REIT Short Sellers Help The CRE Market To More Accurately Reflect Value
MyEListings' markets and economics editor and creates content about global macro events and their impact on US commercial real estate.
A financial trading tactic known as "short selling,” where investors borrow shares of a stock, sell them at market value, and later seek to repurchase the shares from the market at a lower price, whereupon they`re delivered to the lender, actually helps the CRE market too. Despite its much-maligned reputation, short selling actually performs a valuable function within the market: it enables speculators to provide 2-sided market liquidity where little might otherwise exist. As commercial real estate (CRE) has generally declined in price during the last year, market participants have broadly become more bearish on the market, largely because markets are illiquid, and buildings have not been offered at the fire sale prices that might be more commensurate with their current value, given the probability that a large chunk of office properties will not return to their prior occupancy levels, and that these properties must be repurposed or replaced to achieve their highest and best use. A number of factors have contributed to this development. The idea of short selling REIT shares, its effects on market stability, and its function vis a vis CRE valuations are discussed herein.
Overview of Short Selling
In order to sell a stock (or REIT) short, an investor first borrows the shares from a financial intermediary and then sells them at current market prices, betting that the stock`s value will fall. To close the position, the investor buys the shares again at a (hopefully) lower price, keeping the difference and returning the shares to the lender. By promoting price discovery, supplying liquidity, and allowing market players to voice their disapproval of overpriced assets, this facet of trading helps to maintain a healthy and robust market.
Market Dynamics And Short Sales
Because transactions must ultimately close, the vast majority of short positions ultimately generate support via the buying that must happen for short sellers to profit and close positions. One risk of having large short positions in a given issue is a so-called `short squeeze,` where short sellers run for the exit at the same time out of fear, driving prices steeply higher. There are, however, certain exceptions to this rule, such as when businesses fail or are delisted, as happened to Silicon Valley Bank, Silvergate Bank, and Signature Bank, and which, in retrospect, First Republic Bank probably should have experienced as well.
How Short Selling Indirectly Helps Liquidity In CRE
Real Estate Investment Trusts (REITs) own about 9.4% of the CRE industry. If these CRE assets were owned outright by private investors, there would be no opportunity for the market to relieve tensions through short selling. Price discovery, the back-and-forth argument between supply and demand, would take longer to work itself into equilibria if no public companies operated CRE as a business unto itself. The presence of publicly-traded REITs, which are tightly regulated, forces prices of commercial properties to more quickly reflect market realities than would occur otherwise, because short sellers can simply extract the calculated difference between the market value of the REIT and the value of its idividuated holdings by selling the REIT itself short until it reflects the proper sum of its properties.
The Much-Delayed CRE Selloff
Market participants have anticipated a selloff in the CRE market, particularly in office buildings, since early 2022, yet transaction volumes have been about one third their value in Q1 2023 as in Q1 2022. This has taken place as a result of a number of factors including shifting work cultures, a fast-rising rate environment few have been able to hedge effectively, and investors and their lenders collectively betting on hope as a strategy. Real estate selloffs can be systemically, as well as financially damaging, hence the reluctance of property owners to sell at much lower valuations. But thanks to public REITs owning as much of the property market as they do, this effect could be somewhat mitigated by short sellers` at least partial ability to match valuations with prices. Depending on which lenders have liens on which assets, any ensuing selloff may take a variety of shapes, with facets such as strategic defaults, fire sales, and loan extensions. The path of least resistance will likely vary by relationship.
Market Corrections: Short Sellers` Impact
With REIT-owned CRE, short sellers can help discover overvalued assets, and alleviate the discrepancy between price and value which can lead to market corrections and ultimately promote a more stable and accurately-reflective market environment. They alert market players to underlying problems that might not be visible at first, giving both regulators and other market participants useful information to act upon.
CRE Resolution Techniques
When property owners experience lower rents, they typically manage the process until the market rebounds and rents return, often having improved their properties in the meantime, so that profit margins are greater once this occurs; but office properties are not likely to rebound, because they represent cultural and economic shifts toward greater automation, decentralization and individual autonomy in business.
When property owners realize not only are rents unlikely to return to their high water mark, but that they have also failed to hedge away the losses generated by duration mismatches in these streams of income, the options for disposing of the properties and resolving their discrepancies are few. They include the following, as well as hybrids of each.
Fire Sales: In some circumstances, property owners may choose or be forced by lenders to sell their possessions at a sharply discounted price. Fire sales offer purchasers the chance to purchase assets at a bargain, but they can also result in significant losses for the sellers. Ultimately, this is the final solution when all else fails, but is unpalatable until other avenues have been exhausted.
Extensions of Existing Loans: As an alternative, lenders may decide to lengthen the terms of current loans, hypothetically giving property owners more time to recover from poor market circumstances or to find better financing options, but this rarely works at scale. By preventing massive key defaults and the potential systemic collapse of property prices, this method can play a role in stablizing markets, but playing for time and hoping are ill-conceived strategies at scale.
Refinancing: Rather than extend a current loan, which is necessarily loaded with fees that compensate the lender for the risk of extending a low-interest loan in a market in which they could otherwise lend several hundred basis points higher. The problem doesn`t go away, but becomes temporarily larger as financing costs increase but rents have still not recovered.
The Path Of Least Resistance
The best course of action for lenders and property owners will rely on a number of variables, including the specific assets at stake, the property owner`s financial stability, the systemic risk posed by the parties involved and the lender`s willingness to tolerate losses or renegotiate loan terms. Market participants will need to carefully consider their choices and make strategic decisions as the CRE price-value resolution progresses in order to limit losses and guarantee the long-term viability of their assets. The path of least resistance is likely to be a hybrid of the above resolution avenues, tailored to specific actors.
Summing Up
In conclusion, short sales are crucial to the liquid securities markets, and vicariously to the commercial real estate industry since they help maintain market stability and speed up the long-awaited resolution of price-to-value of office buildings. Borrowers and lenders could be forced at a point to resolve their situations on terms possibly not their own. Prior to then, it is in the market`s and the economy`s interest to hasten these resolutions, and short sellers of REITs deserve some of the credit for a speedier recovery than would be possible otherwise.
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