REITs may appear cheap, but they are very dangerous to hold right now. A basic tenet of corporate finance is that a company or a sector is only creating value for shareholders if its return on invested capital (ROIC) exceeds its weighted average cost of capital (WACC). If its WACC exceeds its ROIC, it is destroying value. This describes the situation facing the REIT sector for the next few years.

Most REITs cannot float unsecured debt at anything less than 10% or 12%, so their cost of capital is high and rising. At the same time, due to the glut of supply in commercial real estate supply, and waning demand from stressed tenants, the returns on incremental investment in new capacity are very low — possibly negative.

Summing it all up: REITs will be destroying shareholder value until supply and demand for commercial real estate reaches equilibrium. The free market is screaming as loudly as it can that millions of square feet of capacity need to be absorbed or eliminated over the next several years in order for the surviving REITs to have a chance at generating respectable returns on capital.

This process has barely even begun, after the biggest lending binge in the history of commercial real estate. It will last a long time. The lending binge ensured that a large swathe of REITs will not make it to see the next commercial real estate up-cycle, which is still several years away at minimum. The title to many properties will go back to creditors in bankruptcy, and auctions will bring down asset values across the sector until they are cheap enough to earn respectable returns in a weak rental environment.

Another example of stress surfaced earlier this week. The auction to settle credit default swaps related to the General Growth Properties bankruptcy indicates serious pain to come for mall REIT owners: GGP’s senior loans effectively liquidated for 44 cents on the dollar! This means that lenders are demanding extreme discounts and high yields to hold debts secured by mall collateral. This isn’t good news for peers like Kimco (NYSE: KIM) and Simon Property Group (NYSE: SPG).

Another argument I’ve seen lately is that REITs will be a good inflation hedge if you buy them at these prices. This is an overly simplistic view of Fed-created inflation and its ultimate symptoms.

Fed Chairman Bernanke can debase the dollar all he wants, but most of the new dollars will act to push up the prices of goods and services in sectors with relatively tight capacity. Mostly, this translates into lower living standards for the average American — an echo of the 1970s, only without the real estate appreciation.

The Fed’s inflation will find its way into tangible assets like gold and silver, oil and gas, uranium ore, farmland, potash mines, and any other commodity China needs to import. Conversely, the fed’s inflation will NOT find its way into the pricing of American shopping malls, which arre in a condition of extreme oversupply.

Over time, the capacity to supply light, sweet oil to the global economy will be far tighter than the capacity to supply American retailers with real estate in malls. Demand for oil will be far more resilient than the U.S.-centric consensus expects, while demand for discretionary items — like “Color Fiend Neon Green Hair Spray” at Hot Topic (this product actually exists) — will fluctuate up and down, but generally head lower. Rising prices for several necessary goods and services will crowd out discretionary spending in many family budgets.

Inflation does not re-inflate old bubbles — especially in the case of residential and commercial real estate. It will only slow the previously violent deleveraging process.

On a related note, it was a breath of fresh air to hear Howard Davidowitz of Davidowitz & Associates interviewed on Bloomberg Radio recently. (You can find a link to download an mp3 of the 17-minute interview here). Davidowitz has decades of in-the-trenches experience in retail consulting and analysis. Rarely do you find an industry analyst express an informed opinion so forcefully in the mainstream financial media. I highly recommend listening to the interview for an overview of how the retail and commercial real estate business will evolve in the coming quarters.

A preview: It ain’t good.

This from Eric Fry:

“Success is never final. But failure can be,” Bill Parcels, the former NFL coach, once observed. Investors in real estate investment rusts (REITs) might want to pay particular attention to this truism.

REITs, as the name suggests, invest in real estate of various types. But what the name does not suggest is that REITs usually utilize leverage in their pursuit of investment returns. Leverage, as many investors learned during the last 12 months, is fun on the way up, but potentially fatal on the way down (unless you happen to be one of America’s 19 largest financial institutions).

