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Does public commercial real estate (CRE) represent a risk, an opportunity, or both? The answer may depend on investors’ goals and constraints. In this piece, we explore the implications of the ongoing stress in the public CRE debt, or commercial mortgage-backed securities (CMBS), space for investors. Earlier this year, we shared our views on the commercial real estate space amid US banking-sector turbulence. Now, we explore how today’s challenges impact ratings-constrained insurers and identify areas of potential opportunity for unconstrained investors.
We expect that CMBS credit bonds, particularly those with higher exposure to offices and challenged metropolitan statistical areas, such as San Francisco and Los Angeles, are headed for declining ratings from both the rating agencies and the National Association of Insurance Commissioners (NAIC) in the coming quarters. We believe this has already been partly reflected in pricing, with segments of both the CMBS conduit credit and CMBS single-asset single-borrower (SASB) markets pricing in dire outcomes.
This has created and will continue to create challenging decisions for insurers trying to underwrite the risk in these securities, balance locking-in realized losses, anticipate ratings action, and deal with this exposure across both their public and private CRE portfolios. It’s worth noting, however, that even with this negative backdrop, the capital markets are still open for most property types. The exception is among offices, an area in which access to capital is in question. In fact, we would argue that we’re in an office CRE recession.
It may be prudent for insurers to reduce risk in their portfolios in anticipation of rating agency actions in favor of bonds with strong fundamentals that are more likely to withstand some volatility. It’s important to remember, of course, that tolerance for risk or downgrades may vary among insurers, and many bonds that are good sale candidates for some portfolios can be equally good buy candidates for more opportunistic, ratings-agnostic investors with the ability to invest with a loss-adjusted-yield framework. It’s our expectation that as revised NAIC scenarios are announced, some insurers may reduce exposure as rating agency actions hit and capital charges increase to hold these securities. This said, it’s still early days for insurers shedding risk in CMBS. We expect to see more price declines from here in CMBS credit bonds.
While investors will do well to be aware of the pressure facing ratings-constrained mandates, opportunities may exist as well. For example, consider BBB-rated CMBS, which has high downgrade risk to BB. This has been the worst-performing component of the structured finance sector over the last year. It has significantly underperformed corporates on an excess return basis to the tune of about 1,100 basis points over the 12-month period ending June 2023 as spreads widened significantly (Figure 1).
We believe the market is being overly punitive in many cases by painting the sector with a broad brush. While the work-from-home trend is negative for office spaces, we expect to see more employees returning to work, instances of better workout terms or loan modifications due to idiosyncratic property or sponsor characteristics, or an improved financing environment overall. These factors would delay or mitigate losses within the office-space market and could potentially lead to attractive returns in the high-single-digit/low-double-digit range. It’s also possible that broad rating agency downgrades could lead to forced sales, creating an opportunity to be a liquidity provider in select transactions with attractive valuations relative to fundamentals.
We don’t think this is something investors can capture through buying CMBS “beta,” nor can it be done as a tactical trade in/out. However, for investors who are not ratings constrained and can give liquidity to ride out the storm, this opportunity has the potential to produce high-single/low-double-digit excess returns and even higher total returns. We believe skilled security selection will be critical as the difference in performance between the weakest properties and the strongest ones will become even more pronounced and fundamental credit research could help inform those decisions in the current environment.
Now is a moment to consider the balance between appropriately sizing this allocation in portfolios and being patient with the understanding that the worst may still be ahead for CMBS. In our view, there may be significant opportunities for active managers with deep integrated research and trading teams to add value for clients by exploiting market mispricing of CMBS markets in the quarters and years to come.
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