The Commercial Mortgage Story Gets Better For Investors

By Aaron Levitt | August 27, 2013 AAA

After being one of the worst hit sectors during the credit crisis and global recession, commercial real estate came back with a vengeance. Broad-based funds like the First Trust S&P REIT ETF (NYSE:FRI) saw assets swoon as investors rushed into the beat-up sector. However, much of renewed love for commercial real estate extended to the buildings themselves and the real estate investment trusts (REITs) that owned them.

Commercial loans and commercial mortgage backed securities (CMBS), on the other hand, remained in the “don’t buy” camp as a plethora of the bonds faced a refinancing nightmare. However, with those fears subsiding, the bullish trend for CMBs is still at hand.

For investors looking to diversify their fixed income holdings commercial mortgage backed bonds could be an ideal way to add some yield.

Delinquencies Down Significantly
While the recession increased the number of stalled construction projects, empty store fronts and defaulted building mortgages, the commercial sector has bounced back significantly since then. Factors such as rising consumer spending, lower unemployment and rebounding building values have helped real estate development companies reduce the number of delinquent mortgage backed securities.

After peaking back in July 2011- at 9.01%- delinquencies for CMB bonds is nearly 2.23% below that high. Late payments for commercial mortgages are now at just 6.78% of all loans according to data provided by Fitch. That continues a downtrend and now sits at the lowest levels since the end of the recession. Secondly, Fitch’s report also showed that those commercial real estate loans that were becoming delinquent have been decreasing in size. The average new late loan was just $8.5 million, with only four loans larger than $25 million.

Then there is rising issuances of new commercial real estate loans to consider as well.

With the Fed continuing to be accommodating with its interest rate polices, many firms have taken out new debt to retire old loans. According to investment bank Nomura (NYSE:NMR), new issuance of CMBS loans are on pace to hit 2006’s record highs as firms take advantage of low interest rates. Perhaps more importantly, debt service coverage ratios are stronger than previous averages. This means that firms aren’t taken on as much debt and the odds of default is slim.

Adding A Swath Of Commercial Mortgage Debt
Given the improving characteristics and higher yield available on CMBS bonds, investors may want to consider adding a chunk of them to a portfolio. However, unlike buying an individual corporate bond from a company like Pepsi (NYSE:PEP), buying CMBS bonds are pretty much an institutional investor hunting ground. Yet, there are plenty of broad ways for investors to gain access.

The easiest and purest way to gain exposure is through the iShares Barclays CMBS Bond ETF (NASDAQ:CMBS). The fund spreads its $71 million in assets among 185 different CMBS bonds and currently yields around 2.1%. Expenses are a dirt cheap 0.25%. Likewise, the closed-ended PCM Fund (NYSE:PCM) can be used to provide an attractive approach to commercial mortgage loans. The fund is currently trading at a slight discount to its net asset value and features a juicy 8.59% distribution rate.

Another choice in the sector could be the various REITs that either originate or invest existing CMBS and collateralized debt obligations (CDOs) strictly tied to the commercial real estate sector. A top choice could be Starwood Property Trust (NASDAQ:STWD). The firm engages in originating, financing, and managing commercial mortgage loans and other commercial real estate debt investment. Only going public back 2009, Starwood has continually grown its book value as well as revenues through careful loan origination. Shareholders have been rewarded as well with Starwood’s hefty 7.4% yield. Additionally, both Apollo Commercial Real Estate Finance (NYSE:ARI) and iStar Financial (NYSE:SFI) represent a higher yield play and a turnaround opportunity, respectively.

The Bottom Line
Things are looking up for loans tied to commercial real estate mortgages. Delinquencies continue to drop, while refinancing opportunities have lowered debt-service coverage ratios. All in all, that’s not a bad deal for investors. For those looking to add some extra yield to a portfolio, now could be a good time to add some CMBS bonds. The previous picks are ideal ways to play the sector.

Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.

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