Short Equity REITs ICF S
October 16, 2006 - 1:41pm EST by
2006 2007
Price: 96.05 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 100,000 P/FCF
Net Debt (in $M): 0 EBIT 0 0
Borrow Cost: NA

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“I besmirch ye: ‘Wall of Money!’” -Doobadoo

After a brief but sharp pull back in late ’93, the Nasdaq Composite continued its long-term bull run, moving progressively higher for six consecutive years, from a base of roughly 750 to a record smashing high of just over 5,000. In the last two years of the run, proponents of the so called “Fed Model” threw up their hands in utter despair, as earnings yield plus rose colored long term earnings growth assumptions still made completely no sense with respect to their historic relationship to long duration risk free bond rates.  Possible explanations included: a large structural upshift in long term growth prospects combined with a secular decline in risk premiums.  This Brave New World of low risk and accelerated growth would be driven by the internet’s: global free trade, pricing transparency, communication, and supply-chain collaboration opportunities; And the tech-heavy Nasdaq was the vehicle of choice to participate.  But as soon as every one was in, liquidity tightened as the growth slowed, and it turned out it was just the Kool-aid talking.

After a brief but sharp bear market in ‘98 & ’99, the Nareit equity Real Estate Investment Trust (REIT) index continued its long-term bull run, moving progressively higher for almost seven consecutive years, from a base of 2300 to the current level of just over 9,000.  In the last two years of the run, proponents of the REIT equivalent of the “Fed Model” are throwing their hands up in utter despair as underlying cap-rates/dividend yields plus long term FFO growth expectations continue to make little sense with respect to their historic relationship to both long duration corporate and risk free bond rates.  Possible explanations include a large structural upshift in property values, and a secular decline in risk premiums and return expectations.  This Brave New World of accelerating commercial real estate values is being driven by: a lack of developable land in large MSA’s colliding with continued economic growth and productivity gains, and a the sudden ‘maturity’ of commercial property investment methods, greatly expanding the base of investors globally; And a highly levered and illiquid PE allocation is the vehicle of choice to participate. Now that every one is almost in, liquidity is tightening, and as the growth slows, it will once again turn out to be that darned Kool-aid talking, again.

Equity REITs, What Are They?:
But before I dive into attempting to argue why there is essentially a commercial real estate bubble, lets go back to school for a quick primer on equity REITs.  The business model is very simple, an equity REIT owns and develops commercial properties (no lending), which it then leases to various tenants with various terms, collects the rents, and then passes on a majority of the cash-flow to investors as dividends.  REITs are tax advantaged, as they pay no corporate taxes so long as they distribute 90% of income as dividends.  REITs tend to use a moderate amount of leverage (40-50% debt/capital), structured as combination of preferred, convertible, commercial mortgages, and revolving credit.

Dispelling the Kool-aid:
‘God isn’t making any more land, but he keeps making more people’:  

As mentioned earlier, part of the justification for record low cap-rates is the lack of developed land in most MSA’s as productivity and growth continue.  The ‘Land is inherently More Valuable’ argument flows into construction costs, which is then used to justify current valuations based on replacement costs.  The non-Kool-aid truth is that while commercial real estate is a decent hedge against long-term inflation as it slowly elevates replacement costs, if one excludes land cost from replacement cost, valuations are well above construction costs.  Developable land values are driven by the economic value of the completed property itself.  In short, land has no intrinsic value aside from what you can put on it.  When developed property appreciates, developable land owners rationally demand higher prices and thus take margin from potential builders.  When completed property values are soft, land owners either refuse to sell or sell at a lower price.  Land prices are a function of potential property values, not the other way around and thus, cannot be used to justify the value of developed property.  If you don’t believe me take a look at all the homebuilders writing down land options as real sales prices for homes (including incentives like flat screens, Jacuzzi’s and granite countertops) have declined.  In short, land owners are price takers, not makers.  Land is always a fraction of development costs.  Even in a highly land constrained market like Manhattan, developable/redevelopable land/air rights trade for $200-$400/developable sq ft, while developed condos go for $1,000-$1500/sq ft.

