What is the right approach to CMBS?

Securitised real estate debt has been battered by the covid-19 pandemic. Now institutional managers must decide what to do about it.

Commercial mortgage-backed securities are at a crossroad. As covid-19 causes delinquencies to rise within these conduits and their valuations to fluctuate, it is worth questioning their appeal to institutional capital.

This month, two New York-based firms made headlines in this sector. Private equity giant KKR closed its second fund targeting subordinated CMBS on $950 million and private equity real estate titan Blackstone announced a plan to wind down Blackstone Real Estate Income Fund, a dedicated platform for investing in securitised real estate debt.

Blackstone has remained an active buyer of new-issue CMBS, to the degree that market has come back to life in recent months, PERE understands, so it is by no means in full retreat from the asset class. But, as private real estate’s biggest landlord, its decision to sunset even a small CMBS platform on the heels of one of the sector’s worst two-quarter stretches is noteworthy.

Certainly, CMBS conduits have borne the brunt of real estate debt distress during the covid-19 pandemic. Delinquency rates on lodging and retail loans within these structures have skyrocketed as coronavirus-induced shutdowns put hotels and shopping centres in a chokehold. Overall delinquency is just two basis points off 2012’s record high of 10.34 percent, according to the data firm Trepp, a hurdle it will easily clear before all is said and done. Unsurprisingly, just $9 billion of private-label CMBS was issued last quarter, the weakest showing in eight years.

Meanwhile, listed debt vehicles that used CMBS as leveraged liquidity instruments were burned when banks suddenly wrote down the value of those securities this spring. Scrambling to pay down margin calls, groups such as TPG’s RE Finance Trust lost hundreds of millions of dollars on forced sales that all but liquidated their real estate securities portfolios.

Challenges for both CMBS borrowers and investors are likely to continue until covid-19 is resolved. Yet, the outlooks for other real estate debt sources are not much better. Private funds closed only $4.4 billion of new commitments during the first two quarters of this year, their worst start since 2012, according to sister title PERE‘s just released H1 2020 fundraising report. Similarly, investment banks, which have limited their property exposures since the global financial crisis, are expected to be even more discerning as they focus on remedying the distressed loans already on their books.

CMBS conduits are often lenders of last resort. When other institutions pull back, CMBS steps in to fill the void, so the sector is not going away anytime soon. A quick return to stability is also unlikely. So, what are institutional managers to do?

For KKR, the plan is to lean into the risk. Real Estate Credit Opportunity Partners II is its second fund focused on B-pieces, or junior tranches, of new-issue CMBS, which come with greater risks but, potentially, higher returns. A provision of the 2010 Dodd-Frank financial reform act requires CMBS issuers to either retain 5 percent of the first-loss positions in their conduits or sell them whole. KKR is among the few eligible B-piece buyers, though that status is conditioned on its willingness to hold them unlevered for at least five years. Last year, Matt Salem, who heads the RECOP strategy, told sister title PERE he views B-pieces as at least 10-year investments, so KKR’s vision for this space is long-dated.

Blackstone remains committed to CMBS as well, but it clearly does not see its Real Estate Income Fund as the best vehicle for it. The firm has not shared the rationale behind its proposed wind-down of BREIF, but the fact that the $500 million program is comprised of only retail investors indicates a lower overall risk tolerance.

As covid-19 continues to shutter properties and stifle mortgage payments throughout the US, many questions remain about the real estate debt space, especially with regards to CMBS. For now the sector is best left to long-dated capital with a high tolerance for risk.

Contact the author at kyle.c@peimedia.com.

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