WeWork, too big to fail

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Your Regular CRE Grinding Update

Yesterday brought a few vivid stories about everyone’s favorite slow-motion car crash—commercial real estate. WeWork wants to cut rents, reports the Financial Times:

WeWork is seeking to renegotiate nearly all of its leases around the world. . . Chief Executive David Tolley told landlords in a business update call that WeWork expected to exit some “unsuitable and underperforming locations,” but would retain most of its buildings.

He said in a statement after the call that WeWork is “taking immediate action to permanently fix our inflexible and costly leasing portfolio.” . .

As recently as the first quarter of this year, WeWork accounted for nearly a quarter of new leasing activity in New York, but some industry members have sought to downplay the impact of a potential bankruptcy. “It’s only a small part of the market,” one person said. The company occupies approximately 6.4 million square feet of the Manhattan office market of 414 million square feet.

The Wall Street Journal has an article long readthere are a ton of important statistics on how commercial real estate still threatens U.S. regional banks:

Trillions of dollars in (commercial real estate) loans and investments pose an imminent threat to the banking industry and potentially the wider economy. The bank’s exposure is even greater than usually reported. Banks are in danger of starting a vicious cycle in which loan losses lead banks to cut lending, which leads to further falls in house prices, causing more losses.

Loyal unhedged lenders will be aware of our view that if a deep recession can be avoided, the disruption in commercial real estate may not be an existential threat to many banks. But write-downs on commercial property loan defaults could slash bank profits and equity capital, for reasons illustrated in these two articles.

The WeWork story clearly shows once again that floating rate loans are not completely immune to interest rate risk. In a higher interest rate environment, some tenants will be unable to meet their lease obligations and therefore some asset owners will be unable to meet their loan obligations. Renegotiation or default would follow. When rates rise rapidly, the spread between a lender’s rate and their cost of funding tends to narrow.

The second lesson from the WSJ report: Low loan-to-value ratios are no guarantee against loan defaults.

In January, a developer defaulted on a loan to OZK Bank of about $60 million due to rising construction costs, OZK Bank said. The loan is considered relatively safe because it is well below the construction site’s 2021 value of $139 million. In December, a new appraisal put the property’s value at $100 million.

The bank is effectively stuck with the property.

The loan had an initial LTV of 43%; even after the cut, the LTV was still 60%. But the borrower didn’t think the loan was worth repaying. Defaults happen long before the equity in commercial real estate projects disappears.

These two stories raise an interesting question: From the perspective of the banks with access to CRE in cities where WeWork still has a significant presence, is the company too big to fail? In other words, is it better for the landlord to renegotiate with WeWork so that it can move forward, rather than say no and increase the possibility of bankruptcy, putting its $13 billion in existing lease obligations at risk? The company accounts for about 1.5 percent of Manhattan office space. The office asset market is all but frozen, and financing is already scarce. Perhaps, the high-profile WeWork bankruptcy will shock the market, leading to further declines in valuations and triggering more defaults. I have no idea. But if I were one of WeWork’s landlords, or the banks of those landlords, I’d think about it. hard.

More about Private Equity

Last week we discussed the SEC’s new rules for private equity funds. Among other things, they instituted standardized quarterly disclosures of fees and performance while limiting “side letters” — a better deal for some investors but not others. The SEC believes baseline disclosures are required even by large institutional investors when investing in fast-growing but opaque private equity funds.

Several readers wrote in to welcome the new rules. One of them, Larry Pollack, highlighted the principal-agent problem plaguing the industry. That said, returns are not more important to pension fund managers (agents) than simple compliance or low volatility, even if such prioritization is not in the interests of pensioners (principals). Our readers wrote:

I’m a libertarian and a pension actuary who has worked in asset management (though not private funds).

I believe the SEC rules may be necessary. Mostly not because the private equity fund managers have some kind of asymmetrical intellectual advantage, or the buyers are rednecks (i.e. dumb), although both may be true to some extent.

Instead, it’s because. . . The US public pension funds (managers) provided large sums of money to private investment funds in a situation very similar to what is happening now. As long as private investment funds can pretend to be virtually guaranteed higher returns, lower volatility, and uncorrelation with other asset classes, agents who buy these funds on behalf of pension plans will gain the kind of professional success they may be willing to pay for in return. at the expense of taxpayers and plan participant principals.

If the new rules better reveal what’s really going on through better disclosures and audits, it will ultimately benefit pension plan managers who don’t have the money or knowledge to monitor their agents.

This is an important point, although we’re not sure how much of an impact these rules will have. Greater transparency in terms of performance and fees could allow for greater comparability across private equity funds. Maybe it helps hold pension fund managers accountable. The bullish mark, on the other hand, is the crux of private capital “volatility laundering,” which the rules seem to have no effect on. (If we’re missing something here, please let us know.)

Andrew Parker of the American Institute for Financial Reform added that the rules do help overcome the collective action problem, in which individual private fund investors are incentivized to push side deals, rather than banding together to negotiate better terms for all investors . That may be part of the reason the private equity industry is now suing, arguing in a filing last week that the SEC wrongly helped investors who didn’t need it:

The commission has shown no need for the intrusive rules it has adopted. Private equity investors are among the largest and most sophisticated in the world. . . These investors know what they’re doing and have plenty of options for where to invest. If, as the Commission claims, the long- and widely used private-equity business arrangements do require government reform, these investors will not increasingly be putting their money into private-equity funds.

One might notice that while the agent may be one of the most sophisticated investors in the world, the principal (ordinary retiree) is not. Still, as we discussed last time, this public policy debate about the virtues of protecting cutting-edge people has sound arguments in both directions.

However, the core of the lawsuit is a procedural issue, and the core is whether the SEC has the right to supervise private equity funds. The SEC points to the powers it has under the Dodd-Frank Act. The industry petition counters that such powers are only meant to protect retail investors. Akin Partner Brian Daly explained:

A fair reading (of the relevant portion of the Dodd-Frank Act) is that Congress is envisioning additional protections for purchasers of securities, primarily retail purchasers, the petition says. This is to grant rule-making powers to protect buyers from bad selling practices. The petition alleges that this provision has grown beyond recognition and into the domain of regulating an entirely different part of the market — the economics of regulatory advisory relationships, not the sale of securities.

Private equity funds are waiting to see whether courts will issue injunctions to block the rules. If not, compliance must begin as soon as possible; funds cannot rely solely on SEC failures. That could happen within weeks, Daly said. Private capital may soon be changing before our eyes. (Wu Yisen)

good read

The author is a New book on FTX Some criticism was made of Michael Lewis, who is also about to publish a book on FTX.

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