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Wednesday, June 13, 2007

Mixed Picture on Real Estate in Fed Beige Book

Today's release of the Fed Beige Book lit a fire under the markets. The Beige Book painted a picture of an economy that was growing at a modest pace without suffering undue wage pressure or other inflationary impacts (except the usual jumps in food and energy prices).

The situation in the real estate sector was another story.

Residential construction is still in the doldrums. There were declines noted in new and existing home sales as well as falling prices and rising cancellations of new home sales. My expectation is that home builders are not yet out of the woods and ETFs like the SPDR S&P Homebuilders (XHB) will see more weakness in the near term. Today's results for XHB, however, were anything but weak as investors, caught up in the euphoria of an overall benign read on the economy from the Beige Book, bid up shares in defiance of common sense. Maybe they didn't read the paragraphs on residential real estate.

The commercial real estate sector appears to be gaining strength and that gave a big boost to ETFs that focus on REITs like the iShares Dow Jones US Real Estate (IYR). Demand is strengthening, vacancy rates falling and office rents increasing. Those districts that mentioned commercial construction activity gave positive reports.

Still, interest rates are the highest they have been in a year and that has to have an effect on the REIT sector. Rates did weaken a bit today, but remain close to their recent highs. One reason the REIT sector has prospered for the last few years is due to liquidity supplied through low interest rates, enabling commercial real estate investors to enjoy "phenomenal returns in the face of poor fundamentals" as Brian Lancaster, head of structured products research at Wachovia Securities, said last year. Furthermore, though residential real estate will be very much effected by the rise in rates, "commercial and industrial real estate, ... will be less affected because the acceleration of economic growth will bring about more demand for real estate, still ...the effects will be negative there. It perhaps will be most serious in the owner-occupied residential housing industry, which is not as strongly affected by swings in the world economy." This last quote is from Jeremy Siegel of Wharton.

As I mentioned in a previous post on REIT buyouts, a lot of real estate is being bought with the notion that there will be exceptional growth in fundamentals, ie, increasing rents and property valuations. There is a good deal of optimism embedded in the current pricing structure for commercial real estate much as there was in the residential real estate market.

It is my view that we are at a risky stage in the REIT cycle with multiple cross-currents at work. We have today's report of positive activity in the commercial real estate market and yet we have interest rates rising. Property prices and rents are relatively high and may not have much room to rise higher. REIT dividend yields are at multi-year lows. If you believe the stock market is a leading indicator, the charts of ETFs like IYR show trouble is brewing.

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