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Buy REIT puts?


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Many commentators are speculating that June 30 will mark the end of QE2.  In advance of an anticipated rise in Treasury yields, Bill Gross's flagship Total Return Fund sold all its Treasury holdings and is now net short. In his latest letter to clients, Gross speculated that Treasury yields are at least 100 - 150 bps too low. The big question that should be on everyone's mind is, if the Fed does stop buying Treasuries, who will step in? The only way demand will pick up is with increased interest rates.

 

Anyway--I've stated several times on this board that REITs are very unattractive to me because of interest rate risk. With a defined date for the potential end of QE2, I'm thinking about buying REIT puts.

 

Some back of the envelope math:

 

Simon Property Group's (SPG) dividend currently is $3.20, or 2.91% at a current share price of $110. If we assume that the 100 - 150 bp increase  in Treasuries will flow through into demanded yield on REITs, SPG should need to yield 3.91% - 4.41% after QE2 is over.

 

If earnings don't increase, this would translate into a decline in share price of 26 - 34%. On the conservative end we're talking about a share price of $82.

 

$105 Jan 2012 SPG puts are $8.65. If the price of SPG falls to $82, you stand to make nearly 125%. If SPG falls to $73 (the less conservative end), the potential gain increases to 225%.

 

The biggest risks in my mind are timing--how long would it take the end of QE2 to funnel into the stock market--and, more importantly, whether the Fed will look to a QE3.

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correct me if my thinking is wrong, but what about this scenario. i think it's too hard to out smart the market most of the time. everyone knows about the qe2 being stopped, so the market should (theoretically) already be pricing this into things, reits included.

 

However, let's say my assumptions are wrong (happens often enough!) and reits do tank. Wouldn't an end to qe2 indicate a strengthening economy? with a strengthening  economy, we're probably talking about higher inflation, and reits tend to be a good hedge. although, a rising rate environment does make them somewhat less attractive.

 

 

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Seems like a smart asymmetrical bet on rising yields. If you could get 2 year leaps then it makes sense. Half the smart people predict inflation and the other half deflation. I have my hedges in place. This seems like a good way to guard against one, I would perhaps pair it with something. REITs are overvalued on an absolute basis but seem fairly priced based on where treasuries are at. 3% though is really short, I think perhaps people are pricing in a recovery in consumer spending and mall rents / activity.

 

Its tough, timing has to be spot on for this to work. REITs will tank when rates rise. I just dont know when, its a tough game.

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Unfortunately the profit potential isn't there using the 2-year options. Also just a bit of warning, I actually made a math error above so the potential profit is a little less but still exists.

 

Also, in my mind, the risk of rising inflation on REITs dwarfs any benefit from hedging inflation in my mind. Of course, it's impossible to know whether this risk is already priced into the market (judging from how stupid the market's price action has been the last few months, I don't think this is the case).

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It appears to me that as a broad group REITs (and MLPs) are overvalued as their yields are well below historic averages. Investors have been buying them because bond yields are so low. I don't see earnings and dividends growing fast enough to offset the prices...which means their prices will likely fall, bringing yields back to norms with or without QE2/3...the question is when and how much...

 

Perhaps inverse bond funds or ETFs would be better?

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