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Blackstone's Huge Yellow Flag

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While this may sound overly simplistic, there is no reason for the company to subject itself to public scrutiny, were it not for an inkling that its current financial backers are pulling in their horns.

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Just about a year ago I explained why REIT's pretty much had stopped caring about what they were paying for properties:

"Part of the reason is that REIT's these days don't see cap rates as meaningful. (For those not familiar with "capitalization rates," they reflect the expected rate of return on a property based on the underlying cash flow. If a property is bought at an "8 cap" it means that it will yield 8% return on the price).

The commercial real estate game - at least in major cities - has turned into a game of "flipping." As late as 10 years ago institutional investors had investment time frames of 5-10 years; today they are looking out 2-5 years at the most. In such a short period, cash flow is viewed as a course of funds to spruce up the property until the next fool rushes in to buy it at a higher price. That's when the return on the investment is realized. Therefore, cap rates are ignored because "this time is different."

The valuation stick of choice today is "replacement cost." Would it cost more to put up a property or to buy one already there? This thinking of course is nonsense because the buyers know full well that building a new property is usually not an alternative; but it lets the purchaser assign to replacement cost pretty much whatever number they need to justify the price they are going to pay.
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Fast forward to today and very little has changed except for even higher valuations, and the holding time of assets having shrunk to 12-18 months. As we saw with the Blackstone / Equity Office Property deal, where more than half of the assets were flipped within two weeks, the game now looks something like this: Large operators go around and buy individual assets, put them into a basket and then flip the whole basket to the next institution. That institution then reshuffles the properties with assets from other pools, repackages them, marks them up, and flips them to the next guy. There is no fundamental rhyme or reason for this type of activity except for the price of the transaction. As a friend of mine close to the activity says, due diligence is "streamlined" (read "there is basically none") because for the desired purpose – flipping – none is really needed.

I am revisiting this for two reasons: The spreads on Commercial Mortgage Backed Securities (CMBS), the debt that allows this kind of monopoly to take place, have widened yet some more from the first time I mentioned them. Second, this morning's news that Blackstone intends to go public is a huge Yellow Flag IMHO. While this may sound overly simplistic, there is no reason for the company to subject itself to public scrutiny, were it not for an inkling that its current financial backers are pulling in their horns.

It does not mean that the party in the commercial real estate / private equity world is over, but it may be that the revelers are now comfortably drunk.

No positions in stocks mentioned.
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