The CRE squeeze continues

Good morning. Is WeWork cooked? The company’s shares fell more than 20 per cent after-hours yesterday, after it said there was “substantial doubt” it could keep the lights on. Commercial property is not a nice market to be in right now (more on which below). Where would WeWork, which once commanded a $47bn valuation, go in a ranking of greatest-ever value destruction? Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

CRE Reits have CRE-itis

This doesn’t sound like great news for commercial real estate:

Some of the biggest names in commercial real estate lending have all but turned off the spigot.

Blackstone Mortgage Trust and KKR Real Estate Finance Trust, two of the biggest mortgage real estate investment trusts, have halted loans to any new borrowers. While these firms continued to provide financing related to existing loans, they didn’t originate any new loans during the first half of this year, according to the companies. Starwood Property Trust, another lender in the sector, has greatly decreased its appetite for new lending in recent quarters, securities filings show . . . 

That’s from Peter Grant, in The Wall Street Journal. In Unhedged’s continuing coverage of when-will-the-next-shoe-in-commercial-real-estate-drop, this is an angle we hadn’t covered: the possibility that non-bank CRE lenders would exit the market. The CRE Reits’ share prices have fallen a lot in the past couple years:

Here’s Grant again:

Most mortgage Reits aren’t in financial peril. They have access to lending markets and don’t face liquidity issues . . . 

But many of them aren’t able to issue new stock because their share prices have fallen so far since interest rates surged. Mortgage Reits also can face capital calls from their banks if the quality of their loan portfolio deteriorates to a certain point.

But if the big CRE mortgage Reits are not in financial peril, why have they stopped making loans to new borrowers? They’re in the lending business, after all.

I had a quick look at the balance sheets of Blackstone Mortgage and KKR Real Estate (Starwood’s Reit has a slightly different business model, which makes comparisons tricky). And by traditional lending-company metrics, the financial structures of both companies are indeed quite conservative, and are not under stress in any obvious way. Asset/equity leverage ratios, at 5-6, are way below what a bank would use. Loan-to-value ratios in the asset portfolio are reasonable. The assets are floating rate and for the most part their maturities match Reits’ own financing from banks and the securitisation markets. Some stats:

Most telling of all, regarding the riskiness of CRE business models, is the modest returns they have earned: return on equity at both businesses has rarely reached as high as 10 per cent. That does not scream leverage, concealed or otherwise. Similarly, if the Reits’ borrowers were wobbly, one would hope they would be paying spreads over 4 per cent. It pains a muckraking financial journalist to say it, but the big CRE Reits look like rather dowdy businesses.

So why have they been forced to pull in their horns? Part of the appeal of the Reits is that they own floating rate assets. When rates go up, all else equal, they make more money (and indeed, both Reits are comfortably covering their dividends with earnings). But the 4-5 per cent increase in rates cannot simply be passed on by the Reits to all their borrowers, because such a large, fast increase would put some of the borrowers into financial distress. 

While many borrowers will have bought derivatives to protect them from high rates, eventually those derivatives roll off, and replacing them is expensive. Given the financial limits of at least some borrowers, then, the big jump in rates may increase interest income at the Reits. But they will tend to earn slightly lower spreads over their own financing costs than they did when rates were low.

This is important, because Reits are basically income investments. So if Reits’ dividend increases do not quite keep pace with interest rate increases, they look less desirable. In order for their dividend yields to stay competitive, the Reits have to trade at a discount to book value. This, in turn, makes it more dilutive for the Reits to issue new shares to finance new loans, at the same time as other forms of capital become more expensive, as well.

Furthermore, the risk that more borrowers may suffer distress in the higher rate environment means the Reits have to stockpile some cash. Suppose, for example, a Reit has lent $65mn against a $100bn office building, and has borrowed (say) $50mn from a big bank to do that. If the building’s valuation is cut to $80bn, the loan may still be performing, but that big bank is going to insist the Reit put up more money against that loan.

