The Real Estate Canary Has Something to Say

Everyone remembers when Bear Stearns collapsed...

But almost nobody paid attention to the canary in the coal mine a year earlier.

Bear Stearns' undoing officially stemmed from unexpected swings in the credit markets in 2008. The housing crisis led the subprime credit market to implode. Large asset managers just weren't prepared.

And those unexpected swings hit Bear Stearns' hedge funds... hard.

The collapse took much of the market by surprise. And yet, issues were already arising as far back as 2007. The subprime mortgage market was seeing loads of delinquencies. The market value of those mortgages started to go down.

Even though the economy is doing OK today, regular readers know we're seeing similar concerning rumblings in real estate...

One of the first warning signs was a near-run on the Blackstone Real Estate Income Trust ("BREIT") in late 2022. Right as investors started getting uneasy, the fund put up "gates" to stop the run. Its new rules stated investors could only take out 5% of their holdings per quarter.

 And BREIT isn't the only real estate canary to start singing lately...

Last month, news came out that another large property investor had to throw up gates for its $10 billion fund...

Investors were rushing to withdraw money from Starwood Capital's Starwood Real Estate Income Trust ("SREIT"). SREIT drew more than $1.3 billion of its $1.55 billion unsecured credit facility to meet the liquidity drain.

With less than $300 million of undrawn cash, SREIT is in danger of running out of credit and cash in late 2024.

This REIT is private... So like Blackstone (BX), it can stop withdrawals and stay away from selling too many assets.

Yet this hasn't done much to calm investors. They see that a lot of real estate valuations have started falling... and they want out.

Both SREIT and BREIT are part of much larger corporations, and they're both still plodding along. Even though neither has gone bankrupt, they're both under duress.

Investors have largely ignored the warning signs... just like they did when Bear Stearns' funds collapsed.

Bear Stearns was unprepared for the subprime market to blow up. Most of its positions were leveraged... meaning when they lost money, Bear Stearns owed far more than it initially put up. The bank experienced extreme losses and didn't have enough credit insurance.

Lenders got scared, since they were the ones financing Bear Stearns' leveraged investment strategy. As the subprime mortgage market – their collateral – dropped, they demanded even more collateral to keep supporting their loans.

The fund didn't have enough cash, which just exacerbated the issue. By August 2007, things had gotten even worse...

Many quant strategies unwound at once during the "quant crash." These portfolios were run by computers that traded near-automatically. As the stock market started dropping, some funds automatically liquidated to prevent further losses... causing a chain reaction of selling.

Investors once again shrugged it off as a contained incident, and the market almost fully rebounded in late 2007.

Even more important, Bear Stearns' High-Grade Structured Credit Fund collapsed... losing more than 90% of its value. And its Enhanced Leverage fund lost pretty much all of its $600 million.

No one thought anything of it when those funds blew up... until nine months later, when Bear Stearns blew up as well.

After that, the entire system ended up on the verge of collapse.

A similar canary is singing today... and this time, we're listening close.

Just a year after BREIT's pain, Starwood is in the exact same situation. And that shows a broader issue possibly arising.

Whether or not the market recognizes it, the real estate sector is struggling. Private investors are quietly trying to get out of these real estate funds... and the funds are trying to slow them down.

These funds are dipping into – and nearly depleting – their available credit to pay off redemptions. If they run out of credit, they'll either have to slow investor withdrawals further... or they'll have to sell assets to drum up the cash.

Real estate hasn't seen a true reckoning this time around. Based on these pre-shocks, it may only be a matter of time.

Regards,

Joel Litman
June 11, 2024