Stephen’s Posterous

Barron's Online recently asked Kelly Rush, portfolio manager of Principal Global Investors' Real Estate Securities Fund about the REIT landscape. His $1.1 billion fund managed to be among the top five performing REIT funds in 2008, despite a loss of 33%, according to Morningstar data.

Mr. Rush said that REITs are weak and will continue to be weak for some time, well into 2010, and there is a lot of pessimism built into the stock price. Historically, real-estate stocks have averaged a 12 times multiple. Today, real-estate stocks are trading at a little bit less than a nine times multiple. There is a lot of room there for growth.

Mr. Rush does not believe that leverage was a major problem for the industry. General Growth Properties turned out to be a poster child for a company that went too far with leverage.

Mr. Rush's favorite REITs begin with health-care operator, Ventas (VTR), who lease their facilities to companies that run health-care operations and Public Storage (PSA), which rents mini-warehouse buildings.

One REIT that may benefit from the security of long leases is Entertainment Properties Trust (EPR), whose emphasis is with movie theaters.

Real Estate Securities Fund has owned two companies in the industrial sector for a long time: AMB Property (AMB) and ProLogis (PLD). Both have been involved in the development of industrial space worldwide. ProLogis has a lot of financial stress, but Mr. Rush believes that they are going to be able to survive.

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Hedge fund guru Bill Ackman is still fighting with Target Corp. as reported by the Wall Street Journal, Mr. Ackman has called a meeting in Manahattan on May 11, 2009, to introduce his five directors, which includes him, for election on May 28.Editing a post - Posterous

Target's stock has dropped 58% from September 2008 to March 2009, and rebounded recently with other stocks, but is currently down 39% from its peak of $70 in July 2007.

Target is prepared to fight Mr. Ackman and may spend around $11 million fighting this battle. Mr. Ackman was successful in pushing Target to sell a stake in its credit card portfolio and wants the company to sell more. Mr. Ackman estimates he will spend about $15 million fighting this battle as written in the Financial Times.

The Financial Times also reported that Mr. Ackman's Pershing Square hedge fund owns about $1bn in Target common stock along with options on another $280 million. The company's fund, Pershing Square IV, consists entirely of call options on Target stock. Mr. Ackman also said in an interview with the Financial Times that his agenda is also to fix corporate elections.

Mr. Ackman was not successful earlier in convincing Target management to spin off land it owns under its stores to create a public traded real estate investment trust, REIT.

Shareholders may be somewhat receptive to Mr. Ackman's offer seeing that  Walmart has been able to have strong growth despite the recession while Target's sales have been trailing Walmart's by up to 6 percentage points. In the past, Target has trailed Walmart's sales by only 1 or 2 precentage points as pointed out in the Wall Street Journal article.

Although somewhat hipper and cooler than Walmart, Kmart, or Sears, Target is about one sixth the size of Walmart in terms of market capitalization. In the first quarter of 2009, Target had an operating margin of 4.82 percent while Walmart had an operating margin of 5.84 percent.

Mall owner General Growth Properties Inc. sought bankruptcy protection early Thursday, April 16, 2009, in one of the largest real-estate failures in U.S. history, capping a precarious, months-long effort to juggle the crushing $27 billion debt load it shouldered in past acquisition sprees.

The long-anticipated Chapter 11 filing might wipe out what remains of the Chicago company's stock, but it won't result in mall closures. Many analysts suspect General Growth will survive a lengthy bankruptcy intact, but perhaps smaller after selling properties, without resorting to liquidation. General Growth, which owns and manages more than 200 malls, is the second-largest U.S. mall owner by number of properties behind Simon Property Group Inc.

General Growth's board voted Wednesday, April 15, to make the filing in U.S. Bankruptcy Court in New York after efforts to piece together a plan for an out-of-court restructuring with a growing list of creditors failed to gain traction, according to people familiar with the talks.

