Real Estate's Looming Liquidity Crunch?

Siobhan Riding of the Financial Times reports property funds stay shut amid fears of liquidity crunch:

Large UK property funds are keeping trading suspensions in place because of fears that low cash buffers and regulatory uncertainty could trigger an investor run. 

All of the UK’s major commercial property funds suspended trading in March, trapping close to £22bn of investor money, after the coronavirus-induced halt in economic activity made it difficult to value real estate. 

Yet while three investment managers — St James’s Place, Columbia Threadneedle and most recently L&G — have announced they will reopen their property funds, most others remain suspended as groups weigh whether they will be able to cope with redemption requests on reopening. 

A chief concern is that UK regulatory proposals, which are designed to prevent fund liquidity mismatches by introducing longer redemption notice periods, could have the opposite effect by encouraging investors to withdraw en masse before the rules come into force. 

This risk, which could ultimately lead funds to suspend again, is compounded by the low cash balances of some property funds. Aegon Asset Management’s fund holds cash equivalent to 7.3 per cent of its portfolio, while M&G’s holds 8.2 per cent. This compares to 24.4 per cent and 18.5 per cent held by L&G and Columbia Threadneedle’s funds respectively. 

“Property managers will be fearful that just when they are ready to reopen they lurch straight into another crisis brought about by the potential rule change,” said Ryan Hughes, head of active portfolios at AJ Bell. He warned an investor exodus could lead to a “liquidity death spiral” as managers try to sell assets in an uncertain market. 

One property fund manager who asked not to be named said: “The FCA proposals seriously bring into doubt whether people will want to remain invested.” Resolving outstanding questions surrounding the rules was “vital to the ongoing health of property funds”, the manager added. 

John Forbes, an adviser to property fund managers, said that one of the main issues was whether property funds would continue to be eligible to be held through Individual Savings Accounts (ISAs) or Self-invested Personal Pensions (SIPPs) tax wrappers following the reforms. 

The FCA acknowledged this was an issue in its August consultation paper but is yet to propose a solution. The regulator told the Financial Times: “We appreciate that ISA eligibility is an important consideration for retail investors, and will take this into account in our final decisions.”

But Mr Forbes said the FCA’s statement did not go far enough. He urged the regulator to “make it clear that there will be no instant implementation of new rules” and that it intended to find solutions to the current sticking points before going ahead. 

Aegon portfolio manager Richard Peacock said uncertainty around the reforms, combined with other redemption risk issues, were factors affecting whether his fund would reopen. “For this reason we are engaging with all our investors to discuss the outlook and their intentions,” he said. 

Canada Life said it expected its fund to be reopened after its month-end valuation date. Standard Life Aberdeen and BMO said they would continue their suspensions and reconsider at month end. Janus Henderson, M&G and Aviva Investors said they would focus on raising liquidity to meet potential outflows. 

The FCA said it expected managers to conduct “as much due diligence as possible” to ensure they have enough cash to fulfill redemptions on reopening

I was wondering how long before I'd start reading articles like this about the looming liquidity crunch in publicly traded commercial real estate funds.

The article focuses on UK property funds and how onerous regulations are adding to uncertainty but I can assure you, all publicly traded REITs (listed funds) all over the world are worried about a similar outcome hitting their fund.

And the evidence is piling up.

Nathalie Wong of Bloomberg News reports Brookfield Properties will cut 20% of employees in retail unit:

Brookfield Property Partners LP, a large owner of malls in the U.S., is cutting its workforce as the pandemic batters the retail industry.

The job cuts will hit approximately 20 per cent of the employees in the real estate company’s retail arm, according to a memo to staff on Monday. The unit has more than than 2,000 workers, according to a spokeswoman, who declined to comment beyond the memo.

Brookfield bet big on retail in the U.S. with its purchase of mall owner GGP Inc. for about US$15 billion in 2018. Since then, pressure has been mounting across the industry, with the pandemic pushing even more customers to embrace the convenience of e-commerce.

The firm’s shares have dropped about 40 per cent this year. In May, Brookfield Asset Management Inc., the parent company of Brookfield Property Partners, announced a plan to invest US$5 billion to take minority stakes in retailers that have been hit hard by the pandemic.

The job cuts were reported earlier by CNBC.

Brookfield Property shares (BPY) are down 40% this year but they were down considerably more in March:

They rallied today, gaining 2.7% but it remains to be seen if they will continue paying that big fat dividend of 12.4% (unlikely but they are cash rich and can borrow for nothing to keep paying it out, and besides, even if they cut it in half, it's still a nice divvy!).

