How Real Is the Rally In Real Estate Bonds
November 8, 2009 : Posted in Repo Motorhomes |A slew of financial heavy hitters, including Starwood Capital’s Barry Sternlicht, Colony Capital’s Thomas Barrack Jr., and Apollo Global Management’s Leon Black, are piling into the distressed mortgage market.
They and other savvy real estate investors have been setting up real estate investment trusts to raise funds to buy mortgages and mortgage backed securities. But is the timing right for these REITs?
Since the start of the year, four new real estate investment trusts have raised $1.8 billion, according to Renaissance Capital, a Greenwich (Conn.) firm that tracks initial public offerings. An additional 18 are in the works, with plans to raise $6 billion. Investors should proceed with caution, says financial planner Harold Evensky. He adds: “I get nervous whenever Wall Street touts something as the hot product.”
Distressed investing requires a strong stomach. More than 13% of home loans were delinquent or in foreclosure in the second quarter, according to the Mortgage Bankers Assn. For subprime loans, that number was 40%. Meanwhile, delinquencies of commercial mortgage loans which tend to trail their residential counterparts topped 4% in August, compared with less than 1% the year before, according to Trepp, a provider of data about commercial mortgage backed securities (CMBs).
Adding to risk now is that the market for residential and commercial mortgage bonds especially, the AAA rated ones has rallied strongly since its March lows. “A lot of money is chasing an asset whose fundamentals haven’t changed,” says Thomas Atteberry, co-manager of FPA New Income Fund. “We think it is somewhat early to do this.” But while AAA-rated bonds are up sharply, many BBB-rated ones still trade for less than 20 cents on the dollar. As Manus Clancy, a senior managing director at Trepp, says of the low rated CMBS: “I think people are pricing them to the worst case scenario.”
While the spotlight has been on the residential market, the commercial market may offer better opportunities. One reason is uncertainty over how the government’s role in home loan modifications might change. Two of the most experienced distressed investors, Colony and Apollo, target commercial mortgages.
An alternate, far riskier approach is the one taken by PennyMac, which is run by a former executive of onetime mortgage giant Countrywide Financial. It buys portfolios of home loans from banks and the Federal Deposit Insurance Corp. PennyMac has its own loan servicer, which seeks to renegotiate its distressed loans to avoid foreclosures.
Investors should check the manager’s expertise, of course particularly if it will need to negotiate with homeowners facing foreclosure. They should also consider that some REITs have hedge fund like fees -1.5% management fees plus a significant share of any profits.
A more cautious way to invest is through mutual funds such as TCW Total Return Bond Fund. It returned 14.6% over the past year. Perhaps tellingly, manager Jeffrey Gundlach has been reducing exposure to riskier nonagency bonds (bonds not backed by Fannie Mae or another quasi-governmental institution) as the mortgage market has rallied.