Declining interest rates come at good time for CMBS market

Commercial mortgage rates staged a strong rally during June and early July, according to the Barron's/John B. Levy & Co. National Mortgage Survey. The Barron's/Levy 10-year prime mortgage rate is now at 7 1/2%, fully 0.50% less than it was just 30 days ago.

The interest rate decline could not have come at a better time for the exploding commercial mortgage-backed securities (CMBS) market. The market has been on a tear as of late with June's volume of $6.3 billion the largest issuance in any single month for the relatively young market. Based on CMBS volume for the first six months and deals already in the pipeline, industry analysts are expecting volume to top $32 billion this year as compared to the previous record of slightly less than $31 billion in 1996.

June volume was helped by a large $1.4 billion securitization from Credit Suisse First Boston, as well as two other securitizations involving collateral originated by Heller Financial and Wells Fargo. Morgan Stanley was the lead manager for the latter two. The incredible outpouring of new CMBS supply had some buyers wondering aloud whether supply might finally overwhelm demand. Clearly by the end of the month, CMBS buyers had run out of appetite, and CMBS spreads had, for the first time, "paused" and even widened in some tranches. To be sure, the spread widening was minor but, nevertheless, a startling change in the market where spreads have seemed to tighten with each new transaction. According to Donaldson, Lufkin & Jenrette, 'AAA' spreads are now in the 0.62% to 0.65% basis points range, while 'BBB' can expect to be priced at 0.88% to 0.90%. In mid-June, each of these tranches would have been priced 0.02% to 0.03% tighter. The 'BB' tranche widened out a bit more appreciably to a range of 1.95% to 2.00% from 1.85% to 1.90% during mid-month. But the spread widening was only part of the story. In several late-June securitizations, investment bankers were left holding a number of the bonds in inventory as the market was unable to digest all of the June supply in an orderly fashion. Notwithstanding the apparent surplus, investment bankers holding these bonds seemed confident that they will sell promptly due to a sparse offering schedule in July and August.

By contrast, there were no records set on the whole loan side of the market during June. In fact, most survey members commented that they were finding it increasingly difficult to meet their loan origination goals. More than a few mentioned that they found the market "too competitive" for their liking. Institutional lenders continued to compete with each other and, to their chagrin, are finding that commercial mortgage conduits are now able to efficiently price not just B-quality, but A-quality transactions as well.

Several survey members noted that they were distraught over the continued and accelerating deterioration in underwriting standards (the process by which lenders decide how much money to lend on a specific property). Until recently, most lenders capped loans at 75% of the property's value, with the exception of apartments which occasionally went as high as 80%. Now loans of up to 80% are available for many property types, including shopping centers and warehouses. Some real estate analysts with long memories are quick to point out that the incredible losses of the early-1990s were caused by loans limited to 75% of value and wonder about the increased damage that might come from upping the loan-to-value standard to 80%. But today's market is so competitive that it appears the 80% standard is here to stay. Short amortization schedules have also become virtually a thing of the past. Today, almost every real estate project, regardless of its age and condition, can qualify for a 30-year amortization schedule, which greatly increases the lender's risk since very little of the loan's principal amount is being repaid during the loan term.

Comments and questions are welcomed at our World Wide Web site:

John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va.

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