Borrowers Leverage Their Strength

Known as the hand-to-hand combat of the financial world, commercial-mortgage lending has become so intensely competitive that lenders might consider hiring Navy SEALs as originators. The commercial-mortgage business continues on a roll, no doubt because of extraordinarily low interest rates, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

Research from Bear, Stearns & Co. shows that the number of first-quarter conduit-fusion offerings — pools containing a few loans on major buildings and numerous loans on smaller properties — increased a whopping 27% over the same period a year ago. The party was expected to continue this month with more than $10 billion scheduled to come to market.

In Search of Higher Yields

With low interest rates and tight spreads over comparable Treasuries, investors in commercial mortgage-backed securities (CMBS) are reaching for yield, buying lower-rated tranches to gain slightly higher yields. Competition is so intense that migrating down the credit curve from triple-A to double-A CMBS gives investors a scant pickup of seven basis points, or seven-hundredths of a percentage point. Further movement from double-A to single-A bonds gains only a modest seven to eight basis points.

One of the most interesting deals in the market was the recent $892 million offering of five- and seven-year loans from Goldman Sachs, called GS Mortgage Securities 2004-C1. Carved out as a separate tranche in the securitization was a class of multifamily loans totaling some $168 million, which industry sources said was sold to Freddie Mac (which continues to take public heat over its continuing purchases of CMBS), the single largest purchaser of triple-A securitizations. Such carve-out classes in past securitizations have drawn complaints from buyers.

Since Freddie Mac purchased nearly all the multifamily loans in the Goldman Sachs offering, the rest of the securitization lacked this property type. But some large institutions prefer the carve-out structure. “With a carve-out class, there is a truer indication of demand for the non-multifamily securities,” says Steve Switzky, managing director at global money-management firm BlackRock.

Buyers of the Goldman Sachs securitization also noted that almost 65% of the loans are interest-only for the entire loan term. Since there is no amortization on such loans, refinancing them upon maturity is more difficult — and securities buyers could find to their dismay that the loan terms are extended.

‘Chinks in the Underwriting Armor’

The flood of capital seeking new commercial mortgages has led to a relaxation of credit standards. As one major Wall Street originator puts it, “We may not be breaking the rules, but we're darn sure bending them with regularity.” Says Tad Philipp, managing director with the CMBS group at Moody's: “We're beginning to see some chinks in the underwriting armor.”

A sharp rise in interest-only loans is a good indication of more relaxed underwriting. According to the analytics firm Trepp LLC, an average of 2.1% of all commercial-property loans were interest-only from 1998 through 2002. But that percentage shot up to 8.3% last year and to 15% so far this year.

Also on the increase: the pari passu loan — a large financing spread among two or more securitizations, each with a pro rata piece of the first mortgage loan. Lisa Pendergast, managing director at RBS Greenwich Capital, says 12 offerings already this year included pari passu loans totaling $2.6 billion. (The Goldman Sachs transaction had three pari passu loans totaling $149 million.) Some pari passu loans in the pipeline may be included in as many as seven separate securitizations.

Meanwhile, subordination levels — representing the percentage of securities that are junior to a specific class — have declined for more than six years. In 1999, 10.3% of the securities were subordinate to the triple-B-minus class, the lowest investment-grade tranche. This year the level is 4.6%.

Part of the decline is due to the changing makeup of newer securitizations, which have fewer loans on problem property types such as health-care facilities and hotels. But skeptical analysts note that just one significant loss in a single large loan could scuttle investments well into the lower investment-grade tranches.

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 4/5/04 3/8/04
AAA 69-70 70-71
AA 76-77 77-78
A 83-85 86-88
BBB 115-120 120-125
BB 390-400 390-410

Whole Loans*
Prime Mtge. Range Prime Mtge. Prime Mtge. Range
Term of loan 4/5/04 Rate 3/8/04
5 Years 4.30-4.40% 4.30% 4.48-4.58%
7 Years 4.75-4.85 4.75 4.88-4.98
10 Years 5.25-5.35 5.30 5.45-5.55
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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