CRE Me a River

Malt Liquidity 114

The old adage goes, “those who can’t do, teach.” Similarly, those who can’t buy, rent. And perhaps those who can’t work, write, but I digress. While my opinions on the real estate market are generally known (or predictable) to any long term reader,

Housing is a physical rates product leveraged on 30 years of forward earnings, versus renting, which is immediate cash return in the form of “needing a place to live”

it’s shockingly hard (for good reason, as it’s the most backstopped market) to shake the American mentality of “A Home of your Own”.

11 words: A Home of Your Own, Patriot Act, No Child Left Behind

You would not believe the amount of times I’ve heard “rent is just throwing away money”, or the “novel” investment thesis of “buying a place and rent it out for income.” Look, the way real estate works is by already having a ton of properties with cash flow and levering off of those to buy even more properties. But that’s a rant for another time (or, in all reality, it’s buried somewhere in the archive.)

No, instead we’re going to look at the other people who have assumed real estate “just goes up” — the industry professionals themselves. Recall Opendoor’s catastrophic attempt at “market-making” in the peak (post ‘08) housing bubble just last year:

In Phoenix, Opendoor lost money on 89% of the homes it sold in the fourth quarter, an average of $58,000 apiece, before accounting for fees and expenses, according to Tom Ruff, an analyst with Arizona data firm Information Market. The company in that same quarter on average flipped homes for 12% less than it had originally paid, he found. In November, Opendoor wrote down its real estate portfolio by $573 million. As of Friday, its shares had fallen 94% since their high in February 2021.

The real estate industry is littered with fund managers who simply don’t believe that the market can ever actually stagnate, falter, or god forbid, recede. Pretty much every real estate fund thesis seems to be “buy land because God ain’t making more of it.” Well, as far as I can tell, interest rates couldn’t have been conceived until day 6, so how much borrow cost could God have possibly accrued during creation? Instead of living on the land, however, we lever off the land. Take, for example, this never-ending BREIT redemption saga:

Blackstone has limited investor redemption requests from its $68 billion real estate trust for high-net wealth investors for nine consecutive months while storm clouds continue to gather over commercial real estate markets.

According to a letter obtained by Bloomberg, Blackstone Real Estate Income Trust (BREIT) recorded investor outflows of $3.7 billion in July -- the lowest redemption requests since the run on the fund began in November 2022. However, BREIT only returned about $1.3 billion, or approximately 34% of what was requested -- as it continues to gate redemption to prevent massive outflows. 

Much like people missing credit card payments or the panic selling of stocks, when it rains, it pours. Everyone wants to get into the market when it’s hot, such that an environment is created where you can offload a property seemingly overnight, but when rates are high and nobody needs more office space due to remote work, good luck getting rid of that property exposure. $3.7 billion in withdrawals is not a critical mass request, but gating them is certainly a terrible sign of underlying liquidity and ability to deliver the promised returns. Just take a look at the terms BREIT had to offer to bait inflows:

The Office of the Chief Investment Officer of the Regents of the University of California (“UC Investments”) and Blackstone (NYSE: BX) today (Jan 3, 2023 ~ed.) announced a long-term strategic venture in which UC Investments will invest $4 billion in Blackstone Real Estate Income Trust, Inc. (“BREIT”) Class I common shares, the largest existing share class. Blackstone will then contribute $1 billion of its current BREIT holdings as part of a strategic venture with UC Investments….

In addition, Blackstone and UC Investments have entered into a separate strategic agreement that provides for a waterfall structure with respect to the total return to be received by UC Investments on its investment in the Class I common shares. As part of the agreement, Blackstone will contribute $1 billion of its current holdings in BREIT to support an 11.25% minimum annualized net return for UC Investments over the effective 6-year hold period. In exchange, Blackstone will be entitled to receive an incremental 5% cash promote payment from UC Investments on any returns received in excess of the specified minimum, in addition to the existing management and incentive fees borne by all holders of Class I shares of BREIT.

Note that

The redemption requests were down slightly from $3.8 billion in June and were the lowest so far this year. Redemption requests peaked at $5.3 billion in January, but remain high even though BREIT has paid out $9.4 billion to investors since limits on withdrawals were put in place in November.

You can essentially read all this as Blackstone’s cost of liquidity to make investors whole and continue running the fund being priced at 11.25% for 6 years. That’s… not great relative to current borrow cost. So how are they going to generate this return? Well, AI of course:

“With approximately $10bn in immediate liquidity, BREIT has significant financial flexibility,” Blackstone said in a statement to the FT. Last month, investors sought to redeem $3.8bn from Breit, a 30 per cent decline from January. Disposals in recent months, like the $800mn sale of a resort in Texas and a $2.2bn sale of a portfolio of self-storage properties announced earlier this month, come as Blackstone is raising cash to prepare for what it believes is a “once in a generation” opportunity to build properties to handle rising computing demand from a boom in artificial intelligence. Blackstone has committed to spend more than $8bn to build new data centres for several large scale technology companies, according to two sources familiar with the matter.

Values like net worth, theoretical value, and market cap are all liquidity-assuming calculations. As my principle goes, you can have the best asset pricing model out there, but it doesn’t matter if nobody will transact at that price with you. Similarly, you can state that the return is there and cite your past returns, but if you can’t get investors to buy in/raise the liquidity to make the proper investments, you might as well not have any standing at all. Certainly Blackstone is not alone in this conundrum, and it seems that their share price has recovered since the “big scare.” Note that I obviously don’t think Blackstone is going to fold over this — but it’s been the constantly singing canary in the coalmine for the past 9 months that commercial real estate (CRE) might be irrevocably fucked. Take the perennial laughing stock that is WeWork, finally collapsing under the weight of Adam Neumann’s manic leasing:

David Tolley, chief executive, told landlords that dialled in that WeWork expected to exit some “unfit and underperforming locations” but would remain in most of its buildings. In a statement after the call, he said WeWork was “taking immediate action to permanently fix our inflexible and high-cost lease portfolio” that he described as a legacy of a “period of unsustainable hypergrowth”.

