The Institute for Innovation Development, as part of our ongoing series of interviews exploring niche markets and innovative viewpoints from active asset managers, recently talked with Craig Sedmak and Thomas Harney of Ladder Capital Asset Management. Ladder Capital is an internally managed commercial real estate finance REIT that counts TPG, KKR, Blackstone and Starwood among its peers, and is considered one of the leading non-bank U.S. commercial mortgage lenders. They also manage the Ladder Select Bond Fund (Institutional class ticker: LSBIX), a no-load mutual fund focused on investment grade commercial mortgage backed securities. We asked Craig and Tom questions on their firm’s singular vantage point and research on the unique nature of the commercial mortgage-backed securities (CMBS) market.
Bill Hortz: While not a new asset class, what did your expertise in commercial real estate finance tell you about the opportunity of establishing a no‐load mutual fund of commercial mortgage‐ backed securities (CMBS)?
Harney: Our investment team has longstanding experience in the CMBS new‐issue and secondary trading markets, including familiarity with a significant portion of the actual real estate collateral underlying CMBS and their associated borrowers. This experience is particularly important, because we expect uneven growth rates and equity price action across industries, assets types, and geographic regions. By making available a pure‐play commercial real estate (CRE) finance fund with daily liquidity, we believe we’ve created the opportunity for informed investors and institutions to make razor‐sharp, self‐selected allocations to this senior secured space as a diversifying complement to traditional fixed income portfolios dominated by unsecured corporate bonds and Treasuries.
Hortz: Tell us more about the unique nature of these securities.
Craig Sedmak: Commercial mortgage-backed securities are principally bonds secured by mortgages on commercial properties. CMBS provides liquidity to real estate investors and commercial lenders and has been a longstanding favorite of insurance companies, pension funds, and other institutional investment platforms. When compared to a residential mortgage-backed security (RMBS), CMBS provides better prepayment risk protection because commercial mortgages are most often set for a fixed term with prepayments locked out for a defined period and carry substantial prepayment penalties thereafter. As we said before, CMBS provides an opportunity for investors to allocate to the commercial real estate market on a diversified and secured basis which can be a nice low correlation complement to a traditional fixed income portfolio dominated by unsecured corporate bonds.
Hortz: What are the potential benefits of a non-diversified CMBS bond fund strategy on providing current income and capital preservation versus traditional diversified bond portfolios?
Sedmak: There are several investor benefits that we recognize. First, CMBS investments tend to offer a yield advantage over similarly rated unsecured corporate bonds. This enhanced yield comes with the additional security from holding first mortgage liens against physical real estate assets. Since most CMBS trusts are secured by a uniquely diversified mix of commercial properties and tenants, we believe a sophisticated investor can create their own portfolio diversity within their fixed income portfolio by adding a custom-made exposure to CMBS with an experienced manager.
We also note that the CMBS market currently exhibits strong credit fundamentals with attractive loan-to-value and debt service coverage ratios. The underlying collateral for CMBS bonds are generally 5, 7 or 10-year fixed-rate commercial mortgages, and Agency CMBS feature a U.S. government agency guarantee. Also, third-party equity from the borrower as well as credit enhancement from junior securities help to create a protective cushion for investors in the senior, investment grade-rated tranches of CMBS bonds we’ve traditionally targeted.
Hortz: What nuances can you glean in analyzing and constructing a CMBS portfolio that other fixed income asset managers might not catch?
Thomas Harney: The CMBS market was valued at over $1 trillion as of September 30, 2018, according to Trepp, and CMBS is growing as a percentage of the total U.S. fixed income market. Our portfolio managers have on average 25 years of experience dedicated solely to commercial real estate lending and investing, and they have profitably invested through a wide range of market cycles. As one of the most active non-bank lenders in the U.S., Ladder enjoys competitive advantages in understanding commercial real estate markets, sub-markets, property-type trends, and knowledge of actual borrowers and their industry reputations. This depth of knowledge is exceedingly helpful in making well-informed decisions related to commercial real estate finance investing.