It doesn't surprise me that retail real estate operations at Brookfield or anywhere else are struggling.

It's offices that concern me right now as most institutional portfolios are more exposed to office and multi-family real estate. 

On that topic, Brookfield Insights put out some interesting research stating the future of the office isn't what you think. 

You can view it here and download the PDF file here.

Note the following in their short-term outlook:

Throughout the pandemic, Brookfield’s commercial properties, including offices, have remained largely open to enable tenants to maintain critical infrastructure and operations. Our primary focus is currently on helping our tenants implement back-to-operations best practices—and on communicating the steps we are taking to make our office properties safe for workers to return.  

As part of this process, we have considered the potential short-term effects of the crisis on the office sector, surveying our tenants and seeing the implications play out firsthand. What we’ve found suggests that the sector impact in the near term will be limited.

Lease payments throughout the pandemic have been stable for high-quality office properties—in fact, our collections through June remained largely unaffected. Moreover, since office leases are long-term in nature (10 years or more), we believe the sector should be well protected against any short-term market downturn or negative sentiment that might arise over the next 12 to 18 months.

When it comes to working from home, we have seen employers take different approaches throughout this period. Some highly visible tech companies have announced that their employees will continue to work remotely for an extended, or even indefinite, period. However, we remain skeptical that a significant number of tenants will end up with a truly remote workforce for any longer than they need to under their regions’ reopening plans. Indeed, after having announced that up to half of its employees would work from home within the next 10 years, Facebook recently signed a lease for 730,000 square feet in Manhattan’s West Side—in addition to another lease it signed late last year for 1.5 million square feet just a few blocks away.1

The decisions by certain companies to keep their employees at home for the foreseeable future do not necessarily reflect long-term strategic shifts. In many cases, these companies cannot fit more than 50% of their workforce in the office while maintaining social distancing, and many government guidelines and plans have been in flux with uncertain timelines. Finally, it’s worth pointing out that some tech companies are in the business of selling cloud services, online goods and apps, and therefore are in no rush to encourage their people to come back.

In the meantime, many of our own tenants are actively engaged in developing and executing return-to-office plans, the pace of which varies across regions. In many Asian countries, including China and South Korea, we have seen much of the workforce return to the office.  

When employees return to the office, they will find that their environment has undergone significant changes. These may include heightened cleaning procedures in line with revised health guidelines, policies to ensure that sick employees do not come to the office, company-provided personal protective equipment and social distancing requirements. Employees may also notice new office layouts and upgraded features, such as spaced-out workstations with transparent barriers, no-touch elevator systems and new air filtration systems to circulate cleaner air. In fact, at Brookfield, we are piloting advanced air ventilation and filtration systems in our New York, Toronto and Calgary offices, with an eye toward utilizing this technology in all our leased office properties.

And this in their long-term outlook

Certainly, potential shifts in office demand will hinge on broader factors. Governments need to balance safety concerns with reopening goals, which will play a major role in determining corporate plans. The development of an effective vaccine or treatment for COVID-19 will, when it comes, also clearly be a game-changer in the evolution of the pandemic and its effects on employment.

Regardless, based on our investment experience across real estate markets, we already see some trends emerging over the longer term:

Working from home will ultimately become a supplement to, rather than a substitute for, the office. While remote work can provide flexibility for employees, office work allows for collaboration, connection and culture—essential ingredients for enterprise growth, risk management and control, and employee development. According to a recent report by the FICC Markets Standards Board, widely distributed remote workforces pose over 40 specific risks to companies, including those related to cybersecurity, confidentiality, execution, staff treatment and productivity.2

In-person interaction is particularly important when onboarding and mentoring younger employees—which, of course, are key to a company’s long-term growth. Our tenants tell us that these processes cannot be replicated and maintained through video conferencing over the long term.

It appears the tide may already be turning on the idea that working from home will last forever. According to The Wall Street Journal, more companies are now saying that they don’t see working from home as a long-term solution.3 Barclays CEO Jes Staley recently commented on the importance of having workers in the office over the long term: “We want our people back together, to make sure we ensure the evolution of our culture and our controls, and I think that will happen over time."4 Indeed, most of our tenants tell us they are excited to get employees back in the office and interacting. A recent survey of over 2,300 workers in the U.S. shows that many employees feel the same way.

Very interesting research and again take the time to view it all here and download the PDF file here.

I must admit, when I first read this, I thought "there goes Brookfield, talking up its real estate book again". 

But then I thought this is Brookfield, one of the best alternatives funds in the world, so take the time to read it carefully a few times.

I will admit, however, I remain unconvinced and still feel strongly there is a paradigm shift going on in real estate led by premiere tech firms dead set on cutting their carbon footprint over the next decade.

Moreover, if class B buildings are losing tenants, you can bet it's going to impact class A buildings too.

Anyway, I shared Brookfield's research with an astute blog reader of mine in Vancouver who shared these thoughts:

Seems to me this is the key statement: "Working from home will ultimately become a supplement to, rather than a substitute for, the office." 

It always was a supplement to the office. I think all reasonable people can agree that it will be more of a supplement than it was in the past, but also that it will remain a supplement to the office. The question that no one can answer now is how much of a supplement? Brookfield's arrogance in purporting to be able to accurately answer that question derives from its desire to talk its book. 

But to my mind the big issue that is not being discussed is the extent to which white collar jobs will be outsourced to low cost jurisdictions. If executives can WFH, they can work from home in India. The WFH crowd may regret what they wished for. While the low end of the income spectrum has suffered the most to date, I wonder whether the shoe is about to drop on the higher income workers. If it is, demand for office space in some areas might suffer just as it benefits other places. 

Complex adaptive systems are hard to predict. 

He's absolutely right, working from home sounds great until you sit down and really think about what it means for a lot of high-paying tech and finance jobs that can easily be outsourced to India, China and elsewhere.

In fact, some big tech companies are already cutting salaries of employees working from home:

And then there are bigger issues in the US labor market that will likely impact real estate for a long time:

I'm not trying to sound bearish on real estate, just realistic, I think it's really important that institutional investors stop only viewing the glass half full and start preparing for what can be a long tough slug in real estate ahead. 

This is what sovereign wealth funds are doing and I suspect others as well.

And the pandemic might also impact mutli-family properties as rents take a beating in major cities as everyone rushes out to the suburbs to buy single-family homes.

Mark Obrai, Director of Investment Solutions at CIBC Asset Management, posted this chart on LinkIn earlier today showing the flood of new condo rentals in Toronto:

I added my two cents:

"Canadians are short condos/ long single-family homes. The pandemic has killed Airbnb market and a lot of condo speculators in Toronto and Vancouver are getting wiped which is why condo prices are declining in these markets. It also doesn’t help that international students aren’t coming to Canada and immigration is down. The pandemic has increased demand for single-family homes but there’s a big problem brewing. As the Bank of Canada slashed rates to zero, and stated they will keep them there for years, more Canadians are taking on record amount of mortgage debt through banks and increasingly through subprime mortgage lenders because big banks are clamping down. What happens when CERB and extended unemployment insurance ends and permanent unemployment spikes? If housing market gets hit hard, a lot of households putting everything they make into their homes will be sitting on negative equity as their payments are only covering interest payments. And God forbid rates rise along with unemployment, then the great Canadian housing bubble is really toast!"

I don't know, Canada's fragile housing market makes me really nervous, too many young households buying houses (and cars) they can't afford, all on credit, it's a disaster waiting to happen (yes, I know, the Bank of Canada will follow the Fed and keep rates at zero for years, cough, cough!).

Interestingly, the head of the CMHC seems to be on the same page as me:

But not everyone is in agreement. Jon Love, CEO of KingSett Capital, shared these thoughts on LinkedIn:

An opposing view:
  1. Interest rates will stay lower for longer
  2. Immigration which was on hold Q2 is picking up
  3. New supply is lagging demand
While prices could moderate, in the high demand markets a significant price drop would not be my base case.

By the way, it's not just Canada, the same thing is happening down south where Americans are fleeing to suburbs, pouncing on record low mortgage rates:

I guess the one good thing about multi-family is people need somewhere to live and if they can't afford to buy, they will rent.

Lastly, if you need more evidence that a liquidity crunch will hit segments of the real estate market, check out the leader, Blackstone, which just raised the biggest real estate distressed debt fund ever, an $8 billion fund ready to lend to distressed real estate operators.

There's a reason why Blackstone raised a record amount to lend to distressed real estate operators, it's because they see the writing on the wall and there are a ton of opportunities out there:

Keep all this in mind the next time someone tells you all is well in real estate, the pandemic was just a hiccup and longer term there won't be any meaningful residual effects.

Always exercise humility when analyzing public and private markets, we simply don't know what the future holds.

Yes, in a zero-bound world, real estate and infrastructure look like a much better alternative to long bonds, but you'd better pick your spots carefully and make sure you add value over the long run.

