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REITs... A Thing to Avoid |
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Markets rally...but not on underlying economics,
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The best short-selling opportunities in the REIT sector,
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Plus, Bill Bonner on the jobless "recovery," and other unsolved
mysteries...
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Eric Fry, reporting from Laguna Beach, California...
Occasionally, it's a great idea to pay top dollar for a hotel room... But
it's almost never a great idea to pay top dollar for a hotel REIT.
"Real estate investment trusts are still priced at bubble valuations,"
insists Dan Amoss, the analytical mind behind the Strategic Short
Report. "These valuations bear little connection to economic reality.
"2009 was the year that the REIT sector bought itself some time by selling
lots of bonds and stock to the public as the financial markets recovered,"
Amoss explains. "Investment bankers worked overtime to promote these deals
to their institutional clients. Robert W. Baird's real estate research
team estimates that REITs raised $17 billion in equity from secondary
market offerings in 2009. But that wasn't enough capital for the most
highly levered REITs, which remain at risk of bankruptcy in a double-dip
economy.
"These levered REITs still need much more capital to repair their balance
sheets," says Amoss. "Baird estimates that another $26 billion in new
equity needs to be raised over the next few years. But it's doubtful that
REITs will be able to raise that kind of money anywhere near current
prices...or at any prices. So 2010 may be the year that REIT promoters run
out of greater fools to buy secondary stock offerings at bubble
valuations."
REIT valuations are stretched, Amoss argues, even though fundamental
trends in commercial real estate are grim. "Deflationary forces in
commercial real estate will continue to weigh on REIT valuations in 2010,"
Amoss predicts. "In cases where lenders can no longer 'extend and
pretend,' we'll see properties repossessed and sold at fire-sale prices to
vulture buyers. Supply will far exceed demand in most geographies and
property types, so rents and REIT profits will remain under pressure."
Net-net, if you are going to be any kind of fool at all, Amoss advises, be
the kind of fool who buys a crazy-expensive hotel room for a night, rather
than the kind of fool who buys a crazy-expensive hotel REIT.
Admittedly, no automatic correlation exists between the price of a hotel
room and the delights that hotel room nourishes. For example, the one-star
Jolly Roger Motel in Santa Monica, California could easily produce a
5-star memory. (In fact, it did). On the other hand, the upscale Casa Del
Mar Hotel that sits right on the sands of Santa Monica beach could easily
produce a 5-star nightmare. (In fact, it did).
Let's not blame the Casa Del Mar; but your editor would have preferred a
night in a cardboard box anywhere outside the hotel to the "getaway" he
experienced inside the hotel. An oceanfront balcony and
800-thread- count Egyptian cotton sheets are simply no match for an
enraged lover with a wine glass full of pricey cabernet.
And so what? Even in the worst of outcomes, the overpaying hotel guest
would have dropped $600 for a miserable night and a great breakfast
buffet. There are worse things in life.
The pricey hotel room, like a call option, never costs more than the
initial "premium." But like a call option, the hotel room merely offers
the promise of potential reward...not a guarantee. So if things go wrong,
blame your companion...not the Egyptian cotton sheets.
By contrast, if you overpay for a hotel REIT, you have only yourself to
blame, as Dan Amoss explains in today's edition of The Daily Reckoning.
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The Daily Reckoning
Presents: |
In today's essay, Strategic Short Report editor, Dan Amoss,
shares with us some of his insights on the crippled fundamentals of the
REIT market...including one sector that might just be ready to pop...
REITs... A Thing to Avoid<
By Dan Amoss
Jacobus, Pennsylvania
The commercial real estate crisis may be the most anticipated crisis in
history. But just because it's widely anticipated doesn't mean that the
crisis won't be destructive for REIT shares. Since most REITs are richly
valued, the slow-moving commercial real estate crisis will ensure that
future returns disappoint.
