The brand spanking new team (and legacy boy Craig Schmidt) that Merrill recently acquired from some other bank (I wrote about this, but frankly don't remember where these clowns came from nor do I care), just went to town all over the REIT bathroom and marked their territory effusively. ML in fact distributed a 45 page reinitiation report, which I have no intention of ever reading. The summary ratings and price targets are below.
Is it just me or does Merrill have a Sell (and $4.50 price target) on recent Goldman Conviction Buy List and Greatest REIT Pick Ever CBL & Associates? Oh wait, Goldman in fact had some nice rah-rahish words on CBL earlier today did it not.
So... same company and yet: Merrill at Sell - $4.50 PT, Goldman at Buy - $10.00 PT. That's a pretty wide differential, and indicative again that nobody has any idea what the hell is going on with REITs (except for State Street of course which is still making shorting of REITs impossible).
We venture to guess: Goldman prop desk is very heavy with big CBL exposure they need to offload: Merrill - vice versa. Sounds like some great synergies can be extracted here. Goldman prop - meet Merrill prop (or the 3 traders that are still left there).
And, indeed, GS still has about 370k shares it needs to offload (to join the 500k or so it already sold last quarter).
As if anyone needed more confirmation just how bad commercial real estate is. Also includes a brief survey on the collapse of the SoCal regional market.
Been a while since we heard from the most popular (and profitable) research (and trading) desk on Wall Street. Last night Merrill analyst Craig Schmidt went to town upgrading pretty much anything he could get his hands on. To wit, all from the last 24 hours:
Simon Property: "We are moving from Neutral to Buy on Simon given the company’s opportunity to boost external growth (and improve SPG’s core U.S. portfolio) as they prepare to become a major player in the emerging “M&A” market in U.S. retail real estate. We are modeling acquisitions of $1 billion in ’10 at an 8.5% cap rates. These new assumptions take our ’10 estimate from $5.75 to $5.95."
Federal Realty: "Quality premium justifies Neutral rating. We are upgrading Federal Realty from Underperform to Neutral due to the fact the stock’s premium relative to its peers (on a price-to-FFO multiple basis) has contracted from 42% to 26% during the beta rally. [TD: upgrade on underperformance vs peers based on beta, not on fundamentals... fucking brilliant].
Developers Diversified: "Maintain Neutral, raising price objective. We are raising our DDR PO from $3.50 to $5.00 based on a higher forward NAV (from $3.76 to $4.84), and a modest reduction in our price objective’s discount to that forward NAV (was 5% is now 0%). We are also raising our ’10 FFO per share estimate from $1.44 to $1.59, to reflect the reduction in dilution given the issuance of fewer shares at the stock’s current price. [Give it 2 weeks until ML does another follow on here].
Taubman Centers: "Maintain Neutral, raising price objective [take DDR template, change name of company, recycle everything else]. We believe that Taubman is positioned with a solid balance sheet and has better than average liquidity than many of its retail REIT peers."
Likely much more coming over the next week as economic fundamentals and beta underperformance over the past 2 months has drastically changed the prospects for REITs.
All in all, a nice preamble for SPG to raise yet another round (2nf, 3rd, 9th - I have lost track at this point) of equity, compliments of the ever gregarious with other people's money Merrill Lynch sales/trading desk.
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Finally a market test valuation of Commercial Real Estate, which is not just hype and Merrill Lynch speculations. The Buffalo News reports that REIT Developers Diversified Realty is selling back 11 upstate New York shopping malls to the entity it originally purchased them from, Benderson Development Co., at a 30% discount to their 2004 purchase price.
In 2004 DDR acquired 110 properties from Benderson for $2.3 billion, an average price of $21 million, and is now selling back 11 of these for a total price of $160-$175 million, of roughly a $15 million average price, and a 30% discount. Not bad for Benderson which buying back what it sold 5 years ago at a 70 cents on the dollar.
And for all intents and purposes, this transaction was very opportunistic for DDR:
“It’s good that the ownership is going in the direction that it is,” said Michael C. Clark, director of retail tenant services at CB Richard Ellis in Buffalo. “There’s going to be a lot of markets in other parts of the country where they have portfolios for sale by different REITs and they don’t have someone like Benderson to step up.
“We’re pretty fortunate in terms of the market, in regard to that. How much better can you get than the folks that developed them and are intimately familiar with them and live and breathe here? They certainly know what they’re doing,” Clark said.
As Retail Traffic points out, this is very surprising as current estimates have been that retail properties would post at most a 40% decline from peak values achieved in 2007. A 30% discount from a 2004 price implies a significantly higher discount from the peak. RT calculated that the final closing discount from the peak is roughly 50%. As David Bodamer at RT points out:
There are a lot of things we don’t know about these assets. Are they healthy assets or do they need work? What do the current tenant rosters look like? Are the rents at market rates or lower? When do the leases come up for renewal? Did Developers Diversified sell these assets at a deeper discount than is truly reflective of market conditions out of a need to raise cash? Without this information it is hard to draw a full conclusion on what it means for the market. But the fact remains that this represents a massive drop in values from just more than two years ago. And the drop in value is larger than even the most pessimistic estimates have been for the peak-to-trough change in prices for retail real estate.
Notable is that DDR is raising cash in a non-equity offering form. Maybe Merrill has gotten to the saturation point where there is just not enough reverse inquiry into the phenomenally overpriced REITs.
Also, thanks to this market test, one will be able to recalculate what fair Debt-to-Market Value of Assets ratio is for the majority of mall REITs. The result will likely be an dramatic rise from previously consensual ratios, presenting yet another data point indicative of the REITs bloated overvaluations due exclusively to short squeezes.
