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Real estate’s next big short is so
risky it’s called “The
Widowmaker”
Betting against offices is easier said than done
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By Rich Bockmann
MAY 1, 2023, 7:00 AM
Eric Yip came tantalizingly close to the jackpot on a bet that struggling
malls would suffer sweeping losses. Then he got wiped out by “the
widowmaker.”
Half a decade ago, Yip’s hedge fund, Alder Hill Management, was one of
the leading players shorting CMBX, the commercial mortgage market’s
answer to the S&P 500. Malls did perish, but their death took longer than
Yip had accounted for, and in 2019, after more than two and a half years
bleeding capital, he acknowledged defeat and shut the fund down.
Had he been able to hold out just a little longer, Alder Hill would’ve still
been in the game when Covid hit and Yip’s bearish trade would have
reaped riches.
“He was in it too early and didn’t have the staying power to survive,” said
John Devaney of United Capital Markets, a CMBX market maker. “Some of
the guys who shorted mall derivatives greatly misunderstood how long it
would take.”
Yip fell victim to what Wall Streeters call “the widowmaker” — an esoteric
corner of the securitized mortgage market that seduces gamblers with the
siren song of the next big short.
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Now, speculators are trying again. Only this time the existential crisis
they’re targeting isn’t in malls, but offices. Short sellers are placing billions
of dollars’ worth of bets on CMBX on the belief that remote work and $108
billion worth of securitized office loans set to mature in the next five years
will wreak havoc on bondholders and the overall market.
It seems like a good bet. Hardly a day goes by without news of an office
building in default or lenders who are unable (or unwilling) to refinance
debt.
But that’s just the beginning. Nailing the short requires an intimate
understanding of how these trades work, according to CMBX veterans.
Even the most thoughtfully planned trade can be undone by the various
parties — special servicers, bondholders and even outside meddlers —
looking out for their own interests.
Real estate’s tendency to extend and pretend its problems for another day
can stretch timelines from months to years. And the tricky technical aspects
of CMBX can wreck a position long before loan-to-value ratios or maturity
dates come into play.
Most of all, the people who’ve seen firsthand why the CMBX short has
earned its ghoulish nickname say the secret to success is twofold: get the
timing right and then have the fortitude to white knuckle it when the
widowmaker acts out.
Out of Office
CMBX is a series of mortgage indices that first came out in 2006. It’s since
been one of the main ways speculators can bet big on the real estate debt
market.
Each series is made up of 25 CMBS deals representing different types of
properties (malls, offices, apartments and more), which are sliced into
tranches of debt based on risk. The safest slices, the AAA tranches, are
used mostly for mundane risk management.
But the riskier pieces, most likely to be impaired when a borrower defaults,
are the realms of the gamblers. The BBB- tranche, rated just above junk, is
what’s known as the widowmaker.
You’d need the entirety of commercial
real estate to fall by 25 percent in
valuation. That feels like a lot.
RICH HILL, COHEN & STEERS
That’s where the cowboys like Yip and billionaire corporate raider Carl
Icahn were playing years ago when they shorted the mall-heavy sixth
series of CMBX, a bet that became known as “the Big Short 2.0.” The index
has since shifted, and the seven series that have come out since 2017 have
been weighted heavily toward office loans.
Investors began increasingly piling their bets on those series soon after
Covid hit. The net value of bets on the BBB- pieces of those office series
peaked at $5.6 billion in February of last year, according to figures from the
Depository Trust & Clearing Corporation, a financial services company.
That’s compared to $9.6 billion at the height of the mall short in March
2020.
Those on the short side of CMBX are betting that offices will default. They
include Bruce Richards’ $22 billion investment firm Marathon Asset
Management and Dan McNamara of Polpo Capital, who became something
of a CMBX celebrity for his very public mall short in 2018.
“I think there’s going to be massive amounts of stress,” McNamara said,
adding that he predicted a wave of office distress long before Silicon
Valley Bank and Signature Bank went under in March. “The wildcard we
didn’t predict was the regional banking crisis, but it’s just been like a triple
whammy — the perfect storm for CRE markets.”
With their bets placed, those investors are sitting back and waiting to see
what happens. Those reading the headlines today and thinking about
jumping in are probably too late.
Prices on some of the office-heavy tranches have dropped to the
low-$0.70s on the dollar. When 25 to 30 percent of distress is already
baked into the price, it would take extremely deep pain in not just offices
but all CMBX deals in the index to make a trade profitable.
