The current financial crisis resulting from a global economic shutdown in the face of covid-19 is unlike anything any of us have experienced.
Compressed into a little more than a month, we have seen a calamitous rise in unemployment as economic activity across the globe ground to a halt. Countries are shut down. Other than healthcare workers and other service providers working tirelessly to keep our communities safe, most work from home – if still employed. It took six weeks for unemployment to rise in the US from a more than 50 year low of 3.5 percent to more than 10 percent at time of writing.
It has been well chronicled that real estate did not cause this financial crisis. In fact, the real estate market entered this crisis in good shape, with supply and demand in relative balance – at least based on pre-covid demand – and enough global economic growth to maintain leasing momentum. There were some problems in retail and in a few condominium and hotel markets, but generally speaking, conditions were relatively benign and liquidity was ample.
Like every sector of the economy, real estate is now severely impacted by the economic consequences of the shutdown, primarily given the implication for rents and mortgages. There is a further unknown about the frictional costs of delays to completing developments, moving tenants, completing tenant fit-outs, leasing space, touring assets, and other everyday property practices while we’re in lockdown. That being said, the real estate markets and the properties themself continue to function. But without clarity on when we get out of our homes and physically back into a functioning economy, projections are either aspirational or pessimistic depending on whether the sun is shining that day.
We will learn more as time passes. But investment markets don’t like mysteries, especially involving hard assets. Markets like certainty. It was therefore strangely comforting when some of the early distress we observed was of a familiar nature, reminiscent of prior sharp downturns. While we may not understand the science around covid-19 and how long it will take to develop vaccines and testing protocols, we know from past experience how things play out when there is an abrupt downturn in the real estate capital markets.
No place is this more apparent than in the recent meltdown of the mortgage REIT and real estate credit sectors. This is the fourth time in my career I’ve witnessed the mortgage REITs implode, and it’s always the same story. Leveraged finance requires you to maintain adequate collateral to satisfy your lenders. When your assets reprice quickly, your lenders will require additional collateral or they will reduce or call in your loans. If you don’t have cash reserves, which by nature of their structure, REITS cannot, or the ability to call capital, which public vehicles generally do not, then you can disappear quickly.
It was not surprising that as perceived risk increased, mortgage loan and bond values declined, and the inevitable margin calls ensued. Distressed buyers snapped up as many bonds as they could at yields that had doubled and tripled from earlier this year. This was predictable behavior.
What was surprising, on the other hand, was seeing industry leaders on the financial talking heads programs pounding the table to suspend mark-to-market rules complaining how the pricing now “makes no sense.” What makes no sense to me is this: the basic rules of leveraged finance are simple, yet investors want to squeeze out higher yields by using leverage. Managers need to limit borrowings to levels that allow you to withstand a meaningful decline in the value of your bonds.
Managers may have gotten religion over the years about spreading the risk and not crossing entire portfolios. But most important of all, managers have to be prepared for the margin call even if the sensitivity resembles a 500-year flood. In my experience, for the mortgage REITS, these floods actually happen about every 10 years. Investors have to weigh the incremental additional returns during the good years against the binary risk of a severe market correction that often leads to insolvency.
While covid-19’s economic crisis is unprecedented in its characteristics, some of the behavioral responses to the impact on the real estate market are recognizable. We can take cold comfort in this familiarity, but we’ve gained relevant experience to draw on in order to find workable solutions.