Looming Liquidity Crisis?

InVinoVeritas's picture
Rank: Almost Human | 6,881

Each quarter I see increased late cycle behavior in the real estate world. From vast amounts of SFR home flipping at an institutional level (see Door/Zillow/Redfin) to development sponsors needing to farm out their 10% equity pieces due to insufficient cash at the operations level plus the reemergence of unsecured and interest-only debt at record high leverage points this cycle, irrational exuberance seems to be inundating the space. Multiple sponsors have approached us seeking opco level investment to recapitalize their firm because they have become so overextended chasing promote despite lengthening construction periods, high costs, higher opex, and weaker than expected rents. Much attention is paid to healthier CMBS performance this cycle, but the debt fund and mezzanine space seems to a real issue.

How do you all feel about the current state of the market in the space and MSA you work in?

Comments (49)

Oct 14, 2019

God damn it, I had a nice reasonably long response which had an error when I hit submit and lost it.

Long story short: with 15 trillion dollars of negative yielding debt and more downward pressure than upward on treasuries I dont see there being a good alternative for this cash to turn to (to create this "crisis") when you can still buy Class A coupon clippers with RET abatements for 4%+ caps.

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Oct 14, 2019

I agree that core CRE is an outstanding place to be long-term. REIT's like CPT, O, and LTC should fare well through a recession.

I am more concerned with, at least in Texas markets (which make up a gigantic amount of debt expansion over the past 5 years), all of the wrap multifamily trash developments on the fringes of city center penciling in $2+ psf mo. rents along with the dramatic amount of mixed-use developments without substantial office/grocer tenants with pro forma rents north of $40 psf yr. for both office/shop spec space.

There is a gigantic wave of 3-5 year construction loans coming due over the next 24 months, and I wonder if there will be enough bridge capacity to payoff especially considering another election year coming up.

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Oct 15, 2019

Student here...totally don't know what you mean by "Class A coupon clippers with RET abatements for 4%+ caps." Could you clarify?

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Oct 15, 2019

earning CFs of roughly 4% per year vs what you can get in the treasury markets. basically "there are no better alternatives" at the moment. although this is how people will get hurt if they are trying to kick equity out the door for the sake of it

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Oct 14, 2019
InVinoVeritas:

ll feel about the current state of the market in the space and MSA you work in?

Not to sound callous, but I'm not too worried. Underlying mortgages seem strong, which should buffer the wider market from the effect of defaults. Mezz lenders who have been making 8-12% returns are taking all that risk knowingly. Overeager developers going bust won't have much an impact either. That's business. If you get greedy and overextend, you kind of deserve to go bust. Deserve is perhaps the wrong word. But chasing returns should bring a commensurate amount of risk.

I'm in NYC and while this is a bit of unique market, I don't think there is a major issue. Plenty of GPs syndicating out their equity pieces, but that seems less like desperation and more like operators realizing that they can reduce their exposure because there is so much money desperate to pour in. Smaller shops without good institutional relationships will get hammered when condo and office pricing doesn't match aggressive underwriting. But CRE is a risk business at heart, so I don't mind seeing developers who are playing roulette with the market on every deal take a bath. Not everyone should survive, and the guys who think/thought that paying thousands of dollars a foot for land was justified are exactly who should be getting f**ked.

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Oct 14, 2019

The typical data points on the debt side look strong such as CMBS and balance sheet charge-off rates, but there has been some pretty irresponsible construction lending this cycle despite dramatic construction cost growth, lengthened construction periods, slowing absorption periods, and lagging rent growth. For example, assisted living overall occupancy dropped nearly 10% over the past 5 years as senior citizens simply cannot afford to pay the rates. Instead of marking rates down, the properties just tread water at 80% occupancy - this is the new normal in many markets, Despite this, money seems to continue funneling into the space per the NIC conference I went to; people hardly even commented on the record low occupancy levels particularly in Texas.

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Oct 14, 2019
InVinoVeritas:

The typical data points on the debt side look strong such as CMBS and balance sheet charge-off rates, but there has been some pretty irresponsible construction lending this cycle despite dramatic construction cost growth, lengthened construction periods, slowing absorption periods, and lagging rent growth. For example, assisted living overall occupancy dropped nearly 10% over the past 5 years as senior citizens simply cannot afford to pay the rates. Instead of marking rates down, the properties just tread water at 80% occupancy - this is the new normal in many markets, Despite this, money seems to continue funneling into the space per the NIC conference I went to; people hardly even commented on the record low occupancy levels particularly in Texas.

