An early heads up on another important real estate trend!

You want to know how to make big money in the markets? Be early.

By picking up on a trend in its infancy, you’re able to position your portfolio for the day when that trend explodes onto the front pages of the nation’s business sections. Then, when mainstream investors pile in, you’ll be there to sell to them.

The same goes for protecting yourself from suffering big losses. If everyone around you is losing their minds and buying everything in sight, but you perceive that conditions are starting to change, you don’t want to wait. You want to sell with both hands and squirrel away your cash. Then, when the mainstream guys finally see what you saw months earlier and sell in a panic, you’ll be ready to jump in and scoop up the bargains of a lifetime!

Now, it’s not always easy to stay ahead of the crowd. You can be too early. Other times, you may spot what appears to be a trend only to find out you were wrong.

But sometimes, all the signposts are there â€¦ and based on the risk-reward trade-off â€¦ it’s far better to be early than late. I believe now may be one of those times.

My call: Jump off the REIT bandwagon, Here’s why â€¦

Real Estate Investment Trusts
Go from Leaders to Laggards

Real estate investment trusts, or REITs, are like corporate landlords. They own and operate all kinds of properties, such as apartment buildings, office property, shopping malls, and industrial warehouses. They take the income generated from rents and pay out most of it in the form of dividends to shareholders.

Over the past few years, REITs have been stellar investments. Indeed, the commercial REITs kicked the snot out of the Dow Jones Industrial Average. Let’s compare the iShares Dow Jones U.S. Real Estate Index Fund (IYR), an exchange-traded fund that holds shares of major REITs, against the Diamonds Trust (DIA), an ETF that owns the Dow stocks:

In 2006, the IYR returned almost 30% vs. 16% for the DIA.
In 2005, the IYR was up 4% while the Dow ETF was down 0.5%.
In 2004, real estate was up 24% vs. a measly 3% gain for the DIA.

And REITs really outperformed once you factor in dividend reinvestment! The IYR delivered a total return of 166% between the beginning of 2003 and this week (including reinvested dividends). A comparable investment in the DIA would have handed you 72%, less than half the return.

But the times they are a-changing. The DIA has gained almost 7% so far this year (through May 2). Meanwhile, the IYR has posted only a 3% increase over the same period.

The divergence looks even more dramatic if you measure from the market’s recent low on March 13. The Dow is up almost 10%, while the real estate index has budged just 1.8%.

Now, it’s possible that this is just an unimportant blip. But I think it’s something much more â€” a sea change in market sentiment (and thus future returns). After all, I see â€¦

Five Fundamental Forces that
Signal a Turning Tide for REITs

First, we’ve been experiencing a wild bout of commercial real estate takeovers recently. If you thought individual investors lost their minds flipping town houses and condos a couple years ago, you should see what the big-money commercial guys are doing these days.

Take the Blackstone Group. The private equity firm bought Equity Office Properties, a large REIT, earlier this year for $39 billion. Within a few weeks, it turned around and sold many of the buildings it had just bought for more than $22 billion. Bloomberg estimated the profit from this colossal “flip” at $2 billion.

That’s not the kind of thing you see in the early stages of a boom. It’s what you see at the tail end of a bubble.

Second, the valuations of commercial properties are getting absurd. Why? Investment banks, pension funds, and other investors flush with cash are paying an arm, a leg, and maybe even a torso or two on building purchases. Prices on some Manhattan buys have surpassed the $1,000-per-square foot threshold.

One common valuation measure for commercial property is the capitalization rate, or “cap” rate. You compute it by dividing the net operating income a property throws off by its purchase price. Cap rates are plunging as prices soar, a sign commercial property is being richly valued. That, in turn, is a major red flag!

Third, the valuations of REIT shares are in nosebleed territory. Just check out the dividend yields on some of these stocks. Several of these alleged “income” investments sport yields two full percentage points â€” or more â€” below the interest rate on three-month Treasury bills. Others are yielding the least in history!

