Profiting from Market Dislocations

September 12, 2016

Post-Traumatic Stress Disorder, noun: A condition of persistent mental and emotional stress occurring as a result of injury or severe psychological shock, typically involving disturbance of sleep and constant vivid recall of the experience, with dulled responses to others and to the outside world.
. . .
Investors worldwide readily recall the devastating bear market that began in October 2007 and lasted until March 2009. Major global indices lost more than 50 percent in value. Dragging investor fortunes down commensurately.
Those allocated to the triumvirate of stocks, bonds and cash found little refuge. Spending the 2008 holidays in a daze. Only to incur further volatility in Q1 2009.

Eight years later, many remain on the sidelines. Like victims of a violent accident. Suffering from a financial form of PTSD. Because, even as markets have recovered, their fragile psyches, the parts that enable them to invest with confidence, have not.
Further, with the S&P 500 sitting near all-time highs, even seasoned investors have become loathe to allocate capital to stocks. Which they believe could correct any time. Worsening matters, interest rates sit near historical lows, rendering worthless the yields on fixed-income investments.
Too much risk in equities? Too little reward in fixed income? Where can an investor not seeking equity exposure turn for a respectable risk-to-reward setup?
Find the nearest dislocation.
Dislocation, noun: Disruption of an established order.
. . .
Throughout history, renown investors have identified and exploited various dislocations in global markets. Moving capital away from the stampeding herd in order to profit by some temporary occurrence.
Soros and the British pound. John Paulson and the Credit Crisis. Wilbur Ross and the 2001 steel tariff. Henry Flagler and oil. Each invested capital into temporary market dislocations. Profited handsomely. Then removed their chips from the table.
Such a dislocation exists today.
2007 represented the peak of issuance in collateralized, mortgage-backed securities (CMBS). With the volume of real estate mortgages having hit record levels over the prior two-year period. As the lion's share of these mortgages were ten-year loans, they are currently maturing. Even though loan supply is down. Because of the hyper-regulatory environment under which banks and lending institutions currently operate.
Consequently, there are fewer lending institutions available to handle the current tsunami of maturing CMBS.
According to The Economist, "Bankers had hoped that, after seven years of penance for their part in the financial crisis, the end of wrenching overhauls forced by fierce new regulations might be nigh. But, to their dismay, the regulator's zeal is undimmed. Far from giving banks respite, they are toughening up old rules and devising new ones..."
Thus, there exists a wall of maturities coming due from 2015 to 2018. During which these loans must be paid off and -- usually replaced with new loans. This demand to replace maturing real estate loans, combined with limited supply, creates a void of hundreds of billions of dollars over the next few years. A void that must be filled by new sources of capital.
Two primary drivers are creating favorable opportunities for providing commercial real estate loans:
1) The limited amount of credit available to borrowers from traditional lending sources.
2) An increasing number of commercial real estate loan maturities. Specifically:
--The availability of mortgage financing from banks is constrained by regulatory requirements.
--An unprecedented amount of commercial real estate debt is set to mature through 2017, much of which was originated at the peak of the past market cycle.
--There is a shortfall between the amount of maturing debt and the amount of new first mortgage debt available.
Accordingly, mezzanine debt can be a very attractive risk/reward opportunity for investors. As the shortage of real estate financing provides savvy investors an immediate opportunity to augment loans provided by traditional lenders.
For the next three years or so, we believe there will be an opportunity to originate prudent loans, secured by quality real estate, while locking in interest rates higher than those currently available in most fixed-income investments.
We have partnered with companies issuing commercial real estate mezzanine debt. Secured by high-quality commercial properties like offices, apartments, retail and hotels. Commercial real estate mezzanine debt provides substantial dividends. While avoiding the volatility accompanied by equities and junk bonds. In fact, mezz debt can yield low-double digit coupons. Better than dividends on the S&P 500, junk bonds or REITs. Perfect for investors starved for yield. And as its backed by hard assets, investors have some protection in the event of a default.
Following the Credit Crisis, mortgage factories closed en masse. Commercial real estate mezzanine loans were in short supply. Just as demand began percolating higher. Bringing rates to reflect the lack of supply of -- and increasing demand for -- such loans.
Consider that ten-year Treasurys pay less than two percent. The dividend on the S&P 500 index sits at two percent. The LQD corporate bond index yields 3.21 percent. The iShares HYG high yield index provides 5.48 percent -- and a lot of volatility.
Commercial real estate mezzanine debt? Could provide anywhere from nine to 15 percent, depending on the opportunity.
Comfortingly, mezz loans are senior to the property's equity owners and junior to the first mortgage. Meaning, when a property is sold, the first mortgage is paid first, followed by the mezzanine loans, and only then does the property owner collect any proceeds.
Property investors pick the deal, complete due diligence, and yet we get paid before they do? Not bad. And because these investments are secured by quality commercial real estate, the risk is lower.
Once this financial dislocation dissipates and the opportunity runs its course? Most likely in three to five years? Investor capital will simply be returned.
So, if high-yield, short-term real estate loans secured by quality U.S. commercial properties that do not correlate to the equity markets sound attractive, then we should speak.
Because it's a great time to be a lender.

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