The opacity of CRE

Good morning. We mentioned in yesterday’s letter that on Tuesday the Vix reached its sleepiest since January 2022. Well, the Vix sank even lower yesterday, so now it’s lowest since November 2021. Howard Marks would like the financial press to ditch these sorts of not-always-meaningful calendar comparisons. Should we? Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

Why no one can agree on CRE

By now you’ve already heard the flashlight-under-the-chin scare story about commercial real estate. Rising rates squeeze levered assets such as CRE. Remote work is punching offices in the face. And Silicon Valley Bank’s failure has pushed regional lenders, who finance most CRE, into a defensive crouch. The combination of these factors could prove fatal for many CRE owners, and perhaps for their lenders too. In the words of The Economist, it is not just “the next shoe to drop” but a “hellish-perfect-dumpster-fire-storm”.

We don’t share this view, but many do. The investors and analysts we’ve talked to are split. Why? What accounts for the wide dispersion of opinion?

We asked around, and a few sources of uncertainty came up repeatedly. A non-exhaustive list:

1. CRE is slow-moving. Illiquidity means valuations are often theoretical. As buyers wait for further price declines, transaction volume is even lower than usual and has more than halved year-over-year, according to MSCI Real Assets.

2. CRE is opaque. Outside the special case of commercial mortgage-backed securities, data is patchy. Firms such as MSCI track originations and transactions (ie, flows), but assessing the CRE stock is hard. Many deals are negotiated bilaterally and loans held privately on bank balance sheets. As the FT’s Alex Scaggs flagged recently, a handful of regional lenders are slowly offering more disclosure about CRE exposure, but there is no doubt selection bias at play. If you are a deposit-taking institution with teetering CRE loans, you might not rush to volunteer all the gory details.

3. CRE is ridiculously diverse. What do nursing homes in New York and warehouses in Phoenix have in common? This is a big reason regional banks do the bulk of CRE lending; it is highly localised. Even within just offices, the regional dispersal is striking. Kiran Raichura of Capital Economics (generally a CRE pessimist) has produced detailed office price forecasts by metro area. Property values are expected to fall across the board, but remember these are income-generating assets. By contrast, returns look more spread out:

4. CRE lenders, who really do not want to deal with a default, often prefer dragging things out. Most lenders’ comparative advantage is not in the day-to-day management of a building with tenants. That creates an incentive to keep the building owner in charge and play for time. In a recent note, Lotfi Karoui and Vinay Viswanathan of Goldman Sachs point out that CMBS issued in 2007-08 took five to seven years to rack up “materially” large losses. On the other hand, as Arpit Gupta of NYU Stern told us, “Extend-and-pretend works really well when it’s a liquidity problem [but not] when there’s structural shock to cash flows” like in offices.

5. We still don’t know how the work-from-home experiment ends. Once labour markets loosen, will employers muscle us all back into the office four days a week? Five? The answer will matter to long-run office valuations. In a paper last year, NYU’s Gupta, alongside Columbia colleagues Vrinda Mittal and Stijn Van Nieuwerburgh, modelled how far valuations could fall. Their modal scenario, something like 40 per cent wiped off US office valuations, is cataclysmic. But notable too is the uncertainty surrounding that forecast. Using New York as an example, the authors simulate various paths office prices could take through 2029, depending on economic cycles and the stickiness of remote work. None of their scenarios includes a full return to pre-pandemic norms, but less apocalyptic outcomes are in the realm of the possible. The red line shows a world where working from home remains widespread:

   

Severe pessimism against a backdrop of genuine uncertainty creates temptation for swashbuckling value-hunters. As the FT’s Stuart Kirk wrote recently: “So OK, sure — there are risks out there. What matters for investors, however, is whether they are in the price or not . . . While [valuations] are not screamingly cheap, don’t forget they are aggregate indicators, which include bits of commercial real estate that are holding up.”

Ben Nabet, trader at GMO, has spotted one such opportunity. He told Unhedged he has no qualm with the dominant pessimism — but believes that prices have run ahead of the narrative. He points to newly issued triple A CMBS, the tranche most cushioned against defaults, which have had yields blow out past investment-grade debt. The spread of high-grade CMBS over IG hasn’t been this high since the financial crisis:

Nabet does caution against any CMBS with higher than roughly two-thirds office exposure and, in any case, buying CMBS tranches is probably best left to the pros. But it underscores Kirk’s point that you don’t need to be cheery about CRE to buy CRE. Just calmer than the panicked market. (Ethan Wu)

Liquidity set to dry up?

There is a certain amount of consternation among inventors and analysts about how well risk assets have performed recently, even as economic growth declines and a banking mini-crisis unfolds. According to the latest Bank of America survey, for example, investors are very bearish and overweight bonds, but stocks have been grinding higher for more than a month.

One explanation for stocks’ refusal to take a hint from the economy is that financial system liquidity has been increasing for a while. Regular readers will recall that Unhedged is generally sympathetic to the view that liquidity and risk asset prices are linked — the “hot potato theory,” as we call it.

Michael Howell of CrossBorder Capital, whose work appears in this space with some regularity, thinks liquidity is firmly on the upswing. “A bull market in liquidity has started,” he wrote recently. He calculates there has been $1tn in global central bank liquidity injections since the UK pensions crisis last October. In the US in recent weeks, this has taken the form of discount window lending and the Fed’s new bank term funding programme. While the European Central Bank remains tight, Chinese and Japanese central banks are making liquidity contributions, too. Howell provides this chart of change in what he calls the “world shadow monetary base.” It consists of central bank money, available collateral such as risk-free bonds, and cross-border liquidity sources such as swap lines and Eurodollar deposits:

Howell thinks that liquidity moves in multiyear cycles, so (from the point of view of asset owners) we are at the start of something good. But he does acknowledge some near-term risks: a resurgence of higher bond-market volatility would inhibit private sector multiplier effects, rendering higher liquidity inert. Intermediaries matter too. In particular he warns that if US money-market funds park more money in the Fed’s reverse-repo facility, that would drain money from the financial system.

Matt King, a strategist at Citi, agrees that there has been a liquidity surge, which explains the recent healthy performance of risk assets. Unfortunately, he thinks it is about to end:

High-frequency liquidity indicators suggest this [expansion] is already stalling, and coming weeks seem increasingly likely to bring a sharp reversal. Higher TGA [Treasury general account] and RRP [Fed reverse repo], ECB QT [quantitative tightening] and reduced China easing could easily see a net drain of some $600bn-800bn, even before any additional spike thanks to the debt ceiling

To unpack that a bit, the TGA is the government’s operating account. When it is drawn down, that adds liquidity to the banking system, as the government is disbursing more cash by spending than it is absorbing through taxes. Here is what the TGA has done in the last year:

This week is tax week, though, so the TGA is going to go up a lot, drinking up several hundreds of billions in liquidity from the bank accounts of millions of Americans. Next, King thinks the RRP is headed up further, because higher rates are driving depositors to money market funds, which can get a better rate on their cash in the RRP than by buying bills.

Joseph Wang, aka the Fed Guy, pointed out to me that the Fed cannot prevent the RRP’s absorption of banking-system liquidity by simply reducing the rate the facility pays. The Fed uses the RRP to absorb demand for short-term debt that would otherwise drive the fed funds rate below the Fed’s target. Wang also noted that as the government approaches the debt ceiling, it will issue less short-term debt (bills) to stay below it. With less bills to buy, more money market funds may invest in the RRP instead. King mentions another potential source of RRP demand: brinkmanship over the debt ceiling may also make the RRP look like a better bet than buying Treasury bills.

Finally, King thinks that China’s surprisingly strong recovery means less monetary easing from the People’s Bank of China. In sum, “With peak liquidity past, we would not be at all surprised if markets were now to experience a sudden pressure loss.”

We will keep an eye on liquidity indicators in the months to come. The rest of 2023 could be a good test of the liquidity theory of asset prices.

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