The CMBS Market with Jim Gubitosi, Co-CIO of IR&M

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Stewart: Welcome to another edition of the Podcast. My name’s Stewart Foley, I’ll be your host. Welcome back. We’re very happy to have you. Today’s topic is CMBS and commercial real estate. We’re joined today by Jim Gubitosi, co-CIO of Income Research and Management. Jim, thanks for being on.

Jim: Thanks for having me, Stewart.

Stewart: Man, this is a good topic. Really, really a good topic. I’m thrilled to have you. And before we get going too far, can you tell our audience the hometown where you grew up, your first job, and a fun fact?

Jim: Sure. I grew up in Boca Raton, Florida, which is far from where I am right now, Boston. And my first job was as working in a warehouse at a semiconductor distribution company, which was really interesting. They would buy all kinds of excess electronic equipment and I’d have to catalog it and store it so that it could be sold later. It was very interesting.

Stewart: Wow.

Jim: Yeah, and something that maybe folks find interesting, I’ve lived in Boston since 2000, and I’m a New York sports fan, which, as you know, if you’re in Boston as a New York sports fan, can be a challenge. So I kept it a secret for a while and finally let it come out over time. It’s not as heated as it used to be, but it’s still nice to be rooting for the other side.

Stewart: Yeah, when I moved to the East Coast, that’s when I realized actually there’s no World Series. It’s just who wins between the Sox and the Yankees, and that’s it. And that’s all anybody cared about. And then it was on to something else, right?

Jim: Yes, those early 2000s, that was a really fun time for that rivalry.

Stewart: Absolutely. So commercial real estate, CRE is very topical, and perhaps more so given the recent banking stresses that have been in the headlines and continue to be today. Well, I like to timestamp these podcasts and so today is Tuesday, May 2nd, just because markets move around a lot. Can you give us a quick recap of what has happened and how we got here?

Jim: Sure. Yeah. And certainly, markets are moving fast around all of this news on the commercial real estate side, on the banking side. So, there’s a lot of info going around here right now. Would say that over the years, that pressure in the commercial real estate universe has grown, given we are at a period for low rates for a long time post the GFC. You had lending standards, which were much better than going into the GFC. But over time with low rates, you start to see people be more aggressive and that can lead to potential distress when rates go up. And I think that’s what we’re seeing now. And then when you combine that with changing work behavior, changing demographics, those two factors are leading to a fair amount of concern around commercial real estate as a whole but the office sector probably most so, and those pressures are certainly starting to be felt when people are looking through to see who the owners of the debt are and what the options are going forward.

Stewart: That’s really helpful. And so with rates up, I think generally speaking, insurance companies, the consensus is that we’re better off with rates up where they are as opposed to where they were. But that creates some stress on some of these securities from a refinancing perspective, from an increase in interest expense perspective. What can you talk about with regard to mortgage costs and changing demographics?

Jim: Yeah, and I’d add another one in there, and that is the valuation of the properties, which is based on what is known as a cap rate. And as those cap rates go up, essentially the values of properties go down. And so 10-year interest rates are a big driver of cap rates. And so cap rates have gone up a few hundred basis points, maybe into the 7% range, let’s say, 7% to 8%, and that increased cap rate translates to a lower property value. Then you combine that with rates on the loan side being higher. So when properties now have to refinance, they’re refinancing into a higher rate and they’re being more challenged on the valuation side. So they’re kind of feeling it on both sides of the equation there.

Then when you combine that vacancy rates for some office properties are now in the 20% plus range, and utilization is maybe even lower for some of those properties given the shift in work and where people are working from now, those factors can be a lot of headwinds for certain properties. I think it’s very important to say that you can’t judge the commercial real estate with a broad brush. It’s not the type of thing where you can apply very linear projections on and get results and say that’s the way it could be. It’s very much property-by-property, city-by-city, tenant-by-tenant. So it’s a much more granular analysis than just applying broad assumptions.

