Existing Investing Opportunity: Commercial REITs

For the most part, the big banks have now reported earnings. And there’s a lot to digest. But when we’re done with today’s discussion, I believe we’ll have a strong handle on a big opportunity for small cap investors.

So bear with me as we set the stage…

Wednesday morning Morgan Stanley (MS) reported that it returned to profitability after three consecutive quarterly losses. While the bank reported strong results from its investment banking and growing brokerage businesses, it said real estate investments are still a drag.

Wells Fargo (WFC) sang a similar tune. The third-largest U.S. bank by market cap recorded $3.2 billion in Q3 net income, but expects loan losses to rise further, and to peak next year. Their acquisition of Wachovia is not helping matters. Those loan losses rose over 70%.

We’re hearing the same story from nearly all the big American banks, whether they made money or not. “Profits are positive, or at least less negative, but we’re still loosing money on bad real estate and consumer loans.” This was the news from Bank of America (BAC), US Bancorp (USB), Citigroup (C), and JPMorgan Chase (JPM).

No doubt we’re all growing weary of the stream of bearish news on the housing front. The Commerce Department said Tuesday that September New Home Construction and New Building Permit applications were lower then expected. Foreclosure filings hit a record high. Another report stated that national median home prices will drop more than 10% by June 2010.

These factors are clearly showing in the poor bank earnings.

What good news there is been has been created by the First Time Homebuyer Credit. But the deadline to extend that program is drawing near. Still, mortgage rates tick higher, and fewer consumers are filing applications. The Mortgage Bankers Association (MBA), an industry trade group, said its index of applications fell last week by 13.7%.

All of this data is saying one thing: the consumer is not in great shape. And the housing market is following suit. There’s simply no way to avoid this truth, and the market knows it. The major indices are trading in a tight range.

We’re not going to see a return to the same level of consumer spending that we had pre-recession, we know that. Right now, simply restoring enough strength to the consumer to pay their bills would be huge. So for the consumer’s health, as well as the health of the big banks, I feel confident that the first time homebuyer credit program will be extended. It would be crazy for Obama not to get this done.

So what does this have to do with small-cap stocks? Well, it suggests there may be upside for real estate related stocks. But which ones?

It would seem the homebuilders would be a logical choice. But we’ve been seeing a lot of movement in commercial real estate stocks lately. It would be remiss to focus in on homebuilders without some comparative analysis with commercial REITs.

This morning I dug a little deeper and created my own ‘basket’ of six REITs, with an average market cap of $558 million. The companies in this basket include the three we’ve talked about here in SmallCapInvestor Daily: Maguire Properties (MPG), Strategic Properties (BEE), and Roberts Realty Investors (RPI).

I also created a basket of six homebuilders, with an average market cap of $2.27 billion. (This is stretching the small-cap ‘top’ a bit, but given how far many of these stocks have fallen, I think it’s appropriate.) This basket includes Hovnanian (HOV), Toll Brothers (TOL), and KB Home (KBH).

Now, let’s compare the results. In the last 6 months, the REITs outperformed the Homebuilders by 54%. And over the last 3 months, the REITs outperformed by 70.7%. Now, it didn’t surprise me that commercial real estate companies are doing better than homebuilders, but the amount of the difference was surprising.

What’s more, had you purchased the REIT basket, you would have made money over both periods, 73% over 6 months, and a little less, 61% over the last three months. Not so with the homebuilders. My hypothetical basket made 19% over 6 months, but lost 10% over the last three.

I think these results show us clearly that REITs have momentum on their side. And that’s because the “fix” for commercial REITs is easier then for the homebuilders. The REITS need to refinance their debt to a lower cost structure. And Fed Chief Bernanke has said that helping the commercial real estate market is a priority.

The “fix” for the homebuilders is far more complicated. They need the housing market to work through existing inventory while they struggle to keep their employees on payroll. And with unemployment approaching 10%, this is clearly a challenge.

Investors are voicing their opinion - the existing opportunity is in commercial real estate. I’ve already looked at a few nice opportunities like Maguire Properties and Strategic Properties. I’ll be bringing more to your attention in coming issues of SmallCapInvestor Daily.

As for the homebuilders, let’s let the sleeping dogs lie. Because they’ve underperformed, it may seem like there’s more upside, but it could be a while. When these dogs get off the porch and start running, maybe we’ll tag along. But for now, it’s commercial REITs for me. This analysis shows how we can look at sector trends to help pick winning stocks.

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