Colin Barr

Following the money in banking, economics, and Washington

Riding the unlikely commercial real estate rebound

December 20, 2010: 6:41 AM ET

For years commercial real estate has been billed as the next big train wreck. So why are some investors shouting all aboard?

A slowly recovering economy is part of it, though no one expects to make a quick killing on loans and securities tied to office buildings, hotels, shopping malls and the like. The bigger drivers of this rally are the low rates pushing investors to reach for yield by taking on more risk, and the wide open junk bond market that has allowed lots of companies once left for dead to refinance loans and trudge forth.

All aboard the CMBS express?

Those trends made commercial real estate debt and commercial mortgage-backed securities, or CMBS, among the top-performing asset classes this year. Buyers aren't banking on a repeat of the past year's mega-returns, which were driven by the sector's stubborn failure to collapse and by a surge in bond prices fueled both by liberal government buying and fear that the economy was turning Japanese.

But at a time when investors feel the powers that be are forcing them to take on more risk, some strong supply-and-demand factors appear to be on CMBS investors' side, at least if they keep their wits and stick to higher-quality deals.

"Commercial real estate is one of our favorite risk assets," said Christine Hurtsellers, chief investment officer for fixed income and proprietary investments at ING Investment Management. She said the firm has 10% of assets in whole commercial loans and is also overweight CMBS.

Greg Michaud, who is the head of real estate finance at ING, said CMBS values have been especially aided by loose Federal Reserve policy because they are priced against Treasury bonds, which until recently were trading at yields near longtime lows. The yearlong decline in Treasury yields helped to bring in CMBS spreads as well.

"If you can give it some time, employment will bounce back and then commercial real estate will start rising," said Michaud. "And you're getting paid enough that you can afford to wait for a bit, because it's not going to happen tomorrow."

No indeed. A recent Deutsche Bank report notes as "headwinds" the continued weakness of household balance sheets, the rising number of underwater mortgages, the lack of corporate pricing power and the unhappy fiscal outlook for all levels of government. So it's pretty windy out there. Add to that the recent back-up in bond yields, and you have a good, stiff breeze blowing in your face.

"Investors should be cognizant of the impact downside risks could have on their portfolio," Deutsche Bank analyst Harris Trifon counsels.

Even so, many investors are crossing their fingers and hoping for a low double-digit return in 2011, on the assumption spreads will further tighten. CMBS spreads have narrowed sharply over the past year in part because the worst case scenario widely discussed in mid-2009 failed to materialize, and more of the same is expected for 2011.

"A year or two ago these were priced for the second Depression and then some," said Arne Espe, vice president of fixed income research at USAA Investment Management in San Antonio. "We haven't seen the huge defaults a lot of people were expecting."

Bank of America analysts say the high-yield default rate should fall to 2% in 2011 from 13% or so at the worst of the 2008-2009 crisis. Meanwhile high-yield issuance could hit $300 billion, in line with this year's record performance.

Yet CMBS issuance remains deeply depressed, an artifact of the near total collapse of this market after the bust of 2007. New bond sales are expected to rise for the second straight year to a range of $40 billion to $50 billion, yet are likely to remain some 80% below the 2007 peak. As long as the bond market stays open, it appears there will be deals to be had.

No one can guarantee the slow moving commercial real estate recovery won't jump the track, obviously. Deutsche Bank's Trifon warned this month that while banks have managed to slash commercial real estate exposure by $150 billion over the past 15 months, the sector still poses "a systemic risk to the banking system if the economic recovery falters."

What's more, the flood of high-yield issuance creates the prospect of a refinancing cliff in coming years. Deutsche Bank points to $700 billion of high-yield refinancing obligations coming due this year, though it sees that sum as eminently manageable.

Less optimistically, Moody's warned in a recent report that while the wave of extend-and-pretend deals in high-yield land "has allowed many to avoid default and continue to ride out the halting economic recovery, it has built a towering debt obligation in the years ahead."

That doesn't sound healthy. Even so, some bond buyers say the deleveraging and property price declines of recent years make both commercial loans and CMBS a decent relative value at a time when value plays are few and far between.

"With low yields, people are sniffing around everywhere," said Espe, who helps run funds including the USAA Cornerstone (USCRX) fund, which invests up to a fifth of its money in real estate related plays. "There is some risk, but it is hard to stress super seniors enough to lose money."

And while it may seem like everyone and his brother is piling into high-yield this and mortgage-backed that, the lesson to skeptics from the past decade is that the market can stay irrational far, far longer than you can stay solvent.

"Yes, I'm worried about herding," said Espe. "But I think the move into these assets is just beginning to happen."

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About This Author
Colin Barr
Colin Barr
Senior Writer, Fortune

Colin Barr has covered finance for Fortune.com since November 2007. Previously he was a writer and editor for TheStreet.com, winning a 2006 Society of American Business Editors and Writers award for "The Five Dumbest Things on Wall Street," and for Dow Jones Newswires. He is a 1991 graduate of Penn State and lives in Port Washington, N.Y., with his wife Meena Bose and their two kids.

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