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In the last decade, real estate builders have been eager to build and investors have been eager to invest. Real Estate Investment Trusts (REITs) have become the vehicle of choice, as investors have plowed a record $7.1B into real-estate related funds this year as of 9/15/16 according to Bloombergf, more than twice any other sector. A combination of low financing rates for new construction, low returns on other fixed-income investments and an influx of non-U.S. investors looking to park large blocks of capital in hard assets has fueled the real estate investment bonanza, but REITs face several structural challenges in the next year.
1. Excess Supply of New Inventory
Major U.S. cities are seeing the fastest pace of new construction in several decades. In just one 9-block area along New York City’s far west side, developers are constructing 17 million square feet, the equivalent of eight Empire State buildings. According to the New York Building Congress, more new office space is being built in that city than at any other point in the past quarter century, while spending on residential construction is at an all-time high and likely to produce more than 90,000 new units between 2015 and 2017. Around the country, U.S. construction spending has risen to within 1% of the record $1.15T high in 2005.
Burgeoning supply has cut investment in future NY Metro area projects by 9% this year, according to Real Capital Analytics (RCA). And it’s not just the Big Apple. Nationally, RCA’s 2Q overview shows gross investment in new commercial properties has fallen 16%. RCA cites declines of 49% in Houston, 29% in Atlanta, 24% in San Francisco and 21% in Chicago. Demand can only absorb so many new properties, and developers are beginning to realize they may face oversupply in coming months.
2. Insufficient Cash Cushion
In addition to the simple math of more properties coming to market without more tenants to buy/rent/lease them, loan documents analyzed by RCA on thousands of projects nationally indicate developers have financed at historically low capitalization rates of 3%, meaning that the net cash flow generated by tenants is just 3% of a building's purchase price. Say for example that a developer spend $100 million on a building which produces $3 million annually after taxes and operating costs. $3 million may sound like a big number, but at that rate an owner has very little cushion if the roof needs repair. Additionally, the capitalization rates are calculated based on full occupancy, and at 3%, the owner simply cannot afford to lose tenants. As for recouping the initial investment, since a 3% cap rate only pays you back 3% of the purchase price each year, the owner has to own the building for 33.33 years just to get his or her money back.
3. Higher Costs in a Rising Rate Environment
On September 20, Fed Chair Janet Yellen said “The committee judges that the case for an increase in the federal funds rate has strengthened” and traders now put odds of a December rate hike at 55% as of October 4, 2016 based on fed fund futures traded by the global electronic exchange CME Group. This is not good for REITs. Company filings show REITs fund themselves with combination of fixed and floating rate debt, and floating rate adjustments will raise overall borrowing costs. Meanwhile, a combination of sluggish economic growth and increasing supply will likely cap the ability to raise rents and/or lease prices. The resulting margin squeeze sets the stage for a potential cash flow crunch which at best lowers effective earnings and at worst threatens REIT dividend payouts. Bottom Line: The looming prospect of rising rates in a weak economy is bad for REITs, and rates are about to rise for several years.
4. Shrinking Retail Tenant Base
Total e-commerce volume in the U.S. has risen 4.5% in the past year and now accounts for 8.1% of U.S. retail sales according to the Department of Commerce. By contrast, total sales per square foot at mall operator Simon Property Group Inc. (SPG) fell 2.3%. SPG is the largest mall operator in the country, and the pivot by consumers away from brick-and-mortar stores represents a very direct threat to mall operators. It’s one of the reasons why Sears/K-Mart, Macy’s and Target have
announced over 200 store closures this year. Fellow mall REIT operator General Growth Properties (GGP) has seen revenue decline 7%, while top line growth
at SGP has slowed from 8% to 3% this year. Meanwhile, Amazon’s U.S. retail sales have doubled in three years to $82.14B based on consensus estimates of 2016 revenue tracked by Bloomberg.
Room To Fall
Anyone invested in REITs today should recognize that oversupply is just the tip of the iceberg. REITs have some serious structural issues and the outlook is not good, in spite of their dividends. The easiest way to express a negative view on REITS is to short the Vanguard REIT exchange traded fund (VNQ). It holds 150 REITs and the average P/E is 34.8x, double the valuation of the S&P 500 Index. VNQ sports successively lower highs on rising volume, which implies accelerating sales as it falls. Short VNQ in the upper 80s, with a $72 target, the 12-month low.
Adam Johnson is the founder of Bullseye Brief, an investment newsletter that presents thematic, actionable investment ideas every month. For more ideas, go to Bullseye Brief.