Bank Volatility & Real Estate

Hawkeye Wealth Ltd. • March 28, 2023

Private real estate funds apparently are not the only thing being gated right now. The collapse of Silicon Valley Bank (SVB) and the other institutions that followed has shifted expectations and market perceptions in a dramatic fashion. And while every expert and news channel has weighed in on the event (and the subsequent reverberations in the financial markets) our team wanted to provide our insight from a real estate perspective. So, what happened, will it spread, and what does it all mean to real estate investments of the sort Hawkeye Wealth partners with?

What Happened?

SVB suffered a classic bank run. Their clients, primarily composed of tech companies and start-ups with significant cash holdings, lost faith in their ability to withdraw their deposits when the bank failed to raise over $2 billion in capital to cover losses they suffered in the bond market.

The issue originated partly on the fact that SVB’s deposits tripled between 2019 and 2022. Their loan business could not keep up with that much cash so the bank decided to purchase long-dated U.S. treasury bonds, which lost significant book value due to the interest rate increases that followed. And due to an unexpected volume of deposit withdrawals, the bank had to realize those losses when they sold them for liquidity. When they announced they were raising capital to fill the gap, the alarm bells rang and the run on the bank followed.

What should be a surprise to most is a bank not following one of the most important tenets of investing: diversification. They did not diversify their investments (largely government bonds that were hit hard by interest rate increases) or their deposit base (primarily a small number of tech businesses with several million dollars of deposit each).

At the time of its collapse, approximately 97% of the $175B in deposits were not insured by the U.S. Federal Deposit Insurance Corporation (FDIC). The idea of that capital being wiped out rattled the markets. Luckily (at least in hindsight), the government stepped in quickly enough with measures that guaranteed customers’ full access to their funds (and at the time of this writing they also secured a buyer for the embattled bank). While this helped calm the situation on the SVB front, the concern over banks’ balance sheets had already become a widespread concern.

How Far Will It Spread?

From Signature Bank to First Republic, to Credit Suisse and bank stocks the world over, these past two weeks have been a rollercoaster. Government intervention has been robust and swift, providing massive loans to certain banks and convincing large banks to move deposits to the embattled institutions, among other measures.

The more you read about this topic, the more it starts to look like a soap opera: there was an arranged marriage (Credit Suisse’s merger with UBS orchestrated by the Swiss central bank), characters from previous seasons re-emerging (Barney Frank, from the Dodd-Frank Act, was a board member at the now-closed Signature Bank), and unexpected plot twists (central banks whipsawing their policies).

The jury is not yet out on whether the actions by the private and public sector will keep these collapses from becoming a systemic issue. On the one hand, the reaction seems quicker than in previous crises, with liquidity in other forms providing a back-stop to these institutions. On the other hand, it is clear that it will still take some time for investment managers, lenders, and capital allocators to feel like they can see clearly what is around the corner. The concern over lending and a risk-mitigation-first approach can be felt across our issuer partners, industry colleagues, and others in finance.

What Does It All Mean for Real Estate?

While market uncertainty is never helpful for making any investment decisions, the latest developments are relatively bittersweet for real estate.

Start with interest rates. There is a saying about central bank policy that states they raise interest rates until something breaks. And with the confusing macroeconomics of late (consider how good news for the labour market meant a bad day for stocks due to higher expectations of further interest rate increases), perhaps this is the type of breakage that central banks needed to see.

This has already been reflected in the 25bps increase in the latest Fed announcement this past week, when markets were pricing a 50bps raise just before SVB collapsed. Minutes from the meeting signals a less aggressive rate hike regime for the rest of the year. In fact, while the Fed hasn’t announced any plans for rate cuts this year, markets disagree and are already pricing in cuts.

Thus, for real estate deals with floating rates and well positioned to refinance and restructure their capital stack, this could be a welcome sign that we are nearing an end of interest rate increases and potentially welcoming rate decreases some time later in the year. That should help ease the financial burden on a number of properties, allowing for much needed liquidity.

This brings us to the more important question of whether you have a bad asset or a bad ownership structure. Liquidity drying up, higher market uncertainty and high asset prices in early 2022 makes for a bad cocktail. Many asset owners have had to resort to creative financing, unfavorable equity terms, and other forms of capitalizing their properties that choke out the returns of the deal. Many are turning to rescue capital in the form of preferred equity (a topic we plan to cover soon).

On the one hand, that is a difficult position for the current asset holder but it presents an opportunity for groups with the right amount of patience and strong balance sheets. In fact, some industry colleagues are indeed reporting an ability to negotiate better acquisition pricing as owners are having a harder time re-structuring their assets.

Conclusion

The collapse of SVB itself was in fact an example of improper patience and bad balance sheet management. The assets they held were not necessarily bad assets, but rather owned in an illiquid, improperly managed way. They had to sell at a loss at the worst possible time. And we are seeing a number of real estate operators having to do something quite similar.

While we do not have a crystal ball to determine with certainty whether this current bank turmoil will reverberate across all markets, it does serve as a reminder that an investment strategy with the right fundamentals can ride out a liquidity crisis–as long as the operators themselves are managing their balance sheets well and staying prudent with debt-usage.

As one large Vancouver developer put it in a recent seminar: “We have put some of our properties for sale at the prices we need for the returns we want. If no one is willing to pay that now, that is fine. We’ll wait. We can afford it.”

Those are the words of someone with patience afforded by a fat wallet. Those are the words of the type of real estate partner we are looking to (and do indeed) work with.

Barring a complete collapse of the economy, we believe that when acquired in good terms with a properly structured capital stack, and managed by a professional team with the right track record, real estate can weather times of market uncertainty like these.

If you have any questions or would like to learn more about investing with Hawkeye Wealth, email us at info@hawkeyewealth.com or call us at (604) 368-2980.

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