A primer on commercial mortgage funds
June 17, 2020
The last decade of persistently low interest rates, exacerbated by the coronavirus crisis, has created challenges for institutional investors looking to generate income on their bond investments. The challenge has been more acute for pension funds and foundations, who rely on bond investments to fund their ongoing benefit and program obligations.
Moreover, indications from global market regulators seem to signal a commitment to maintain low policy rates for the foreseeable future to support economic recovery. The low interest rate environment has left institutional investors looking for ways to safely enhance the yield of their fixed income portfolios.
Commercial mortgages offer attractive yields spreads over traditional bond portfolios, allowing investors to effectively trade off liquidity for a significant yield enhancement. In the current environment the yield enhancement over Government of Canada bonds would be in the range of 2.5 per cent to 3.5 per cent, a significant amount given the current yield for a 10-year Canada bond is below 0.6 per cent.
When they are backed by high quality commercial properties, commercial mortgages offer these enhanced yields with more safety. Core mortgage portfolios will have low loan-to-value ratios (typically below 65 per cent). This means that, provided the real estate market does not correct by more than 35 per cent, the loan principle should be protected. Unlike direct exposure to real estate, the mortgage collateral is received without direct ownership of real estate assets, thereby reducing the exposure to real estate market price volatility. The duration of commercial mortgage portfolios also tends be lower than most traditional bond portfolios, better protecting mortgage portfolios in the event that interest rates eventually rise above these artificially low levels.
An additional important benefit associated with mortgage portfolios is the strong risk/return profile of the asset class. Commercial mortgages have historically had a low correlation with equities. They also have a lower volatility level than many other yield enhancers, such as corporate bonds, high-yield bonds or preferred shares.
The benefits of these characteristics are evident when looking at the recent coronavirus-induced market correction. Mortgage funds’ performance for the first quarter was marginally impacted by the coronavirus shutdown, but less so than most public market asset classes. The median performance among Canadian mortgage funds was approximately 0.4 per cent. While the asset class performed well over the quarter, the stress in the sector could continue because delinquencies may persist if government-mandated lockdowns were to continue.
At the same time, the performance among mortgage managers differed significantly, highlighting the fact that not all mortgage funds are created equal. The skill and experience of a mortgage manager can temper the impact of an unexpected market correction.
When evaluating a mortgage manager, a well-diversified portfolio by location and property type can help to ensure that a portfolio is not overly exposed to any one risk. Throughout a market disruption, there will likely be sectors that are more impacted than others. For instance, given the forced closures resulting from coronavirus, the hospitality and retail sectors have come under more pressure than other sectors. Diversification by region and sector will help to moderate portfolio performance during a crisis.
Further, the underlying real estate securing a mortgage can greatly influence the risk and return profile of the portfolio. For example, a mortgage on a core property, that is tenanted and generating steady cash flow has a lower risk and return profile than a construction or land loan, where the property is not generating cash flow. When the underlying property is generating income, the borrower can use that cash flow to help fund the loan payments to the lender.
Plan sponsors should also ensure the manager they select has a disciplined underwriting process. For example, a focus on loans with a conservative loan to value ratio and strong debt service coverage ratio, will help to improve the portfolio characteristics and better protect the portfolio in a market disruption. Similarly, negotiating strong loan covenants into a loan structure, such as full recourse to the borrower, or an interest reserve to ensure that payments can be made, will also help to reduce risk during a market disruption.
Another important factor to consider is the skill and experience of the investment team. Strong relationships in the market, will ensure better deal flow, which will generate more attractive deals. Additionally, in times of stress, strong long-term relationships with mortgagors can facilitate negotiation of terms to restructure mortgages, where there are short-term cash flow issues.
Finally, it’s important to consider the level of portfolio activity. Many mortgage funds utilize a buy-and-hold strategy, which provides a more static portfolio over time, but may limit the ability of a portfolio to reposition as conditions are changing. Certain managers employ a more active strategy, which enables them to trade an existing mortgage holding, as opportunities arise. This additional lever can help the manager increase the value added over the course of a market cycle. More importantly, it may offer flexibility to reposition their existing portfolio in the face of unexpected headwinds.
Overall, commercial mortgages can offer institutional investors with spare liquidity a safer option to enhance portfolio yields for investors than many popular alternatives. However, if safety is the primary objective, it is important to identify a portfolio manager with the approach, risk controls and experience to deliver the desired risk and return profile.
Colin Ripsman is the founder of Elegant Investment Solutions. These views are those of the author and not necessarily those of the Canadian Investment Review.