Consider the valuation of REITs versus the S&P 500, which itself is
overvalued. Despite being 25% below its late 2007 peak, the US stock
market - measured by the S&P 500 index - is very expensive. The "Shiller
P/E ratio," developed by Yale professor Robert Shiller, measures the S&P
500 against the average S&P 500 earnings over the previous 10 years,
adjusted for inflation. It's a much more robust measure of valuation,
considering the fluctuation of corporate earnings, and the fact that after
bubbles, much of the earnings booked during the boom are written off
during the bust. Consider that the earnings booked by Citigroup and other
big banks near the peak of the bubble were largely written off during the
bust. Therefore, a 10-year average of earnings is a better indicator of
true earnings.
The Shiller P/E ratio for the S&P 500 Index is now 21 - up dramatically
from 13 at the March 2009 lows. This 21 P/E is higher than at almost any
point in stock market history, outside of the late 1920s bubble, the late
1990s bubble, and the market peak in 2007. The S&P 500 is overvalued based
on the Shiller P/E, but corporate earnings are supposedly going to soar in
2010, right? Well, even if you believe the optimistic 2010 estimates, the
market is still more than fully valued on that metric.
Ditto REITs.
Commercial real estate - and the REITs that hold commercial properties -
began to deflate rapidly in late 2008. But the Fed stepped in with bailout
funds and easy money to halt the deflation...and even pumped the bubble
back up a bit. The nearby chart shows the results of the Fed's handwork.
REITs of all shapes and sizes more than doubled off the stock market lows
of last March, while the Bloomberg Hotel REIT Index more than tripled.
(We'll come back to this chart a little later).
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This rally has the look and feel of a dead-cat bounce, which means that it
provides an attractive short-selling entry point.
REITs soared as the bubble inflated from 2000-2007, then crashed when the
bubble popped in 2008 and early 2009, and then launched a dead cat bounce
when the Fed flooded the system in mid-2009 with massive injections of
liquidity and cheap credit. Now REITs are priced at bubble valuations -
valuations that bear little resemblance to economic reality.
This bounce has postponed a healthy purge of assets in which old
capital invested by foolish speculators during the bubble would have been
wiped out - clearing the way for new owners to assume title to real estate
at reasonable prices. When central banks prop up deflating
bubbles with super-easy bailout cash, the bubble investors don't liquidate
their overly inflated assets. They hang on and hope for a turnaround.
But bubbles always deflate...always. Government intervention merely
muffles the hissing sound for a while. This story played out in the
Japanese real estate bubble that peaked in 1990, and it's happening with
the US commercial real estate bubble that peaked in 2007. Capital becomes
trapped in a dead asset class, thereby stretching the bubble's resolution
out over decades.
Toward the end of 2009, it became clear that "extend and pretend" had
become the official policy at most banks that hold commercial mortgages.
We won't see a cleansing flush of hundreds of billions in underwater
properties changing hands to new owners. Instead, properties will be
dribbled out of the foreclosure pipeline at a slow pace. This measured
pace of foreclosures will add to the chronic glut of property that will be
quickly listed for sale into any bounce in demand.
Some of the best short-selling opportunities in the REIT sector may be in
the hotel REIT sub-sector.
It's not a stretch to expect the hotel business will be ugly for a long
time. Corporate and leisure travel is in the midst of a depression. And
leveraged hotel owners built or acquired too many hotels near the peak of
the commercial real estate bubble.
Now many hotel owners are desperate to generate cash in order to pay down
debt and retain titles to properties. Some are slashing nightly room rates
below break-even levels. You know from the growth of Internet hotel
booking services just how much more competitive and transparent hotel
pricing has become over the past decade. Unless competitors are willing to
match the pricing of the most desperate hotel owners, healthier
competitors will suffer lower occupancy.
Some levered hotel owners, like Sunstone Hotel Investors, are abandoning
their equity in some properties to salvage others. In the fourth quarter
of 2009, Sunstone defaulted on several nonrecourse mortgages held against
13 of its properties and turned the title over to its lenders. Sunstone
calls this a "deed-back," but it's really a strategic default.