At the moment, the REIT industry finds itself squarely in the middle of the “way down” phase – both because asset values are plummeting and because interest rates are climbing. Just yesterday, the yield on 10-year Treasury notes kissed 4%, which means that the 10-year yield has nearly doubled since the start of this year!

When long-term interest rates rise this dramatically and rapidly, many different industries suffer. But few industries suffer as much as the commercial real estate industry. Even in the best of times, rising interest rates increases the cost of capital, while also undermining the value of commercial real estate assets. In the worst of times – or even in less-good times – rising rates can produce catastrophic consequences.

Today’s commercial real estate market was distressed, even before rates starting rising. The problem, in a nutshell, was excess capacity. During the last several years, America constructed shopping malls and office buildings to satisfy the excess, phony demand that easy credit produced. But now that home equity loans and other readily available forms of credit have disappeared, so has the phony demand.

The unfortunate result: a glut of shopping malls, office buildings and hotel/motel properties.

“Vacancies are definitely rising across the commercial real estate market,” observed hedge fund manager, Jason Stock, at last month’s Value Investing Congress in Pasadena, California. “You’ve got office vacancies well over 15%. We think those are going to approach 25% before this is over.”

Stock and his partner, Will Waller, oversee the M3 Fund, a hedge fund that invests solely in the banking sector. Stock and Waller claim they are finding a number of attractive stocks to buy. Nevertheless, they remain very anxious about the health of the overall banking sector. In particular, they fear that commercial loan defaults will skyrocket from current levels, causing a large number of banks to fail during the next two years.

“So far this year there’s been just over 30 bank failures,” Stock reported in early May. “We expect they’ll be roughly 150 bank failures by the end of the year. And we would actually expect that number should be significantly higher.

Stock continued:

“Every Friday night (we jokingly call it ‘death watch,’ because that’s when you get the notices of the banks that have failed [from the FDIC]), when we look at the banks that are coming across as failures, we’ll say to ourselves, ‘Geez, that bank is a lot better off than 20, 30, 40 banks that we can think of. The regulators right now are completely overwhelmed. You have to have people to close down banks. And it’s not a very quick and easy process. It takes a fair bit of manpower. So if the regulators had the staffing to do it, there are definitely 50 to 100 banks that you could say, ‘This Friday we are going to go in and close all these banks down.’ So it’ll just be a matter of time before that pace picks up.”

In last month’s letter to their investors, Stock and Waller reiterated their skeptical outlook:

“The Government’s release of the ‘stress test’ results on May 7th was a key driver of the rally in large bank stocks. The results indicated that nine of the 19 firms have adequate capital under the test’s most adverse scenario…In our opinion, this ‘stress test’ was in no way stressful and could more accurately be compared to a beach vacation in Hawaii where the weather forecast had a 10% chance of afternoon showers.

“The ‘worst case’ scenarios that the Government utilized in this test included unemployment reaching 8.9% in 2009 and 10.3% in 2010 (as of May 31, 2009 the unemployment rate was 9.4%), and GDP growth of .50% in 2010. We believe unemployment could easily exceed 10.3% and that it is absurd to use a positive number as a worst case scenario for GDP in 2010. This ‘stress test’ created a false sense of stability in the banking sector and created a historic opportunity for banks to raise capital at significantly inflated valuations…While extremely beneficial to the banks, we believe the investors who participated in these offerings will be choking on these investments over the upcoming months.”

Contradicting the sanguine conclusions of the stress tests, Stock and Waller point out, “The Federal Reserve chimed in with an alarming report on first quarter loan delinquency rates at commercial banks. Total loan and lease delinquencies increased by 96 basis points, a 20.7% increase in only one quarter (from 4.6% to 5.6%)…We maintain our bearish outlook…we believe this bear market rally is unsustainable and that fundamental trends for banks are negative…”

Your California editor concurs, which is why he does not hesitate to say that most bank stocks are better sold than bought at their new and improved “recovery prices.” Similarly, most REITs are better sold than bought.

