Commercial mortgage REITs are well-positioned to take advantage of increased borrower demand and the upcoming wave of maturing commercial property loans, although some risks remain.
“Demand for commercial real estate loans, as reported by the Fed, is as strong as it's been since 1998,” says Calvin Schnure, NAREIT's vice president for research and industry information.
In fact, the January 2012 “Senior Loan Officer Opinion Survey on Bank Lending Practices” conducted by the Federal Reserve Bank reported that 39.3 percent of respondents said demand for commercial real estate loans was moderately strong during the fourth quarter. The change was more notable for large banks — 47.1 percent reported that demand surged during that period.
“Commercial mortgage REITs have an opportunity to really capitalize on the maturity wall and to receive an attractive return on their investments,” says Stephen Laws, a mortgage REIT analyst with Deutsche Bank Securities Inc.
Defining Commercial mREITs
There are 26 mortgage REITs in the FTSE NAREIT Index, and nine commercial mortgage REITs.
Commercial mREITs account for only 10 percent of the total mREIT universe based on market cap. Starwood Property Trust (Ticker: STWD) is the largest, with a market cap of $1.8 billion, while Capital Trust (Ticker: CT) is the smallest with a market cap of just over $55 million.
Commercial mREITs invest in a combination of commercial mortgage assets. They either originate their own loans or purchase distressed loans and commercial mortgage-backed securities (CMBS). Unlike residential mREITs, commercial mREITs are largely focused on taking credit risk as opposed to interest rate risk.
So far this year, mREITs have performed well. The total return as of Jan. 31, 2012, for all mREITs was 7.21 percent. However, the past several years have been difficult. For the one-year period ending Jan. 31, 2012, they recorded a total return of -6.54 percent, compared to 11.29 percent for all REITs and 3.78 percent for all mREITs, according to NAREIT. And, their total returns for the three- and five-year periods were pretty awful - primarily because of the credit crisis and problems with non-performing loans because property values took a hit. (See chart, page 67.)
Commercial mREITs are one of the most complex sectors within the REIT world, making it difficult for both advisors and investors to understand the risks. Moreover, disclosure in this sector has historically lacked transparency; fortunately, newer REITs are disclosing more information about their operations.
Weighing the Risks
Consider the following factors:
Commercial property performance
When commercial property valuations and operating performance (i.e. occupancy and rental rates) take a hit, owners have trouble paying their mortgages. The REITs' loan portfolios take a beating.
High leverage
Legacy commercial mREITs were highly leveraged through a mix of securitized financial instrtuments. Since the securitization market is mostly inactive, today's REITs have less leverage.
Underwriting
Today's commercial mREITs are better at underwriting risk for their investments, using in-place cash flow and current valuations. Previously aggressive underwriting used projections and inflated values; they stumbled when property values cratered.
Quality of loans
The amount of risk a commercial mortgage REIT takes on each loan investment is tied directly to the quality of the borrower, the quality of the assets, and the REIT's position within the loan structure.
In particular, commercial mREITs are vulnerable to property value variations.
“The biggest risk to these companies is if we haven't hit bottom in terms of property values, and there's another decrease,” Laws says. “In that case, it might be too early to deploy capital.”
Changing Markets
While acquisition activity in the commercial real estate sector has been slow in recent years, commercial mREITs have an opportunity to lend to borrowers who have properties with loans that are maturing and need refinancing.
However, Laws doesn't expect property values to decrease. Moreover, he points out that today's commercial mREITs have better underwriting standards and the added cushion of lower LTVs.
In fact, many commercial property loans have already “matured,” but borrowers were able to work with their lenders to postpone the need to refinance given the upheaval in the debt markets. The commercial real estate industry dubbed this action “extend and pretend” because it gave both borrowers and lenders some extra time for property valuations to rebound and for bank balance sheets to improve.
However, experts say the “extend and pretend” days are coming to a close. The capital markets have thawed enough that borrowers do have options, although they must deal with more stringent loan-to-value (LTV) parameters. For example, most senior mortgage lenders are unwilling to provide loans above 70 percent LTV, forcing borrowers to either find additional equity or slot in mezzanine money to fill the gap in the capital stack.
Commercial mREITs not only originate first mortgages, they've become active in mezzanine finance, creating new opportunities for growth. In addition, many maturing loans are CMBS, and the CMBS lending market is not as active as it was before the credit crisis. That translates into additional opportunities for commercial mREITs, according to Boyd Fellows, president and director of Starwood Property Trust. “Borrowers who previously looked to the CMBS markets for capital are now forced to look for balance sheet loans,” he says.
In fact, Wells Fargo estimates about $350 billion in commercial property loan maturities in 2012 alone and a shortfall of about $178 billion primarily because of decreased LTV parameters. Of that total, roughly $55 billion is CMBS loans. By 2017, roughly $1 trillion of commercial real estate loans will mature.
“For us, real estate values have been pushed down to the point that it makes the risk-adjusted return disproportionately high,” Fellows says.
Even better, competition from other lenders is muted, allowing commercial mREITs to cherry-pick assets for which they want to provide loans.
“Commercial mortgage REITs are taking on loans for a sector that is lagging the overall economic recovery,” Schnure points out. “But, remember the banker's adage: best loans are made during the worst times.'”