The good and the bad at the beginning of Y2K

The commercial mortgage industry started the new millennium with higher rates yet again, according to the Barron's/John B. Levy & Company National Mortgage Survey of more than 30 whole-loan and CMBS participants. Ten-year Treasuries were almost 2% higher than they were at the beginning of 1999, causing a number of discretionary borrowers to postpone their financings.

Y2K turned out to be an absolute non-event for the commercial mortgage crowd. Although some lenders did stop funding new loans by the middle of December, a number were funding new transactions up until New Year's Eve. One large state pension fund reported that its only Y2K glitch was that its "Received Mail" stamp couldn't go beyond 1999.

The New Year has started on a positive note as spreads have continued to contract on both the whole-loan and CMBS sides. There is a general feeling that new mortgage originations will be down significantly, causing spreads to continue to tighten.

Despite the market's positive tone, Moody's is sounding a cautionary note. The big rating agency is concerned about the degree of speculative construction in most of the major markets. According to Moody's Sally Gordon, in more than half of the 50 office markets that the firm follows, two-thirds of the new office space has not been preleased. This is in contrast to the conventional wisdom, which states that the market is in balance with most new office construction being preleased. In fact, according to Gordon, "In these 27 markets, supply has exceeded demand by levels sufficient to cause downward pressure on rents."

In order to deal with this, Moody's, in a forthcoming report, will create a series of flags indicating the condition of these major markets. For example, the Phoenix office market is currently flying a red flag. Inventory is growing by 15% while absorption is only 3% per year. On the flip side, a green flag market is the Los Angeles multifamily market where the absorption is currently 1.8% of inventory per year, while the new construction is a scant 0.3% of inventory. This new monitoring system will be used in the future on new and existing CMBS ratings.

Despite Moody's concerns, the forthcoming CMBS calendar is chock-a-block with any number of transactions. Perhaps first out of the blocks will be a $813 million conduit transaction led by J.P. Morgan to be closely followed by a $1 billion floating-rate transaction led by Deutsche Bank and a $900 million fixed-rate conduit transaction led by Bear Stearns and Wells Fargo. The latter is expected to garner razor-thin spreads due to its low leverage.

Last June we asked a number of market participants to give us their forecasts for year-end triple-A spreads and issuance volume for the second six months. The group's average spread of 117 turned out to be incredibly prescient and virtually right on top of the actual year-end spread, but the volume forecast was anemic with the group estimating only a $20 billion second half compared to the actual $33 billion. We've invited back several participants who were close to the pin for another round and also added an entirely new group (see Industry Insider, p. 10). The average volume of $29 billion reflects a general sense that higher interest rates will keep a lid on issuance volume, whereas the average spread of 107 is assuming some contraction due to limited supply. We'll check back this summer to see how well the panel did.

On the whole-loan side, insurance companies are gearing up for another year of battle against the Wall Street crowd. Most insurers now have new allocations for 2000, which are generally showing no increase over the previous year. Several did note that they, like Moody's, are concerned about the business cycle and therefore are becoming more conservative in their lending habits inan attempt to minimize future losses. Although life companies have not normally been a source of floating-rate loans, a number of survey members noted that they are more than interested in doing adjustable rate transactions as a way to increase their loan production in the year ahead.

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