Sunstone's lenders will probably keep and operate the hotels, rather than
dump them at a distressed price. The behavior of Sunstone and its lenders
shows how many hotel owners and lenders are putting off the necessary
liquidation of underwater properties with bloated cost structures. The
industry still needs to make more progress on downsizing, slashing
operating costs, shrinking mortgage sizes, and lowering room rates to
match demand. Until it does, the industry's returns on capital will not
consistently exceed its cost of capital.
Hotel REITs are highly sensitive to perceptions about the near-term health
of the hotel business. Trends in occupancy and room rates shape
perceptions about earnings. Hotel REITs own portfolios of hotels and
outsource the management to companies like Marriott for a fee.
Because of the relatively fixed costs of paying management companies a fee
for operating hotels, Hotel REITs operate with high operating leverage: A
20-30% decline in revenues can translate into a 50-75% decline in
operating income. Also, unlike offices or retail REITs with sticky
long-term leases, the cash flow for hotel REITs adjusts quickly to
changing conditions on a day-by-day basis.
Over the past nine months, hotel REITs have soared on the perception that
corporate and leisure travel will rebound strongly in 2010 and 2011.
Analysts have forecast a sharp rebound in earnings.
But I'm not buying it. In fact, I'm selling it.
Regards,
Dan Amoss
for The Daily Reckoning
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And now to Bill Bonner, who has today's reckoning from Baltimore,
Maryland...
What a marvelous recovery! But there are so many unresolved mysteries! GDP
growth over 5%...but, mysteriously, no jobs...and no rally in the housing
market.
And now, to compound the mystery, Mr. Obama has come forward with a $3.8
trillion budget.
The markets like it. Stocks rose 118 points on the Dow yesterday. Gold
went up $21. Investors see more hot money on its way...a Vesuvius of it...
The amount of the budget itself is staggering. That's a lot of money. But
even more staggering is the glaring omission: the Obama administration is
planning to spend $1.6 trillion it doesn't have. And that's on top of the
$1.35 trillion it didn't have, but nevertheless spent, last year. Where is
all this money coming from? Another mystery...
Let's see...put those two deficits together and you've got a budget hole
as big as the Milky Way... Nearly $3 trillion, or more than 20% of GDP.
Another thing that is mysterious about this galaxy of debt is that it
comes just as the economy is supposed to be recovering. If you thought the
economy were recovering, why would you risk such a huge, record-
shattering deficit?
Nothing quite adds up. The GDP is expanding at a healthy pace - according
to the numbers handed out by the feds. But people have few jobs and little
income.
"Wage and benefit growth hits historic low," reports The Wall Street
Journal.
Employers aren't employing. Workers aren't working. And houses are no
longer throwing off cash. That leaves more and more people with empty
pockets.
Apparently, not even the feds themselves believe the economy is really out
of the ditch. We are already rolling along on the recovery road -
supposedly. Still, the feds send out the most expensive tow truck in
history!
And now The Financial Times draws the obvious conclusion:
"US Deflation No Longer Seen as a Risk."
You wanna bet?
The world's number one economy is running huge deficits. But the world's
number two economy is running even bigger ones. Not much bigger...but
slightly bigger.
In Japan, deficits are a bit larger than tax receipts. In America, they
are a bit smaller. In both cases they are enormous...and growing.
For all its colossal deficits, Japan has not bought its way out of
depression...or out of deflation either. Au contraire, the more it spends
fighting deflation the further prices fall.
How could this be? Another mystery. How could government be so inept as to
shoot itself in the foot whenever it pulls a trigger? How could it be so
near-sighted as to aim for one thing and hit the thing it was meant to
protect? How could it be so lame-brained as to do exactly the wrong thing
at exactly the wrong time?
We can't answer those questions...at least, not this minute.
So, let's turn to the evidence. There it is in yesterday's news report
from Bloomberg:
"Consumer prices in Japan in record fall."
