Checking Whether Higher Risk Is Priced Into CRE
Look at the spreads between CMBS securities and corporate bonds and you might be pleasantly surprised.
Successful investment in any area — and that includes commercial real estate — means managing risk. To do that, you have to know not only that it exists, but whether investments are making it worth your while, depending on risk tolerance.
CRE debt is an area throwing off plenty of worry at the moment. After a too comfortable stretch at easy money and credit terms, reality has kicked back in. Cap rates are up, as are interest rates. Property values are falling, rent increases are leveling off, and lending standards are much tighter.
The risk of defaults and loss is up. As Green Street recently noted, if investors want to know whether they’re getting an adequate risk premium in CRE markets, one way of doing so is looking at the spreads between liquid CMBS securities and corporate bonds.
The liquid CMBS securities offer a proxy for real estate debt. Being liquid, it can regularly reprice, so you can see a reasonable market value. Then you look at the spread to corporate bond data with equivalent ratings as a benchmark.
As Green Street noted, for 12 years, investment grade CMBS has traded about 25 basis points inside corporate bonds on average. The presence of collateral, versus unsecured corporate agreements to pay, explained the differential.
Today? CMBS investors get about 20 basis points more premium than corporate bonds, a total swing of 45 basis points. “While it is hard to assess the level of widening that would be ‘warranted’ to fully compensate for the elevated default risks, these risks are not lost on bond investors.” That doesn’t mean CRE debt is safe, but with enough care, it does seem like there is money to make with enough reward for the risk.