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The greatest commercial real estate Kool Aid convention is currently in progress at the Waldorf-Astoria where NAREIT is holding its annual circlejerk week (oddly Zero Hedge was not invited), during which REITs try to convince other REITshow great the market is, how the GGP bankruptcy was the greatest thing since sliced bread, and how rents will (all facts to the contrary) continue to rise to infinity + 1 in perpetuity, as cap rates eventually become negative. Of course, if they really want to continue living in their humongous bubble, it's their right.
Now every now and then, someone utters something so dialectically stupid, that my ears start bleeding - it was only fitting that this year's "Kool Aid statement of the year" came from NAREIT itself.
Brad Case, vice president for research at NAREIT (who apparently lives in a cave and is locked into a 20 year lease agreement with exponentially accelerating rent increases), had this priceless gem of a statement:
"Real estate investment trusts in the U.S. may raise about $582 billion by 2013 for acquisitions as competitors sell properties and values fall. Publicly traded REITs will probably accumulate about $728 billion, including debt, for purchases. REITs including Vornado Realty Trust and Simon Property Group Inc. raised $11.5 billion in offerings in April and May and that’s just the front edge of the iceberg. The process that’s taking place starting right now looks very much like the process that we saw starting in early 1991."
Where does one even begin? Of course, while serial upgrader and totally unconflicted equity underwriter and loan redeemer (and NAREIT conference sponsor, duh) Merrill/BofA would love nothing more than to see REITs raise 25x more than what they have issued in follow-ons already ($$$ signs dancing in the eyes of whoever is left in the REIT research department at Merrill), for that to be an even remote possibility, Commercial Real Estate funds (such as Cohen and Steers) would all need to get nationalized, and Barack would have to announce that it is every man, woman and child's sworn duty to buy each and every share ever to be issued in perpetuity by such pristine and massively leveraged companies as Kimco and Duke Realty. For god's sake - if investors don't even feel like purchasing AAA-rated TALFCRE/CMBS paper at 12x leverage, who in their right mind would keep buying infinitely diluted equity offering from trusts that dont even pay the mandatory cash distribution in cash anymore (why are REITs attractive again?). If investors are really so deluded and bullish, they should just go out and buy ghost mall X directly and skip the middleman completely. Oh yes, there are quite a few of these available compliments of the rising tide of upcoming bankruptcies in the space.
For those who want to "Just Say No" to the REIT Kool Aid, I continue presenting data exposing what a complete fraud any statement is that CRE is due for a rebound, let alone the garbage statement that REITs have yet to raise half a trillion in equity (i mean come on, there are only so many shorts ML can squeeze, right, right?). Today's installment comes courtesy of Massey Knackal, who has put together a great long-term analysis of Manhattan multifamily data. I would love to get Brad Case's insights on just what this chart implies for his venerable coverage universe. Some of the most relevant charts from the presentation (attached below)
So while the jokers at the Waldorf Astoria congratulate bet the farm that CRE savior TALF will bail them all out, things are getting uglier by the minute. We wish them all the best, especially in advance of the Fed adjusting the TALF inclusion criteria yet again. However, no matter how you spin it, unemployment, economic contraction and lower rents which are the new normal, will sooner or later catch up with them. There is only so much time that inflating your numbers will buy you. Sooner or later someone will have to pay their rent as well... Maybe that is the key issue that Case should have addressed instead of some waxing philosophical on some whimsical future page pulled out straight from the 2006 uber-leverage days.
Moody's out with a piece, in which it joins the S&P chorus (well, not technically a chorus if just one is singing) Zero Hedge wrote about earlier, in which it seems the two major rating agencies are now taking both REITs and associated securitization conduits to the woodshed, and making it inevitable that Geithner adjusts the requirements for CMBS TALF participation. For once being a 1-10 year lagging indicator may actually be a market normalizing influence.
In the meantime, I present some of the relevant leverage charts from Moody's piece titled "US REIT and REOC Review & Outlook: Declining Fundamentals Cloud Outlook for Ratings." These should probably be kept in mind as one considers Bill Ackman's "bull" case in GGP. The debt/EBITDA trends should soothe all those who keep buying follow on after follow on offering. Come refi time, those 10% cap rates will also make sure their lives are a walk in the park.
In a research piece titled "REITs Cutting Residential Rents, Setting Stage for Further CPI Disinflation" Goldman Sachs analysts conclude that based on recent declining rent trends from residential REITs, the impact on price levels in the housing market (especially in major metropolitan centers where rent are only just now starting to unravel) will get progressively adverse, but will also feed ongoing general asset deflationary pressures, and by implication, added weakness to REIT cash flow. From Goldman:
With unemployment approaching double-digit levels, housing vacancies hovering near all-time highs, and industrial capacity utilization plumbing record lows, pricing power is nowhere in sight. And if our forecast of a sluggish economic recovery is correct, pricing power is unlikely to return soon in most industries.
Disinflation seems particularly likely for rental prices given the large overhang of available housing. Vacancy rates in the owner-occupied housing sector and the rental housing sector are both near all-time highs, so any “output gap” model of inflation points strongly towards disinflation in this sector. Furthermore, rent and owners’ equivalent rent (imputed rent for owner-occupied households) make up 39% of the core Consumer Price Index and 18% of the core price index for personal consumption expenditures. Thus, not only does a further decline in rental inflation look likely, but it is near-essential in order for overall core inflation to drift down towards zero as we expect.
