Strategic Opportunity: Commercial Mortgage Backed Securities (CMBS)

The LANDCO team includes specialists in CMBS.

Commercial Mortgage Backed Securities, especially those issued prior to the financial crisis, remain subject to loss of value due to a variety of factors: losses incurred on the underlying real estate loans; loan modifications and erosion of the transaction structure due to losses on the collateral. However, the most senior tranches and the strongest deals are no longer selling at bargain prices, because certain markets and CRE sectors have recovered and bondholders no longer believe that prudence dictates that they sell senior positions at a discount in order to avoid greater losses. The collateral value of mortgages supporting most pre-crisis CMBS transactions appears quite adequate at the present time to support the most senior tranches.

Although the incredible bargains available in the aftermath of the crisis are no longer available, there remain opportunities in discounted/distressed CMBS. Depending upon the transaction and how the underlying loans have fared the degree of remaining structural protections (credit enhancement) built into the structure, coupled with additional support provided by discounting the price, still makes many bonds attractive.

To determine where opportunities may lie among the subordinate tranches, investors must recognize how real estate distress affects the value of each piece of underlying collateral and how potential losses may impact the structure. Every bond needs to be modeled individually and in detail to fully reflect today’s proper value. Too often in the recent past bonds were underwritten to overly optimistic scenarios, or non-stabilized properties were included in CMBS deals. In addition, many CMBS managers apply “black box” econometric models that treat various CMBS bonds as though they are comprised of the same collateral, rather than taking a “bespoke” approach to collateral analysis.

LANDCO’s lengthy experience in managing, constructing, developing and financing CRE of all types, combined with its specific CMBS expertise, gives it a distinct advantage in evaluating the real asset value of the real estate supporting the bonds. The stress-runs that LANDCO models for each particular bond are more accurate because we fully understand the affect the physical condition, local markets, and operating characteristics of the individual mortgaged properties have on their value. The combination of boots-on-the-ground real estate experience, coupled with significant capital markets experience, is LANDCO’s advantage in CMBS.

CMBS is volatile, since it is traded in the financial markets on a daily basis and is also subject to ratings changes. Most importantly, it is a derivative of CRE, which remains under stress. Consequently, the key to successful CMBS investment is to look carefully at the performance and prospects of the underlying CRE assets that collateralize the bond, to understand the structure and to model the bonds with a realistic view of the likely performance of the collateral.

A. Risk Mitigation

  • Subordination – Discount – Diversification-Deleveraging
  • Individual forensic analysis of each bond … not “one size fits all” model-driven analysis
  • Bottom up / top down analysis of bonds, markets, and sectors
  • Monthly oversight via servicer’s reports
  • LANDCO operational experience

B. Basic Fund Operations

  • Full due diligence prior to purchase — credit and collateral value
  • LANDCO asset management to perform individual property analysis as needed
  • Secondary market purchases using primary dealer relationships

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