The Private Debt and Commercial Real Estate Crash Nobody Sees?

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Harriett Agnew and Eric Platt of the Financial Times report Oaktree’s Howard Marks warns of crunch time for private credit:

Howard Marks, the co-founder of $172bn investment group Oaktree Capital Management, has warned that the boom in private credit will soon be tested as higher interest rates and slower economic growth heap pressure on corporate America. 

The 77-year-old billionaire told the Financial Times that big asset managers had competed aggressively to lend to the largest private equity groups as money poured into their coffers in 2020 and 2021, raising questions over the due diligence the funds conducted when they agreed to provide multibillion-dollar loans. 

“[Warren] Buffett says it’s only when the tide goes out that you discover who has been swimming naked,” he said. “The tide has not gone out yet on private lending, meaning the portfolios haven’t been tested.” 

He added: “Did the managers make good credit decisions, ensuring an adequate margin of safety, or did they invest fast because they could accumulate more capital? We’ll see.” 

Private credit has ballooned since the 2008 financial crisis prompted regulatory reform that pushed banks away from speculative lending and new lenders stepped in to fill the void, including many backed by private equity titans such as Blackstone, Apollo and KKR. 


Data provider Preqin estimates the private credit market, which includes loans for corporate takeovers, has grown to about $1.5tn from roughly $440bn a decade ago. Fundraising has been brisk, eclipsing $150bn every year since 2019. 

But part of that influx of capital was lent when markets were on a seemingly unstoppable march higher — before the US Federal Reserve began aggressively raising interest rates. Competition among private lenders pushed borrowing costs down at the time. 

Investors have raised questions over a number of loan deals signed in that period, including some that were based on a company’s revenue growth as opposed to its profitability. Higher interest rates are also beginning to put pressure on companies, eating into profits, with some businesses asking their lenders to forgo cash interest payments. 

Analysts with Moody’s, who are calling for an uptick in corporate defaults as economic growth cools, have separately warned that the lack of insight into the private credit market suggests “that the sector could harbour risks that are not currently visible”. 

Marks set up Oaktree in 1995 with chief investment officer Bruce Karsh and three others. Known for his popular investment memos, he is an unequivocal contrarian, bargain hunter and follower of market psychology who tries to live by Buffett’s investing maxim: be fearful when others are greedy and greedy when others are fearful. 

Right now he sees a fertile environment for lenders such as Oaktree to step in and provide financing where banks are further retrenching following the collapse of Signature Bank and two other US regional lenders. The Fed said this month that banks were tightening lending standards for businesses and warned of a potential credit crunch. 

 “Now you have some meaningful interest rates and some scarcity of capital as banks are restrained,” Marks said. “This is a good climate . . . you can get equity returns from debt now, and when you invest in debt you have a much higher level of certainty of return relative to equity ownership.” Marks said that this contrasted with the investment landscape from 2009 to 2021, when interest rates were low and “everyone was eager to invest”. 

“If everyone is eager to invest, you’re not going to get a bargain,” he said. “It’s simple supply and demand. For more than a decade it wasn’t a great time to be a lender. Now it’s a much better time.” 

Oaktree has expanded beyond its roots in distressed debt and now invests across credit, private equity, real assets and publicly listed equities. The firm is in the midst of a fundraising push as it looks to raise $10bn to finance large private-equity backed takeovers.

Great insights from Howard Marks who on the one hand is warning it's crunch time for private credit and on the other, he sees excellent opportunities to lend money to businesses now that banks are retrenching from this space. 

He notes that now is a much better time to be a lender because rates have risen and you can get equity like returns in debt which ensures higher certainty of payment (higher up in the capital structure).

But he also notes the influx of money into private debt has led to lax underwriting standards:

“[Warren] Buffett says it’s only when the tide goes out that you discover who has been swimming naked,” he said. “The tide has not gone out yet on private lending, meaning the portfolios haven’t been tested.” 

He added: “Did the managers make good credit decisions, ensuring an adequate margin of safety, or did they invest fast because they could accumulate more capital? We’ll see.”

When you lend money to a business, any business, you need to really understand its sources of revenues and the risks of not getting paid on that loan.

