In this uncertain economy, several sectors have taken hits at various times over the past few years. Some investors think commercial real estate (CRE) could be the next shoe to drop.
Interest rates soared for the first time since just before the Great Recession, which makes borrowing more expensive. The popularity of working from home and the ability to use the internet to do more activities online has put pressure on certain pockets of CRE, like office space and retail, and a recession could be brewing.
Distress can create opportunity, and billionaire investor Seth Klarman, who co-founded the now $25 billion hedge fund Baupost Group, thinks he sees opportunity emerging in CRE. Here's why.
Klarman: Look around the edges for opportunities
Klarman has been wildly successful as an investor, with Baupost Group posting 20% average annual returns since 1983 and soundly beating the broader market. Klarman is a value investor, and he's never been afraid to take the contrarian view.
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In 2012, Baupost Group purchased more than $450 million of creditors' claims to Lehman Brothers after the company went bankrupt in 2008. A year later, those claims traded well north of 100% higher and would turn into huge returns for the funds that purchased them.
Klarman spoke with CNBC recently and talked about looking for opportunities around the edges of what other people are doing and finding them if you are patient enough. Klarman said he thinks a similar credit situation to what happened with Lehman Brothers is developing in the commercial real estate space, where the problems are very real but perhaps not as bad as some people think.
"We think real estate is an area that is full of so many fundamental challenges, but the fundamental challenges have caused urgent selling," Klarman told CNBC. "You can see a pullback in lending, you can see vacancies in office, troubles in retail for years and years. And so that doesn't automatically make it interesting. But it may mean that as other people abandon it ... there may be opportunities to buy."
In his conversation, Klarman also seemed to be advertising Baupost Group as a great counterparty for deals because he said there's no price the fund can't afford. He said his company can hold assets in a number of different forms and be flexible when it comes to deal structure.
Klarman told CNBC he does foresee a slowdown taking shape early next year as consumers continue to spend down their excess savings and the Federal Reserve continues to try and cool off the economy, but he plans to remain opportunistic.
How to think about commercial real estate
Based on its holdings at the end of the first quarter, Baupost Group doesn't own any real estate investment trusts (REITs) or banks with heavy CRE exposure. However, based on his comments, it seems like Klarman is more interested in buying actual CRE assets or debt tied to these that may be distressed.
While there will certainly be issues in CRE, especially if a full-blown recession materializes, I would agree with Klarman that there will likely be opportunities as well. I can't speak for CRE loans in the shadow banking system, but when you look at the loans on bank balance sheets, a lot of them were underwritten much more prudently than during the Great Recession.
Banks have gotten borrowers to put more equity down, so property values can decline significantly before losses hit bank balance sheets. This, in my opinion, creates an interesting opportunity to purchase some bank stocks with heavy CRE exposure that are well underwritten, because many of these stocks have been painted with a broad brush and have been sold off significantly.
