Sunday, April 13, 2008

UltraShort Real Estate ETF: The Only Safe Haven for Commercial REITs

From Seeking Alpha:

"Your premium brand had better be delivering something special, or it's not going to get the business." - Warren Buffett

Inverse leveraged ETFs provide a great way to maximize returns in a challenging bear market. I would like to call attention to UltraShort Real Estate ProShares (SRS), an ETF which seeks to track twice, or 2x, the inverse of the underlying index of the Dow Jones Real Estate Index.

Among the top holdings which SRS seeks to short is Simon Property Group (NYSE:SPG), an Indiana based retail and mall developer. It currently has lofty valuations of 52x earnings. SPG is listed under the Forutne 500, and does have an admittedly quality management team which has guided SPG through other difficult times, including September 11th.

However, their success must also be attributed to the volumes of cheap credit which was able to fuel their expansion during the last seven years. Look at REITs, and their ability to grow from 1994 to 2001, which were essentially low single digit growth, in line with the rest of the economy and GDP expansion. Home builders follow a similar pattern as well, low, flat growth during the 1990's and a sudden explosion post 2001 with the availability of Greenspanian cheap credit. After soaring to high valuations, the time is ripe for large contraction in commercial real estate, which historically lags residential real estate by one year.

Such growth is clearly unsustainable. Solid mall tenants such as Gap (GPS) and American Eagle (AEO) all posted 10-20% declines in revenue. What about weaker mall tenants such as retail jewelry or Footlocker (FL)? Sharper image did not even make it past the 1st quarter of 2008. Retail is struggling and any plans for expansion will be put aside by retail store managers in exchange for improving existing operating efficiency. This expansionary growth is what fuels the REIT sector; the ability to make new deals upon new deals. What did the Fed estimate the damage to be? They reported that delinquencies on commercial real estate loans surged in the fourth quarter of 2007 to 2.71%. This is the highest level since the fourth quarter of 1996, and more than double the 2006's of 1.32%. I simply do not see retail tenets improving on their default rates in this especially difficult environment.

Even SPG management is decidedly cautious, where there is the "potential for modest increases in store closings and bankruptcies in 2008 over 2007 levels and generally flat retail sales." Analysts are cautious as well, according to Banc of America:

While the fourth-quarter beat is good news and long-term core fundamentals appear intact, we believe that given the current concerns about the consumer and potential for recession, the market could potentially [home in] on the 2008 guidance range.

Options traders are pricing in a large fall too. Large July options activity suggests that SPG can fall by 10%. Not an unreasonable estimate by any means.

Of course, if domestic expansion is slowing, the logical step would be look abroad. This is what SPG has recently done, looking east to Japan, by expanding a 390,000 sq foot premium shopping center, which seeks to cater domestic shoppers as well as international tourists. However, did they take any measure of consumer sentiment which according to the Bank of Japan is at a 5 year low? How are declining export dollars from Japan going to flow back into the Japanese salary men who will in turn buy Gucci or Dolce Gabbana?

Other large holdings of SRS include Vornado Reality Trust (NYSE: VNO), currently at 27x earnings, and Boston Properties Group (NYSE: BXP), at 42x forward earnings. The jury is still out these REITs which have a historically strong exposure to hot markets including New York City and Boston. With large predicted layoffs in the financial sector, these REITs are eventually going to have to write down their prime class A Manhattan properties currently valued anywhere from $60-$100 a sq/ft. balance sheets will take a hit, and their highly leveraged operations will halt in the expansion.

Sound familiar?

No comments: