Commercial Mortgage-Backed Securities: Approaching the Later Innings of a Recovery

Transcription

1 Viewpoint February 2015 Your Global Investment Authority Commercial Mortgage-Backed Securities: Approaching the Later Innings of a Recovery U.S. commercial real estate (CRE) prices reached an important milestone in September 2014: They recovered 100% of the sector s peak-to-trough loss, as measured by the Moody s Commercial Property National All-Property Index. Lending conditions in the sector also continued to improve in 2014, with commercial mortgage-backed securities (CMBS) issuance exceeding $85 billion, an increase of more than 10% year-over-year. Bryan Tsu Senior Vice President Portfolio Manager Mr. Tsu is a senior vice president and portfolio manager in the Newport Beach office, focusing on commercial mortgage-backed securities (CMBS) and collateralized loan obligations (CLOs). Prior to joining PIMCO in 2008, he worked at Bear Stearns in New York, syndicating collateralized loan and collateralized debt obligations and other asset-backed transactions. He has nine years of investment experience and holds a bachelor's degree in economics and operations research from Columbia University. PIMCO believes that while the CRE recovery has come a long way from the depths of the financial crisis, property prices are in the middle to late innings of their recovery and there is room for further improvement in However, the continued recovery in the sector requires increased caution among investors. This sentiment was reflected at a recent industry conference: Many attendees were concerned about the tradeoff between low yields and the need to deploy capital, whether or not valuations are justified by fundamentals and the potential contagion from volatility in other asset classes. These concerns were in stark contrast to the sentiment just a year ago, when the CMBS community seemed unanimously exuberant. CMBS rebound continues As with most asset price recoveries, credit availability has played a critical role in recent CRE growth. Secured by mortgages on commercial properties, CMBS is a primary source of financing and liquidity for real estate investors and, at over $640 billion outstanding, represents an important source of debt capital, filling the gap that traditional lenders such as banks and insurance companies cannot or will not fill. The sector accounts for approximately 20% of all commercial-

2 mortgage-related debt outstanding in the U.S. as of 30 September 2014, according to Trepp and Federal Reserve data. CMBS issuance has increased for five consecutive years, and projections for 2015 are for growth of 20% 30%, driven largely by an increase in maturing loans on the supply side and the continued search for yield on the demand side. Despite improvements, 2015 has been viewed as an inflection point by CMBS investors for several years, as it marked the beginning of the dreaded wall of maturities : large amounts of 10-year commercial mortgages made in that were scheduled to come due. However, what was close to a $400 billion wall then is only a $300 billion wall today due to prepayments, liquidations and defeasance (see Figure 1). Scheduled loan maturities in 2015 are now only $71 billion, and if CMBS issuance this year is anywhere close to forecasts of more than $100 billion, there should be sufficient credit available to accommodate them. FIGURE 1: MATURITY PROFILE FOR COMMERCIAL MORTGAGE-BACKED SECURITIES CMBS loan maturities by year ($ bil.) Source: Credit Suisse, Trepp; As of 31 October 2014 While a positive in many ways, the growth in issuance in recent years does not come without concerns. A year ago, we highlighted the expansion of the credit box in CMBS loans, as increased competition among lenders led to a downward creep in underwriting standards. Throughout 2014, signs of this appeared in the form of incrementally higher leverage and looser loan terms. It appears that the CMBS market is poised to start 2015 in much the same way; CMBS underwriting will likely continue to slip, mostly because there is no nearterm catalyst to slow the lender competition and the need to deploy capital FEBRUARY 2015 VIEWPOINT 2