‘Finance technology like securitized CMBS, and the modern REIT structure have greatly expanded liquidity, and the base of investors, permanently shifting required rates of return lower.’    
Don’t get me started… CMBS spreads, while possibly structurally declining haven’t fallen materially out of line with Baa’s, which have been around forever.  Today, equity REITs are priced for perfection with far lower long-term rates of return, which are no longer competitive with alternative asset classes, even if they have earned their fair place amongst the competing world of bonds & stocks.
REITs have long-term dividend growth of 2.5%, with more risk than corporates, but somewhat less risk than S&P stocks.  So their expected returns should be in the middle of those two goal posts, but currently aren’t.  Stocks have an E/P yield of about 6% off ’07 numbers and long term expected growth rates of 3-6%, leaving expected returns at 9-12%.  Corporates are yielding 6.4%, with only 20-40bps of expected default loss.  So, with REITs yielding 3.8%, and affording for 10% near-term growth followed by a return to the long-term 2.5% yield growth, leaves us with an expected total return of 6.7%.  That expected return is only 190bps over treasuries, 50 to 70 bps over corporates (with expected default loss), and 230-530 bps below expected returns on stocks.  If REITs move any higher, then investors are essentially saying that they are willing to take a similar return on REIT equity as they are currently taking on the debt, which has a ~50% equity cushion in front of it.  The basic law of demanding higher returns for higher risk cannot, and will not be violated, no matter how much ‘finance technology’ we throw at it.

Structural Bull Market:

For the last 7 years REITs have been on a tear as dividend yields and implied cap-rates have declined dramatically while FFO (cash earnings) & dividends have grown slowly (low single digits).  Behold the following 10-year graph of the Wilshire Equity REIT index:

View Graph

NAREIT Equity REIT index total excess returns relative to 10 yr:

View Graph

Why Short Equity REITs?

So REITs have been going up a lot and we are seeing parallels to previous bubbles with all the ‘its different this time’ rhetoric.  But what are the solid reasons for stepping in front of this freight train now? I believe that there are 3 basic roles a short REITs/Long 10 year position can play in a portfolio:

  • 1-    You are a fundamental, long term value investor who knows that if the market declines significantly, regardless of how well chosen your businesses are, they are likely to go down somewhat with everything else.  Therefore you wouldn’t mind being short something that is poised for both poor long-term performance, and will likely get creamed in a bear market.
  • 2-    You are macro/quantitatively driven and realize that REITs are dramatically historically overvalued and want to make money on it.
  • 3-    You hold a bearish position on Credit (for example Credit default swaps) and are looking for a potentially cheaper/more effective way to play it.

Reason I: Fundamentally Overvalued:
Feasibility & the Wall of Money:

I use the phrase ‘deal feasibility’ a bit in this write up, and maybe I should explain what I mean.  Before buying a commercial property, such as an office or apartment building, real estate investors usually do a quick ‘back of the envelope’ calculation to check the feasibility of the deal.  You take your potential rental income in year one and divide it by the asking price of the property and you have the ‘going-in cap rate.’  This going in cap should be in line with your required unlevered total return.  That is  R(u) = Cap-rate + long term NOI growth rate.  According the Green Street Advisors, nationwide NOI growth has a tendency to trail CPI by approximately 100bps.  If that long term relationship is still valid (and how can it not with rent being a cost of living and cost of production for so many), then structurally declining cap rates would imply only 2 things:  Expected rates of return are falling for all competing asset classes, and/or long term inflation expectations have risen.  Now while it is true that asset return expectations have declined, as I’ve shown they’ve come down far more for REITs and commercial real-estate.  Thus, long-term inflation/NOI growth expectations have risen materially.  But yet the TIPS spread (10 year – Tips Margin) has recently backed off and is implying only about 2.5% long term CPI.  Something is amiss: are stocks, corporates treasuries and TIPs valuations all nuts, or is it just unbridled kool-aid consumption among REIT investors at the tail-end of a near 7 year bull run?  A metaphorical ‘Wall of Money’ pouring in to chase hot returns?

The Assets Underlying:
Lets do a quick walk through of REIT’s portfolio implied valuations.  With yields of 3.8% and cost of long term debt just under 6%, and 50%D/Capital, REIT equities are trading a 5% implied cap rate.  Private market caps are in the low 5’s, putting the index at a modest 10% premium to liquidation NAV; in line with historic averages.  However, between the late 80’s and 2002, commercial cap rates have ranged between 6.5% and 10%.  Obviously buyers are anticipating robust near term NOI growth in order to justify deals in the low 5’s.  But assuming that indeed, NOIs grows 25% over the next few year, going in caps at that time will still be at the bottom end of the historic range, with no price appreciation.  Who is causing this?

REITs themselves taking each other out as well as real estate equity funds armed with a wall of fresh pension allocations.  Some of these PE deals are trying to juice IRR with very high 60-90% debt/capital deals.  With low 5’s going in caps, and the blended cost of debt at 6.5-7.5% on highly levered deals, we have big negative carry’s off these going in cash cap-rates.

