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.