This brings up the ongoing question of just why are REITs of all shapes and sizes, across all verticals (office, industrial, multi-apartment, etc), clamoring to be raising cash in order to "buy distressed properties?" If anything, SPG et al should be buying wrecking balls instead of bankrupt malls. The wave of overcapacity, coupled with rents which are only now starting to turn, will force REITs to be hit with the double whammy of i) increased interest expense from higher cap rates once they discovered that absent TALF version 29938.444, any refinancing is impossible, and ii) lower rent income... all leading to the conclusion that the current wave of equity follow on offering will be a great benefit to all REITs... when they seek to satisfy 2-3 quarters of cash burn at best.
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In his first note released in the post Sakwa world, Craig Schmidt continues to attempt to restore confidence in retail REITs. It would, after all, seem prudent to bang clients' heads into their desks until they see the light at the end of the tunnel (oncoming bullet train?) at a time when the only cash, and equity value, REITs can create is by raising expensive, dilutive equity in order to repay the cheapest form of capital (that of secured loans previously held by Mr. Schmidt uber parent, Bank of America). This is especially true, after these same clients have plunked down about $20 billion in new equity in companies that at this point exist on fumes of hope, speculation and short covering. not surprisingly, the report comes just prior to Realtors's release which indicates that Commercial Real Estate activity in Q1 fell 4.8% from Q4 of 2008 and 12.9% year over year, while vacancy rates are poised to rise to 12.1% from 9.7% last year.
While the title is expected, even Mr. Schmidt is at a loss to present the REIT "green shoots" that would substantiate his note. Amsuingly, Schmidt quotes favorable restaurant trends to back up the stabilization thesis:
Some positive signs included Dr. Mark Zandi’s (Chief Economist, Moody’s economy.com) citing that restaurants reported stronger same store sales gains than supermarkets in the most recent period, which suggests an increase in consumer confidence. Additionally, retail trends, while still negative, have improved from 4Q08, which were so dramatically negative that retailers were behaving like “deer caught in the headlights.”
Now that people are rushing to Nobu, maxing out their Centurions and hoping, very much like YRC, they can apply for and receive TARP funding, all must be good. The other "solid" positive:
Of the most seriously troubled retail markets (Southern California, Florida, Phoenix and Las Vegas), the only market that seems to have improved somewhat is Southern California. We still hear very distressing things about the other markets.
Nothing like Californians spending with reckless abandon, concurrently with voting down Schwarzenneger's hail mary proposals to scrape up some semblance of a budget. Next stop: California's utter fiscal collapse, and Geithner fixing that problem as well, by securitizing all default credit cards through a AAA rated TALF issue. Now, as for that foreclosure moratorium ending in Cali - don't worry, TurboTaxTim has that covered as well: banks will hold those shadow homes on their books until such time as 10% inflation has set in and debt is worthless, just in time to reflate the next Inland Empire housing bubble. Nothing is f****d here.
Among the bullet points presented by Schmidt, who after all has to maintain some semblance of objectivity, are the following stabiliziation zingers:
Low attendance at annual ISCS Spring Convention shows pain
Leasing with already constructed projects are a priority
Few see recovery to positive NOI until 2010 or later
Downturn accelerating bifurcation of shopping centers
Detroit sales finally succumbs to downward pressures
Asset sales still hard to come by
Greater emphasis on service tenants
Thinking outside of the box becomes a necessary skill-set
Store closing selections may surprise outsiders
So, yes, aside from all these points, retail REITs are certainly on the road to stabilization.
Lastly, and most curiously, is the reported departure of Ross Nussbaum, yet another Bank Of America/ML REIT banker to go to... UBS, which just yesterday had virtually its entire REIT team poached by Bank Of America itself. Is this tango merely normal Wall Street rotations, or is it indicative of something deeper at Bank Of America. People are still scratching their heads over Steve Sakwa's departure.
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Steve Sakwa, whose work product Zero Hedge has not spared its praise for in the past, has left the building. The "top rated" REIT analyst, who gained prominence in the past 2 months for such great work as an upgrade of virtually all companies he covers, has departed for greener, although unknown, pastures. It is quite odd that Sakwa would leave the bank at a time when his group was generating more revenue than virtually any analyst/trading group on Wall Street.
His pastoral style will be missed, if briefly, as he will be replaced by not one, but five REIT analysts that have jumped ship at UBS and are coming to Merrill. Seeing how the banks has generated over $100 million in revenue from REIT underwritings since March 9, it may have even been so generous as to give the UBS team some very sweet guarantees.
Zero Hedge will now focus on his legacy partner, Craig Schmidt, who has been oddly quiet lately with very few companies under coverage left that could get a bump in their price targets.
From Bloomberg:
Steve Sakwa, the top-rated analyst of U.S. real estate investment trusts, left Bank of America Corp. and the lender hired five analysts from UBS AG.
The analysts joining Bank of America include Jeffrey Spector, who was named head of the REIT research team, and James Feldman and Michelle Ko, hired as senior analysts, Bank of America said today in a statement. Lindsay Schroll andAndrew Ryu join as associates. Carrie Gray, a spokeswoman for Bank of America, confirmed Sakwa’s departure in a telephone interview. “You’re getting a proven commodity that’s able to hit the ground running quickly if that’s what you’re looking for,” said Jeffery Harte, an analyst at Sandler O’Neill & Partners LP in Chicago.
U.S. REITs including SL Green Realty Corp. and Vornado Realty Trust have raised more than $10 billion from share sales this year to pay debt and take advantage of buying opportunities as property prices fall and weaker REITs fail or are forced to sell assets. The 111-member Bloomberg REIT Index is down 13 percent so far this year and commercial property prices fell 21 percent in March from a year earlier, according to Moody’s Investors Service.
