Full Throttle Ahead

It looks as if the summer doldrums in the commercial-mortgage market have been canceled this year, at least according to the Barron's/John B. Levy & Co. National Mortgage Survey. To be sure, loan requests from developers of commercial properties have backed off a tad, but the securitization side of the business is running at full tilt. Market observers predicted that there would be precious little rest for the weary during the late summer period.

In late July, the market focused on two securitizations: a $1.3 billion floating-rate offering from Lehman Brothers and a $2.6 billion fixed-rate offering from Goldman Sachs and Greenwich Capital Markets.

Buyers crowded around the Lehman deal, even though it priced at rock-bottom yields. For example, the $750 million A-1 class rated triple-A, was priced at London interbank offered rate plus 13 basis points, or 0.13 of a percentage point. Demand for some of the smaller classes was overwhelming; Lehman had more than eight times as many orders than it could fill.

With interest rates rising, institutional money managers are increasingly attracted to floating-rate transactions and shorter-term, fixed-rate offerings, which are less affected by rate increases. European buyers seem especially attracted to the Lehman offer because it included a number of well-known properties, such as the Sheraton Chicago Hotel and Towers and a New York office building, 230 Park Ave.

Large Tranches Encourage Liquidity

But there was also much market chatter in the last week of July about the Goldman-Greenwich offering, known as GGII. This mammoth $2.6 billion issue included a $1.3 billion A-6 tranche, rated triple-A. Tranches this large ensure secondary-market liquidity and attract buyers hesitant to purchase smaller offerings, which could be hard to sell in the future. More than $192 million of triple-A paper was placed with Freddie Mac, which has been a subdued market presence of late.

Insurance companies are doing a masterful job of meeting the competition from Wall Street, which is trying to take away the business that the insurers once owned exclusively. To stay competitive, most insurers are taking on riskier loans or offer loan structures not easily obtained elsewhere.

A frequent area of negotiation involves prepayments. The standard pre-payment provision in a mortgage from an insurance company calls for the loan to be closed for half its term. Then, if the borrower wants to prepay in the remaining half, he or she pays a yield-maintenance penalty to the lender — that is, a penalty large enough to allow the lender to replace the loan's income stream with the same income from a Treasury security.

But with rates at today's low levels, many insurers also are offering fixed-rate prepayment penalties. In a typical five-year mortgage, the loan will be closed to prepayment for three years, then open in the fourth at a 2% penalty and the fifth at 1%, with the last 90 days of the loan prepayable at par.

Additionally, insurers are willing to lend on properties that are not fully leased. They may seek additional letters of credit or personal guarantees, which are released once the properties have become stabilized.

Interest-Only Loans Proliferate

The flood of liquidity in the market also has prompted a sharp rise in requests for interest-only loans. Such loans used to come along once in a blue moon, but today they are almost an everyday occurrence. In the first half of this year, close to half of all loans sold through conduit issuers have at least some interest-only period.

Interest-only loans for the entire loan term aren't unusual, either. The risk in an interest-only loan is that, with no amortization, the borrower may be unable to refinance. Combining higher interest rates in the future with today's interest-only loans could be a recipe for disaster.

Spreads also are being affected by the surplus of capital. For example, borrowers seeking low-leverage transactions, generally thought to be 65% of the property's value, can often obtain loans priced only slightly higher than triple-A-rated commercial mortgage-backed securities.

Such aggressive pricing leaves little room for lender mistakes in selling the loan in the securitization market. As one observer put it, “It might not be dumb money, but it sure is hungry money.”

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 8/2/04 7/5/04
AAA 84-85 84-85
AA 91-93 91-92
A 102-104 102-103
BBB 135-140 139-144
BB 350-365 375-385

Whole Loans*
Prime Mtge. Range Prime Mtge. Prime Mtge. Range
Term of loan 8/2/04 Rate 7/5/04
5 Years 5.15-5.20% 5.15% 5.14-5.19%
7 Years 5.46-5.51 5.46 5.41-5.46
10 Years 5.88-5.93 5.88 5.96-6.01
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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