The LEAPS Trader
105 W. Monument Street
Baltimore, MD 21201
Thursday, June 22, 2006
Email – #324
** Betting On A Commercial Property Bust
A few months ago we sold our DR Horton homebuilding put for a slight gain. A few months before that we sold our Toll Brothers housing put for a loss, after hitting our sell stop. Darn! I wish we were holding both of those today, we would be swimming in profits.
(It was actually a good thing that we stopped out of both positions; it reinforced my convictions about dumping our stop-loss provisions on “already cheap” leaps. Now, we use a real-time stop-loss system – I send out an alert if we get close to a point that I think we should exit a position.)
Ok, housing shares are getting trashed – no big news here. It was a matter of time. The economy is slowing. Interest rates are rising. Property values are still sky high.
Logic dictates that the next leg down will be in the commercial property market. If businesses are making less because consumers are spending less, then rents are NOT going up, and growth will be subdued in the years ahead. In fact, signs are already emerging that rents are not increasing in the commercial markets at the same pace as last year. There are even indications that rents are heading down.
So, to take advantage of this upcoming trend, we’re going to short a commercial property REIT, a very famous one, with a very famous manager at the helm.
Now, I don’t make it a habit to bet against billionaires, after all, they are where they are and I am where I am – enough said.
But I am willing to make a bet that we have seen the peak in real estate prices, residential and commercial – probably a few months ago…
This company, Equity Office Properties (NYSE: EOP), has been around for a while. It has prime holding all over the U.S., and it is run by Sam Zell, not an amateur manager.
But the company is not experiencing any type of stellar growth, not even when the market is going bananas. In fact, there’s evidence that it’s doing worse than many of its competitors. Yet its share price is almost at 52-week highs.
The evidence comes in the form of a low dividend. Not low because of the high share price, but low because they CUT it. Funds from operations, the place from which REITS pay their dividends, has fallen sharply… Not a good sign. Of course, there’s always next quarter, when the company is banking on higher income… It may happen, but what happens next year, and the year after is what I am interested in.
The company has been selling properties and recording fat gains from those sales, but it has not been acquiring more than it has been selling, hence we are about to see an income conundrum: Just where are the new rents going to come from to allow them to boost the dividend?
Gains from sales are great, but that is not continuing income from operations. And when you are trading at the highs and sporting a dividend yield that is a full 200 basis points lower than a risk-free treasury or CD, and the outlook for the short-term in the U.S. property market is not great, in my opinion there may be some bumps ahead.
There are three flies that could appear in the ointment. The first fly is a takeover. Recently Trizec walked away from its property portfolio with an 18% premium to its share price. What a GREAT move on Trizec’s part – top dollar at a time when the market is weakening. But the price of EOP and many other office REITS have already gotten a little bounce from that deal.
And second, we could see a dividend increase because of better fundamentals that occurred in the last six months, prior to the property price negativity. If the company signed up enough suckers at higher long-term contracts, it could salvage some decent profits. However, judging form the most recent earnings release, it may be too little too late. EOP acknowledged that it had to make fewer concessions in the last quarter and were able to pass on increases.
Finally, the Fed could stop or even pause in the rate hike cycle. That would cause some initial euphoria for all real estate shares, but that will be a short-term phenomenon… The bull market in real estate is over – and will not be back for a while.
But, the market and investor are supposed to look forward, not backwards, and one or two quarters of positive movement in the face of what may be the end of the biggest real estate bull market in history, are not good odds. So, we may see a bump up for a while, but then it should be a free fall.
Here is what you should do.
Buy the Equity Office Properties January 2009 $30 PUT leap. The symbol is OLH MF, and the current price is $2.85 on the offer. These options are liquid, but not as liquid as other companies that we have traded SO USE LIMIT ORDERS and DO NOT PAY more than $2.85. If you are patient, you will be filled. I don’t expect the commercial property market to tank tomorrow. And neither should you. Our initial target is $32 to $33 in the next 12 months, which should provide us a gain of 30% to 50%. Our secondary target is to leg into a spread and get all of our money off the table.
Good trading,
Karim
