Mortgage-Backed Securities Popularity Grows: Report

While in the past CMBS were the favorite of insurance companies, investment banks, hedge funds and money managers are diving into the sector, attracted to its compelling risk adjusted returns, according to the report by Lend Lease Real Estate Investments.

Growing Investor Base

The investor base have continued to grow, particularly due to changes in ERISA regulations in late 2000, which allowed pension plans to invest in all investment grade CMBS, not just AAA rated ones.

The report, Fixed Income Portfolio Enhancers: Commercial Mortgages and CMBS, notes that in mid-2000, private pension assets totaled $5.1 trillion, $774 billion of which was invested in credit market instruments.

A 1% increase in that figure would translate into an incremental demand of $7.7 billion, compared with the year?s new supply of AA- through BBB rated CMBS totaling $6.9 billion.

While the report expects the up-tick in investment by pension funds in these lower-rated assets to be gradual, the asset class can only benefit from the increase in investor base.

Capital market exposure has made its mark on the commercial mortgage market, particularly in terms of pricing, liquidity, underwriting standards and transparency of information, making the instruments more attractive to institutional investors.

Structural Changes

Investors increasingly compare CMBS pricing to other traditional fixed income securities. If the latter is more attractive, the demand for CMBS declines, driving up the yield for commercial loans since less capital is flowing into the market, and vice versa.

When non-real estate related factors affect the pricing of mortgages, disconnects can occur between their pricing and their fundamental value. These disconnects can lead to long-term investment opportunities.

Furthermore, liquidity has improved in both the primary and secondary markets, with AAA rated CMBS typically trading within a 50 basis point bid/ask spread, according to the report.

Stricter underwriting standard have improved the risk/return profile of today?s commercial mortgage market. Agencies rating these securities now calculate a property?s cash flow based on the lower of contractual rents in place or market rents, and not based on prospective cash flows, which was often the case in the past.

Lastly, exposure to the capital markets and advances in technology have led to an increase in the availability of property performance information and market data, increasing the transparency of these securities.

These structural changes have altered the risk/return profile of commercial mortgages and made the sector an attractive alternative to other fixed-income investments.

Risk Return

The report notes that, on a risk adjusted basis, the returns on CMBS compare well with those of traditional debt instruments because:

• real estate assets operate on a different business cycle, diversifying credit risk in a portfolio, and
• credit risk within the commercial mortgage portfolio is further diversified by geography and tenant credit risk.

– Camilla Klein editors@plansponsor.com

The complete report can be viewed at the Lend Lease Real Estate Investments site