Executive Summary
- Senior mortgage returns exhibit a higher correlation across property types compared to direct property investments.
- These returns are closely aligned with other fixed-income asset classes, such as Baa corporate bonds.
- Key drivers of senior mortgage returns include BBB CMBS, Baa corporate bonds, and the bond default premium.
Introduction
This installment in the CRE Quadrant series delves into private debt, specifically senior commercial mortgages, analyzing their historic performance in relation to public/private debt and equity markets.
To evaluate these returns, we utilize the credit-adjusted Giliberto-Levy Index. The data reveals a striking consistency in senior mortgage returns across property types, with an average correlation of 0.963, significantly higher than the 0.744 correlation observed with property returns. This consistency stems from the low leverage inherent in senior mortgages, reducing sensitivity to market shocks or defaults.
Key Findings
Correlations Across Asset Classes
Senior mortgage returns are tightly linked to broader fixed-income markets:
- They align strongly with Baa corporate bonds and BBB CMBS returns.
- Mortgage losses surged post-GFC, but their recovery closely mirrored that of corporate bonds, as illustrated in Figure 2.
Impact of Market Factors
Senior mortgage returns are predominantly influenced by:
- Baa Corporate Bonds: A 1% increase in these returns correlates with a 0.4% increase in senior mortgage returns.
- BBB CMBS Returns: These act as a proxy for property risks like rental volatility and vacancy rates.
- Bond Default Premium: A 100 bps rise in this premium reduces mortgage returns by 28 bps, reflecting compensation for default risk.
Interestingly, NOI growth and leveraged property returns have minimal direct impact due to the lower risk profile of senior mortgages.
Model Insights
Our model explains 78% of the variation in senior mortgage returns, underscoring the interconnectedness of private debt and broader capital markets. Key takeaways include:
- Corporate bond returns wield greater influence than CMBS returns on senior mortgages.
- Monitoring Baa corporate bond returns and default premiums is crucial for private debt investors.
- Mezzanine debt returns (outside the scope of this paper) are likely more influenced by subordinate CMBS returns.
The high Durbin-Watson statistic further emphasizes the stability of senior mortgage returns compared to the volatility often associated with property investments.
Conclusion
Private debt investors must adopt a holistic approach, integrating insights from wider capital markets alongside traditional property underwriting. Senior mortgages, though illiquid and private, are deeply tied to corporate bond and CMBS markets.
This interconnectedness highlights the need for a diversified perspective when assessing return expectations, reinforcing the alignment between real estate quadrants.
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