Below, in a recent episode of "Talks At GS Presents: Insights From Great Investors," Blackstone President and COO Jon Gray discusses the historic dislocation in markets brought on by the pandemic, the themes driving Blackstone’s investment strategy moving forward, and the importance of “high conviction” in his approach to investing.

Listen carefully to Jon Gray, he's one of the best real estate investors of our time (he used to run Blackstone's real estate before being promoted to President and COO).

In another recent episode of "Talks At GS Presents: Insights From Great Investors," TPG co-CEO Jim Coulter talks about investment trends accelerated by the pandemic and why he thinks a good investment strategy is “not consensus.” 

Both these episodes are packed with great insights from two of the world's best investors (one in real estate and one in private equity) and I suggest you listen to them very carefully, but with a critical ear.

Third, Jonathan Litt, LAND and BUILDINGS founder, on what's next for commercial real estate. With CNBC's Melissa Lee and the Fast Money traders, Guy Adami, Tim Seymour, Karen Finerman and Dan Nathan. Litt certainly doesn't sound bullish on commercial real estate.

Lastly, Jean Boivin, Head of BlackRock Investment Institute; Beata Caranci, Chief Economist and SVP, TD Bank Group; and Stéfane Marion, Chief Economist and Strategist, National Bank of Canada speak with Bloomberg’s Shelly Hagan at the Canadian Fixed Income virtual event about the outlook for the Canadian housing market. Good discussion, take the time to watch it.

Update: Mihail Garchev, the former Head of Total Fund Management at BCI, shared these thoughts with me after reading this comment:

You are right – distressed managers are back in and they are really good at sensing turning points and scooping the value before anybody else. They are usually early by 12-18 months before anybody else. And it is in all the capital structure/asset class spectrum. A “beta” approach of just buying real estate would probably not work as well as it might have had before (same for infrastructure, BTW). Selectivity would be the key.

Another realization is the question about liquidity as a risk premium and a key risk. I know it sounds off-the-shelf, but it brings an interesting thought. What is happening to the UK property funds is also something you can see in hedge funds, credit and special opportunity vehicles, and all kinds of artificially marketed as liquid vehicles. Ironically, while this liquidity premium is not necessarily observed in pure private asset transactions where the law of one price does not necessarily hold as these markets are incomplete and may be driven by other objectives (think SWF buying resources for political reasons, or assets for their cash flows, not prices). So oftentimes, investors are paying a premium to acquire these assets, and not a discount. So the liquidity premium actually becomes a liquidity discount. The minute, however, when the same private (or exotic other assets) are packaged into promised liquidity vehicles and then sold to investors who do not have the required long-term liquidity to hold these assets, and are given the possibility to exercise their Pavlovian reflexes of fear and capitulation, the liquidity premium rises from the ashes and rears its ugly head.

As for the future of offices as a work environment, I can see the validity of all these points about the culture, values, creativity, onboarding of new talent. There would be a need for a core interaction, especially at the large complex organizations and activities. The truth is that while there has been a lot of maturity in their systems and processes, these are far from a seamless system, both technologically, but even more so, decision-making.

That said, some of these organizations are also realizing that there is a lot of “bloatware” which the WFH and the pandemic showed that these organizations don’t necessarily need. So there is a sort of a realization of efficiency and being lean and built for purpose. There are probably already talks about these issues in the boardrooms. It also exposes the weak links in processes (of any kind) and technology so this is a positive to focus on addressing these aspects which before were masked in the office bureaucracy and politics.

Another aspect is foreign offices (regardless of whether this is an actual office building or not, but rather footprints). With all the complex and sizable investments in private assets, sourcing, due diligence, and subsequent asset management (to the extent it is there for direct investments) become a problem because of potential travel disruptions and other pandemic impacts. This reinforces the need for a local footprint, as well as being able to have a more advanced process via technology to do it remotely (a form of a desktop due diligence), or expand platform investments which become the outpost of not only specific expertise and outsourcing, but also physical geographic footprint.

I thank Mihail for sharing these wise insights with my readers. 

Update #2 (September 27th): Lisa Abramowicz of Bloomberg shared this tweet stating: Commercial properties hit by the economic effects of Covid are being written down by 27% on average: Wells Fargo data. “The numbers themselves are atrocious. A 30% markdown in appraisals pretty much across the board is horrific.”

I think it's worth noting YTD, US REITS are down 10% whereas Canadian REITS are up almost 2%. Is the difference due to COVID cases hitting the US harder? Probably, but I’m not sure these declines in appraisals are fully reflected in the share prices of listed REITS. Logically, they should be but market is forward looking, so maybe investors see light at end of tunnel (vaccine, better economic recovery, etc.).