Sakwa was named the top analyst in Institutional Investor magazine’s “All-America Research Team.” He estimated in a December report that U.S. REITs would pay out $11 billion in dividends this year and a similar amount in 2008. That’s down from about $13 billion in 2007, according to the National Association of Real Estate Investment Trusts in Washington. Merrill Lynch
Sakwa worked for Merrill Lynch & Co. when Bank of America, the biggest U.S. lender by assets, bought the securities firm in January. Banc of America Securities-Merrill Lynch Global Research, the unit that hired the UBS REIT team, has hired 12 analysts in the U.S. and another 23 worldwide since January, Bank of America said in today’s statement.
Spector and his UBS team were named among the “runners- up” in the Institutional Investor All-America Research Team survey last year. Sakwa and his team were named the top analysts. The “second team” went to Citigroup Inc. and the “third team” was Barclays Plc. Messages left at Sakwa’s Bank of America number and a private number were not immediately returned.
UBS spokeswoman Allison Chin-Leong declined to comment on why the REIT group left the firm. UBS does plan to have coverage of REITs in the future, Chin-Leong said.
Gray declined to comment on Sakwa’s departure beyond confirming it.
Craig Schmidt, senior U.S. REIT analyst at Banc of America Securities-Merrill Lynch since 1995, will report to Spector and remain in his current position, according to today’s Bank of America statement.
As Zero Hedge's all time favorite investment bank Merrill Lynch is all too happy to attest, the REITs have proven to be a phenomenal source of underwriting revenue. Amusingly, the REITs which face staggering near-term maturities are still unable to access the debt capital markets (with one or two notable exceptions), yet have raised well over $10 billion in equity to date (which they have used almost exclusively to pay down the cheapest form of capital: secured credit facilities: why?) leaving one to truly wonder just what is the big picture here really all about (aside from ML pocketing dilution cash). So just how far down the road are recent equity raises going to take the (still) very troubled REIT space? (Why still? Redo the FFO calc with a 9% cap rate. Come back then). Answer- not all that far.
Below, I present a summary of the most notable REIT follow on offerings done in the past 2 months: as one can see the amount raised is staggering, and the main lead underwriter (sole or joint) by a vast margin is Merrill Lynch.
The two immediate take home messages here are that despite an average 24% dilution for REITs which have undergone the ML Cohen and Steers treatment, they have still outperformed the general REIT universe in price appreciation (P/FFO) by a factor of almost 300% (8.4x to 9.6x for broad universe compared to 11.7x to 14.4x for the diluted names). Odd you say?
And while the chart above shows not only the ridiculous prominence of ML in the pantheon of busy little underwriters, it also demonstrates just how much capital REITs have raised to date. The reason of course is the imminent maturity schedule for the vast majority of these. The chart below shows the 2009-2011 maturity schedule for the bulk of the major REITs split by category. One can see that based on just these main 15 companies, there is almost $20 billion in upcoming debt maturities over the next 3 years, which explains why any and all REITs will take advantage of every single orchestrated market bubble from now until they ultimately follow in the shoes of GGP, to sell the pieces of paper better known as common stock.
In other words, mother Merrill will likely not stop (and the market squeeze will likely not loosen) until there is at least another $10 billion in additional dilution from the remaining usual REIT suspects (and until ML has pocketed at least another $100 million in underwriting fees). Even so, I have not disclosed the 2012-onward maturities, where things really start to get interesting. But by then, as everyone knows, we will either have hyperinflation, and all the REITs' exiting debt would be payable down with one mere $1 trillion bill, or the S&P will be at 6.66, in either case current investors will long be gone, having sold to whatever hot potato holders are the most fervent believers in Jim Cramer's economic "fundamental analysis."
Another retail casualty about to hit, this time clothing chain Filene's Basement. Bloomberg cites two people familiar with the situation, who claim a Chapter 22 (that is a repeat 11 for the less than cynical) may be filed as soon as tomorrow.
Filene’s Basement, the century-old clothing chain, may seek bankruptcy protection this week, according to two people with knowledge of the plan.
A filing may come as early as tomorrow, said the people, who declined to be identified because the information isn’t public. There are several parties interested in buying assets out of bankruptcy, one person said.
Former Filene’s Basement owner Retail Ventures Inc. said April 21 that it transferred the unit to Buxbaum Group, a company that appraises and liquidates assets, for no proceeds. FB II Acquisition, the Buxbaum affiliate formed to acquire Filene’s Basement, said in a statement two days later that it was reviewing “all available” options for the chain, which sells discounted designer goods.
Buxbaum, based in Agoura Hills, California, is a liquidator and appraiser of retail and wholesale inventories, and provides turnaround, expansion and other consulting services.
The first time FB filed for bankruptcy was in August 1999, and was bought out of chapter by Retail Ventures predecessors, owner also of the DSW shoe chain. If Linens 'N Things is any indication, the ensuing liquidation will leave yet more strip malls with one less tenant. The company's retail locations are concentrated in the northeast, and at last count had about 25 soon to be vacant storefronts... This is yet another "investment highlight" for Commercial Real Estate and Merrill Lynch's REIT prospectuses, which has at least another $30 billion left to raise before the squeeze is over.