In other words, underwriting standards matter a lot and I would add now more than ever!

Why? A deep and prolonged recession is headed our way and it will impact all assets, including private debt, real estate, infrastructure and private equity.

Private debt is essentially legalized loan sharking, you lend at an attractive rate and you get inflation adjustments and certainty of payments, unless the business goes belly up or experiences severe hardship and is unable to meet its loan requirements.

Since a lot of private credit is done in the mid-market space where private equity funds are active, it's not surprising to see these sponsors also raise private debt funds to lend money to their businesses.

I recently took a critical look at whether it's really private credit's time to shine and raised a lot of these concerns.

At the beginning of the year, i warned my readers that private debt might be the next subprime credit crisis.

Private debt still makes me very nervous and it makes me even more nervous when I ask pension funds simple questions like "how much of your total portfolio is in private debt and how much of that is exposed to junior loans?" and they ignore me or can't/ won't answer me.

Admittedly, these days I am much more concerned about a crisis in commercial real estate led by the implosion of offices all over the world with the US leading the trend.

Yesterday, an astute blog reader of mine sent me this tweet by Richard Whalen:

Sure enough, he's right:

It’s unofficial. SKS Real Estate Partners will pay up to $67.5 million to buy the office tower at 350 California Street in a fire sale that could reset office prices across San Francisco.

The San Francisco-based firm teamed up with a South Korean investor to pay between $200 and $225 per square foot for the 297,600-square-foot building in the Financial District, the San Francisco Business Times reported, citing unidentified sources.

The seller of the 22-story glass-and-stone tower was Mitsubishi UFJ Financial Group, based in Tokyo.

The deal comes out to $60 million to $67.5 million — or around 75 percent below the $250 million sought when the building hit the market in 2020. Before the pandemic, California Street was home to some of the world’s most valuable commercial real estate. Now, in the era of remote work, the city’s office vacancy has jumped to a record 32.7 percent, compared to 4 percent before the contagion.

Some of the city’s most noted corporate tenants, from Salesforce to Meta Platforms, have sublet offices, flooding the market with square footage. 

The plunge in office workers has slammed the Financial District, leading restaurants, stores and other small businesses to lay off employees or close up shop.

The sale of 350 California may establish a new office benchmark.

I am getting a really bad feeling in the pit of my stomach that when new office benchmarks are established across the United States, a slew of pension funds are going to have to drastically cut their valuations on the office buildings they hold.

I call this "hidden valuation risk" and it's better to take your lumps earlier than later.

And wait, when the severe recession I am forecasting hits us, it's going to get be even uglier for offices:

I know, offices only make up 10-15% of pension funds' commercial real estate portfolios but that is still signifcant.

What about the stock market ripping higher on news that they've reached a deal to expand debt ceiling?

Be careful, regardless of these sham debt ceiling talks, the reality is there are plenty of downside risks in stocks:

Alright, let me wrap it up there.

Below, Howard Marks explains why the era of easy money is coming to an end and the tide is going out.

And Steve Weiss explains why he's not too negative on the market and thinks the regional bank crisis isn't over. Listen carefully to what he says about banks writing down loans as commercial real estate values get written down hard.

Third, a deep dive into the breakdown of the San Francisco commercial real estate market meltdown. This sobering clip reveals the alarming signs pointing to an imminent collapse in the SF office market and what awaits other major US cities (vacancy rate went from a low of 4% in 2019 to 32% recently).

The same thing is happening in L.A. (fourth clip) and around the country and it will put more pressure on regional and big banks.

When New York City office vacancy rates reach a record 23% this year, you know there's big trouble in commercial real estate. Expect regional and big banks to start writing down these loans.

Lastly, the commercial real estate sector has recently experienced huge problems in large cities in the USA. After the Covid-19 pandemic, several office-buildings are left empty due to the work-from-home trend. As vacancy rates rapidly increases, both the already troubled banks, and the housing market are shaking their legs. By the end of this video, you should have a great understanding of why the commercial real estate sector is struggling, how it may affect the housing market, worsen the banking crisis, and why you should not believe in all you read in media.

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