Many investors are jittery about the crisis in the commercial real estate sector, with speculation that a correction in the asset class will lead to a recession in 2023. On the contrary, Shikha Gupta, portfolio manager of Astra Asset Management, believes that a deep recession is unlikely and investments in real estate may even prove, once again, to be a reasonable hedge against inflation.
Astra Asset Management, an investment firm with expertise in asset-backed securities and corporate credit, was founded over a decade ago by Anish Mathur who serves as the Chief Investment Officer of Astra Asset Management. Based in London, Astra Asset Management recently featured in the 20th edition of the Global Investment Report and was the only European credit manager in the list of the 50 most consistently performing hedge funds.
In this article Shikha Gupta, PM of Astra Asset Management, shares her perspective on the risks of a severe real estate market correction, the outlook for the wider economy and the unique window of opportunity for long-term investors.
In the near term, valuations are expected to sink lower, and it is evident in the market that this process has already begun. However, Ms Gupta at Astra Asset Management expects valuations to come back to levels that bring cap rates in line with historical levels and ultimately yield higher than the medium-term government bonds.
Astra Asset Management on Economic Downturns Triggered by Real Estate Crises, a Recurring Theme
Weakness in the real estate market, in conjunction with substantial leverage, has historically been a cause for concern to borrowers, lenders and investors. Shikha Gupta at Astra Asset Management points to the economic headwinds the asset class can cause: the CRE crisis in the United States some forty years ago; the collapse of the subprime mortgage market in 2008; recent tensions in the office sector because of post-COVID-19 increase in working from home; and pressure on home prices in many countries around the world resulting from steep increases in mortgage rates.
Shikha Gupta at Astra Asset Management believes that a deep recession is highly unlikely and on the contrary, investments in real estate may even prove, once again to be a reasonable hedge against inflation that has spiralled out of control in recent times.
This is not to say that valuations will not grind lower in the nearer term. This process has already begun and is likely to continue, giving rise to short-term turbulence, although it is not something that prudent long-term investors cannot prevail through.
Over the next two years, Shikha Gupta at Astra Asset Management, expects valuations to come back to levels that bring the cap rates in line with the historical levels adjusting for the change in the stable medium-term government bond yields. The rental income is also expected to increase, albeit with a lag, bringing the real estate nominal value back up again and not far from 2022 levels.
Commercial Real Estate Debt Concentration Risk, perspectives from Astra Asset Management
The diversification of the risk is as much a concern as the sheer size of the potential problem. Put simply, who owns how much problematic CRE debt?
Shikha Gupta at Astra Asset Management highlights, with regard to the market size, that the total CRE market was estimated at 34 trillion USD in 2021. With the US contributing the lion’s share (ca. 20 trillion USD) and the UK market contributing 1.7 trillion USD. These figures might leave a feeling of unease with those of us who recall that the size of the US subprime market in 2008 was well below two trillion USD, or less than 10% of the US CRE sector (based on above 2021 estimates).
The greatest concern when it comes to potentially widespread consequences appears to be banks, as sizeable amounts of non-performing loans on their balance sheets tend to dampen their ability and willingness to lend, and hence lead to tighter credit conditions overall. Fortunately, the numbers do not look too alarming for larger banks: recent data shows that CRE lending makes up around seven per cent of European banks’ exposure; the figure is roughly twice as high for the larger US banks.
However, smaller regional banks in the US have more than 40% exposure to CRE lending, which is obviously significant. In light of the recent troubles stemming from concentrated risks at Silicon Valley Bank, amongst other regional lenders, investors are still concerned about this segment of the US banking sector.
So where does that leave other actors in the financial industry, particularly insurance companies and pension funds? Fewer data is available with regards to the direct exposure of the sector, although in Astra’s view secondary effects are more likely to lead to asset-liability mismatches: over recent years, pension funds, in particular, have become much more involved in private equity and private debt, with investments frequently linked to the property sector; we have seen the credit quality of some of these assets deteriorate significantly, eventually resulting in widely reported defaults.
Some of these borrowers will struggle to refinance and might require equity paydown at refinancing in the next year or so. These borrowers will require innovative debt solutions coupled with higher LTV and equity injection from the borrower. This will be a unique opportunity for investors to not only lock in a higher yield on the debt but also be able to participate in CRE recovery from 2024 onwards, which was not the case before for Investment Grade Investors.