3 outweighs credit concerns, at least for the time being. Though it is a borrower s market, the deterioration in lending standards is at least a disciplined deterioration. Banks have far less ability and desire to recreate the conditions at the height of the lending craze, as regulatory oversight and rating agency scrutiny prevent the most dangerous pro-forma underwriting practices. Fundamentals required to drive CRE recovery further While the initial leg of the recovery was driven by the global compression in interest rates, and subsequently the discount rates that are used to value commercial properties, the next leg of the recovery will likely depend more on domestic growth and a subsequent improvement in property-level fundamentals. PIMCO forecasts real U.S. GDP growth of 2.75% 3.25% in 2015, and expects further improvements in consumption and employment conditions. The result should be a supportive backdrop for both credit assets generally and CMBS specifically. PIMCO expects CRE prices to rise 4% 6% in 2015, driven by continued improvements in absorption rates and rents (due to still-low positive net supply nationally and an improving economy). Importantly, bifurcation remains a key theme in terms of both geographic location and property type. For example, prices of multifamily and office properties in select markets are well above their late-2007 peaks, while many industrial, office and retail properties outside of major cities are still 15% 20% below their pre-crisis highs. While we expect this trend to continue, secondary market properties that have underperformed in the past few years should benefit from improving commercial real estate finance conditions. What can go wrong While PIMCO remains constructive on both CRE prices and CMBS valuations, higher valuations and rapid increases in credit availability drive us to be cautiously optimistic. In addition to deteriorating underwriting standards, weakness in the retail segment continues to be a structural headwind for the sector, and recent volatility in oil prices has reminded investors of the idiosyncratic risk in commercial credits. Lastly, regulatory challenges cannot be overlooked. Requirements born of the Dodd-Frank Act will require CMBS sponsors, or the investors that buy the most subordinate CMBS bond classes, to hold more capital against the securities and maintain those positions for a minimum of five years. The consequences of this are likely to be higher borrowing costs and reduced credit availability. While the goal of these measures is more responsible lending, as seen in the residential mortgage market, too much regulation can move the pendulum too far in the FEBRUARY 2015 VIEWPOINT 3

4 other direction, and the impact of the new capital requirements on CMBS overall is unclear. While we expect lenders and issuers to adapt to new regulations, legal complexities and high operational costs may result in less credit availability than the market has become accustomed to. What does all this mean for CMBS investors? Bolstered by tremendous demand for yield, CMBS spreads have remained resilient even amid expectations for another year of record post-crisis issuance and continued weakening in underwriting standards. PIMCO expects CRE prices to increase modestly in 2015, driven by healthy domestic growth and improving employment. Against a backdrop of lower risk premiums and flatter credit yield curves, PIMCO believes the CMBS sector as a whole is neither glaringly expensive nor cheap at this point. However, as compensation for risk has normalized in the post-crisis environment, security selection is king. This holds true even when investing in the most senior portion of the capital structure. We continue to favor senior CMBS bonds with high-credit-quality collateral, as these bonds often have embedded downside protection at minimal cost. In more credit-sensitive sectors, we are wary of valuations but see attractive opportunities for investors that can perform granular loan-level analysis and identify mispricings. The bottom line: CMBS are largely fairly valued. We continue to maintain a healthy exposure to the sector given its unique diversification benefits relative to other credit sectors, as well as the excess-return opportunities that arise from the structural and collateral-level nuances of each CMBS deal. FEBRUARY 2015 VIEWPOINT 4

5 All investments contain risk and may lose value. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA is regulated by the United States Securities and Exchange Commission. PIMCO Europe Ltd (Company No ), PIMCO Europe, Ltd Amsterdam Branch (Company No ), and PIMCO Europe Ltd - Italy (Company No ) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam and Italy Branches are additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority s Handbook and are not available to individual investors, who should not rely on this communication. PIMCO Deutschland GmbH (Company No , Seidlstr a, Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str , Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. PIMCO Asia Pte Ltd (501 Orchard Road #09-03, Wheelock Place, Singapore , Registration No K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. PIMCO Australia Pty Ltd (Level 19, 363 George Street, Sydney, NSW 2000, Australia), AFSL and ABN , offers services to wholesale clients as defined in the Corporations Act PIMCO Japan Ltd (Toranomon Towers Office 18F, , Toranomon, Minato-ku, Tokyo, Japan ) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, o andar, Rio de Janeiro RJ Brasil No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. 2015, PIMCO. Newport Beach Headquarters 650 Newport Center Drive Newport Beach, CA Amsterdam Hong Kong London Milan Munich New York Rio de Janeiro Singapore Sydney Tokyo Toronto Zurich pimco.com