Duck and Cover

Virtually every major business publication has predicted the collapse of the great real estate bubble of the 2000s. So far, the warnings of a collapse have not panned out. But, it is increasingly clear that it is a question of when — not whether — real estate prices will revert to historic norms, reflecting true demand for homes on the consumer side and traditional rates of return in commercial properties. That could come in a cataclysm or in an orderly readjustment, but history proves that anomalous prices for Dutch tulips, dot-com stocks or yet-to-be-built Miami condos cannot be sustained forever.

Ira, a financial advisor based in the west, thinks the day of reckoning is fast approaching. Why? Ira, who works for a national broker/dealer and asks that his full name not be used, doesn't point to lots of tables and charts, and he freely admits that he is no expert on real estate economics. He knows something is very wrong because his clients are gaga over real estate.

“I'm hearing more, ‘Cut me a check. I'm going to buy some rental properties,’” says Ira. “And they don't know what they are doing; they've never been a landlord. That's a sign that we're late in the cycle.”

Indeed, the tell-tale sign of the end of a boom is when the least sophisticated investors cash out their life savings to get in on a “sure thing.” Joe Kennedy, the patriarch of the political dynasty and a notorious stock speculator in the 1920s, said he got out of the market in the late summer of 1929, just weeks before the crash, after a shoeshine boy passed him a hot stock tip.

Like Joe Kennedy, the smart money has heeded the signs. In the past year, private real estate investors have been net sellers of commercial real estate. These seasoned investors — who bought a net $2.14 billion in apartments, retail, office and industrial properties in 2003 — unloaded $13.53 billion last year, according to Real Capital Analytics. In the first quarter, they sold another $6.8 billion. At the same time, insider sales by executives and directors of publicly traded real estate investment trusts (REITs) have jumped and experienced fund managers are taking profits; short positions in the sector have risen in 11 of the 13 months through April.

“What do you think it means when private investors — whom everyone considers the most forward-thinking, astute investors — turn into net sellers? The smart money is already starting to get out,” says Dan Fasulo, an associate with Real Capital Analytics, a real estate research firm in New York City.

Castles in the Air

For financial advisors like Ira, the end of the real estate boom could have an upside, because investors will reallocate money back to stocks, bonds and mutual funds. But only if they can get out of those real estate investments in time.

A crowd of investors to worry about most: those employing the new tenant-in-common (TIC) structure — which enables individual investors to pool resources to chase large commercial properties. They give individuals tax benefits but are highly illiquid. At last count, more than 50 sponsors of TIC funds had raised $1.5 billion, according to Omni Brokerage. That's up from nine companies and $167 million in 2001. The investors are typically 1031 exchangers, who are buyers that acquire a property, hold it for a few years and can defer taxes by flipping into a similar property. TICs are creeping in to buy mid- to low-end commercial properties. But as part of the TIC structure, individual investors rely on sponsors who manage and lease the property. Retail investors also can't cash out by themselves and have to wait until the property is resold. If the real estate market does come down, TIC investors will be left holding low-quality commercial properties with no hope of recouping their investment. They could wind up watching helplessly as the managers sell at a discount in a post-bubble market.

Most retail investors have played the commercial real estate boom by investing in REITs. In the aftermath of the 2000 to 2001 market crash, when most classes of equities were performing miserably and when low interest rates depressed returns on fixed-income investments, many reps moved clients into REITs to get guaranteed yields of around 5 percent and more. Even as the economy recovered and equities rebounded in 2003, REITs continued to attract capital.

At the end of 2004, 193 public REITs had a total market capitalization of $307.9 billion. That's more than double the size of the REIT universe in 2002 when 189 public REITs had a combined market capitalization of $138.7 billion. REIT analysts in the past year have raised concerns about the sector, with many downgrading it to neutral. Lehman Brothers, for example, only has four of the 30 companies it covers rated “overweight” in contrast with 17 that is has rated “underweight.”

With all that money heading toward the real estate sector, REIT companies have been raising debt and equity in public markets at a record pace. Last year, there were 266 REIT IPOs and secondary debt and equity offerings — the most since 1998. They raised $38.7 billion in debt and equity. The 29 IPOs equaled the total for the previous six years. (That is eerily reminiscent of the Internet mania: In 1999, 292 IPOs raised $24.1 billion. In 1998, 45 IPOs raised $2.1 billion.)

All that money continues to push the price of commercial real estate to new highs. “Last year was a record year for REITs raising money in the stock market, and once they have that money, it can't just sit there — they have to put it into play,” notes Fasulo. Average asking prices for commercial real estate rose considerably in all sectors. Apartments jumped 26 percent, industrial went up 21 percent, retail rose 14 percent and office 6 percent, according to Real Capital Analytics.

