Riding the unlikely commercial real estate rebound

Posted by Colin Barr
December 20, 2010 6:41 am

For years commercial real estate has been billed as the next big train wreck. So why are some investors shouting all aboard?
A slowly recovering economy is part of it, though no one expects to make a quick killing on loans and securities tied to office buildings, hotels, shopping malls and the like. The bigger drivers of this rally are the low rates pushing investors to reach for yield by taking on more risk, and the wide open junk bond market that has allowed lots of companies once left for dead to refinance loans and trudge forth.
Those trends made commercial real estate debt and commercial mortgage-backed securities, or CMBS, among the top-performing asset classes this year. Buyers aren’t banking on a repeat of the past year’s mega-returns, which were driven by the sector’s stubborn failure to collapse and by a surge in bond prices fueled both by liberal government buying and fear that the economy was turning Japanese.
But at a time when investors feel the powers that be are forcing them to take on more risk, some strong supply-and-demand factors appear to be on CMBS investors’ side, at least if they keep their wits and stick to higher-quality deals.
“Commercial real estate is one of our favorite risk assets,” said Christine Hurtsellers, chief investment officer for fixed income and proprietary investments at ING Investment Management. She said the firm has 10% of assets in whole commercial loans and is also overweight CMBS.
Greg Michaud, who is the head of real estate finance at ING, said CMBS values have been especially aided by loose Federal Reserve policy because they are priced against Treasury bonds, which until recently were trading at yields near longtime lows. The yearlong decline in Treasury yields helped to bring in CMBS spreads as well.
“If you can give it some time, employment will bounce back and then commercial real estate will start rising,” said Michaud. “And you’re getting paid enough that you can afford to wait for a bit, because it’s not going to happen tomorrow.”
No indeed. A recent Deutsche Bank report notes as “headwinds” the continued weakness of household balance sheets, the rising number of underwater mortgages, the lack of corporate pricing power and the unhappy fiscal outlook for all levels of government. So it’s pretty windy out there. Add to that the recent back-up in bond yields, and you have a good, stiff breeze blowing in your face.
“Investors should be cognizant of the impact downside risks could have on their portfolio,” Deutsche Bank analyst Harris Trifon counsels.
Even so, many investors are crossing their fingers and hoping for a low double-digit return in 2011, on the assumption spreads will further tighten. CMBS spreads have narrowed sharply over the past year in part because the worst case scenario widely discussed in mid-2009 failed to materialize, and more of the same is expected for 2011.
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Corey Dwan
Benson Sotheby’s International Realty