Hortz: How is it that CMBS can be less susceptible to the negative effects of rising interest rates? What makes CMBS a more “all-weather” asset class?
Sedmak: Although much of the CMBS market is fixed rate, there is also a significant supply of floating-rate CMBS available. In a rising interest rate environment, we’ve invested a fair portion of the Ladder Select Bond Fund in floating-rate senior bonds and kept duration pretty short for fixed-rate investments. By sticking mostly to the senior part of the capital structure with holdings principally in investment grade-rated bonds, the seniority of the security also helps to mute price volatility because of expected payoffs at par within a reasonable timeframe. We’ve traditionally focused on more senior and shorter term bonds which aren’t “sexy” but have produced a reliable and less volatile stream of cash flow.
Hortz: What other strategies does your firm use to unlock value from commercial real estate securities across market cycles?
Sedmak: We stick to our knitting and focus exclusively on what we know. We take a conservative approach, typically stay senior in the capital structure and are careful on duration. We believe our ability to perform fundamental bottom-up analysis has helped us to generate attractive relative returns with muted volatility, even in volatile macro market conditions. Bottom line: we try to keep it simple and focus on what we know best.
Hortz: What might be some still lingering concerns about commercial mortgage-backed securities (CMBS) from the market sell off in 2009 and its historic liquidity characteristics?
Harney: Like many asset classes CMBS was re-priced by the Financial Crisis, but the impact was muted and relatively short-lived compared to the residential / single-family home markets. To some degree, the favorable supply and demand dynamic and more conservative underwriting standards we’re seeing today are a direct result of the Financial Crisis. Staying senior in the capital structure further mitigates risk through credit enhancement. CMBS made up about 2 percent of the total U.S. fixed income market as of year-end 2018, so it’s a significant and growing portion of the fixed income sector with plenty of institutional investor participation.
A large and liquid CMBS market is now accessible, due to a liquid, institutionally dominated, secondary market of 20-plus years. The most active issuers of Agency CMBS are Fannie Mae, Freddie Mac and Ginnie Mae. These factors enhance market liquidity, especially for the more senior investment grade-rated bonds we favor.
Hortz: Why are there few, if no other, mutual funds with a strictly Commercial Real Estate Finance/CMBS orientation?
Harney: We believe a portfolio of commercial real estate finance investments / CMBS bonds is best managed by professionals with deep expertise in the field, and many investment professionals just don’t have the necessary experience to manage a CMBS mutual fund. In real estate, many investors take on significant risk to generate outsized yields, whereas we go the other way and seek strong protection of principal via highly‐rated senior secured bonds. We like this approach for the long‐term and it’s consistent with Ladder’s approach with its own capital. We’re pleased that this approach makes us fairly unique in the world of daily liquidity funds.
Hortz: How best would you recommend advisors employ your fund for their client portfolios?
Sedmak: While many other fixed income funds may own CRE Finance / CMBS, only Ladder Select Bond Fund provides a purpose-built, custom allocation to the asset category in a no-load, daily liquidity fund solely focused on commercial real estate finance / commercial mortgage-backed securities (CMBS). Because CMBS investments tend to offer a significant yield advantage over government bonds and similarly‐rated secured corporate issues, we think the Ladder Select Bond Fund provides enhanced income and diversification within a traditional fixed income portfolio.
In addition to income, senior secured CMBS securities provide helpful capital preservation protections, and the Fund has the flexibility to actively manage duration and interest rate risk depending on market conditions. Investment grade-rated CMBS typically exhibit strong credit characteristics, trade in a liquid market, and are generally less correlated with broader fixed income holdings than many other fixed income alternatives. By its nature, CMBS typically offers geographic, property-type, and industry-specific diversification.
We think there’s a prudent place for a custom-made allocation to a CRE Finance /CMBS fund in many fixed income portfolios where the advisors and/or principals are seeking secured income, reduced correlation, and enhanced diversification. Can I also note that the fund (LSBIX) is currently available on the TD Ameritrade, Charles Schwab, and Pershing FundVest platforms and the advisor can waive the $100,000 institutional investment minimum down to $2,500 to accommodate individual investor demand on those platforms.
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