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CRE Finance World, Summer 2014

Ways to Play the Cycle For the technical and fundamental reasons mentioned above, we believe that the CMBS market will continue to provide attractive opportunities across the capital structure for the next four years. Along the way, there will be many “bolts from the blue” (related to events such as “tapering,” the Eurozone, etc.) that will create numerous unpredictable trading opportunities. Additionally, unlike the majority of the Corporate market, what appeals to us about CMBS is its deep credit tranching that allows investors to pinpoint their credit decisions at very precise attachment points with clear delineation of risk and reward. Below are areas of current investment interest. • New Issue. The new issue CMBS market is well underwritten at the top of the capital structure and provides compelling relative value to Corporates. From a trading perspective, it represents a safe opportunistic investment when the market sells off as it did immediately post “tapering”. • Whole Loans. While new entrants continue to enter the market and the Wall Street conduit machine is fully engaged, given current CMBS underwriting parameters, private lenders who are able to provide slightly higher loan proceeds and/or structuring accommodations, can negotiate premium terms and either originate attractive loans to hold in portfolio or sell these loans into the secondary market at decent premiums. • The “Legacy” Market. We continue to favor the CMBS legacy market where purchase discounts of 10-15% can still be achieved against seasoned portfolios with relatively short remaining terms of 1-3 years. In particular, we emphasize single borrower and large loan portfolios that through repayment have been reduced to a handful of assets that can be underwritten individually. Here, and selectively in the legacy AM and AJ markets, unleveraged opportunistic returns can be generated. • Floating Rate Loans. Given concerns regarding historically low interest rates, we are currently emphasizing floating rate CMBS which are, by their nature, hedged against inflation. Not only do they not lose value when rates rise (as fixed rate investments do) but they can also provide additional earnings as their floating rate index (typically LIBOR) rises and is paid as a part of the loan coupon each month. CRE Finance World Summer 2014 50 • CRE CDOs. While there may have been no dirtier word following the GFC (except perhaps “sub prime”), mature CRE CDOs that are past their reinvestment periods, particularly “whole loan” CDOs where each remaining individual loan can be re-underwritten, continue to trade at attractive discounts and offer compelling value. • B-Pieces. For a variety of reasons, we feel that the B-piece opportunity is currently full. Pro forma returns have been driven in from 20% to mid-teens (pre-losses), the “interest only” breakeven has been stretched out too far, CMBS underwriting has continued to degrade, and the amount of dedicated investors has never been greater in the space. That said, a back-up in prices, a negative global event and/or the impact of the pending new “risk retention” regulations, could make the strategy compelling again. • Event Driven Investing. CMBS provides many opportunities for “event driven investing.” For example, if one has a view on the valuation, timing and resolution of an asset such as Stuyvesant Town (contained in four distinct CMBS trusts), one can express that view through the CMBS or through the related “IO “. Similarly, as large pooled loan transactions have been reduced to a handful of assets, CMBS can be an effective way to express a credit or an event view on a distinct asset. Where to be Cautious Significant losses have yet to be realized in the $360 billion of CMBS loans that are maturing in the short-to-medium term. Due to adverse selection and the aggressive underwriting of the 2006-2007 vintages, we estimate loss severities of 50% to 100% greater than historical norms. However, we anticipate that while the average loss severity could be as high as double historic levels, it will be highly concentrated and by no means “across the board”. Increasingly, we are witnessing loss severities of greater than 100% that, as CMBS trust pools continue to shrink, are profoundly impacting trust level recoveries. In particular, we note the following “watch list” items. • Remaining Pool Collateral. Carefully analyze what is left in your CMBS trust pool. Trusts with higher concentrations of retail and hospitality have traditionally fared worse. The Case for Commercial Real Estate Debt Now “CMBS spreads remain stubbornly wide to pre-crisis levels — creating opportunities.”


CRE Finance World, Summer 2014
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