Billionaire Investor Sends ‘Shocking’ Warning Against REITs
Famed short-seller and billionaire investor Jim Chanos recently went on CNBC to share his views on the current market and it isn’t pretty!
He spent a good portion of the 20 minutes discussing how valuations remain excessive across the board. He explains that the forward P/E of the S&P 500 (SP500) may not seem high at 18x, but this is based on exceptionally high margins that won’t last in a recession. As we experience some reversion to the mean, earnings will deflate and share prices will decline:
“The market is at 18x forward. Profit margins are at all-time highs so that has not yet mean-reverted. One of the most mean-reverting things of finance is corporate profitability, but it has been stubbornly high. Since I have been on the street, 1980, not one bear market has ever traded above 9-14x the previous peak earnings. 1987, 1990, 1994, 2002, 2009… If you think earnings are peaking now, that’s a long way down. We are nowhere near that.” Jim Chanos (emphasis added).
He then also talked a lot about risks such as the rising tensions with China, and the war in Ukraine, and how that could have an especially big impact on companies like Tesla (TSLA), and this is why he is shorting it.
But that’s not even the most interesting part of the interview.
What really caught my attention was his thoughts on commercial real estate and a few specific REITs that he is shorting.
He opened the discussion by saying that:
“I just don’t get people buying almost any type of commercial real estate that doesn’t have good demand at 3, 4 or 5% cap rates. It makes no sense.”
In other words, the low cap rates only make sense in today’s higher interest rate environment if there is strong demand for the properties and the rents are actually growing at a good pace.
As an example, it may make sense to buy an apartment community at a low 4.5% cap rate if its rents are 20% below market and growing rapidly since the stabilized cap rate a few years out would be a lot higher.
But it may not make sense to buy an office building at a 5% cap rate if its future demand is very uncertain and rents are expected to decline…
He quickly followed that by highlighting his first short: SL Green (SLG).
“NYC offices, which we have been short now for a couple of years, trades at a 5% cap rate, it’s leveraged massively to its cash flow and I just don’t want to buy NYC office buildings at a 5% cap when the balance sheet is leveraged 15-to-1.”
Generally speaking, I am bullish on REITs, but even I can’t really argue against Jim Chanos’s logic here.
I am not as bearish as he is and I surely wouldn’t short SLG, but it sure does not seem to be as cheap as many claim it to be.
I am not sure what assumptions Jim Chanos used to come up with his cap rate estimate. It appears that he used somewhat lower NOI and higher capex, but even if the implied cap rate was higher, is this really what you want to own?
The discount to NAV may be significant today based on yesterday’s cap rates / NOI but this discount may rapidly disappear in the future since the company is heavily leveraged.
SLG just recently released its results and the main highlight for me was the following (emphasis added):
“The mark-to-market on signed Manhattan office leases was 4.7% lower for the fourth quarter and 9.2% lower for the full year than the previous fully escalated rents on the same spaces.”
Also, keep in mind that they achieved this outcome, despite very weak leasing volumes. If they had closed more deals, rents would have likely dropped even more. That’s also before we enter a potential recession which would only make things worse.
Lots of companies and people moved away from NYC in recent years because now increasingly many people can work remotely at least part of the time, so it makes less sense to stay in NYC, which is incredibly expensive, has bad weather, and some of the highest taxes in the U.S. The incentives to move to Florida or elsewhere are so high that I expect this to remain a problem for NYC in the coming years.
For this reason, I am avoiding the common equity of SL Green and Vornado Realty (VNO) for now.
Then Jim Chanos also noted that he is shorting data center REITs. He said:
“We are also short data centers, which I think are the worst businesses I have ever seen. They trade at 100x earnings. Earnings are the metric because of capex equal depreciation… So valuations are still in the stratosphere and make no sense to us.”
He did not go more into specifics in this interview, but he has previously also noted that the biggest cloud providers Amazon (AMZN), Google (GOOG), and Microsoft (MSFT) are increasingly interested in building their own data centers to have particular specifications, and this increases the supply and lowers the value of legacy properties.
“When your biggest competitors are three of the most vicious competitors in the world, then you have a problem,” Chanos said.
This has led to declining same-property NOI in many cases.
Digital Realty (DLR), Equinix (EQIX), and other peers may not seem that pricey based on funds from operations (“FFO”), but Chinos believes that their valuations become way excessive once you account for capex/depreciation, which is a real expense in the data center space.
Should You Sell REITs?
No. On the contrary, I am very bullish on REITs after the crash of 2022:
Valuations are now historically low, rents are growing at a good pace, and balance sheets are the strongest ever. But there are exceptions… and NYC office REITs and data center REITs may be some of them.
At High Yield Landlord, we avoid those sectors and invest instead in more defensive sectors like net lease, residential, and healthcare properties:
These property sectors offer many opportunities with REITs trading at large discounts to the fair value of their properties.
To give you just a quick example: BSR REIT (OTCPK:BSRTF) owns Texan apartment communities, its rents are growing rapidly, and it is today priced at a 35% discount to its net asset value.
So by investing its shares, you essentially get to buy a small interest in its portfolio at 65 cents on the dollar, and then get the added benefits of professional management, diversification, leverage, passive income, and limited liability for free on top of it.
The bottom line is that you should be very selective when investing in REITs. It is a vast and versatile sector with lots of value traps.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.