Market Perspective

Commercial Real Estate as the Next Shoe to Drop, What are you Yellen?!

The U.S. commercial real estate market accounts for over $2 trillion of associated debt with 23% of that found within Commercial Mortgage Backed Securities (CMBS). We have long been participants in the CMBS sector as it often provides both diversification within the broad fixed income market as well as compelling relative value versus other sub-sectors. Despite the clear benefits, we must be diligent when analyzing potential CMBS holdings as they are slightly less liquid than corporate bonds and while they may look homogeneous on the outside, the securitized deals themselves have unique collateral as well as structural differences.

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We are highlighting the CMBS sector since it has come under a bit of scrutiny this year and we believe some opportunities may arise in the near term.

Taking A Look In The Review Mirror

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Looking back to the Great Recession, the consensus view was that CMBS would suffer a similar fate as the sub-prime and residential mortgage (RMBS) market, an implosion that brought down Bear Stearns and Lehman Brothers. While there were some similarities, namely overvalued properties and overleveraged owners, CMBS was not the next shoe to drop as some had speculated. Sure commercial property values had soared from 2001 to 2007 and property prices fell hard in the aftermath of 2008, but it was not Armageddon as fewer than expected forced sellers came into the market.

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Unlike single family homes, commercial real estate produces rental income. Since leases are usually long-term commitments, owners have a built-in cushion that buys them time during periods of market stress. It takes a significant loss of tenants in a short period of time to bring a commercial mortgage underwater. Despite the extreme financial stress associated with the Great Recession, this did not broadly occur post-2008.

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With that being said, CMBS prices performed worse than the underlying properties during the financial crisis because it was the only part of the market banks could try to use as a hedge. Prices for valuing holdings can be quite different than prices of actual transactions – especially if no one is buying commercial properties or trading many CMBS bonds in the shadows of a crisis. Valuations eventually realigned, however, and both the real estate and CMBS markets recovered within a few years at a faster rate than residential property prices.

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Additionally, rock bottom interest rates provided multiple opportunities to refinance commercial mortgages, giving property owners another way to make it through to better times. In turn, all the positive cash flow generation attracted a broader buyer base hunting for yield.

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The upshot is that commercial property, on average, is now worth more than twice its value from the lows – a star performer in the land of physical assets.

Today – Prices Are Running Hot

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Janet Yellen, Chair of the Federal Reserve, voiced her concerns about rising commercial property prices during her visit to Capitol Hill last month. The CMBS market shuddered slightly in response. What Chair Yellen did not mention was the Fed’s own culpability for fueling over-heated prices in many markets. By leaving interest rates low for so long the Fed crowded investors out of traditional markets and sent them on a hunt for yield. Capital eventually found its way to the commercial property market and prices have increased. While commercial property prices look to be a little frothy, we see a few reasons why this trend will likely slow.

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Property valuations and total debt are at all-time highs. There is also the dual threat of rising interest rates and higher spreads resulting from tightening lending standards and new rules for securitizations. This makes refinancing less attractive and should reduce the velocity of property price gains going forward.

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The retail sector of the economy also factors into our view that average property values have peaked. The continued maturation of internet-based shopping continues to cannibalize physical store sales and has led to chain store difficulties across the country. In turn, shopping malls and other retail related properties are suffering. Retail based properties are a large sub-group within the commercial real estate market and, by extension, some CMBS deals. It will take time to reposition malls and other retail oriented space. Life style projects are the theme du jour, but it will take time to know if this is the wave of the future, a fad or just wishful thinking.

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Given this profile, where is there value in commercial real estate? Lending directly to a well-seasoned property operator with a recognized niche can still be an interesting investment for a long-term investor. Borrowing rates are still within the lower end of the historical range and the relative value over other fixed income instruments remains. Most fixed income investors, however, are not equipped to own loans outright and cannot lock up their clients’ capital.

