (C)). Commercial real estate prices have gone down that much.
This is by no means an isolated incident. Morgan Stanley walked away from its $6.5B investment in the developer, Crescent Cities Real Estate Equities Co., and Morgan Stanley lost the Maui Prince Hotel to foreclosure last year. Many smaller players have to be in significantly more dire circumstances. This bubble is set to pop. When the bubble does pop, commercial real estate prices will plummet still further. In conjunction with the still troubled residential real estate market, this situation could cause another credit seize up.
Most expect the US economy to grow decently in 1H, but they expect it to lag in 2H of 2010 as stimulus monies are used up and/or withdrawn. We are in the good phase currently. Hotels and airlines have been showing signs of health. It is easy to be lulled into a false sense of security. There is no great winning scenario for commercial real estate. If the economy continues to look good, oil prices will go up. This will translate into higher airline ticket prices (and lower profits). The higher oil prices will hurt the US economy badly as it runs a huge oil trade deficit. This oil trade deficit will grow by roughly the size of the oil price hike. The economy, the airline bookings, and the hotel bookings will go down. If growth continues more slowly or not at all, it will not be enough to stave off the huge commercial real estate and residential real estate crises. So much for why the US needs to become energy independent, but that’s another topic.
Many of the commercial real estate stocks are currently sporting high PEs. They are forecast to earn more as the economy improves. However, there is no guarantee that the economy will improve that much. We have yet to really see what will happen as the stimulus measures are withdrawn. A lot of people have predicted a double dip. Meredith Whitney has predicted a huge drop in real estate prices. Such an occurrence might bring on another bout of deflation. The amount of real estate lending has already gone far down. The banks do not want to hold more mortgages than those they already have. The market for MBSs has dried up. The Fed is ending its MBS buying at the end of March. This is an extra $70B per month in mortgages that the banks will likely end up holding. This will make the banks even less willing to make further real estate loans. With the doubts of both the lenders and the buyers to contend with, real estate sales will likely trend downward. Ditto prices. Ditto the prices of commercial real estate equities.
I have identified four REITs that seem to fit the bill: AVB, BRE, WRE, and MAA. Their average PE is 47.28. Their average PE for FY2011 is 17.97. This is still high for stocks that may see their book values fall by 10%-20% in the next year. All are currently above their analysts’ average target price. None have great cash flow. The table below has a lot of the relevant statistics. The data is from Yahoo Finance and TD Ameritrade.
| Stock |
AVB |
BRE |
WRE |
MAA |
Ind. Avg. |
| Price |
$87.78 |
$36.80 |
$30.37 |
$53.64 |
-- |
| 1 yr. target |
$75.80 |
$29.60 |
$28.00 |
$50.17 |
-- |
| PE |
45.43 |
38.70 |
42.59 |
62.44 |
-- |
| FPE (2011) |
22.74 |
18.97 |
15.34 |
14.82 |
-- |
| Avg. Rtg. |
3.0 |
2.9 |
2.9 |
2.6 |
-- |
| Beta |
1.5 |
1.4 |
1.3 |
1.2 |
-- |
| Debt/Capital (MRQ) |
56.5% |
63.9% |
62.0% |
75.4% |
54.6% |
| Price/Book |
2.35 |
1.98 |
2.44 |
3.63 |
2.60 |
| Price/Cash Flow (TTM) |
25.01 |
17.72 |
15.05 |
13.45 |
-- |
| Short Interest |
15.24% |
8.41% |
7.88% |
8.1% |
-- |
| % Held by Institutions |
95% |
95% |
-- |
87% |
-- |
| Quick Ratio (MRQ) |
-- |
-- |
-- |
-- |
4.08 |
| Interest Coverage (MRQ) |
0.73 |
0.80 |
1.29 |
1.51 |
4.5 |
| Return on Assets |
1.04% |
1.28% |
1.25% |
1.71% |
1.38% |
| EPS Growth (MRQ) |
79.06% |
-153.62% |
6.46% |
-4.35% |
-167.23% |
| EPS Growth (TTM) |
-14.90% |
-39.39% |
211.24% |
8.24% |
-36.25% |
| Revenue Growth (MRQ) |
1.93% |
-1.66% |
7.72% |
2.08% |
30.95% |
| Revenue Growth (TTM) |
4.59% |
-0.20% |
10.13% |
2.31% |
-0.02% |
| Annual Dividend |
$3.57 |
$1.50 |
$1.73 |
$2.46 |
$1.44 |
| Gross Profit Margin (TTM) |
59.76% |
68.23% |
82.34% |
75.80% |
61.33% |
| Net Profit Margin (TTM) |
8.97% |
11.07% |
8.48% |
8.81% |
-14.57% |
| Price/Sales |
8.41 |
5.89 |
5.92 |
4.14 |
5.62 |
| PEG Ratio |
17.65 |
12.48 |
15.74 |
6.05 |
11.23 |
| FY2010 EPS |
3.73 |
1.93 |
1.93 |
3.56 |
-- |
| FY2011 EPS |
3.86 |
1.94 |
1.98 |
3.62 |
-- |
| FY2010 Revenues |
842.96M |
326.72M |
308.31M |
385.37M |
-- |
| FY2011 Revenues |
880.11M |
333.90M |
317.09M |
406.16M |
-- |
AVB:
BRE:
I leave it to the investors to pick which stock(s) they want to short. My own plan is to watch these stocks as the current rally likely turns into a retracement after the quarter ends. Most likely I will not make a decision until next Monday, April 5. If one or more takes off to the downside earlier, I may acquire a short position. The Investor can draw in support points underneath the current prices to use as likely short position exits. I am currently estimating at least a 15% to 25% retracement in these stocks on average. They should outperform the market to the downside on a retracement.
Good luck trading.
Disclosure: I have no positions in these stocks at this time.
About the author
David White is a software/firmware/marketing professional and a long time investor. He has worked in the networking field, the semiconductor equipment field, the mainframe computer field, and the pharmaceutical/scientific instrumentation field. He has bachelor's degrees in bioresource sciences and biochemistry from U.C. Berkeley. He is a former Ph.D. student in biochemistry. He has done significant graduate work in EECS and business.
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