Wealth Building Lessons

I’ve been under the impression that after the collapse of the residential real estate market, the commercial real estate market will follow.
My assumption is three fold:
1. Unemployment is much higher than is being reported.
2. Consumer spending will drastically slow down.
3. There will be a credit crunch regarding mortgages for commercial lending

The official unemployment numbers for January 2008 is 4.9%. However, this includes people who aren’t trying hard enough to find work or who, being dissatisfied with what they see have given up looking for jobs. If you ask me, they’re still unemployed and ought to count in official figure. If you expand the definition to include “total unemployed, plus all marginally attached workersk plus total employed part time for economic reasons, as a percent of the civilian labor force plus all marginally attached workers“, we get 9% for the same period. By the time the official number is 6.5%, the unofficial number may be closer to 14.5%.

It seems logical that high unemployment will be bad for commercial real estate, including office buildings, apartment buildings and malls. Local neighborhood strip malls which have grocery stores, liquor stores, a 7-11 and a barber should be relatively unaffected because people need basic food and services. But everything else should suffer.

The US economy is highly dependent on consumer spending. The average American saves only 2% of his income and has been refinancing his house every 2 years to buy fancy stuff and fuel the economy. Since there’s no more of that going on, consumer spending is bound to decrease sharply. I’m on the mailing lists for Best Buy, Circuit and several other big stores. Since last Thanksgiving the volume of their emails and sales and discount coupons has increased dramatically. Even Costco has doubled its emails in the past few months. I think they’re either seeing a drop in sales and/or anticipating a further drop and are desperate to get people in the store to buy nice big TVs and PS3s.

A drop in consumer spending should affect large malls especially badly. Mall owners typically earn a percentage of the stores gross receipts. A drop in that figure can hurt both the stores bottom line as well as the mall owners. Also, theres a chance that stores may file bankruptcy or may chose not to renew their leases. REITs that own malls will start to suffer when this happens.

However, based on the performance of REITs over the past few weeks, you wouldn’t think there was anything wrong. Looking at the chart of Simon Property Group (SPG) over the past few months, we see it hit a low of around $75 in late January. Since then the Fed had to orchestrate a bail-out of Bear Stearns but it still managed to rally to around $100 (that’s a 33% jump) in the first week of April.

I chose SPG because its one of the largest REITs and 24% of its earnings come from malls in California and Florida, 2 of the states most affected by the subprime crisis and having amongst the largest number of foreclosures and home price drops.

It also seems that the Federal Reserve is going to provide ample credit for all mortgage companies and financial institutions. So my 3rd argument is no longer valid.

Based on these events, investors might be willing to believe that the market has priced in all the negative action and now is a good time to buy SPG (and other REITs). After all, the management did increase the dividend recently, its off its highs of about $120 that it hit in early 2007, and it is rallying in the face of terrible economic news.

Somehow I’m still suspicious of this rally. Looking at the long term weekly chart, it looks like SPG has tried to break it previous high repeatedly and failed. Each time it makes a lower high and a lower low. This is could be a sucker rally and its headed back down again in the long term.

However, I’d like some sort of external confirmation of what I’m seeing, preferably using same different data. What I found was pretty interesting. Stock newsletter editor Tom Dyson has an interesting theory on when to buy REITs:

Real estate investment trusts (REITs) are huge portfolios of real estate that trade just like stocks on the major exchanges. They own about 15% of the commercial property in the United States. With the low occupancy rates in my town’s commercial property market, I wondered if there might be any good bargains in the REIT sector yet.

The key to making huge, safe gains in REITs comes down to one question. Investors have to ask themselves:

“How much more in dividend payments can I earn in REITs than I can by just placing my money in a risk-free 10-year U.S. Treasury note?”

You see, REITs can become over- and undervalued, just like stocks and private real estate can…

For example, back in 2001, investors didn’t care for REITs at all. They just wanted another hot tech stock. REITs as a group were paying dividends of 8.3%, while Treasury notes were only paying 3%. The “spread” between the two assets was huge. Investors had a big incentive to get their money out of risk-free Treasuries and into riskier REITs.

REITs gained more than 250% over the next six years as investors chased the higher yields. Of course, the huge real estate boom that got going in 2003 helped, but you get the idea: When REITs offer high yields versus risk-free Treasury notes, you make a fortune in REITs.

Now… before you get too excited about the possible gains here, remember that REITs can also go the other way… They can become highly overvalued. For instance, in 2007, REITs – which carry the risk of land ownership and stock market volatility – were yielding less than risk-free Treasury bonds.

When REITs are yielding less than safe bonds, you want to lighten – or even eliminate – your REIT holdings…. After REITs reached such low yields in 2007, they fell more than 40% in 10 months. This kind of fall is hardly cushioned by 6% dividend yields.

Bottom line: We want to be heavy buyers of REITs when they offer high yields relative to safe bonds, and we want to lighten up or even avoid them when they offer low yields relative to bonds.

Right now, the Treasury note yields 3.53%. And the National Association of Real Estate Income Trusts Equity REIT index yields 4.99%. The spread is 1.46%.

Below, you’ll see a chart showing historical REIT performance in the top pane, and the historical spread between REIT yields and Treasury yields in the bottom pane. (We used NAREIT’s equity REIT index to find performance and yield for the REIT sector.)

As you can see, when REIT yields are 2%-3% greater than 10-year Treasury notes (like they were in 2001-2003), REITs are a great deal. When REIT yields are less than those offered by Treasury notes (like they were in 1997 and 2007), it’s a sign to exit REITs.

The low occupancy rates in my town tell me must be getting close to bargain territory in commercial real estate. But with a spread of 1.46% over Treasury notes, we’re not there yet. Wait for a 3% spread… and then start buying.

Quite a useful piece of information. Whenever the spread between the T-bills and REITs are 3%, its time to buy! Not sure how historically accurate it is since it only goes back 15 years, but it definitely makes sense.

Even though I do know that the Federal Reserve is going to bail out Fannie Mae, Freddie Mac and any bank that goes under, I’m still skittish about investing in the financial sector. It’s certain that there won’t be a credit crunch in the near future, and most likely real estate and financials will do well over the next few months. However, I’ll stick to my original hypothesis and skip investing in commercial real estate for now.

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