(Bloomberg)—A hedge fund manager who made a 119% return shorting debt linked to shopping malls is betting on fresh pain in the US commercial property market.
A large number of older offices will fail to lure back workers in the post-Covid era, making them less attractive to occupiers and spurring a wave of defaults, according to Daniel McNamara, founder of Polpo Capital Management.
“No one is going to want to be in the worst-looking office in suburban New Jersey or downtown Manhattan,” said McNamara in an interview. “We think there’s a lot of room for this thing to fall in the short term. And in the longer term, at maturity, they’re going to be worth a lot less.”
He joins the likes of Bruce Richards, the chief executive officer at Marathon Asset Management, in speculating that the fall in demand for less-desirable workplaces - older buildings or those in unpopular locations — will render big swathes of the office-property market obsolete and loans linked to them at risk of delinquency.
Both investors are making bets using derivative indexes that track the performance of commercial mortgage-backed securities, a similar strategy to the big mall short that handed McNamara and others a windfall in 2020.
Landlords including Brookfield Corp. and Pacific Investment Management Co.’s Columbia Property Trust are among those that have already defaulted on mortgages in the US, sending shockwaves across Wall Street. Office property values have plunged 25% in the past 12 months, according to Green Street, and higher interest rates will only add to the pain.
Excess Space
Falling demand and the rise in remote work means the US will end the decade with about 330 million square feet (more than 30 million square meters) of excess office space, according to broker Cushman & Wakefield Plc. That’s the equivalent of about 70% of Manhattan’s entire stock.
It’s a similar story in Europe where 42% of non-residential buildings were constructed before 1970, the report says. Broker Savills Plc says a crash of 25% to 30% in office values in Europe from the peak in early 2022 “is appearing more likely.”
“Reduced appetite for exposure to office loans can further hinder property transactions, resulting in even lower valuations,” Barclays Plc analysts Lea Overby and Anuj Jain wrote in a note. They forecast a 30% peak-to-trough drop in US office prices, “although deteriorating fundamentals increase risk to the downside.”
Almost $92 billion of nonbank debt on US offices is due to mature this year, according to the Mortgage Bankers Association. About 25% of tenants in properties with debt maturing through 2024 in 11 major US cities have options to leave, potentially reducing rent available to landlords, a report by Trepp and CompStak estimated.
While the volume of distressed debt remains small for now, the problems are expected to spread. Lenders have become increasingly wary of financing older offices, analysts at DBRS Morningstar wrote last month. Sales of new commercial-mortgage backed securities in the US have dropped, as rising interest rates cut into lending volumes.
That presents an opportunity for investors like McNamara, who started his long-short hedge fund in 2021 to focus on distressed opportunities in the CMBS market after making a fortune at MP Securitized Credit Partners with the mall short.
Polpo Capital gained 1.55% in February, bringing its return since inception in November 2021 to 13.49%, according to an investor presentation seen by Bloomberg. The firm manages about $100 million, said a person with knowledge of the matter.
During his mall short, McNamara, along with investors like Carl Icahn, used credit-default swaps indexes known as CMBX to bet against bonds tied to retail properties. These days McNamara is using more recent series of the derivatives to bet against bonds tied to lower quality and poorly located offices. Wagers against the riskiest tranches will pay off if debt linked to the buildings fail to perform.
Spreads on more recent versions of the gauges could widen from 770 basis points to more than 1,200 basis points in a “real recession,” Richards at Marathon said by email.
How the CMBX trade works
CMBX are derivatives indexes tied to tranches of bonds backed by commercial mortgages. Investors use the gauges to wager on office property values in the US. They’re similar instruments to those used by hedge fund trader Michael Burry of ‘The Big Short’ fame to bet against the US housing market more than a decade ago.
McNamara previously notched outsize gains with a wager against the index’s sixth series, or CMBX 6, because of its heavy exposure to loans linked to malls. Finding a similar trade for offices is more difficult as there’s no obvious index to short, he said.
Still, he’s wagering against CMBX 12, 13 and 14, which are linked to CMBS issued as recently as 2020. The carry cost of shorting, or the expense incurred, is about 5%, which McNamara pairs with long positions in highly rated commercial real estate debt, such as floating-rate CRE collateralized loan obligations that yield 7% to 8%.
“The cost of carry isn’t as burdensome in this macro environment,” he said. “When rates were at zero, paying 5% was a lot.”
Meanwhile, Marathon is shorting the riskiest tranche of debt in CMBX 13, according to Richards.
Not everyone is convinced that using the derivatives is the best way to bet against offices. Morgan Stanley’s CMBS desk sees the wager on the riskiest tranches as a momentum trade after it reached a “fever pitch of panic and pandemonium in the back half of last week,” trader Kamil Sadik wrote in a March 6 note.
CMBX indexes have been falling recently with a BBB- gauge hitting an all-time low.
“It may continue to be profitable to set fresh shorts here, but it requires a continuation of momentum, and there being someone else selling at the lows to take you out of your position,” Sadik wrote.
Short Bets
For bears, there are no shortage of signs that trouble is mounting.
“There are early indications that delinquencies on office property in CMBS are starting to tick up,” Federal Deposit Insurance Corp. Chairman Martin Gruenberg said in a speech on Monday.
Hedge funds are also betting against workplace providers. Short interest in WeWork Inc. is at 12% of shares outstanding compared with about 4% a year ago, according to data compiled by IHS Markit. Short sellers borrow shares, planning to buy them back at a lower price and make money from the difference.
Still, only about 1.7% of outstanding US office loans by value currently face some trouble or distress, Cushman’s report says, citing data from MSCI Real Assets.
That’s led to a standoff between buyers and sellers. US sales of offices fell 76% to $2.8 billion in January from a year earlier, according to MSCI. Deals won’t pick up again until owners are forced to sell at prices that reflect how far values have fallen, McNamara said.
“The bid-ask spread is huge now,” he said. “Owners are selling at yesterday’s prices. Buyers are saying that’s crazy.”
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