Unthinkable? Buy Real Estate?

Known by everybody on Planet Earth: Real estate is “a disaster.”  As with any trend, this disaster appears to be unending; the media confirms it daily.

But there is real estate and then there is real estate: residential and commercial. It used to be that most people bought the former to live in and invested in the latter. But after home prices had been soaring for years, cranial light bulbs lit up all over the USA and many Americans “invested” in homes and condos—skyrocketing prices were simply irresistible.  No matter that prices had already increased many-fold, that rents wouldn’t cover even a fraction of the carrying costs or that they financed the deals with funny money time bombs.
When the bartender finally turned off the jukebox and turned up the lights, the collective financial migraine has been massive and, as always, there appears to be no end in sight.

During the salad days, commercial real estate was also a great investment: In February 2007 real estate investment trusts (REITs) rolled over after having increased over 300% the previous six years (the broad stock market as measured by the S & P 500 was up less than 20%).  The bear market was severe: By January 2008, REITs were down 38%, considerably more than home prices in most regions.

At about that time (1/26/08) a Wall Street Journal column headline read: “REITs Point to Further Declines in Commercial-Property Values.” Sounded pretty grim—unless you read beyond the headline. In the body of the article they quoted Green Street Advisors, arguably the savviest U.S REIT research firm:

“The good news for REIT investors…is that real estate declines are ‘baked into REIT pricing.’  REITs…are now on the ‘cheap side’ of being fairly valued.”

In other words, in January the slide in REIT prices had already discounted the forecasted drop in commercial real estate values; since, they have since rallied a little over 10%.

Whether you choose to invest in or avoid REITs, we can be sure of a few facts:

  • In commercial real estate, funny money financing is relatively rare; 70% to 75% financing is typical. Lease income typically covers debt service and then some, so time bomb financing is not a widespread concern. 

  • Obviously, there is 25% less risk than there was at the top.

  • The average REIT is selling at a 10% discount to net asset value versus an average 4% premium the last 15 years.

  • Stock prices discount the future.  REIT prices started dropping many months before property values softened and prices are likely to turn up many months before prices begin to rise.

  • The weak dollar has made commercial real estate enticing to foreign buyers.

  • Rising commodity and material prices (copper, cement, etc.) are boosting replacement values.

  • Good quality REIT yields are in the 4% to 5% range—not bad compared to 2% to 3% rates for treasuries and CDs or the 2% yield of the S & P 500.

  • Ever since they made dirt, real estate has been notoriously cyclical, but the long-term trend has been decidedly up.

As with any investment, the case for REITs is not perfect. Historically, compared to bond yields and stock valuations the last 15 years, they appear to be moderately expensive.  However, comparisons with the early 90’s, when REITs were considered out-of-the-mainstream investments (they had yet to be added to the major stock indexes), may overstate REITs’ relative overvaluation.

One thing is certain: Headline-driven investment strategies garner fools’ returns. So if you’re considering buying REITs, buy them when real estate is a “disaster.” If you wait until the headlines improve, you’ll pay higher prices. 

May 18, 2009

—Jerry Tweddell