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At Performa, we still favor investing within the CMBS sector. Maturing CMBS deals have outstripped new transactions, creating negative supply and a favorable technical landscape. This has been countered by lower CMBS bond trading liquidity due to the increased bank/broker-dealer regulatory capital requirements. Periodic supply/demand imbalances can create wide divergences from fair value, which creates pockets of opportunity at certain times and good exit points at others.

The Year Ahead

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As weaker hands fold in response to negative headlines, we actually see some potential to add CMBS exposure at more attractive levels in 2017. Below we discuss several factors that will allow us to pick and choose deliberately.

Factor 1: Sometimes Older Is Better

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We like to graze in the more mature, lush pastures. The CMBS market’s best years in terms of new issuance and its worst in terms of underwriting, since the market went mainstream in the early/middle 1990’s, was 2005 to 2008. Many of these deals have loans with balloon payments coming due in the next 24 months. The wall of maturities is not as dire as feared as elevated property values and interest rates that are still historically low will allow for successful refinancing. However, some of the delinquency numbers in these transactions are scaring off buyers – even before they look under the hood of a 1 to 2-year bond.

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While 60-day delinquencies in pre-2009 deals are over 15% (scary to some), the loan balances are smaller after a decade or more of principal payments. So, the outright number of delinquent borrowers has not increased substantially, but their properties represent a growing percentage of a shrinking pool of loans (Source: Credit Suisse). The average CMBS deal has experienced only a 5.4% loss, (slightly higher for the later 2006-2008 deals according to Credit Suisse).

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Even with large delinquencies, older CMBS deals provide more collateral protection today than at new issuance since they have been deleveraging. Avoiding deals with properties that face potential refinancing trouble still leaves us with a large enough buying universe for short-term, high quality bonds with attractive absolute yields.

Factor 2: Retail – Keeping The Tourists At Bay

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The negative headlines from the retail sector keep coming, helping to create potential buying opportunities, as others leave the market. In the first two months of 2017 both JC Penney and Sears announced a combined 270 store closings and employee layoffs. Investors who only dabble in CMBS are shying away from new transactions with significant retail industry exposure. New, diversified CMBS deals average between 20%-30% of retail-based collateral.

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While the overall decline in retail store space must be monitored, not all strip and shopping malls are the same nor will all of them board up. The property type, owner’s track record and location are important differentiators as well as the mix of non-clothing and big box retailer tenants (food and service industry). For CMBS buyers, there are structural components within CMBS deals that protect investors beyond good property analysis, primarily in the form of overcollateralization, which protects bondholders at the higher end of the cash flow waterfall. In other words, the lower rated bonds within a CMBS deal support senior, higher rated bonds.

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These deal enhancers allow us to focus on the highest quality portion of the market that offer the first claim of cashflows and around 30% additional protection from the features above even when real estate prices may not move much higher or, in a worst-case scenario, start to fall.

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Using an example of the latest CMBS deal in the market, 100% of properties would have to default on their loans and be sold in foreclosure at a 30% loss before the senior (AAA rated) bond took a hit to its principal. Isolating just the retail loans, and defaulting of the entire 23% of retail property loans in that transaction, even with a complete loss in a liquidation, an investor would not lose one dollar in the highest rated bond principal. Are these draconian loss scenarios possible? Perhaps, but the pre-2009 CMBS deals offer some clues.

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2008 vintage CMBS deals are the worst on record, with collateral losses averaging 11% of the original pool balance. For new deals, this still leaves around a 20% cushion for the senior bonds, which continues to grow back over time. In order to take broad senior losses, the market would need a recession event that tripled those experienced in 2008 and an acceleration in the timing of the losses. We view such an event as quite unlikely.

Factor 3: Relative Value

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Finally, there is the relative value proposition. We have historically compared AAA rated CMBS bonds to their single A rated, Corporate bond counterparts. The chart below illustrates the correlation between them over the past six years with CMBS looking slightly on the rich side.

