Episode 93

May 10, 2023

D.J. on the CMBS market

Daniel J. Lucey Jr., CFA, Senior Managing Director, Senior Portfolio Manager at SLC Management, discusses pressure in the commercial mortgage back securities market, how it's changed since 2008, and pockets of opportunity for investors to consider.

Steve Peacher: Hey everybody, it's Steve Peacher, president of SLC Management. Another episode of “Three in Five.” I'm with the D.J. Lucey today. He's a senior portfolio manager on our fixed income team. D.J., thanks for taking a few minutes.

D.J. Lucey: Thanks Steve.

Steve Peacher: Today it's a really a timely topic. CMBS, commercial mortgage back securities. That sector has been under a lot of pressure because the commercial real estate sector is under pressure. People are concerned about valuations and fundamentals, especially in the office sector. And so it's the right time to be talking about CMBS, so D.J. let me start with this, within the CMBS world what is the typical exposure to office, which is a sector everybody is concerned about. What is a typical exposure to office within your typical CMBS deal? And what is your view? What is your team's view on the office sector?

D.J. Lucey: Yeah, the typical CMBS deal has, you know, right around 30% office. Some are less some a little more. In a conduit transaction there's anywhere from 30 to 100 loans or more, and there are the other major food groups to look at in commercial real estate. So you have retail, which has done fairly well coming back out of Covid. There's hospitality, leisure destinations. If you ever try to book a hotel room lately at a place you want to go and a lot of people weren't traveling for the last 2 or 3 years, you know those have done very well. Also the industrial sector for example and multi-family. So there's, office is a large part of the CMBS market, and you know, I think the pressures that are out there are well known and acute. But there's lots of ways to invest in the CMBS market without staring the office problem directly in the face. And so some of the deals that we're doing are as low as 15, 20% office as well, and you know, so it's important, I think to understand that when people think about commercial real estate, I think it's in instinctive to just think about office right away. It's in the news a lot, and you know, and the work from home trend is certainly looked more structural than just than just what Covid entailed. But that's how we're viewing the universe. There's lots of opportunities out there, both in higher quality office that's doing really well, or some of those other real estate food groups.

Steve Peacher: You know obviously the CMBS sector was at the heart, to some extent, of the great financial crisis in 2008 and 2009, so talk about how the CMBS sector has changed since the great financial crisis, you know, now I guess, almost 14, 15 years ago. And are CMBS deals today better able to withstand stress then they might have been going into the financial crisis in 08?

D.J. Lucey: That's a great point, Steve. I really think, not just today, but also really going through the experience of Covid, you know, having 2008 in the rear-view mirror, actually, you know, helped insulate the market more than it otherwise would have because of the way deals were structured in 09, 2010 when they first started up again coming out of 2008. And what I mean by that is, you know, we haven't seen large amounts of principal losses materialize at the deal level, and the deals are structured to withstand more losses than they were in in 08. The easiest example to understand is a typical 2007 or 2008 AJ, as the market parlance calls it. but that stands for AAA, a AAA junior tranche. That used to start taking losses, the Tranche, the bond investment, if there were 10% cumulative losses on the in the deal. So that was the subordination in the tranche. That's still got you a AAA rating. We have Triple B flat, and some lower single A rated bonds, now that have similar or even slightly more protection. So what used to get rated to AAA now maybe even rated single A or BBB. So you have a lot more subordination which is protection from if a loan or two or three then defaults and you have some recovery by selling the building you know you can still have, and often do have things like that happen in in these deals with, say, 70 loans in them, and you can withstand that experience. So, that's number one. Number two is on loan to value is really important. I think it was really well known in the residential mortgage crisis in 08 and 09, and the commercial mortgage backed industry, where you saw high amounts of leverage and debt compared to the equity in deals. We were just chatting with CoStar and they’re great, you know, resource for data, and they track virtually every loan in the CMBS universe and have all sorts of property statistics, and they're coming up with an average loan to value right now in the CMBS universe overall in the mid sixties. So if it's 65 LTV, even adjusting for all this property to stress that's already happened you know there's still a 35% equity in, you know, in these loans right now. So you know, those are the two major factors – equity in deal, and the subordination and credit protection and the structure of these deals.