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As documented previously on Zero Hedge, concern #1 by a large margin for the administration is the issue of commercial real estate, and more specifically the disconnect between price discovery of CRE securities (especially in equities) and their deteriorating cash flow fundamentals. Investors who have actually done their homework and have established directional bets on CRE valuations, have, over the past month, been left wondering how it is possible that equity prices of REITs and other leveraged plays on CRE could possible be skyrocketing by over 100%, despite massive rolling dilutions and increasing fundamental weakness. Additionally, for all practical purposes, recent equity raises have been used merely to pay down secured debt financing (for the benefit exclusively of underwriter banks). As REIT analysts at Merrill Lynch would be happy to attest, the "improved" balance sheets, at best afford these companies several quarters of time, absent wholesale deleveraging (in or out of court), as declining FFO coupled with massive interest expense simply means that these credit facilities will only end up getting drawn down again sooner rather than later.
In this sense the equity raises are merely a desperate attempt by a select few fund managers who are massively underwater on their REIT bets, to prop up stock prices (after all these funds have some very concerned LPs they need to answer to, and as there is a monthly P&L reporting obligation, their very viability depends on posting at least a marginal rebound for one or two months so they can "live" to fight another day). This also explains the reverse inquiry nature of most recent REIT equity raises: these are not voluntary institutional and retail investors channeling interest to the Merrill and Goldman syndicate desks: it is, in fact, the opposite. On the day before an equity raise, the head of equity syndication at Merrill will call fund XYZ and ask them, essentially, if they would be willing to throw some good money after bad. The potential side effect of a forced short squeeze or, even more sinister, the feedback loop of leveraged ETFs getting thrown into the equation as a price trajectory perpetuating mechanism, is hopefully not discussed, although after last week's cloak and dagger disclosure about Bernanke and Paulson illegally strongarming Ken Lewis, nothing should surprise readers anymore.
In my search for candidates of this possible reverse inquiry mechanism, I stumbled upon some interesting clues, which have lead me to reexamine some old Zero Hedge favorite names. I present some observations.
A few days ago, Cohen & Steers (CNS), possibly the largest publicly-traded, long-biased REIT-focused asset manager reported its First Quarter results. As expected, the numbers were horrendous, underperforming the S&P500 by a vast margin. Of course, Zero Hedge readers should not be surprised by this performance: virtually the entire CNS portfolio is comprised of long REIT positions, which in Q1 lost over 30% of their value (in addition to a massive drubbing in all of 2008). It is thus not surprising that CNS reported that it saw major declines in Assets Under Management, which dropped to $11.6 billion at March 31, 2009, a 23.2% decline from from $15.1 billion at December 31, 2008, and a 60% decline from the $28.6 billion in AUM at March 31, 2008! What is very interesting is that of the $3.5 billion reduction in AUM, a majority, or $3.4 billion, was due to asset depreciation, and only $76 million was due to net capital redemptions, a major moderation from the $2.9 billion in redemptions year over year.
What is even more interesting, is that Cohen and Steer's institutional separate accounts (or managed accounts) stood at $5.6 billion, or nearly half of CNS's total AUM. And following up on this, and most interestingly, somehow Cohen and Steers managed to convince institutions to invest $395 million in its managed accounts, despite the decline in AUM for institutional separate accounts from $6.3 billion to $5.2 billion, before new capital inflows, an 18% decline. That is some truly phenomenal marketing PR. Just who these institutions are that have a (vested) interest in providing fresh capital to a REIT manager which demonstrates a market underperforming loss in AUM across the managed account class is truly very interesting and likely source of further much more focused investigation.
The last is an open question I will return to shortly, but in the meantime, it makes sense to present Cohen & Steers March 31 investment commentary for the Q1 period. Most notable here is CNS's disclosure that without it, none of the new equity raises in March (and likely April) would have been completed.
Cohen & Steers was instrumental in these capital raisings, and was a cornerstone investor in the offerings. We believe these transactions have demonstrated to the market that high-quality REITs have access to capital and can reduce their leverage, as needed. In our view, these companies, along with others that have strong balance sheets, will weather this recession and credit cycle and remain industry leaders.
Without the inflow of $395 million in "institutional separate account"capital, CNS would likely have been unable not only to be a "cornerstone investor", but to participate at all in any of these financings, which due to their reverse inquiry nature, would thus likely never have occurred in the first place as a seed investor is always critical in order to generate additional reverse inquiry interest. The first question a syndication desk gets when solicitation reverse inquiry interest is: "Who else is participating?" Absent a clear cut answer, the offering dies right then and there. This makes the question of just where these managed account inflows came from, all the more interesting.
The innocent conclusion is that Mr Robert Steers must really believe in dollar cost averaging. Alternatively, the fact that Merrill Lynch was the lead underwriter of virtually every single Cohen and Steers closed-end fund may potentially raise a few question marks (for our readers' convenience we have compiled some of the relevant Cohen & Steers prospectuses here - please note the lead underwriter in every single instance: Global Income Builder, Dividend Majors Fund, Quality Income Realty Fund, REIT and Preferred Income Fund, Premium Income Realty Fund, Total Return Realty Fund, Closed End Opportunity Fund, and the list goes on). The not so innocent conclusion is that Merrill, as Zero Hedge discussed previously, which would be very happy offload its credit exposure (via Bank Of America's key role as lead and syndication manager on the bulk of REITs secured credit facilities), with the assistance of its equity analysts, who would upgrade the respective REITs from Sell to Neutral or Buy ratings as soon as the offering was priced, may have had an ulterior motive to work with CNS, and facilitate their new capital generation, in order for them to serve as lead investors on all of the equity offerings (dilutions) that Merrill was lead underwriter on. An even more unwholesome pattern thus emerges: Merrill sells, CNS buys (using closed end funds which Merrill underwrote or new capital from "who knows where"), Merrill upgrades, REIT pays off Merrill secured loan, CNS marks profit on position as short squeeze in REIT stock is generated, and new investors put money into CNS after seeing "phenomenal" monthly or quarterly returns.