“You’d need the entirety of commercial real estate to fall by 25 percent in
valuation. That feels like a lot,” said Rich Hill of real estate asset manager
Cohen & Steers. “CMBX is not necessarily a great short if you’re just
focused on office loans.”
Timing is everything. Show up too early and you risk running out of capital.
Too late, and you need an apocalypse to get paid.
Send bachelors and come heavily armed
Yip’s Alder Hill became a cautionary tale of CMBX, but it was far from its
only victim.
Sorin Capital Management, a Stamford-based hedge fund run by Jim
Higgins that shorted CMBX.6, eventually had to pull out and return money
to investors in 2019. Anchorage Capital Group, one of the biggest hedge-
fund investors in distressed debt, had a position in CMBX that it closed in
2021.
As buzz around the big office short became louder in March, Morgan
Stanley trader Kamil Sadik issued a warning.
“Shorting CMBX BBB- is regarded as the widowmaker — the undoing of
many a young trader’s career,” Sadik wrote, adding that betting against the
index while it had already underperformed similar shorts on high-yield debt
“was viewed as psychotic.”
Here’s how it works: An investor who wants to short a CMBX index enters
into a credit default swap with someone on the other side, who wants to go
long. It’s similar to an insurance policy. The short investor pays a premium
each month for the insurance, and the other side compensates them if a
borrower in the pool falls short on interest payments or can’t repay their
loan.
CMBX has come to be known as the “widow maker,” a nickname for the left main coronary artery, a frequent
cause of fatal heart attacks.
This is one of the main risks of shorting through credit default swaps: It can
take a very long time for those payment events to happen. The resolution
time for special servicers averaged around 23 months last year. If you’re
waiting around months or years for these properties to fail, those premiums
add up.
“If you’re short, time is your enemy because you’re paying these premiums
year after year and the losses have to be very big to offset your carrying
costs,” said Trepp’s Manus Clancy. “I think the biggest issue for shorts over
the last three years has been a willingness for owners of properties to fight
for them.”
In extreme cases, those fights can drag on forever. One CMBX contract has
been outstanding for nearly two decades. It’s from the first series that came
out in 2006 and includes a zombie loan on a Denver shopping center that
was foreclosed on but never sold.
There’s reason to believe offices can hang around even longer.
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Malls and shopping centers often have co-tenancy clauses that allow
smaller tenants to split if an anchor tenant leaves, hastening a property’s
failure. Offices don’t have those kinds of agreements, and with staggered
10-year leases, it can take a long time for changes in work patterns to affect
property values.
Matthew Weinstein of the investment firm Axonic Capital said the fate of
shorts depends on how special servicers decide to work out troubled
loans.
“It’s a widowmaker if every office loan gets extended five years,” he said. “If
realizations occur and special servicers start taking back assets and selling
assets, then it’s definitively not.”
Special interests
One person who’s certainly got opinions on the special servicers is Carl
Icahn, who disclosed that as of late 2020, he had made $1.4 billion on his
CMBX.6 bet.
If not for a special servicer, it might have been more.
Icahn last summer sued Rialto Capital, alleging the special servicer had
dragged its feet on the sale of a foreclosed outlet mall near Las Vegas.
Icahn claimed Rialto was pressured to do so by mutual fund manager
Putnam Investments, which was on the long side of the mall trade and
stood to benefit from any delays in selling.
Icahn’s legal team likened it to an insurance provider pressuring a doctor to
declare a sick patient healthy.
As evidence, they included a letter Putnam had sent threatening legal
action. But Rialto’s attorneys pointed out that the letter was sent to a
different servicer regarding a different trust — saying Icahn was barely
concealing his real motive: intimidating the servicer that got in the way of
his short.
“What Icahn wants is for declines in value to be realized more quickly,” the
servicer’s attorneys wrote.
To sue Rialto, Icahn purchased bonds in the index he’s shorting. It’s an
ethically dubious move, comparable to shorting a company’s stock and
then gaining a seat on its board to call for the CEO’s ouster. But Icahn’s
team said there was no conflict of interest.
“The complaint is very candid and above board about the Icahn fund’s
interest in CMBX,” Mike Hanin, Icahn’s attorney at Kasowitz Benson Torres,
told TRD. “It’s shedding light on a pattern and practice of servicers like
Rialto that sit on these properties for their own benefit in a manner that is
contradictory to the interest of all bondholders.”
TKO
Even if you’ve got the real estate fundamentals figured out, the technical
intricacies of the widowmaker can get you.