The filing includes General Growth, its Rouse Co. subsidiary and most of its malls. It doesn't include General Growth's management company or joint-venture holdings. All told, the filing covers roughly $24 billion of debt, these people say. A General Growth spokesman didn't immediately return messages seeking comment.

What finally forced the bankruptcy filing after months of payment-deadline extensions was General Growth's failure to secure a deal with holders of $2.25 billion of its bonds and other lenders to abstain from demanding immediate payment while the company tried to restructure its balance sheet outside of bankruptcy.

Several holders of past-due bonds notified the company this week that they intended to sue for payment. Meanwhile, additional debts came due on an almost weekly basis.

General Growth has since November negotiated with its lenders for reprieves, sometimes ending up at odds with the likes of Citigroup Inc., Deutsche Bank AG and Goldman Sachs Group and occasionally going for weeks at a time with debts that were past due but not called for payment.

The bankruptcy will have far-reaching implications for the mall industry, including putting pressure on the declining property values of U.S. malls, and mall mortgages, if General Growth dumps property. It also could consolidate power in the mall industry if major players like Simon Property, Westfield Group and Taubman Centers Inc. can come up with the capital to pick up choice pieces.

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Lee Neibart is the 58 year old CEO of real estate investment firm AREA Property Partners. The New York Observer sat down with Mr. Neibart to discuss the current commerical real estate environment. Mr. Neibart believes that multifamily is the best business to be in at the moment.

Question: One of the biggest things bandied about right now is that there’s capital on the sidelines, waiting to invest. Is that true?

Mr. Neibart: There certainly is capital on the sidelines. We have capital on the sidelines. The interesting question is how much capital really is there on the sidelines because everything’s measured against the liquidity of these investors. Some have lots of liquidity when the stock market’s 14,000; some have less liquidity when the stock market’s 7,000.

So there’s no real measure of the amount of liquidity on the sidelines. But there certainly is a lot; my guess is, it’s not as much as people think it is.

Why do they think it’s out there, then?

Because you hear big numbers raised. You hear that this fund raised that amount of money and this fund raised that amount of money. But if you really do the hard work, and add up the total amount of the actual commitment sizes, it’s probably not the range that people think it is.

When does the capital dive in? A lot of people say 2009’s a write-off.

The difference in this market from the previous down market is people are starting to question tenants. Before, it was an issue of mortgages coming due; in the early 1990s, they were rolled over and extended, but they were backed by very good and solid tenants.

And the problems that are occurring now with tenants such as AIG and Citibank, and the health and welfare of these tenants, against the continued bankruptcy of some retailers, are some of the major reasons why the capital is on the sidelines. People just have to see stability in tenants’ ability to make their rent payments.

That might be a long while.

That may be a long while, but there are lots of examples of people who dove in in 2008, when the prices were 20 percent lower than they were in 2006; and they, in fact, made a mistake by doing so because those prices have fallen further.

What kinds of investors are on the sidelines?

It runs the [gamut] from pension funds and sovereign wealth funds to private-equity funds and private investors. No one wants to dive in unless they can start to understand what backs the cash flow or the rents that they’re receiving in these buildings. And those diagnostics are going and analyzing and understanding [tenants’] ability to pay rents. That’s what’s going on now.

Your firm was involved in the development of this building, Time Warner Center.

We were the co-developer with Related.

Could a building of this size and grandeur and location happen today?

No. Projects like this are definitely on the shelf, I would guess, at least for another five years and maybe even longer.

What sorts of conditions would need to arise to allow them to happen?

Mixed-use projects like this, you’d have to be able to sell condominiums that exceeded the cost of building them. We were lucky enough to have Time Warner as our anchor; so you’d have to find a major user like that who, in fact, needed 900,000 or a million square feet of space. And, in fact, the quality of the retail tenants has to duplicate itself, and be available to expand into other mixed-use projects like this.

What about commercial development in general?

