Carl Icahn (Trades, Portfolio) was in the spotlight a couple of times in the last week. First, it was because of the significant drop in the Occidental Petroleum Inc. (OXY) share price. Second, it was his revelation of increasing his stake of Occidental to 10% from just 2.5%. The guru went on to confirm that he would push for major changes in the board of directors of the company.
In other Icahn news, the activist investor recently appeared in an interview with CNBC. Commenting on the current status of the capital markets and the U.S. economy, the guru predicted that the housing market will collapse the same way it did during the financial crisis. Specifically, he went on to confirm that he is short the commercial real estate (CRE) market, and that this accounted for the largest position of his portfolio.
In the interview, Icahn said:
“You’re going to have this blow up too and nobody is even looking at it. You have a bunch of mortgages, so the banks went out and loaned money against a lot of shopping malls, office buildings, hotels, and retail. It’s all credible institutions doing it again.”
In the last few months, many investors were beginning to feel comfortable with the overall real estate market in the United States as a result of declining interest rates. Under such circumstances, the guru is betting against the commercial sub-section of this industry, which calls for an analysis of its prospects.
A top-down view of industry dynamics
There are a few factors that determine the success of the real estate industry. Carefully evaluating these drivers can provide some valuable clues that help assess the long-term success of this sector.
First, economic growth, or the lack of it, can have a massive influence on the demand for commercial properties such as malls and retail stores. Stellar GPD growth translates into higher corporate earnings on a national scale, and this relationship is visualized in the below chart.
Source: U.S. Department of Commerce
This creates robust demand for commercial properties as companies, including retailers, allocate a higher budget for capital expenditure. Since the fallout of the financial crisis, the U.S. economy grew at above-average rates. This is one of the reasons behind the strong performance of the real estate market in the last decade.
Source: GuruFocus
In the next few years, however, the U.S. economy will likely grow at subdued rates because of a few reasons.
First, the economy is now reaching maturity in its cycle, as indicated by the slowdown of corporate earnings growth. Second, the impact of the Covid-19 virus will contract the growth rate for at least a couple of quarters as factories shut down and consumers stay at home. Third, declining oil prices are not welcome news for energy companies, who depend on oil and drilling activities.
Factoring in all these developments, the Organisation for Economic Co-operation and Development revised its forecast for 2020 U.S. GDP growth by 10 basis points to 1.9%. What is noteworthy is that the initial forecast of 2% was already reflecting a 30 basis points decline from the 2.3% growth achieved in 2019. This expected slowdown will continue in 2021 as well, which is a negative development for commercial real estate companies in the United States.
The interest rate environment needs to be analyzed. Low rates, in almost all instances, are a blessing for property companies. The availability of credit at attractive rates fuels the demand for new rental space as businesses bank in on such opportunities to expand into new regions and scale up their operations. This is one of the primary reasons why the Federal Open Market Committee tweaks policy rates to revive growth.
Going by the remarks of Jerome Powell in the first week of March, a rate hike seems very unlikely in the remainder of this year. However, concluding that this would be a positive development for property companies might prove to be naĂŻve. This is because of the impact of low rates on commercial real estate prices. As illustrated below, persistently low interest rates since 2009 have resulted in exponential growth of property prices.
Source: Green Street Advisors
As Icahn puts it, the soaring prices push the entire industry toward a massive collapse, the same way it happened during the financial crisis. Considering the meager economic growth outlook for the U.S. in the next couple of years, the demand for properties might decline considerably, prompting a collapse in these sky-high prices.
What is riskier, however, is if tenants use excessive leverage to buy even more properties because of the low rates. In such a situation, the bubble-like formation will grow even further. In fact, the outstanding debt of the industry has already spiked in the last 10 years to levels never seen before.
Source: Federal Reserve
Even though an increasing amount of debt is not an indication of future troubles in and of itself, capitalization rates can provide meaningful insights. As exhibited in the below chart, cap rates have been declining steadily since 2009, which indicates deteriorating profitability.
Source: Real Capital Analytics
Combined with a high debt level and bubble-like property prices, capitalization rates are issuing an early warning sign of a possible crash. Icahn is betting on such a collapse.
Takeaway: worrying signs are looming on the horizon
There is no immediate reason to run from the commercial real estate market, as a recession is unlikely to occur this year or the next in my opinion. However, there are a few signals that point to a troubled time for the U.S. commercial real estate market. No investor or analyst would be able to predict when exactly the bubble would burst, but make no mistake, one is in the making.
There is an alternative perspective as well. According to Schroders, there will be many winners in this industry in 2020, but identifying these companies will be much difficult than it was a few years back. The best course of action is to look for companies that operate in regions that have high capitalization rates.
As Schroders analyst Paul Bratten wrote, “Differentiation – particularly identifying winning cities – will be the primary source of stable income and protection from overvaluation concerns.” It’s always a good decision to invest in property companies with strong balance sheets, i.e. a low level of debt and an acceptable level of liquidity.
Jesse Colombo, the analyst who shot to fame by predicting the housing market collapse of 2008, has joined hands with Icahn in claiming that the commercial real estate market will face severe troubles in the future.
Being diligent and carefully analyzing the fundaments of a company is the best cause of action for investors to avoid getting burnt from an eventual crash.
Disclosure: I do not own any stocks mentioned in this article.
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