I’m usually pretty good when it comes to eating.
For lunch, I bring stuff like low-calorie, low-fat frozen meals, fresh fruit, and yogurt, instead of buying burgers and fries in the cafeteria.
And when we cook dinner, we make main dishes with lower-fat ground turkey or chicken breasts instead of ground beef.
But when I’m on a cruise ship (like I was recently), look out! My eyes just get too big for my stomach.
My wife, Stacey, tries to gently nudge me in the right direction, saying things like “Honey, are you sure you want to eat that?†I love her for that. Of course, her warnings fall on deaf ears.
The reason I bring this up: I think a whole lot of mainstream investors will soon be suffering from their own brand of financial indigestion.
They binged on the housing sector last year, and they’re paying for it now.
And this year, they’ve been gobbling up REITs and commercial real estate property. I think the end results might be enough to turn your stomach …
Warning Signs Are
Flashing Red on REITs
I want you to take a look at this chart of the iShares Dow Jones U.S. Real Estate Index Fund (IYR). This exchange-traded fund holds shares in major U.S. Real Estate Investment Trusts (REITs).
Just three of the companies in the fund: Mall operator Simon Property Group (SPG), office building owner Vornado Realty Trust (VNO), and industrial REIT Prologis (PLD).
You can see that the ETF has surged from a low of about $35 in 2002 to $80 a share.
There’s no question that some of that gain stemmed from an improvement in the fundamentals: We’ve seen strong global economic growth, slumping unemployment, rising rents, and tighter occupancy rates.
But that’s in the past. Now, several forces are aligning that could lead to the end of this fantastic run.
Take job growth. It’s been slumping for several months now. So is the U.S. economy. That will translate into less demand for office space … and stem the rise in office rents that propelled office REIT shares higher.
Retail? We’re seeing consumer spending cool and retail sales tail off. That doesn’t bode well for mall rents.
And what about apartments? The housing boom actually helped that sector. First, so many people were priced out of homes that they were forced to rent instead of buy. That boosted demand. Then, thousands of apartment complex units were converted into condominiums at the tail end of the boom. That tightened supply.
But supply is exploding now. Flippers are renting out single-family homes and condos they can’t sell. And many of those apartment-to-condo conversions are being re-converted into apartments because the units didn’t sell. One conversion complex just down the street from my house, in fact, threw in the towel on the condo sales approach in just a few weeks.
In short, you’ve got a fundamental picture that’s deteriorating. On top of that, you have many REITs trading at valuations that are absolutely bonkers. Three examples:
- Simon Property’s shares are selling for a grossly overvalued 57.7 times earnings. That’s more than triple the S&P 500’s 17.3 times earnings. Worse, Simon’s indicated dividend yield is just 3.32%. That’s an incredible 1.4 percentage points less than the yield available on a risk-free 10-year Treasury Note.
- Prologis’ indicated yield is even worse — 2.82%, based on the stock’s recent price. That’s almost the lowest in history. Compare that to the situation back in 2001, when the stock was yielding 7%!
- Vornado’s overvaluation is the worst in eight years. Like many REITs, the company also reports a figure called funds from operations (FFO). This is a “core†profitability figure adjusted for various REIT-specific costs. Vornado’s FFO rose only about 6% year-over-year in the most recent quarter, but its share price surged more than 21%, or over three times more. That’s way overblown.
All this leaves me wondering …
Why Doesn’t Anyone Care
About Valuations Anymore?
Remember what happened in residential real estate? The boom started out healthy, but then it took on a life of its own. Eventually, it morphed into an all-out bubble — one that’s now in the process of bursting.
Now, the same thing is happening in the commercial sector. As I’ve just shown you, surging valuations in the commercial real estate sector are coinciding with a deterioration in the underlying fundamentals. But why?
My answer: The Fed’s easy money policy. Not only does easy money help inflate obvious, tangible things, like the price of consumer goods and services … it also inflates asset values far beyond any reasonable level.
In this case, a virtual 100-year flood of money has poured into commercial real estate investments:
- Private real estate equity funds bought $14 billion worth of U.S. REITs this year. That’s up 15-fold from 2004, according to the Financial Times.
- A recent Jones Lang LaSalle report says global investment in real estate is poised to surge 26% to $600 billion this year.
- Office buildings, warehouses, hotels, and malls are being bought and sold at ever-increasing prices and ever-declining capitalization rates (a measure of how profitable these buildings are).
What are investors thinking? That the buffet will never close? That they can stuff their portfolios with fat and never suffer the consequences? That the Fed will loosen its belt and allow still more room for rising asset values?
Those don’t seem like good bets to me. I know a lot of income-seeking investors have piled into REITs. I know these investments look tempting, given the recent price gains. And I know I’m in the minority here. A lot of pundits have been praising commercial real estate property and commercial real estate shares as a “safe haven,†even as the residential real estate market goes to pot.
But with the fundamentals going soft … valuations at pie-in-the-sky levels … and a veritable feeding frenzy going on in the sector, I think a nasty bout of indigestion could be coming, and soon.
If you’re hip-deep in commercial real estate holdings, this may be a good time to step away from the table and call it a day. Right now, there are still plenty of voracious buyers out there looking for risky real estate plays. I say let them eat all they want. Sell some of your holdings while you can. The gluttons will be the ones who end up reaching for the Pepto-Bismol when it’s all said and done.
Until next time,
Mike
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