In other words, back in the day, incremental debt would lever you to both: going-in cash on cash income returns and exposure to long-term growth.  With the inversion, each incremental dollar of debt robs the equity tranche of near term cash-on-cash income and…levers you to long term growth.  Which pricing method sounds correct in our slow to moderate growth/inflation world?  On these highly levered deals, debt coverage is near 1.0x.  Thus, current valuations are sustainable only if/when NOI grows cap rates to at least the cost of debt.  The longer it takes, the further you hurdle towards the distressed auction.  Will lenders accept going in debt coverage of 1.0x, after a few cowboys get theirs?  I think we all know the answer to that one, and all commercial lending will share in the pain of the subsequent credit pinch.

Reason II: Quantitative Mean Reversion & Macro Driven Theories
A Meaningful Anagram (Beating a Dead Horse?):

Q: Ok doob, so if all this ‘relative yield’ hooey is so great, why hasn’t it worked in the past?
A: It actually has worked very well in the past to predict 18-month forward REIT returns relative to 10 yr (predicting forward returns of a long REITs short 10 yrs position).

I like two quantitative indicators that make sense fundamentally and have proven to be surprisingly good at predicting forward 18 month returns of a portfolio long REITs and short the 10 year (thick blue line, right axis).
  • -The first  indicator (green line) is the REIT yield minus the 10 yr yield going back to 1988 (unscaled left axis). 
  • -The second is the [REIT Yield - Baa Yield] / 10 year. (scaled to fit nicely on the left axis). 

Why they work:
Fundamentally speaking, when the REIT dividend yield is below the Treasury yield (green line negative), the implied cap rate is likely also below the baa rate.  Thus investors are clearly very bullish about near term dividend growth.  Also, REIT returns over last 20 years mainly come from the dividend yield, and less so from capital appreciation.  Hence, the majority of the expected return is already uncompetitive with risk free rates.  Consequently, REITs tend to under perform 10 ys over the ensuing 18 mos (blue line goes negative).

When the orange line is low or negative, it means that REIT yields are sizably lower than BAA corporates when adjusted for the risk free rate.  Thus, any slip up in credit quality, will force the market to demand less of a yield discount to BAA’s, while BAA’s themselves may be rising in yield relative to the 10 year (credit spread expansion).  This manifests itself as REITs underperforming 10s, even if dividend growth hasn’t rolled over or imploded.   Both indicators are pointing to returns for REITs over the next 18 mos being from -15 to -30%. 

There has been an obvious breakdown of this indicator around the beginning of ’05.

View graph:

Why they don't work:
Of course, if I expect this to be a decent indicator I must somehow explain away why this indicator was near perfect at predicting the direction and decent at prediction the magnitude of returns for this trade, but has recently failed. The answer is the ‘Wall of Money’ theory.  Pension funds (both foreign and domestic), recycled petro dollars, yield hunger, and momentum are the reasons I cite.  Now, if that’s true, why won’t those trends just continue to render the indicator ineffective?  The simple answer is that no matter how enthusiastic investors are, US commercial real estate in a ~5 Trillion dollar asset class, which leans on the debt markets to finance about 50% of the purchase price.  Commercial lenders and those who buy their securitized paper, may not currently see the danger of Debt Coverage Ratios of 1.0-1.3x on going in metrics, but certain macro developments could finally cause them to return to a more normalized lending environment.

Future Macro Outcomes: Where’s Waldo?
It seems for the fist time in history, legitimate arguments can be made for any one of the 4 basic economic scenarios, one of which, will inevitably unfold over the next few quarters: 

  • -Inflation not in check, economic growth slows
  • -Inflation in so much check we fear deflation, economic growth implodes
  • -Inflation not in check, economic growth remains robust or accelerates
  • -Inflation in check, economic growth remains robust or accelerates

Of those 4, I figure this trade wins in the top 3 of them and maybe hurts somewhat in last one:

Best Macro Scenario: Inflationary Bust/Stagflation (Significant portions of the70s & early 80s):
  • As years of Fed pumping and the resulting reckless credit expansion finally pours into pricing in a meaningful and stubbornly accelerating way, yields across the curve press higher.  Ben Bernanke is crucified on a cross of gold for the sins of helicopter drops: past, present and future.  The consumer hunkers down for the coming economic nuclear winter, as Keynesians are fed to lions in public circus.  Although higher inflation acts as a tail wind via rising replacement costs, it is greatly trumped by 8-9% commercial mortgage rates, all in the face of rising vacancy.  This diabolical combo destroys ‘deal feasibility’ and dramatically reduces justifiable commercial property price.  However freakish, this scenario is highly unlikely.

