Commercial mortgages have long been an attractive asset class for institutional investors, with excess liquidity, who are seeking to safely enhance the yields in their fixed income portfolios.
Commercial mortgage funds invest in pools of commercial mortgages on behalf of their investors. They can be structured as open-ended funds, that permit withdrawals, or as closed-ended funds, that are locked in over the life of the fund. The returns are the interest payments received from the mortgages held in the fund, as well as capital gains (or losses) on those mortgages as a result of changes in interest rates, mortgage spreads, and overall credit performance of the mortgage.
Mortgage funds often fall into three categories: core, core plus, and high yield. Core funds are core loans (highly occupied buildings) and offer yields in the range of 2.5 to 4.5 per cent. Core plus loans also have reasonable occupation levels, however, they may incorporate value-added construction projects to increase rental yields. The yield on a typical core plus portfolio ranges from four to six per cent.
These portfolio will typically have a conservative loan-to-value (LTV) ratio, commercial mortgages have long been an attractive asset class for institutional investors, with excess liquidity, who are seeking to safely enhance the yields in their fixed income portfolios.
Commercial mortgage funds invest in pools of commercial mortgages on behalf of their investors. They can be structured as open-ended funds, that permit withdrawals, or as closed-ended funds, that are locked in over the life of the fund. The returns are the interest payments received from the mortgages held in the fund, as well as capital gains (or losses) on those mortgages as a result of changes in interest rates, mortgage spreads, and overall credit performance of the mortgage.
Mortgage funds often fall into three categories: core, core plus, and high yield. Core funds are core loans (highly occupied buildings) and offer yields in the range of 2.5 to 4.5 per cent. Core plus loans also have reasonable occupation levels, however, they may incorporate value-added construction projects to increase rental yields. The yield on a typical core plus portfolio ranges from four to six per cent.
These portfolio will typically have a conservative loan-to-value (LTV) ratio, below 70 per cent. This ratio is a measure of safety, which reflects the total mortgage loan balance, divided by the total appraised value of the properties. If a mortgage has a 70 per cent loan-to-value ratio, the property value can fall by 30 per cent before the first dollar of collateral is at risk, in the event of a mortgage default.
In contrast, a high yield mortgage fund will typically hold a riskier portfolio of mortgages, which may include construction loans, short-term bridge loans, and value-added loans for buildings that have low occupancy levels and may require significant construction to increase occupancy levels and rental yields. A high yield portfolio will often have a higher proportion of second priority mortgages and a higher loan-to-value ratio (often in excess of 75 per cent). In exchange for assuming more risk, investors are compensated with higher yields, typically in excess of eight per cent.
The benefits of commercial mortgage funds include:
Attractive Interest Rates – Commercial mortgages offer higher yields than traditional bond funds. Current yields on Canadian universe bond funds are in the range of two to three per cent, compared to three to six per cent in core/core plus funds.
Safety – Commercial mortgage loans are backed by commercial properties. If the borrower defaults on a payment, the lender can look to the property to satisfy the loan principal and any outstanding interest payments. This feature provides mortgage investors with more safety than a traditional bond. Unlike direct real estate ownership, this protection is obtained without direct real estate equity exposure, thereby reducing the portfolio’s exposure to fluctuations in the real estate market.
Less Interest Rate Sensitivity – The duration (or interest rate sensitivity) of commercial mortgage portfolios tends be lower than most traditional bond funds. This provides better relative protection against the inevitable rise in interest rates. Some funds utilize variable rate mortgages, which have floors to protect against unexpected market corrections. The interest rates paid through variable rate mortgages adjust upwards, as rates rise, to help the portfolio in rising interest rate environments.
The Coronavirus Experience
We can see the benefits of these mortgage fund characteristics in the recent coronavirus induced market correction. COVID-19 closures caused a spike in volatility and a sharp correction in equity markets globally in the first quarter of 2020. Business closures and province wide lockdowns resulted in a sharp drop in demand for goods and services and a sharp reduction in the value of most risk asset classes. At the lowest point in the correction, the S&P 500 lost 34 per cent of its value and the TSX lost 37 per cent of its value (although markets rebounded by the end of the year).
