Liquidity Risk
My favorite story from the Global Financial Crisis is about a risk model, because I am a nerd that way. But it captures the whole thing, it captures all the blind spots.
The story goes that one of the banks that got blindsided did so because of a flawed risk model. Their risk model accounted for the chances of declining home prices in a given year, and it accounted for the chances of increased mortgage bond defaults in a given year. But it didn’t account for the correlation between the two.
So let’s say there was a 10% chance of each event happening that year. The odds of them both happening the same year are .1*.1 = just 1%. It’s a black swan event! But of course, if you understand the overlap between the two events, if you understand that mortgage defaults ONLY happen after house prices decline, the odds look very different. In hindsight it was a plain old white swan after all.
Blackstone has a problem. Their BREIT fund is sitting on $70 Billion in AUM, generating an estimated 2.4 Billion in fees*. It’s a juggernaut.
*Management fee + selling fee + performance fee applied to average historical annual returns, all at current AUM levels. Fee source: BREIT prospectus
The fund can stomach a downturn in commercial real estate prices. The fund can stomach a wave of redemption requests. But these two events are highly correlated. And Blackstone can’t stomach both.
Private REIT funds had been the biggest buyer of commercial real estate.
During 2021 the private REIT reportedly raised about 70% of all the equity capital raised by private REIT companies. Since its 2017 inception, the company has raised a staggering $59.9 billion, repurchasing approximately $7.3 billion of this amount through its stockholder liquidity program. As of June 30, the NAV was reported to be $68.3 billion... if BREIT were a public company, its reported value would have the company ranked fifth amongst all equity REITs in terms of equity market capitalization. - Chris Volk, Seeking Alpha
This is just BREIT, mind you. There are several private non-traded REIT funds. These funds had been buying everything they could find, and paying top dollar for the privilege. Ascending prices caused fund inflows, which caused more buying, and so on.
And now the process reverses. Declining prices causing redemptions, redemptions causing selling, and selling causing declining prices. Error: circular reference.
So now the biggest buyer has become the biggest seller. And a forced seller at that.
According to Blackstone’s valuations, they have $130 Billion in Real Estate assets on the books (including CMBS). That means that they are leveraged.
So to summarize the state of things, we’ve got a large & leveraged fund that has been setting their NAV using lagged appraisal data which spills back over a timeframe where economic conditions looked nothing like they do today. So the fund appears overpriced and under-risked relative to reality. This is not a good time for Blackstone to be a forced seller and taking write-downs.
The public REIT vs private REIT valuation divergence could hold forever, theoretically, unless or until they have to sell properties. Until they need liquidity. And like home prices + mortgage defaults, these two events are highly correlated.
Lost in the BREIT analysis I’ve put out already, perhaps due to a thread formatting problem, was an examination of BREIT’s implied cap rate and AFFO. If you want to take a look, start here:
Overvalued and overpriced, that’s a hell of a combination.
So here we are, and Blackstone needs to either sell properties or generate inflows to meet redemption requests. And getting those inflows already cost them an arm and a leg!
So next they have to sell properties, and what will market transactions look like? Who will buy Blackstone’s portfolio? Who is big enough to buy? Who still has liquidity?
I’ve been running ETFs under independent issuers for six years now, and for six years it’s been a conga line of risk managers, fund gatekeepers and anyone else who matters telling me that my funds are too small for them to use.
Because my small funds pose a liquidity risk.
Entrepreneurs and small business owners not welcome here.
But they had it backwards. The bigger the fund, the more contagion, the worse the liquidation price, and the bigger the liquidity risk.
It’s not just BREIT. It’s not just BCRED and SREIT.
Look at GBTC. Here’s a fund that owns $11 Billion worth of Bitcoin based on current mark-to-market prices. So big, so liquid! Except it is so big that investors are trapped. Investors can sell on the open market at a 39% discount, or the fund’s issuer, Grayscale, can open up the fund to redemptions to allow the discount to disappear… and in doing so invite open market Bitcoin liquidations that will crush it’s price and Grayscale’s sister companies. To say nothing of the 2% fee that Grayscale is charging on the $6.8 Billion market cap $11 Billion implied NAV of the fund.
Caught in their own trap.
Look: liquidity ain’t an appraisal based NAV, and liquidity ain’t a mark-to-market price against a sparsely traded asset. Liquidity is a bid. An actual cash bid. And public market funds of a modest size have that, every weekday from open to close. Oversized funds of illiquid assets don’t. That right there is how you define liquidity risk.
Top notch commentary and analysis!!
Flawed analysis, I spoke to Blackstone directly. There valuation data is based on current transactions. They are selling all the time and have real time data on sale values. There assets are only in strong markets that still have migration and are growing. Also their expiring leases are 10-20% below the current market. Remember people who are unable to purchase single family properties due to increased interest rates have to rent! The rental market will not get soft like housing!