March 23, 2008

Commercial Real Estate Debt

I have been writing about how irrational debt market is and how panic stricken it became, see my posts here and particularly about commercial real estate debt, see my posts here and here.

There are a lot of opportunities in debt due to the out of whack risk adjusted spreads on debt instruments. Investors stopped accepting risk and are avoiding uncertainty at all costs. However, successful investing, in my mind, is about accepting sufficient returns for risk in face of uncertainty. Now investors are accepting no returns or negative real returns, in case of treasuries, to avoid economic uncertainty. And that is creating several investing opportunities.

To zero in some of these opportunities, I will focus on the commercial real estate debt (CMBS) market. The irrationality in the pricing of these instruments and their credit default swaps, insurance against default of the debt, are perfectly illustrated here. Currently some of the most senior and triple AAA rated debt requires $170-200 of insurance premiums for each $100 of principal over the life of the debt. Lower rated bonds are trading at much higher spreads, ridiculously higher spreads, see the chart from Markit Group.

The market implicitly is saying that none of the commercial debt will make it to maturity and betting that they can collect on the swap sometime within the next few years, most CMBS debt is amortized over 10 years. To those buying credit protection, it is no longer a matter of if, it is a matter of when. An investor seeking a 10% return on a short position would, at current levels, need all 25 bonds underlying the CMBX index to lose all principal within 4 years.

But what kind of an economic realty will produce such default rates? In such an environment it means that most tenants of retail and office properties will have to stop paying rent in sufficient amounts to make the debt default, or a major economic catastrophe where most tenants are out of business.

Moreover, subordination levels on the super-senior tranches of CMBS deals typically run at 30%, a multiple of what the rating agencies require for their highest credit ratings. With 30% of subordination, the deal could suffer a cumulative default rate of 75% and average loss severities of 40% – well above the norm – before any dollar of principal would be at risk. To put it in perspective the current default rate on the average CMBS had a cumulative loan default rate of just under one tenth of one percent, and zero cumulative losses. The market is pricing in excess of 50% default rates and losses on the debt; this scenario have a low to zero chances of occurring.

Investors are confusing the residential debt market with the commercial real estate market sufficiently to anticipate a repeat of the problems of subprime in commercial real estate. The fact is the economics of the two markets are entirely different. I have discussed those economics in a previous post and defer you to it to understand my rationale.

I am actually somewhat bearish on Commercial real estate economics. The fundamentals are currently good but will deteriorate with a slowing economy sufficiently to increase default rates but nothing close to what the market is pricing. Once the "deleveraging" of the system is finished, some of those spreads have to narrow and once the clouds of the doom and gloom or uncertainty is cleared, CMBS prices will shoot up as investors will seek real returns on their capital. And that's why I see an opportunity in the the CMBS debt.

However for the retail investor to buy outright CMBS debt is a very difficult endeavour. I am currently searching for closed end funds with enough focus and good quality assets to invest in but so far I have not find any. If you have any names pass them along and I will review them here.

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