Source: Real Estate Investment (Dis)Trusts

Editors Note: Dan Amoss appears courtesy of today’s Rude Awakening.

Forecasting loan losses at banks is an inexact science. In fact, it’s not a science at all. It’s more like a game of chance, like craps or roulette. Even if you know the odds, you still have no idea about the outcome. Forecasting future cash flow from existing loans is also a game of chance. Both of these unknowable forecasts lie at the core of last week’s stress test.

The market’s reaction to the stress test — in the form of soaring bank stocks — tells me that the consensus is treating this stress test as if it has the ability to magically predict yearend 2010 capital levels with pinpoint accuracy.

Most of us do not have magic predictive powers — only the ability to make judgments based on knowledge and experience. In my judgment, the stress test was not stressful enough. For instance, it is not really accounting for borrower behavior in a scenario where they are underwater on their mortgage and under- or unemployed.

For example, the stress test’s estimated losses on second-lien mortgages in particular seem very low. In foreclosure, these are often total losses. With another big wave of Alt-A resets and foreclosures in the pipeline, the performance data on second lien mortgages should worsen. Several state-imposed and bank-imposed foreclosure moratoriums are ending.

The bulk of housing activity right now consists in foreclosure auctions and short sales. How much are second mortgage liens worth under this scenario? Not much.

Most big banks already have low levels of tangible capital relative to towering trillions in risky assets. The cash flow from their existing and new loans must exceed their loan losses in order to simply maintain existing capital levels (let alone increase capital).

Think of this situation as a bathtub. Bank capital is the amount of water in the bathtub, and the faucet pours new water into it (that’s cash flow from existing, paying loans and securities, plus new capital infusions) and the drain sucks it out (these are the loan losses). Pessimists claim that the drain of losses is sucking water out so fast that it will empty the bathtub within a year or two, depending on the bank. They tend to ignore or downplay the new water coming in. Optimists claim that if regulators prevent the water from falling to a very low level during this crisis (regulatory forbearance), in time, the water level will eventually rise back to normal levels. There’s a risk that if the optimists are wrong about the amount of new water coming in, we’ll be stuck with a Japanese-style “zombie bank” situation.

After last week, I think the risk of the zombie bank scenario is much higher. We’ll probably see this manifested in continued tight credit conditions. The banks under the most intense scrutiny will tend to reinvest cash flows into less risky assets like Treasuries and agency mortgage-back securities (another form of government guaranteed debt) — rather than write new commercial or consumer loans.

The big banks certainly will not be underwriting many commercial real estate loans (this is central to my thesis on buying the UltraShort Real Estate ETF (NYSE: SRS). Any commercial real estate lending that’s done will incorporate much lower loan-to-value ratios and higher interest rates. With property prices down 50%, the equity in levered deals done at the peak of the bubble has mostly vanished. REITs are a form of equity in leveraged commercial properties.

As you can see in the term sheet of the latest iteration of TALF lending for CMBS, the Fed is in no position to lower its lending standards (see link here). It is not willing to lend against commercial mortgage collateral that’s below investment grade or was created before July 2008 (“All mortgage loans must have been originated on or after July 1, 2008.”). These terms exclude virtually the entire pool of distressed commercial real estate assets. So even if the Fed lowers its collateral standards further, REIT equity will still not avoid massive dilution or elimination. Underwater commercial property owners (including REITs) are finding it nearly impossible to refinance maturing loans.

Certainly, the Federal Reserve will continue trying to cushion the deleveraging process underway in commercial real estate. The market’s expectation of Fed intervention in this sector has fueled much of the recent rally in REITs. But I think the market has it wrong here. The Fed may be able to slow the destruction of wealth in this sector, but it cannot preserve the equity value of overleveraged REITs, any more than the Fed’s 2007 lending programs could preserve equity value for Citigroup (NYSE:C) shareholders.

Source: Commercial Real Estate…The Crisis Begins