You're obviously more educated on this than I am, and I don't disagree in general anyway. That being said, these properties treading water at 80% occupancy or whatever... I don't know the business or the individual deals (obviously), but my gut reaction is that this isn't catastrophic. Those kinds of occupancy levels will murder owners/operators but the underlying asset doesn't seem to be underwater and the lenders will easily recoup principal balances. If assets need to be marked down 15-20% to be viable, it's the sponsors who suffer. That isn't bad in and of itself - markets occasionally need correcting and as I said, these guys are making a ton of money building and operating these assets, this kind of risk is the other side of that coin. I don't have pity for folks who stretched to make deals work because they wanted to keep the gravy train flowing. If you can't make your numbers work, the responsible decision is to scale back operations, retrench, and either focus on managing assets more efficiently or finding new business/product lines to pay the bills until the market turns back in your favor. Not blow out your core underwriting assumptions to justify borderline deals.

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Oct 14, 2019

I dont think it's necessarily irrational. If you read the book, the irrational part was coming from lenders lending on zero cash flow waiting for the appreciation to refi their position so they'd recycle the money and make a return. Most UW i see at least values the property off of cash flow or realistic cash flow from real improvements to the property (value add capex, etc).

Plus, the debt funds are not all linked together like the CMBS products and insurance companies were. A lot of funds are under performing, and a lot of developers are likely having trouble refing out of projects or getting returns back to their investors. The problem will likely be severe under performance in returns, maybe some developers going bust, but i doubt RE will cause a catastrophic problem like in the big short this time.

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Oct 14, 2019

I agree that the bust won't be a repeat of '09 due to major regulation of the CMBS market and loan issuance, but I feel bad things lurking beneath the surface, particularly in office, retail, and mixed-use. Most (if not all according to some pundits) of the S&P 500 earnings growth over the past 5 years would completely disappear if financial reporting adhered to GAAP principles. Leveraged loans represent 80% of total corporate bonds now - total outstanding non-investment grade bonds have tripled since the recession. This will eventually affect job creation and corporate user growth, which represents the root source of income for all of these commercial developments that are being built with a larger and larger spec % of total GLA.

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Nov 14, 2019

You mention "Leveraged loans represent 80% of total corporate bonds now." Historically, what would be a healthier number here?

Oct 14, 2019

More often than not, I've seen principals keep money on the sideline for the dips. So the contrarian in me says we are not going into one soon. I'm not seeing a lot of over leverage, granted as someone mentioned the mezz space is still active, but those lenders are getting compensated. JV equity is moving lower in the capital stack to pref equity.

Everyone says we are about to go into a recession, but everyone in acquisitions is so very cautious right now, with money socked away. Also, clearly on a macro-level more and more people are moving from rural areas to dense urban areas. As long as this demand keeps up, real estate will do OK.

Oct 14, 2019
C.R.E. Shervin:

Everyone says we are about to go into a recession, but everyone in acquisitions is so very cautious right now, with money socked away. Also, clearly on a macro-level more and more people are moving from rural areas to dense urban areas. As long as this demand keeps up, real estate will do OK.

Right but my gut feeling is that people have that cash socked away because they're fighting the last war, so to speak. In 2008/09 and beyond, developers and sponsors with dry powder made a killing because you had all these basically viable assets that we're being sold at deep discounts because the former owner was so badly overlevered and banks were so desperate to get all their NPLs off their books.

That clearly isn't the case this time around. I feel (and only feel, I have no data to back this up except anecdotal data with folks in the market) that all this liquidity is waiting for a shoe to drop that doesn't even exist. Waiting to buy at 75 cents on the dollar when deals can be had now at 90 cents. I know we're looking at the MF market in NYC and thinking that we can lock in long term cheap debt and buy assets at real 6 caps. The 200+ bps spread is really attractive; yes, there is risk that expense growth outpaces rent growth (though the Rent Guidelines Board has been making noises about higher increases than we've previously seen under deBlasio), but the same way that regulatory change screwed a lot of owners in June, could easily swing partway back in a future legislative session. Even if it's only an increase in IAIs or a return of a modified vacancy bump, that gives you the potential of unlocking additional upside on what's already an extremely enticing spread.

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Oct 15, 2019

I could not agree more.

Oct 14, 2019

Data error

Oct 14, 2019

I'm invested in a lot of gold and silver so I hope so.

Oct 14, 2019

I might be too if it wasn't all lost in a terrible boating accident...

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Oct 16, 2019

Sorry to hear that, I've had many friends lose their firearms to similar boating accidents.

