News Analysis date published New: 
Friday, July 13, 2012 - 14:30
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Friday, July 13, 2012 - 17:09
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Friday, July 13, 2012 - 14:30

3 Reasons Why This Overheated REIT Could Tumble

Friday, July 13, 2012 - 2:30pm

Considering real estate was at the epicenter of the 2008 financial crisis and continues to hold back the economy, it's ironic the sector has been one of the best investments of the past few years. I'm referring specifically to the commercial real estate market, which delivered overall returns of 30% a year during the three-year period ended July 6. This occurred despite dire predictions of commercial real estate going the way of residential real estate and maybe triggering a second financial crisis.

This hasn't come to pass, however, for several reasons, like the fact that the commercial real estate market is a lot smaller than the residential side (commercial debt amounts to about $3.5 trillion, compared with nearly $11 trillion for the residential market). Commercial real estate has certainly seen its share of defaults, but besides being on a markedly smaller scale, these events have unraveled in a much more orderly fashion. Moreover, the foreclosure wave resulting from the financial crisis actually helped boost the commercial market by creating a flood of new renters looking for apartments.

But if you weren't in on the commercial real estate run-up, be careful about chasing past performance now. You could get burned, especially if you've set your sights on the sector's top performers. Many of these stocks have risen far faster than the overall commercial real estate market and, at current prices, are likely to underperform or could even lose you money.

There's one investment in particular I'd be very cautious of right now.

The stock price for this large, well-known real estate investment trust (REIT) has more than tripled in the past few years, jumping from $46.90 on July 8, 2009 to about $157 currently. In other words, the stock delivered 49% a year while the overall commercial real estate market was returning 30%. But the future of this company, Simon Property Group Inc. (NYSE: SPG), may not look much like its past. In fact, I wouldn't touch it at this point, and there are three main reasons why.

1. It's all about retail.

Over the years, Simon Property Group has built itself into a commercial real estate giant. It now generates $4.4 billion of annual revenue by developing, owning and managing upscale regional malls, premium retail outlets and community/lifestyle centers. It's the largest mall operator in the United States, with 151 regional malls in 41 states and Puerto Rico. U.S. operations also include 58 premium outlets, 66 community/lifestyle centers and 15 shopping centers. Plus, Simon Property Group owns 36 properties in its "Mills" portfolio. The typical Mills property is a one-million square-foot facility with a combination of businesses from malls and outlets to big box retailers and entertainment vendors.

That's all very impressive, but the company's retail focus is a major concern, in my opinion, because of the risk of a "new normal" in the economy -- a term used by economists to describe what could be a very long period of slow growth or stagnation marked by weak consumer spending. If it comes to pass, the new normal could hit Simon Property Group especially hard because retail tenants may try to protect themselves by seeking better lease terms or even closing stores.

2. It's getting too big.

It's not a question of Simon Property Group's market cap ($47 billion) but its share of the U.S. market. This has grown so large -- to almost 25% -- that the company has begun to run into antitrust issues.

On Aug. 2, 2010, for example, the company reported it would scale back a $2.3 billion deal to buy mall operator Prime Outlets Inc. The revised deal went through Aug. 31, 2010, but it wasn't the end. On Nov. 11, 2010, Simon Property Group agreed to additional FTC demands aimed at preserving competition, such as selling off other mall outlets.

3. It'll have to focus on foreign expansion.

Since domestic growth may be hitting a wall, because of the sluggish economy and potential antitrust obstacles, Simon Property Group has no other choice but to seek foreign growth opportunities in places like Europe, Canada, Brazil, Japan and China, among other countries.

The latest and largest deal since the Prime Outlets acquisition was the Mar. 8, 2012 purchase of a 29% stake in Paris-based shopping center operator Klepierre for $2 billion. Klepierre has 271 shopping centers in 13 countries, with about half its properties located in France and Belgium and a fourth in Scandinavia. On April 10, 2012, Simon Property Group announced an $825 million joint venture with Sao Paulo-based BR Malls Participacoes SA (OTC: BRMSY) to open 12 shopping outlets across Brazil between 2013 and 2019.

While these and other efforts at foreign expansion should help with revenue generation, they'll also pump up risk by increasing exposure to foreign currency fluctuations, unfavorable political developments and foreign environmental, labor and tax laws. Then there's the issue of economic conditions, which at this point are worse in Europe than in the U.S and have even begun to decelerate in China, Brazil and other higher-powered emerging markets. When the global economy slows, retail-dependent businesses like Simon Property Group can be among the hardest hit as consumers everywhere curtail spending.

Action to Take --> Avoid Simon Property Group. Based on its meager 2.5% yield alone, the stock is way overpriced and at a high risk to take a big tumble, especially if inflation kicks in and interest rates go up.

It also looks like a poor value based on analyst forecasts for earnings per share (EPS) growth. After climbing from $1.05 to $3.48 a share between 2009 and 2011 (an 82% annualized growth rate), EPS are only projected to rise by 4.5% a year to $3.65 in 2012 and $3.80 in 2013. This means investors would have to pay a whopping 43 times 2012 earnings and 41 times 2013 earnings to own the stock -- far too expensive.

If you're looking for a REIT, then consider a far less retail-oriented stock that hasn't run up quite so much. I suggest looking into Brookfield Asset Management (NYSE: BAM), which also owns commercial property, though mainly offices, not retail outlets. It's also into hydroelectric power, power transmission and timberland. At about $33 a share, it trades at a far more reasonable 18 times 2012 projected EPS of $1.80 and 16.5 times 2013 projected EPS of $2.00.

Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.