Investors pile into risky commercial real estate debt, even as Fed warns of trouble

It takes a fortune to design a city’s skyline.

But it also often takes money borrowed from Wall Street, the kind of debt that can be tied to a lonely skyscraper worth a billion dollars, or a few dozen buildings that are eventually turned into bonds and sold to investors that looking for a return.

One of Wall Street’s hottest “reopening deals” has been in the $ 600 billion commercial mortgage-backed securities (CMBS) market betting on risky real estate debt that could result in large losses or rewards when hotels are replenished With business travelers, workers return to the office and shoppers return to stores as the COVID-19 threat subsides.

“High yield is trading near 4% and CMBS has followed suit,” said Daniel McNamara, principal at MP Securitized Credit Partners, a hedge fund that has been in the spotlight for its successful short sale of debt to weak malls are bound.

Not to mention, much of that pursuit of returns has been stretched over an unprecedented length of time while interest rates have been held at all-time lows.

While McNamara’s team is still betting on shopping malls, commercial mortgage bonds are also selectively going long, mostly by owning lower-rated bonds that have higher potential returns – and risks.


“Everyone has been very vocal about struggling malls, but I really think several sectors of commercial real estate are in secular decline.”

– Daniel McNamara, MP Securitized Credit Partners

As with floods, mortgage bond losses flow bottom-up, meaning that investors in BBB-stamped bonds with higher risk ratings are paid more than creditors of real estate than holders of AAA-rated securities. It would take an extreme downturn if losses climbed all the way to the top.

However, given today’s compressed bond yields and an uncertain commercial real estate background, McNamara sees “little margin for error” in owning some lower-rated bonds that could cause losses with little credit problems.

“Everyone has been talking very loudly about struggling malls, but I really think several sectors of commercial real estate are in secular decline,” he told MarketWatch.

Federal Reserve Chairman Jerome Powell said during two days after Capitol Hill testified that he was monitoring hotels, offices and some retail centers for signs of distress from the pandemic, including the potential impact on the banking sector, which is at significant risk Commercial property is exposed.

“These changes can be permanent, temporary, or somewhere in between,” Powell told the Senate Banking Committee. “The best that can happen,” he said, “would be for the economy to recover.”

How much will the losses increase?

The past year saw a deluge of US companies defaulting on high-yield or junk-rated bonds. This has been a painful cleanup process that has also improved the sector’s prospects.

Commercial real estate, however, remained largely in limbo during the pandemic, despite US property prices most recently about 7% below pre-COVID levels, according to the Green Street Commercial Property Price Index.

“People across the grocery chain have been asked to do the right thing,” said Carl Chang, CEO and founder of Kairos Investment Management, a private real estate company.

“Whether that means holding an indulgence request or working with the borrower or tenant, everyone has been politely asked to put it all on hold,” said Chang, who is also a member of the Los Angeles federal board of directors at the Reserve Bank of San Francisco, advises on real estate terms.

But after a year of COVID, Chang warns that “only so much forbearance can happen” before anything else is on the market. “Bondholders need to generate returns,” he said. “Unfortunately, I think we’ll see more defaults reported and things like that.”

Recently, commercial mortgage bond prices have been suggesting otherwise, or at least that investors will remain bullish enough now to take the risk that they may be wrong later.

The boxes below show that the median of sub-AAA commercial mortgage ratings has fallen to about 88 cents against the dollar during the brunt of last year’s pandemic crisis.

Bond prices are falling, recovering

Empirasign

Mezzanine mortgage bonds are classified as those sold with an initial rating of AA (low risk) to B (high risk). They sit below the AAA rating and are more delicate because they are built with tight buffers to protect against losses, what Wall Street parlance calls “credit enhancement”.


“But at the BBB level, you are still seeing a 7-8% credit improvement depending on the business, which is not a ton.”

– John Kerschner, Janus Henderson Investors

Overall, mezzanine bond values ​​have risen sharply from last year’s lows, recovering almost all losses overall, with far fewer bonds valued in distressed areas. However, the graph also shows significant credit levels between quartiles.

In particular, some bonds fell below 50 cents against the dollar in March, while others were worth around 70 cents in November. The data was compiled by Empirasign, a bond tracking platform, using monthly information on mutual funds that are delayed by 60 days.

When it comes to mezzanine bonds, investors often focus on the middle BBB rating bracket as this is the line in the sand before bonds are given a non-investment grade rating. This often means that they are the riskiest real estate bonds available to money managers, insurance companies, and pension funds.

In the wake of the global financial crisis, losses from BBB-rated classes have diminished, and this PennMutual chart shows that they also increased up to the A-rated bonds issued in 2008, the height of the plight.

BBBs could take losses again

PennMutual Asset Management

No “meme stick”

With the pandemic’s acceleration in online shopping and flexible working arrangements, as well as the deprivation of tourism and business travel and other factors that were not necessarily at the fore when signing the recent commercial mortgages or bonds, there are new concerns about the durability of real estate bonds surfaced after the crisis initially sold.

The spread, or premium, that investors with BBB-rated debt above the 1.452% 10-year risk-free treasury TMUBMUSD10Y has recently fallen from a year-long high of 1,200 to 357 basis points, according to the German bank data.

The data also showed that 19% of all conduit-packaged hotel loans were more than 60 days past due in February, compared with 8% in retail and about 6% overall. Conduit deals are those that collect payments from dozens of mortgages on various properties.

Criminal borrowers are at greater risk of default than those who manage to keep up to date. Missed payments can also be a bad sign for bond investors who are counting on getting their money back and making a little extra for their troubles.

Analysts stressed that contrary to speculation in “meme stocks”, like GameStop Corp.. GME, + 2.36% and AMC Entertainment Holdings Inc.
AMC, -0.36%,
This has been driven by stock traders on Reddit and other social media platforms. These are hedge funds and professional investors who place bets on securities linked to commercial real estate.

However, it also requires careful bond selection, and realizing that buying the most profitable product on the market also means taking some risks.

“If you look at the deals issued, they are definitely safer than the ones before the global financial crisis,” said John Kerschner, head of US securitization products at Janus Henderson Investors. “But at the BBB level, you are still seeing a 7-8% credit improvement depending on the business, which is not a ton.”