Brookfield Building

One of the strangest things we’ve been hearing over the last several months is the idea that if/when a recession comes, it won’t be anything like the Global Financial Crisis because that was a credit problem, whereas, what we see today is a liquidity problem.  It’s a fascinating distinction, but we wonder if this nuance may be hiding bigger issues that would have been intuitive in years passed. 

Take for example some of the recent defaults that have happened in the commercial real estate world.  Massive institutions like Brookfield and Pimco have defaulted on loans associated with CRE and they won’t be the last.  These defaults though, are not being caused because these large institutions can’t service their debts.  Of course, they could, but the reason they are not is actually because of their fiduciary duty to their clients.  Sounds weird right?  These players are sending equity value in a property to zero to prevent further loss to the vehicle they were purchased in.  Well, in many cases, the expense associated with the work out of a loan or an additional interest rate cap exceeds the value of the equity.  Rather than incur additional losses, it makes sense for the borrower to hand over the keys.  

Historically, intuition would indicate that the smaller or more speculative property owners would have been among the first to default, but in this cycle, the opposite has been true.  In fact, delinquencies are very low right now, as most players are trying to hold on to see what the future has in store for interest rates.  But it’s tough to know how long some of these smaller investors will be able to hold out.  For now, the consequences to defaulting are bigger for smaller institutions than the consequences are to the larger institutions, so the little guy is holding on for dear life.  It will be interesting to see how resilient those folks are as the cycle plays out.  But we look at interest rate cap pricing as the expense most likely to drive defaults in the short term. 

Source: Wall Street Journal


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