Wednesday, October 22, 2008

Is Commercial Real Estate Ready to Tank?


Before I get into commercial real estate, a few words about the manic-depressive stock market. As everyone knows, stocks plunged today with most major indexes falling more than 4 percent, including the Dow Jones industrial average, which finished off its lows with a loss of 514 points.

Now before you go off and sell everything, take a step back from all the noise. From a technical point, stocks might be retesting their lows:

The big themes weighing on stocks are the same ones that had the market down this morning:

  • Dollar strength as investors flee "risk assets" be they emerging markets, commodities (oil hit a 16-month low) and, yes, equities. Despite ultra low yields and continued improvement in credit indicators, Treasuries continue to attract buyers seeking safety - or the perception thereof.
  • Concerns about a global economic slowdown slamming commodities and emerging markets, which in turn is reinforcing the dollar's strength. Commodity producers like Exxon, ConocoPhillips, and Freeport McMoran were among the biggest losers Wednesday, a mirror image of Monday's advance, which has now been totally wiped out - and then some.
  • Realization that earnings expectations still haven't been lowered enough for the fourth quarter, much less 2009. Thanks to strength in last night's earnings reporters, Apple, Yahoo, EMC and Broadcom, tech stocks held up relatively well Wednesday. But Amazon.com's weak post-close guidance is likely to eradicate any talk about big-cap tech "outperforming".

If there's any consolation for those groping for a bottom, it's that the market closed above its session lows, which were above the intraday lows of Oct. 16, which in turn were above the lows of Oct. 10.

Higher Lows (Intraday)

10/1010/1610/22
Dow7,7738,1768,335
S&P840866876

In other words, a successful retest of the retest. Cold comfort, perhaps, but something to hang your hat on -- assuming you haven't already lost your head.

Unfortunately, most people have lost their shirts in these casino markets. Excessive leverage spurred by excessive greed and irrational exuberance is now giving way to virulent deleveraging spurred by the collapse of the securitization bubble, hedge funds liquidating their portfolios, causing panic and irrational pessimism.

Listen to me carefully: institutions will do everything they can to slowly bring this sucker up. Am I dreaming? Maybe, but if this market continues to free-fall, hitting new lows, it's game over for a long, long time. Mutual funds, hedge funds and pension funds have a vested interest to start buying these dips or face the wrath of their investors and their stakeholders.

Most of the people I speak with outside the financial circle are all sick and tired of the excessive volatility of the stock market. I often hear "it's a stupid casino" or "it's all a scam so hedge funds can get rich". And they are worried about the economy and their jobs.

Today, the International Monetary Fund issued a gloomy economic outlook for the United States (and Canada), saying U.S. economic growth will be close to zero or even slightly negative for the rest of 2008 and the economic recovery will not begin until the second half of 2009, and will be more gradual than previous recoveries because of the exceptional nature of the asset price adjustments taking place.

Serious strategists know the U.S. recession is deep and that it's going to last a long time:

The U.S. economy is in a recession that began in late 2007 and is likely to last much longer than the typical downturn, says Liz Ann Sonders, chief investment strategist at Charles Schwab & Co.

Contrary to popular belief, "consecutive quarters of negative GDP" is not what defines a recession. In fact, the National Bureau of Economic Research uses five parameters to determine whether the economy is growing or not:

  • Real GDP (inflation-adjusted GDP, that is)
  • Industrial Production
  • Employment
  • Personal Income
  • Wholesale/Retail Sales

Four of five of those indicators rolled over late last year and are now showing the economy in a "deep" recession, Sonders says.

The good news is the stock market typically turns up about 60% through an economic downturn; the bad news is that it's unclear whether we've reached that point quite yet, and Sonders is understandably worried about the "deleveraging" of both the financial system and consumer's dependence on debt.

