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Fundamental Tailwinds for Commercial Real Estate Shorts

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Sanguine about mark-to-market losses.

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Based on some of the emails I received over the weekend, there seems to be some real angst associated with long positions in the Proshares UltraShort Real Estate (SRS).

Let me revisit the reasons why I'm rather sanguine about my current mark-to-market losses. The data I use below come from the components of the Dow Jones US Real Estate Index (IYR), excluding mortgage and healthcare REITs.

On the fundamentals side, REITs aren't in a good place:

  • The median growth in Funds From Operations (FFO = Net Income + Depreciation + Amortization - Gains on Sales Of Property) is estimated at -1% for this year, -3.5% for next year, and 0% for 2010; the average stands at -3.5%, -6.5% and 1.3%. Against these non-growth rates, the average P/FFO is 13.

  • While long-term leases cushion the speed at which FFOs tend to drop year-over-year, as rents get reset lower, pressures on FFOs tend to last for years.

  • The 55 companies I considered have a total of $202 billion of debt outstanding at a weighted average cost of debt (WACD) of 5%, against current FFO of $17.4 billion. Every 1% increase in the WACD would eat away $2.0 billion of FFO.

  • Even if we reasonably assume that commercial mortgage Backed rates come down from their current moon-shot, given the reduction in lending capacity caused by the de-levering of financial institutions, a best case scenario for super-senior spreads is 4-6%. Assuming 10-year Treasury rates at 3%, WACD for the best credits could easily rise to the 7-9% range.

  • The current 8% average yield payout requires distribution of 82% of available FFO. If the WACD increases just 2%, dividends will have to be slashed. Even assuming dividends can be sustained at current levels, who in his right mind would take equity risk for an 8% return, when debt yields for these companies are in the double digits?

  • While REITs have yet to recognize any meaningful impairment to their asset values -- and a modest reduction of 15% across the board is something they are hoping and praying for -- the median debt-to-equity ratio already stands at 340%, and the average is 140%.

    A November 20th report by Moody conservatively suggests a decline in values of 20-30%. Rising debt-to-equity ratios add pressure to the cost of debt, and/or could force equity raises.
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