Thursday, July 05, 2007

Real Estate Sees the Best of Times and the Worst of Times
Thursday July 5, 8:55 am ET
By TradingMarkets Research

Cheap debt and a boom in private equity have been key drivers for equities this year, even as the U.S. economy faces a stiff headwind from the deflation of the housing bubble. But all good things must come to an end. The outlook for deal flow is dimming as it gets harder for underwriters to place high-yield debt. Subprime problems at Bear Stearns (NYSE:BSC - News) have soured investors on high-yield debt, and the latest casualty came on July 5. A private equity firm had to resort to a bridge loan for $1.1 billion in financing for the leveraged buyout of ServiceMaster Co. (NYSE:SVM - News). This is a troubling sign, since U.S. equities will suffer if

Since real estate has been the key driver of this credit cycle, this week we look at REITs, which represent a broad range of subsectors. Even a cursory glance shows that real estate in America is now a tale of two cities, with boom times for downtown office space even as the suburbs go bust.

With apologies to Dickens, you could say that it is the best of times and the worst of times for U.S. real estate. Residential real estate continues to sag after peaking in 2005, while commercial real estate is hitting new highs. Office space on Park Avenue in Manhattan sold this week for $510 million, which comes to $1,600 per square foot. That is a record for commercial space in the U.S. Meanwhile, delinquencies on residential mortgages climbed to an 18-month high in the first quarter, and housing prices continue to decline.

The PowerRatings for REIT industries reflects this bifurcated outlook. The REIT industries with higher ratings are in Healthcare and Office space, both of which have bright fundamental outlooks. Pulling up the rear are Residential REITs. This group has a PowerRating of 2, which makes it one of our Industries to Avoid. Hotel/Motel REITs also have high exposure to the U.S. consumer, and it has a PowerRating (for Industries) of 2. In the short run, however, the Hotel/Motel industry got a boost on July 5 when Blackstone Group (NYSE:BX - News) announced a deal for Hilton Hotel (NYSE:HLT - News).

For investors who insist on exposure to real estate, it makes sense to stick with REITs that have the highest PowerRatings (for Industries). Right now this means commercial REITs such as Offices or Healthcare Facilities. Granted, these industries don't have high PowerRatings on an absolute basis. But they make better alternatives than the consumer-driven REITs at the bottom of our industry ratings. Our quantitative data from 1995 through 1996 have shown that PowerRatings do an excellent job for investors who seek high annualized returns over the next three months.

Unwinding Big Positions

Credit problems take a long time to fully emerge. Weaker borrowers suffer first, and then the problem spreads to stronger borrowers. And many mortgage derivatives are complex products, so it takes a while for credit defaults to show up in more complex products. That may be why subprime lending problems originally showed up at HSBC in February, yet it took until June for the hedge funds at Bear Stearns to take a hit.

Another issue is scale. Many bond investors have placed huge directional bets. High leverage is common in fixed income, and some hedge funds have levered their bond portfolios 10-to-1 or even 20-to-1. This means that even tiny declines in bond prices can have a devastating effect on capital.

This is a combustible situation. Bonds are less liquid than stocks, especially when prices are falling. Many of the more exotic bonds are not regularly priced, and portfolio managers don't want to create "fire sale" conditions that force them to mark to market at the worst possible time. This is another reason that it will take investors quite a while to fully unwind their positions.

Sticky Downward

There is yet one more reason that it takes a long time for real estate cycles to turn. People hate taking losses on their homes, so they just take them off the market. This makes real estate prices "sticky downward," which is how Keynes described wages (people don't like pay cuts, either). So the combination of forces is going to make this real estate cycle a protracted, messy affair. Real estate was the engine that drove the U.S. economy for many years. The engine stalled last year, and now it has become a slow-motion train wreck with no caboose in sight.

Rob Martorana, CFA, is Director of Content for

Rob was most recently at as the Director of Content for Professional Products. Rob has spent 22 years on Wall Street, and was a portfolio manager and head of U.S. equity research at Barclays Private Bank. Robert also managed small-cap stocks at Schroder Capital Management International, was an equity analyst at Vontobel USA, and was an editor and senior industry analyst for The Value Line Investment Survey.

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