While fairly dour about the current environment or the likelihood of a turnaround in housing anytime soon, Sonders is optimistic the U.S. economy won't suffer a "lost decade" (or more), akin to Japan's post-bubble malaise. Her view is fueled, in part, by confidence that while our policymakers are far from perfect, they've been much more proactive in tackling the current crisis than Japan's were in the 1990s.

I am not sure if stock market is still a leading indicator. If the recession is already "priced into" stocks, why do investors react after some lousy economic or earnings report? To be sure, earnings expectations remain lofty, but analysts are always the last to adjust their expectations.

Now, if it is going to be a deep and protracted recession, then you would expect commercial real estate to tank:

Commercial real estate has been strangely impervious to the housing crash, but its luck is about to run out. Economists and industry analysts say the recession and credit crunch pretty much ensure a bad year for commercial real estate in 2009, and at best a tepid recovery in 2010.

Any doubt about insiders' gloominess was erased on Oct. 21, when the Urban Land Institute and PricewaterhouseCoopers issued the 30th annual Emerging Trends report, which is based on surveys or interviews with more than 700 investors, developers, lenders, and other experts.

The report predicts that returns for private equity investors are likely to be negative in 2009 for the first time since the sector's severe downturn in 1991-92. In 2010, the experts interviewed for the study predict "a slow recovery, hampered by risk aversion, constricted financing sources, and a weakened economy."

...

In other commercial real estate news on Oct. 21, Moody's Investors Service (MCO) announced that commercial real estate prices fell 0.1% from July to August. In a statement, Moody's Managing Director Nick Levidy said, "Although we have not seen a significant decline in prices since June, we believe it is premature to call a bottom at this time." He added: "Rather, the low transaction volume suggests that the flattening of prices is more likely the result of loss avoidance on the part of sellers."


And there are plenty of pension funds out there holding billions in private real estate portfolios that are doing everything they can to avoid losses. Some pension funds do not need to sell their real estate holdings, but as prices start tanking, it will be difficult for them to ascribe generous valuations on these private investments.

In fact, if an avalanche of selling occurs in commercial real estate, most pension funds will suffer serious losses as they mark down their private real estate portfolios.

Amazingly, according to the consulting firm Preqin, private equity real estate fund raising defied slumping property markets in the third quarter, as investors hoped for cheap property buying opportunities in coming years:

Preqin, which produces data on private equity, hedge funds and other parts of the financial sector, said $30.8 billion was raised in aggregate globally in the third quarter, down only slightly from $32.4 billion in the second quarter.

But Preqin said investors were more likely to commit to larger funds with proven strategies than smaller, unproven rivals charging the same level of management fees.

"Investor appetite for private equity real estate funds still remains at a high level, but these investors are becoming much more cautious in terms of where they place their money," said Preqin spokesman Ignatius Fogarty in a statement.

The number of funds reaching final close dipped to 32 from 41, leaving a total number of 378 funds still seeking an aggregate $243 billion, up from 273 funds seeking $127 billion as recently as January this year.

"In the current economic climate, many smaller firms could find market conditions too challenging, and it is likely that we will see firms putting their funds on hold until the market becomes more settled," Fogarty said.

I would add that in the current economic environment, many large firms will find it equally challenging to deliver returns in real estate.

What worries me is that pension funds keep plowing billions into private equity real estate without any proper assessment of the risks attached to these investments given where we are in the current cycle.

I guess they prefer stale pricing, hoping they can get away with generous valuations which defy logic. But if you ask me, "alternative accounting" in private equity real estate is about to get a rude awakening.

***Update:

I noticed that the Ultashort Real Estate ETF (SRS) spiked to a two year high recently. This is a way to play the downside of real estate but it is highly volatile given that it increases by twice the amount that real estate stocks fall.

I had recommended it when it fell near $80. The way to play this leveraged ETF is to wait for it to come down again below its 50-day m.a. and then buy it for another pop. Be pateint and nimble with these leveraged ETFs - you can make a lot but lose a lot too.

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