Looking for Upside? Try Commercial Property Bonds

Commercial real estate—like its much bigger residential cousin—is starting to get hammered by the credit crisis and slumping economy. But for investors, the news isn't all bad.

Regional banks and some real estate investment trusts, or REITs, are likely to get hit hard as delinquencies on commercial real estate loans rise. But oddly, commercial mortgage-backed securities, or CMBS, are offering outsized gains with less risk than you might think.

This offers some attractive benefits for investors in REITs and mutual funds that have CMBS in their portfolios.

“Those bonds today are trading at 14-16 percent yields—it’s outrageous," Darrell Wheeler, a CMBS analyst with Citigroup. "I’d rather have that than a US Treasury—that’s how dislocated the market is.”

Commercial-mortgage securities are in far better shape than their residential counterparts, even though they've been sold off as investors dump anything related to real estate. That's because the underwriting standards have typically been tighter for CMBS, especially in recent years when people could get residential mortgages with little or no documentation.

Roughly 80 percent of CMBS bonds are still rated Triple A. They're also structured so that investors are largely insulated from anything but large-scale defaults.

“That means three-quarters of the pool has to default before you could lose any money,” explains Wheeler.

Oliver Quillia for cnbc.com

Another reason is that investors get much more information about the health of the commercial mortgages, allowing them to bypass the credit rating agencies.

“It’s not a market that has been ... trustful of the rating agencies," said Darrell. "It is really driven by real-money investors that work closely together—they meet every 6 months—and so they have negotiated to get pretty good information on these pools and to screen them pretty well.”

While some commercial mortgage-related exchange traded funds are still in development, individual investors are able to play this asset class indirectly through REITs that focus on commercial property, such as NorthStar Realty Finance or Arbor Realty Trust , as well as through mutual funds that have CMBS in their fixed-income or high yield funds.

But investors should drill down into these trusts' portfolios because the investment focus may have put them lower in the capital structure through purchases of subordinated debt or construction loans that may not have a recession full priced in, cautions Wheeler.

Indeed, JPMorgan cautions against overweighting Triple-A bonds “solely because of the wider spreads,” in part because “the year-end delevering still appears to have some legs.”

But for “investors with patient, longer-term money that can stomach another potential round (or two) of spreads widening [and] heightened spread volatility may want to consider beginning a slow extended buy program,” according to a Nov. 21 note.

CONTINUED : 20 Percent Drop From Peak?

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