Quite interesting for the conspiracy minded.
But that's not all. On its April 23, Q1 conference call, Cohen and Steers had some interesting observations about the state of the REIT "deleveraging". CNS President Joseph Harvey had this to say about the company's willingness to throw tons of new capital at the REITs in the recent equitization wave:
"Our approach to these recapitalizations are to provide equity to these companies, to provide solutions to their balance sheet issues. Of course, you can't create 100% uncertainty. However, we believe that the equity that we and others are providing will be sufficient to get these companies through the year 2012. So we think that's a very long time horizon. We're confident that – by that time, the equity markets, other capital markets, will have improved. So we're extremely excited about these opportunities and the position of these companies once we execute these transactions."
Looks like Mr. Harvey has not focused a lot on threat of REIT refinancings. But who cares about 3 years down the line, when in the meantime you can bump up profits on a short squeeze and generate some additional investor interest in your fund (thus maintaining your biweekly paycheck).
Some more insightful disclosure from Mr. Harvey, who responds to Merrill analyst Cynthia Mayer's question of how far down the REIT equitization process the market is.
"In rough numbers – and again, this is a moving target depending on how the capital markets open up, but to delever the US REIT sector to levels that we think are sustainable, let's say it takes 40 to $50 billion of equity capital. In one-months' time, there has been about $10 billion that's been raised. So that's a pretty significant bite out of the apple. Now, of course, that's just the US. We think there is other opportunity outside of the US.
Let me also point out that if we have seen the lows in these stocks and we're gaining confidence that that's the fact, as we think through the next return cycle for REITs, I'd break it down into three phases. Phase one is the re-equitisation of the sector. There is going to be a phase two that we believe will be very dynamic and exciting from an investment perspective, and that phase is for our universe of companies to acquire assets from the private market who has their own leverage issues. And we know because of what the debt maturity schedule looks like in the real estate industry and what the capital structure of those assets is that there will be fore-selling. And based on our experience through the early to mid-90s, we believe that the public market will provide the capital to our universe of companies to take advantage of those opportunities to acquire from distressed sellers.
Zero Hedge would beg to differ that there is anything even remotely comparable between the current situation in the CRE market and that in the early 1990's. But that is irrelevant: Mr. Harvey essentially is hoping that there will be a greater fool available, to whom CNS can offload its REIT securities, ahead of what CNS believes will be a flouring period for commercial real estate beginning in 2012, which of course is contrary to what Zero Hedge and more and more market participants believe will happen, namely the refi crunch in 2012, which will expose CRE for the massive sham it truly is.
Amusingly, subsequent the call, Cynthia Mayer, who likely is not with the program, reiterates her Sell rating on Cohen & Steers.
Another last amusing point from the CRE conference call, is Harvey's response to UBS analyst Phil Wilhelm, who asks the logical question of what exactly is it that makes CNS comfortable that the REIT market has seen the bottom, and what themes is the company seeing that can support this claim. The answer leaves much to be desired:
We're really not comfortable discussing our short-term thinking on market movements and why. That's what we get paid to do for our clients. So, I'm not going to answer your question as to what gives us confidence as to why REITs have bottomed. We feel pretty confident in that, but we'll let you draw your own conclusions on that.
As I mentioned earlier, there is probably $30 billion US in equity that still needs to be raised over a couple of year period. So that's still a lot of capital relative beside the universe, and there is over a 100 REITs, so I'd say 15 of them have raised equity already. So there is going to be a lot of activity. We believe that the share prices have overshot on the downside to discount this financial risk. So as these balance sheet issues are solved, I know the stocks have performed and that's what has attracted investors to the area. So there is no assurance that this is going to continue if share prices rise to the point where the stocks reflect the opportunity to recap, it's going to get tougher for these deals to be done. But we think as long as they're done right and we've got a very specific formula for how they should be done, the market will – there is lot of capital out there that can absorb this equity.
May Zero Hedge ask just what this specific formula for how deals get done is? Could it involve managed accounts, a short squeeze, and Merrill Lynch in some capacity? Inquiring minds want to know. Because, despite CNS' stern promise that things are getting better, I for one would be happy to challenge anyone from CNS's management team or their portfolio managers one on one or one on many, that things, in fact, are not getting better, and once the refi cliff hits, thing will likely get a whole lot worse. I also have the numbers to back my assertions. One thing is for sure: Harvey is likely correct that there is another $30 billion or so in new equity raises down the pipeline. Zero Hedge would speculate that Merill, which is likely to be an underwriter on the bulk of these, will easily generate $1.5 billion in equity underwriting fees (the customary 5%), and CNS will likely be a happy "cornerstone investor" as more and more short squeezes are sprung. Technicals will dominate as fundamentals tell each and every investor will half a brain to run for the hills.
But then again, we live in a market where fundamental don't matter, and there is much more going on behind the scenes than is being let on. And for the most convincing example of the later, I bring your attention to the April 24 Q1 earnings call by Developers Diversified Realty Corp, one of the many beneficiaries of the REIT short squeeze. I bring your attention to the very end of the Q&A from the conference call, where EVP and CIO David Oakes chimes with the following cryptic disclosure:
"And I would like to add – to chime in here too, Jim, that I was at the real estate roundtable meeting the other day and we spent a few hours with Ben Bernanke, and he's pretty confident that we're going to see this help program for CMBS up and running within a few weeks; and very helpful that that's going to start to create a little bit of liquidity in the CMBS market, and we're in the queue with one of the major investment banks to do a significant self-financing when that becomes available."
