“Cat” bonds, short for catastrophe, are risked-linked financial instruments used by an insurer to transfer a specified set of risks from its account to that of a third party. These bonds have been around for the past ten years or so; they were created after Hurricane Andrew and the Northridge earthquake and have provided a mechanism for an insurer to mitigate some portion of the risk it would face. How do they work?
An insurance company, via an intermediary such as an investment bank, issues bonds that are then sold to institutional investors. The bonds, which usually are short in duration—say, three years or less—are rated BB by one of the rating agencies such as Standard & Poor’s, Moody’s, or Fitch. If no catastrophic event occurs, the investors receive semiannual interest payments; investors receive a premium rate of interest on the bonds to offset the risks. If a catastrophic event does occur, repayment of the principal amount owed by the insurance company is forgiven by the investors and the insurance company may use the funds to satisfy claims.
What does this have to do with real estate? As usual, nothing and everything. So far this year, $5.5 billion of catastrophe and similar insurance-linked bonds have been issued. Most recently, an insurer issued $130 million of bonds linked to payments of damages as the result of meteor strikes, volcanic eruptions, and some wildfires, thunderstorms, and blizzards. The offerings appeared to sell well; after offering, trading seems fine . . . so far. Our concern remains rooted in the fact that institutional investors seem willing to go further and further afield and appear willing to take increasingly large risks in search of yield because returns on more mundane assets are so paltry. But what happens when the markets are disrupted by some geopolitical or economic event? A hedge fund might be prepared for this, but what about a pension fund?
The Trepp survey for the week ended May 23 showed spreads widening about 4 basis points; fast forward one week and the survey (dated May 30) show spreads coming in at 4+/- basis points. The implied ten-year commercial real estate mortgage rate for institutional properties remains at 4.00+/- percent.
Asking Spreads over U.S. Ten-Year Treasury Bonds in Basis Points
The Cushman & Wakefield Equity, Debt, and Structured Finance Group’s monthly Capital Markets Update of commercial real estate mortgage spreads, dated June 5, showed spreads coming in 15 to as much as 20 basis points since the previous survey, dated May 9, as lenders compete for business in a very competitive business environment. No one expects this to change in the near term.
In its “Market Commentary” accompanying the survey, C&W noted the following:
- The current data suggest that strength in the economy during the second quarter of 2014 will more than offset the contraction experienced during the first quarter.
- Deal flow may be slightly lower than last year, but only at the margins. Commercial mortgage–backed securities (CMBS) issuance, which is running slightly below last year’s pace, seems to be picking up, with a number of conduits readying offerings for marketing before June 30.
- Ten-year Treasury yields continue to drop and spreads continue to narrow, bringing lending costs to their lowest levels in more than a year.
- At low loan-to-cost levels (50 percent or less), nonrecourse construction loans are becoming available from commercial banks in the LIBOR-plus-400-basis-points range.
|Ten-Year Fixed-Rate Commercial Real Estate Mortgages (as of June 5, 2014)|
|Class A||Class B|
|Multifamily (agency)||75–80%||T +170||T +170|
|Multifamily (nonagency)||70–75%||T +165||T +180|
|Anchored retail||70–75%||T +185||T +195|
|Strip center||65–70%||T +190||T +200|
|Distribution/warehouse||65–70%||T +180||T +200|
|R&D/flex/industrial||65–70%||T +190||T +210|
|Office||65–75%||T +185||T +195|
|Full-service hotel||55–65%||T +240||T +260|
|Debt-service-coverage ratio assumed to be greater than 1.35 to 1.|
Year-to-Date Public Equity Capital Markets
Dow Jones Industrial Average: +2.10%
Standard & Poor’s 500 Stock Index: +5.47%
NASD Composite Index (NASDAQ): +3.47%
Russell 2000: +0.13%
Morgan Stanley U.S. REIT Index: +13.77%
Year-to-Date Global CMBS Issuance
(in $ billions as of 6/6/14)
|Source: Commercial Mortgage Alert|
Year-to-Date Public U.S. Treasury Yields
|U.S. Treasury Yields|