At A Glance
Commercial mortgages can add significant value to investors’ portfolios by providing stable, reliable income and an enhanced yield relative to traditional fixed income investments.
The Covid-19 crisis has impacted commercial mortgage portfolios, but the impact to mortgage portfolio performance has varied between managers. Further, commercial mortgages have exhibited less volatility than other asset classes, such as equities.
A manager’s investment process and the positioning of a mortgage portfolio heading into a market disruption play a significant role in how a mortgage portfolio performs throughout the disruption.
A manager’s response to a market disruption is another key consideration when assessing the performance of a mortgage portfolio. A mortgage manager with a well-defined and widely-communicated protocol that addresses the change in market environment will typically outperform other managers.
Other important factors to consider during a market disruption are the experience that the mortgage manager has with past market downturns, and the strength and longevity of the manager’s relationships with borrowers and other market participants.
As investors assess the impact of Covid-19 on their portfolios, they are left to question how this market correction has impacted private market investments. This article will explore the impact of the recent market correction on commercial mortgage portfolios, as well as best practices that investors and consultants should require of mortgage managers to ensure that the impact of an economic shock on a mortgage portfolio is minimized.
The Impact of Covid-19 on Commercial Mortgages
Today, investors who either have an allocation to commercial mortgages or are considering one are contemplating the impact of the current economic environment on the asset class. Like many asset classes, mortgage portfolios may experience stress resulting from the impact of public health advisories and the government mandated lockdowns that may result in borrower delinquencies. In the first quarter of 2020, market liquidity tightened, with some lenders pausing all new lending activity and others shifting their focus to the core market, which is characterized by conservative loan fundamentals and lower risk and return profiles. Further, reduced liquidity in the first quarter resulted in wider commercial mortgage spreads relative to Government of Canada bond yields. That said, mortgage funds continued to perform well with an average quarterly return of 0.67%, according to eVestment. This compared favourably to many other asset classes, such as investment grade corporate bond funds, which returned an average of -3.3%. Meanwhile, Canadian and global equity markets were down approximately 21% in the first quarter.
Interestingly, the performance among mortgage managers differed significantly, highlighting the fact that not all mortgage funds are created equal. We have seen similar divergence of performance in past market corrections, illustrating that the skill of a mortgage manager can temper the impact of an unexpected market correction. In fact, the performance of a mortgage fund during a market disruption can be directly linked to the following two factors:
the positioning of the portfolio heading into the crisis; and
the speed and strength of the manager’s response to the change in environment.
Positioning of a Mortgage Portfolio Heading into a Crisis
The first factor relates to the positioning of the portfolio prior to the disruption. A manager’s investment process and risk management guidelines can help to insulate the portfolio from unexpected economic shocks. Key factors to consider when evaluating a portfolio include:
The Underwriting Process: A disciplined underwriting process, consistently applied by a mortgage team, can greatly improve the performance of a portfolio during a market disruption. Loans supported by conservative loan metrics, such as a loan to value ratio below 75% and a debt service coverage ratio above 1.2x, can help insulate a portfolio against a weaker economic environment. In addition, incorporating loan covenants, such as full recourse to the borrower and/or sponsor, or adding an interest or other capital reserve to ensure that all payments are made, will also help prevent loan defaults. Having strong sponsorship linked to full recourse is particularly important during a market disruption as it provides the lender with more flexibility in responding to borrower deferral requests. Managers who loosen their underwriting criteria in response to an active market with more competition among lenders are often the first to be negatively impacted when market conditions change.
Diversification: It is often difficult to predict the long-term impact of a market disruption. In a market disruption, certain sectors tend to be more impacted than others. For instance, given the forced closures resulting from Covid-19, the hospitality and retail sectors have come under more pressure than other less cyclical sectors, such as multi-unit residential properties. Similarly, Alberta- based businesses are under more pressure than businesses in other regions due to the negative impact that the crisis has had on the oil sector. A well-diversified portfolio by location and property type can help to ensure that a portfolio is not overly exposed to any one risk and helps to minimize the negative impact of a market disruption on portfolio performance.
Property-Level Risk: The nature of the underlying real estate securing a mortgage plays a significant role in determining the risk and return profile of the mortgage. For instance, a mortgage on a core property, that is tenanted, stabilized and is generating a steady income stream, has a lower risk and return profile than a construction or land loan, where the underlying real estate 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. By contrast, when the underlying property is generating little to no income, the mortgage may be more heavily impacted during a market disruption, as falling market liquidity makes it difficult to finish projects within the initial projected timelines and budgets. Accordingly, a portfolio with more exposure to core properties that generate cash flow will be better equipped to withstand a market disruption than a portfolio with significant exposure to assets under development.