Aside from this being a blatant attempt at Reg FD breach, would this bank potentially be Merrill Lynch one would wonder? But more relevantly, just what is it that Ben Bernanke is promising managers of very troubled REIT companies such as DDR? Perhaps, once done investigating Merrill-gate and Ken Lewis, and whether or not Mr. Bernanke was instrumental in putting that deal together, direct threats to Mr. Lewis' career notwithstanding, the new York State Attorney General can take a look at just how widespread taxpayer fund misappropriation is at the Federal Reserve level in order to buy a few quarters of breathing room for doomed REITs at the expense of fundamentally sound investment analysis.
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Zero Hedge has voiced its thoughts on the matter repeatedly (to the point where a broken record sounds outright creative) so I will present those of BCA Research instead, as the latter has some notable conclusions on the rationality of equity investments into the REIT sector.
REITs have historically been at the top of the yield-generating heap, but look to be in jeopardy of losing their appeal as reliable cash flow growth vehicles.
At first blush the attractiveness of REITs looks good. The dividend yield on the S&P REITs group is almost as high as at the end of the relative performance bear market in 2000 (Chart 15). Piling into REITs back then would have generated substantial capital gains as well as an attractive running yield in the subsequent years. But the differences between now and then are enormous.
Many REIT operators took advantage of what looked to be a permanent increase in demand and undertook a rapid facility build out. Our construction composite for the primary REIT sectors has been growing far above-trend for several years. If the residential market is any guide, a prolonged building retrenchment will be needed before underlying property prices will stabilize, especially in view of the plunge in occupancy rates.
Chart 16 highlights a number of indicators of demand. BCA’s REIT demand indicator continues to sink, consistent with a drying up in demand for commercial real estate loans (top panel, Chart 16). Vacancy rates have exploded higher in some categories. Our overall vacancy rate indicator, a composite of our REIT demand and supply indicators, shows that the vacancy rate composite is headed much higher (second panel, Chart 16). Property owners will have a very difficult time raising rents to existing tenants given a glut of unfilled space, and the ability to attract new tenants will be limited until overall economic activity improves significantly. The implication is that generating cash flow growth will become increasingly challenging, and some payouts are at risk of getting slashed.
Adding it up, the REIT sector does not offer an attractive opportunity to gain exposure to income. In fact, excess capacity argues for moving up in the corporate capital structure towards bonds. [very critical to note for investors who just threw a ton of money down the follow-on equity offering chutes in several names]. Deflation risks will hurt earnings before balance sheets. Deleveraging also favors credit over stocks. Perhaps investors are already moving in the direction of corporate bonds. Net sales of corporate bond funds have soared. In contrast, net sales of equity funds continue to sag. Retail investors appear to be looking to take advantage of juicy corporate bond yields that are already pricing in a grim financial outcome in most sectors, including REITs and utilities. The same cannot be said for the REIT sector in the equity market (in relative terms).
In a nutshell - if you really want, nay need, REIT exposure, buy bonds, stay away from equity. If recent stock actions by REITs such as KIMCO and ProLogis benefit anyone, it is the bondholders, since they will see benefits long before any incremental cash flows through to equity holders. Yet bonds have not had nearly comparable moves to what these companies' equity prices have demonstrated (30-60% upside moves in 2 weeks): in short, REIT stock are far ahead of the recovery curve, especially since even bondholders don't believe in significant upside value. Then again, if the whole thesis of marginal upside purchasing on declining volume has been true for the broader market in general and the REIT space in particular, once the real money (quants) becomes a participant in the next market move leg, watch out below. As ML pointed out, the quants have missed the upmove, but one can bet they will not do so with the move lower (not if but when it occurs). The only conclusion - once the flip occurs, and the quants jump on board for the reversion, the carnage will be unprecedented.
Goldman has been really pounding the REIT space. Which, of course, skeptics will say simply means their prop desk (or what is left of it) is buying REIT assets hand over fist. Or maybe they just really hate the space. Either way, the main concern GS has is the massive overhang of upcoming debt maturities (through 2011), and if the recent financing by SPG is any indication of what kinds of costs of capital REITs can expect, it will get ugly fast. Furthermore, GS believes charge-offs are set to skyrocket over the next several years.
Additionally, GS is expecting a dramatic rise in cap rates: in the neighborhood of up to 500 bps:
The core of the problem for REITs and the entire CRE space in general is the rate of vacancy increases across different sectors. This one would be a doozy for the government to "intervene" in unless it decided to spill its employees out of DC and have them populate New York's midtown, all the while paying peak-market, 2005 rents.
Lastly, Zero Hedge's approach at REIT scatter-bubble charting seems to have found fans. An moving chart from Goldman evaluating a whole lot of three-axial data.
A three-axial analysis of some of the most prominent REIT names yields some interesting results. The chart below is a 3D scatter plot of Z spreads of REITs bonds (for this analysis bonds maturing in 2015/2016 were selected) based on today's bond market levels (Z spread is the CDS equivalent spread for a specific bond; as most names are trading sub 1,000 it is fair to say that convexity is not much of an issue), versus the company's leverage level, and juxtaposed to today's stock market capitalization of the underlying company.
The chart above excludes outliers Prologis whose 5.625% of 2016 had a 1,577 bps Z-spread on 19.7x leverage and DDR, whose 5.5% of 2015 bonds had a 2,145 Z-spread on 10x leverage. PLD indicatively has $1.7 billion market cap while DDR is at $267 million.
