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Minyan Mailbag: The State of SRS


Opportunity or danger in real estate?


Aloha, Prof. Zucchi,

How do you objectively determine where the price of the UltraShort Real Estate (SRS) may get to? Are things so badly screwed up in the industry that it's not beyond comprehension to assume that the price could get back to 150? Is the state of the commercial real estate market as bad as non-commercial? Mahalo for all your help during the last two years.

-Minyan Duke


Hi. I'll answer your questions in reverse order. First off, I do not believe the office real estate market will end up like the homies in the residential space. I have repeatedly suggested, and I continue to think, that the financial strength of most institutional commerical real estate (CRE) owners is such that they will not go belly up en masse. That's the end of the good news.

Now for the bad news. I believe the returns to investors in both public and private REIT's will be miserable if there will be returns at all. The mounting headwinds include:

  • A whole batch of properties worth meaningfully less than what they were acquired/built for. At some point these assets will need to be marked down.
  • An almost complete dry-up of transactions, which will prevent locking in capital gains from deals that were made at the right time.
  • As these deals get refinanced rather than sold, refinancing rates will run 150-300 bps higher than they used to. This is money that comes straight off the top from shareholders' returns.
  • Energy costs at current energy prices are running at least 10-15% above what most long term budgets forecast, and energy costs are at least 15% of operating expenses.
  • Municipalities are trying to pass the real estate (RE) tax burdens from owners to commercial users. Even though RE taxes are usually pass-through items to tenants, they end up putting pressure on rents.
  • Lots of deals were structured on internal rate of return (IRR) assumptions. Without an active transactional market, sales can't get done and holding periods rise. As holding periods rise IRRs fall. If deals do get done it is at distressed prices.
  • Rents have peaked and have started heading down the slope.
  • And if the dollar keeps ripping, fuggeddabout the foreign buyers.

Where can the SRS shares head to? I don't know. I do know that it is hardly a perfect vehicle to short CRE – its components are some of the most solid companies out there – but unfortunately it is the only broad tool I know of.

Finally, I will leave you with this passage from the Jones Lang LaSalle (JLL) conference call of a few days ago:

"The credit crisis which began a year ago in the U.S. has impacted virtually all financial centers and economies to some degree. For commercial real estate the major impact continues to be declining capital markets activity and much stricter debt financing, especially for large transactions. In the US, first half transaction volumes decreased by more than two thirds from a year ago, while in Europe, first half volumes fell by around a half from the same period in 2007.

Asia Pacific volumes showed wide divergences across the region but in total were level with last year for the quarter. However, the momentum declined falling 28% between the first and the second quarters of this year.

This slowing transaction activity has been accompanied by a 15 to 25% price correction and a significant price disconnect remains as sellers, whose expectations have yet to adjust to the investment climate, hold assets rather than accept current pricing. At some point, that seller motivation will increase, which will resolve the stalemate by creating transaction levels that trigger meaningful price discovery. That increase in motivation is likely to be precipitated by loans coming due on properties purchased in recent years at very high loan to value ratios and the generous underwriting conditions on debt. (
Emphasis mine).

We are expecting -- sorry -- we are beginning to see signs of forced or distressed sales and expect this trend to continue with equity investors reentering markets where there is restricted debt availability. The effects of the slowing global economy have also started to show in leasing markets. Tenant demand and leasing activities slowed as companies across the industry and across the industry sectors delayed decision taking."

- Prof. Zucchi

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