Stewart: So let’s talk just a little bit about the connection between commercial real estate and the banking sector. You’ve got some very interesting statistics here on who actually is holding this paper. What can you tell us about where CRE resides in the banks?

Jim: Sure. So if you take agency multifamily out of the equation and you say, “Okay, the total CRE balance X multifamily is $2.5 trillion,” about a trillion of that is at banks with the remaining being within CMBS and also within the insurance space via whole loans. So you’ve got about a trillion dollars in this CRE debt that is now in the banking system, and the majority of it, or I shouldn’t say the majority, a big portion of that is within smaller banks, those that have $100 billion or less of assets. And those are probably of most concern, they’re generally going to be smaller loans, they’re generally going to be maybe not in the central business district, but maybe in secondary or tertiary markets. They’re going to be more in the class B and C space versus the class A space. So when you keep on peeling the layers of risk away and see where some of the areas that could be under most pressure, you get your way into some of the banks that potentially have some commercial real estate on their books that is going to be under pressure from both evaluation standpoint and a refinance standpoint when the time comes due.

Stewart: And if I’m reading the notes correctly, the banks with $100 billion or less hold over 60% of CRE loans. Is that an accurate number?

Jim: I believe that number is of the loans that are within the banking space, but yes, it is very much centralized in those smaller banks.

Stewart: So this is one of the reasons that there’s concern about regional banks, maybe not just this ALM mismatch that was a problem for SVB, but the fact that there’s this exposure to CRE that’s fairly heavily concentrated in some smaller institutions, that could also be a concern.

Jim: Exactly, yes.

Stewart: Yeah. So what areas of CRE are under the most pressure? And you mentioned office and that makes sense to me. Just in particular, what are a little more specificity around those issues and where do you think the most distress is going to come from?

Jim: Yeah, so it’s likely not as much of the trophy office buildings, although those could come under some pressure when refinance comes along, but it’s generally going to be more within the outside of the central business district, those secondary tertiary areas, the Class B and C that needs more capital improvements from the property owners in order to re-lease the space. It’s really focused in those areas. Now, it can also be a building that has a large tenant that then leaves that property and is left with a fair amount of open space that needs to be released right around the time that a refinance might be happening on an existing loan. So it can be very situational, but broadly speaking when you look at where the stress is these days, you can look at San Francisco, Washington DC area, some areas within Texas as well that we’ve seen maybe potentially more of a shift away from the office, but also just some of the similar demographic shift trends where people are moving away from higher tax states to lower tax states. You put all of those things together and you start to get a picture as to where the stress could be broadly speaking. But again, then you really have to get into the property-by-property specifics.

Stewart: One of the things that managing bonds for a long time got me was to be a contrarian. And whenever I hear… I’ll give you an example. We did a relative value survey with some CIOs and two different ones, and public equity came in really low on the list. And when I talk to people about CRE, you hear office and it’s so consistent… And it makes sense, it makes total sense given change in how people are working and so on and so forth. Is there a chance that in office there is somehow an opportunity there, or do you think there will be an opportunity at some point? Can those B and C office properties be repurposed in some way? I’m just trying to take the contrarian view of what seems to be consensus and just ask you is that just a non-starter or do you think that there’s a potential for there to be value there that maybe folks aren’t seeing?

Jim: I think there’s a similar comparison to be drawn to retail back from maybe 10+ years ago when you had the constant discussion of the shift away from bricks and mortar to internet shopping and other away from people wanting to just go to the mall and shop, which we definitely saw. But I also think during that time you saw people be able to take advantage of properties trading at distress levels, repurpose the property, come up with a new way to get the right tenants into that space and ultimately see some success. So without a doubt, I think you’ll see that there’ll be opportunities for that, especially if assets start trading at very distressed levels. There’s a lot of capital on the sideline that’s been raised for real estate. The number I’ve seen is $300+ billion of private equity, essentially capital that could be spent either in buying properties or providing loans or doing other things to the real estate space so there’s a lot of money on the sidelines.

