Ready to Rethink Commercial Mortgage-Backed Securities?

In a Thanksgiving frame of mind, investors in commercial mortgage-backed securities gobbled up all they could find in November, according to the Barron's/John B. Levy National Mortgage Survey. The month tested their appetites, as no less than six transactions were in the market, including three floating-rate offerings and three large fixed-rate deals.

In early November, a $1 billion offering from Merrill Lynch and KeyBank led the way with pricing that was respectable but no barn burner. The $483 million of Class A4 rated triple-A tranche was estimated to price at interest-rate swaps plus 33 to 34 basis points, but widened to close at interest-rate swaps plus 35 basis points. (A basis point is 1/100th of a percentage point.)

Buyers found the securitization to be “lumpy,” in that the 10 largest loans accounted for slightly more than 60% of the pool. The transaction also carried a “Freddie class,” a $179 million tranche of multifamily loans bought entirely by Freddie Mac.

Early November's agenda included a $1.7 billion fixed-rate offering from Bank of America, which was delayed a month for technical securities violations. This securitization, probably the largest of the year, also included a Freddie tranche of $486 million. Bank of America traders have estimated that the triple-A rated A-4 will price in the range of interest-rate swaps plus 32-33 basis points.

Securities buyers continued to pour into the CMBS sector, even though spreads are low. In fact, according to Greenwich Capital Markets Managing Director Lisa Pendergast, triple-A spreads to comparable-term Treasuries haven't been this low since February 1998. One significant buyer groused that he expects triple-A spreads to be in the mid-to-high 20s by year end. But the predominant view is that spreads will be fairly constant, at least until the early January CMBS securities conference.

A Case of Irrational Exuberance?

And just when most observers seemed more optimistic about commercial mortgages, there was a reminder of the sector's risks. In late October, a 770,000 sq. ft. twin-tower San Francisco office complex, known as Market Center, was purchased for $79.5 million, or some $103 per sq. ft. Formerly Chevron's headquarters, the downtown property had been purchased in 1999 and became part of a floating-rate offering from Morgan Stanley, styled Series 2000-XLF. At the time of the securitization, most real estate professionals still had a frothy view of San Francisco. The Moody's Investors Service presale report indicated the building was worth $242 million, despite its purchase for $192 million just nine months earlier.

But as one major buyer noted, the building suffered a “perfect storm.” The dot-com bust ravaged the San Francisco market, and new leases have been virtually impossible to get signed. As a result, the buildings have been sold by affiliates of Tishman Speyer and Travelers Insurance, leaving a number of investment-grade classes with significant losses.

The Class E, originally rated triple B, will suffer a total loss of its current face value of almost $18 million and the Class F-1, originally rated triple-B minus, will also see a total loss of $11.6 million. But the losses could have been dramatically worse. After the loan had defaulted, a new appraisal was commissioned showing the building's value as $48 million, some $41 million less than the actual purchase price.

Competition for Loans Heats Up

On the whole-loan side, a major lender notes, “competition for new loans is brutal.” And it's unlikely to ease anytime soon. According to the Giliberto-Levy Commercial Mortgage Performance Index, commercial mortgages showed a total return for the third quarter of 0.46%, about in line with duration-adjusted triple-B corporates as measured by Lehman Brothers, which garnered a total return of 0.40%.

But investment-grade CMBS returned a negative 0.72% for the third quarter. Meanwhile, high-yield CMBS were down 1.65%. Commercial-mortgage losses continue to be virtually non-existent — just seven basis points in the past 12 months.

John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va. © Dow Jones & Co. Inc., 2003.


Selected CMBS Spreads*
To 10-year U.S. Treasuries
Rating 11/10/03 10/6/03
AAA 74-75 77-79
AA 82-84 86-88
A 91-93 96-98
BBB 132-137 139-144
BB 415-440 415-440

Whole Loans*
Prime Mtge. Range Prime Mtge. Prime Mtge. Range
Term of loan 11/10/03 Rate 10/6/03
5 Years 5.01-5.11% 5.11% 4.51-4.61%
7 Years 5.40-5.50 5.50 4.95-5.05
10 Years 5.92-6.02 6.02 5.52-5.62
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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