Yet the stocks of real estate investment trusts (REITs), which are popular among income-oriented retail investors, are still trading at high enough levels that discount just a garden-variety recession in commercial real estate. REITs were designed to invest in portfolios of rental properties, and generally pay no corporate income taxes if they distribute at least 90% of their profits as dividends to their shareholders.

REITs were designed to thrive in an environment of steadily rising property values and rents. But in this ice age for commercial real estate, the REIT business model will cease to function properly; a REIT’s tax-free status doesn’t allow it to retain much excess capital during lean times. Since REITs pay out all their earnings, they cannot grow without taking on more debt. During the boom, a REIT strategy encompassing growth, leverage, and acquisitions was a virtuous cycle that led to juicy dividends and soaring stocks. But in this bust phase, the REIT business model has morphed into a vicious cycle of dividend cuts, dilutive equity offerings, debt offerings at double-digit interest rates, and bankruptcies.

The REITs that levered up and grew too fast at the peak will go to zero in bankruptcy. Others could fall into the low single digits by year-end as the market anticipates that creditors will take title to many properties in 2009 and 2010. These developments would push the value of the REIT Index dramatically lower.

The REIT sector is woefully undercapitalized — just as the big banks were last year. If you mark the value of commercial real estate to market, it tells you that REIT debt in all its forms — commercial mortgages, unsecured notes, secured lines of credit – is much too burdensome. Equity cushions that seemed adequate at the commercial property market peak are now thin. REITs don’t have to mark their assets to market each quarter like investment banks. But you can be sure that before committing a single penny to a secondary offering of REIT stock, institutional investors will mark property portfolios to market.

Marking property to market will result in many underwater commercial properties. This is critically important because the combination of underwater properties (insolvency) and imminent debt maturities (illiquidity) tends to wipe out equity. The maturities over the next five years are staggering, and these debts were sloppily underwritten near the peak of the credit bubble. According to Goldman Sachs research, roughly $1.6 trillion in commercial real estate debt is coming due 2009-2013.

Lenders will not be willing to refinance mortgages in situations where mortgage debt exceeds the value of the property — so-called “underwater” properties. In order for all of these $1.6 trillion in loans to qualify for refinancing, hundreds of billions in new equity will need to be injected into properties. This much new equity capital dedicated to commercial property ownership will not exist in the investing environment of 2009-2013. So many of these loans will default.

In a scenario of paying off staggering debt loads under stress, the claims of common shareholders are either diluted or wiped out completely. This is the scenario facing General Growth Properties, for example, and shareholders will be lucky to recover anything. You can find shades of the General Growth saga throughout the REIT space.

Bulls argue that REIT stocks are cheap enough to buy. After all, they’ve declined to the point that you’d be buying ownership stakes in commercial real estate at prices well below peak values. Also, the high dividend yields already reflect plenty of pessimism.

What is the credit market’s response to REIT bulls? Creditors will take title to many properties in bankruptcy, and dividends will be paid mostly in new shares of REIT stock, rather than cash. I side with the credit markets.

A review of the aggregate REIT balance sheet — and the delusional commercial real estate purchases during the 2006-2007 peak — will tell you that this won’t be a garden-variety bear market in REITs. Supply of retail, office, hotel, and industrial space will greatly exceed demand for several years. In most cases, tenants will have the upper hand in lease renegotiations. This bear market, which is still in its early stages, will go down as the worst REIT bear market in history.

So will the TALF come to the rescue? Wasn’t the Federal Reserve’s “term asset-backed securities loan facility” (TALF) designed in part to mitigate the systemic damage from the time bombs ticking inside of CMBS? A primary reason for the recent rally in REIT shares is hope that the TALF will help restore value to equity of the most-indebted REITs by loosening up lending for commercial mortgages. The Dow Jones U.S. real estate index rallied from an intraday low of 80 in early March to a recent 130. But this REIT rally is based on hope, rather than strong fundamental evidence.

The Fed does not restore equity value to leveraged financial companies sitting on toxic assets; it merely tries to prevent stressed borrowers from unwinding positions too quickly. Look at how little equity value the Fed’s unprecedented lending facilities salvaged for Citigroup shareholders. TALF will do little to preserve equity value for highly indebted REITs. The Fed did not eat the losses on Lehman Bros.’ garbage securities, nor will the Fed or the Treasury eat losses that must be first absorbed by shareholders of overleveraged REITs.

Plus, potential limits on executive pay could limit interest in TALF participation. Special Inspector General Neil Barofsky said in a recently published report that executives involved with the TALF program “could be subject to the executive compensation restrictions.” Whether or not compensation restrictions are enacted as part of TALF, the mere threat of capricious rule changes and taxes imposed by Congress and the administration will scare many potential managers away from TALF.

While there are certainly opportunities to be had in this market, as I see it, REITs aren’t one of them.

Source: Sell REITs, Part II

Although vacancy rates haven’t hit their recent 2003 peak, they should surpass it in the next month or two.

This is a clear signal that most commercial real estate investment trusts (REIT) are going to see their earnings take a big hit.

We already saw commercial REIT Developers Diversified Realty Corp. (NYSE:DDR) take a huge hit.

