Industry Rank Analysis 11-25-09

Commercial real estate is in big trouble, with rising vacancy rates leading to lower effective rents. On top of that, the Cap rate, which is sort of like the P/E ratio for stocks (or to be more precise, like the E/P or earnings yield for stocks), has been rising, meaning that investors are willing to pay less for each dollar of operating earnings.

Moody’s recently estimated that commercial real estate values are now 43% below peak levels. This has weighed heavily on the real estate-related industries, and the Zacks Industry Ranks reflect those troubles.

Out of 206 industries that we follow, Real Estate Operations now rank 180, with an average Zacks Rank of its constituents of 3.31. The ranks range from 1-5; Zacks #1 Rank stocks indicate a strong buy, which is assigned to the 5% of stocks which are most timely. Stocks which are in the 6th through 20th percentile earn a 2, with similar rules for the 5’s and 4’s.

Almost as badly viewed by the industry rank are the mortgage REITs, which are in 178th place with an average rank of 3.30. Equity REITs fare better, but not by much, sitting in 165th place with an average rank of 3.27. Individual stocks with the dreaded #5 scores in those three related industries include: Capital Trust (CT), Investco Mortgage (IVR), Ramco-Gershensn Properties (RPT) and Glincher Realty (GRT).

Generally, commercial mortgages are for much shorter terms than the 30 years associated with most residential mortgages. Five years is the standard. That means that the owners of the properties are going to have to go to the banks and try to roll over the mortgage. For the banks, this presents a problem, since they do not want to lend out more than the collateral is worth.

Owners of commercial properties are far more likely to ruthlessly default than are homeowners — after all, it’s not like their kids are going to hate them for forcing them to move away from all their friends if they just let the banks take over the property. Most banks, particularly small to mid-sized banks are far more exposed to commercial real estate than they are to residential real estate and mortgages. Even if they make a residential mortgage, they are likely to package it up and sell it off to Fannie (FNM) or Freddie (FRE) rather than hold it in their portfolio.

As a result, the Zacks Ranks for the regional banks look even worse than the ranks for the real estate companies themselves. The 206 total industries have seven related to the regional banks, with five regional industries plus one for the major regional banks that cover several different regions. With the exception of the major regionals and the banks in the Northeast — both of which are neutral and tied for 104th place with average scores of 3.00 — the banks all look downright ugly.

The worst of the bunch, by a hair, are the Western Regional banks in 198th place with an average score of 3.64, followed by the Midwest in 197th place and a score of 3.51, the Southeast (180th place, 3.31) and the Southwest (177th, 3.29). I don’t think the differences between them are all that significant — just stay away from them all. Some of the larger names among the banks with Zacks Rank #5 scores include: Private Bancorp (PVTB), Sterling Bancshares TX (SBIB) and Peoples Bancorp of Ohio (PEBO). None of them will be mistaken for J.P Morgan (JPM) or Bank of America (BAC).

If you need to have a bank in your portfolio, it would be a good idea to look overseas. In very distinct contrast to their domestic cousins, the Foreign Bank industry is in 15th place, with an average score of 2.27. Some of the banks showing up with coveted 1 scores include major institutions like Credit Suisse (CS) and Deutsche Bank (DB). If you want a more Latin, emerging market flavor for your bank investments, consider Banco Santander (SAN) of Chile or Banco Bradesco (BBD) of Brazil.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com.

Zacks Investment Research

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