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The Speculator
More evidence REITs are on the
brink
Loyalists rushed to the defense of real estate investment
trusts when we predicted a fall. That's just another sign they're
about to lose their shirts.
By Victor
Niederhoffer and Laurel Kenner
Real estate is fraught with paradoxes. Land is the
only thing that lasts -- but land prices are often boom or bust.
Just when developers and banks are most convinced that business
conditions are good enough to warrant expansion, it’s the perfect
time for contraction. And just when investors are most optimistic
about real estate securities, the peak is near.
The
psychological bias involved is called the recency effect. The
last few price levels and the last few changes are remembered much
too vividly. A related problem in decision-making is the human
proclivity for going along with the herd at exactly the time it
would be appropriate to stand alone.
Real estate decisions
take a relatively long time to reach the marketplace, and when they
do it is all too likely that conditions will be much worse. Rent
rates and demands tend to fall at the same time. Regrettably, these
negative factors are at maximum bearish levels at this very moment.
Office vacancy rates are heading to levels unseen since the late
1980s -- levels that were followed by bankruptcies, related bank
failures and dismal performance for real estate investment trusts
(REITs).
At year-end 2001, the national office vacancy rate
was 13.1%, up from 6.2% in the third quarter of 2000. A post-Sept.
11 report from Grubb & Ellis projects an increase to 15% by the
end of 2002. The one thing the report saw as certain: “The market
has shifted dramatically from 18 months ago.” Worse, a Feb. 13
report from PricewaterhouseCoopers predicts: “The majority of U.S.
real estate markets will remain in contraction, rather than
recession, in 2002 and through 2003…. Of the 3.5 billion square feet
in the office market, 3.3 billion square feet will be in contraction
or recession.” The firm predicts expansion and recovery “by the end
of 2003.”
Increasing vacancies are a crucial negative
signal. Evidence documented by PricewaterhouseCoopers, plus our own
statistical studies, suggest that REITs have historically done
poorly two years after a big gain, such as the 26% rise in
2000.
Taking down the
REITs
Our article last week was published at the all-time
high in the Morgan Stanley REIT index ($RMS.X)
and was followed the next day by the biggest decline in four months.
We were vilified like never before in our career. Some samples:
- “Your REIT article was the most poorly researched and
written article on this sector in the past eight years…. I’m not
alone in this view. I’ve spoken to 10 institutional clients this
morning who are all incredulous that this article saw the light of
day.” (Louis W. Taylor, senior real estate analyst, Deutsche
Bank Alex. Brown)
- “Victor, Victor, Victor… It was with horror that I read the
piece that you and Laurel wrote on REITs…. Your article belongs in
the trash compactor!” (Barry Vinocur, editor-in-chief, Realty
Stock Review and Property magazine)
The above is typical of
what we received from experts who know infinitely more about the
subject than we do. We also received a raft of critical comments
from what appeared to us to be more typical readers, such as this:
“It is people like you that create panic and people begin to sell. I
hope your poor judgment falls on deaf ears.”
The article
elicited some notice on the Motley Fool real estate message board,
where “fatuous” was a typical comment. Our credentials received
considerable negative scrutiny. It was noted with derision that
Laurel had been an aerospace reporter and that Vic had played
squash. “This guy is as bad a columnist as he was a hedge-fund
operator,” one critic wrote. We can only add that most of the
companies Laurel covered from 1989-1994 have been sold off, and that
the hardball squash game that Vic ruled for a decade is
extinct.
Even those who agreed with us had bones to pick. Ron
Kaiser, a principal of a major firm in this field, reviewed our work
and pointed out that we omitted “the single most impressive reason
for being bearish: REITs usually trade at about 20% below net asset
value, and they are currently closer to 100% of NAV.”
More
typical was the disagreement of William Wheaton, a principal in the
respected Torto Wheaton Research, a real estate consulting firm and
the source of the best statistics of office vacancies and
completions going back to 1967. He told us he believes that the real
estate markets are “really healthy” and that he expects an upturn
spurred by economic recovery in the middle of this year.
Jon
Fosheim, co-founder of Green Street Advisors, an independent
research house that produced a study we cited approvingly, also
found many areas of disagreement with us. Fosheim noted that while
REITs have had two very good years, they followed on the heels of
two years of underperformance, and that REITs have done about as
well as the S&P 500 Index ($INX)
over the past five- and 10-year time frames. He emphasized that
while his firm had indeed noted accounting hocus-pocus, as we
mentioned in our article, nothing suggests that REITs are any worse
in this area than other companies. His most important quarrel with
us was the contrary evidence provided by “the collective opinions of
thousands of investors on Main Street who risk their capital every
day buying and selling real estate. . . . We place high faith in
their opinions as to how to price REITs.”
The evidence on our side
And yet,
wethinks these experts doth protest too much. Purely by coincidence,
Monday’s lead Wall Street Journal article was titled “Commercial
Real Estate May Damp the Economy.” After reciting a litany of
negatives that made our own piece sound quite muted by comparison,
who should the Journal trot out to confirm the negative but Green
Street Advisors? “We haven’t seen the bottom,” Green Street analyst
John Lutzius told the Journal. “Quite a lot of jobs were lost in the
last quarter of 2001, and that may not be reflected yet in the
vacancy and rent statistics.”