And there you have another mystery, don't you? Japan inflates the money
supply with its zero rates over more than a decade...and its Godzilla
budget deficits. And what happens? Its economy sinks and its consumer
prices go down!
And so here comes the US of A following the Japanese lead...in the
sincerest form of flattery...
Will it not get the same results?
We don't know. But we wouldn't be surprised.
We have a lot more to say about this...
..about how the economic theories behind these moves are corrupt, linear
and superficial (if not downright stupid)...
..and about how the real driving force behind these deficits is politics,
not economics. Economists are just useful idiots. The politicians are
using them to grab more money and power for themselves and their
friends...
..but let's go directly to the denouement of this mystery story. Here's
what is really going on:
First, the GDP growth story is one part statistical noise, one part
counterfeit, and one part damned lie. We're in a depression. It will take
years to resolve itself.
That's why unemployment remains high...and why there will be no recovery
in housing prices. They may go up. They may go down. They won't ever get
back to the bubble highs of 2006 - not in real terms. Not in our
lifetimes.
Second, the mystery of the $1.8 trillion deficit - it too is a mixture of
mendacity, audacity, and intellectual laxity. In short, the feds are
spending so much money for one reason only: because they think they can
get away with it.
Can they?
Of course not...not really. Here's what is going to happen...
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And our thoughts continue:
The reality of the non-recovery is going to catch up with this market.
Stocks were down in January. Most likely, they'll sink for the rest of the
year too.
The economy will slide as the de-leveraging process continues. It won't be
straight down. But by fits and starts, the mistakes will be corrected...
..but that brings us back to this $3.8 trillion government budget. Its
purpose, in large part, is to prevent the corrections from occurring. The
feds will try to turn the US into Zombieland, just like the Japanese feds
did. You'll see massive federal spending taking up some of the slack from
the private sector - but essentially wasting money on useless projects.
And you'll see major zombie corporations - GM...AIG...etc - propped up
with taxpayer's money.
Speaking of AIG, special agent Neil Barofsky is on the case. He's
'probing' 25 cases of possible fraud involving TARP funds. The AIG bailout
is one of them. The original price tag for saving Goldman's speculative
positions with AIG was $85 billion. The whole tab later came to $182
billion.
The flatfoot Barofsky wants to know where the money went. To tell you the
truth, we're curious too - although we doubt there will be any surprises.
But back on our beat...how the mysteries get resolved...
..we know why the economy is winding down...and we know why the feds are
running such huge deficits...
..but big deficits aren't pushing up prices in Tokyo; they're having the
opposite effect. They're pushing them down. Does that mean US deficits
will get the same results - the economy and prices lower instead of
higher?
We don't know...but our guess is that 'yes' is the right answer. More on
this later in the week.
"I'm glad you're home, darling," said Elizabeth when we got back to the
house on Saturday.
"I kept having to call the landlord...
"I called him first because there was a leak in the basement...and then
because the fire alarm went off and I couldn't figure out how to turn it
off. And then, calling him just got to be a habit, I guess...because you
weren't here...
"So when I got stuck in the snow, I didn't know who to call. So I called
him. And he came right over with a couple Latin Americans. They helped
push me out of the snow...
"And then, I got my finger stuck in the corkscrew. I know this sounds
silly. But I was opening a bottle of wine and a bit of my skin got caught
in the mechanism... And the more I tried to get it out, the more stuck it
became...
"What could I do? It wasn't an emergency...I couldn't go to the emergency
ward... Or, I guess I could have gone to the hardware store...or maybe to
the kitchen appliances department...
"I didn't know who to call, so I called the landlord... I guess I've come
to depend on him..."
"Sounds like I got back just in time..."
Regards,
Bill Bonner,
for The Daily Reckoning
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Here at The Daily Reckoning, we value your questions and
comments. If you would like to send us a few thoughts of your own, please
address them to your managing editor at
joel@dailyreckoning.com
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