REIT Insanity

While you wouldn’t know it from watching the stock market, the commercial real estate scene is still getting worse. The vacancy rate among offices for rent has climbed to 16.5%, a five-year high, says research firm Reis Inc. today. Meanwhile, office rents fell 8.5% in the third quarter, year over year. That’s the steepest fall since 1995. Cities with big financial sectors (well, what used to be “big”) got hit the hardest… New York City, we’re looking at you. Rents there are down 18.5% over the last 12 months, the most of any U.S. city.

But here’s the part we don’t quite get: Real estate investment trusts (REITs) have turned in blockbuster performances this year, with REITs based in New York City leading the way. Check out shares of SL Green, perhaps the biggest office landlord in New York:

SL Green vs The Market

SL Green rocketed up 91% in the third quarter alone, the best performing large-cap REIT on the market. These guys are Citigroup’s landlords… up 334% since March?

That’s par for the course for the whole sector. The Dow Jones Equity All REIT Index rose 33% in the third quarter, the best quarterly gain since the index’s inception in 1989. According to today’s Wall Street Journal, that means REITs now trade at an average 24% premium to their net asset value, about the highest level of this entire decade.

“REITs remain overbought and overloved,” opines our short side analyst Dan Amoss. “I’ve been following the sector closely and have been amazed at the market’s desire to bid up the price of stocks with such horrible fundamentals…

“There are expectations that larger, healthier REITs will be able to keep raising new debt and equity to be vulture investors during the property fire sale that everyone knows is coming.

“I have my doubts about existing REITs becoming big winners during the impending restructuring of U.S. commercial real estate. They have enough problems of their own to deal with, including a leasing environment that will remain persistently weak.

“This may be stating the obvious, but the big rally in REITs off their oversold levels in March was a function of investors wanting to pay more for REITs. That’s all. The fundamentals are horrible, and will remain bad for years. I think the REIT index as a whole has rallied far beyond justification.

“The Moody’s/REAL Commercial Property Price Index fell 5.1% from June 2009 to July 2009. It’s now 39% below the October 2007 peak, meaning that the equity invested in commercial real estate near the peak has vanished. Bulls are delusional if they think prices are returning to anywhere near the 2007 peak anytime soon. Let’s stay bearish on REITs and wait for the crowd to acknowledge reality.”