In the New York Times Nov 21st article titled Wall St. Finds Profits by Reducing Mortgages, Louise Story describes an unexpected relationship between Wall St. and Main St.:

For instance, a fund might offer to pay $40 million for a $100 million block of mortgages from a bank in distress. Then the fund could arrange to have some of those loans refinanced into mortgages backed by an agency like the F.H.A. and then sold to an agency like Ginnie Mae. The trick is to persuade the homeowners to refinance those mortgages, by offering to reduce the amounts the homeowners owe.

The profit comes when the refinancings reach more than the $40 million that the fund paid for the block of loans.

As reported on 11/16/2009 in The Financial Times

Developers Diversified Realty, an Ohio-based owner of shopping malls, on Monday sold the first commercial mortgage bonds under a government scheme to boost lending to the troubled sector. The deal drew strong demand and came at low yields, which bodes well for the availability of new loans for commercial property.

and as a follow up on 11/20/2009 also in the Financial Times:

Bank of America plans to sell $460m of commercial mortgage bonds backed by properties owned by Fortress Investment Group as this battered market begins to show signs of life, people familiar with the deal said.

The CMBS offer encouraged the market since most was sold without lending from the Fed program. Reuters

677- Trough 03/09/2009

1,099 – Current Level 11/11/2009

Peak to Trough – 10/09/2007 of 1565 to the Market Bottom of 03/09/2009 at 677 the S&P lost 56.8% or 888. (Not including Div)

Market Top 2007 to Market Bottom 2009

As of Nov 11th, 2009 the S&P has recovered and  is up 62% at 1099 a retrenchment of 422 points. (Not including Div)

2009 Bottom to Nov 10th, 2009

As of Nov 11th, 2009, the S&P 500 is still down 466 points or 29% from its Peak. (Not including Div)

2007 Peak to 11/10/2009

Many of the differences in historical returns are deeply affected by leverage and by the way that each asset subclass uses various forms of debt.

The Commercial Real Estate asset sub-class’ include:

Investment Garde CMBS – ‘AAA’ to ‘BBB’ issued by low- to medium-risk lenders. Securitized , usually structured as multiple tranches, rather than typical residential “passthroughs.”

Below Investment Grade CMBS -same as above except typically issued by lenders rated at ‘BB’/'Ba’ or less.

Core Equity – investments  typically have leasing income in place and use low leverage (e.g., acquiring an office building leased by a Fortune 500 tenant for the next 10 years);

Value-added Equity – investments typically have some income in place, use higher amounts of leverage, and seek to derive a larger component of
return through value appreciation (e.g., buying a 70 percent occupied retail center with the aim of redeveloping part of it and bringing occupancy to 95 percent)

Opportunistic Equity - investments  typically use large amounts of debt with most of the return coming from value appreciation (e.g., ground-up development). Behave more like private-equity.

Whole Loans – originated by a lender and held on its balance sheet through maturity.

Guide to CMBS: http://www.cmbs.org/borrowers_guide/brochure.pdf

Credit Quality: http://www.investopedia.com/terms/c/creditquality.asp

Early on

In an effort to generate demand in Real Estate Congress formed REITs in 1960. Prior to this Real Estate investing was limited to Direct/ Private transactions for institutions and the very wealthy . This made large-scale Real Estate accessible to smaller investors by creating a more liquid Real Estate equity market.

As of 1971, when the NAREIT Index was founded, the number of US listed REITs jumped from thirty-four with a market capitalization of $1.5 billion, to one hundred thirty four REITs with a market capitalization of $191 billion ending 2008 (Down from $312 billion in 2007).

At first the market was dominated by Mortgage REITs which provide debt financing through investments in Mortgages and Mortgage Backed Securities (MBS). Equity REITs were limited due to the required separation of ownership and management.  This requirement was changed by Tax Feform in 1986, spurring a sudden spike in equity REIT IPO’s in the early and mid 90′s. Today equity REITS represent nearly 85% 0f listed US REITs.

Additionally fueled by the 90′s economic boom, private capital from pension funds, insurance companies, bank trust departments, and some retail investors – demand for REITs grew rapidly.

Overbuilding in the 1980′s, abusive tax loopholes, and miss-managed lending practices prompted the Tax Feform Act of 1986 and Deregulation of S&L’s.

This event severely decreased the value of Real Estate which had been held mostly by passive investors for their tax-advantaged status rather than for their profitability. This contributed to the end of the real estate boom of the early to mid ’80s and facilitated the Savings and Loan crisis.

As equity markets continued to post gains, the difference in property valuation between the public markets and the private markets widened. The listed REIT market peaked in 1989 and later bottomed in 1991, while Private Real Estate continued to deteriorate until bottoming in 1994.

After hitting bottom in 1991, 1992 saw an explosion of REIT stock offerings. Owners of Real Estate portfolios could now convert to REITs and had access to new capital at low prices (based on Dividend Yields) via Wall Street. The cost of this capital was less than the return they could get from investing that capital in buying properties at depressed private martket prices which were also impacted by lack of liquidity. Before this era from 1982 to 1992 total new and secondary REIT offerings averaged $1.5 billion per year for a total of $16.7 billion.  From 1993 to 1998 REIT offerings grew dramaticaly to $98.9 billion or on average $16.5 billion per year.

However, REITs depend heavily on there underlying portfolios and stock market conditions.  When the stock market dropped in 1998 the NAREIT Equity REIT Index peaked in 12/1997

Current Stats (NAREIT 12/31/2008)

• 136 publicly traded U.S. REITs with capitalization of $191 billion.
• 1100 REITs filed tax Returns in 2008 (Includes Traded, Non Traded, Private)

Qualification

• Historical referrence
• Asset class attributes
• Sub-asset class’
• Current environment

1. The Risk-free rate: Treasury bonds with like maturity &
2. The Risk-premium: Spread above Treasuries with like maturities. Spread compensates investors mainly for Credit Risk or the risk of default.

In respect to a rise in interest rates and its effect on fixed income, if we focus tactically, not only are we looking for lower duration and thus lower price sensitivity but we’re also looking for greater discounts to absorb interest rate moves.

Treasuries have had a dramatic ride over the last two-years. Take a look:

10-year Treasury Price

10-year treasury Yield

With massive improvements in the credit markets and historic flows into fixed income investments YTD it is hard to find discounts in low Beta Fixed Income.  As we can see from the Option Adjusted Spread graphs, one can only find these discounts and greater than historic Risk premium in BBB, High Yield, and Preferreds.

Both the 10-year Treasury and High Yield OAS Spread over the 10-year are important indicators.  If the 10-year Treasury broke bellow 3% and the HY OAS widened above 900, the market recovery takes a significant pause.

1. 1933 +53.99%
2. 1954 +52.62%
3. 1935 +47.67%
4. 1928 +43.61%
5. 1958 +43.36%

Worst

1. 1931 -43.34%
2. 2008 -37.00%
3. 1937 – 35.03%
4. 1974 -26.47%
5. 1930 -24.90%