Agora Financial’s Rude Awakening

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Taipei, Taiwan

• Credit markets broadcast the following warning…
• When is a falling asset price a rising one?
• Insolvency, meet illiquidity, and plenty more…

Joel Bowman, reporting from Taipei, Taiwan…

Pattern-seeking creatures that we are, the human species will happily settle for a quack theory over no theory at all. Worse still, however, is our propensity to favor “warm and fuzzy” explanations over “cold and prickly” ones…even if the former variety fails to exhibit one iota of actual truth.

A falling asset price, for example, is never a rising one. Never. Ever.

By the same token, a job lost is not equal to a job gained; a dollar spent is not the same as a dollar saved; a unit consumed is never the same as one produced.

And yet, as we thumb through our virtual newspapers every day, we find bad news passed off as good more often than not. We see editors dress sinning facts in saint’s halos to parade them out in front of their congregation.

“GE earnings down, but better than expected,” announces CNNMoney from the financial pulpit this morning.

“Bank of America Profit Drops Less Than Expected on Fee Income,” choruses a Bloomberg headline below.

Let’s quickly review our premises before continuing here:

1) Something cannot fall and rise simultaneously relative to the same fixed point.

2) Falling earnings are bad.

So, now that we know falling earnings ARE NOT rising earnings, and that falling earnings are bad…how are the above headlines positive for the economy again?

It is this warped preference for rainbow-coated explanations over reality-coated ones that too often lead us to interpret otherwise terrible data points as cause for champagne by the pool.

According to the Bloomberg story, net income over at BofA fell 5.5% to $3.22 billion, or 33 cents per diluted share, from $3.41 billion, or 72 cents, from a year earlier. Whether that number was more or less than “the average estimate of 21 analysts surveyed” is as irrelevant as those analysts’ numbers are in the first place. What if the average analyst estimate had been much better, say 40 cents? Would the EXACT SAME BofA result now a “more bad” one merely because the expectation from a group of terminally incorrect economists was different?

Last month, 80 such economists were asked to predict how many employees were sacked during the previous 30 days. They were off by 100,000. Even more disturbing, the range between what can only be referred to as their “guesswork” was almost as big as the actual job loss number itself. (Low estimate, 150,000; high estimate, 500,000; actual number lost 365,000.)

We know instinctively that 365,000 lost jobs is a bad thing…but what if those same economists had predicted we would lose 400,000…or a million? Should we now celebrate an annualized job loss rate of 4.4 million simply because it is not 5 million or more?

For better or worse, truth is utterly unconcerned with and unaffected by our petty wish thinking. The intelligent investor usually makes a point of separating the two.

In today’s edition of the Rude Awakening, Dan Amoss, the mind behind the Strategic Short Report, delivers the second and final part of his insightful analysis of the commercial real estate sector. Hint: he is not bullish. Please enjoy…

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Sell REITs, Part II
By Dan Amoss

Investors in common stocks tend to ignore warning signs coming from the credit markets, often at their peril. Right now, the credit markets are broadcasting the following warning: The equity of overleveraged REITs is at risk of elimination or permanent impairment.

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.

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[Rude Endnote: Finally today…Did you hear? Goldman Sachs is in talks to acquire the Treasury! Well, not really…but this story is pretty funny anyway.

That will have to do for today as we’re a bit over time. We’ll return tomorrow with our usual weekly wrap-up. If you have any thoughts or comments in the meantime, please shoot them over to us at the address below.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com