Many investors are seeking to increase their exposure to real estate because it offers limited duration and is supported by global growth showing some signs of recovery, continued central bank initiatives, and an improving lending environment. There are several options available, including direct equity investment, REITs, covered bonds and loans. We think that mortgage-backed securities (MBS), particularly in European commercial real estate, currently offer attractive spreads and compare favourably with other asset classes.
Commercial mortgage-backed securities (CMBS) offer a happy medium between high-return, high-volatility REITs and the more stable but relatively illiquid direct real estate.
Investment-grade-rated European CMBS with floating rate coupons should provide protection against rising interest rates and inflation, while offering spreads in the 300-400bps range. The low duration of floating rate securities and high spreads compared with similarly-rated corporate bonds make CMBS an attractive option for income and spread compression as growth and credit conditions improve.
The global mortgage backed securities market has more than $10trn in outstanding issuance financing residential and commercial real estate (CRE). There are three main types of mortgage-backed security: covered bonds, residential mortgage-backed securities (RMBS) and CMBS.
Covered bonds are effectively senior bank debt secured by both a pool of mortgages and their underlying security, supported by a legislative framework, varying by jurisdiction. They have a dual-recourse nature, being backed both by the collateral and issuer credit, and have seniority over depositors and unsecured creditors. Furthermore, favourable regulatory treatments make this a very high quality investment. However, this tends to mean a lower spread compared with other mortgage-backed products.
RMBS are bonds issued by a special-purpose vehicle collateralised by loans on residential properties with cashflows coming from homeowner payments on their residential mortgages. The difference between RMBS and covered bonds is that there is no recourse to the issuing bank and also the security is tranched to give different risk profiles. Various central bank and government initiatives, such as the UK’s Help to Buy scheme, have improved residential property fundamentals, while secondary market inefficiencies provide opportunities at 30-100bps pick-up to similarly rated corporate bonds.
CMBS are structured similarly to RMBS. Here the cashflows come from mortgage payments from the rental income paid by tenants to the property owner (the borrower). The lender pools the mortgage loans together and then slices the pool into tranches that receive sequential payment, each containing a different level of risk, which accommodates a range of investor appetites. The lender then sells the entire package of loans to a trust or a special purpose vehicle (SPV) to complete a ‘true sale’. The process of originating, packaging and selling the securities is typically completed within three months.
Commercial property rents and values are a direct play on economic activity within a region, and in Europe, economic stabilisation is under way and CMBS prices remain dislocated relative to fundamentals. While the CRE markets have not been direct beneficiaries of central bank support, an improvement in the lending environment has been reflected accordingly in fundamentals. There has been significantly better demand in the US and UK due to constrained supply following record-low construction activity. In addition, an expanding direct-lender base has resulted in more refinancing, lower delinquencies and fewer losses. Credit metrics should continue to recover, which should facilitate spread compression.
The US CMBS market is well established and has experienced a significant recovery post-2009, with high returns and relatively low volatility compared with other asset classes. However, a characteristic of the US market is that it is predominantly fixed rate, which is less attractive at this juncture given the threat of rising global interest rates.
On the other hand, there has been minimal new European CMBS issuance since 2008. The historical European CMBS investor base (structured investment vehicles and conduits, many of which disappeared post-crisis) is evolving and in the process of finding stable ground. However, the gradual recovery in Europe and existing price dislocations have resulted in institutional investors gradually shifting focus to European CMBS. Furthermore, the predominantly floating-rate nature of European CMBS gives them a naturally low duration and price volatility.
The CMBS asset class does face some headwinds. The primary one is the evolution of regulatory rules, especially Solvency II and regulatory capital charges, which has created uncertainty for structured products. The most recent proposals indicate a more favourable capital treatment for direct CRE loans versus CMBS (negative for new CMBS issuance but positive for CMBS refinancing via loans), increased risk retention by underwriters (aimed at improving alignment of interests) and higher disclosure and transparency requirements. However, the growing interest and participation by other institutional investors should help to mitigate any reduced demand from banks and insurance companies.
Duration exposure is also something to consider carefully given the relatively low current level of benchmark rates and likelihood of increases over the next 3-5 years. For investors wishing to access the market, a flexible global approach will give the best chance to exploit the opportunity set over the long term.
Malie Conway is head of global credit portfolio management at Rogge Global Partners