Canadian mortgage fund performance for the first quarter was negatively impacted by the COVID-19 correction, but less so than most public market asset classes. The median first quarter 2020 performance among Canadian mortgage funds was approximately 0.4 per cent. Over the course of the year, they performed strongly, with a median annual return of around five per cent. Some funds experienced payment deferrals on certain mortgages, which may have hurt performance. However, most, particularly those with longer durations, benefited from the drop in the Canadian yield curve.
Factors that helped mortgage funds successfully navigate through the crisis that should be considered when selecting a commercial mortgage manager include:
Diversification – Generally, a portfolio well diversified by location and property type can avoid overexposure to any one risk. The COVID-19 market disruption impacted certain sectors more than others. Hospitality and retail sectors have come under more pressure than other sectors and over the coming months, we can expect the downtown office sector to come under pressure, as companies re-evaluate their long-term space requirements. Portfolios that were better diversified by property type and region were less impacted by some of these trends.
Underwriting process – A disciplined underwriting process that selects loans with conservative loan-to-value ratios and strong debt service coverage ratios will help to improve the portfolio characteristics and better protect the portfolio in a market disruption. Similarly, negotiating strong loan covenants, such as full recourse to the borrower or an interest reserve to ensure that payments can be made, will also help to control risk. Furthermore, borrowers that own a range of properties in different sectors are often better able to withstand a downturn.
The activity level of the portfolio – Many mortgage funds utilize a buy-and-hold strategy, which provides a more stable portfolio over time, but may limit the ability of a portfolio to reposition in order to address changing market dynamics. Certain managers employ a more active strategy, which enables them to trade existing mortgage holdings as opportunities arise. This can help the manager increase the value added over the course of a market cycle and offer some flexibility to reposition their existing portfolio in the face of unexpected headwinds.
Utilization Of Mortgage Funds
Historically, pension funds and foundations have treated mortgages as a component of their fixed income allocation. In the current environment, these investors are looking for safe ways to enhance the yields on their fixed income portfolios. Mortgage funds are typically less liquid than bonds, which trade daily. In contrast, open-ended mortgage funds typically offer only monthly or quarterly liquidity. However, most pensions and endowments have excess liquidity due to the long-term nature of their obligations. A direct allocation to commercial mortgages can enhance fixed income yields, while maintaining a similar risk profile. The security of the mortgage provides better long-term protection than most corporate bonds. At the same time, those with lower durations can also reduce the yield curve sensitivity of the fixed income portfolio.
In the current environment, plan sponsors may also choose to allocate a portion of their alternatives allocation to mortgages. Mortgages may be considered a preferred substitute for a portion of direct real estate allocation within the alternative bucket.
Historically, real direct estate has offered attractive and stable yields, generated from rents, with low correlations to traditional asset classes. The five-year annualized return for real estate on the MSCI/REALPAC IPD index was 6.4 per cent, as of December 31, 2020. For the typical institutional real estate fund, approximately two-thirds of that return was income and the other third capital gains from property valuations. Going forward, if we assume that rents will remain unchanged, we can expect a continued income of around four per cent in these funds. However, as commercial property prices continue to adjust to post-pandemic demand, we may begin to see significant capital losses emerging in real estate portfolios.
Median Canadian institutional mortgage fund returns over the last five years have been approximately 3.75 per cent. Unlike in real estate funds, most of this return is generated from income (interest payments on the underlying mortgages). By avoiding direct ownership in these properties, mortgage funds should avoid much of the negative impact of the real estate market correction.
In a COVID-19 embattled market, commercial mortgages have re-affirmed their role as a safe way to enhance portfolio yields. In a persistent low interest rate environment, commercial mortgages should be readily considered by investors looking to enhance the yield in their fixed income portfolio or those looking for an alternative to direct real estate exposure.
BPM By Colin Ripsman (LL.B., MBA)
is president of Elegant Investment Solutions, Inc.
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