Real Estate ETFs: Should You Dump Your REITs Now? (IYR, REK)

Mike Larson:  Right here in Money and Markets — in May 2007 — I issued one of my most important and prescient warnings ever. I proclaimed the multi-year run in the real estate investment trusts, or REITs, over. And I told you … in no uncertain terms … to dump every last REIT you owned, warning:

“We’ve had way too much excess money and credit floating around out there. It’s causing what I call a series of ‘rolling bubbles.’ Residential real estate had its turn in 2001-2005 … and since about 2003, commercial real estate has been experiencing its own private mania. But a turn may finally be at hand.”

What happened in the wake of that piece? The iShares Dow Jones U.S. Real Estate Index Fund ETF (NYSE:IYR), a benchmark for the sector, began a sickening almost-two-year slide from $86 to just $21. Investors who failed to heed my warning lost a stunning 76 percent of their money through March 2009.

The Federal Reserve’s largesse and other factors helped turn REITs around at the time, with many doubling or even tripling off their lows. But even with that rally, the IYR is STILL trading more than $26 below where it was when I issued my landmark warning. More importantly, I believe …

“Phase II” of the meltdown is getting underway!

What Prompted the Recent REIT Rally …

REITs own and manage commercial property. Think warehouses where massive amounts of goods are stored … retail shopping centers … and those suburban office buildings you commute by every day. They take in money from rents, and pay out handsome dividends to shareholders.

The anemic economic rebound we’ve seen in the past couple years helped pump a little life into the commercial real estate sector. A report from research firm Cassidy Turley noted that demand for retail space has generally climbed since July 2010. Meanwhile, CoStar Group said a net 80 million square feet of commercial real estate space was absorbed in the past year. That helped stabilize vacancies in the industrial and warehouse subsectors.

At the same time, the Fed pumped up virtually every asset class in the world by flooding the markets with easy QE2 money. That forced large investors like pension funds and life insurers OUT of low-risk Treasuries and IN to higher-yielding investments, such as junk bonds and REITs.

Investors also piled into physical real estate in major financial and political centers like New York and Washington. Why? Because a commercial property’s value doesn’t stem from the steel, concrete, and glass it’s built of. It’s the income stream from rents that investors crave — making commercial property almost like a type of higher-yielding bond.

… And What’s Telling Me It’s Now Over!

But here’s the critical point: That’s all “rear view mirror” stuff! The end of QE2 is looming, and political pressure will keep the Fed from launching another money printing program. The search for yield is starting to blow up in investors’ faces, with junk bonds and riskier mortgage securities starting to fall sharply in price.

At the same time, the residential real estate sector is already rolling over again — bad news for commercial, which ALWAYS lags residential. And the broader economy is weakening again, as I’ve detailed over and over in recent columns. All of that tells me the two-year long rally in REITs is kaput. Over. Done.

You can already see commercial property owners tentatively heading for the exits. To cite just one city as an example, look at Chicago …

The owner of the Chicago Board of Trade, CME Group, just announced it would try to sell its landmark 80-year-old Art Deco towers. The Willis Tower (the former tallest building in the U.S. previously called the Sears Tower) was also just put on the market a couple weeks ago. That adds even more properties to the 15-strong-and-counting pile of downtown buildings up for sale.

Meanwhile, the same Markit CMBX indices that foretold the first phase of the crisis are rolling over again. Those indices track the value of commercial mortgage backed securities (CMBS), and their recent declines suggest that smart-money investors are once again starting to flee.

Finally, there’s this chart of the IYR. You can see that it’s been stair-stepping higher for the better part of the past two years. But a few days ago, it knifed through that uptrend line on the heaviest trading volume in several months.

What to Do … before It’s Too Late!

If I’m right, this is just the beginning of what will be a nasty spill in the REIT sector — the second since 2007. So if you own these stocks, whether for income generation or capital gains, my advice to you is simple. Sell and don’t look back.

What if you have real estate stocks you can’t sell, for whatever reason? Or commercial property you can’t unload? Then I would strongly recommend you hedge that exposure.

One option to consider is inverse real estate ETFs. The ProShares Short Real Estate (NYSE:REK) is designed to rise 1 percent for every 1 percent decline in the Dow Jones U.S. Real Estate Index, for instance.

You can also buy leveraged inverse ETFs that rise even faster in value when REITs fall. But as with many leveraged ETFs, long-term tracking error is a concern, especially if volatility picks up.

So if you want a more active strategy — one that allows you to get in to these ETFs, grab profits, then get back out — consider my Safe Money’s Crisis Trader . I believe it’s tailor made for this environment.

Bottom line folks: With the economy weakening, residential real estate clearly rolling over, and savvy investors looking to dump their commercial real estate exposure, it’s time to get your portfolio out of harm’s way.

There’s no telling how nasty Phase II of this crisis will get. But considering how much of a disaster Phase I was, I don’t think you want to stick around and find out!

Until next time,

Written By Mike Larson From Money And Markets

Money and Markets (MaM)is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaMare based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell, Selene Ceballo, Amber Dakar, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

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