Tuesday, March 4, 2008

WSJ: Building Slowdown Goes Commercial

Another good piece from the Wall Street Journal on one of my long held theories. For those newer to the blog, my top two Ultrashorts since inception have been Ultrashort Financial (SKF) and Ultrashort Real Estate (SRS) - the latter is focused on REITs not homebuilders. While the Financial has been the better performer since October 2007, I think in many ways the Real Estate position will fare better in 2008 [Dec 26: Credit Downturn Hits the Malls]. Reasons for this are multiple (a) much (not all) of the financial mess is becoming known, as more and more cockroaches are discovered (however I still think people understate the economic strains on Americans and how it's going to cause a lot more writedowns in non mortgage areas) and (b) the entire Federal government is here to support the financial system. Commerical real estate on the other hand is more a play, not as much on credit crunch (although it's affected by it) but simply stated a slowing economy. Especially in retail and restauraunts which I believe this country has too many of. Especially in areas showing slow population growth or net migration. We have too many stores based on spending levels that were inflated by the steroids of easy credit and housing ATM. As inflation continues to erode buying power these stores and restauraunts will continue to flounder and begin to close. Hurting rents. That's why if this were a real fund that I could short individual names, I'd be focusing on those in certain regions and in certain subsectors. But instead I must use the blunt instrument of Ultrashort Real Estate (SRS). Last, unlike financials which the government and all the king's horses (and men) plan on saving by any way possible (read: your tax payer dollars in the end), they won't have such warm hearted spirit for commercial real estate.

So this is a revisit for newer readers of why I've been against this sector and believe it has much more downside as we move from denial to realization of the problems. If you believe in a 6 months recession (or no recession as was popular consensus last fall and early in the winter) my position would make little sense. But by going against the consensus I've made a lot in both positions, and this is why I continue to hold the Real Estate Ultrashort as my top short position. I believe the slowdown will be deeper and longer than people want to admit, simply because this slowdown is based on the consumer, not business. Now that the evidence is finally appearing in front of people's faces, they might finally finally face reality. If you were drinking the Kool Aid, you would simply be saying "it will all be ok in 6 months" back last summer.
  • Cracks are starting to show in commercial construction. For the second month in a row, the Commerce Department reported a decline in spending on nonresidential construction -- which includes everything from hospitals to office parks to shopping malls. The report yesterday showed construction spending fell 1.7% in January from December, the steepest drop in 14 years. While residential construction accounted for a big part of the decline, spending on nonresidential construction slid 0.8%.
  • Meanwhile, there may be an oversupply of shopping malls and office buildings after a period of intensive construction. It adds up to bad news for employment, the economy and investors.
  • While the boom in commercial construction wasn't as dramatic as in home building, the impact of a slowdown on the economy could be significant. Nonresidential construction accounted for 3.6% of gross domestic product in the fourth quarter of 2007, up from 2.5% five years ago and the most since the second quarter of 1988, according to Moody's Economy.com. (but don't worry about it, it is ONLY 3.6% of GDP... just like they said don't worry about this minor housing issue - it is ONLY 4.5% of GDP)
  • As home construction got caught in a downward spiral last year, nonresidential construction continued to expand at a healthy clip. Spending on nonresidential structures rose 16% in 2007, the biggest four-quarter increase since 1984, according to Morgan Stanley.
  • Signs of trouble cropped up at the end of the year. As credit markets tightened, office space sold in the fourth quarter dropped 42% from a year earlier, and sales of large retail properties declined 31%, says Real Capital Analytics, a New York real-estate research group.
  • Nonresidential construction payrolls, down 2.7% in January from their recent peak in March, posted year-over-year declines in December and January, the first such drops since August 2004. A construction slowdown will be especially tough on specialty-trade contractors, such as plumbers, painters and electricians, who account for about two-thirds of overall construction payrolls. This could spell trouble for consumer spending, which accounts for two-thirds of the U.S. economy.
  • In the past few years, builders aggressively put up stores and strip malls amid easy financing and resilient consumer spending. Spending on construction of shopping centers leapt 67% in 2007 from 2005 levels.
  • Last year, developers built 144 million square feet of retail projects in the top 54 U.S. markets and are slated to build another 131 million square feet this year, according to Property & Portfolio Research Inc., a Boston research company. Property & Portfolio Research calculates that demand justified 36% of the new space built last year and will support 15.7% of the space slated to be completed this year. (take a moment to mull over that, we continue to build stuff that is not justified - sound vaguely familiar?)
  • Another problem: Property values of commercial real estate are declining. A Moody's index of commercial real-estate values fell 1.5% in December from the previous month. It was the fourth steepest monthly decline in the seven-year history of the index, which nearly doubled from the end of 2000 through October.
  • Moody's expects a peak-to-trough decline of 15% to 20% in commercial real-estate values, returning prices to where they stood about four years ago. Goldman Sachs Group Inc. analysts have projected a drop of as much as 26%.
  • Retail is one of the more vulnerable sectors of commercial real estate, tied to the housing market and consumer spending. As the economy lists toward recession, retail property stands to suffer higher vacancy rates, constrained rent growth and declining values. Results for publicly traded retail landlords look healthy. After several years of rapid expansion by retail tenants and strong spending by shoppers, real-estate investment trusts that own and develop retail properties boast occupancy rates in the low- to mid-90% range.

Again, the parallels are striking to residential in many ways. There is also a lot (but not as much as in home mortgages) of securitization in this area. However, it won't be anywhere near as bad as residential in my view, but a lot worse than people have thought the past 6, 3, or 1 months as the economy degrades. As the last paragraph says, shopping is most at risk... while we'll ebb and flow and this Ultrashort will fall when Kool Aid runs rampant and denial is all the rage, I expect the larger trend to be up. So far it's proven to be true, and Ultrashort Real Estate has been the 4th biggest winner for the fund since inception.

Bigger picture for the economy - less construction jobs (if you combine residential and non, 8% of GDP in the US is just "building buildings"), and then we go into the multiplier affect I've been stressing for a long time - each job lost in a service economy means less need for every other service as people can't afford to pay for it. Further, we are going to see a lot of (first) cut backs on expansion plans in retail and (second, after reality hits) closing of stores. We are starting to see the first whiffs of that now... and we are not even "in recession", right Ben?

Long Ultrashort Real Estate, Ultrashort Financial in fund and personal account

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