The market for commercial mortgage loans CML has run on tailwinds in the last 10 years with more insurers bringing the asset onto their portfolio than ever before. But, with a looming economic downturn, is the love affair with CMLs about to run out?
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Commercial mortgages close up
Strong returns, stable performance, low risk
The US commercial mortgage loan (CML) market has proven a rich mine for US insurers for the last decade, offering an uptick on returns and a downtick on risk. According to AM Best, the US life industry had $500bn in mortgage loans at the end of 2017 — 11.8% of total invested assets — up from $350bn in 2012, making it the largest allocation to the asset class since 2000.
Indeed, insurers are currently the fourth biggest investor in the market overall with mortgage investments spread across retail, shopping centers, office buildings, factories, hospitals and apartments.
Allocation to CMLs has shown little signs of dropping even as the broader economic environment veers towards a possible downturn in the next years.
With interest rates appearing to have topped out in the short term, CMLs have provided good yield.
"Over the last 10 years we have found significant value in the asset class against public corporate bonds," says Sean O'Connell, senior vice president, head of real estate and alternatives at Securian Asset Management, the asset management affiliate of Minnesota Life. "Our default and loss history over the past 20 years informs our opinion that the risk profile in CMLs is similar to A-rated corporate bonds and yet has generated a significant yield premium over BBB corporates."
Minnesota Life currently has 15.9% of its portfolio in CMLs, up from 11.6% in 2010, and the portfolio has yielded 4.8% over five years compared to 2.5% for the Bloomberg Barclays US Aggregate Bond Index. O'Connell says the market has proven particularly attractive relative to corporate bonds, in particular the BBB category which is the focus of much negative attention these days.
"We think of CML's in conjunction with our opportunities in the BBB corporate market," he says. "We buy BBBs but there comes a time when you already own all the names you want and are only adding to those names as the portfolio grows."
Larger insurers have also been growing their portfolios. MetLife, whose focus is on larger commercial mortgage loans averaging around $100m in size, increased its allocation from around 8% of assets five years ago to 11% now, bringing its total commercial mortgage portfolio to $48bn.
"The asset class provides enhanced returns that are capital efficient in many regulatory jurisdictions," says Lisa Longino, head of insurance asset management, MetLife Investment Management. "Commercial mortgage loans provide diversification of names, risk and liquidity. The secured interest in commercial mortgages provide valuable protections for investors."
Indeed, the protective element of CMLs has been widely trumpeted. According to Gary Otten, head of real estate debt strategies at MetLife Investment Management, credit losses have been extremely small over the last decade. It appears to be borne out by the statistics.
According to the American Council of Life Insurers (ACLI), 99.6% of the mortgages held by life insurers were in good standing in 2017. In the same period only 2% of mortgages had a loan-to-value ratio above 95%, compared to 89% with a loan-to-value ratio below 71%.
The attractive risk/return profile is undoubtedly a draw and insurers have been spreading out their investments across the commercial real estate sector. According to AM Best, office space constitutes the largest share of insurer-held mortgage loans — as it has done for a decade — though allocation has shrunk to 26.3% in 2017 from 29% in 2013. Apartment building allocations, meanwhile, have grown, with investments accounting for 22% of insurers' mortgage portfolios in 2017, compared with 16.8% in 2013.
Retail is the one area to have substantially declined in recent years as the "Amazon effect" — shoppers going online — has scared investors.
"They don't know how far Amazon will go," says one interviewee who asked not to be named. "But we think that retail will always want to get close to the customer. Those types of buildings are well bid and popular."
In recent times a new niche has opened up for the CML market — middle market loans, where average sizes run from $2m to $25m. Schroders set up its US middle market lending business in 2016 and says it has seen explosive growth from insurers in the last two years
"The advantage is taking on smaller loan sizes at additional spread and similar to lower amount of leverage," says Andrew Terry, institutional director, US insurance, at Schroders. "Smaller loan sizes allow investors to own whole loans. We also source direct from borrowers rather than through brokers which means we are less beholden to larger markets."
Terry says the middle market business has increased in geographical diversity and credit quality making this a viable alternative to the normal structure. Meanwhile, from a pure spread perspective, current middle market loans offer 180 basis points (bps) to 240bps over treasuries, which appears attractive against that of larger size CMLs.