The big CRE Reits, in short, have a growth and profitability problem, not an about-to-blow-up problem. Jade Rahmani of KBW summed up to me:

The non-bank lenders depend on financing from the banks, mostly secured warehouse lines and securitisations the banks arrange. The cost of those liabilities has increased dramatically, and the asset yields have not kept up. So the spread the Reits are targeting has compressed . . . 

The big Reits stuck to first mortgages, large loans and careful liability management. But the returns on equity they were tethered to, in the range of 8-9 per cent, were tied to the lowest interest rates in human history. When [the] 10-year was at 2 per cent, 8-9 per cent was compelling . . . now the market wants maybe 11 or 12 per cent. If the Reits can only make a 9 per cent return now and [the] market requires 12, they can’t grow, can’t issue equity, can’t finance new buildings.

Those of us who remember 2008 keep expecting the problems in CRE to cause an explosion. The reality is more like a slow, painful squeeze.

China deflates, the party waits

Last year in the US, as recession pessimism grew in spite of strong consumer spending, some declared a “vibecession”. This year in China, as growth wilts and the economy falls into deflation, there shall be no vibecession:

Seven well-regarded economists told the Financial Times that their employers had told them some topics were off-limits for public discussion. The China Securities and Regulatory Commission, the stock regulator, has accused brokerage analysts of playing up risks facing the economy, which is suffering from weak consumer demand, declining exports and an ailing property sector.

Two think-tank scholars and two brokerage economists, all of whom serve as government advisers, said there was pressure to present economic news positively in order to increase public confidence. “The regulator doesn’t want to hear negative comments about the economy in public,” said an adviser to the central bank. “They wanted us to interpret bad news from a positive light.”

There’s plenty of bad news to spin. In July, Chinese exports, which had risen earlier in the year, fell 15 per cent year over year, while imports fell 12 per cent. This is bad, though not as bad as it might at first seem. The big picture is that the Chinese export machine is stalling, not utterly surprising given tepid global growth. Faced with soft demand, exporters are cutting prices. That, at least, is keeping Chinese exports afloat:

China’s property problems are well known, but have become no better. Nationwide property sales fell 9 per cent in the second quarter and housing starts have more than halved since 2019. On Tuesday, Country Garden, the biggest private developer left standing, missed payments on two US dollar bonds, after sales fell 75 per cent in two years, creating some $81bn in losses. A default is not official yet, but the company faces a daunting $2bn in bond repayments this year. 

As private developers falter or collapse, property-market investors are looking towards the state. Reuters notes that listed state-owned developers tend to trade at higher multiples than private ones. Another striking data point:

The top five developers by sales in the first half [of this] year were state-backed, showed data from China Real Estate Information Corp. Longtime leader Country Garden [has fallen to] sixth.

This fits with recent research by Mark Williams and Gabriel Ng of Capital Economics. Based on a sample of 50 large developers, they calculate the state’s share of property sales has risen rapidly to nearly 60 per cent. This is not due to state expansion, but private-sector retreat. Their charts:

Together, the slide in exports and property have delivered a two-headed deflationary shock. Any growth momentum built up around the zero-Covid reopening has evaporated. Even so, the central government is treading lightly. It has enacted some monetary and regulatory easing, including lowering mortgage rates, and last week cut taxes for small businesses and rural households. This modest approach, argues Wei He of Gavekal Dragonomics, reflects the Communist party’s view that “post-Covid recoveries in other countries have taken a year or more to unfold, China’s will also, and thus policy does not need to overreact to short-term disappointments”.

That could be a recipe for prolonged weakness. The nagging question for China is where it will find future growth. By definition, it can only come from increasing consumption, investment, government spending or exports. But consumers are still feeling risk-averse, scarred in part by zero-Covid insecurity, as the FT’s Robin Harding wrote recently. Property investment is out of the question. Exports could do it, but that is not entirely within China’s control, and the July exports number doesn’t inspire confidence. That leaves greater government spending. Without it, shushing-up Chinese economists will only go so far. (Ethan Wu)

One good read 

From the archives: Christopher Hitchens versus Mother Teresa.