CMBX is what’s known as a synthetic index, meaning that it’s designed to
replicate the performance (or nonperformance, in this case) of CMBS loans
— but it’s not actually tied to them.
In theory, the price of CMBX should rise and fall depending on whether
borrowers are repaying their mortgages. And most of the time it does. But
at certain points pricing tends to diverge, and this is when it can be the
most unpredictable.
“The index kind of has a life of its own,” said Constantine Korologos, a
structured finance professor at NYU.
One reason that prices can become disconnected is that CMBX, like other
synthetic indices, can be influenced more by the supply and demand for
credit default swaps than the bonds it tracks.
The index kind of has a life of its own.
CONSTANTINE KOROLOGOS, NYU PROFESSOR
That happened during the big mall short. When mall losses failed to
manifest early on, the prices for the default swaps should have fallen. But
they were being propped up by Putnam and asset manager
AllianceBernstein, which were pushing around the market based on the
huge positions they’d built up on the long side of the trade.
That points to another quirk of CMBX — it’s a relatively small market that
trades in chunks of a few million dollars at a time. Investors with large
positions have serious sway.
It’s also got something of a liquidity issue. One of the benefits of CMBX is
that the default swaps are much easier to trade than the underlying bonds.
But that liquidity tends to dry up in times of volatility, which can leave
investors in the lurch when they need to sell the most.
Nick Godek of S&P Global, which last year merged with the company that
administers the index in a $140 billion deal, declined to comment on
CMBX’s drawbacks. But he did point to one of its big strengths: It allows
investors to focus entirely on credit risk.
Mortgages come with different kinds of risk. One is duration risk: If you
hold a fixed-rate mortgage and interest rates go up, your asset is worth
less than others that are now yielding a higher return.
The credit default swap isolates that duration risk and focuses solely on a
borrower’s ability to repay their loan.
Empty offices, crowded trades
In the heart of downtown Milwaukee, a 36-story office tower stands at 100
East Wisconsin Avenue. The property, long a fixture of the city’s skyline, is
now a poster boy for what happens to older, undesired office buildings.
Last month, a judge approved the sale of the property to a residential
developer for just shy of $29 million — well less than its $47 million CMBS
loan.
Good news for short sellers? Not exactly.
The portion of the loan in CMBX.10 makes up a relatively small piece of the
index, and according to Trepp it’s not significant enough to trigger a
payment to the hedge funds shorting the BBB- tranche.
That’s a scary reality for anyone shorting the index now. The writing may be
visible on the wall for offices. But because these indices are diversified, it’s
not clear that shorting CMBX is the best way to cash in on that belief.
Some have suggested moving away from the BBB- tranche and up to the
more highly rated pieces of debt where the fear of distress is not yet priced
in.
Trepp’s Clancy said he thinks that even if special servicers move quickly to
take properties, it will take considerable time to resolve them. Shorting the
office space, he said, is no sure thing.
“I don’t think it’ll be like shooting fish in a barrel,” he said, “where shorting
office is a clear pathway to making a fortune.”
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Inside the Greek tragedy at the
Flatiron Building
A partnership spat, a botched auction and a mysterious
outsider who briefly became the most talked-about man
in NYC real estate
By Keith Larsen
MAY 1, 2023, 7:00 AM
Real estate is high drama playing out on the skyline. But rarely does it rise
to the level of Greek tragedy that it has at the Flatiron Building.
After coming out of nowhere to win a live auction for the iconic property in
March, then failing to produce a deposit to secure his $190 million bid, a
complete outsider, Jacob Garlick, spent the weeks that followed
scrambling to show that he had the money.
Even as its owners prepare to restart the auction process that he
dramatically derailed, the 31-year-old with zero track record in big-ticket
real estate has maintained that he’s still in the running to buy the property.
Nobody seems to believe him.
GFP Real Estate’s Jeffrey Gural, who has long held a stake in the office
building and was the runner-up in the March 22 auction, said there was
only one scenario in which Garlick’s bid should even be considered: if he
wired the entire $190 million into an escrow account.
“Why would you take anything he is saying seriously?” Gural said.
According to Gural, immediately after Garlick won the auction on the steps
of the New York County Courthouse — which, unusually, did not require
participants to post an upfront deposit or proof of funds — Garlick turned to
him and asked if he wanted to partner in the deal. Later, Gural said, Garlick
even asked him if he would put up the $19 million deposit in exchange for a
10 percent stake in the vacant building.
“It was such a ridiculous proposal,” said Gural. “It concerned me. It was a
red flag that he didn’t have the money.”
