By Randy Myers
The commercial real estate market remains under pressure but isn’t without opportunity for stable value managers, say four industry experts who spoke at the 2023 SVIA Fall Forum.
Commercial real estate has been challenged over the past few years by the sharp uptick in remote work since the COVID-19 pandemic, rising interest rates, and a banking crisis that saw three small and mid-size U.S. banks fail in March 2023. These developments, in turn, have put pressure on the commercial mortgage-backed securities (CMBS) market, where some stable value portfolios invest a portion of their portfolios.
“So far it’s been a repricing exercise on the underlying assets … (but) that’s beginning to change,” said Stephen L’Heureux, global commercial real estate and collateralized mortgage-backed securities strategist at Loomis, Sayles & Co. “You’re seeing alarms of concern rising at the banks. You’re seeing delinquencies rise. So our outlook—my outlook—is cautious.”
L’Heureux was joined on the dais by Yulia Alekseeva, a portfolio manager in the investment grade fixed income group at Barings, where she also serves as head of securitized credit research; Kevin Collins, co-head of structured investments for Invesco Fixed Income; and Kyra Fecteau, vice president and fixed income portfolio manager at Wellington Management. Ben Soltsov, vice president and stable value portfolio manager for Goldman Sachs Asset Management, moderated the discussion.
Fecteau noted that the two biggest stressors in the commercial real estate market right now are a lack of adequate capital due to regional banks stepping back from the market and uncertainty surrounding what hybrid work will mean for office properties over the long term.
“From a contagion perspective, the stress really is in office, but it is going to take a long time to play out given that the underlying leases of the tenants are long-term, and those tenants are on the hook for (paying their rent),” Fecteau added. “We’re cautious, yes, but not all things are bad.”
“I agree office is more of an isolated story,” said Alekseeva, who added that her firm nonetheless sees “some very clear winners and some very clear losers” with “a lot of resilient property types away from office that people are just not focused on enough.”
Nonetheless, Alekseeva cautioned that any further rise in interest rates would put even more pressure on the commercial real estate market. From a stable value perspective, she encouraged investors and retirement plan participants to be patient, noting that when interest rates finally do fall, it will be a strong tailwind for the market.
Collins sounded slightly more cautious about commercial office space, saying that while the long-term nature of leases provides some time, “we’re already seeing noticeable cracks.” With office occupancy levels at 30-year lows, he said, his outlook on the office market is “pretty negative.” Yet he, too, sees slivers of opportunity, noting that some sectors of the office space—particularly newer and well-amenitized product—are outperforming others. And, he said, the fact that the CMBS market is already pricing in a lot of downside risk makes some securities in that sector look attractive.
Still, he said, investing successfully in commercial real estate debt right now is not a clearcut undertaking. “It’s very city-specific, very asset specific, and underwriting is going to matter”
The panelists generally agreed that the most creditworthy mortgage-backed securities—those with AAA ratings and 30% plus credit enhancement—face notably less risk than lower-rated issues. The current environment isn’t as bad as the aftermath of the Great Financial Crisis of 2008, Fecteau said, pointing out that even back then most senior AAA-rated bonds took no losses.
The borrowers in the biggest trouble today, Fecteau continued, are those that took out floating interest rates—typically single-asset single-borrower (SASB) loans. To have their loans extended they will need to buy new interest-rate caps, and those caps have become considerably more expensive than they were a few years ago.
Alekseeva predicted that most forthcoming bond rating downgrades will be concentrated in the BBB part of the capital structure. She also noted that while CMBS holdings in stable value funds skew toward the very high quality end of the rating spectrum, “ there might be some positions that become fallen angels.”
With so much negative sentiment in the market right now, the panelists noted that credit spreads on CMBS are wide. If interest rates remain high, Collins said, they will continue to pressure property valuations, robbing the market of any catalyst for meaningful spread tightening.
Still, L’Heureux suggested that higher-rated CMBS could be compelling investments for stable value managers, with the potential for “dramatic appreciation” when banks finally return to the marketplace.
“The CMBS market is not completely closed for business, which was the case for a couple of years after the Great Financial Crisis,” Alekseeva added. “It’s not thriving, by any means, but the market still priced north of $30 billion in new issue year to date.”
Asked which parts of the market they like best right now, the presenters generally pointed to higher credit-quality securities, with some modest differences of opinion.
“We’ve been very selective,” Collins said. “We’ve been (investing) up in the capital structure—largely multi-borrower, fixed rate, super senior. Definitely bonds that have 30% subordination.” And, he said, Invesco has been investing across property types and the U.S. geographically.
Alekseeva encouraged investors to look at three areas of the market for opportunities: higher-quality conduit loans, SASBs, and higher-quality CRE CLOs. SASBs could be a good fit for a lot of stable value portfolios, she said, because investment managers can get a deeper understanding of the assets securing those loans than they might in the conduit sector.
“Managers need to be very selective, very thoughtful and deliberate … to meet the objectives of stable value portfolios,” she said.
L’Heureux said Loomis, Sayles is being very cautious with CRE CLOs, a sector the firm doesn’t view positively right now in part because of its high exposure to multifamily properties.
“The values there (multifamily) are down 30% this year, and the credit situation is just deteriorating,” L’Heureux said. “Revenues have slowed, but the expenses are going up at a 20% rate.”
L’Heureux reiterated that the most attractive securities at the moment are those with high credit quality and credit protection. He also observed that while his firm participated in a few new CMBS issues lately, it views seasoned bonds trading in the secondary market more favorably. That includes some subordinated bonds, he said, even though they can be subject to significant price volatility with so few buyers interested in them right now.
Wellington Management’s Fecteau characterized the current environment as a “great time” to be buying in the conduit market for investment managers willing to do their homework.
“The seasoned conduit market has a lot of (loan) extension risk priced in, so it’s really a great time to be a bond picker and roll up your sleeves and do the underlying credit work to understand what the true extension risk is,” Fecteau said. She added that investors may be “over-penalizing and under-appreciating” this sector.