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That said, the credit quality of the CMBS bonds are materially higher and the give up in yield is around 20 basis points per year. Looking at previous market pull backs, CMBS tends to dislocate briefly from its Corporate cousin – something we will continue to monitor.

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It is fair to expect current unease in the retail space to be followed by an uptick in delinquencies. As these loans are worked out it is also our expectation that certain cross over buyers will pull back from the market and demand will wane. The decreased appetite for CMBS will result in wider spreads versus Corporate debt, which should create an opportunity that savvy investors will look to exploit.

Tying It All Together

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Ultimately, we view the commercial real estate market as one that carries potentially significant risks, and with it, the opportunity to generate strong risk adjusted returns under certain circumstances. We do not view the sector as the next catalyst for a market meltdown. The securitized market will certainly see pockets of stress, highlighted by the retail sector, but supply in the overall market has remained largely constrained leading to favorable sup- ply/demand technical factors. Away from securitization in the whole loan market, we are more concerned about the amount of existing debt and how the current business cycle may impact the value of current transactions in the future. That said, much of the debt outstanding is in the strong hands of investors with longer term investment horizons which should be able to withstand short to mid-term price volatility.

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At Performa, we view CMBS as a valuable subsector within our overall Structured Product allocation. We have recently maintained a position between 5-15% within Fixed Income portfolios depending on market conditions, and concentrate on high quality structures (generally rated AA/Aa2 and above), that can offer interesting return profiles while also buffering from potential broader losses in the CMBS space. As bottom up investors with substantial experience over different market cycles, we are able to take advantage of attractive buying opportunities when the sector gets oversold.

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So Janet… Please stop Yellen!

Airline Industry Focus – New Paradigm or Chasing Returns?

The post-election day rally continued well into February, confounding the many pundits crowing about elevated “market uncertainty.” While the president’s messaging medium (Twitter) and tone (abrupt) remain fascinating, his initial flurry of executive orders and laundry list of broad economic and foreign policy changes remain primarily in idea form.

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It will take a while before we have clarity on the policy prescriptions that will ultimately come out of Washington. Even so, risk assets continue to rise in anticipation of all the economic perks to come and U.S. equities appear priced to perfection.

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Even if Trump meets peoples’ expectations over the near term, a short dip buying opportunity may emerge. However, if the Trump rocket fails to launch – likely sabotaged by a less than enthusiastic Republican legislature – we would expect a greater pull back in risk assets.

Donald’s Ban Grounds Airlines?

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Late on Friday, January 27th, President Trump signed an executive order limiting incoming travel and immigration from seven countries. The immigration order, or travel ban as many called it, immediately created mass confusion and protests. Which brings us to the subject of this Performa Market Perspective: airline investing.

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The U.S. equity market sold off immediately in response to the travel ban only to quickly recover and resume its skyward trajectory. Airline stocks followed suit, but with a bit more volatility. In any event, a sector that has historically performed extremely poorly has been on an impressive multi-year run. Leaving some investors to wonder if the airline industry has shifted to a new paradigm?

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Just the other day, Berkshire Hathaway revealed it now holds over $10BN (over 8% of the total market cap) of U.S. domestic airline stocks after initially buying stakes last quarter. Warren Buffet now holds more than $2BN each of United, Delta, American, and Southwest. We were curious as to what spurred the Oracle of Omaha to let his lieutenants buy so much of an industry he historically hates!

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Flash back to 1994 when Warren Buffet said: “There’s no worse business of size that I can think of than the airline business. You’re selling a commodity product with no variable costs. Huge fixed costs. It’s a terrible business. I have an 800 number now which I call if I ever get an urge to buy an airline stock. I say, ‘My name is Warren, I’m an air-aholic,’ and then they talk me down.”