If we get to more distressed prices, I do think that contrarian view can pay off then you’ll see people that can take advantage of that. So I think that’s definitely a possibility and something that needs to be factored into the analysis. I also think when people start to paint with a very broad brush, that creates opportunity too. And I think we’ve seen that in the past with commercial mortgage-backed securities, especially back if you go to 2007, 2008, 2009, there was a lot of stress within the system there, but there was also opportunity to buy at very attractive levels in securities so that worked out very well.

Stewart: Thank you. That’s really helpful. So what’s next from here in your mind?

Jim: I think we’re going to start to see more loans come due for refinancing. So each year about 10% of the universe is going to come due for refinancing. These are generally 10-year loans. There’s 5, 7, 10-year loans, but let’s just say about 10% of the universe comes due. You’re going to start to see extensions for those loans, which is also one of the positive factors within the commercial mortgage space, it’s flexible. It’s not like the loan comes due, the borrower can’t refinance, and that’s a default. It can be in the lender’s incentive to extend those loans and to provide some changes, modifications to the loan that allows the borrower to work out of that situation ultimately gets to a better point overall versus selling into a distressed market. So I think as we start to see more loans mature and more loans come due, you’re going to see some extensions, you’re going to see modifications and likely somewhat of a kick-the-can play out where you see the situation get dragged on potentially into an environment where interest rates are lower again, which helps cure some of the issues that we’re seeing right now.

Stewart: It’s funny you use that term, that’s what I was going to use. I go, “Some people are calling that kick-the-can.” The slang for that is ‘amend and extend’, right? It’s amend and extend those terms as opposed to having a big D default and it’s a way to work through some of these refinancing concerns.

Jim: Exactly. Within the CMBS space, there’s an entity called the special servicer, which is there to help work out some of these issues and amend and extend loans to basically provide the highest NPV for the trust versus going out and doing a fire sale and selling it to a distressed market. You’d much rather have that operator continue to operate that property, maybe you give them some relief in certain areas, you extend the loan a little bit and you can work through the situation.

Stewart: Yeah, it makes sense. And I’m glad you mentioned the CMBS market. It seems, from my standpoint, that the CMBS market is less exposed to the negative headlines surrounding CRE, but not fully insulated. And so can you explain for those folks who maybe are not as familiar how that works?

Jim: Yes. So the CMBS market, if you paint a broad brush and say it’s a $500 billion market, you’ve got conduit CMBS, which is pools of loans packaged and those loans are diversified across property type, geography, borrower, and so the risk is much more diversified. And then you also have what’s known as single asset, single borrower, CMBS, that is much more concentrated either in one building or one borrower across multiple properties. Within the conduit CMBS space, which is where we focus, you’ve got a diverse pool of assets, you’ve got diverse geographies, you’ve got different borrower types, you’ve got that special servicer there to help work properties through. So ultimately you can watch how those loans perform and then ideally see how that performance could impact your bonds.

On top of that, the deals have been structured, as I’m sure many of your listeners know, into different tranches, the super senior tranche, which is the highest rated tranche, that’s triple-A rated, that has 30% credit enhancement, meaning the deal would have to take on 30% losses before that tranche were to suffer a dollar of principal loss, that’s on top of the equity that’s at the property level. So if traditional LTVs are 60% within CMBS, then you have an additional 30% of protection on top of that. If you go back to the GFC, which was a great testing ground for these trusts and how well they can withstand distress, no super senior triple-A securities took any principal loss during the GFC, and those loans back then were way more aggressively underwritten. So it’s a testament to how strong the structure is.

Stewart: I don’t know quite how to ask this, but insurance companies are concerned about downside. Risk is rarely upside surprise. It’s measured in volatility, but really risk is on most of these investments you’re making money in basis points and losing it in percentage points, and it’s a very asymmetric payoff. So when you look at the CRE market today, what do you think the downside is or how bad could it get?