But DDR has already dropped too far to be an attractive short.
(As a general rule, if a stock is selling for under $5 it’s too cheap to short).

Kimco Realty Corporation (NYSE:KIM), on the other hand, still has a ways to drop.

Better still, KIM recently hit new lows and is sure to suffer as the commercial real estate market continues to fall apart.

This from Today’s Financial News:

Should a retail chain be severely and directly impacted by the fall of the nation’s real estate market? Should retailers divert from their core strategic mission and invest directly in the nation’s real estate market? Those are the questions Target Corp. (NYSE:TGT) investors are asking the company today.

According to William Ackman, the boss at Pershing Square Capital Management, the answer in Target’s case is no. He is pushing the company’s management to spin off its nearly $20 billion in real estate holdings into an independent real-estate investment trust (REIT).

Sure, almost every retailer’s revenues will be negatively impacted by an economy that is slowing because homeowners can no longer use their houses as built-in ATM machines. But that is something retail investors must expect. What they may not expect is the value of their positions to drop because of fluctuations in the value of the land their stores are sitting on.

By unloading its land investments, Target is free to focus solely on its retail mission without the threat of fluctuations in the real estate market dramatically altering its earnings potential.

For example, shares of Target have dropped by nearly 50% in the last year. While it is impossible to accurately determine how much of that drop can be attributed to lower retail sales growth and how much can be blamed on the decline in its real estate holdings, we can be certain that the fall would be dramatically smaller without the burden of real estate losses.

But we must remember the real estate pendulum swings both ways. Right now, real estate prices are depressed and share price is down. When the momentum swings the other direction, Target shareholders would see their holdings appreciate at a higher rate thanks to real estate gains.

Even with this risk, Ackman is right. It is not Target’s responsibility to hedge against real estate fluctuations. All it does is distract the firm from its core goals. By selling off its holdings and leasing its properties, investors are given a much more pure revenue stream to analyze and predict.

After the spinoff, if investors want to remain invested in the land holdings, they can use their proceeds of the sale to invest directly in the newly created REIT.

When investing, it is extremely important to compare apples to apples and oranges to oranges. When a company’s balance sheet is compromised by non-strategic irregularities, it makes forecasting difficult and smart investing nearly impossible. It is impossible to tell what is an apple and what is an orange.

Keep a close eye on Target over the next few months. Share price jumped on the notion this morning and has since leveled off. If Ackman’s demands find momentum, share price will continue to climb.

Source:Target (TGT) investors call for real estate sale

This from Today’s Financial News:

It is a fact that the real estate industry has historically been a leading indicator of the American economy. When it falls, Wall Street falls. When home prices rise, so does the Street. If that continues to be the case, the American economy is on the rebound.

For proof, look at today’s new-home sales figures released by the Commerce Department. Compared to sales in August, the amount of new homes that sold in September rose by an unexpectedly high figure of 2.7%.

Over 464,000 freshly built houses traded hands across the country. Three years ago, that number was nearly three times higher. But that is all in the past. What matters is that this month’s figure marked an end to the real-estate landslide.

So what has caused buyers to return to the markets? Two things, falling prices and fear of the stock market.

As for falling prices, take a look at these figures. One year ago, the average new home sold for $240,300.  Right now, that figure is just $218,400.  Buyers smart enough to realize home prices are not going to drop any further are getting an instant 10% discount on their homes.

Next, there are plenty of folks unwilling to take a leap into the stock market right now. With the nation facing a deep recession, the equities market is a scary beast for the uninitiated. They figure if they invest in real estate, their investment will always hold at least some value. After all, a piece of land cannot go bankrupt and disappear overnight. Smart idea. Instead of burying their money in their backyard, they are making it work for them.

News you can use

Even with the strong selling last month, inventory levels are still near record-high territory. Over 390,000 new homes remain unsold across the country. According to the experts that calculate such things, that is a 10.4-month supply. Inventories dropped by over 7%.

With prices falling and such a high inventory of homes still on the market, few builders are willing to raise a new house unless it is already sold. That simply means the market is correcting itself and the free economy is working.

As long as the government stays out of the industry, it should recover in short order.

So where is the investment potential? It depends on how much you have to invest.

If you have plenty of cash and have access to the markets along the western coast, buy all the deeply discounted properties you can afford. Rent them now and sell them in a few years. Your investment will pay off handsomely.

If you don’t have a few hundred thousand dollars lying around, you can reap equally large gains by investing in a few choice real estate investment trusts (REITs). Trusts like Post Properties (NYSE:PPS), which is involved in apartment rentals and condo sales, and American Campus Associates (NYSE:ACC), which is taking advantage of the shortage in student housing and a real-estate industry bottom, will do well. And just as almost all REITs do, they both pay nice dividends of 9.7% and 5.5%, respectively.

The facts are obvious. The real estate market is turning around, proving the American economy will be on the rebound fairly soon. We have seen the worst of this crisis.

Now is the time to re-allocate your portfolio and ensure you are properly positioned to take advantage of the bull that lies just over the horizon.

Source: Last Chance for Deep Discounts In Post Properties (PPS) and American Campus (ACC)