End To Frothy Underwriting In Sight spects

Take a gigantic issuance pipeline for commercial mortgage-backed securities, sprinkle in moderately higher U.S. Treasury rates and two headline-grabbing corporate bankruptcies, fold in major selling activity in the secondary market, and stir.

What do you get? One might expect a recipe for disaster. But, according to the investment pros contacted for the Barron's/John B. Levy & Co. National Mortgage survey, that hasn't been the case. Says one CMBS buyer: “I was pleasantly surprised by the normalcy of it all.”

Historically, October is considered a treacherous month for the commercial real estate market, as well as for stocks, but it didn't live up to its reputation this year. In fact, in October the market absorbed the largest CMBS deal ever — a $4.3 billion offering from Goldman Sachs (ticker: GS) and RBS Greenwich Capital, styled GG5.

Money managers and other crossover buyers flocked to the $1.5 billion, Class A-5 rated triple-A tranche, which sported the now standard 30% subordination level. There were several orders for more than $250 million each.

CMBS issuance totaled $21.5 billion in October, slightly less than the record set in July, reports Merrill Lynch analyst Roger Lehman. It's not unusual for the commercial mortgage market to catch a cold when the corporate market is dealing with major credit announcements.

Interestingly, the bankruptcy filings by auto parts maker Delphi Corp. and commodities broker Refco Inc. had virtually no impact, except for one loan that was removed from the GG5 transaction in which Refco was a major tenant.

Spiraling out of control?

The secondary market for commercial mortgages was hopping as well. Freddie Mac, the largest single owner of CMBS securities, sold $5.8 billion of older securitizations in October. To be sure, this weighed on the market and created somewhat sloppy secondary trading, but no white-knuckle moments appeared.

Commercial-mortgage originators and CMBS buyers continue to grouse about the market's lack of underwriting discipline, but their appetites continue unabated. Commercial mortgage buyers sense that loans are still grossly overleveraged, and that interest-only terms are granted with reckless abandon.

But according to Managing Director Tad Philipp of Moody's Investors Service, “The apex of frothy underwriting may well have been reached.” If so, the top is coming after a huge run-up. When Moody's looked at fixed-rate conduit loans issued in the third quarter, it found that 65.6% were interest-only for either part or all of the term. That's a high percentage to be sure, but it's virtually flat compared with the second quarter, when 65% fell into this category. On the loan-to-value side, Moody's finds much the same story, with overall third-quarter leverage of 101%, just a bit over the second quarter's 100.5%.

Dose of Halloween fright

Moody's noted that the loans that were interest-only for their full terms also had the highest loan-to-value ratio in the third quarter — 104.9%. Loans that came with amortization during their entire terms measured a significantly lower 97.2% on the loan-to-value scale. Higher-leverage loans that carry low interest rates could lead to refinancing difficulties down the road, especially if interest rates are materially higher than they are today.

Retail centers no longer golden

Institutional lenders have long viewed both grocery-anchored shopping centers and multifamily loans as falling in the no-brainer category. Both insurers and CMBS players are often willing to buy them at a spread of less than one percentage point over comparable U.S. Treasuries.

But now, some insurers are suggesting that it may be time to lighten up on their retail exposure because of Wal-Mart. The giant retailer's super centers and its new neighborhood-market stores are eating into the market share of competitors. As a result, some mortgage lenders are only willing to place mortgages on centers with grocers whose market share is either No. 1 or No. 2 locally. The fear is that Wal-Mart eventually will crush smaller players.

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


Selected CMBS Spreads*
To 10-year
U.S. Treasuries
Rating 10/31/05 10/3/05
AAA 75-76 74-75
AA 92-93 92-93
A 102-103 102-103
BBB 159-164 155-160
BB 300-310 290-310

Whole Loans*(Interest Rates)
Mtge. Range
Mtge. Range
Term of loan 10/31/05 Rate 10/3/05
5 years 5.55-5.60% 5.55% 5.24-5.34%
7 years 5.60-5.70% 5.60% 5.30-5.40%
10 years 5.67-5.77% 5.72% 5.39-5.49%
For loans of $5 million and up, on amortization schedules of 25-30 years that can be funded in 60-120 days with 0-1 point.

*In basis points, or hundredths of a percentage point.

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