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Undaunted By Unsettling Trends

As fictional character Alfred E. Newman of Mad Magazine might say about the state of commercial lending today, “What, me worry?” Retail consolidations, highly leveraged loans, and rock-bottom spreads are having no impact on the commercial mortgage juggernaut, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

Retail consolidation is a hot topic as the merger of Federated Department Stores and May Department Stores is front and center. Although the two retailers own some 950 stores between them, commercial mortgage investors and originators are dealing with this as just another “so-what” issue. Several Wall Street types note that the merger could lead to the closing of up to 70 stores, but analysts argue that the impact will be minimal at best.

Roger Lehman, director of CMBS research at Merrill Lynch, notes that “if both Federated and May overlap at the same mall, the mall is likely dominant in its trade area, affording the landlord substantial leasing opportunities.” Developers and mall owners have been innovative in re-tenanting old anchor stores, converting many to either additional mall stores or adding food courts and movie theaters, so that the net result is added cash flow.

CMBS activity on a tear

The volume of new CMBS issuance continues to head inexorably higher. Analyst estimates vary, but a number predicted $15 to $18 billion in new deals in March alone, which would bring the first quarter total close to $30 billion, dramatically ahead of the $21 billion posted for the same period in 2004.

Still, there's no lack of chatter from both institutional lenders and CMBS buyers about the increasing leverage of the loans they are buying. By all accounts, underwriting standards have deteriorated to a new low. Data from Moody's Investors Service confirms it. Through February, Moody's loan-to-value is now a whopping 96%, an all-time high that is up a tad from 95% recorded in fourth-quarter 2004. More than 32% of the loans had a loan-to-value in excess of 100%, again up from 30% in the fourth quarter.

As recently as two years ago, loans exceeding 100% of value were in the single digits. Additionally, interest-only loans are also setting new records with some 52% of the loans issued thus far in 2005 having no amortization for part or all of the term, up from 45% in the fourth quarter of 2004. Interest-only loans have been climbing steadily over the past two years. Though buyers complain, there's nothing remotely close to a buyers' strike. “We're victims of our own track record with too little focus on the credit risk of a highly cyclical business,” notes Tad Philipp, managing director at Moody's.

Insurance companies and pension funds have been engaging in mortal combat with conduit operators for their share of new commercial mortgage loans. Conduits now offer loans that are not only more levered than are generally available from insurance companies, but they're also cheaper. Insurers note that their hit rate of attracting new business is down, and they are trying desperately to find ways to entice borrowers. In order to compete, several insurers are either lowering their spreads or are offering higher loan-to-values. In many cases, they're also willing to take some leasing risk, a gamble that a particular property will lease up in the near future.

Borrowers embrace fixed rates

Treasury rates have hiccupped of late — some 25-30 basis points from their February low — finally giving lenders a chance to say, “I told you so.” Federal Reserve Chairman Alan Greenspan noted that he couldn't explain the continued low level of the 10-year Treasury yield, which was enough to scare many borrowers into quickly locking in a rate.

But despite the miniature stampede, a look at the forward Treasury curve shows that expectations aren't nearly as bad as might be expected. The forward Treasury market suggests that the 10-year Treasury yield on July 1 will be 4.52%, a modest 17 basis points higher than the level as of early March, and 4.62% at year's end. Citizen Bank's Stuart Muir, vice president of the Mid-Atlantic group for interest rate derivatives, notes that “over time the forward Treasury curve tends to overstate future interest rates.” Nevertheless, that's not a guarantee, and at the end of June rates could be dramatically higher or lower than the curve currently suggests.

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 3/7/05 1/31/05
AAA 63-64 61-62
AA 71-72 69-70
A 81-82 78-79
BBB 125-127 118-123
BB 285-300 280-300

Whole Loans*
Prime Mtge. Range Prime Mtge. Prime Mtge. Range
Term of loan 3/7/05 Rate 1/31/05
5 Years 5.09-5.19% 5.14% 4.90-5.00%
7 Years 5.24-5.34 5.29% 5.09-5.19%
10 Years 5.46-5.56 5.51% 5.37-5.47%
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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