Fourth, lenders are doing the same dumb things with commercial mortgages that they did with residential mortgages! Just this week, the New York Times ran an article titled “A Warning on Risk in Commercial Mortgages.” It said â€¦

“Low interest rates and an abundance of investment capital have led to heady times for buyers and sellers of office buildings, hotels and other income-producing property. Buildings have traded at record prices and loan terms have become increasingly generous, with many buyers putting little or no equity into the deals.”

The story goes on to talk about how ratings agencies that grade bonds backed by pools of commercial mortgages are seeing several warning signs in commercial deals. Among them:

Lenders are handing out many more interest-only loans than in the past â€¦ building owners are making overly optimistic forecasts of future rent growth â€¦ and landlords aren’t setting aside large enough reserves for taxes, insurance, and other costs. Jim Duca, a Moody’s managing director, put it this way:

”Underwriting has gotten so frothy that we have to take a stand â€¦ The industry was heading to Niagara Falls.”

Am I the only one who thinks these guys must be dumber than a bag of hammers? I mean, residential mortgage defaults are soaring, residential foreclosures are skyrocketing, and residential subprime lenders are going out of business left and right because they made too many high-risk residential mortgages. Yet everyone’s assuming all these high-risk commercial mortgages will work out just fine!

Fifth, cracks are staring to appear in a key sub-sector of the REIT market â€” the multifamily, or apartment, industry.

Back in November, I told you that apartment fundamentals were weakening, due in part to the huge overhang of speculative housing inventory. Speculators snapped up homes, town homes, and condos during the housing bubble in the hopes of flipping them quickly for a profit. Now, they can’t sell, so they’re dumping them on the rental market. I said,

“Given their deteriorating fundamentals, multi-decade-high valuations, and paltry yields, now is not the time to pile into apartment REITs. In fact, I’d be looking for the exits.”

I upped the ante in early March, warning that “it’s getting easier to find an apartment these days, which means landlords are being forced to offer more concessions or reduce base rents to attract tenants.”

I wrapped up by saying, “The next big leg down could be fast approaching â€¦ if you’ve got a stake in this segment of the housing market, I urge you to act accordingly.”

Lo and behold, the Census Bureau just reported that the nation’s rental vacancy rate jumped to 10.1% in the first quarter of 2007. That was up from 9.5% a year earlier and only a touch shy of the all-time high (10.4%).

Lo and behold, companies like Equity Residential (EQR) are saying they’re seeing lots of “reversions” â€” apartments that were converted to condos turning back into apartments. That’s driving apartment supply and tenant competition higher.

And lo and behold, major apartment REITs are starting to break down. Look at AvalonBay Communities (AVB), which just reported disappointing first-quarter profits. The news caused the stock to plunge through its 200-day moving average on heavy volume. It’s the first time in this REIT’s mega-run, which began in early 2003.

What You Can Do Right Now,
Before This Trend
Hits the Mainstream

I’ve been saying for a while that we’ve had way too much excess money and credit floating around out there. It’s causing what I call a series of “rolling bubbles.” Residential real estate had its turn in 2001-2005 â€¦ and since about 2003, commercial real estate has been experiencing its own private mania.

But a turn may finally be at hand, for all the reasons I’ve just discussed. So â€¦

If you’re invested in apartment REITs, dump them now.

If you’re holding office or retail REITs, the fundamentals remain fairly strong. But as I’ve just shown you, valuations are at record highs while financing risk is through the roof. I’d pare back exposure, or think about getting out of these stocks altogether.

And if you’re feeling more aggressive, you can profit from a decline in REIT shares. One way is by using so-called “inverse” mutual funds and inverse exchange-traded funds (ETFs), which go UP in value when REITs go down.

I can’t discuss names here because it wouldn’t be fair to Safe Money Report‘s paying subscribers. But if you do your own research, you might turn up some interesting opportunities.

Keep in mind that buying one of these funds is risky. Moreover, this is still a nascent trend, not a definitive mega-turn in REIT shares. But if I’m truly onto something, and REIT fundamentals do deteriorate, those kinds of speculations will pay off handsomely. At the very least, they’ll help hedge any exposure you may have to commercial real estate investments.

Until next time,

Mike

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