Short sellers have ramped up bets against commercial mortgage REITs, wagering that more borrowers will default on office debt as interest costs increase and property values fall.

Short interest in the largest mortgage real estate investment trusts focused on business properties, including Blackstone Mortgage Trust Inc. and Starwood Property Trust Inc., hit post-pandemic highs in the past month, according to data compiled by S&P Global Market Intelligence.

Hedge funds have been using credit derivatives and equities to bet that the rise of working from home will cripple demand for poorer-quality properties and hurt landlords. US office vacancy rates have already risen more since the start of the pandemic than they did during the financial crisis, according to broker Cushman & Wakefield.

If borrowers can’t find tenants then their risk of default rises, potentially hurting commercial mortgage REITs, which make money from the difference between their cost of capital and the interest they charge borrowers for loans.

There’s “growing concern among investors that there will be ballooning defaults on held loans” because of higher refinancing costs, said Gavriel Kahane, co-founder of real estate investment firm Arkhouse. “Mortgage REITs in general do better when the Fed funds rate stays constant, and in this hyper-turbulent environment distress bubbles up.”

Loss Protection
Blackstone Mortgage Trust Chief Executive Officer Katie Keenan said mortgage REITs like hers have multiple layers of protection from losses.

“As a floating rate lender our cash flows are growing,” Keenan said in an emailed comment. “The interest we collect on each loan, each payment de-risks our return and that of our investors.”

A Starwood spokesperson declined to comment, while a representative for Apollo didn’t immediately respond to a request for comment.

The surge in shorts comes amid signs of emerging trouble in the wider real estate loan market. The delinquency rate on office loans across all lenders — banks, insurance companies and commercial mortgage-backed securities — climbed to 2.7% at the end of 2022, up from 1.6% in the previous quarter, the Mortgage Bankers Association reported.

Bets against property firms aren’t rising across the board, with commercial mortgage REITs perceived to be in a worse position than their residential peers based on the level of shorts.

Booking Reserves
Wednesday’s better-than-expected earnings by Blackstone’s vehicle showed the risks of shorting the REITs. The firm’s shares rose after it reported that borrowers continued to pay their loans even as it tripled its expected credit losses from a year earlier.

“If the value of an asset is down 10%, 20% or even 30%, the expected outcome is the same: full recovery of our loan,” Keenan said on the earnings call. “We will not be immune from credit impact, especially in the office market. That is why we have booked significant reserves” against the most challenged loans.

Office loans are a minority of the portfolios for the mortgage REITs that are being shorted. For example, only 23% of Starwood Property Trust’s $16.8 billion loan portfolio are tied to offices as of Dec. 31. The firm has previously said it is insulated from commercial real estate market risks.

“We are the only mortgage REIT with multiples of cushion to cover potential losses should CRE market weaken from here,” President Jeffrey DiModica said during a February call with analysts. The firm is scheduled to report earnings on May 4.

Stuart Rothstein, the CEO of Apollo’s mortgage REIT, downplayed the firm’s risk of losses when it reported earnings Thursday. Overall office exposure stood at only 18% of the loan portfolio at quarter-end, more than half of which is in Europe, where office usage has been higher than the US, he said.

“With respect to the balance of near-term maturities, we are in dialog with all borrowers and expect full or partial repayment on these loans,” Rothstein said during a call with investors.

The ongoing crisis facing regional lenders, a key source of financing for the property industry, is exacerbating the turmoil for office landlords by making it more difficult for them to obtain credit. Almost $1.5 trillion of US commercial real estate debt comes due for repayment before the end of 2025, according to Morgan Stanley.

“We expect private equity and commercial real estate to suffer as regional banks were disproportionate funders of these sectors and the crisis has shut leveraged lending primary markets for the time being,” fund managers James Hanbury and Jamie Grimston of Brook Asset Management wrote in a letter to investors seen by Bloomberg News. A spokesperson for the firm declined to comment.

--With assistance from Nishant Kumar.

This article was provided by Bloomberg News.