Absolute and relative yields of commercial mortgage strategies are near 15-year highs. At the same time, sentiment towards commercial real estate, particularly office buildings, remains negative. Such crosscurrents often present rare investment opportunities, and today’s commercial mortgage market is no exception.

A new article by TD Asset Management Inc. argues that by understanding the different return drivers of commercial mortgages (debt) and commercial real estate (equity), followed by developing clear evaluation criteria for loan loss probability, investors can sift through the noise and capitalize on elevated commercial mortgage yields.

Without predicting future returns for the commercial real estate market, an investor can still analyze expected returns for various types of commercial mortgage strategies, even in a potential commercial real estate downdraft.

Typically, commercial mortgage and commercial real estate strategies display very low performance correlation. As a result, expected returns for commercial mortgages can increase as the expected returns for commercial real estate decreases.

For instance, when sentiment for commercial real estate falls, the availability of capital declines, causing the cost of capital (i.e., compensation for lending) to increase. This is currently the case, and the TD Greystone Mortgage Fund is taking advantage of the current environment by underwriting high-quality mortgages with elevated coupons.

While commercial mortgage yields are at 15-year highs, it's important to keep in mind that high-quality (lower-risk) commercial mortgages are likely to outperform lower-quality commercial mortgages if the commercial real estate market were to experience a significant downdraft.  

Allocators can discern high-quality versus low-quality commercial mortgages by evaluating key risk metrics, such as the borrower's ability to pay its current debt, the loan security in-place and the lender’s ability to enforce security by pushing the borrower into default if that is the most prudent decision for the commercial mortgage investors.

In addition to considering standard metrics, allocators should further investigate the quality of borrowers and collateral to take advantage of this rare opportunity.

For more details, read the full article.

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