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Higher Rates to Crimp Borrowing

It was the calm before the storm in June — literally and figuratively — as the commercial real estate market prepared for an onslaught of securitizations, and coastal areas braced for the start of hurricane season. The commercial mortgage-backed securities (CMBS) market expected to notch $20 to $25 billion in new offerings for the month, which if realized would top off a gangbusters first half. However, the remainder of the year looks to run at a much slower pace, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

Buyers show some restraint

Higher interest rates are having the desired effect on the commercial mortgage business, although it will take a bit of time for the results to become more visible. Once the 10-year Treasury yield crossed over the 5% threshold, a number of leveraged buyers stepped to the sidelines waiting for capitalization rates — the inverse of the price/earnings multiple — to increase.

With fewer properties trading hands, there are also fewer financing opportunities. As a result, some conduit lenders are reporting that their pipelines of pending business are down a strong 20% to 40%. Treasuries are now up some 100 basis points from their low. But for most property types, cap rates have barely budged. According to Real Capital Analytics, apartment cap rates are up some 20 basis points, but for other property types they appear flat.

Potential buyers who are waiting for cap rates to increase and property values to decrease may find themselves quite disappointed. Torto Wheaton's Ray Torto expects that even if the 10-year Treasury yield were to rise another 100 basis points, cap rates would only increase a modest 20 to 60 basis points from their low point.

Spiraling insurance costs

The start of hurricane season has caused many property owners and insurers to rethink last year's experiences, and for the insurance industry the results were ugly. Most insurers found that their loss models didn't perform as well as expected and are either reducing the amount of coverage that they're willing to offer along the East and Gulf coasts or are charging exorbitant premiums (see insurance story on p. 32).

In South Florida, one major property owner experienced sticker shock upon renewing insurance on waterfront properties. Last year, for $55 million of all-risk coverage, the premium ran approximately $400,000. When the new premiums came in, insurers were willing to up the fire and casualty limits to $65 million but only offered $40 million in coverage for wind, flood and earthquake damage. The new premium for the revised coverage: a whopping $2.8 million, or seven times the previous level!

Unfortunately, this is not an aberration as property owners can expect their insurance bills to rise a minimum of two to three times previous levels in coastal areas. And in some cases, there will be no insurance available at all.

The commercial real estate industry last worked through an insurance debacle following the terrorism events of 9/11. In that case, it took a federal government fix to ensure adequate terrorism insurance coverage. Don't look for the federal government to step in this time. Property owners and developers will have to fight this battle on their own.

But the staggering increases in insurance costs could bring about some interesting and unintended consequences. Some property owners are already taking their increased insurance bills to the local tax assessor and asking for tax relief since the properties are clearly worth less with the increased costs.

Landlords would love to pass the cost directly along to the renters, but that doesn't even seem remotely possible in most markets. Additionally, some highly leveraged properties may now find that their net operating income isn't sufficient to pay the debt service. This could cause some isolated loan delinquencies, but in general capital is way too plentiful for this to be more than a blip on the radar screen.

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 6/5/06 5/1/06
AAA 80-81 74-75
AA 91-92 85-86
A 101-102 95-96
BBB 131-136 136-141
BB 290-310 290-300

Whole Loans*(Interest Rates)
Mtge. Range
Mtge. Range
Term of loan 6/5/06 Rate 5/1/06
5 years 6.12-6.22% 6.17% 6.01-6.11%
7 years 6.15-6.25% 6.20% 6.05-6.15%
10 years 6.20-6.30% 6.25% 6.16-6.26%
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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