Commercial mortgage returns are driven by different factors than corporate bonds or stocks—and those differences have important implications for investors. For starters, real assets including real estate actually benefit from inflation. Moreover, although real estate prices have moderately declined in recent quarters, commercial mortgage borrowers generally use 30% to 50% down payments,1 creating a cushion against value declines. These factors have been important to investors, as new research from MetLife Investment Management (MIM) shows that over time commercial real estate loans have delivered less volatility and higher risk-adjusted returns than many other major asset classes.2 Yet for all these appealing attributes, many institutional investors have largely ignored this asset class.
“While some segments of the institutional investing community have invested in commercial mortgages, many institutional investors are underexposed,” says William Pattison, head of real estate research and strategy at MIM. “On an aggregated basis, just 8%-9% of institutional assets are in real estate,3 while our research suggests that to optimize risk-adjusted performance many portfolios could benefit from 15% exposure.”
Pattison says in recent years leaders in the commercial mortgage space have improved their underwriting and risk management processes, including how they evaluate the distinct risks in different economic environments. Today, Pattison says high inflation is supporting income from properties to service debt, but high interest rates are pressuring property values and leading investors toward properties with lower leverage.
Risk management
In the 1980s and early 1990s, the quality of commercial mortgages held by publicly traded life insurance companies was similar to BBB-rated corporate bonds, according to MIM’s analysis of public filings. Currently, commercial mortgages held by publicly traded insurance companies are more comparable to single-A rated corporate bonds. This improvement is due to careful analysis of credit quality, underwriting and risk management.4
Still, MIM’s research has shown significant distributions in results among different insurers and banks. Between 2009 and early 2022, annualized losses ranged from 0.04% to 0.24% among 10 major publicly traded life insurance companies.5 Meanwhile, the weighted average loss for banks was larger, at 0.57% during the same time period.6
“While some segments of the institutional investing community have invested in commercial mortgages, many institutional investors are underexposed.”
— William Pattison, Head of Real Estate Research and Strategy, MetLife Investment Management
Pattison says the range of outcomes illustrates the importance of selection of assets, markets and the application of effective risk management processes. He notes that one key is to have local teams on the ground evaluating loan candidates, rather than relying on third parties. A second key is to look at how the economic cycle affects risk: Identifying the most risky loans requires considering the particulars of what’s happening in the economy.
During the recession following the tech bubble, property values remained stable but incomes fell, and debt service coverage ratios—which measure a borrowers’ income to cover loan payments— were highly correlated with mortgage losses.7 Later, during the financial crisis and recession, property values lost nearly 30%, and loan-to- value metrics were more closely tied to losses.8
In today’s market, Pattison says high rates are pressuring property values, which necessitates careful evaluation of leverage when considering loans and potentially less emphasis on debt service coverage ratios. He expects that property values will continue to fall during the coming months, but that we may see the trough during the summer of 2023.
A $5 trillion market
At roughly $5.2 trillion, the commercial mortgage market is a little more than half the size of the corporate bond market. Despite its scale, many institutional investors have limited holdings.
In years past, the commercial mortgage market may have appeared opaque and required significant resources to access. But as the market has evolved, new investment products have made it easier for institutional investors to evaluate and gain exposure to this asset class.
MIM research shows that commercial mortgages have actually delivered higher returns and lower volatility than government bonds or A-rated corporate bonds.
Commercial real estate performance has little to no correlation to other major assets, with the exception of commercial mortgage-backed securities. From 1998-2021, the average correlation of commercial mortgages to other major asset classes was 0.25.10 Lower correlations mean commercial mortgages have the potential to improve the overall risk-adjusted performance of a large institutional portfolio.
The low correlation between commercial mortgages and corporate bonds is due in part to the fact that corporate bond performance is driven by the issuing company and economic growth. Real estate returns, on the other hand, tend to be driven by inflation and employment. Also, commercial mortgages are secured by real assets, which has meant higher recovery rates and lower loss rates relative to public corporate bonds.
In 2022, the different drivers of returns were notable as bonds and stocks both experienced losses while commercial mortgages delivered strong results.11 Pattison says one reason inflation helps real estate is that it slows down the construction pipeline, given higher cost of construction inputs, limiting supply. Higher interest rates seen now could also limit supply by making construction loans more costly and support prices for the next several years.
