Borrowers suffer late-year sticker shock

Commercial mortgages have felt the sting of an inflation-driven market, according to the Barron's/John B. Levy & Co. National Mortgage Survey of participants in the whole-loan and CMBS markets. Commercial mortgage rates were pushed well north of 8% by a Treasury bond which is now up more than 1% from the beginning of this year. The new higher rates have caused many borrowers to suffer from "sticker shock" as they ponder the loans that they could have closed at dramatically lower rates.

The CMBS market continues to roll along at a pace which will see more than $60 billion come to the securitization market this year. As one large CMBS investor put it, "the market's stable but currently lacking momentum either way." A number of significant transactions are currently in the market, including an especially large $2 billion floating-rate transaction priced by Lehman Brothers at the end of October. These floaters have enjoyed strong investor support in the past, and the current offering labeled SASCO-C3 was no exception.

Investors liked the floating rate nature of the assets in a generally inflationary interest rate environment. The large $780 million Class-A, priced at LIBOR plus 0.40%, was in line with expectations, while the Class-H rated triple-B priced at the wide end of the range at LIBOR plus 2.25%. A $1.2 billion transaction from Credit Suisse First Boston is also in the market, although not as far along, as is a somewhat smaller $750 million transaction led by underwriters including Merrill Lynch and PaineWebber.

In most of the current CMBS securitizations, the classes rated triple-A sell quickly to a buying public that includes large money managers, life insurers and banks. But the mezzanine classes, which carry ratings from double-A to triple-B, are significantly slower to move. Because these classes require some understanding and appreciation for real estate risk, they c ater more to the life insurers. Most life insurers have filled up their CMBS allocation for the year and, thus, aren't aggressively seeking new investments.

As Bear Stearns' CMBS trader Jim Higgins puts it, "people are not compelled to be aggressive." On a positive note, Paul Selian of Aetna Investment Management noted that there is a light level of upcoming CMBS paper between now and the end of the year, and, as a result, technical factors should lead to significant spread tightening.

Sounding a cautious note, Standard & Poor's recently issued a report entitled "Cracks in the Foundation," which noted that, although real estate fundamentals are sound and the economy appears to be on track, there could be trouble ahead. Peter Kozel of Standard & Poor's noted that it would not "take a huge decline in economic activity to tip certain markets from balance into oversupply." He went on to note that S&P is most cautious about retail and especially about the Internet's impact. In the report, Kozel notes that the Internet alone could reduce incremental demand for new retail space by one-third over the next several years.

While new loan originations intended to be securitized in the CMBS market are down dramatically, the life insurance industry is enjoying a good year. Most insurers note that, although their pipelines are down, they have virtually filled their quota for 1999. A number of insurers have already started hunting for new mortgages to fund in the first quarter of 2000. In an attempt to help borrowers deal with "sticker shock," some insurers have trimmed their spreads, albeit almost imperceptibly. Meanwhile, one senior life company executive noted that virtually all of the "low-hanging fruit" had been picked and that every deal he saw had a story or a wart attached to it. In summary, he noted that it might be very hard to meet his aggressive production goals in 2000.

For the third quarter, commercial mortgage whole-loans performed almost exactly in sync with Baa duration-adjusted bonds, as measured by the Giliberto-Levy Commercial Mortgage Performance Index and Lehman Brothers. But it was a different story for the year-to-date, as commercial mortgages outperformed the Lehman Bond Index by a whopping 0.80% in the first nine months.

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