It all seems to be holding fair for now. And yet, despite the apparent strengths, concern over a turning credit cycle is seeping through to investor minds.
Commercial property prices hit their highest levels ever this year and are at twice the level of 2000, according to an index published by research company Real Capital Analytics.
At the same time, increased competition for CML deals means that the attractive premiums of the past are being squeezed, leading to potentially more leverage and risk going up on the margins as demand outstrips supply.
CML demand has been principally driven by a wave of new commercial mortgage funds which entered the market post-financial crisis and whose riskier approach has been concerning veteran mortgage investors.
"Higher risk private commercial mortgage funds barely existed before 2010 but have been growing at an incredible pace in recent years, and often with managers who are new to commercial real estate lending," says Otten. "Part of the reason these funds became popular was to fill a void in the bank lending market that Dodd-Frank regulations created. Those regulations have been generally clarified or repealed in recent years and banks and private debt funds are now competing and driving down spreads on higher risk loans."
Otten says the commercial mortgage market is large enough to meet investor demand for the time being. Still, while MetLife has been active in the higher risk commercial lending space in the past, it is generally only investing in the moderate to low risk space today.
Meanwhile, Sun Life's chief investment officer Randy Brown says his company has moved to "core" real estate markets in gateway cities like New York, Boston, San Francisco and Chicago, and shifted to industrials, which may hold up better in case of a market downturn.
Interviewed stakeholders remain hopeful the underlying quality of CMLs will carry the asset through a financial downturn, pointing to the last crisis where CMLs showed dramatically low levels of impairedness, compared to residential loans. All the same caution is urged.
"Real estate underwriting has remained relatively disciplined so far this cycle, with rent growth and vacancy projections both significantly more conservative today than during prior late-cycle points in time," says Otten. "If real estate underwriting standards were to change as the cycle continues to mature, it could reduce our appetite for commercial mortgages."
Standard's micro CML play
Life insurer StanCorp Financial Group (The Standard) is one of the more unusual players in the CML market. The insurer, owned by Japanese mutual insurer Meiji Yasuda, has one of the biggest exposures to commercial mortgages of any insurance company in the US.
Of its $17bn in general account assets, $6.7bn (38%) is allocated to CMLs, managed by its asset management subsidiary, StanCorp Mortgage Investors (SMI).
Its focus is in the micro loan business. Average loan sizes are between $2m to $4m and the company aims to "diversify like crazy" on the smaller loans that others overlook.
"Our niche for mortgage lending is pretty narrow," says Mike Morey, vice president and managing director at SMI. "We are operating in a different world to those types of insurance lenders. We believe we can get excess yield in that niche. Having created an underwriting platform over the last 40 years, we don't compete head to head with the big insurers."
The insurer taps mortgage loans via a broker network it has built over those 40 years and follows a co-investment policy for every loan it originates. On average 45% to 75% of every loan is kept for Standard Insurance, the rest farmed out to a partner investor.
Morey says that while others see small loans as a lot of work, The Standard's commitment to the business has allowed it to develop over time to a specialist in this sector. It currently has 75 people working on CML investment and opened up the business to other insurers in 1996.
"We try and automate much of it but at the end of the day this business needs a lot of people," says Morey. "That's the biggest hurdle for others."
Indeed, the company has some 6000 plus loans on its books currently. The diversification has helped lower risk. The portfolio had a delinquency rate of 0.04% last year.
At the same time, the income stream from CMLs has outperformed other assets on a return basis over time. The company derives 60% of overall net investment income from mortgages even though this is 40% of total assets
"What we give up on the bond side with the higher rated bonds we make up on the mortgage side," says Morey.
Morey says SMI would like to grow its CML business and is being encouraged to do so by its parent in Tokyo. But, at the same time, he is clear the company is not looking at growth for growth's sake.
"CMLs are strong which has gone along with the wider economy," says Morey. "It won't be like that forever which is something we monitor all the time. The prospect of an economic downturn has caused us to adjust — for example, investing less in one kind of property type than another based on what's in the market. But we don't see any immediate emergency."
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