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Apparently, Doug Parker, American’s CEO left the Berkshire crew impressed after last March’s JP Morgan airline conference when he said that the industry has a new reality. Hmmm. “New paradigm” you say? Let’s look under the wings. From a top down perspective, massive industry consolidation, lower fuel prices, and more efficient planes are all positives. Those, in theory, address the previous industry struggles with a lack of pricing power, volatile variable costs, and better fixed asset margins. Looking at the past may shed better light on this perceived paradigm shift.

Deregulation & Shareholder Value Erosion

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The 1978 Airline Deregulation Act ushered in an era of airline competition as new, low cost carriers entered the market at will. The legacy carriers had a difficult time adjusting as their business models were originally designed around a monopolistic framework. Adjust they did however, and over time, when a startup Icarus strayed too close to the sun, the majors came out swinging.

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However, one by one, old and new airlines managed to bankrupt themselves. In the wake of the 9/11 terrorist attacks, all major U.S. carriers filed for bankruptcy – some sooner than others but most by 2006.

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These attacks wiped out almost all of the shareholder value for the entire U.S. airline industry. In less than 2½ years, the ARCA/NYSE Airline Index (XAL) fell 78%. Expand the period to include the 2008 credit crisis and the decline reached 90% by early March 2009. For comparison, the S&P 500 declined during the same period (down 35% from 9/10/01 to 3/4/09), but most of that occurred from late 2007 through the March 2009 low.

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The only airline that managed to survive 9/11 has been Southwest, the longest running low cost carrier. And while JetBlue is recognized as an airline that people like to fly, if one bought JetBlue shares at the IPO on April 11, 2002, they would still be underwater today.

That Was Then and This is Now…

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The past decade of impressive performance is clearly what led Doug Parker to suggest the potential of a new paradigm. It has been our experience that all too often a deviation from the trend is immediately tagged as a paradigm shift. New paradigms, while rare, can and do happen. However, this tendency to over label leads to a plethora of false positives.

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The general benefits from consolidation, lower jet fuel costs, and better planes have collectively been a tailwind for the industry. However, there are also macro factors at play making it hard to identify exactly what is propelling the airline industry higher. Below we highlight additional themes that have supported the recent run, provide perspective as to why we remain cautious on the sector, and highlight alternative areas to gain exposure to the airline industry.

Bankruptcy and Cost Resets

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Since 2001, airlines have significantly cut costs during bankruptcy through renegotiating labor contracts and retiree benefits. Balance sheet and fleet restructuring provided a second round of cost savings.

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Today, however, these costs are rising. Average wages per employee fell during 2002-2006, but have been rising dramatically since.

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Additionally, another spike will likely occur after all the labor contract renewals that took place over the past six months kick in. Last year, United went through massive labor negotiations with 80% of their workforce now represented by labor unions. We expect to see more deals in 2017 and while the timing and structure of these negotiations varies by airline, one trend has been consistent; higher wages. These new deals have led to wage gains of over 30% for just three to four year contracts. The employees and their unions have successfully clawed back the cuts that made survival possible years ago.

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Finally, borrowing costs are set to rise with interest rates due to tightening monetary policy.

Mergers and Supply

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Since the airline industry as a whole had been suffering, regulators turned a blind eye to any anti-trust issues and let the major U.S. carriers merge at will, with only a few minor concessions made by the airlines regarding route or asset disposals. For a while, seat supply was tightly managed and paved the way for industry profitability after 2009.

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Unfortunately, all was not as rosy as it seemed. It took a few years for business travel to return to pre-2008 levels, which kept average ticket prices low. Now seat supply is expanding and unit costs are rising, not to mention a lack of merger candidates available domestically.

Loyalty Programs & Ancillary Fees

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Airline frequent flyer programs are a windfall in many ways. Credit card, hotel, and rental companies purchase unlimited mileage credits at more than face value and airlines can issue as many miles as they want. The airlines also sell their future profits to willing investors. Mileage awards are never fully used and program benefits and trip availability keep eroding. Consumers are wising up but many business flyers are still hooked. The large, onetime program monetization gains may be in the past, but the revenue source will remain healthy for the foreseeable future.

