The chief investment officer of one of the world’s largest money managers is warning of further pain for owners of hotels, malls and office blocks across the US, spelling trouble for the $1.2tn market for bonds backed by the mortgages on these commercial properties.
Dan Ivascyn, CIO at California-based Pimco, which oversees $1.92tn in assets, said it has steered clear of riskier debt linked to the sector in favour of securities that are better protected from defaults.
“We are in the midst of a shock. You are going to see elevated losses across commercial real estate debt and equity,” Mr Ivascyn said. “We have avoided lower-rated tranches because they do not trade well during market volatility.”
Hotels and malls are areas of particular concern, he added.
Since the outbreak of coronavirus, hotels have been forced to close their doors. Shopping malls have been deserted. Offices have been thrown into an uncertain future as tenants reassess their needs for desk space. Owners of apartment blocks, having so far weathered the storm, are at risk of tenants failing to pay rent if US government support for the unemployed ends.
Mortgages on these properties are often packaged up into bonds, layered into different slices with varying degrees of sensitivity to defaults by the underlying borrowers. The Covid-19 crisis has turned up the stress throughout the commercial mortgage-backed securities market, as health concerns focus on locations where people gather.
The safest, most highly rated triple-A slices of this debt have bounced back since the sell-off in March that ripped through all areas of financial markets. For that debt, the yield premium that investors demand above benchmark interest rate swaps has returned close to levels seen before the turmoil, in part due to support from the US Federal Reserve.
But the premium on triple-B minus bonds — still considered to be relatively safe assets — remains a hefty 3 percentage points higher than where it started the year, according to data from JPMorgan, as more investors stay away and buyers demand bigger returns to hold the debt.
Investors and analysts note that it would take just 7 per cent of the underlying borrowers in a triple-B rated slice of these instruments to default to leave bondholders with losses.
Analysts at Wells Fargo have suggested that this trigger is likely to be hit. Delinquencies on so-called “conduit” deals, which are backed by pools of smaller mortgages across multiple properties, will rise to between 6.5 per cent and 8.7 per cent, the bank predicted in May.
“The depth and breadth of the coming downturn may weigh more heavily on commercial real estate than did the fallout from the [2008 financial crisis],” the bank’s analysts warned. “Unlike in past crises, broad swaths of properties have been completely shuttered, causing cash flows to plummet.”
Coming into the coronavirus crisis, 96 per cent of the CMBS investments in Pimco’s mutual funds and separate accounts were in the higher-rated, triple-A slices of debt — though it also holds lower-rated bonds in some hedge funds and private accounts.
The manager also opportunistically bought some riskier debt when the sell-off hammered valuations earlier this year, before selling it when the market had recovered some ground.
For a sustained pick-up in the asset class, “you need to see some fundamental improvement in the economy”, said Mr Ivascyn. “You need to see some improvement in the sectors tied most closely tied to the shock, but we just aren’t the most constructive on the macro economy right now.”
In July the proportion of mortgages in CMBS deals that had not been paid for 30 days or more reduced slightly from a near-record 10.3 per cent to 9.6 per cent. The figures are led by delinquency rates of almost 24 per cent for lodging properties — which include hotel loans — and 16.1 per cent for retail, according to data from Trepp.
“Hospitality has been the focus,” Mr Ivascyn said. “It feels the pressure first. We think you need to be cautious in the hospitality space.”
Mr Ivascyn also pointed to the dire performance of some of the large, private equity-managed real estate investment trusts as evidence of investors souring on commercial real estate. Shares in Blackstone Mortgage Trust have tumbled more than 40 per cent from their peak this year, while TPG’s Real Estate Finance Trust has sunk almost 60 per cent.
“We happen to think there is some value in those public positions and there is a little bit of overreaction,” said Mr Ivascyn. “But it is a warning sign that there is significant pain to come in the commercial real estate market. That is what these valuations are telling you.”
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