Investors taking on more risk in US commercial real estate are now receiving the lowest return since the housing crisis. The premium spread for buying BBB- tranches of commercial mortgage backed securities versus AAA is the lowest its been since May 2007, according to a new report from analytics company Trepp, the FT reports.
The euphoria associated with the US economy even as the overall global economy is rolling over means that those bearing the brunt of risk for commercial mortgage backed securities are getting paid the least. This also comes as a result of investors chasing yield, which could be another obvious canary in the coal mine that the now record bull market could be reaching an apex.
“As you get toward the latter innings of the credit cycle, people have money they need to put to work and they take on more risk for less return,” said Alan Todd, a CMBS analyst at Bank of America Merrill Lynch.
Commercial mortgage backed securities are made up of a combination of types of mortgages which are then divided up by risk. Traditionally, as with any financial instrument, the more risk that investors bear, the more they get paid. But now, investors are looking more and more like they're "picking up pennies in front of bulldozers" as demand for AAA tranches of CMBS' has fallen. Meanwhile BBB- slices of CMBS continue to see an influx of demand. The conclusion?
“You are probably not getting paid for the risk you are taking and that definitely concerns us,” Dushyant Mehra, co-chief investment officer at Hildene, told the Financial Times.
The Federal Reserve's tightening could be another potential cause for the shift: higher quality fixed rate investments like AAA tranches of CMBS, have fallen in price as a result of Fed policy. This, in turn, has caused investors to seek out riskier products, like floating rate company loans, to juice returns.
Meanwhile, the boom in commercial housing has resulted in a significant amount of CMBS supply. $49 billion in new issuance between January and July of this year eclipses the $45 billion that was sold throughout the same period of time last year.
The credit premium between AAA and BBB-, which is as low as you can go without hitting a junk rating, has fallen to 2.1% in August from 2.2% in July, according to the report. While this is below the 2014 low of 2.3%, it still is nowhere near the pre-financial crisis lows of just 0.67%, which printed in May 2007 when everyone was long, and just before RMBS and CMBS blew up, catalyzing the financial crisis.
“It is something everyone frets over,” Gunter Seeger, a portfolio manager at fund manager PineBridge, said of the evaporating premium investors are demanding. “You are always concerned that the pendulum swings too far but the reach for yield is still there.”
Everyone may be "fretting" but it has yet to step them from buying.
As is the case during any euphoric period, few are paying attention and taking the data as a warning. Perhaps once the numbers start to move closer to May 2007 levels, it will catch people's attention, although considering that even the Fed has repeatedly warned about "froth" in commercial real estate with no change in behavior, it is safe to say that no lessons from the financial crisis have been learned.