Controversial
Oct 14, 2019

Plz fix tks * Litquidity *

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Oct 16, 2019

Anyone read about the glut of BBB bonds that could pose a risk? Apparently they make up a significantly larger percentage of the market than markets pre-'08 and if the economy gets rocked that means a lot of them would become riskier if not fail.

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Oct 23, 2019

Yeah this is a huge issue compounded by corporate earnings gaming where GAAP accounting would have resulted in earnings losses despite the fact that they are showing growth.

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Most Helpful
Oct 16, 2019

There have been a bunch of RE topics lately, with good information throughout. I'm a fan. That's all, thanks.

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Oct 29, 2019

Real estate peeps are just more interestin'

Oct 16, 2019

There is too much capital availabilty to create a credit crunch. When you have soverign debt in Europe that has negative interest rate it is further reducing yeilds on corporate debt and pushing capital to other areas, primarily to VC, PE, CRE and the general equities market.

Follow the shit your fellow monkeys say @shitWSOsays

Life is hard, it's even harder when you're stupid - John Wayne

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Oct 16, 2019

Lot's to digest here...

I'm generally in @Ozymandia 's camp. Dry powder levels reported by Prequin and the like are taken out of context. A meaningful percentage of that reported capital is comprised of value-add / opportunistic investors that are waiting for the "correction". It's very unlikely that real estate is the crux of the next recession as it was in the last so this subset may be unsatisfied when they do make their move. Also, typically when everyone is waiting for it, it doesn't come. These guys have to deploy that equity eventually. Also... a significant amount of that capital is BX and Brookfield... A BX acquisition is not an accurate temperature of the market as they are playing a game within the game (I've talked about this before).

What is concerning, especially in the industrial landscape, are the new capital market participants, in both the wholly owned and LP space. The entrance of unsophisticated players in a marketplace can have (is having) serious impacts to valuation levels. Cost of capital is alarming low for some groups at the moment, which effectively prices out the investors that rode the meteoric rise of industrial as an investment. So what happens? Those guys seek cheaper capital and it is a vicious cycle which lowers returns in the marketplace while risk (theoretically) is at an all time high considering stage of the expansion. This is a dynamic largely ignored and worrisome.

I suspect this trend is pervasive across product types. To be expected as the cycle matures and to an extent a function of the global interest rate environment. On interest rate front, and this is what a lot of guys miss, real estate is not a bond. Although it is reasonable to benchmark to global bonds, relying on this methodology is silly and ignores the inherent risk of real estate: you don't always get your principal back. This is a risk that I see overlooked at this junction in the cycle. Yield premia for real estate are risk premia...

Now I'm done rambling. To @Ozymandia 's point, there are overzealous developers and repositioning guys out there. I see some initial signals of an overbuilt market in a couple markets I cover; however, developers/risk takers get burnt all the time regardless of cycle.

In short, I don't feel. I may be smart, I may be an idiot, idk but I KNOW for a fact there are SOME idiots playing in my space right now. idiots = f'd up returns and cause of concern. Licking my chops at the opportunity to eat their already decomposing corpse like a maggot when the time arises.

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Oct 17, 2019

Can you link into the BX game within a game?

Oct 17, 2019

I can't find it but I think it is posted on a thread about another BX massive buy.

I think the jist of it is
That BX doesn't buy stuff for the entity level returns like other REPE funds, they buy portfolios and because they have BX Core Fund, BX Opp Fund, BX Industrial Opp Fund, Ect to the point that they can take down huge portfolios to place the properties across these funds depending on where they belong and increase value/ get fund returns based on their ability to take down portfolios and then figure out the best way to piece it all together afterwards. They are creating value due to the scale of their operation rather than every property being a home run.

Oct 17, 2019

"a cause for concern" to the system, or to your group bc it is harder to find value? People overpaying in assets classes doesn't necessarily concern me right now, bc there is so much equity in the deals, the people who will be burned are the investors piling in. It doesn't strike me as a systemic problem because the lenders and CMBS buyers and generally the public and tax payers are not the ones exposed to the high equity risk in those markets/asset classes. It just sucks, personally, bc it is hard to find value, deploy capital, and get paid

Oct 17, 2019

Okay so I kinda went on a tangent... I apologize. I did not really address the main question here - will there be/is there a liquidity crises?

Probably not. Debt has gotten smarter. Regulation has gotten stingy. Real estate as an investment has matured. A Black Swan event would need to occur for there to be a crisis.

Oct 17, 2019
Comment
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Oct 25, 2019