Jim: I think at the CMBS level, let’s start there, that we’re focused top of the capital structure so I think really where the downside is right now is just in price volatility, and you could see spreads widen here in the short run as you see more stress within the space. So downside is more probably price volatility than ultimate losses. As you go further down the capital structure, that’s really when you start to get way more levered to losses and assumptions. And one of the reasons why we avoid subordinate tranches is once your subordination has been wiped out, it can be the difference between 3% or 5% losses at the deal level that could wipe your entire tranche out, and you get very levered to those losses because you’re such a thin portion of the deal. So for investors, understanding where they are in the capital structure, where losses start to trigger and what are the scenarios that could get to that trigger point where enhancement is wiped away, that’s really key to understanding the downside for each individual security.

Stewart: And income research and management has been an investor in the CMBS market for a long time, do you think that there’s opportunity in the CMBS space? And if so, where are you focused?

Jim: We certainly think there’s opportunity. CMBS provides great alternatives to maybe some of the financials that you see from a relative value standpoint. It can be a good portfolio diversifier with a high quality asset that can trade at a spread that is wide to similarly rated corporate bonds. So it’s a good diversifier. It’s certainly a reason why insurance companies have focused on the space. It gets good risk capital rules because of its high quality, so it is an attractive asset class from that standpoint. Unlike a lot of other securitized sectors, you don’t have the same level of prepayment risk because the underlying loans have prepayment protections, sometimes there’s even penalties that can flow through to the bond holder if those loans try to prepay early. So you have very stable cash flows, very strong from a quality standpoint, as I mentioned, in terms of no bonds taking losses during the GFC for triple-A super senior, and a really good diversifier. So we think those are reasons why within a broader portfolio it makes sense.

Stewart: So I’ve got a tremendous education today on CMBS and CRE. What would you say is one takeaway that you would want our audience to remember when you’re thinking about CMBS and CRE today?

Jim: I think it’s that you’re going to see more and more headlines, and those headlines are likely going to get worse before they get better, I think. And you can’t judge the market with a broad brush. You really do have to look at the individual exposures, understand what the motivations are for the borrowers and the lenders, and understand where the protections are within the deals that you own or that you’re looking at from as an investor. And so I think my single takeaway would be, don’t panic with the headlines, there’s going to be winners and losers here, so really understand what you hold.

Stewart: That’s fantastic advice. I got a new-for-2023 wrap question. You can have your pick.

Jim: Okay.

Stewart: Best piece of advice you ever got, or who would you most like to have lunch with alive or dead?

Jim: All right. I’ll go both, I think-

Stewart: Oh, wow, both. I love this.

Jim: Sure.

Stewart: I love it.

Jim: And you can choose the better one. I think the best piece of advice would be just slow down, no need to rush through life. Sit back and enjoy it, and don’t always be looking to tomorrow. And then, I guess, my father, who’s not here anymore, I’d love to have lunch with him.

Stewart: That’s nice. That’s really nice. Thanks for a great education today, Jim. I really appreciate you being on, man. Thanks for taking the time.

Jim: Thanks, Stewart. It was a great chat.

Stewart: We’ve been joined today by Jim Gubitosi, co-CIO of Income Research and Management. Thanks for being on, thanks for listening. If you have ideas for podcasts, please shoot me a note at Please rate us, like us, and review us on Apple Podcast. We’d certainly appreciate it. My name’s Stewart Foley, and this is the Podcast.

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Income Research
Income Research

IR+M is a privately-owned, independent, fixed income investment management firm that serves institutional and private clients. Our investment philosophy and process are based on our belief that careful security selection and active risk management provide superior results over the long-term. By combining the capacity and technology of a larger firm with the culture and nimbleness of a boutique firm, we strive to provide exceptional service for our clients and a rewarding experience for our employees.

Rob Lund, CFA
SVP, Senior Client Portfolio Manager
BOSTON, MA 02110

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