Along the lines of what we have been saying for well over 18 months now, we are concerned about the macroeconomy- specifically commercial real estate and highly levered businesses/individuals. These sentiments come after continuing to underwrite countless deals across industries, widespread layoffs, multiple domestic bank runs, all-time high debt rates, overall economic uncertainty, and less manpower being needed to do the same jobs with the democratization of AI through OpenAI and other platforms (all deflationary).
We are being more careful underwriting than ever, sticking to our fundamentals of analyzing product/market fit as well as levered and unlevered cash flows to the business. As many debt maturities are approaching, we are mostly looking at deals with no debt, strong cash flows, and sophisticated underlying technology. Many of the deals done in the last decade or so, especially in commercial real estate, do not have great underlying fundamentals which is creating a unique set of circumstances across markets.
There is over $1.5 trillion in commercial real estate debt maturing in the next three years, most of which was financed in a near zero interest rate environment. This debt will need to be refinanced in a much less liquid market with lower values and higher interest rates.
As people are forced to refinance in stronger debt markets, this will inventively cause many operations to go out of business, or at least have massive negative impacts to their cash flows and valuations. This will create great strategic arbitrage opportunities across the capital stack. Some early signs of this are a myriad of price reductions and a spike in foreclosures across the country.
All markets are related to each other, but real estate is particularly interesting to analyze because it’s one of the more illiquid assets, taking 4-8 quarters to catch up to the rest of the more liquid economy. Real estate loans are at all-time highs and have seen a sharp increase in the last few years. Similarly, consumer credit is also at all-time highs and has seen a sharp increase in recent years.
Long story short, whether you are a highly levered business or a highly levered individual, things aren’t looking great for you given current market conditions. Your operations are likely to go under and/or lose serious value in the coming months (maybe even years). This is primarily because rates will probably not go as low as they have been for the last several decades for many, many years. Those who have held cash and have businesses with strong levered and unlevered cash flows will be greatly rewarded in these times.
The coming of many debt maturities, paired with serious regional banking issues, will cause a rise of “Shadow Banks,” or large debt funds like Blackstone and Starwood, to step in as the economy’s primary lenders. Their deals will likely have predatory terms that lendees won’t have much negotiating power in, causing free and clear takeovers if the lendee defaults, not to mention much higher interest rates than regional or other traditional banks.
People frequently ask why we are pursuing such a complicated and difficult business model and I think this exemplifies it perfectly. Large asset managers with multiple strategies and pools of capital always seem to end up in a winning position no matter the economic conditions because they are able to play all sides of the market- a position we one day hope to be in and have tried to place ourselves as closely to as possible for the time being with our broad and dynamic fund mandate and by sitting cash for most of 2022.
In commercial real estate, most buyers aren’t willing to pay prices set by the low interest and cap rate environment that sellers have grown accustomed to. Accordingly, sellers aren’t willing to drop their prices to more accurately reflect current market conditions, which has resulted in a tapering of real estate transactions in the last year or so. This “cat and mouse” will likely continue until sellers are willing to drop their prices even more as, given the FED’s recent action and massive wealth destruction globally from stock markets crashing, war, and natural disasters, they will likely be on the losing side of this current stalemate.
We have started to see signs that this thesis is correct in smaller and more volatile markets like the “micro-VC” market, which has resulted in some exceptional opportunities that we have been taking full advantage of (discussed above). As more and more people get pressed for liquidity (particularly sellers), we expect to continue seeing better and better deals across industries, asset classes, and capital stacks- read more about this in our most recent capital stack arbitrage article.