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Going mainstream: Fund managers to bring CMBS to the masses

Mutual funds and ETFs can offer a liquidity sleeve for institutional investors.

A small but growing number of commercial estate fund managers are trying to give individual and smaller-scale institutional investors access to high-quality commercial mortgage-backed securities through exchange-traded funds and mutual funds.

The move comes as the Securities and Exchange Commission last month issued a report that called for greater access to private funds for individual investors, arguing that there will be a rise in demand as retirement planning shifts towards individually managed accounts.

While investors have long had access to real estate investment trust securities, securitized debt has been the domain of the larger institutional investors, said Karen Schenone, a fixed-income product strategist in BlackRock’s global fixed income group.

“For a lot of investors, when they think about real estate, they think about REITs first

“They’re probably less familiar with some of these debt structures,” Schenone told Real Estate Capital USA.

This lack of familiarity combined with low interest rates has meant that many investors are underweighted to fixed income, Schenone said. Additionally, most retail and even many smaller institutional investors may not have the knowledge or access to seriously invest in CMBS or commercial real estate collateralized loan obligations.

Bridging the gap

BlackRock, which has operated its $800 million iShares CMBS ETF since 2012, sees a larger and broader audience for the fund due to the credit quality of the underlying securities and the in-place income.

The passively managed ETF mirrors the Bloomberg Barclays Aggregate Fixed Income Index and holds a basket of high-quality CMBS, with underlying properties that mainly comprise multifamily assets. There are a handful of securities from other sectors that include retail, office, lodging, industrial and self-storage, Schenone said.

The fund’s current portfolio is comprised of bonds with a weighted average life of about 5.5 years, with yields of about 1.5 percent. “The credit quality is about 90 percent AAA-rated,” Schenone said.

The ETF posted a solid 7.84 percent return in 2020. This is slightly better than the $88 billion iShares Core U.S. Aggregate Bond fund, the largest fixed-income ETF in the world, which returned 7.43 percent during the same period.

Although the iShares CMBS fund’s target audience is relatively small, it could appeal to individual and smaller institutional investors that want to grow their real estate and fixed income exposure.

“I could see this being a great way for an insurance company that wants to add CMBS or an offshore investor that is looking for higher yields and wants to diversify away from government credit,” Schenone said, noting that there needs to be more education around how the asset class could enhance a portfolio. “CMBS is underrepresented in people’s portfolios.”

Mutual fund focus

RiverPark Funds, a New York-based investment management company, runs an actively managed open-ended CMBS mutual fund that is focused primarily on highly rated single-asset/single-borrower bonds.

The fund was one of the first in the mutual fund space, which meant that RiverPark spent a good deal of time educating regulators about CMBS, how it behaves and has performed historically, and its liquidity features, Ed Shugrue, RiverPark’s portfolio manager, told REC USA.

The RiverPark fund is focused on single asset/single borrower deals from institutional quality sponsors, Shugrue said.

“Right now, the fund is comprised of all income-producing assets that are 95 percent leased to institutional sponsors that include Blackstone, KKR and Fortress Investment Group. [These bonds] have an average LTV of 50 percent,” Shugrue said. “If you had a bucket of capital to invest in fixed income as part of asset allocation strategy and you’re concerned about inflation or volatility, 100 percent of our investments are floating-rate. None of our assets have had a monetary of cash flow default and the metrics of the portfolio are very conservative.”

Despite the positive attributes of the sector, there continues to be obstacles to the ability of the CMBS market to attract the same scale of investment as mutual funds and ETFs in other sectors. One issue is the negative impression many investors continue to have of mortgage-backed securities because of what unfolded in the residential sector in 2008.

But Schenone is eager to point out key differences between CMBS and RMBS, including strong historical performance and higher-quality collateral in the bonds that are part of the BlackRock ETF.

Additionally, unlike RMBS, which have significant pre-payment risk, there are provisions in place in CMBS that prevent or penalize borrowers if they try to pre-pay a loan. “The interest rate risk or the duration risk is a lot more stable in this particular fund, and you don’t have that kind of prepayment risk,” Schenone said.

Still, Schenone believes a CMBS-focused fund with such a high concentration of high-quality bonds should grow in appeal to investors.

“The investment-grade bond market is about 2 percent of the bond market, it’s a pretty small component of it,” Schenone said. “If you’re looking to diversify away from just pure government bonds, this is the highest quality way to do it in the market.”

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