Hedge funds are always on the lookout for the next big short a phrase coined by Michael Lewis in his book, The Big Short, which details the exploits of a group of funds that made billions betting against the US sub-prime housing market in 2008/2009.
Last year, the favorite big short among funds was the Chinese yuan, a trade that has produced results but not the career making profits many managers were hoping for.
Now the industry has moved on to a different target, which once again focuses on overpriced debt.
According to some the next big short trade among major hedge funds is shorting the debt of B and C class malls.
Hedge Funds’ Next Big Short: US Malls
The thesis behind this trade is based on retailers store closures and consumers’ shift from traditional brick and mortar retailing, towards online sales. Enclosed malls are the most exposed to these challenges as their largest tenants are retailers where e-commerce competition is most acute, and store closures are already well underway. Also, retail properties – mainly malls – often have limited alternative uses, and thus face steep drops in value if the assets “go dark.” However, Class A+ malls, which have multiple anchor stores, entertainment options and dominate the retail industry in their area are more protected than the B and C class malls that lack entertainment options and a sufficient number of anchor stores.
According to Deutsche Bank, retail property has missed the post-crisis commercial property rebound in the bleak outlook for malls is only adding to the pain for property/debt holders. Traditionally, commercial mortgage-backed securities have been a critical source of financing for retail properties. $142 billion of such securities are outstanding in conduit.
Deutsche Bank’s equity retail analysts believe up to 15% of the retail stores they cover (more than 6000 properties) are at risk of closure and based on this analysis, as retailers improve their online penetration, more store closures are likely. Fewer retail stores, particularly anchor stores such as Sears, Macy’s and JC Penney should translate into an overall decline in mall foot traffic as well as other tenants thanks to “co-tenancy” clauses in lease agreements that can allow other tenants to break or renegotiate their leases after a loss of an anchor tenant. These developments could push malls into a death spiral:
“Our equity analyst Paul Trussell estimates that most of the inline retailers he covers will need to reduce stores by ~15%, with some exceptions. Green Street Advisors has estimated a range of 10-43% closures for major anchors. As noted above, anchor store closures are more problematic as they can set off the mall death spiral. Taken together, in a downside scenario these figures could translate into a 20-30% “closure” rate for Class B/C malls, either going “dark” or seeing a big drop as an alternative use property (data center, community center).”
Declining occupancy will push the most indebted malls and commercial borrowers into distress – bad news for CMBS. And this is where some funds believe the next ‘big short’ is located.
CMBS does not offer a pure play to be short retail commercial real estate risk as retail loans represent roughly 30% of new issue conduit CMBS loans, though there is considerable variation across individual deals. Instead, Deutsche Bank likes CMBX, a synthetic index that can be used to go long or short CMBS risk across different vintages. As the bank’s report on the topic explains:
“To date, we have hesitated to put on short trade recommendation in CMBX subordinate tranches. Our view was that it was “too early”, and these trades suffered from relatively high carry cost. However, the challenging holiday for retailers make us more concerned about the contagion effect within retail, where there are some large loan exposures in earlier CMBX vintages.
We initiate a short risk recommendation on CMBX 6 BBB- (492bp) and CMBX 7 BBB- (431bp). We choose those indices due to their higher exposure to weak retail and greater seasoning. The seasoning should bring the event risk closer, as newly originated commercial real estate loans typically take time to develop problems. Naturally, CMBX BB tranches are closer to taking principal losses, given they have less subordination. However, we favor BBB- due to potentially better liquidity profile and the lower cost of carry. CMBX BB spreads are roughly 400bp wider, and do provide some perspective on how BBB- tranches will react if we see loss-adjusted enhancement erode (i.e. Investors increase their loss assumptions across deals). We highlight that a mark-to-market price adjustment for BBB- risk is the bigger driver of our recommendation, rather than the payout from ultimate write-downs.”
But is it really theNext Big Short?
One hedge fund manager notes that several big hedge funds are chasing looking for “20-40 bond points on a short over two years that costs 6 points (3 per year) on BBB-6.” He goes on to say that this isn’t “really close to the ‘Big Short’/BlackSwan” but it is an attractive “high-yield” short with a mall put.” Finally, he comments that timing on this trade is “uncertain of course.”
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