REIT ETFs Await Tidal Wave of Foreclosures

Wednesday, May 6, 2009

A tidal wave of commercial real estate restructurings and foreclosures will soon rival that of the residential sector, analysts warn. Have real estate investment trust ETFs priced in all the bad news?

Remarkably, REIT ETFs have fallen so far that they may be at fair value even with the coming onslaught. Prices for broad-based, low-cost REIT ETFs firmed up in April 2009 after falling 70% during the previous year:

Vanguard REIT ETF (AMEX:VNQ) leads with the dubious distinction of losing only 45% of investor capital over three years, and it also sports a phenomenal 0.12% annual expense ratio. Close behind are iShares Cohen & Steers Realty Majors ETF (NYSEArca:ICF) at 0.35% fees and iShares Dow Jones US Real Estate ETF (NYSEArca: IYR) at 0.48%.

Economic fundamentals for the industry are dire. In 2009 occupancy is expected to decline to 86% for retail space and 83% for office space, both considered recessionary levels. Far more troubling is an overhang of debt. Delinquency levels of bank loans to commercial real estate hit 4.4% in Q1 of 2009, according to analysts Keefe Bruyette & Woods and could easily exceed the 6%-7% delinquency level of residential mortgages. Research outfit Foresight Analytics projects that more than a quarter of $525 billion of commercial mortgages coming due in the next four years will remain underwater (where the asset is worth less than the mortgage). Deutsche Bank estimates that a majority of $1.3 trillion in commercial loans coming due by 2013 will fail to refinance, and two thirds of commercial mortgage-backed securities will fail to roll over. Many will foreclose and sell at fire-sale prices.

Forced sales could trigger a downward spiral. For example, if rental income drops in a building and its value falls by 40%, owners who only put 20% down due to lax lending standards will be 20% underwater and they will hand over the keys unless they come up with sufficient capital. The bank will sell the building into a weak market, depressing appraisals for nearby buildings whose loans need to refinance soon. If this occurs, valuations could undershoot far below historical norms as measured by financial ratios such as rental income-to-valuation. Thus investors are encouraged to use such ratios conservatively.

Why have REIT ETFs fallen 70% while buildings they own on average have dropped only 30% to 40%? Because REITs borrowed money to place their bets, amplifying loss. Investors expect their shares to be diluted badly as REITs issue new shares to bolster their capital base. More cynical investors see collusion between REITs management and lenders in maintaining inflated appraisal values of buildings to keep their funds and loans from blowing up entirely (and getting them fired).

Sadly, the same players who created chaos in the residential market also figured prominently in the commercial debacle. Lehman Brothers, for instance, securitized mortgages from the commercial side just as it did from the residential side, pocketing fees up-front. In recent years commercial credit standards evaporated, especially by unregulated non-bank institutions now being bailed out by US taxpayers.

The Fed is granting banks low interest rates, but they are not passing on the bounty. Banks are charging unheard of spreads (between what they borrow and what they loan) of 8%, ostensibly to cushion expected drops in asset values, or perhaps to help dig themselves out of their own holes. Unfortunately, with current occupancy rates building owners cannot possibly roll over loans into interest rates approaching 10%.

Inflation, always present with high interest rates, should work to REITs' favor. As the dollar devalues, hard assets will increase in dollar terms. Somewhat dampening this, inflation takes a toll on tenants who may seek less space to rent. The US Treasury and the Federal Reserve are contemplating various ways to bail out commercial real estate. Most involve issuing more credit to help push out loans into the future to forestall refinancing. Another potential source of price support is the hundreds of billions of dollars gathering on the sidelines with individual investors and private equity funds. Unfortunately, this source of funds will flow only at bargain basement prices.

Volatility in REIT ETFs has skyrocketed as short-term traders flocked to place quick bets. Many of them have shorted the ETFs, which depresses prices initially but which also snaps them back when traders buy back ETF shares to close out their position. Other broad market US REIT ETFs include:

  • iShares FTSE EPRA/NAREIT North America ETF (NasdaqGM:IFNA); 0.48% annual fees
  • First Trust S&P REIT ETF (AMEX:FRI); 0.70% fees
  • iShares FTSE NAREIT Real Estate 50 ETF (NYSEArca:FTY); 0.48%

Picking the right sub-sector clearly can make a difference as the following graph shows. Here they are plotted against SPY, an S&P 500 ETF:

The sub-sector ETFs of the above chart include:

  • iShares FTSE NAREIT Industrial/Office ETF (NYSEArca:FIO); 0.48% annual fees
  • iShares FTSE NAREIT Mortgage ETF (NYSEArca:REM); 0.48%
  • iShares FTSE NAREIT Residential ETF (NYSEArca: REZ); 0.48%
  • iShares FTSE NAREIT Retail ETF (NYSEArca:RTL) ;0.48%

Going international is attractive because it should dampen volatility and would protect against dollar devaluation expected by many economists. Choices include:

  • First Trust FTSE EPRA/NAREIT Global Real Estate ETF (NYSEArca:FFR); 0.6% annual fees
  • iShares FTSE EPRA/NAREIT Asia ETF (NasdaqGM:IFAS); 0.5% fees
  • iShares FTSE EPRA/NAREIT Europe ETF (NasdaqGM:IFEU) 0.48% fees
  • iShares FTSE EPRA/NAREIT Global Real Estate ex-US ETF (NasdaqGM:IFGL); 0.48% fees
  • iShares S&P World ex-US Property ETF (NYSEArca:WPS); 0.48% fees
  • WisdomTree International Real Estate ETF (AMEX:DRW); 0.58%

While not a REIT ETF, investors should be aware of sector offering PowerShares Dynamic Building & Construction Portfolio ETF (AMEX:PKB), which contains mostly firms serving the housing industry. Curiously, no actual builders are included.

Two interesting trader's tools are expected in Q2 of 2009:

  • MacroShares Major Metro Housing Down ETF (NYSEArca:DMM); 1.25% fees
  • MacroShares Major Metro Housing Up ETF (NYSEArca:UMM); 1.25%

They track S&P/Case-Shiller Indexes of residential housing in 10 major US metro areas.

Investors who want to add an active element to their strategy should look to PowerShares Active U.S. Real Estate ETF (NYSEArca:PSR), costing 0.8% in annual fees. PSR uses quantitative and statistical models to try to beat the FTSE NAREIT Equity REITs Index, and it generally makes changes once a month. This is similar to a fundamental ETF and is worlds away from the typical "kick the tires" subjective analysis of most active mutual funds - all of which is a good thing.

Finally, traders can make directional, leveraged bets on REITs (as if the volatility wasn't big enough!) with:

  • ProShares Ultra Real Estate ETF (AMEX:URE); 0.95% annual fees
  • ProShares UltraShort Real Estate ETF (AMEX:SRS); 0.95% fees

Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.