Great: Disinflationary/Deflationary Bust (Severe example 1930s, ’01-‘02):
  • It started with a mysterious decline in long term treasury rates, followed by the sudden realization that super tight credit spreads were super dangerous.  What appeared to be the sweet and innocent ‘Goldilocks’ scenario, was suddenly ‘outed’ as a deviant deflationary bust, by a junk market implosion.  Recession was sure to follow leading up to the subsequent downward revision of REITs’ consensus forecast of 9-10% FFO growth for ’07 &’08.   Despite treasury yields trading down to 4% and The FED cutting violently, the vengeance of the debt-economy’s bond defaults kept Baa yields bouncing around 7%.  Just like each credit crunch and recession of yore, REIT yields largely closed their discount to Baa’s, sending the index down ~40%.  I believe this is more likely than most talking heads are willing to admit.  And although it will not likely be as severe as my above hyperbole, the point is made: the combination of slowing economy, tightening credit and subsequent larger credit spreads means big trouble for REIT valuations.

Probably Very Good: Inflationary Boom:
  • This is the least likely scenario to persist, because rising inflation in the absence of a soft economy gives The Fed room to take a hawkish enough stance on the fed funds rate to maintain price stability.  But if inflation suddenly pops back up, The FED will likely overshoot (as if they have a choice).  The credit pinch eventually hits, and REIT yields are forced back to near parity with rising corporate rates.  I don’t think a short term pop or blow-out of inflation is good for REITs.  their pricing is based off long term cash-flow growth expectations, which show proxy to long term inflation.   In short, short term inflation will have to be dealt with harshly by The Man and should be bearish.  If they do indeed run up with a potentially falling 10 year price (rising yield), the trade becomes a chunk richer and you will have the opportunity to add to it and make more money.   Either The FED wins quickly and REITs implode quickly, or they derelict their most important ‘price stability’ duty, letting inflation get out of hand, which itself ultimately wrecks the economy and debt markets.

Maybe not so Good: Disinflationary Boom (Deja-1990s):
  • The best environment for commercial real estate is a robustly growing economy combined with declining inflation, which is evidence of rising productivity and aggregate demand.  So cash-flow growth remains robust, while treasury yields stay low or decline.  But even in this ‘Goldilocks’ scenario the trade can still make money, as REITs appear to have already priced this as in the bag, while stocks, relatively speaking, haven’t.  Even during the roaring 90s we had a mid-cycle slowdown in ’98, likely precipitated by Russia/Asian Contagion/Fed Tightening.  The hot money in REITs may shift capital toward booming large cap equities, which I think does very well in this economic scenario.  This scenario looks perhaps a bit too likely for comfort.  But if you’re still reading this write up and haven’t already voted “1”, then you probably have your doubts like me.

Reason III: You’re a Closet Credit Bear
Shorting REITs against 10s, better than buying CDS:

I argue that REITs are more liquidity sensitive of an asset class than many realize. Equity REITs have a tendency to trade at a slightly tighter spread to 10 yrs than corporates (due to a long term 2.5% dividend growth), but every time there is a liquidity pinch or credit spread blowout (90-91 recession, ‘94-‘95 fed tightening cycle, LTCM//Emerging debt blow up of ’98, and Fed tightening/recession of ’00-‘01) the REIT current yield discount contracts to near parity with Baa corporates (see graph below).  With REIT spreads now severely negative to treasuries and corporates (3.8% REIT yield vs, 4.75% 10 yr, 6.4% Baa), a reversion to the historic yield “between 10’s and Baa’s” would mean that REITs could fall 20-40%, even if they are poised for good dividend growth.

View Graph:

This trade (Short Reits, Long Treasuries) pays big in either a credit spread blowout, or interest rate spike.   A trade like that sounds very similar to a credit default swap, and I advertise that a short REITs, long 10 year position is a superior way to hold a bearish position on credit considering the size of the current spread.  In addition, there is the extra kicker of being on the right-side of a fundamentally overvalued asset class, which may go down on its own without a ‘blood in the streets’ economic or credit blow up.

Some may ask, “but how do you know that this is a better trade than just buying CDS?  CDS’s appear historically cheap.”   While this may be true, it’s also true that it’s not possible to put together a quantitative relative risk/return of this trade vis-a-vis a long CDS position.  Instead I will try to prove the logic of this trade via inductive reasoning:
  • -CDS have a negative cost of carry, as any one who’s been holding them for the last few years knows.  One could argue the loss of being short REITs and long 10 yrs this past year would have been equally, if not, more painful.  (REITs up ~20% relative to 10 yr  YTD).  However, only now is the carry ex-borrow slightly positive, and REIT spreads to Baa have recently made a 20 year low, on top of a structurally low interest rate environment.
  • - CDS spreads don’t necessarily make money in a slow and steadily rising interest rate scenario in which credit doesn’t go sour.  REIT yields would have to be dragged higher, b/c we are already at record low yields & spreads.

