It takes a fortune to shape a city’s skyline.
But it also frequently takes borrowed money from Wall Street, the kind of debt that can be tied to a lone billion-dollar skyscraper, or a couple dozen buildings, that ends up spun into bonds and sold to investors looking for a return.
One of Wall Street’s hottest “reopening” trades has been playing out in the $600 billion commercial mortgage-backed securities (CMBS) market, through bets on risky slices of property debt that could end up with big losses, or rewards, if hotels fill back up with business travelers, workers return to the office and shoppers wander back to shops as the COVID-19 threat subsides.
“High-yield is trading near 4% and CMBS has followed suit,” said Daniel McNamara, principal at a MP Securitized Credit Partners, a hedge fund that’s been in the spotlight for its success shorting debt tied to struggling malls.
Not to mention, much of that quest for yield has been stretched out during an unprecedented span in which interest rates have been pinned at historic lows.
While McNamara’s team still has its wagers against shopping centers, it also “goes long” selectively in commercial mortgage bonds, mostly by owning lower-rated bonds that come with higher potential returns — and risks.
‘Everyone has been very vocal about struggling malls, but I really think multiple sectors of commercial real estate are in secular decline.’
Like floodwater, mortgage bond losses flow from the bottom up, meaning investors in bonds stamped with BBB and riskier credit ratings get paid more to act as creditors on properties than holders of top AAA rated securities. It would take an extreme downturn for losses to climb all they way to the top.
But with today’s compressed bond yields and an uncertain backdrop for commercial properties, McNamara sees “little room for error” in owning some lower-rated notes, where trouble on only a couple of loans could trigger a loss.
“Everyone has been very vocal about struggling malls, but I really think multiple sectors of commercial real estate are in secular decline,” he told MarketWatch.
Federal Reserve Chairman Jerome Powell, during two days of Capitol Hill testimony, said he’s watching hotels, office and some retail centers for signs of distress due to the pandemic, including how it might hurt the banking sector, which has significant exposure to commercial properties.
“Those changes may be lasting, or may be temporary, or may be somewhere in the middle,” Powell told the Senate Banking Committee. “The single best thing that can happen,” he said, “would be for the economy to recover.”
How high will losses climb?
Last year saw a flood of struggling U.S. corporations default on high-yield or”junk” rated bonds, a painful clean up process that also improved the sector’s outlook.
But commercial real estate has mostly remained in limbo during the pandemic, although with U.S. property prices last pegged at about 7% below pre-COVID levels, according to the Green Street Commercial Property Price Index.
“People all the way down the food chain were being asked to do the right thing,” said Carl Chang, chief executive officer and founder of Kairos Investment Management, a privately-held real-estate company.
“Whether that means entertaining a forbearance request, or working with the borrower or tenant, everybody in a polite way was asked to put everything on hold,” said Chang, who also serves as a member of the Los Angeles board of directors of the Federal Reserve Bank of San Francisco, advising on real estate conditions.
But after a year of COVID, Chang warns there is “only so much forbearance that can happen” before something else in the market gives. “Bondholders need to make yield,” he said. “Unfortunately, I think we will begin to see more reported defaults and things of that nature.”
Lately, prices on commercial mortgage bonds suggest otherwise, or at least that investors remain bullish enough now to risk potentially being wrong, down the road.
The below boxes show that median valuations of commercial mortgage bonds, rated below AAA, fell to about 88 cents on the dollar during the brunt of last year’s pandemic-induced crisis.
Mezzanine mortgage bonds are categorized as those sold with original ratings of AA (low risk) to B (high risk). They sit below the AAA class and are more dicey, because they come with skimpier buffers to protect from losses, called “credit enhancement,” in Wall Street parlance.
‘But at the BBB level, depending on the deal, you’re still looking at 7%-8% credit enhancement, which isn’t a ton.’
Values for the mezzanine bonds overall turned sharply higher from last year’s lows, and in the aggregate regained almost all their losses, with far fewer of the bonds valued in distressed territory. However, the chart also shows significant credit tiering remains between the quartiles.
Specifically, some bonds plunged below 50 cents on the dollar in March and others still were valued around 70 cents in November. The data was compiled by Empirasign, a bond-tracking platform, using monthly mutual fund disclosures, which are delayed by 60 days.
Within mezzanine bonds, investors often focus on the middle BBB ratings bracket, because it’s the line in the sand before bonds become noninvestment grade, which often means they are the riskiest property bonds available to money managers, insurance companies and pension funds.
In the wake of the global financial crisis, losses cut through BBB rated classes, and this PennMutual chart shows they also rose all the way up to A rated bonds issued in 2008, the peak for distress.
Not a “meme stock”
Fresh concerns have emerged around the durability of postcrisis property bonds, given the pandemic’s acceleration of online shopping and flexible work arrangements, while also gutting tourism and corporate travel, as well as other factors not necessarily at the forefront when recent commercial mortgages were signed or bonds initially sold.
Yet, the spread, or premium, that investors earn on BBB rated debt, above the risk-free 10-year Treasury
rate, recently has plunged to 357 basis points from a one-year high of 1,200, according to Deutsche Bank data.
The data also showed 19% of all hotel loans packaged into “conduit” bond deals were more than 60 days past due in February, compared with 8% for retail and about 6% overall. Conduit deals are those collecting payments from dozens of mortgages on different properties.
Delinquent borrowers are considered a higher risk of default than those who manage to stay current. Missed payments also can bode poorly for bond investors counting on getting their money back, plus earning a bit more for their trouble.
Analysts stressed that unlike speculation in “meme stocks,” like GameStop Corp.
and AMC Entertainment Holdings Inc.
that’s been fueled by stock traders on Reddit and other social-media platforms, it’s hedge funds and professional investors placing bets on securities tied to commercial properties.
But it also takes careful bond selection, and the recognition that buying the most yielding product out there, also means taking some risks.
“If you look at the deals that have been issued, they’re definitely safer than pre-global financial crisis,” said John Kerschner, head of U.S. securitized products at Janus Henderson Investors. “But at the BBB level, depending on the deal, you’re still looking at 7%-8% credit enhancement, which isn’t a ton.”