Very, very few commercial developments are happening. You see the postponement of major projects in midtown Manhattan, and I would expect those to continue to be postponed. No one will be able to get what they call a ‘spec loan’ or a ‘spec construction loan’ without some type of pre-leasing. Even today, having a building 50 percent pre-leased to a major tenant may not be able to get you the financing to build the building.

What about the CMBS markets? What opens them up?

I think what opens them up is basically that the buyers of these securities feel comfortable that they are investing in monies that have the proper loan-to-value ratio. No one’s going to jump in if there’s this continued uncertainty.

Should the ratings agencies be trusted when it comes to these securities?

I think that, as part of the total re-analyzing of the entire CMBS process, all aspects of this will be reexamined.

How long will that take? I guess I’m asking about a sort of return to normalcy.

I think the return to normalcy and the absence of exotic and different types of securities, I think we’ve quickly reached that point. Investors, lenders will go back to the way they used to do business in terms of lower leverage and more coverage on the loans, and it’ll be just a return to safety across the board.

You’ve been around for a while. How would you compare the boom market to previous eras?

This was, by far, the craziest three- to four-year period that I’ve ever seen. I started in 1974—we never saw cap rates reach these low levels of rates of return; we never saw situations where the rates of return were less than the interest costs on the mortgage. So, sometimes you have to be careful what you wish for because what we created was something that was unrealistic, not sustainable, and, in fact, has caused great pain.

What’s AREA working on right now?

AREA is working on about four different types of funds. We’ve raised a new opportunity fund which will be investing in distressed assets, distressed loans; so we’re actively working on that in the U.S. We also have a value-added fund that works on properties that are half-leased and in need of repositioning. We have an urban fund which works on rental apartments in major cities, improving them for renters. And we also have a major European fund that is involved with opportunistic and with value-added investing.

And what’s your general opinion of the federal stimulus and its effects on commercial investment?

I haven’t seen any real evidence of there being any loosening up of credit for lending institutions to lend money for commercial real estate. We’ve not seen it.

Wasn’t that supposed to have happened as part of it?

You would hope so.

Do you expect it to happen?

I would expect that it may happen, and it’s going to happen much slower than we think; because even the size of the stimulus, given the amount of mortgages out there, can only do so much.

You went to the University of Wisconsin, correct?

I did.

So did my dentist. And he was saying to me the other week that what’s going to happen is stuff is going to cost what it’s supposed to cost. Do you think, during the boom, certain commercial assets were just simply inflated? If so, what caused that? And will the assets’ prices come down more to in line with the market?

The assets will certainly come back to a much lower level, and I think a lot of that will strictly be a reflection of what tenants can pay. So, law firms, accounting firms, public-relations firms, major corporations, banks will only be able to afford a certain amount of rent. That will then dictate the value of the building. If, in fact, the rents get too high, they’ll move out.

What is the most desirable commercial real estate investment right now?

At the risk of my competitors hearing this—they know it already—we feel the multifamily is the best business now to be in; because the values have come down and they’re still very well leased. So, on a risk-adjusted basis, we think multifamily represents the best bet today.

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U.S. REITs are preparing to grit their teeth and issue stock.

It'll be a rough ride. Investors are already shell-shocked from the 60% swoon suffered by many real-estate investment trust shares since September. Moves that could dilute their ownership might rattle them further.

But REITs need more equity: to replace debt coming due, and, for the lucky ones, to buy distressed commercial property. Healthier REITs, at least in relative terms, such as office REIT Vornado Realty Trust and mall giant Simon Property Group Inc., have already decided to pay chunks of their dividend in stock to conserve cash. But if they can raise more capital to get through the worsening slump, there should be cheap commercial property deals, with unusually high yields, to take advantage of.

Others, like shopping center owner Macerich and warehouse developer Prologis, need to pay down debt that's coming due. Facing declining demand for space and a frozen debt market, REITs are scrambling to avoid the fate of mall owner General Growth Properties Inc., which has been teetering on the brink bankruptcy.