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Extra bags, picking a seat, less waiting in line, and even carry-ons are all fair game for additional fees as ticket prices have not kept up with inflation. Airlines rely on ancillary fees more each year. Sadly, this is one area where backlash from customers has little effect and we do not see this trend changing anytime soon.

Jet Fuel

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Jet fuel is a major airline expenditure and both management and investors love cheap gas. What would normally be an inverse relationship between oil prices and airline stocks became distorted recently. Looking at normalized comparisons between the airline index and oil prices shows three distinct periods since March 2009.

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Asset Recovery (3/09-11/11) – For a few years, both oil and airline equities rose in concert. Historically, investors have considered higher jet fuel
prices an airline’s Kryptonite; not the case during this time period. Instead, during this time period, both rose in tandem, primarily reacting to the recovering stock market and cheap cash from the Federal Reserve.

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Oil Stability (11/11-8/14) – Oil prices were range bound around $100/barrel from November 2011 until the commodity meltdown that began in August 2014. At that point, oil fell precipitously, losing more than half its value in four months. During the same period, the airlines continued their meteoric rise with the XAL index more than tripling by December 31, 2014.

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Positive Correlation (12/14-present) – Today oil trades around $53/barrel – just as it did on December 31, 2014 – and the airline index is only marginally higher. Although market prices have rebounded (after significant volatility) to a level that is close to where they began, market conditions certainly have changed. The inverse relationship between oil and airlines has vanished with both moving in lockstep. The length of this positively correlated period is surprisingly long (2+ years) and is not explained by good or bad internal hedging programs that delay benefits or additional costs associated with oil price trends. The last nine years have produced three distinct relationships between oil and airline equity price. The lack of a clear, reliable relationship between the two only makes it more difficult for equity investors.

Immigration Executive Order

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Historically, we have been cautious about taking an equity position in airlines. Trying to time jumps onto and off of the airline equity roller coaster is fraught with danger, especially for an industry with sizable exposure to a variety of shocks.

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The short-lived market reaction to President Trump’s executive order on immigration was undeniably a negative for airlines. But the bigger question is whether or not there will be lingering effects as the order gets kicked around the court system. In general, protectionist type policies usually leave outsiders feeling unwelcomed. On the margin, we expect the negative headlines will lead some foreigners to pick a more welcoming destination. While it’s impossible to estimate the exact impact of the president’s order on future human behavior, holding all else constant, we expect the order to potentially damage international earnings of domestic carriers which had been the most lucrative portion of most airlines’ business models.

Where We Do Invest

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All hope is not lost, as there is an avenue to gain airline industry exposure in a much safer setting. Within a smaller pocket of the bond market, we have been investing in a security type that has long shown the ability to protect principal on the downside during even the most hardened bankruptcy proceedings.

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Our preferred sector is the Enhanced Equipment Trust Certificates (EETC) market. Similar to other structured product bonds backed by actual assets, EETCs hold the rights to an airline’s specified list of airplanes as collateral. Investors receive interest payments passed through the lease or mortgage on each group of planes.

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The EETC market grew after the advent of other securitized assets, such as mortgage pools, and provided the airline industry an effective way to finance purchases starting in the late 1990s.

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Principal protection comes from the bankruptcy statutes of U.S. code 1110, which effectively bars airlines from walking away from the leases and mortgages in place on each aircraft within an EETC transaction. These 1110 bond holder rights withstood the wave of airline bankruptcies in the mid-2000s and have serious legal precedence in both the context of airlines as well as commercial real estate.

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Although not as liquid as corporate bonds, EETCs offer a yield advantage of 50-75 bps, which on a ratings comparative basis more than makes up the difference.

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Additionally, EETC transactions are structured to pay down principal balances on a regular basis which, in turn, protects the value of the underlying pool of aircraft as they age. As with many securitized bonds, there are senior and junior bonds within each deal with the latter providing additional credit enhancement to the senior tranche.