In Gural’s telling, Garlick’s group kept promising that the money was
coming. It was to be wired from one bank, then from another. The deadline
arrived, but the money never did.
Now the building will be auctioned off again on May 23, on the same
courthouse steps in Lower Manhattan where Garlick’s 15 minutes of fame
began.
Cracks in the facade
Garlick’s wild ride only came about because of a partnership spat between
the building’s owners.
Sorgente Group, GFP Real Estate and ABS Real Estate Partners, who
together controlled a 75 percent stake, could not see eye to eye with the
remaining 25 percent owner, Nathan Silverstein, about the landmarked
property’s future.
The majority owners sued, claiming they simply could not go on co-owning
the property with Silverstein, who they said had proposed physically
splitting up the building. Gural, in court filings, called that idea
“preposterous.”
It’s highly unorthodox to do an auction
without requiring a deposit.
GREG CORBIN, ROSEWOOD REALTY GROUP
“It boggles the mind to suggest that we could nevertheless agree on a plan
to physically divide this building into five smaller, independent properties,
none of which would be marketable — and then agree on a plan as to how
that work would be financed,” Gural said.
The building’s tenancy-in-common ownership structure, which gave each
of the stakeholders veto power over decisions at the property, led to a
stalemate.
By that point, the building’s longtime anchor tenant, Macmillan Publishers,
which occupied all 21 floors, had announced plans to move out.
In 2019, co-working startup Knotel was in talks to lease the entire property,
but a deal never materialized. Silverstein blamed Newmark, which GFP
Real Estate had split off from only two years earlier, for failing to market the
building after Macmillan left and said Gural was negotiating to lease it to
Knotel at an “exceptionally low cost.” He also claimed in court filings that
Newmark CEO Barry Gosin held a large stake in Knotel. The co-working
firm filed for bankruptcy in 2021 and was acquired by Newmark.
The majority owners eventually sought a partition sale, which would put the
building up for auction but provide them an advantage by allowing them to
buy it back using their existing ownership interests as part of a bid.
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“I was hoping that we would be able to buy [Silverstein’s] interest at a lot
lower price,” Gural said.
Garlick, who seemed to want the property no matter what, price be
damned, spoiled those plans.
Insiders speculated that Garlick was connected in some way to Silverstein.
Garlick, the theory went, was there to drive up Gural’s bid, giving
Silverstein a bigger payday as a minority owner.
Silverstein confirmed to The Real Deal that he is a “distant relative” of
Garlick, but said he’s only ever met him once.
Others involved in the auction said that Garlick’s continued effort to seal
the deal after flopping on the deposit was news to them. Matthew
Mannion, the auctioneer, and Peter Axelrod, the court-appointed referee,
both said last month that they were not aware that he was a realistic
contender to acquire the building.
Gural added that Garlick could be liable for the deposit regardless.
“I hope he has $19 million,” he said.
“Highly unorthodox”
The fracas Garlick set off might never have been possible without a key
lapse in the proceedings: Bidders were not required to put down any
deposit before participating in the auction, according to court filings.
“It’s highly unorthodox to do an auction without requiring a deposit,” said
Greg Corbin, a bankruptcy specialist at brokerage Rosewood Realty Group.
“Over the past 15 years of conducting distressed asset auctions, only once
have we allowed people to bid without providing funds up front.”
“I’ve never seen that before,” said real estate attorney Adam Leitman
Bailey, who noted that he generally asks for proof of funds before an
auction.
Those present at the auction said Garlick, wearing a charcoal suit with a
patterned tie and pocket square, stood just a few feet from the auctioneer,
like a prizefighter steeling himself for a title bout. He rarely broke eye
contact, calmly raising his paddle to outbid Gural until the price hit $190
million.
Garlick told NY1 on the scene that owning the historic building had been
his “lifelong dream since I’m 14 years old.”
“I’ve worked every day of my life to be in this position,” he said.
That night, he had a celebratory party at the Ritz Carlton in NoMad with the
same entourage that had accompanied him to the auction, according to
witnesses.
Reality came knocking two days later, when Garlick failed to cough up the
$19 million deposit. As runner-up, Gural had the option to buy the building
at his final bid of $189.5 million, but declined to make the deal at that price.
The building, which Gural estimates needs a $100 million renovation, is
now set to be auctioned again unless a deal can be made with Silverstein
to buy out his stake.
“I’m not Nathan’s favorite person,” said Gural. But “the reality is, we have an
empty building.”
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