How do commercial mortgage yields compare with similar risk corporate bonds?

DP: From our experience we have seen the premium over comparably rated corporate bonds to generally be north of 75 basis points and can go up to 150bps based on estimates from our commercial mortgage team. When spreads are tight, that premium might be smaller, but when markets are a bit dislocated we tend to get a better premium and markets will pay more for that risk. 

WP: The 75-150bps premium that David mentioned is compared to single A-rated corporate bonds. Over the last 20 years, we feel commercial mortgage performance has been more in line with single A and double A-rated corporate bonds, which suggests to us that the true outperformance level could be modestly higher.

What types of losses have investors historically realised in mortgage portfolios, based on the experience of recent downturns?

WP: We believe one of the best benchmarks is a data series that we built internally using public filings from the 10 largest US peer insurance companies. That data shows that between 2009 and Q1 2022, the average annual commercial mortgage portfolio has realised 13 basis points of loss per year.

How is the office sector performing, given the rise in working from home?

WP: Office vacancy rates are currently averaging about 17 percent, which is certainly above the 12 percent level that they were at pre-pandemic and much of that increase is due to the effects of working from home, according to CBRE-EA data. Pricing has adjusted and, as a result, we think that, despite the work-fromhome headwinds, there are pretty good opportunities in the sector today. In 2019, we were generally underwriting or assuming a 3 percent average annual market rent growth, and that compares to today when we are considering new deals where we are assuming 2.2 percent average annual rent growth. Spreads are also much better and it is a “lenders market” for office, in our opinion. 

DP: We believe the market is in our favour and we are able to charge appropriately for the risk we are taking, which means we can get an appropriate risk-adjusted return and achieve good relative value compared to other fixed-income products. Since covid there has been some migration of population out of higher cost of business locations into lower cost locations, and that has definitely driven where most of our focus has been over the last three years.

What does mortgage structuring and pricing currently look like?

DP: In the post-covid world, with rising interest rates, things have shifted from the borrower having leverage to the lenders having the leverage. Over previous cycles we have seen that shift happen many times, but it does mean that right now the lenders are in the driving seat to deal with anything in mortgage structuring and pricing, from negotiating loss rollovers to charging a bit more for risk than they were in the past. Between 2015 and 2019, we saw a real shift in structuring terms and pricing in favour of borrowers, but at this point the negotiating power really rests with the lenders when it comes to structuring and pricing to adequately reflect the risks in the market.

Which regions of the country, or cities, currently offer the best real estate value?

WP: We wrote a research report at the end of 2020 called The Pandemic Pitfall, which outlined which of the 30 largest US office markets we thought would be most impacted by remote working, based on employment sectors prevalent in the city, average commute times, and how young or old the labour force is.
Almost two years later, we can now say that those forecasts have been a reliable indicator that the markets have seen both the most and least increases in occupancy levels and rent levels. We are currently favouring quite a few West Coast cities for multifamily, including Seattle, San Jose, Los Angeles and San Francisco. This is due to a mix of factors related to property fundamentals, the age of the average renter, and current market pricing. In retail, we are a little more focused on projected population growth than we were in the past as we think this measure will more directly and immediately benefit from the high inflation environment the US has been in. This has led us to favour a number of sunbelt markets, especially in the south-east, such as Miami and Palm Beach.

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