CRE Part 2: How REITS Will Hurt Banks

Issue 68

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Today’s Bullets:

• What’s a REIT?

• State of the CRE & REIT Markets

• REITs Setup to Ruin Banks

• Investing Around the Risks

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Inspirational Tweet:

Non-recourse mortgages, banks with asymmetric downside, fiat ponzi mechanics and houses of cards.

A whole suitcase of scary terms right there. But what the heck is Greg talking about, and just how does it all relate to the CRE market, anyway?

There’s lots of important details to gleam from this post, so let’s unpack it nice and easy, as always, shall we?

Grab that cup of coffee, and settle in. It’s Informationist time.

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🏠 What’s a REIT?

First things first, what exactly are REITs and how do they fit into the overall CRE market?

REITs or Real Estate Investment Trusts have been around for more than 60 years in the US, after being created by Congress in 1960 as an amendment to the Cigar Excise Tax Extension.

What?

Ah yes. An instant reminder of how twisted and convoluted our legislative system has pretty much always been.

Back to REITs.

REITs are companies that own, operate, or finance income-generating real estate. Modeled after mutual funds, REITs allow individuals to invest in large-scale, income-producing real estate.

Like cigar farms. 🙄

But it’s basically like owning a stock. Of course, like stocks, there are different ways to own REITs, as well.

Public REITs trade on listed exchanges like the NYSE or NASDAQ. These are most liquid type, with the most required transparency.

Some are non-traded public REITs, which are like unlisted stocks. These are less liquid.

And then we have private REITs, which are not registered with the SEC and are not publicly traded. These are the least transparent and least liquid type of REIT. They are also usually reserved for institutional or high net worth individuals.

In any case, to qualify as a REIT, a company must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.

Hence, some REITs can be a great way to generate annual income for investors.

So, what exactly do REITs own?

As you may have guessed, most own a variety of income generating real estate properties, like offices, shopping centers, apartments, warehouses, hospitals, and hotels.

Sound familiar?

You got it. They own Commercial Real Estate or CRE.

Which essentially makes REITs a subset of overall CREs, with a market size of approximately $2T or 10% of the total $20T CRE market.

OK, so how’s the overall market and market within the market doing, then?

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🫣 State of the CRE & REIT Markets

If you’ve been reading The Informationist, then you know we dug into the overall CRE market last week. If you haven’t seen that or want a refresher, you can find that article right here:

Commercial Real Estate, The Next Crisis?

TL;DR: There appear to be a tsunami of problems on the horizon for CRE, especially in the Office Building and possibly soon the Retail sectors.

Why?

Simple, really. With a rise in interest rates and a fall in office usage, many landlords are not re-signing leases. They are simply turning in the keys, walking away, and taking a loss on the property.

And why not?

As Greg pointed out above, the majority of CRE loans are non-recourse mortgages, which means that the landlord (the one who took out the mortgage) can just walk away from the loan and stick it to the bank. The bank is left with a property that is likely worth far less than the amount owed on it, and so it also takes a loss—likely the majority of it.

In this way, as Greg also points out, the landlords own a put on the property, sold to them by the banks.

Remember, a put option is the right to sell something at a certain price. And so, in this case, the landlord ‘sells’ back to bank with no recourse (no financial or legal consequence) and just loses its premium (the cash down for the mortgage).

The landlord is stuck with the underwater property.

If the properties were rising in value, then the landlord would keep the mortgage and continue to generate returns on its leveraged investment.

This is what makes the returns asymmetric.

Positively asymmetric for the owners.

Negatively asymmetric for the banks.

Even still, with investors concerned about being saddled with premium losses and/or the prospect of months or years of lower income, a number of private REITs have seen a wave of redemptions this past few months.

Blackstone, which operates BREIT, a $70B REIT, received $4.5B of redemption requests in April, after receiving the same amount of redemption requests in March.

And this is after a total of $9.2B of requests in January and February.

That’s over $18B or redemptions in four months.

Using their redemption limits, though, Blackstone has thus far only paid out $6.2B of these requests.