Steve Peacher: Whenever any sector in the markets is under pressure, it also means that you can find opportunities. So, when you look at the market there are conduit deals, which are generally comprised of a diversified portfolio of loans or there are single asset borrower loans, which is where it's one property, one loan one property. Do you have a preference for a single property deal versus a deal with a more diversified portfolio, and away from office are there kind of subsectors or other pockets within the CMBS industry that you're particularly focused on?

D.J. Lucey: Yeah. So, we have a mix of single asset single borrower, which is also referred to in the industry as SASB. That's what the acronym stands for, and we have a mix of that, those deals as well as conduit. SASB, I think, through a lot of the last 12 to 24 months, or even coming out of Covid is a little bit easier to underwrite, because if you have one trophy asset which typically is in a SASB deal, you know, you can get your arms around that, and really know what you're investing in versus a conduit deal has just some of the smaller loans, it's just if there's say, 80 loans in a deal it's very hard to have the same level of comfort with the 79 loan that's a much smaller loan. So SASB from a fundamental standpoint, you know, you can really hone in on what you want to invest in, like we talked about retail earlier, some of your kind of A plus retail destinations are doing really well. And you know, in SASB you can really isolate that and that is also cheapened on the widening that you've seen across the CMBS space. I will say, because I think investors have gravitated towards that theme, that has opened up some really incredible opportunities within conduit, because most investment in capital markets environments, when a sector is under a lot of pressure and becomes very hated that that can be sometimes the best investing opportunities out there. And so in conduit, cleaner conduit deals with really good assets underneath them, even some office, like we talked about, I think there's a real quality bifurcation in office where newer buildings with reasonable debt on them and high occupancy are still destinations for financial services firms like our firm, but also a lot of other professional services firms. And you know, we still feel like there is a an investment opportunity within office. It's just, it's an area that requires more, you know careful analysis at the moment. So, a balance of both. But we are seeing some exciting opportunities out there, you know, in both sectors of the CMBS market.

Steve Peacher: Well, there's a lot to talk about. We could probably talk for easily half an hour on this sector because it's big, it's complicated and it's, and there is a lot of stress. So actually I like to end these with a personal question, but maybe somewhat related. I think one of the big things we're all trying to figure out is where is return to office going and to what extent, and it's not so much next month, but five years from now, is it going to be, people are going to be back in the office the way they were pre Covid? Or is this here to change? Is it structural as you mentioned earlier? So today we're recording this, and we're both, I think, at home at our respective homes recording this. But personally what do you like? I know you're used to sitting on a trading desk, you know, as most fixed income professionals are, and that was really upended during Covid. And again, we're all kind of back in a hybrid sense. But personally what's the right, what do you like?

D.J. Lucey: Yeah, so I think, and this actually is both a personal question, but it also dovetails with the that some of them, but you know, better office still makes for a great investment. I think it's clear that flexibility is one of the things that's here to stay, but I do think there's some sense of camaraderie and some missing personal connections that we, you know that we had during Covid, or felt a loss during Covid in terms of personal connections. So for me, I personally like going in as we have a hybrid model that SLC. I like going in three days a week and seeing colleagues and really getting their insights on not just the market, but you know what restaurant they went to the night before or things like that. You know we have offices and a lot of really destination type cities that you'd like to visit and great cultures. So I think that hybrid model is really a strong model. So I think you're gonna continue to see people go in more and more, you know, two, three, four days a week, according to their preference, and I think that flexibility part where you know you have an appointment, or you have a doctor's appointment, or you have some a personal travel or whatever, I think is gonna be a part of the working experience long term. But I do think having that anchor of the office for culture and camaraderie is a good thing, and so I think that firms are trying to kind of work out right now that what that balance looks like.

Steve Peacher: Well, I would also say, you know, relative to a trading desk, where it can be a great way to communicate, but it can be also loud and a hard place to think that, certain times, having in some ways being able to stay at home, or at least go somewhere, you can actually not have chatter in the background you know the whole time, which is what a trading desk is like can be can be beneficial. Well, anyway, D.J. it’s a great topic. Thanks for taking a few minutes, and, thanks to everyone for listening to this episode of “Three in Five.”

D.J. Lucey: Thanks Steve.


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