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A Broken Record for CMBS Market

Trees may not grow to the sky, but it sure looked that way in commercial real estate last year. According to the Barron's/John B. Levy & Co. National Mortgage Survey, loans on commercial properties hit record volumes, surprising even industry participants. A staggering amount of income-producing real estate was sold in 2005, and spreads between commercial-mortgage yields and comparable Treasury yields tightened.

There was a record $170 billion in domestic commercial mortgage-backed securities issued in 2005, topping the previous record set in 2004 by more than 70%. Insurance companies and pension funds also steered unprecedented sums into the market for loans on income-producing properties.

In May, Wachovia Securities carved the triple-A tranche into a super-senior tranche with a 30% subordination level. After some resistance, the market joined the new trend. Now, almost every CMBS issue comes replete a 30% tranche. Some 75% of the underlying loans would need to default before affecting investors in the 30% class.

The move to the new tranche was led by bond investors uncomfortable with deteriorating mortgage underwriting. By year's end, it wasn't unusual to see leverage at more than 100% of property value on offerings. Some 65% to 70% of loans were interest-only for at least part of the term, and up to one-third of issues were also subject to additional debt outside of the securitization.

First-half predictions

Last July, we assembled a group of market experts and asked for their year-end forecast for the 10-year Treasury yield, super-senior triple-A spreads and domestic CMBS-issuance volume. Because this was an industry group, one might have expected the panel to respond bullishly and predict fairly high issuance volume. But they turned out to be a timid bunch — with one exception — and projected that issuance volume would total only $135 billion. That was way off the actual pace of $170 billion.

However, Haejin Baek of Barclays Capital forecast $175 billion, landing closest to the pin. The gang was more accurate when it came to the 10-year Treasury, predicting an average yield of 4.32%. JP Morgan's Brian Baker, at 4.35%, was closest to the actual result of 4.39%. Their predictions for the next six months are shown in an accompanying table.

Numbers from this year's panel show an expected issuance of $84 billion in the first six months of 2006, way ahead of the $73 billion recorded in the same period last year. The first quarter is expected to be especially active, with some $43 billion already on tap, compared with $31 billion in the first quarter of 2005.

The key to continued loan volume is a stable Treasury rate, and our panel doesn't foresee much change, predicting an average of 4.61%, or fewer than 25 basis points above current levels. Giving credence to the panel members' estimates were the notes from the most recent Federal Reserve meeting, which disclosed that the central bank's string of consecutive rate hikes — now at 13 — may be approaching the finish line.

As Pimco's Dan Ivascyn notes, “It's probably one and done” — meaning one more 25-basis-point rise in short-term rates. As to the super-senior triple-A spreads, the forecast calls for practically no change.

John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va. © Dow Jones & Co. Inc., 2004.


A panel of experts provided its forecast for CMBS volume and spreads through June 30, 2006.

Name Company 10-Year Treasury Yield Triple-A Spreads to 10-Yr. Interest-Rate Swaps* CMBS Issuance Volume (billions)
Haejin Baek Barclays Capital 4.75% 30 $100
Brian Baker JP Morgan 4.75% 25 $85
Rob Bloemker Putman Investments 4.60% 25 $90
Kent Born PPM America 4.50% 26 $75
Mike Buchholz Northwestern Mutual 4.65% 23 $88
Bill Green Wachovia 4.50% 25 $65
Mike Higgins CIBC 4.80% 26 $70
Dan Ivascyn PIMCO 4.50% 30 $70
Marc Peterson Principal Global Investors 4.50% 23 $80
Brian Schwartz RBS Greenwich 4.25% 29 $89
Steve Switzky BlackRock 4.85% 29 $80
Paul Vanderslice Citigroup 4.60% 30 $100
Derrick Wulf Dwight Asset Management Co. 4.65% 34 $100
AVERAGE 4.61% 27 $84
*in basis points, or hundredths of a percentage point
Source: John B. Levy &Co.

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