- Dan McNamara’s Polpo Capital is shorting office real estate, a risky move that could be lucrative.
- The trade has drawn comparisons to “The Big Short,” which McNamara says is overblown.
- His office playbook includes some shorting, distressed-debt buys, and interest-only loans.
Dan McNamara’s office sits on the 19th floor of a nondescript office tower in midtown Manhattan. From his conference room overlooking Sixth Avenue, just south of Central Park, he can look out over a sea of concrete and steel skyscrapers representing what the New York City comptroller estimates to be the largest office-property market in the world.
For McNamara, it’s more than a magnificent sight showing hundreds of years of blood, sweat, and progress. It’s also an investment opportunity.
McNamara, 41, is the cofounder and chief investment officer of Polpo Capital, a small hedge fund spun up in 2021 to bet on commercial-real-estate distress in the wake of the COVID-19 pandemic, which has altered how Americans shop, work, and interact in large metropolises such as New York.
He made his name in 2020 by shorting a real-estate-debt instrument tied to shopping malls, which resulted in a 119% return for his investors in just three months. The mall trade, which also led to handsome profits for the billionaire Carl Icahn, has been dubbed the Big Short 2.0, in reference to the handful of traders who made millions shorting the housing market leading up to the Great Recession, which was the inspiration for a best-selling book and Hollywood movie.
Now, he and a handful of other reputable hedge-fund managers are eyeing a $500 billion collapse in office valuation as the next payday. In a May research paper detailing “the office real estate apocalypse,” researchers from New York University and Columbia found that office valuations declined by $506 billion between 2019 and the start of this year. For many short-sellers of office real estate, there’s little reason to see that decline improving as the number of people who embrace some form of remote work continues to grow, suggesting a more permanent shift in our work culture.
To get a sense of McNamara’s view on the market, look no further than his X (formerly Twitter) feed, which functions as an almanac of almost every media report on commercial-real-estate distress. If you’re looking for a doomsday vision of commercial real estate, you can find it there.
“We think that losses will be similar to the GFC, if not worse,” McNamara said, referring to the great financial crisis of 2007 and 2008. “There are cyclical issues in a lot of sectors, but then there is a secular issue in office. And I don’t think that’s ever getting better.”
Prediction of a sustained office apocalypse has also attracted attention from the famed short-seller Jim Chanos of Kynikos Associates, known for its bets against the collapsed energy company Enron, and the $20 billion credit hedge fund Marathon Asset Management. And it’s drawn criticisms from experts who say shorting office real estate will be far more complicated — and riskier — than the mall short, leading some to say it will be the next “widow-maker” trade.
Even though McNamara expects the office disruption to be huge, he agreed with critics who said that shorting this market wouldn’t make anyone fantastically rich — or lead to any movie deals.
“I don’t think this is the ‘Big Short,'” McNamara told me.
This doesn’t mean he doesn’t have a game plan to make money off cultural shifts that could forever change the state of commercial real estate. In an interview with Insider in his office on August 1, McNamara explained his short positions, his view on the commercial-real-estate bonds worth owning, and how he planned to make money when the market finally hit bottom.
Who is Dan McNamara?
McNamara’s career started in 2004, and by the time of the Great Recession, he was a trader of commercial-mortgage-backed securities at UBS. It was a scary time for anyone in the industry, with asset values crashing, a banking crisis, and new CMBS issuance falling from $229 billion in 2007 to merely $3 billion in 2009. He credited his bearish views with those dark days, views that he said he shared with many traders in that segment.
McNamara left UBS in 2009, followed by short stints at the tradings desks of Braver Stern & Co. and Societe Generale before landing at MP Securitized Credit Partners, part of MatlinPatterson, a distressed securities fund that spun out of Credit Suisse in 2002, where he stayed for nearly 10 years.
By the end of 2019, McNamara and his team turned their eyes to the rapidly deteriorating conditions of shopping malls across America. The shift to e-commerce was emptying out America’s brick-and-mortar retailers, putting department stores out of business and leading to high vacancies in malls.