Overseas, where real-estate stock prices have sometimes fallen even further than in the U.S., leading REITs are raising new equity. Three U.K. giants hope to raise more than $2.9 billion through rights issues. Westfield Group, the Australian mall owner, launched a $1.9 billion capital raise last month.

While Health Care REIT raised about $200 million in the U.S. in January, the chances are that equity sales wouldn't go as smoothly for companies more desperate for cash. After all, pension funds and college endowments, among the biggest investors in REITs, don't have money to throw around right now.

But for less leveraged REITs there could be an opportunity. With many private-equity property investors paralyzed by losses on debt-heavy, top-of-the-market buys, REITs that can round up enough equity to play another day could yet emerge as winners.

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Just when investors in commercial real-estate investment trusts thought they had seen it all, magicians at the Internal Revenue Service have a new trick. It makes dividends disappear and taxes them anyway.

REITs such as Simon Property Group and Vornado Realty Trust are getting in on the act. The ruling, introduced in December, lets them for one year skip a longstanding requirement to pay 90% of pretax income to shareholders in cash. Instead, they are keeping the money to shore up balance sheets -- weighed down by large debt loads and souring property investments.

That sounds sensible. But investors should beware a sleight of hand. REITs now are allowed to pay as much as 90% of the dividend in stock and just 10% with cash. Dividends paid in shares are the equivalent of a stock split, worth nothing to investors, or in this case a forced rights offering because the REIT keeps the cash it would otherwise have paid out.

The snag: Tax is still due on 100% of the dividend. That can mean that investors face a tax bill bigger than their cash payout. Simon is using the rule to its limit, declaring a quarterly dividend of nine cents in cash and 81 cents in stock. Vornado will pay 40% of its dividend in cash, which should at least leave shareholders with enough money to cover their tax liability.

Shareholders had good reason to expect dividends to hold up. In return for an exemption from corporate taxes, REITs had to pay 90% of pretax income as a cash dividend -- at least until now.

Indeed, Simon could have cut its dividend to about 70 cents and stayed within the threshold. Investors might have found that a better option than being given a tax liability if the shareholding isn't in a tax-exempt account. Retail investors historically have owned about 30% of commercial REITs, according to Barclays Capital.

REITs are struggling as their traditional funding sources dry up -- such as unsecured bond financing and the commercial mortgage-backed securities markets.

That leaves REITs with every incentive to preserve capital. Simon has $24 billion in net debt, and Vornado has $14 billion, although neither has an imminent problem from big debt maturities. The REIT industry overall has about $100 billion in debt due by the end of 2010, which could pose a challenge if real-estate markets continue slumping.

From a valuation perspective, Green Street Advisors reckons Simon's shares trade at a 15% discount to the value of its assets, while Vornado trades at a 6% discount. Those aren't far from the average discount of 10% across the industry.

But when it comes to comparing dividend yields, investors should be careful to include only payments that come in hard cash.

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Canadian-born Mort Zuckerman is the co-founder and chairman of commercial real estate firm Boston Properties, the business to which he owes his fortune.

His avocations are journalism and public punditry, and he has been able to indulge those with his ownership of the New York Daily News and news magazines US News and World Report, as well as frequent appearances on television talk shows and cable news programmes. Mr Zuckerman has been in particular demand in recent weeks, after it was revealed that his charity was one of the victims of the Bernard Madoff scandal.

A 71-year-old who was educated at Montreal's McGill University before earning an MBA at Wharton and an LLM (Master of Laws) degree from Harvard Law School, Mr Zuckerman is a US citizen and longtime resident of Manhattan's posh Upper Eastside.

How much worse will the economic crisis get? If the government has to intervene even further in the financial system, how much extra do you think it's going to end up spending on that?