Going forward, Pattison expects inflation to normalize. Still, the decreasing supply of new commercial real estate could support rents and property values for years. He says he expects some of the COVID-era trends to reverse, with more businesses and workers heading back to New York City and other major hubs. For investors, careful loan selection could help them tap into the advantages of commercial real estate as these trends unfold.
Sources
1. ACLI Investment Bulletin: Commercial Mortgage Commitments Q4 2022.
2. “Investment Opportunities in Private Commercial Mortgage Investment,” MetLife Investment Management, October 11, 2022.
3. Federal Reserve Selected Assets and Liabilities of Commercial Banks in the United States. ACLI Invested Assets Portfolio Profile 2020. PREA Investor Report 2017. 2021 NACUBO-TIAA Study of Endowments.
4. Morgan Stanley Fixed Income Research, “Commercial Mortgage Defaults: 30 Years of History,” September 2004, and Berkshire Investment Advisors, “Fixed Income Investment: The Commercial Mortgage Alternative,” September 1993.
5. MIM analysis of publicly available SEC filings of 10 insurers.
6. Federal Reserve Selected Assets and Liabilities of Commercial Banks in the United States. ACLI Invested Assets Portfolio Profile 2020. PREA Investor Report 2017. 2021 NACUBO-TIAA Study of Endowments.
7. MIM, NCREIF, Moody’s, Lifetime loss by year underwritten, or vintage. Value and income losses based on NCREIF data.
8. MIM, NCREIF, Moody’s, Lifetime loss by year underwritten, or vintage. Value and income losses based on NCREIF data.
9. The commercial mortgage data shown comes from the Giliberto-Levy Commercial Mortgage Performance Index which models senior commercial mortgage performance based on the American Council of Life Insurers (ACLI) commitments data and is most comparable to the single-A rated corporate and CMBS universe. The commercial mortgage loss data is collected from publicly available SEC filings from life insurance companies. While the commercial mortgages held by these publicly traded life insurance companies have a single A corporate credit risk profile, on average, they also hold below investment grade mortgages as well as subordinated commercial mortgages which are below investment grade.
10. The indices used for each asset class are: Commercial Mortgages, Giliberto-Levy Commercial Mortgage Performance Index which is comprised of fixed-rate commercial mortgage loans held on balance sheets of institutions such as life insurance companies and pension funds; Government Bonds, Bloomberg U.S. Treasury Index; Bloomberg Single-A rated Corporate Bond Index; Core Equity Real Estate, NCREIF Property Index (NPI); Stocks, S&P 500 Total Return Index; Commercial Mortgage- Backed Securities, Barclays Capital U.S. Investment-Grade CMBS Index, Private Equity, Cambridge Associates LLC U.S. Private Equity Index; Hedge Funds, HFRI Hedge Fund Index; International Stocks, MSCI EAFE Index. Data is from 1997Q1- 2022Q1. 1997 is used as a starting point as it was the first time data was consistently available across these asset classes.
11. Bloomberg
12. The indices used for each asset class are: Commercial Mortgages, Giliberto-Levy Commercial Mortgage Performance Index which is comprised of fixed-rate commercial mortgage loans held on balance sheets of institutions such as life insurance companies and pension funds; Government Bonds, Bloomberg U.S. Treasury Index; Bloomberg Single-A rated Corporate Bond Index; Core Equity Real Estate, NCREIF Property Index (NPI); Stocks, S&P 500 Total Return Index; Commercial Mortgage- Backed Securities, Barclays Capital U.S. Investment-Grade CMBS Index, Private Equity, Cambridge Associates LLC U.S. Private Equity Index; Hedge Funds, HFRI Hedge Fund Index; International Stocks, MSCI EAFE Index. Data is from 1997Q1- 2022Q1. 1997 is used as a starting point as it was the first time data was consistently available across these asset classes.
Disclaimer
This material is intended solely for Institutional Investors, Qualified Investors and Professional Investors. This analysis is not intended for distribution with Retail Investors.
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