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REITs: Equities Trading With Total Disconnect to Financials


Here's more data that proves it.


Minyan FR writes:

You continue to talk about commercial real estate. Thus the Simon Property Group (SPG) purchase makes a top; tops usually end with good news, just as bottoms end with bad news...

It would be interesting to hear more about this.

I imagine you're referring to Simon Property Group's acquisition of Prime Outlets for north of $2 billion. I know nothing about Prime Outlets so I'm not sure if Simon got a good or a bad deal. However, I remain convinced that the transaction cannot mark a "top" for REITs, unless you speak of stock prices. Commercial real estate is certainly not making a top because it's not even close to finishing its plunge.

Let me add some more data to the many anecdotes I've offered suggesting that REITs equities are trading with a complete disconnect to the REITs financials.

Yesterday, General Electric (GE) held an analyst day. GE owns billions and billions of commercial real estate -- way more, in fact, than most other REITs. In its presentation (you can find the slides here), GE remarked that from the peak, the equity value of its US CRE portfolio has declined 44%. When looking at CRE-related mortgage losses, conditions are consistent with the "worst case scenario" derived from testing its portfolio against the Fed stress test of the banks. In fact, by the end of the year, GE expects to have restructured 15% of its entire loan portfolio. That means that in some way -- whether non-payment, failure to refinance, or breaches of other covenants -- 15% of its loan book is in some sort of default.

Now here's where things get cute. GE is actually booking reserves for these bad loans as if they were liquidated. So while GE avoids default liquidations (at least for now), it accounts for these bad loans for what they are -- bad loans. That's not the way it works, however, for many banks, hence the latter's ability not to show losses on these loans. And such transparency certainly doesn't apply to REITs. REITs don't have to mark-to-market their equity values; so in true lack-of-spirit of the rules, financial statements reflect REITs equity values as if absolutely nothing had happened to its assets over the last three years.

Let me use Vornado's (VNO) financial statements as an example. As of first quarter 2007, VNO's Gross Real Estate Assets were shown with a value of $14.8 billion. Through the third quarter of 2009, net purchases/sales of real estate added $1.6 billion, and as of the third quarter '09, Gross Real Estate Assets are shown with a value of $18 billion, suggesting increase in value of some $1.6 billion. Now, I'll give Vornado the benefit of the doubt and assume that this $1.6 billion increase in value wasn't actually the result of a mark-up of its assets, but rather some "accounting mechanic" that I don't feel like digging into.

But the point is that Vornado certainly isn't reflecting on its financials any of the 44% decrease in equity values suggested by GE. So for kicks, let's assume Vornado had to mark down its assets by 44%. Vornado's $18 billion of assets would fall to $10 billion. And that's before accumulated depreciation. What doesn't change is the amount of debt the company owes on these properties -- $12.7 billion. If you agree with this rough analysis, Vornado's real estate portfolio is 27% upside down, and its shareholder's equity-- listed at $8.1 billion as of the third quarter -- would be a cool ZERO.

Mind you, Vornado is probably one of the "better" REITs out there, and despite it all, it's generated $760 million per year of cash from operations in the last two years. What's that worth to a shareholder? At a nine cap rate (and that's generous these days, and will be outright unachievable if interest rates rise): $8.5 billion.

So let's wrap it all up. Let's say Vornado puts itself up for sale today. The value of its real estate under GE's assumption is $10 billion. Being generous, we'll assume that such value comes replacement cost, not from the discounted cash flow. The buyer will also pay $8.5 billion for the cash-flow stream, for a total price of $18.5 billion. Back out the $12.7 billion in debt, and shareholders are left with $5.8 billion, or $32 a share -- less than half of where Vernado is trading right now.

If you think that Vornado's or any REIT's stock is a good buy under this scenario, have at it. I'll gladly join you on the other side of that trade.

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