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On a relative value basis, we are including EETC senior bonds in our investment grade fixed income portfolios versus other sub-sectors of the corporate bond market. Our portfolio managers have invested in the EETC market since 2001 across all portions of the credit spectrum and have experience managing through more than half a dozen individual airline bankruptcies.

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In a market that is difficult for larger fixed income managers to navigate and not conducive to passive strategies, such as index funds or ETFs, it is one of the niche areas that we have always liked. Since yield is a significant, long-term producer of fixed income performance, the added layers of protection make EETCs a sensible place to invest a small portion of our client capital.

Rogue One or a New Hope?

Donald Trump was elected president of the United States of America; you wouldn’t believe what happened next. Since his election, U.S. equity markets have reached fresh all-time highs, as year-to-date gains have surpassed even the loftiest of expectations. Meanwhile, the bond market has sold off aggressively, sending yields to multi-year highs. Election night was marked with significant uncertainty, but that quickly dissipated and overall market volatility has fallen steadily through November and into December.

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Behind the surge in stock prices and bond yields are investor animal spirits that have sprung to life after an extended hibernation. Trump winning the White House as well as a Republican majority in both chambers was a low probability outcome, but the most pro-market. High hopes for infrastructure spending, coupled with regulatory relief, have people feeling frisky for the moment.

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The ultimate look, design, and impact of the new administration’s policies are unknown, but for now, financial markets remain rather optimistic as President-elect Trump attempts to take the baton from the Federal Reserve.

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Trump’s victory certainly marks an inflection point for U.S. politics. Interestingly, it may also portend the end of an era in financial markets. Historically, equity and bond prices hold an in- verse relationship – economic growth is good for companies and their stock prices, but inflation eats away at bond returns, causing rates to rise. Conversely, when recessions hit, bonds do better and stocks swoon.

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We have discussed at length the extension of this bond market rally in terms of the distortions created after 2008 due to excessive and unproven global monetary policy. In broad terms, central bankers flooded all markets with cheap money and became the major buyer in most government bond markets. This forced their desired investor Pavlovian response to buy any other asset class not nailed down, irrespective of value or common sense. In response, breaking with historical norms, global bond and stock markets rose primarily in tandem for eight years as asset inflation took hold. It was a guilty pleasure to say the least, but certainly addictive.

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For those, like us, that believe that global central banks wore out their welcome a few years ago, the renewed fiscal focus is certainly welcomed. Inves- tors have taken a shoot first, ask questions later approach, buying up risk assets at the expense of bonds. Prior attempts to normalize interest rates since 2008 have led to tantrums with equities selling off violently (think August 2015, January 2016). In fact, these tantrums have caused the Federal Reserve to delay rate hikes, favoring a risk management approach to monetary policy. For now, it appears that some resemblance of normalcy has returned to asset price relationships.

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Since Trump’s victory on November 8th (rather, the early morning of the 9th) market relationships have been showing signs of reverting back to their historical norms, with equity and bond prices moving inversely.

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While we are encouraged by the post-election price action, years of easy money and financial engineering have inflated asset prices, leaving us to question whether this normalcy sits on the right foundation of absolute prices.

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Yes, we’ve seen an aggressive selloff in the bond market, but yields are still well within their multi-year range. Meanwhile, stocks sit perched atop all-time highs. The materialization of fiscal stimulus should help extend the business cycle and put a floor under economic activity in the medium-term. In addition, an obviously pro-business president could work to stir dormant animal spirits, supporting economic activity in the short-term. Both are clearly positive for growth, but these outcomes are not known with certainty and should be considered with a healthy dose of caution.

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For now the markets appear to be saying “Go ahead President-elect Trump; take the baton from the Federal Reserve and let’s see what you can do.” This handoff could be seamless, however, transition periods are typically defined by volatility. Thus we assign a higher probability to choppy price action as we work through eight years of perverse asset price relationships.