Though they still seem too early for the party, contrarian real estate investors keep predicting that residential mortgage-backed-securities prices are about to find their bottom. Just so, some investors in commercial-mortgage-backed bonds — that is, bonds backed by cash flows from mortgages on office and retail properties — are becoming convinced that it’s time to be bullish. They say prices are too low and bid-ask spreads too wide, considering what they see as the $1.3 trillion market’s healthy fundamentals.
“We think that the market is fundamentally cheap. We are a very active buyer,” says Edward Shugrue III, a managing director at New York–based Guggenheim Structured Real Estate Partners.
Jun Han, a principal at JHP Capital, an Orinda, California, commercial real estate investment consulting firm, published a white paper in June under the auspices of the Commercial Mortgage Securities Association titled “In Search of Fair Value for CMBS.” In it he argues that CMBSs are irrationally underpriced. “Current spreads for most CMBS vintages are still far wider than their fair value,” he says. This spring spreads on benchmark triple-A-rated ten-year bonds were trading as much as 200 basis points wider than they were a year ago. Han blames guilt by association: Continuing price declines in the residential sector have scared investors away from all real estate, even though commercial property values have remained steady.
He also attributes the wide spreads to the reliance by some investors on the CMBX, a synthetic index of CMBSs administered by Markit Group, a New York– and London-based market data provider, that is used to buy and sell credit default swaps. Investors and lenders use the two-year-old index to hedge their CMBS exposure. Han and other CMBX critics say the index has not yet attracted enough liquidity to accurately reflect the market, and as a result has been extremely volatile, notwithstanding low delinquency and default numbers in the underlying securities. (Markit declines to comment.) CMBSs saw defaults of less than 1 percent and delinquencies of about 0.39 percent in 2007, according to data from Fitch Ratings. Han says, “[Current spreads] are implying that future defaults and losses would be many times the levels of historical experience.”
Leonard Cotton, vice chairman of asset manager Centerline Capital Group, contends that the volatility of spreads is even more important than the actual spread. “If volatility is measured by standard deviation, it has increased more than 50-fold over the past 12 months,” he says.
Spreads, however, are starting to tighten on investment-grade CMBSs. Spreads on the benchmark triple-A-rated ten-year bonds, although still about 125 basis points wider than they were a year ago, have narrowed by about 125 basis points since March.
Robert Cestari, a managing director at New York–based Winthrop Realty Partners, says: “The triple-A bonds have tightened to a fairly decent range. At the same time, most of the [spreads for the] mezzanine classes have continued to be fairly wide. Investors are looking at the loans that were made in 2007 and feel that they just can’t go on a rating agency’s ratings. They have got to do the credit work, and many of them are not adequately staffed up for that.”
Kent Born, a managing director of real estate securities at Chicago-based asset manager PPM America, says the market is seeing selling now from bond owners who want to take advantage of gains. “When there are investment-grade bid lists out now, the story is that someone is taking gains or rebalancing their portfolios, rather than a fire sale,” he says.
Of course, a U.S. recession could hurt occupancy rates in buildings, making it harder for borrowers to make interest and principal payments on the loans that back CMBSs. At the moment, most U.S. commercial markets are performing well, with the exception of a few pockets of overbuilding, as in Florida and Las Vegas. Centerline Capital’s Cotton says the market is more transparent than it was during previous downturns. “No one is making stupid construction loans,” he asserts. Furthermore, investors expect demand to remain strong because new construction has not been excessive. Han notes that new construction has made up only about 1 percent of the space added each year over the past five years, with the remainder coming from the redevelopment of existing space.