Well, nobody quite knows where the bottom is, but I think it's going to get substantially worse. Larry Summers estimated it would take somewhere between a trillion and a half dollars and $3 trillion just, in a sense, to refloat the financial system. I would come out near the top end of [that] range.

Do you think the American people, the American political system, is prepared to sign off on that amount of money?

When they see what the alternatives are they'll be prepared to do that.

What impact is this economic crisis having on one of your main businesses, commercial real estate?

We're going to be OK. We won't be great in terms of the new buildings; we're building a number of new buildings that are substantially pre-leased. We haven't halted construction on any projects, but there is at least one project in New York where we've decided not to proceed.

If somebody is renegotiating their lease now, how much discount should they ask for?

Well, we think they shouldn't be asking for a discount, absolutely not, no, no.

Of course not, but let's say you're negotiating a lease for a tenant?

If you were an impoverished journalist, for example, and you were looking for 100,000 sq ft of office we would probably imagine the discount at the high end of the building would be between 5 per cent and 10 per cent.

How is the print publishing business doing?

The print publishing business is an oxymoron. It is no longer a business. It is an advertising-driven business and advertisers have driven elsewhere.

Is this year going to be the one when we see respected newspapers going out of business?

There's no doubt about it, unless they are owned by people who are in a position to afford to carry them, and are willing to do it because they believe in journalism . . . I would say one of the papers in Philadelphia will probably close down. We've already seen the Times Mirror Corporation go bankrupt.

Has the Bernard Madoff affair had a particular impact on the American Jewish community?

On some level. What he did was completely against Jewish values, against not only the way Jews contribute to a community in human terms, but in financial terms, he robbed a lot of charities.

Have you talked to Ezra Merkin [whose private investment firm placed investors' money with Mr Madoff] about this?

I had one brief conversation; I would describe it as intense. I think he will be brought before the bar and there are a lot of people suing him, including myself, for what we consider false inducement and we'll try and claw back whatever we can from him.

Mr Madoff, also?

Yes, I am sure indirectly everybody is trying. The losses Mr Madoff has incurred on some level are still mysterious. If he did it all himself, you'd have to say the guy in some ways is a criminal genius.

Has it become politically incorrect to fly on a private jet or to have a fancy office?

It's going to be very difficult to live a grand life in the way people were doing before. Those days are over, and they should be. Do you know what the bonuses were for the Wall Street community in 2006? I will tell you because it's such a ridiculous answer - $62bn. These are the people who want to be bailed out - it's their mistakes, and their losses. Did they give back their bonuses? I don't know of any that did. So, there's a real rage that these people made so much money on the way up and now everybody else is suffering on the way down.

Given your long-standing bearishness, how are you positioning yourself to get through the coming year?

I am covering my rear end in every way that I could . . .

Does that mean cash?

Yes, cash or the equivalent of cash.

Do you have your own aircraft?

I do happen to have my own airplane, I've had my own airplane for 25 years. But, as I tell my friends, my net worth is now down to a level I never thought I would get up to. I was very, very liquid. I got out about 80 per cent. Nobody escapes entirely, but substantially I stayed out of the way.

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In August 2008 last year, Moody’s issued what was then considered a gloomy outlook for corporates in the US. The ratings agency said it expected the global default rate to reach to 6.3 per cent by the following August, and as high as 10 per cent by the end of 2009 “should the US sink into a protracted recession.”

In December 2008, following the collapse of Lehman, Moody’s revised its estimates for junk-rated companies slightly higher, to 10.4 per cent by November 2009 - compared with 3.1 per cent in the same period in 2008. These levels, if reached - and FT Alphaville thinks they will be attained and surpassed - were last seen in the aftermath of the 2001 dotcom crash.

Consider the parlous state of (non-financial) corporates today, particularly in the US and the UK. The latter has already had a series of high-profile corporate failures, including (but certainly not limited to) XL Airways, Woolworths and Zavvi. In North America, Circuit City’s descent into liquidation and the Chapter 11 filings of Nortel and LyondellBasell do not bode well for their industry peers.

