The Observer

ARTICLES OF INTEREST

Canadian commercial mortgages as a fixed income alternative.

by Michael Beaupré and Andrew Walker, ACM Advisors Ltd.

Much has been written recently about investors shifting away from traditional equity/bond portfolios. The Pension Investment Association of Canada (PIAC) asset mix report, made available on their website, shows that plan sponsors had a 33.1% allocation to domestic bonds in 1997 compared to approximately 23.4% for defined benefit (DB) plans in 2017.
 
Why the shift? Consider the FTSE TMX Universe bond index - yielding 2.91% as of September 30, 2018, with a modified duration of 7.4 years. As a reminder, duration is a measure of how a security or portfolio will react to changing interest rates; for every 1.0% movement in interest rates, a security’s value will change in the opposite direction by the percentage of the duration number. With a 1.0% increase in interest rates, the bond index referenced above would decrease in value by 7.4% (all else being equal) and the income of 2.91% may not be viewed as adequate compensation for this risk.
 
Enter Canadian commercial mortgages.
 
A commercial mortgage is similar to a bond in that it is a fixed income instrument used to secure the repayment of a loan for funds advanced to a borrower, however there are some key differences:

 
  • Security for a commercial mortgage is a registered charge against real, tangible bricks and mortar property.
  • Mortgage payments occur monthly, rather than the typical semi-annual interest payment for a bond, providing more frequent cash flows for investors.

Another similarity to public bonds is the risk that the borrower will fail to make payments, or to repay the loan at maturity. This is where the skill and experience of the lender is critical.
 
A standard commercial mortgage will limit the loan amount to 75% of the underlying property value – referred to as the loan to value (LTV) - and ensure that the income generated by the secured property is 1.25 times the monthly mortgage payments – referred to as the debt service coverage ratio (DSCR). The DSCR and LTV need to be calculated, forecasted and stress tested to ensure they are adequate under different market conditions. To further mitigate real estate volatility, conservative lenders will often negotiate additional security by way of recourse to the borrower.
 
Lenders also perform detailed due diligence on both the underlying security of the mortgage and the borrower, whose track record, history and financial strength all need to be vetted.  As a result of that process, over time, a lending team develops meaningful relationships with strong borrowers that provide future lending opportunities.
 
Commercial mortgages are also exposed to interest rate risk, however fund managers are able to reduce the impact of rising rates by entering into shorter term loans, utilizing floating rates, having shorter amortization periods, and by earning the illiquidity premium.
 
Pooling commercial mortgages allows a fund manager to mitigate the risks mentioned above, and enhance the benefits of the asset class by way of diversification. A pooled commercial mortgage portfolio is typically diversified by geography, property type, borrower and loan type.

Another benefit of pooling multiple mortgages, is that it allows the manager to control the timing of loan maturities within the portfolio adding certainty to cash flows and mitigating the illiquidity risk of individual loans while still earning the illiquidity premium. As a result, many commercial mortgage funds are able to offer monthly liquidity to their investors.
 
As with any asset class, the key to investor success is the selection of the right investment manager. Some characteristics to look for when selecting a commercial mortgage manager:

 
  • Dedicated, experienced team with a sole focus on commercial mortgages
  • Successful track record with no loan losses
  • Strong lending team that sources and underwrites their own mortgages
  • Conservative lending habits in terms of loan-to-value and debt service coverage
  • Good administration with regular site visits, review of property financials and borrower due diligence 

As investors are moving away from traditional equity/fixed income portfolios, commercial mortgages offer improved stability of cash flows and reduced interest rate risk vs public bonds. In addition, investors with a longer term investment horizon that can tolerate reduced liquidity are compensated with an illiquidity yield premium.
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 Michael Beaupré
 Senior Financial Analyst
 ACM Advisors (Montreal)





Michael joined the Montreal office of ACM Advisors in February 2017 as a Real Estate Analyst, where he was responsible for the underwriting and financial analysis of investments. In 2018, after expanding his role to include business development and client servicing, Michael was promoted to Senior Financial Analyst. Prior to joining ACM, Michael worked for PBI Actuarial Consultants in the investment practice advising both pension plans and foundations.  Michael has a B. Commerce from UQAM University and has passed all three levels of the CFA Program and may be awarded the charter upon completion of the required work experience.




 Andrew Walker CFA
 AVP – Fund Management
 ACM Advisors (Halifax)





Andrew joined ACM Advisors in 2018 as Assistant Vice President - Fund Management, bringing with him over 15 years of experience in the Financial Services Industry. In this role he is responsible for the financial and quantitative analysis of ACM managed funds, as well as research and development of new fund strategies. Prior to joining ACM, Andrew was the Manager of Public Investments at a municipal pension plan in Nova Scotia. His previous professional experience also includes VP of Sales and Trading, Fixed Income at a national broker in Halifax and Associate Analyst, Institutional Fixed Income at a large, Canadian fund management company. Andrew holds a Bachelor of Computer Science from Dalhousie University, and was awarded the CFA charter in 2009. He currently serves as Vice President of the board of the CFA Society Atlantic Canada.