Seeing this, McNamara and his team wrote a white paper about a way to make money from troubled malls using a group of financial indexes that tracked commercial-mortgage-backed securities. These indexes, known as CMBX, are sliced into 25 parts, known as “tranches,” that represent different loans, each with their own ratings. McNamara and his team focused on a tranche called CMBX 6, a collection of loans from 2012 that had a large exposure to troubled malls.
MP had already been shorting this tranche, but McNamara said they saw a bigger opportunity and began to raise money for a fund focused entirely on the short. MP Opportunity Fund was launched in February 2020, with the intention of focusing on the mall trade for five or six years.
Then the coronavirus, which had been wreaking havoc on China and Italy, hit the shores of the US.
At the time, McNamara, his wife, and his two young sons split their time between their house in Westchester, New York, and their apartment in the Manhattan neighborhood of Tribeca. The week that New York ordered nonessential workers to stay home indefinitely, his family moved up to Westchester.
“We never slept in Tribeca again,” McNamara said.
He had seen firsthand the chaos that COVID-19 was reaping on real estate. His fund saw it too.
McNamara’s short
While some may think of a short trader and see a brash, overconfident cowboy in the sleekest suit you can find, when McNamara met with an Insider reporter he was dressed like a dad relaxing after a day at the golf course, with a tucked-in golf polo bearing Polpo’s octopus logo, navy pants, and suede loafers. McNamara didn’t come off during the interview as a big risk-taker, and his confidence in the trade felt contagious.
McNamara and his colleagues raised about $100 million in 2021 to launch Polpo Capital, according to Bloomberg.
“It was born with the idea that commercial real estate and CMBS credit is going to be the heart of distress, and it will provide the next opportunity just like residential did in 2008 and 2009,” he said, referring to the real-estate meltdown that defined the early years of his trading career.
Alongside McNamara, there are four others at the fund, including his fellow portfolio manager Josh Nester, who McNamara said spent “every hour of every day underwriting” who would be a winner or a loser in commercial real estate.
Polpo focuses on shorting CMBX tranches 12,13, and 14. No CMBX tranche is entirely one asset class, but office-property loans represent up to one-third of the assets in these groups, more than others. And while he’s most bearish in office property, he does expect further distress across commercial real estate.
Of those tranches, he’s shorting the BB slice of the tranches. Even though these BB indexes are already trading around $0.60 on the dollar, a July 25 Bank of America research note said that some of them could trade below $0.20 on the dollar.
In an effort to explain how bad things could get, McNamara pointed to an asset in the CMBX 6 tranche: the Crystal Mall in Waterford, Connecticut. At one point, it was appraised at $155 million, and Simon Property Group held $81 million in mortgage debt on the property. Earlier this year, it was auctioned off for a mere $9.25 million.
These indexes have high carrying costs of 500 basis points, causing Polpo to have to pay a fair bit to keep the bet going. The returns on his long positions, he said, allow him to hold these shorts until values really collapse and the bet pays off, even if it takes a few years. According to Bloomberg, these long positions can return 7% or 8%, paying for the costs of the short.
Critics of the office-short trade abound. There’s the risk of high carrying costs in the slow-moving (even in a crisis) world of commercial real estate, as well as the risk that a lot of the distress is already priced in and valuations won’t fall for that much longer.
These risks led the Morgan Stanley CMBS trader Kamil Sadik to write in a March 6 note that betting on office distress now, after much of the declines had been priced in, “was viewed as psychotic.”
McNamara said his team had accounted for all this and they still believed in the trade.
The reason he thinks the trade isn’t the next “Big Short” has nothing to do with its prospective success. In his view, it’s that the trade can never get big enough to result in a jackpot. Shorting requires someone on the other side of the deal to pour equity into it, limiting how much money can be made on these deals. And the capital isn’t there.
With CMBX 6, there was more than $2 billion in positions to short, but within the three tranches he’s shorting now, there are only a few hundred million dollars’ worth of investments to bet against. There just aren’t that many people for McNamara to short against.
“There’s not a lot of people sitting around their boardroom saying, ‘You know what? I want to get long right now on office,'” McNamara said.