Astra’s perspective on Contagion risk: Can the Problem be Contained, or will the Spillover Present an Opportunity to Pick some Low Hanging Fruit
It may be instructive to look at past crises to understand how financial instabilities in the property sector have been transmitted into other segments of the economy, causing lasting damage. We have touched upon two potential mechanisms: subdued lending activity due to impairments of banks’ balance sheets, limiting businesses’ access to credit; and losses hitting the insurance and pension industries, possibly affecting people’s pensions and insurance premia.
Arguably, an even larger risk stems from financial markets’ substantial leverage, built up during more than a decade of ultra-loose monetary and fiscal policy. This third mechanism of risk could feasibly play out as follows: one asset class within a leveraged portfolio materially drops in value and forces a de-leveraging of the overall asset pool, typically through the injection of additional cash, be it through margin requirements or otherwise. Seeking to minimise the crystalised loss, the additional cash is generated by liquidating high-quality performing investments that have not seen a drop in value, or only a relatively small one.
This is what happened repeatedly in the early stages of the financial crisis, allowing troubles to spread from subprime mortgages to commercial real estate loans to CLOs, and to corporate bonds as well as equities.
Another more recent, example is what has become known as the LDI crisis: a political misstep by the UK government caused rates to spike, and Gilts (UK government bonds) prices to drop, triggering margin calls that were met by selling – among other things – AAA-rated CLOs, resulting in credit spreads for these instruments to widen roughly twofold. The dislocation was short-lived due to a decisive intervention by the Bank of England. Still, the episode goes to show how leverage can work as an accelerator and amplify what superficially may seem to be a contained issue. Almost every time, cash is generated by liquidating high-quality assets and price fall presents buying opportunities for select good-quality assets. This time, the inning has already begun with the sale of loan portfolios from such banks. One latest example is PacWest, which reported the sale of $3.5bn in lender finance loans to Ares at a discount. Some of these banks are reportedly selling assets that are their highest-quality assets and are short-duration and floating rate in nature. Shikha Gupta highlighted that in such conditions’ specialist managers, such as Astra Asset Management, with extensive asset underwriting experience led by Anish Mathur will be able to pick up good quality assets at discounted prices.
Conclusion
On the one hand, investors may prefer the exposure to be highly concentrated amongst a small number of “crisis casualties”, rendering the consequences a bit more tractable, provided this doesn’t implicate banks who turn off the (credit) taps to the real economy. On the other hand, if the exposure to risk is so widespread that the impact remains marginal across the board, then the distressed opportunity set will be minimal.
In our view, the reality is somewhere between the two extremes; the problem will not simply go away, although given the market awareness, the consequences should be manageable. Some regional markets in the US might face more pronounced headwinds given their dependence on the regional banking sector, but private investors and other banks should be able to step in to fill most of the gap.
Finally, on the issue of causation versus correlation: we do not believe that half-empty offices or retailers vacating high street stores will cause a recession alone. Instead, we apply the reverse logic whereby a recession with higher unemployment might in turn mute the demand for office space, at least temporarily.
That said, no recession lasts forever; in our view, the commercial real estate market will provide some attractive opportunities once the risks are fully reflected in prices, and the remainder of this year is a good time to get ready to re-enter the market and gain exposure opportunistically.
Disclaimer
Astra Asset Management UK Limited is authorised and regulated in the UK by the Financial Conduct Authority and by the Securities and Exchange Commission, in relation to US persons only, as a Registered Investment Adviser.
The information in this article is for general information purposes only and does not comprise investment advice or an investment recommendation. It is not (nor is intended to be) particular to any investors’ individual circumstances and does not (nor is intended to) constitute either an offer to buy or sell or a solicitation of an offer to buy or sell any securities, in any jurisdiction. Forward-looking statements are not guarantees of future performance and undue reliance should not be placed on them: the value of an investment may fall as well as rise over time, and there is no certainty of any given return. It is possible to make a significant, including total, loss on any investment. Before making any investment decisions, prospective investors should take such investment, legal, financial, tax and other professional advice they deem necessary. Astra accepts no liability and assumes no duty of care in relation to the information contained in this article.
