The performance of high-yield commercial mortgages has long been a mystery, given how little information is available. Even estimating the size of the market is difficult.
However, a new study of high-yield loan performance by Michael Giliberto, a co-founder of the Giliberto-Levy mortgage indexes, has some answers. The study found that high-yield debt originated between 2010 and 2020 produced returns in line with its position in the commercial real estate capital stack.
The Giliberto study, first published in the October issue of the “Journal of Portfolio Management,” reported that high-yield debt produced a return of 8.5% during the 2010s decade, more than senior instruments such as senior fixed-rate debt (5.5%) and CMBS (5.9%) and less than equity indexes produced by the National Council of Real Estate Fiduciaries: the ODCE fund index (10.5%) and NCREIF Property Index (9.4%).
Since mezzanine mortgage debt falls between equity and senior debt in the capital stack, those results make intuitive sense and indicate that the industry is pricing risk efficiently. However, the study won’t be the last word on the topic. For one thing, the study was based on a relatively small sample, $20.9 billion of loans in the Giliberto-Levy 2 index, which is the first index to track the performance of high-yield debt.
A much bigger caveat is that there was no property market downturn during the period in which the study took place. That means the study doesn’t cover the impact on mezzanine debt during down markets—such as the early 1990s or 1998, or after the global financial crisis of 2008-10—when high-yield loans experienced a wave of defaults.
G-L index co-founder John Levy said there was no attempt to avoid downturns. The study was made possible by the formation of the G-L 2 high-yield debt index in 2017, which helped the firm to obtain data on loans dated back to 2010. Whatever its limitations, the study provides valuable information on the high-yield commercial mortgage market.
Growth of Mezzanine Market
High-yield debt encompasses different forms of debt that are junior in the capital stack to a senior mortgage. A simple and common form of high-yield debt is a second mortgage/mezzanine loan. Another form of high-yield debt is a B-note, in which a lender originates one high-leverage loan and splits it into senior and junior classes. The originator can then sell or retain either tranche depending on its strategy.
Subordinate debt has long been used in commercial real estate, although before the securitization era, high-yield debt was mostly in the form of a second mortgage. An explosion of high-yield debt was produced in the early 2000s when new structures were employed, and it became common to finance properties with debt totaling upwards of 90% of property value. In some large deals, lenders created layers of high-yield debt—sometimes dozens in large deals—that were sold to debt funds.
The 2000s saw growth of new structures of high-yield debt such as B-notes and resecuritizations of junior CMBS. The financial crisis led to defaults on a large amount of high-yield debt, particularly deals with numerous tranches of highly leveraged loans. After the financial crisis, the high-yield debt market shrank considerably, as many of the investors suffered losses and exited the business, and financing for high-yield debt became scarce.
As the financial crisis gets further into the rearview mirror, however, the high-yield debt market is once again growing. Levy said that the number of investors in the high-yield debt market has grown from less than 50 pre-financial crisis to about 170 today. One driver is the overall success of commercial real estate. Property income and values in most segments continue to reach new highs, leading to a huge inflow of capital into the sector. The strong fundamental performance means that loan defaults in post-GFC loans have been extremely low.
Another driver of capital into high-yield debt is the search for yield. Yields of senior fixed-income bonds and sovereign debt have reached all-time lows in recent years and seem unlikely to increase much. Many senior commercial mortgages have coupons in the 3% range. Investors searching for more return are turning to high-yield commercial property debt, which has less risk than an equity position and can include an option to take over the collateral in the event of a default.
Lessons About Leverage
If there is a lesson in the study, it might be that high-risk strategies pay off during times of favorable capital market forces, when the market is performing well, if originators exercise proper judgment in underwriting the loans. Aggressive lending has doomed high-yield debt funds during market downturns. Highly leveraged loans leave less room for error in the event property income declines or collateral assets—for example, poorly located malls—become obsolete.
Get the full Matrix Bulletin-Mezzanine Debt-November 2021