WeWork has already spent several years seeking to cut its long-term lease liabilities, which exceeded $18bn at the time Adam Neumann stepped down as chief executive after a failed initial attempt at going public in 2019…

Note that WeWork’s leases primarily run until 2028. Not great, Bob!

More concerning is the overall ripple of effect regarding the fact that RTO really isn’t happening fast enough, and it might not ever be enough. Take, for example, this recent report wherein CRE lenders whine about money not being free anymore:

Bank OZK had two branches in rural Arkansas when chief executive officer George Gleasonbought it in 1979. The Little Rock lender today has billions of dollars in commercial real-estate loans, including for properties in Miami and Manhattan, where it is helping fund the construction of a 1,000-foot-tall office and luxury residential tower on Fifth Avenue…

First of all, you gotta wonder why a small Arkansas bank is all tied up in billion-dollar real estate lending in Manhattan. Reminds me a lot of the Penn Square Bank situation, honestly. But it gets funnier:

Bank OZK hasn’t pulled back from lending, but it has started to see some signs of market trouble. In January, a developer defaulted on a roughly $60 million loan from Bank OZK after construction costs escalated, the bank said. The loan was considered relatively safe because it was far below the building site’s value of $139 million in 2021. In December, a new appraisal put the property’s value at $100 million.

The bank is effectively stuck with the property. “Buying land in the current unstable environment is not something that a lot of people will do,” Gleason, the CEO, said during an April earnings call. Bank OZK declined to comment…

Bank OZK’s success over the years allowed Gleason to build himself a 27,000-square-foot French chateau-style mansion in Little Rock, which he filled with a vast collection of European art. “I’ve never said that what we do is risk-less,” Gleason told the Journal in 2019.

Gee, you really feel for the guy here. What would he do without más Picassos in his mojo dojo casa house? I can’t wait for more SVB/FDIC-esque hypocrisy to bail out these poor, poor lenders. What do you mean the number doesn’t just go up?

That indirect lending—along with foreclosed properties, trading portfolios and other assets linked to commercial properties—brings banks’ total exposure to commercial real estate to $3.6 trillion, according to a Wall Street Journal analysis. That’s equivalent to about 20% of their deposits.

The volume of commercial property sales in July was down 74% from a year earlier, and sales of downtown office buildings hit the lowest level in at least two decades, according to data provider MSCI Real Assets. When deals begin again, they will be at far lower prices, which will shock banks, said Michael Comparato, head of commercial real estate at Benefit Street Partners, a debt-focused asset manager.

Remember the “death spiral” I talked about with regards to Credit Suisse (rip)?

Turmoil begets more turmoil. Losses and scandals (and the occasional mysterious death) require constant restructuring and replacement of executives, who will all have different ideas on how to “recover” from the business, but the reputation loss is the real death sentence.

Well, we have a similar situation here, where nobody wants the actual property because the m2m on it is obviously inflated and will have to be written down on the next liquidity event. CRE vacancies beget investors/lenders defaulting/unable to refi at high rates begets creditors absorbing properties nobody wants begets less collateral to lend when the properties are written down. This, in effect, is the core problem with illiquid market valuation versus real time valuation. Take, for example, this chart of NFL team values over time,

and compare it to Manchester United’s real-time stock price (bet ya didn’t know they were publicly traded, huh?)

When the market decides your valuation, as opposed to a Zillow “proprietary” pricing algorithm or a private mark, you're going to be at the whim of market volatility and consequently depend on available market liquidity. Much like when there was an abundance of oil to be delivered and nowhere to store it, CRE is at the stage where nobody wants to take the bet that people do actually go back to the office, in sort of an inverse situation — there’s all this space, but no people to fill it with. Liquidity is not available uniformly regardless of regime — it’s in abundance when it’s not exactly needed (and thus, spreads tighten) and pulls a Keyser Söze when it is heavily demanded. The greatest trick the real estate market ever pulled was convincing you that it’s liquid.

Where does this all go? I’m not entirely sure. I don’t think it’s a bad thing for poorly run banks to fail or for overlevered funds to flush out — frankly, I think that continuously propping incompetent actors creates a much larger nuclear fission down the line when they can’t be bailed out. I do think that on the whole, in the 24-hour-real-time age, we tend to overreact to adverse events, where contagion turns into a self-fulfilling prophecy of sorts (as was the case with SVB.) And certainly I don’t have any sympathy for CRE fund managers and investors, plenty of whom have killed my favorite spots just trying to get by through inane, excessive lease increases (RIP Painted Lady.) But finance, above all, is an industry centered on trust — that the people who hover over the levers will do the right thing. While I make fun of real estate as being a backstopped, absurdly pumped investment class, we all kind of depend on “number go up”. What would the economies of Singapore, Canada, Australia, UAE, China, and more look like without the real estate Ponzi? I suspect it’d be something along the lines of post-80s Japan, where no amount of financial Viagra can initiate growth, and where monetary policy mimics the South Park chicken without a head economic policy roulette.

As Brother Mouzone told Avon Barksdale in The Wire,

Business is where you are now. But what got you here is your word and your reputation.