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Commercial Real Estate Is Starting to Crack

By Dr. Steve Sjuggerud
Monday, July 16, 2007

Commercial real estate in America has been immune from the residential housing bust... So far...

Commercial real estate prices haven't started falling yet. But the cracks are starting to show. The stock market is a decent leading indicator for us here...

The stock market led the way in showing us that residential real estate had peaked, as shares of residential homebuilding companies hit their highs two summers ago. They've lost half their values since.

While shares of residential homebuilders struggled, shares of commercial real estate hardly flinched. They continued higher, peaking early this year.

Their fall has now begun.

The Dow Jones U.S. Real Estate Index – which is significantly made up of commercial property REITs – has fallen about 20% since February. Stock prices can react more quickly than real estate prices, so this fall in the prices of commercial real estate stocks may be a sign of what's around the corner.

Homebuilders Peaked in Mid 2005

Before this drop, this index had risen almost nonstop since the end of the dot-com bubble. Now, shares of commercial real estate companies are ridiculously expensive.

I'm not always negative on real estate, by the way.

When I launched True Wealth in 2001, we bought four commercial real estate stocks (REITs) in the first issue.

Why? Because 1) REITs were incredibly cheap, and 2) nobody wanted to buy them. But 3) they were quietly in an uptrend. So we had all three things we look for in an investment.

So back in 2001, we bought stocks like Simon Property Group. It was paying an 8% dividend. The stock soared after 2001, rising hundreds of percent. Now, shares of Simon Property Group are as expensive as they've ever been. The dividend yield is less than 4%.

It's not just Simon Property. It's all REITs... They're paying the tiniest dividends in recorded history, and they're trading at their highest valuations (REIT P/Es) ever.

Investors buy REITs for high and rising dividends, and the potential for capital gains. History shows (and it makes sense) that when the dividends of REITs are a lot higher than safe Treasury bonds, it's time to buy REITs.

Back in 2001, you could make a lot more than boring Treasuries... REITs as a group were paying dividends of 8.3%, while Treasury bills were only paying 3%. The spread was huge. So investors had a massive incentive to get their money out of risk-free Treasuries and into riskier REITs.

As you might imagine, REITs performed extremely well over the next few years.

Today, we are in the opposite place. Unbelievably, REITs now pay dividends that are smaller than Treasury bond yields. Looking back over history, when this happened, you couldn't make any money in REITs.

For perspective, we've only been here once before, and the outcome was ugly...

Treasuries yielded more than REITs back in 1997. Once that happened, REITs lost 40% of their values from their peak, with most of that loss coming in the following 12 months. And it took seven years to break even again.

When REITs pay less than 10-year Treasury bonds, like they did in 1997, you lose money in REITs. And when dividends on REITs are significantly more than they are on Treasuries, like they were in 2003, you'll do well in REITs.

The chart below tells the story...

What to Buy, When to Sell

Today, REITs are much more expensive than they were at their 1997 peak. As the chart shows, the spread is much wider today than it was back in 1997.

REITs currently pay the lowest dividend yields in their recorded history. The last time REITs were overvalued, in 1997, they paid 6% interest. Today, they pay less than 4%.

So instead of "cheap, hated, and in an uptrend," like we had back in 2001, commercial real estate is expensive, loved, and finally starting to break down.

Residential real estate peaked in the summer of 2005 and has been weakening since. Commercial real estate shares are next, and shares of REITs are overpriced, with plenty of room to fall...

Trade accordingly.

Good investing,


Market Notes


Nokia (NOK)... cell phones
Amazon (AMZN)... online retail
Google (GOOG)... search engine
Intel (INTC)... semiconductors
Apple (AAPL)... computers and iPods
Monsanto (MON)... agriculture
CF Industries (CF)... agriculture
BHP Billiton (BHP)... diversified mining
Teck Cominco (TCK)... diversified mining
Anglo American (AAUK)... diversified mining
Freeport McMoRan (FCX)... copper and gold mining
Chevron (CVX)... S&A Oil Report readers up 54%
Petrobras (PBR)... S&A Oil Report readers up 47%
CGC Veritas (CGV)... S&A Oil Report readers up 32%
Petro-Canada (PCZ)... S&A Oil Report readers up 47%
ConocoPhillips (COP)... S&A Oil Report readers up 39%
Technip (TKP)... infrastructure
Shaw Group (SGW)... infrastructure
Foster Wheeler (FWLT)... infrastructure
Chicago Bridge & Iron (CBI)... infrastructure
Lead, Soybeans, Euro, British Pound


U.S dollar
Lexmark (LXK)... printers
Circuit City (CC)... electronics
KB Home (KBH)... homebuilder
Hovnanian (HOV)... homebuilder
D.R. Horton (DHI)... homebuilder
Pulte Homes (PHM)... homebuilder
Beazer Homes (BZH)... homebuilder
Journal Register (JRC)... newspapers
Whole Foods (WFMI)... expensive groceries

-Brian Hunt

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