If one assumes efficient markets, the greater the leverage (higher on the chart) and the greater the risk perceived from the credit side (further right on the chart), the worse the prospects for equity recovery. Yet as the chart above shows there are some pretty dramatic aberrations.
I leave the chart for your consideration without making explicit conclusions, although will note that either credit or equity markets are mispricing risk substantially at many of these companies.
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Zero Hedge has written much about this so no comments here. Good article from Bloomberg summarizing the upcoming pain. Some salient quotes:
“REITs are cheap but they’re going to continue to be cheap,” said Marc Halle, managing director of Prudential Real Estate Investors in Parsippany, New Jersey, whose firm manages about $32.5 billion in real estate assets. “We’re going to see increased corporate bankruptcies and continued unemployment for the next few months.”
More than a dozen retailers, including Circuit City Stores Inc. and Linens ‘n Things Inc., filed for bankruptcy protection in 2008. Store closures have hit shopping center landlords including Developers Diversified Realty Corp., whose stock fell 95 percent during the past year to $1.89.
The dividend yield on the retail REIT index is almost 15 percent, more than five times the 2.88 percent yield of the 10- year Treasury note, a traditional benchmark of value. During the past decade, REIT yields averaged less than 2 percentage points above Treasury yields.
Retail REITs are worse off because they borrowed more heavily than apartment and health care landlords, said Dean Frankel, a senior portfolio manager at Urdang Securities who helps manage about $1 billion of real estate securities.
Refinancing Risk
The real estate market has been in limbo while investors await government measures to deal with the collapse of the banking industry and boost an economy in its second year of recession.
Refinancing risk is driving REIT prices, said Prudential’s Halle.
“No one cares about value,” he said. “It’s about survival and making your balance sheet as strong as you can.”
REIT Simon Property Group announced results of its dividend election today, which for all practical purposes could be called anything but an "election." The final outcome is that shareholders will receive a dividend of $0.90/share consisting virtually entirely of stock (90%) and the balance in cash. The irony is that when queried, shareholders predominantly opted for a cash distribution (193.6 million shares, or 93%), versus those opting for shares (15.2 million, or 7%), while 22.5 million "shares" didn't care either way.
The REIT, which has roughly $773 million in cash and $18 billion in debt currently, has reason to conserve cash, as the deteriorating cash flow generation from its portfolio of regional malls and community shopping centers is likely being impacted very adversely as a result of the accelerating bankruptcies among its retailer tenant base. Surprisingly, the company has a market cap of $8 billion, which, based on a closing share price of $34.73 and representing a 20x multiple of its consensus 2010 earnings of $1.73 (a number which could be in threat of reduction if ongoing deteriorating within the commercial real estate community continues), seems somewhat rich based on its growth prospects. Without doubt the primary factor in determining its recent share price moves is its short interest which at 24.3 million is slightly more than 10% of the company's total stock float of 212.7 million shares.
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The carnage in homebuilders continues. Hovnainan posted a $2.29 loss, substantially worse than the consensus estimate of -$1.56 after "joblessness climbed and prospective buyers waited for prices to quit falling." Paul Puryear, director of real estate research at Raymond James had some additional choice words: "A couple of builders are on the critical list, Hovnanian being one. The No. 1 driver of household formation is job growth and job growth is negative. We need to turn that around." Lastly, owner Ara Hovnanian gave his 2 cents on the lack of light at the end of tunnel of 10 consecutive quarterly losses
"Given the lack of steps taken by the federal government to address housing demand, prospective home buyers are still faced with making the decision to buy a home against an exceedingly difficult economic backdrop. We expect demand for all homes, both new and existing, to remain far below normalized levels. While we have experienced a typical, seasonal pickup in traffic and sales since the middle of January, this increase is coming off of extremely low levels that have prevailed since mid-September,”
Hovnanian, which features prominently on Moody's infamous death list, was downgraded on March 6 to Caa1 from B3 with the following caution "Government actions will be helpful largely at the margin liquidity will remain tight and lender behavior uncertain, and2009 will be a year of greatly reduced deliveries."
Which leads us to the broader real estate, both residential and commercial, space of which we think the REIT sector is most poised for some dramatic downside surprises (one only needs to look at the GGP soap opera for a good idea of just how bad things really are). The only potential saving grace would be whether the U.S. decides the REITs are the next sector it considers too big to fail (more on this in a subsequent post). However, as we have seen with what happens to other sectors to which the government decides to provide its helping hand, this too could be a two edged sword.
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S&P just announced it was downgrading Camden Property Trust and First Industrial, and putting nine other REITs on downgrade review including AIV, BRE, Capital Automotive, CLP, DDR, HPT, PLD and UDR...
"Commercial real estate trends are eroding at a pace indicating that occupancy and rental declines should match the deep recession of the early 1990s. To that end, we ran a “stress test” for the 36 companies under coverage and now expect a 25% decline in earnings in 2009/2010, far below Street growth forecasts. Moreover, we expect most companies to reduce dividends to help address debt rolls of more than $100 bn into 2012."
Punchline: $26 billion of debt comes due in 2009/2010. Even with all REIT dividends converting to 100% stock/0% Cash, this measure would satisfy at best 25% of needed cash to pay down upcoming maturities. In our opinion a massive wave of commercial REIT defaults is expected.
ZH still thinks SRS is a terrific investment vehicle as this industry unwinds, despite the embedded weaknesses of a double negative ETFs (and yes we do hold a position).
