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The Next Economic Shoe to Drop on the World Economy

Thursday, October 8, 2009

The Next Economic Shoe to Drop on the World Economy

Economic Crisis: U.S. Commercial Real Estate is next to put a huge dent in the Economic Recovery.
Everyone remembers the destructive mortgage practices that lead the US Housing collapse that triggered the Global recession. These mortgage products were not limited to Residential properties, many loans were provided using the same teaser rates for Commercial properties and the affects are beginning to emerge.

According to the Vancouver Sun paper, the Obama White House is preparing for the second round of the real estate/banking crisis by attempting to encourage liquidity for refinancing. There are approximately US$3.7 Trillion in outstanding commercial real estate backed loans. The short term outlook is for around US$400 Billion to reach maturity in 2009 and then exploding to US$2 Trillion in 2010 and 2011.

Why is it a big deal that so much US Commercial Real Estate Debt is maturing?
• Commercial Profits are Down

• Vacancies are up

• Cap rates are up

Obviously commercial property profits are down. The retail goods sector has seen the sharpest declines and services are also way down. Retail tenants can not afford the same levels of rent to turn a profit and neither can Office Tenants. With the decrease in profit levels for tenants, landlords must offer better leases to keep tenants in place. Vacancies are also up so the new leases signed are being signed with many sweeteners resulting in much lower lease rates. Further, there is more risk perceived in these properties now so even though interest rates have declined capitalization rates have actually increased in most areas.

The basic way a commercial property value is determined is by estimating the net operating income and dividing by a capitalization rate (risk return required to hold the asset). In its most simplistic form this works out to a formula like this one (Property Value = NOI/Cap). When NOI declines and caps remain stable the Property value drops. When NOI remains stable and Caps increase the Property Value drops. Obviously if NOI declines and capitalization rates increase the Property value will drop even more and this is exactly what has been happening with US Commercial Real Estate.

Given this very basic information, which should be well interpreted by the market, real estate values have dropped so banks will be looking for more equity on their books. Essentially this means you will not be getting a refinanced mortgage with out putting down a significant amount of new equity. This will lead to a massive amount of cash strapped landlords with a cash crunch dilemma. Do they sell at huge losses, take on high risk high interest mortgages, or do they go bankrupt? We have already seen some of the largest commercial REITS cry for help. For example, General Growth Properties (OTC:GGWPQ) is currently under bankruptcy protection. I bought this a few weeks back for $2.82 a share and sold it a day ago for a huge profit: recall the article General Growth Properties Takeover Target. This stock may be running out of steam though; I sold because I am concerned about the Commercial REITs in general.

It is almost surprising that the iShares Dow Jones Real Estate ETF (NYSE:IYR) has rallied so substantially over the past 6 months. Most investors should be well versed in the current crisis of (lower NOIs, higher vacancies, and higher capitalization rates with so many mortgages coming due over the next year.)

I suspect the only thing holding Commercial Real Estate up on the stock market at this point is pure speculation. NOIs will remain lower going forward and capitalization rates are very likely to continue to rise, especially if the FED decides to rein in inflation by raising interest rates in the future.

If you believe like I do that Commercial Real Estate (NYSE:IYR) is due for a major correction, but don’t want to take on the infinite risk associated with shorting a stock, look to a better strategy that contains risk—BUY Put options on IYR. This way your risk is limited to the amount you put down and your potential upside is very large.

I like the Jan 2010 $37 Puts. This has lots of volume and a tight spread.

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