Commercial Mortgage Market Reloads

After a reasonably quiet September, the commercial mortgage market heated up again in October. As many as 12 fixed- and floating-rate securitizations were expected to be priced in October alone, assuming spreads and Treasuries show some stability. Long triple-A spreads are currently at their year-to-date average — some 0.31% to 0.32% — but the coming supply bubble could cause them to widen, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

Less Aggression from Insurers

Life insurance companies have been both big buyers of CMBS as well as originators of new whole loans at an unprecedented pace. Many have met their goals for the year and are stepping off the gas. In fact, that's probably a good thing as a number of survey participants noted that loan demand in September was quite tepid.

A few insurers have decided to be less aggressive and just do transactions with higher yields. Insurers are getting these higher yields by offering loans on hotels, which carry a 0.25% to 0.5% premium over mainstream real estate. Other insurers are trying to increase their yields by offering more flexible prepayment penalties.

The flood of capital seeking to make real estate loans and the unusually low Treasury yields have caused cap rates to fall to unheard-of levels. Cap rates convert the operating income of a property into its value and are the reciprocal of a price/earnings ratio. With cap rates in many major markets now at or below 6%, property buyers are beginning to wonder how long these unprecedented rates will last. As one major acquirer told us, “These cap rates must be coming from the tooth fairy!”

Loan Delinquency Rate Drops

Those who believe in the predictive powers of commercial mortgage delinquencies are feeling bullish these days as the numbers seem to be trending down. CMBS shopping center delinquencies are at 0.8%, down from 1.18% at the beginning of the year and 1.01% at the end of June, reports Manus Clancy, managing director of Trepp LLC. Office delinquencies are down, and vacancies and delinquencies in the lodging sector are down a startling amount.

For example, lodging delinquencies are at 3.93% as of Sept. 30, having started the year at 7.08%. To be sure, sophisticated real estate analysts would argue that these numbers are a bit rosy, benefiting from the so-called “denominator-effect.” In essence, since loans don't tend to default in the first two or three years of their existence, the growth in the overall securitized market has pushed the denominator to record highs while the delinquencies are generally coming from loans that were originated when securitization volumes were lower.

Perhaps no one is more interested in loan delinquencies than the rating agencies. In a recent study, Moody's Investors Service came to some interesting conclusions. It wanted to know whether loans in larger metro areas tended to fare better than those in smaller areas, the latter generally having shallower economies and less access to the capital markets.

In a study that analyzes loans with an initial loan-to-value of 70% to 75%, Sally Gordon, vice president at Moody's, found that “even controlling for leverage, loans in small towns tend to underperform those in larger metropolitan areas.”

In fact, loans that are not located in any metropolitan statistical area, or MSA, tend to be the worst performers. For example, 1.2% of all industrial loans are delinquent, according to Moody's, while 3.8% of those located beyond an MSA are delinquent.

Smooth Sailing Ahead?

We're not sure that declining loan delinquencies has anything to do with it, but securities rated double-B are clearly on fire. These below investment-grade securities have very low subordination levels — in the 2.5% range — so loan delinquencies and defaults could clearly affect them.

But the current pricing indicates that buyers are viewing the delinquencies through rose-colored glasses and are convinced that there will be smooth sailing. Double-Bs, which were priced in the range of Treasuries plus 4.20% at the beginning of the year, are now fully 1% tighter.


Selected CMBS Spreads*
To 10-year U.S. Treasuries
Rating 10/4/04 9/6/04
AAA 75-76 75-77
AA 82-83 82-84
A 91-92 91-94
BBB 129-134 131-136
BB 320-340 330-340

*in basis points, or hundredths of a percentage point

Whole Loans*
Prime Mtge. Range Prime Mtge. Prime Mtge. Range
Term of loan 10/4/04 Rate 9/6/04
5 Years 4.65-4.70% 4.70% 4.61-4.71%
7 Years 4.95-5.00 5.00 4.93-5.03
10 Years 5.39-5.44 5.44 5.42-5.52
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.

John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va. © Dow Jones & Co. Inc., 2004.

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