The real estate market is one of the most dynamic and exciting markets in the world. From residential to commercial properties, from houses to apartments to offices, it encompasses a vast range of property types and is an irreplaceable component of the global economy. As the world’s most significant store of wealth as of 2020, real estate is more valuable than all global equities and debt securities combined, and almost four times that of global GDP, according to a report published by Savills in 2021.
However, after an unprecedented boom in the real estate market as a result of low interest rates and generous government stimuli, the market is now in turmoil amidst rate hikes, stagnant inflation and unfavourable market conditions. Around the world, the housing market has entered into a rapid downturn, and the authorities must tread carefully to not repeat the catastrophic event of the Global Financial Crisis.
Source: Forbes
High interest rates and the rise of remote work: A case study on Blackstone’s historical CMBS default
Blackstone, the world’s largest alternative asset manager recently made the headlines when they failed to meet their financial obligations and defaulted on multiple Commercial Mortgage-Backed Securities (CMBS) loans across the US and Europe totalling over $1 billion USD, sending shockwaves through the commercial real estate (CRE) sector.
Source: Bloomberg
CMBS are fixed-income securities that are backed by CRE mortgages. Typically, these mortgages are packaged together and securitised, then sold to investors as bonds. For real estate developers and private equity funds, CMBS represent a cheaper way to finance their development or acquisition as opposed to traditional bank financing. For investors, CMBS represent generally low-risk, diversified fixed-income investments that yields relatively high returns compared to other fixed-income investments.
On the 2nd of March, Blackstone defaulted on a $562.5 million USD CMBS loan, backed by commercial properties in Finland, which they used to partially finance the take-private acquisition of said properties. This means that Blackstone is no longer willing or able to fulfil their debt repayment obligations, given the current circumstances. Importantly, this CMBS was originated in December 2017 at a fixed interest rate determined at the time of origination, and was set to mature in February 2023. This is significant as Blackstone would have to either repay the outstanding principal in full, or refinance the remaining debt, at the prevailing interest rate in 2023, which is drastically higher than the interest rate 5 years ago.
This strategic default signifies the pain points of the CRE market in 2023. Specifically, high interest rates, high inflation, high vacancy rates and low valuations means that it is no longer profitable to own and operate these assets. Although the low valuations and high vacancy rates, in this particular case, may be attributed to the ongoing war in neighbouring countries Russia and Ukraine, it is also undeniably a global phenomenon, as opposed to a one-off, regional event.
High Interest rates increases the cost of debt while high inflation reduces the average household disposable income, simultaneously, these two factors negatively impacts rental affordability, leading to higher vacancy rates in both commercial and residential properties. Meanwhile, the rise of remote work as a result of COVID-19 exacerbated this problem, with this specific portfolio held by Blackstone being 45% vacant.
It is important to note that CMBS loans are non-recourse loans, which means that in the event of default, investors would acquire the ownership of these properties.However, if the value of the properties is lower than the amount owed in debt, the borrowers are not liable to cover the difference. This means a strategic default would be the most financially viable option for Blackstone. This is because firstly, the net operating income cannot cover the periodic debt repayment obligations; secondly, as high interest rates, high inflation and high vacancy rates all contribute to lower valuations of these properties, it would not be profitable for Blackstone to sell these properties and repay the debt using their own cash.
Over-leveraging and Illiquidity: A case study on Blackstone’s BREIT fund and the US regional bank run
At the core of the ongoing banking crisis lie two major problems: over-leveraging and illiquidity. In the case of US regional banks, their over-exposure to CRE, an industry in turmoil, arguably exacerbates the issue at hand.
According to Michael Hartnett, the corporate strategist at Bank of America, the CRE industry could be the “next shoe to drop” in this ongoing crisis. Exemplified by defaults from industry giants such as Pimco, Brookfield, and Blackstone, these major companies are exiting their positions in CRE, sparked by a wave of upcoming refinancing of loans at a much higher rate. As a result of this rapid rise in default rate in CREloans, as well as the ongoing banking crisis, there is an evident credit crunch across the economy, meaning that the process of obtaining loans will be lengthier and tougher, especially for those companies and individuals with bad credit scores.
This problem is not solely a problem for the CRE sector. Like a plague, the woe of the CRE sector will largely translate to a worsening of the banking crisis, especially US regional banks. This is because they have so much exposure to CRE loans- According to Bank of America, US regional banks account for 68% of CRE loans, much more than their mega-cap banking peers. The rise of remote work exacerbates this problem, with occupancy rates in offices across the US still far below their pre-pandemic levels, at less than 50%. With the national rent levels steadily falling in the past year, the pressure on the CRE sector is unlikely to be alleviated any time soon.
This over-exposure to illiquid assets like real estate could result in a huge loss for the banking sector, according to JP Morgan. Nearly $450 billion USD in CRE loans will mature in 2023, and about 60% of them are held by banks. It is expected that about 21% of CMBS outstanding office loans will default eventually, implying about $38 billion USD in losses for the banking sector. When this eventually happens, regional banks will fare a lot worse than mega-cap banks, due to their smaller size and limited assets. If the current bank run persists, systemic defaults on these CMBS by borrowers would mean that these US regional banks would acquire illiquid assets as opposed to a stable, fixed income. If the current circumstances persist, there may be an avalanche in the banking sectors, with a particular emphasis on US regional banks.
Source: Tech Xplore
Likewise, Blackstone Real Estate Income Trust (BREIT), one of the largest Real Estate Investment Trusts (REITs), is also facing liquidity problems. As of February, for the fourth month in a row, BREIT has limited investor withdrawals after it received significant redemption requests. In February, Blackstone limited investor withdrawals from BREIT to 35% of redemption requests. This rapid rise in redemption requests reflected a decline in consumer confidence in the market- similar to a bank run, investors rush to cash out when they think the entity may run into liquidity issues and fail to repay in full.
However, BREIT’s decline in popularity does not signify a major problem in real estate- it represents a transfer of capital from privately traded REITs to publicly traded REITs. Although BREIT recorded a 9% net return year-to-date as of December, 2022, the lack of liquidity and lack of transparency and regulation makes privately-traded REITs like BREIT a far riskier choice in the current market condition. Amidst the rate hikes in the past year, almost all of the public REITs in major economies have experienced a sharp decline in their stock prices. This makes public REITs the perfect investment for investors who are confident in the long-run prosperity of the real estate market but also want liquidity and the option to exit their positions with ease in case the market significantly underperforms.
Where to now?
The commercial real estate market is facing one of its biggest challenges since the Global Financial Crisis. In a tweet this week, Scott Rechler, the CEO of RXR Realty, emphasised the importance to develop “responsible, constructive refinancing plans”. With $1.5 trillion USD in commercial real estate debt maturing in the next 3 years, companies are required to refinance their outstanding debt in an environment where rates are higher, values are lower, and in a market with far less liquidity compared to a few years ago. These factors, in combination with the rise of remote work, If not managed properly, could lead to a wave of defaults on CRE loans that significantly weakens the banking system and the global economy as a whole.
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The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.