S&P expects the US corporate default rate to reach all-time high of 13.9 per cent this year, a significant revision of its previous projection a 7.6 per cent base-case and the consequence of “a substantial worsening of the economy and the financial environment”.

Moreover:
The baseline projection of 13.9% would result in an unprecedented trough-to-peak increase of almost 13%, outstripping the rate of increase observed in any prior default-rate cycle since the start of our series in 1981.

The continued high stress level in the financial system–which has wrought changes unprecedented since the Great Depression–is expected to ripple through more broadly, materially affecting the number of defaults. The ripple effect of corporate defaults, Chapter 11 filings and liquidations must not be underestimated.

As Diane Vazza, S&P’s head of global fixed income research and the author of the S&P report referenced above explained in a radio interview:

[Defaults affect] the entire supply chain. And we saw that very clearly with the automotives. We saw that fan out to all the automotive suppliers. You know, it’s like an onion. And the layers of the onion are . . . you get larger and larger as it affects the entire supply chain.

The Circuit City bankruptcy provides a compelling example of this, as the imminent closure of Circuit City’s 567 remaining retail outlets - on top of more than 150 that were shuttered in November - will have a pronounced effect on commercial real estate. Paul Kedrosky estimates these closures mean around 22m square feet of retail space is suddenly empty - in an already depressed retail environment. And, as Reuters rightly noted in a story this week, this will also put pressure on investors in CMBS and REITs:

The loss of the large tenant, whose stores typically run from 35,000 to 40,000 square feet, is likely to be felt by some publicly traded shopping center owners, such as Developers Diversified Realty Corp DDR.N, where Circuit City accounted for 1.7 percent of its annual base rent revenue, and Kimco Realty Corp KIM.N, where the chain accounted for 1.5 percent of its annual base revenue, according to Green Street Advisors analyst Nick Vetter.

Other landlords include Inland Western Real Estate Retail Trust, Simon Property Group Inc SPG.N, Vornado Realty Trust VNO.N, Weingarten Realty Investors WRI.N, First Capital Realty Inc (FCR.TO), Kite Realty Group Trust KRG.N and Arcadia Resources Inc (KAD.A), according to financial data firm SNL Financial.

About half the shopping centers where Circuit City is a major tenant have mortgages that have been pooled and manufactured into CMBS, with more than $4 billion left on the balance of the mortgages, according to Realpoint.

The numbers don’t look good. Circuit City accounts for more than 20 percent of the revenue rent on 176 of the properties.
Those properties contribute 38 percent of the total loan exposure. Without Circuit City, occupancy at 187 centers would fall to less than 80 percent, meaning it would hurt mortgage payments to bondholders, Realpoint said.

Corporate defaults also put pressure on already strained banks and other financial companies that can scarcely afford to be stiffed by one significant debtor after another. And then, of course, there are the job losses, which compound the woes facing consumers.

Nor is the developing world immune. Standard Chartered, for instance, believes “[c]orporate debt is going to be one of the biggest issues in emerging markets in the next two years,” according to this Bloomberg story.

The story also cites data compiled by Commerzbank AG that show “businesses across emerging markets have more than $218 billion of bonds and syndicated loans coming due in 2009″:

Russian companies need to repay $54 billion of debt, followed by Mexican issuers with $29 billion coming due and Brazilian firms with more than $24 billion. Currencies from all three nations have dropped more than 20 percent against the dollar in the past year, increasing the cost of servicing foreign-currency obligations.In Poland, for example, the defaults have already begun.

As CreditSights analyst Chris Taggert put it,

The market is faced with the prospect of a default cycle tantamount to the worst historical periods outside of the Great Depression

Fundamentals hurt, weak balance sheets maim, but liquidity kills.All that, and it’s still only January. Tin hats, chin strap level five at least.

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