Investing for a Recession (Part II)

Having outlined how I have made some useful money from the recession to date, it would be worth now moving to my current main investment at present, so that there is some context when I update on this going forwards.

Apart from putting a proportion of my funds into a gold ETF, which is an excellent hedge both against recessionary worries, a devaluing dollar and future inflationary concerns from all the quantitive easing taking place, I have also placed a significant sum into something that is much less obvious in these turbulent times: US commercial property.

You might think that is insane, and is totally contrary to what everybody else is putting their money into at the moment. But part of investing is looking for value, and sometimes that means looking beyond the conventional wisdom. I have bought into something called a Real Estate Investment Trust (REIT) - these are essentially US commercial property companies, which by and large have plunged by enormous amounts in the last 6 months.

As such, several are rumoured to be on the verge of bankruptcy, and one in particular is down a staggering 97% since the summer of 2008. When you factor in a fall of that magnitude, you have to start looking at the price and ask why, and whether this is rational or fueled by other factors. The underlying reason is the credit crunch, combined with investor fear of a Chapter 11 bankruptcy filing.

To give some background here, REIT's have by and large used a previously acceptable business model, whereby they were highly leveraged and routinely took out large levels of debt to increase their asset base and buy up more property. They then serviced this debt, steadily paying it off while periodicially refinancing this - without problems in a normally functioning credit market. Of course, everybody now sees US property as having been in a huge bubble, and all associated loans as necessarily toxic. As such, suddenly some enormous commercial property companies are on the brink of bankruptcy - including the particular REIT I have invested in called General Growth Properties (GGP).

To put it into context, GGP is the second largest mall owner in the US. That is not an insignificant statistic in itself, and should it fold there would be enormous ramifications for the US retail sector, not to mention a political backlash. I would actually not mind if it did file for Chapter 11 within the next few weeks, for reasons summarised well in this Reuters article.

Estimates suggest that GGP's assets exceed liabilities on the balance sheet by several billion dollars already. Additionally it has no problems servicing its actual debts, just refinancing them. In effect the problems of GGP are not with solvency, as with normal bankruptcy risk, but liquidity - this is a direct result of the banks own liquidity issues that have made them more risk averse.

What is most interesting with GGP is also that the balance sheet is not fully marked to market, which means that if its assets are valued at today's prices instead of when purchased there will be a change. Many properties on its books were bought years ago and have never been revalued, so it is reasonable to expect many will be worth more than marked, even with the current woes of the US property market. As such, assuming GGP were to go bust, what does that mean for ordinary shareholders? Normally it is a disaster and means no money, but in this case it should mean that the US courts would order the banks to agree refinancing terms, after which GGP would emerge out on the other side without that perceived stigma. Meantime the shares will continue trading on the stock exchange.

Since the Reuters article, all indications are that GGP will not file for Chapter 11 however, with its banking consortium of lenders bending over to give multiple loan extensions (including one over the weekend through to mid-March). There are many factors at play in whether full refinancing of the loans due in 2009 will take place - that is what would remove the market risk of bankruptcy that has so severely depressed the share price.

The main sticking point for lenders is several billion dollars of loans that are currently unsecured (i.e. have no assets backing them up), which are due for refinancing. Understandably the banks want assurances they would have some collateral to offset should GGP go under at a later date, and at present the unsecured loans are not acceptable to them. As such GGP is looking to either sell assets to pay those off, or negotiate terms. Both are possibilities, but at this stage it is unclear which is the more likely.

Another factor is the recent extension of uses for the Troubled Asset Relief Program (TARP) by Barack Obama, to now explicitly include money for Commercial Real Estate. This bill has passed through congress, and the campaign is continuing - again it provides political pressure on the banks to lend and not push under a company as significant as GGP.

Once terms are agreed, or GGP manages to sell off a number of assets to enable refinancing, I expect there to be significant upwards movement on the stock price. I have gradually increased my long position on GGP from $1.61 down to $1.03 in the last 2 months, although it is worth adding that a recent sell off last week on fears ahead of the loan deadline (prior to extension again) lead to a sharp fall back to around 55 cents a share. As of yesterday, GGP's share price bounced up 30% on the news of the loan extension, and is now currently at around 80 cents a share as I type.

So I am sitting on an unrealised loss at present. Since I bought into this REIT in December, the share price has risen by 80% at its peak, and fallen by 50% from where I entered at its lows. I turned down the chance to cash in a £50k profit in early January because I am more interested in the bigger picture here. That's how trading works - I have a strategy which does not include day trading this stock, because I do not know when the news will be announced that will make the crucial difference.

To give you an idea of the potential rewards at stake here, if the share price were to rise back to just $3.50, where it was in October, I would make in the region of £150k from the trade.

I should add a cautionary note that this is considered a speculative play. I am speculating on the most likely outcome based on extensive research - what makes this unusual is that there appears to be significant upside regardless of whether GGP files for bankruptcy protection or not. To me the share price of GGP is significantly undervalued, and at some point the market is going to realise that.

Most people are not prepared to accept this level of risk, and that is entirely right, although it is worth pointing out that you can take a zero off the figures and it could easily be you making (or losing) these amounts. In my case, if everything goes as well as I expect, I could make over £1 million from the trade. Admittedly that is unlikely and would require me holding for a couple of years. I am looking at cashing in £250k as a more realistic profit, but it gives you an idea of how risk vs reward works in the markets.

I will keep you updated on the progress of this particular hot potato in the coming months. Anyway back to work.