CMBS competition creates 'can you top this mentality

The commercial mortgage market continues to operate at a blistering pace, according to the Barron's/John B. Levy & Co. National Mortgage Survey of major whole-loan and commercial mortgage-backed securities (CMBS) investors. The CMBS market is clearly leading the charge, where securitization volumes have reached dizzying levels. According to James F. Titus, senior vice president of Donaldson, Lufkin & Jenrette, CMBS volume for the first six months of 1998 totaled $42.7 billion and involved 54 separate transactions. That total is virtually the same as the securitization total for all of 1997, which was in itself a record! The CMBS market has taken on a "can you top this" mentality.

But the white-hot commercial mortgage market is in some contrast to the REIT market, where there has been some cooling off. REIT stocks are down some 9% year-to-date, and this outlook has spilled over to the market for REIT unsecured notes. As one senior trader with a large Wall Street house noted, "REIT bonds are now a screaming buy." Perhaps the best evidence of this is a transaction which priced at the end of June. Simon DeBartolo, the gargantuan shopping center REIT, sold approximately $1 billion dollars of unsecured notes with the 10-year bonds priced at 1.65 percentage points over the Treasury curve. These notes were rated Baa1/BBB+. REIT bonds have traditionally priced tighter than CMBS at the same rating and yet, based on recent transactions, they are now 0.15 to 0.25 of a percentage point wider.

Record CMBS volume levels occurred in what one trader noted as a choppy market. Spreads widened at the end of the quarter due to a heavy schedule of securitizations as well as a general widening in the corporate market. This spread widening was particularly evident in the last major deal to price, which was a $1 billion securitization lead by Citicorp and J.P. Morgan. The A-2 tranche, rated AAA, priced at a spread of 0.87 percentage points, while the Class-D tranche, rated Baa2/BBB, priced at a spread of 1.55 percentage points. The July calendar looked to be somewhat quieter, and perhaps the respite will be good for issuers and give spreads a chance to settle.

The whole-loan market was amply represented in the new production business during June as a number of institutions reported extraordinarily high levels of new loan production. Nevertheless, the word of the day was not production, but rather "yield sensitivity." A number of survey members noted that they were being urged by senior management to bring in commercial mortgages with higher yields and correspondingly more attendant risk. Some opined that this seemed to be exactly the wrong time in the credit cycle to seek higher risk. Others chose to try and bring in more production through new strategies. Several lenders mentioned that they were now actively competing with banks for construction loans and were offering pricing which ranged in the 1.5 to 2.0 percentage points over LIBOR.

Perhaps no recent loan structure gathered more attention than Nomura's "buy-up" structure, which was seen in a late March CMBS offering and drew criticism from many investors (See NREI, May 1998, page 48). In each buy-up, Nomura provided the borrower an additional sum, or premium, over the principal balance; the premiums averaged about 8% of the original principal balance. In exchange, borrowers were required to pay an above-market interest rate. Nomura used the higher rate to form two large interest-only classes, or strips. Borrowers were required to repay only the initial loan amounts, but critics said the structure actually increased the loan-to-value ratios without disclosing that fact, and that the interest-only buyers unwittingly took on more risk.

In a soon-to-be-published defense of the structure by David P. Jacob, managing director of Capital America (formerly Nomura Asset Capital), the firm argues that contrary to popular belief, buy-ups do not provide the borrower with additional leverage. He adds that the structure allows the CMBS to be priced more efficiently, to the advantage of both the buyer and issuer. Jacob also argues that the interest-only strip portion, though larger with a buy-up, isn't, in fact, riskier because of strong protection against prepayments offered by defeasance - a requirement that a prepaying borrower replace the paid-off mortgage with Treasuries.

Capital America has often been a market leader for new trends and structures and, though the structure has certainly gotten the market talking, other major investment banks have yet to duplicate it.

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