The record prices would not be so worrying if the fundamentals of the business were also at their best. But in most commercial real estate sectors, performance has been rocky since 2001. Retail has remained strong, but the apartment and industrial sectors have only recently shown signs of improvement.

The office sector is still probably two or three years away from being able to raise rents. Vacancy rates in the office sector are in the mid-teens. Moreover, many leases on the books were signed at the peak of the market and are above market rate. As those expire, they will be renegotiated at lower rates. Overall, vacancies in the office sector need to drop to the single digits before owners can raise rents significantly again. Apartment and industrial sectors are a bit stronger, though they too need more absorption before owners can raise rents. Retail is the only sector that has retained its strength in recent years, with consumer spending fueled by the boom in single-family housing and the abundance of cheap credit. Meanwhile, the rate of return in all sectors have sunk to historic lows.

REITs are now trading at a greater premium to the net asset value of the underlying real estate than historical norms. In a mid-May report, Lehman Brothers noted that apartment REITs were trading at a 12-percent premium, shopping center REITs at 21 percent, regional mall REITs at 12.9 percent, office REITs at 21.6 percent and industrial REITs at 21 percent. The norm historically has been the 5 percent-to-7 percent range.

Some REITs are even covering their dividend payouts in dubious ways — tapping their lines of credit to fill the gap between their funds from operations and target dividend payouts. Indeed, the investment basis for real estate seems more like Keynes' Castle-in-the-Air theory: People are not interested in the intrinsic value of an asset class but more in a predicting a crowd's behavior in the future. (See also the Greater Fool Theory.)

REIT insiders are taking no chances. In the first quarter, they sold $169 million worth of stock while buying just $1.1 million. That followed a fourth quarter where insiders sold $271 million, versus purchases of $33 million, according to data compiled by Lehman Brothers REIT analyst David Harris. His conclusion: “We do see this persistent heavy selling as a sign that insiders feel it's a good time to liquidate some of their assets.”

Devil Take the Hindmost

Concerns about REITs have some investors swearing off the sector. In the mid-1990s, Leuthold Capital Management had 19 percent of its Leuthold Core Fund devoted to the REIT sector. But it eliminated the last of its REIT holdings in June 2004. Andy Engel, the co-manager for the core fund, says he won't think about buying REITs again until the market sees at least a 15-percent correction.

“When everyone else is flowing in, you know it's time to get out,” Engel says, pointing to the fact that in the first four weeks of 2005, $1.4 billion flowed into real estate mutual funds. “Retail investors really are the bottom feeders. When they are getting in on some of the offerings, it's time to go.”

Leuthold's fund has the luxury of eschewing real estate completely. But even funds that exclusively invest in real estate have been trying to find alternatives to REITs. The Alpine U.S. Real Estate Equity fund, the top-rated real estate mutual fund over the last five years, according to Lipper, has also minimized its exposure to REITs. Instead, it has upped its allocations in homebuilders and hotel companies that do not operate as REITs, such as Hilton Hotels Corp.

Another skeptic is Kenneth Rosen, chairman of the Fisher Center for Real Estate at the University of California at Berkeley and chairman of Rosen Real Estate Securities. He projects that the REIT market will post a 20-percent decline in value over the next few years. His fund has been shorting the REIT sector for the last few months.

To be sure, not all real estate funds are swearing off REITs. Cohen & Steers Realty Shares thinks that the dip in the first quarter was the result of some investors being overallocated to REITs, but that has now corrected and REITs will resume their rise. “We believe that the REIT market is sending a clear message to investors that real estate fundamentals are improving at an increasing rate,” Cohen & Steers' executives wrote in a letter to shareholders. “We believe that real estate fundamentals will continue to benefit from continued, even if slower, economic expansion.”

But real estate mutual funds that were less heavily weighted on REITs performed better in the first quarter. And the run that has seen such funds taking huge jumps in the last five years — they were up 32 percent alone in 2004 — seems at an end.

The last piece of the puzzle is debt, where more lenders have emerged — including European banks opening up new operations for U.S. lending. The competition to meet volume targets has led to the loosening of underwriting standards and the tossing out of traditional safeguards. On the flip side, a lot of borrowers are still taking on floating-rate or interest-only mortgages, despite the Fed's tightening.

All of this adds up to a dangerous equation, even without taking into account the rising speculation in single-family housing. As a whole, it creates a sobering picture that Ira and other advisors need to convey to investors who seem to believe that real estate is a riskless investment. Of course, this is not to say that all real estate will implode. But, as with any cycle, this one is nearing its natural end; it is time to preach caution.