In September 2007, hedge fund manager Andrew Lahde of eponymous Lahde Capital, which had previously earned huge returns by heavily shorting the ABX, launched a new institutional fund to short commercial real estate via the CMBX. (Click here if you are a retail investor and want to know how to short commercial real estate).
At the time, he predicted a “100% likelihood” of a US recession that would cause commercial property to also tumble and that his “commercial fund [would] act as a hedge for all of the carnage still to come”.
His thesis relies heavily on exploiting the leverage often used to finance real estate. Using an analogy he says is from Peter Schiff, he explains that one should picture the commercial real estate market as a beach ball, with an arm holding the ball. If the arm is taken away, that ball will fall to the ground. He says many foolishly believe that somehow if you take cheap financing (the arm) away, the ball will remain afloat.
Despite a relatively placid commercial real estate market thus far, Lahde still fervently believes that the “losses will materialize”. Though he admits he doesn’t have any idea how severe the losses will be, nor does he have a model that can correctly predict all the variables (who does?).
He says he is sure of one thing though: “It is safe to assume a market is dead when deal volume falls to zero, as was the case with CMBS issuance during January 2008.” He goes on to say that “risk premiums for this type of debt have skyrocketed as exhibited by the CMBX. If you dramatically increase the risk premium for an asset class, especially one that is so heavily financed, the value of that asset class must fall. End of story”.
But is the CMBX really an accurate gauge of risk premia these days, or just plain paranoia? Worse, has it become an easy way to create a self-serving and self-fulfilling short prophecy on a popular trade? Particularly if it is one of the few vehicles available to speculate on that strategy?
Interestingly enough, the Markit Group, which runs the index, will not provide daily trading information, despite requests from the CMSA to do so. Obviously, low volume could make it subject to manipulation and price swings that do not actually reflect the current healthy fundamentals of commercial real estate.
Lahde knows this (he is clearly a smart guy), and what he also purposely fails to mention – his shareholder letters are all over the internet – is that although the CMBS market is truly quite dead, that doesn’t also mean the commercial real estate market has died along with it. Before the CMBS came market along, real estate financing was the almost exclusive domain of pension funds, insurance companies and regional banks, the very financiers that are now stepping in to refinance that “dead” CMBS market.
Fitch Ratings decided to look into this very issue and issued a March 25 report examining the default rate of maturing CMBS deals (they all have balloons that must be refinanced on maturity). Fitch found that ninety-nine percent of recently matured U.S. CMBS loans have been successfully refinanced.
Broken down further, a total of 3,354 U.S. CMBS fixed rate loans with a balance of $21.4 billion have been refinanced successfully since the credit crunch began in August. The lenders were mostly insurance companies and regional banks.
Lenders continue to finance assets like these because they produce reliable monthly income, not consume it. The arm analogy was a handy way to promote a niche short strategy, but far to simplistic for the real world.
Indeed, the beach ball is still there, and so are all the old lender’s arms, clamoring for a piece of it.
Click here for an updated Mortgage REIT list, including current yields
Update: “Lack of CMBX Transparency Draws Industry Scrutiny”
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