The Speed and Strength of a Manager’s Response to a Change in Environment
A second critical factor which will help determine the performance of a mortgage fund during a market correction is the reaction of the manager to the changing environment. An active manager who responds quickly and effectively and who proactively identifies the specific risks associated with each loan in the portfolio will typically perform better than a manager who does not implement changes in the investment process to address an economic shock. When the credit environment worsens, for instance, it is prudent to perform an initial evaluation of every loan in the portfolio to identify any potential risk that could emerge during the crisis and the impact these positions could have on portfolio performance. As some sectors are more susceptible to economic slowdowns, it is important to identify the loans that are most at risk and place these loans on a watch list for more frequent monitoring. Equally important is a well-defined and widely communicated protocol for responding to any disruption in borrower payments.
Before underwriting a deferral request, an effective protocol would first require the portfolio manager to validate the true impact of the market disruption on the performance of the underlying property and the borrower’s ability to make loan payments. A prudent lender must be prepared to deny deferral requests if a borrower’s cash flow problems are not attributable to the market disruption. The protocol should also include an assessment of the borrower’s strategy to improve cash flow over time. Information must be gathered from the borrower in order to complete this analysis, and may include some, or all, of the following items:
A detailed description of the impact of the market disruption on the underlying property
Property-level operating and bank statements
Historical rent rolls (generally for the last three months)
A summary of the relief provided to tenants by the borrower
Property-level cash flow budget
Borrower/guarantor financial statements and liquidity report
Where the relief request is validated by the mortgage team, a well-defined underwriting and approval process should be followed. The analysis should utilize updated information provided by the borrower and should incorporate current market data generated by third parties.
Strong relationships between the portfolio manager and their borrowers will also help facilitate effective communication and better cooperation. In fact, establishing trusting and long-lasting relationships with borrowers is critical as this helps to ensure that the borrower will prioritize the loan payments over other obligations and will do everything possible to avoid a default scenario, such as, for instance, involving other partners in the real estate ownership structure who may have additional liquidity sources.
A robust process for responding to borrower relief requests should include multiple steps, including those listed below.
Set a short and defined deferral period (i.e. three or four months). This time frame may need to be adjusted, depending on the ultimate strength and duration of the market disruption and its impact on the borrower/mortgaged asset.
Finalize the terms of the deferral and the repayment schedule for the borrower.
Complete and document a formal approval process using the same approach that is employed when considering a new investment for the portfolio.
If the deferral is approved, amend the mortgage documents (with the consent of all loan obligors) and distribute it to all parties.
The experience and skill of a manager play an important role throughout this process. Managers benefit from their experience in prior real estate downturns by combining the strength of their market knowledge with an established and disciplined underwriting and review process that has been tested and proven in the past.
An event like Covid-19 cannot be predicted. However, mortgage portfolios have been able to mitigate much of the extreme volatility experienced by many public market asset classes. The lessons that can be taken from this market disruption for mortgage managers is that a well-constructed and diversified portfolio with strong underwriting disciplines will better withstand the worst of the correction. Additionally, the skill and experience of a manager in proactively managing the at-risk properties in the portfolio will help to limit fund losses in the long-term.
Benefits of Commercial Mortgages
Investors today continue to face a low yield environment and are therefore searching for opportunities to enhance the performance and diversification of fixed income portfolios. An allocation to commercial mortgages can help investors achieve these goals. Commercial mortgages provide several benefits to a balanced portfolio, including:
Stable, predictable cash flows: regular income is generated through interest and principal payments made by borrowers.
Attractive yields relative to traditional fixed income instruments: the private nature of the asset class provides investors with a yield enhancement relative to publicly traded bonds, such as government and investment grade corporate bonds.
Low volatility: historically, commercial mortgage spreads above Government of Canada bond yields have exhibited less volatility than corporate bond spreads.
Capital preservation: commercial mortgages that are secured by high quality commercial properties and supported by conservative loan fundamentals can provide capital protection to investors.
Low correlation to equity markets: while traditional higher yielding fixed income assets, such as high yield bonds, global bonds and emerging market debt, tend to have a positive correlation to equity returns, commercial mortgages tend to be negatively correlated to equities, thereby enhancing the diversification and reducing the volatility of a balanced portfolio.
Less interest rate sensitivity: the duration (i.e. measure of interest rate sensitivity) of commercial mortgage portfolios is typically lower than most traditional bond portfolios. A lower duration can help protect a portfolio in a rising interest rate environment.
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The information contained herein has been prepared solely for informational purposes and is not an offer or recommendation to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any investment strategy. This information does not constitute legal, financial, investment or fundraising advice and should not be relied upon as such. Although care has been taken to ensure the accuracy of the information contained herein, IMC Limited Partnership, including all of its respective partners or affiliates, does not make any representation or warranty, express or implied, as to the accuracy or completeness of the information contained herein and nothing contained herein shall be relied upon as a promise or representation whether as to past or future performance.