Beat you ! Commercial Mortgage REITs

Using the baseball analogy, I often tell my readers that it’s too early to quit the game in the bottom of the seventh inning.

Of course, I’m referring to the commercial real estate cycle in the United States, in which the markets finally thawed and the extra leverage started to pick up. Remember, while I spend most of my time researching equity REITs (which own bricks and mortar), I’ve become a big fan of structured finance companies – or commercial mortgage REITs – that provide a financing for a variety of commercial real estate products/sectors .

The commercial real estate (or CRE) market is enjoying additional rounds of the cycle, which means investors should remain focused on diversification opportunities and take advantage of the continued economic recovery.

A quick look back in history takes us back to the late 90s when the Russian debt crisis sparked problems with US real estate that subsequently crippled Criimie Mae in 1998. Then, in 2007, we have seen financial collapse, parallel only to the Great Depression and saw the end of Lehman Bros and Bear Sterns with the near collapse of Citigroup and AIG.

There’s a good reason why the words “great” exist before the word “recession” – the financial markets were in turmoil and there was no certainty that a REIT would have access to capital. As a result, most REITs have been forced to cut or suspend dividends.

However, since the end of the last recession, commercial mortgage REITs have become less risky, mainly due to lower leverage and a lower loan-to-value (or LTV) ratio.

Forces leading to extra innings

The CRE market has largely recovered from the global financial crisis that began in mid-2007; however, one of the legacies of the credit boom that preceded the economic recession of 2008 and 2009 is that many existing loans originated at the top of the market and are expected to mature in the short term, which will cause the continuation of a wave of CRE the maturities of the loans which will have to be refinanced or recapitalised.

Today, there is a strong demand for CRE debt capital, driven by a high volume of over-leveraged and short-term debt that offers high transaction volume fueled by improving economic conditions.

In the United States, $398.9 billion in CRE loans, including $136.1 billion in CMBS, are expected to mature in 2017 alone, according to Morningstar Credit Ratings.

the CMBS maturity repayment rate (which estimates, on a weighted average basis, over a given period, the percentage of maturing senior loans that can be refinanced without additional debt or recapitalization of equity) should fall below 65% in 2017 (based on Morningstar LTV of over 80%, which Morningstar uses as a metric to estimate refinancing prospects).

Based on this Morningstar repayment rate and CRE loan data from Trepp, LLC, it is estimated that approximately $47.7 billion of maturing CMBS loans alone may require alternative or additional funding beyond the traditional replacement senior loans maturing in 2017.

Beat you ! Commercial Mortgage REITs

In my newsletter (Forbes Real Estate Investor), I provide a summary of most commercial mortgage REITs, including the upcoming IPO of KKR Real Estate Finance Trust (Pending: KREF).

The commercial mortgage REIT industry can be divided into two categories: pure balance sheet lender and balance sheet/conduit lender.

A pure balance sheet lender issues or purchases loans for its own balance sheet and holds those loans on its balance sheet (although it may sell equity interests in the loans to diversify some of the risk). Blackstone Mortgage Trust (BXMT) and Apollo Commercial Real Estate Financing (ARI).

A balance sheet/conduit lender issues and/or purchases loans for its own account (balance sheet) or to be sold in a securitized vehicle such as CMBS (conduit). Ares Commercial Real Estate (ACRE), Scale Capital (LADR) and Starwood Realty Trust (STWD) are all driven lenders.

There are also differences between these two types and the risk can be further diversified. On-balance sheet lenders issue loans for the purpose of keeping them on their books. Balance sheet/conduit lenders issue loans both for their own books and to sell on securitized markets such as CMBS.

The risk with on-balance sheet lenders is relatively simple – the risk that loans don’t perform as expected. On-balance sheet/conduit lenders bear the risk of non-performance as well as the risk that the conduit market will experience a disruption and not be able to accept as many loans as anticipated.

As you can see below, these commercial mortgage REITs generate dividend yields of 6.3% to 9.9%.

Source: FAST Charts[/caption]

I own shares in BXMT, STWD and LADR.

Source: FAST Charts and SEC filing for KREF

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