Blackstone Group (BX) recently announced they were bringing a new fixed income product to market. This new bond offering should be highly rated, have a yield higher than comparable U.S. Treasury bonds, and be collateralized by real estate. Does this sound familiar?
If the hair on the back of your neck is standing up, you're envisioning Collateralized Mortgage Obligations ("CMOs"). The inappropriate use of CMOs was largely responsible for the real estate boom and ensuing financial crisis of the last decade. Large financial institutions bought mortgages from smaller lenders, packaged them up into CMOs, and sold them to investors around the world. Unfortunately, the underlying asset, residential real estate, was not the prudent investment advertised.
JPMorgan Chase (JPM) is negotiating a $13 billion settlement with the Department of Justice over the sale of CMOs and other products leading up to the 2008-2009 financial crisis. Although this settlement is the first, it certainly won't be the last. Most of the surviving banks had massive exposure to similar securities and practices. Now that the dust has settled and banks have reaped massive profits, regulators appear to be looking to punish wrongdoers.
Although the securities offered by Blackstone appear eerily similar to CMOs, they are in fact different. Following the financial crisis and "Great Recession," Blackstone used a combination of borrowed money and investor capital to purchase residential homes with the intent of renting them. With an estimated horde of 40,000 homes as collateral, Blackstone now wants to monetize a portion of it. According to a recent Bloomberg article, Blackstone has employed Deutsche Bank (DB) to market $500 million of these securities.
Profiting from lending consists of two factors: interest received and invested capital returned. Lenders only profit if the amount received is larger than the amount invested. Unfortunately, many amateur lenders make loans based solely on current assumptions and fail to consider changing conditions. As the saying goes, "bad loans are made in good times;" many people fail to anticipate potential circumstance changes and the resultant effect on their investments.
We were reminded just a few years ago that real estate is a tricky investment. Today's interest rates, income tax rates, unemployment, corporate profits, etc. can change quickly. Residential real estate has experienced large price increases in recent months due to high demand and low supply. In addition to interest rates climbing and further infighting in Washington D.C., changes to the tax code also could be forthcoming.
With real estate demand waning and borrowing costs increasing, Blackstone may be timing its offering well. Thus far, Blackstone and its private equity investors have profited from the increase in property values, and are now looking to collateralize their investment. I have yet to hear what Blackstone intends to do with the money it raises from these Collateralized Rental Obligations ("CROs"). It has three potential options: 1. Pay down existing credit lines. 2. Buy more real estate. 3. Return money to shareholders.
As an investor, I would be leery if Blackstone intends to utilize newly borrowed funds for additional real estate investments. When we look back at today, we may notice we were near a peak in real estate prices. I do not believe we will experience a decline in real estate prices like we did from 2007-2010; however, I do believe investors should look past ratings and yields, and analyze this investment for its underlying merit. I would be concerned with the use of leverage, current occupancy rates, current cash flow, debt service, and current debt structures (floating or fixed).
The fact Blackstone has engineered a new financial product is not alarming. For over 25 years, they have implemented creative solutions for the benefit of their investors. They are extremely experienced in real estate and private equity transactions. With every new product, there are new questions. I look forward to reading the CRO prospectus and learning more about this interesting investment opportunity.
Only after a very thorough inspection and analysis should investors decide whether to invest in this or any investment. All investments have risk and require modeling based on different scenarios and assumptions. Although Blackstone is a distinguished and reputable company, every product is not right for everybody. Consider investments within the context of your investment horizon, risk tolerance, tolerance for ambiguity, and overall investment portfolio.
Note: Collateralized Rental Obligation (CRO) is not a recognized industry term… yet.