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Broken-Down: Why Investors are Shorting Commercial Real Estate

Parth Panchal

The decline of brick and mortar department stores is pressuring commercial real estate. With the rise of e-commerce, it’s no surprise that stores and malls have been struggling for years.

It’s been stamped throughout financial news sources that commercial real estate is the next “Big Short.” This heading originates from hedge funds, along with Deutsche Bank and Morgan Stanley, targeting bets against commercial real estate today.

What a bold statement to make. Deeming another opportunity as similar to the “Big Short” has big shoes to fill, considering Dr. Michael Burry’s trade against the housing market during the Great Recession is one of the most intelligent and profitable trades Wall Street has ever seen.

Where’s the Support?

The data is compelling. With large retailers such as Sears SHLD, J.C. Penny JCP, and hhgregg HGG closing up shop, the data presents the case that 2017 may brew up the perfect storm to take a short position on commercial real estate.

Credit Suisse shows that store closings in 2016 were at their highest levels since 2008; the issue boils down to the point that the spaces these mall-based locations are leaving aren’t being filled. And this struggle has been brewing for years, but now store closings are rapidly increasing and more and more holes are left unfilled.

Next, 2017 is set to mature $200 billion in commercial mortgage-backed securities (CMBS), and 28% of those are backed by retail properties. The Wall Street Journal reports that more than 5.6% of the $390 billion of commercial property mortgages packaged in securities were more than 60 days late in payment in September, 2016. This is an increase from the delinquency rate at 4.6% earlier in 2016.

In plain English, this means that stores in commercial malls are not making their mortgage payments at an increasing rate because of decreasing sales. With that, CMBS, which tracks these mortgages, will fail.

As the ten year loans issued in 2007 are maturing, borrowers will find trouble to refinance in a hawkish interest rate environment. The Fed is set to increase the cost of borrowing, which will make it more difficult for shops to pay their mortgages as sales will not keep up to the increased cost.

Investment Significance

In a commercial real estate environment as described, investors are best off avoiding real estate investment trusts (REITs) and commercial real estate exchange traded funds (ETFs).

Simon Property Group SPG, a REIT, develops and manages retail properties with a focus on malls. Simon Property Group is down 2.19% YTD. As a whole, REIT sub-sector returns in 2016 lagged most in retail.

The Schwab US REIT ETF SCHH is also not performing well due to the issues in commercial real estate. Their largest holding is Simon Property Group at 8.49%. With that, SCHH is down 0.36% YTD.

Opinion

Unlike Dr. Burry’s “Big Short,” a short position on U.S. commercial real estate is going to be a slow bleed. The trade is crowded, and expensive, as news of it is stamped on many investors’ minds from media sources.

Also, it is important to keep in perspective that this real estate “crisis” is nowhere as impactful to the overall economy as the housing crisis was. Rather, it’s focused on retail and retail real estate. Nonetheless, this trade is an opportunity if one believes the story.

If there will be one, we look to be at the early stage of a commercial collapse. The data is compelling and the trends are prevailing. “Every conference I go to, they talk about a softening of the real estate market in 2018, 2019. That’s just the cycle. It’s about the right time. It won’t be like 2008 to 2010, but there will be a softening” said John D’Amico, the director of special asset management at Trimont Real Estate Advisors.


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SCHWAB-US REIT (SCHH): ETF Research Reports
 
J.C. Penney Company, Inc. Holding Company (JCP): Free Stock Analysis Report
 
Simon Property Group, Inc. (SPG): Free Stock Analysis Report
 
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