Interest rates in limbo

Chubby Checker probably didn't have interest rates in mind when he sang “How low can you go?” in the 1962 anthem “Limbo Rock.”

But with interest rates at their lowest levels since the Twist was the rage in the early '60s, some real estate developers have accelerated their borrowing while others are hoping for still lower rates.

The recent plunge in rates has driven prices of existing commercial mortgage-backed securities to new premium levels. The average price of bonds in the September Lehman Brothers CMBS Index was 112 (12% over face value), with many trading as high as 120 (20% over face value).

In the past, CMBS buyers have shied away from high premiums for fear of prepayments or foreclosures, which could result in the bonds being redeemed at par. But those concerns are being compensated by higher yields — about 0.01 to 0.02 of a percentage point for every point in prices. Thus, a bond quoted at 110 would yield about 0.10 to 0.20 of a percentage point more than a par bond.

During the week of Sept. 23-27, six securitizations were offered, including a $921 million standard conduit from Prudential Securities and Bear Stearns. The long triple-A was priced at 0.46 percentage points over interest-rate swaps, while the triple-B yielded 1.20 percentage points over swaps.

The largest offering was a $1.45 billion conduit from Lehman Brothers and UBS Warburg. While diversification of the collateral was limited — 60% consisted of the 10 largest loans — the four largest loans, 43% of the pool, were investment grade, helping to assuage risk concerns.

The triple-A A-4 tranche was priced at 0.49 percentage points over swaps, a bit wider than the 0.46 to 0.47 percentage points expected by the underwriters. But the large size of the class, $860 million, adds to the tranche's liquidity, which should help to tighten spreads.

Included in the Lehman/UBS deal was a bifurcated note on 1166 Avenue of the Americas in Midtown Manhattan, where $92 million was offered publicly and $147 million was sold privately.

The private notes were the first securitization of a single property since 9/11. Even though the transaction offered full terrorism insurance, the triple-A tranche was priced at 0.91 percentage points over swaps, about twice as wide as a garden-variety conduit. Part of the spread probably reflected the long average life of the security — 17.5 years.

Does nonrecourse equal not responsible?

With a steady flow of corporate restructurings and a weak economy, investors wonder when loan defaults will start to accelerate. Virtually all commercial mortgages are nonrecourse, so when the value of the real estate is less than the mortgage, the borrower can give the property back to the lender without risking other assets.

Although that's surely a legal route, creditworthy borrowers are loath to invoke that option. Almost all investment-grade REITs have told rating agencies and investors that they've never given back a property.

But that may change with Kimco Realty's handling of seven Kmart shopping centers on which it borrowed more than $70 million. Kmart, as part of its bankruptcy proceeding, stopped paying rent in June, and Kimco stopped paying the lenders the following month.

CMBS players who had argued that Kimco — a highly regarded REIT with a single-A3 credit rating — would never do such a thing were proven wrong.

Says Mark Streeter, a vice president and senior analyst with JP Morgan, “The actions are not consistent with what the markets expect from an A-rated company.”

If REITs and other owners use nonrecourse loans as hedging vehicles, the commercial-mortgage industry could change dramatically. Lenders and investors expect borrowers to make heroic efforts to save their properties. According to Larry Duggins, president of ARCap, the special servicer on several of the Kmart loans, “Nonrecourse does not mean not responsible.” Kimco officials declined to comment.

John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va. © Dow Jones & Co. Inc., 2002.


Selected CMBS Spreads*
To 10-year U.S. Treasuries
Rating 9/30/02 9/2/02
AAA 109-111 97-99
AA 120-122 108-111
A 131-133 120-123
BBB 183-188 172-177
BB 450-475 450-475

Whole Loans*
Term of loan Prime Mtge. Range 9/30/02 Prime Mtge. Rate Prime Mtge. Range 9/2/02
5 Years 4.89-4.99% 4.89% 5.21-5.31%
7 Years 5.26-5.36% 5.26% 5.61-5.71%
10 Years 5.65-5.75% 5.75% 5.99-6.14%
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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