Cmbs Trade Idea

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Executive Summary
I propose a long position in the single name CMBS security J.P. Morgan Chase Commercial Mortgage Securities Pass-Through Certificates Series 2004-CB8 (“JPMCC 2004-CB8”), Class D. This trade will implement the long term bullish view I have on real estate without exposure to the near term volatility seen in other mortgage products in the U.S. Aggregate index that are highly sensitive to rates due to the uncertainty in QE3 and other macroeconomic factors. * Recovery in commercial and residential real estate will continue without regard to Fed decisions on QE3. * Fed’s commitment to keep short-term rates near zero until the unemployment target is met means higher commercial property valuations. * There should be a mean reversion of 10-year treasury to cap rate spreads as they are near the all-time highs. * CMBS credit is the best way to take a bullish position on real estate.

* Recovery in commercial and residential real estate will continue without regard to Fed decisions on QE3. * Fed’s commitment to keep short-term rates near zero until the unemployment target is met means higher commercial property valuations. * There should be a mean reversion of 10-year treasury to cap rate spreads as they are near the all-time highs. * CMBS credit is the best way to take a bullish position on real estate.

Trade Rationale

There has been a large amount of uncertainty surrounding the future of QE3 and short-term rates causing increased volatility in agency MBS and other interest rate sensitive securities. The most recent FOMC minutes from January allude to many participants becoming concerned about the risks of further asset purchases, while a February 11, 2013 speech by Vice Chair Janet Yellen mentions the importance of fiscal policy and residential investment to economic recovery. However, real estate in its pure form, meaning the hard asset price, should benefit from either direction the Fed decides on going forward. If QE3 continues, real estate prices should benefit from the inflationary effects from Fed purchases. On the other hand, if there is a sharp recovery and unemployment improves, QE3 will come to an end, but investment into residential and commercial real estate will begin. Having the view that real estate is not highly sensitive to short term monetary policy, I believe the growth in commercial real estate prices will remain stable, if not improve in the near future. The Moody’s/RCA CPPI Core Commercial Index (“CPPI”) indicates that the year-over-year growth in the core commercial real estate market (Retail, Industrial, and Office) has been approximately 7-8% for the past two years, improving since the third quarter of 2009 (Figure 1).

Figure 1. YoY Growth in Moody’s CPPI Core Commercial Index

In December 2012, the Fed announced that it would tie its policies to unemployment and inflation by keeping short-term rates near zero until unemployment reaches 6.5% or inflation reaches 2.5%. Creating a mandate to decrease unemployment to 6.5% could inherently mean a directive to increase commercial real estate prices as well. Since the zero policy period the CPPI index has been highly inversely correlated to the unemployment rate as seen in Figure 2. Assuming this inverse correlation continues, it would imply an increase of approximately 20% in commercial real estate prices as approximated by the predicted CPPI index and unemployment rate from a log regression. Figure 2. Relationship Between CPPI and Unemployment

The spread between the 10 year treasury and cap rates can be interpreted as the perceived risk on commercial real estate investing. Spreads to the 10-year tend to be close to or lower than zero during times of high asset valuation as seen during the recent housing bubble as well as the one in the 80s. Given that spreads are currently at or close to all-time highs (Figure 3.), depending on which property type, there should be a tendency to revert to the mean...
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