Yield, The Old School Way

Commercial mortgages making a comeback for plans seeking diversification

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commercial-mortgagesIn the 1960s, commercial mortgages played a significant role in pension investment portfolios — less so today, however, as many investors look to other sources of yield in the relentless hunt for alpha. But, as that search becomes much harder, will commercial mortgages make a comeback?

It’s a distinct possibility says Philip Gillin, executive vice-president and portfolio manager with Sun Life Investment Management, who points to new research on commercial mortgages and their role in helping solve some of the challenges facing Canada’s DB pension plan investors.

The survey started by asking plan sponsors what’s keeping them up at night. Top concerns included low interest rates, low returns and market volatility says Gillin, adding that commercial mortgages can help allay such fears because their loss rates are extremely low, making them highly secure. “This is an asset with three lines of defence,” Gillin explains. “First, you have the income stream coming from the property, which addresses the debt service on the mortgage — the first charge on the property itself gives you the second line. Here in Canada, you also have the covenant of the borrower in many instances.”

Together, these factors provide a very compelling security package, he says, adding that, due to their diversification potential, commercial mortgages also complement an existing fixed income portfolio.

PowerPoint PresentationHOUSING MARKET OVERVALUED?

To find out how plan sponsors view Canadian real estate overall, the survey asked if plan sponsors believe residential real estate values impact commercial mortgage valuations.

Sixty-eight percent said yes they do — and 27% believe that commercial real estate in Canada is generally overvalued, while 57% believe pockets of overvaluation exists but that the market is generally fairly valued.

Low interest rates are driving high valuations in residential and commercial real estate. “Capitalization rates in the commercial sector have declined significantly,” Gillin says. “As underlying interest rates remain low, real estate equity becomes increasingly attractive for investors.”

While 42% of those surveyed say they hold commercial mortgages, there seem to be some knowledge gaps. While respondents acknowledged benefits such as diversification and higher yields than public bonds, there are some perceived barriers, including board education, liquidity concerns and a duration mismatch on the liability front.

PowerPoint PresentationThose results aren’t surprising to Gillin, who points out that commercial mortgages will become harder to ignore as issues such as low returns, rising interest rates and volatility continue to add pressure in the pension space.

With a combination security, premium returns and monthly cash payments, commercial mortgages will likely play a bigger role in pension portfolios going forward.

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