'Doomsdays' and Bargains in CMBS

Commercial-real-estate debt has rallied after months of declines, but some fund managers are betting that top-quality securities can still be bought on the cheap. Their reasoning: Prices of top-quality commercial-real-estate debt are still at levels that are wildly out of line. Securities are priced at levels that imply default rates could reach 80%, or even 100%, of their underlying loans, they say. Historically, though, the worst period in the commercial-real-estate debt market saw defaults on those bonds reach roughly 31%. While fund managers concede that commercial real estate is entering a slump, they argue that the doomsday scenario reflected in prices of high-quality securities is unwarranted. "The implied losses are so severe that under any reasonable scenario you can't justify these levels," says Angelo Manioudakis, a portfolio manager at OppenheimerFunds. "There is still huge value." The culprit behind the apparent disconnect, mutual-fund managers say, is the scramble by banks and brokerage firms in recent months to hedge against commercial-real-estate loans made by those firms. That protection comes in the form of selling CMBX indexes, which are baskets of credit-default swaps on commercial-real-estate debt. Hedge funds, sensing an opportunity for a quick profit, piled on the selling with bets that the index would fall, further driving the index down. Thanks to this downward pressure on prices, the spread between U.S. Treasurys and the highest rated, triple-A CMBX soared. For the triple-A series 3 index, which tracked debt issued in mid-to-late 2006, the spread jumped as high as 2.70 percentage points from 0.60 percentage point at the start of the year. This in turn has translated into lower prices on actual securities. This past week, however, there was a steep decline in those spreads. The rally began after players took note that the CMBX indexes barely budged during the Bear Stearns turmoil despite the securities firm's exposure to commercial-real-estate debt. That was followed by reassurances from Lehman Brothers Holdings Inc. and Goldman Sachs Group Inc. about the relative health of their mortgage portfolios, as well as the Federal Reserve's steps to lower interest rates. These events sparked a rush by speculative players to buy back their short positions. Meanwhile, longer-term investors were encouraged by the bounce and also began to buy, players say. As a result, the spread on the CMBX Triple-A series 3 index has fallen to around 1.90 percentage points, its lowest level since late February. Nonetheless, that kind of a reading on the triple-A CMBX indexes implies cumulative default rates on the underlying loans of as high as 100%, players say, depending on the assumptions made for recoveries that would follow defaults. "If every commercial-real-estate loan is defaulting...I would consider a more appropriate hedge to be canned goods, ammunition, livestock," jokes Derrick Wulf, a portfolio manager at Dwight Asset Management Co. That implied level of default would "far exceed any experience that we've ever seen, even during the savings-and-loan crisis," he says. That isn't to say that there aren't big potential problems in commercial real estate. "There was a deterioration of [loan] underwriting quality and eventually that has to come to the surface...and we will see some very large loans experiencing a default," says Bryan Whalen, a partner at Metropolitan West Asset Management, which oversees $25 billion. One challenge for investors is that unlike residential-mortgage-backed securities, which are typically backed by hundreds of loans, it isn't unusual to see a single loan make up 10% of a commercial-real-estate-backed security. That leaves bondholders much more vulnerable to even a small percentage of defaults if they happen to own one that goes bad. Despite the compelling value that commercial-mortgage-backed securities offer, the lack of price stability is keeping many investors on the sidelines. The volatility of the CMBX is making it difficult to track the pricing of the bonds, says Sam Davis, a senior managing director at Allstate Investments LLC, part of insurer Allstate Corp., who manages a $7 billion commercial-mortgage-bond portfolio. Still, fund managers say the numbers just don't add up to warrant such low prices. Oppenheimer's Mr. Manioudakis notes that loans underwritten in 2007 -- a year that he says is "commonly believed to be one of the worst underwritten vintages" of loans -- haven't had as many first-year defaults as some prior episodes. Historic Lowe Default Rate in 2008 Still, fund managers say the numbers just don't add up to warrant such low prices. Oppenheimer's Mr. Manioudakis notes that loans underwritten in 2007 -- a year that he says is "commonly believed to be one of the worst underwritten vintages" of loans -- haven't had as many first-year defaults as some prior episodes. The first-year default rates on triple-A-rated 2007 debt has been 0.09%, Mr. Manioudakis says. Meanwhile, the default rate on loans underwritten in 1974 was 7.1% in their first year, and in 1975 the first-year default rate was 3.04%. Even loans underwritten in 1986 -- which would turn out to be the worst vintage of loans in the markets' history with the 31% lifetime default rate -- had a 0.92% default rate its first year, 10 times as high as the 2007 loans, Mr. Manioudakis says. A layer of protection There is another reason that some say triple-A commercial-real-estate debt is a safer bet than market prices indicate: The securities typically offer a layer of protection that isn't contained in residential-real-estate-backed debt. Most triple-A commercial-real-estate securities have a built-in cushion protecting investors from losses of as much as 30% on the underlying loans. Even after defaults, recovery rates on those loans can easily be 65 or 70 cents on the dollar. Fund managers also argue that there is an important difference between the commercial and residential real-estate markets. "If the market value of a [commercial] property declines, the owner isn't going to walk away from the investment if it's still producing positive income," says Dwight's Mr. Wulf, who has been buying top-tier, shorter-term commercial-real-estate debt with maturities of one to two years. Metropolitan West's Mr. Whalen is taking a cautious view of the commercial-real-estate debt market, especially anything outside the high levels of the capital structure. Still, he says, at recent levels "it's very attractive."