Real estate investors concerned 'office sector has changed forever'

Pressure at regional banks, a continuing downturn in U.S. office prices and elevated interest rates have money managers piling back into bearish wagers on one of their favorite sectors: commercial property.

Data center real estate investment trust Equinix Inc. slumped to the lowest since January on Wednesday after Hindenburg Research said it was betting against the firm’s shares, while S&P Global said earlier this month that REITs are the most shorted stocks globally.

Investors have been rattled in recent weeks by lenders including New York Community Bancorp. and Deutsche Pfandbriefbank AG setting aside larger provisions for property-loan losses. The ongoing vulnerability in offices saw those property values plunge 15.2% in the year through February in the United States, according to an MSCI Real Assets report published Wednesday.

“Investors are finally waking up to the fact that rates are not going back to anywhere close to zero and the office sector has changed forever,” said Daniel McNamara, founder of Polpo Capital Management, who’s shorting the sector.

Short sellers borrow stock and sell it, betting they can profit by buying it back at a lower price later. They are also using credit derivatives and indexes and equities to bet against landlords, their debt and their lenders.

Almost 13% of NYCB shares are currently being shorted, up from 3% in November, according to S&P Global. One of the reasons is that the lender is a major player in New York multifamily apartment buildings with rents controlled or stabilized, the value of which have been falling swiftly.

Muddy Waters founder Carson Block told Bloomberg Television that concerns about emerging distress in multifamily housing is one reason his firm has grown “more bearish” on Blackstone Mortgage Trust since disclosing its short position in the lender in December, adding it could also have a knock-on effect for smaller lenders.

Almost three quarters of shares in the SPDR S&P Regional Banking ETF are sold short, an increase of more than 10 percentage points since the start of last week.

The latest spurt in short bets comes as investors scale back expectations on the timing for rate cuts that might bring relief to the sector, with U.S. central bankers signaling they’re in no major rush to start monetary easing after a series of aggressive hikes.

Concerns are mounting that problems in commercial real estate may reverberate. More than 40% of fund managers surveyed by Bank of America Corp. now view U.S. commercial real estate as the most likely source of a systemic credit event, compared with fewer than one in four in January.

Already, the distress emerging in lending to apartment complexes means investors are also paying increased attention to the performance of commercial real estate collateralized loan obligations as those debts comes due for repayment.

CRE CLOs bundle up floating-rate short-term loans that are typically used to acquire and renovate rental complexes. Those borrowers have been struggling after being hit by higher interest rates and falling valuations in some markets.

Short interest in Arbor Realty Trust, one of the finance companies that issues the securities, is about 34.5% of outstanding shares compared with about 21% in September, according to data compiled by S&P Global data.

Landlords are also being targeted. Hindenburg alleges that Equinix, which dropped a planned bond offering after the short seller’s report was published, manipulates its accounting. The company is investigating the claim and will respond in due course, a spokesperson said.

Elsewhere, short interest in Hudson Pacific Properties Inc. had surged to almost 11% of outstanding shares earlier this week, the highest level since October, from about 7% at the start at the month, the S&P Global data show. Wagers against Boston Properties have ticked up to almost 2.2%, compared with about 1.2% in December, though that’s still well below the 8.6% level reached in the middle of last year.

Most REITs focus on owning the best buildings so they will avoid many of the obstacles faced by owners of poorly located or lower quality properties, said Kevin Brown, an equity analyst at Morningstar. He expects the real estate market will stabilize over the long term and office landlords won’t have to offer incentives to lure tenants — but he doesn’t anticipate a massive recovery.

“There’s still going to be office demand, but it’s not going to be what it was in 2019,” he said.

A spokesman for Blackstone Mortgage Trust said the firm increased liquidity to near-record levels and reduced leverage while maintaining strong earnings. Arbor declined to comment, while Hudson Pacific and Boston Properties didn’t respond to a request for comment. A representative for NYCB also didn’t immediately respond to requests for comment.

While commercial real estate prices have been falling, private equity buyers have been largely on the sidelines waiting for more distress to emerge as borrowers begin to default and loans sour. That may be changing now, with Blackstone Inc. President Jon Gray saying this month that values have bottomed and there’s an opportunity to buy assets from banks and insurance funds that may have to sell at discounts.

Another source of sales may be property funds, which have experienced a spike in withdrawals in recent months. Investors yanked almost €1.3 billion from European funds in February, compared with just over €25 million a year earlier, according to data compiled by Morningstar, as values decline.

For example, Credit Suisse Real Estate Fund International lost 22% on investments in 2023 as the downturn in global property markets continued. By the end of last year, investors had requested the asset manager redeem about 23% of the units in the fund, according to the filing.

For now, offices remain the most visible source of distress in commercial real estate. Those buildings are the collateral for more than 20% of commercial property loans set to mature in 2024, according to MSCI Real Assets, which said that landlords may have a more difficult time qualifying for a loan extension that those of other assets.

“Even in January of this year, the market was pricing in six to seven cuts from the Fed and people were holding out hope that a recession will cure the work from home attitude of the masses,” McNamara said. “Unfortunately for them, both those things were fantasies.”

With assistance from Sonali Basak.