One of the predictable effects of the sub-prime crisis was that ratings agencies would become more conservative when it came to rating mortgage-backed securities. That has come to pass.
But has the agencies’ caution overreached? News this week suggests that perhaps they have been pricing too conservatively – and there are folk who would exploit that.
Heitman and Rogge Global Partners have jointly launched a short-duration, global real estate bond fund in a sign that both fixed-income and real estate fund managers are sensing opportunities in an underappreciated bond market where credit ratings have fallen below what bonds are actually worth – especially in the 2006 and 2007 vintages.
Consider a structure where one percent of loans are backed by assets in Italy and Spain and 99 percent are backed by assets in healthier markets. Some rating agencies would have downgraded the structure because of the Southern Europe exposure, which means some traditional fixed income investors cannot touch them. However, Rogge thinks that by bringing in Heitman, with its in-depth knowledge of real estate, it can exploit the price suppression and get investors in its fund paid back handsomely.
If the bond has a triple B rating, but a bond fund with a real estate specialist working on it perceives it to be a double A, one can take advantage of the price differential so long as the underwriting is correct.
At this point, Rogge and Heitman's global real estate bond fund is a rarity. But it isn't the only one involving a real estate specialist to launch this year. In March, Brookfield unveiled the Brookfield Mortgage Opportunity Income Fund and raised $483 million to primarily invest in underappreciated mortgage-related securities. London-based Cheyne Capital is a third example.
There are certainly investors who should be interested in such products: those who might have satisfied their direct real estate allocation for instance, or others who need liquidity and don't want to be tied up in a fund for seven years, yet fancy exposure to an asset class that can provide an inflation hedge.
Insurance companies in particular can be relevant here, with their short-term capital needs and a clear preference for relative safety combined with some yield generation. Others might include fund of funds, high net worth individuals or family offices that could view real estate bonds as an 'illiquid alternative' – assets that are illiquid because they are properties, but alternative because a real estate bond is not a pure bond.
As well as highlighting the play on overcautious ratings agencies, the launch of these funds poses yet another intriguing new dynamic. Instead of bond funds being the sole preserve of fixed income specialists, now we have the real estate firms moving in. They think they have an edge over the pure fixed income outfits because they have a better knowledge of the underlying assets.
While Rogge and Heitman say theirs is a global real estate bond, they believe most opportunity will come out of Europe because Europe’s recovery is three years behind the US. In the US, real estate bonds have done pretty well for good quality underlying assets already. Europe should be next, which is a plausible-looking subtext to the bigger picture here. But the main story is this: yet another way for investors to participate on improving real estate markets has emerged – thanks in no small part to credit raters and their current attitudes towards risk.