Doubtless due to the shocking
nature of our bearish views at the top, Laurel was asked to defend
her position on the Money Matters radio show. Host Barry Armstrong
of the $2.5 billion New England Advisory Group said right off that
he has been telling people since 1997 to buy REITs. As a soporific,
the show’s detail man told Laurel he liked what we said about the
vacancy factor. “We are located in an office park. Two years ago you
would have to circle the parking lot forever to find a parking
space, or park in the overflow lot well over a football field away.
Today, you can park almost anywhere you like at any time of day.
Also, the ‘space for lease’ signs are popping up faster than the
crocuses.”
How many other office parks and office buildings
are experiencing similar ample areas for crocuses to
bloom?
A little too
defensive
The unanimous negative sentiment that an article
like ours elicits is all too typical of what happens when a market
is at its high. In fact, the reaction is an example of why the
public consistently loses over and over again much more money than
it has any right to lose. While we can look at this resistance to
even a whiff of pessimism at the top as a beautiful manifestation of
the necessary order that the market creates so that the public will
contribute the most to its upkeep, it is sad to see all these forces
once again coalescing to induce all too many to ruination.
It
was just in May 2001 that Forbes ran an article called “The
Buildings Everyone Knows.” The writer concluded that properties such
as Chicago’s Sears Tower, San Francisco’s Embarcadero Center, New
York’s Rockefeller Center and Boston’s Prudential Center are the
best places of all to be in real estate. Because of their prestige,
owners can count on businesses staying put regardless of economic
conditions.
But the Forbes article’s conclusion was exactly
opposite from the insights of all major economists who have studied
land cycles. Because the supply of land is fixed, in good conditions
prices soar to absorb a large part of the profit arising from
activities that take place on it -- be they agricultural,
manufacturing or financial. Ultimately, land costs take so much of
the profit that the farmer or businessman must close his doors. The
trophy properties that sit on limited and very expensive land are
thus exactly the ones that are bound to suffer most as demand for
space and negotiated prices fall.
Forbes recommended the
purchase of three “unsinkables”: TrizecHahn (TZH,
news,
msgs),
which is not a REIT but owns the Sears Tower; Boston
Properties (BXP,
news,
msgs),
owner of Prudential Center and Embarcadero Center; and Brookfield
Properties (BPO,
news,
msgs)
of Toronto, owner of three of the four buildings of New York’s World
Financial Center, overlooking Ground Zero. Strangely, despite the
obvious and unmentionable factor that would limit demand for such
trophy properties when lease renewals come up, Brookfield has risen
4.21% in price since the article appeared, while TrizecHahn and
Boston Properties are down a modest 8.4% and 3.63%, respectively.
Granted that the knowledge of the experts who have critiqued
us so severely is infinitely greater than ours, and that articles
such as the one in Forbes, written by authors who have not
specialized in squash or aerospace, are greeted at the top with much
more approval than ours elicited, we’ll sell those three stocks
short tomorrow (hedged, of course, with a long in the S&P 500
Index unit investment trust (SPY),
which trades on the American Stock Exchange.
Final note
Without in any way implying
that he agrees with what we say, we wish to thank Don Siskind for
his help with technical queries. Don is past president of the
American College of Real Estate Lawyers and a member of the advisory
board of the Real Estate Finance Journal. Don has participated in
many important transactions, including one of the largest real
estate combinations of all time, the $6.2 billion sale of Cadillac
Fairview to a syndicate led by JMB Realty in 1987. Acting in no way
connected with his firm or his legal capacity, Don has kindly agreed
to answer salient questions from our readers. Write to “Dear Dr.
Real Estate” c/o dciocca@bloomberg.net.
Our
much-ridiculed decision one week ago to get fully invested in stocks
looks a lot better now that the market is up 3% than it did a week
ago, when the S&P 500 was down 6% year to date. Along those
lines, many of the biotech stocks we recommended in accord with our
tested system, which yielded 50% annualized returns over the
previous five years, look just as bad to the public right now as the
REITs look good. Need we say more?
Just one more thing. We
reported last week that we had bought a large line of General
Electric (GE,
news,
msgs)
and said we would opine on it this week. Despite persistent efforts,
we have been unable to garner an interview with any of the important
people whom common sense would expect would make themselves
available. Just as soon as we can surmount the busy schedules
involved, we intend to report on the performance and growth of
General Electric over the last 100 years.
Send us your
comments, encomia or withering critiques, and we’ll send you our
updated biotech portfolio.
In our previous article, we
alluded to a Green Street Advisors report that concluded that
write-offs and charges aren’t being reflected in the funds from
operations of certain REITs. This tends to make financial results
appear better than they are. We fear that some REITs, especially
those highly leveraged, will not be able to maintain their current
dividend payouts in the weak real estate market that we foresee.
Many experts in the industry, however, including Barry Vinocur,
believe that a better measure of earnings coverage, called adjusted
funds from operations, indicates that most REITs have ample room for
dividend coverage.
At the time of publication, Victor
Niederhoffer and Laurel Kenner owned or controlled shares in the
following equities mentioned in this column: General
Electric.
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