CMBS Opportunities: Any Floating-Rate Port in a Storm

CRE Finance World, Autumn 2012

CMBS Opportunities: Any Floating-Rate Port in a Storm Edward L. Shugrue III Chief Executive Officer Talmage, LLC A financial crisis. Consequently, as an alternative, investors investments in defensive capital structures.Given the multiple uncertainties facing the global economy, particularlyin the Eurozone, a stagnant U.S. economy, stubbornly high CMBSdelinquency rates, and the lowest interest rates in more than 60years, we are emphasizing shorter-term duration floating-rate CMBSs CMBS new issue and legacy bond prices continueto rally against a backdrop of historically low interestrates, absolute value has been more challenging touncover in fixed-rate CMBS than at any time since the should consider floating-rate CMBS transactions as a means of generating Alpha. The Case for Floating-Rate CMBS Now While there is no timetable for when U.S. interest rates will increase, Chart 1 as is clearly demonstrated below, interest rates are at historically Historical GG10 A4 Spreads (bps) low levels and ultimately have more upward runway than remaining tightening. In this regard, while the give-up in current coupon may be difficult, floating-rate CMBS tied to one-month LIBOR (currently around 25bps) that resets monthly, effectively hedges the investment against an increasing interest rate environment by passing along the increased coupon to the investor on a monthly basis. Further, unlike fixed-rate investments, floating-rate securities are much less dollar price sensitive to changes in interest rates for two primary reasons: 1) their rates reset monthly with LIBOR; and 2) floating-rate transactions typically have a shorter duration than most fixed-rate CMBS. While floating-rate CMBS typically do not offer call protection, as their underlying assets tend to be more transitional, since most floating-rate CMBS currently trade at a slight discount to par value, the early repayment accelerates the unamortized purchase discount Source: Bloomberg and enhances the bond’s total return. Lastly, as noted below, since most floating-rate transactions are comprised of discrete pools With new issue CMBS AAA dupers priced at their tightest spreads of assets or single borrowers, a comprehensive asset-by-asset since mid-2008 (they are currently quoted in the swaps + 100 bps underwriting is more easily performed than in a typical conduit area), investors are essentially financing the senior 70% of the multi-loan transaction. borrower’s CMBS capital stack at a paltry 2.7% (given a 10-year U.S. swap rate of approximately 1.7%). While purchasing AAAs The Case for Single Borrower Transactions at S+100 bps may appear compelling as compared to pre-crash Single borrower CMBS transactions allow investors to make very equivalent spreads that ranged from 18-30 bps over swaps, the specific credit bets at targeted attachment points along the capital all-in compensation level for investors is vexing. Furthermore, the structure, depending on an investor’s risk tolerance and yield rally in credit spreads and Treasuries has created dollar prices requirements. Importantly, unlike a typical multi-asset conduit ranging anywhere from 110 -115% of face amounts for legacy transaction where diversification protects the senior classes (but fixed-rate CMBS AAA bonds that will only repay par at maturity. challenges the junior classes with di-worse-ification), single asset transactions provide for asset continuity throughout the capital As a total-return driven investor, at Talmage, LLC, we have been structure. As noted below in the GSMS 2007-EOP securitization rotating out of new issue dupers and into floating-rate legacy (EOP), the largest floating-rate single-borrower CMBS securitization, securities with three primary focuses: 1) single borrower transactions; depending upon the investor’s comfort with the underlying credit, 2) large loan pooled CMBS with a limited number of remaining they can acquire EOP risk anywhere from $61 per square foot for assets that can be individually underwritten; and 3) front-pay CRE the Class As to $200 per square foot for the junior most Class L. CDO whole loan and non-CUSIP transactions that are beyond their When compared to a recent fixed-rate conduit transaction (we re-investment period. use the recently priced COMM 2012-CCRE2 transaction that priced in August 2012 for illustration purposes), we find the relative attachment points, compensation and duration of EOP, especially for the E through L classes to be particularly attractive. CRE Finance World Autumn 2012 28


CRE Finance World, Autumn 2012
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