Tying it all up: Why I’m not crazy:
Just to be clear I am making a pretty bold call that there is in fact a bubble in a multi-trillion dollar asset class: commercial real estate, and by inference a bubble in publicly traded REITs in general.  And secondly, that this bubble should unwind soon.  Before you have me carted away to the re-education camp for the financially subversive, please let me explain! 

The long history of commercial real estate pricing calls for deals to have meaningful positive equity cash flows in year one (basic deal feasibility).  There are a segment of buyers, call it private equity generically, that has no problem loading up so much debt (60-90% debt/capital) on deals with cap rates below the cost of financing.  This inversion leaves little excess cash-flow to equity (debt coverage near 1.0x), and calls ‘deal solvency’ into question.  Regardless of whether investors wish to redefine feasibility, these valuations are dependent upon a rather generous cadre of CMBS buyers and commercial bank lenders.  Seemingly irrational investor enthusiasm and expectations, along with complicit lenders, forms the cross-section of a bubble.  Once these conditions are met, there is little doubt if and how the bubble will deflate, but when. 

Going back to the parallel of the late ‘90s equities bubble, it was rather difficult to peg the turning point as events unfolded.  However, with equities, only 20-30% of their long term returns can be attributable to their income component (dividend).  Thus, equity returns are largely driven by the far more mysterious capital appreciation, which in turn is driven by a hard to know future earnings growth rate, and a fickle history of multiple assignment.  On the other hand, a study of return attributions of commercial real estate equity investments indicates that income returns are responsible for 50-70% of long-term returns.  In addition, in terms of capital appreciation movements, they’ve traded in a relatively tighter multiple band of 8-12x forward FFO between ’93 & ’03.  This compares to 18x+ today, depending on whose estimates you believe.  Thus, the present inversion of going-in cap-rates to the cost of debt, and the grotesque inversion of REIT dividend yields to treasuries must be more meaningful. (And historically has been so).

As we’ve seen with the Nasdaq, big asset classes cannot experience supernormal growth and multiple expansion ad-infinitem.  With expected returns barely above Baa corporates, and highly levered deals going off at cap-rates below the cost of debt, I figure we’ve got to be close to a top.  And by shooting against a broad index, one does not have to worry about hitting a pony amongst all the...well you know.  So yes, “I besmirch ye Wall of Money,” and hopefully I won’t turn out to be Don Quixote, smacking the REIT windmill with a tin sword, as it just keeps running.

The Trade:
The easiest way to put this trade on is to short ticker ICF, which is the Cohen & Steers Realty Majors ETF.  The market cap is over $2.5 bil, and is representative of the Equity REITs with 39 large cap names. The yield on the ICF is 3.05% (which is a hair lower than the Nareit equity REIT index b/c of its 60bps mgmt fee and the slightly lower yield of the ‘Majors’).  The underlying names represents about $100 bil of market cap, so if you have trouble or concerns over the borrow (which apparently is fine right now but I recall it being tight some years back when there was less AUM), you can go to and pull up a ticker symbol list and short the underlying names.  They all have low single digit short interest, trade on NYSE, and are very widely institutionally held.

I then recommend that you place the cash proceeds of the short sale into a 10 year treasury yielding 4.80%, or if you want a bit more carry something closer to fed funds.  Also owning a broad portfolio of large-cap value with strong fcf generation is fine too, but I will measure the performance of this trade as (10 year’s return) – (the price performance of the ICF + 3% annual dividend) on a go forward basis.


Good timing due to recent ‘Blow-off’ Top in REITs:
-Year End Pension Funding (DB FY ends 3 mos before corporate fiscal years)
-Speculators bidding up REITs expecting PE money to take whole portfolios private (like Trizec deal)
-Recent M&A returning a lot of cash to shareholders. Most REIT shareholders are institutions who are REIT specific, hence distributions like the Oct 5. closing of the $5 bil cash tender for Trizec just got recycled.

Negligible to slightly positive cost of carry allows one to be patient for:
-Economic Slowdown and/or Rising Interest Rates
-Risk Premium Blow-out (Market Crash)
-Mean reversion to rational return expectations vis-à-vis other asset classes
-Credit Spread Blowout (without the premium decay of CDS)
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