But Blackstone is not alone, notice how the redemptions have been accelerating for all private REITs since last summer. (*Note: Red lines are spaced out because redemptions are done quarterly for private REITs).

Looks pretty dire for both the banks and the private funds, doesn’t it? Like it’s all about to fall off a cliff.

Well, let’s not shed too many tears for those private funds just yet.

Because the big funds have a card, an ♠Ace so to speak, up their sleeve.

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😡 REITs Setup to Ruin Banks

As we stated in last week’s newsletter, occupancy rates have collapsed, office building values are on the path to a $500B implosion in the next few years, and so, more and more landlords will walk these mortgages.

Landlords have already defaulted on $2.5B of mortgages in just the last few weeks.

And with the prospects of a hard recession, the retail sector of CRE will soon be looped into all the fun.

Yay?

Well, one party that won’t be celebrating is the banks. Because they own over 50% of CRE loans, $1.4T of which mature in the next 42 months.

Ouch.

And so, with the collapse of a large part of the CRE market, we should expect these large private REIT funds to be sitting silent in the corner, ashamed of their actions and the pain they will cause so many of these banks.

Right?

Nope.

Because they’re out there right now, fundraising! 🎉

This graphic is a few months old and doesn’t include the latest figures, but one interesting piece of data to note:

Blackstone has recently raised $30.4B for its newest global real estate fund, Blackstone Real Estate Partners X (BREP X).

In Ken Caplan’s own words, the global co-head of Blackstone Real Estate: "We believe the current market is tailor-made for Blackstone (BX) Real Estate. We have made some of our best investments in periods characterized by the market volatility and dislocation we see today."

To recap:

• Blackstone has defaulted on over $1B of CMBS (Commercial Mortgage Backed Securities, i.e., CRE loans), so far, this year

• Banks will be left with these loans, on properties likely deep under financial water

• As these losses pile up, some banks will run into liquidity issues (remember, they lose expected income from the mortgage and then assume an asset on their books that has to be written down for a loss)

• Blackstone has initiated limits to withdrawals from its largest fund, BREIT

• Meanwhile, Blackstone raises another fund, a record-breaking REIT

• On fear of contagion, the government will swoop in to help shore up struggling regional banks…again

• Banks will sell those defaulted properties at a steep discount (a la GFC 2008)

• Newly launched (and deep-pocketed) funds like Blackstone’s BREPX will buy them for pennies on the dollar

What a playbook.

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🧐 Investing Around the Risks

Remember how a few minutes ago we said the CRE market was ~$20T of total value?

Right, so that makes it a significant asset class for investors. One that could have far-reaching ramifications if it slips into meltdown.

To be clear, I am not predicting a real estate implosion of GFC 2008 proportions. The CRE market is a subset of the total real estate market, and the office and retail sectors are yet subsets of the CRE market.

However, I expect the pain of CRE defaults will hit banks, particularly regional banks, the hardest.

I also expect the Fed to step in and help those banks, shore them up, keep them from collapsing, keep them from causing mass contagion.

Exactly. Powell money printer go brrrrrrr.

So what does that mean for your investments?

Well, everyone has different liquidity needs and appetites for risk. But I can tell you what I’m doing, in hopes it helps spark a conversation you can have with your own investment advisor.

As many of you already know, I am holding a large percentage of my portfolio in fully-FDIC-insured cash. This is in anticipation of a market downturn due to either a credit event (possibly caused by CRE defaults, or worse), or just a plain-vanilla, though painful, recession.

In the meantime, I am accumulating positions in hard monies, like gold, silver, and Bitcoin.

I’m buying them opportunistically in here, on price dips and lower levels.

Because even though there will be pain ahead, in my opinion, it is exceedingly difficult to time market bottoms and Fed pivots.

And if the Fed turns and initiates market-saving (read: face melting) QE, hard assets like gold, silver, and Bitcoin will be poised to rise in value along the significant expansion of the money supply.

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That’s it. I hope you feel a little bit smarter knowing about REITS and more about CREs. Before leaving, feel free to respond to this newsletter with questions or future topics of interest.

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Talk soon,

James