Where he’s going long
One risk of shorting real estate is that it’s more susceptible to what’s known in real-estate circles as “extend and pretend.” Instead of letting a transaction die, both the lender and the borrower will agree to push off the maturity date of a loan in hopes that conditions improve and everyone can get back to business as usual without default.
The main downside to the borrower is higher interest costs. For the short-seller, it can translate into a slow death, thanks to the high carry costs.
“Time is your enemy,” Manus Clancy, a senior managing director at Trepp, a data firm that specializes in structured finance in commercial real estate, told Insider about the office-real-estate short bet. “It also takes a real stiff upper lip. You have to have patience, conviction, and the willingness to know it may not work out, and not everyone has that risk tolerance.”
It’s why McNamara’s short positions — which would perform better the sooner office values took a dive — are being matched against investments in a type of bond that will perform best in the face of “extend and pretend.”
Interest-only commercial-mortgage-backed securities are attached to the interest paid on a loan, not the principal. Betting on interest-only CMBS, therefore, is a wager that the owner of the property will look to extend the loan, instead of paying it off in full, which means they will likely have to pay more interest than originally budgeted for the loan.
If, for some reason, the loans are not extended, either through default or because it’s paid off, the investor may not get their expected return.
“You’ve just got to avoid the ones where the keys are coming back next week,” McNamara said.
McNamara’s third play involves buying bonds on the cheap when the market finally hits its bottom, and then making money as things begin to swing positive. He’s basing this strategy on a series of trades that came after the Great Recession, where traders saw opportunities in mortgage-backed securities that had bottomed out.
The hedge-fund tycoon David Tepper’s Appaloosa was among the first to recognize that some bonds were selling at such deep discounts that it could buy them at somewhere between $0.20 to $0.50 on the dollar, Trepp’s Clancy said of the post-financial-crisis era. The firm rode the bonds back up to par, making a killing alongside their legendary trade betting that banks would rebound from the crisis.
McNamara also bought deeply discounted bonds at MatlinPatterson after the Great Recession.
He thinks the CMBX market has a way to go before it bottoms out, he said, and that it depends on how many loans will fall into the “extend and pretend” category. Clancy said, however, that distressed sales in some markets, such as Baltimore and San Francisco, suggested the bottom might be closer than some people might think. He sees the bottom coming in the next six months to two years, while McNamara thinks it will take at least a year or two, maybe longer.
Once the bottom comes, McNamara said he’d focus on two types of bonds, starting with the “fallen angels,” or investment-grade buildings downgraded and sold off in a fire sale. The plan is to buy and wait for them to recover alongside the rest of the market.
The other strategy is to buy control bonds, a technique known as “capture the flag,” where an investor buys the part of the CMBS pool with the most control over the property, giving Polpo the ability to influence either the management of the building or how the bonds will be liquidated to extract the highest return.
“We want to be able to play offense when everyone else will be playing defense,” McNamara said.
The future of the office
In a few years, McNamara expects the view from his 35-story office tower to be largely the same. He doesn’t expect to look out across a bunch of empty lots or office towers warped into futuristically shaped apartments. He doesn’t expect tumbleweeds or a post-apocalyptic scene out of HBO’s “The Last of Us.”
At his own firm, he’s a big booster of hybrid work. In an office full of young parents, he said, the flexibility of hybrid has become a necessity. It’s also necessary in his line of work to meet in person to brainstorm and see clients. He may be betting against offices, but he plans to continue to work in one at least some of the time.
Even a short-term government intervention or a rapid dovish turn by the Federal Reserve won’t be enough to save office landlords, McNamara said. Short of the federal government mandating people return to their offices, McNamara thinks the office collapse is an inevitability, he said.
“Eventually, for lower-quality offices with vacancies around 40% or 50%, the debt will need to be wiped out, and a new owner will have to come in who is happy with cash flow at that level,” McNamara said.
Some of these new operators may look to convert them into apartments. And yes, some of the less desirable office properties will need to be torn down and turned into empty lots.
“There’ll be buildings that will have to be destroyed,” McNamara said. “No one’s paying that mortgage off.”
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