Investor Interest in CMBS Reaches New Heights

We're not sure it's sufficient to describe the commercial mortgage market as frothy, but then again “irrational exuberance” seems a bit overstated. Capital continues to seek commercial mortgages and, as one lender puts it, “there's a dogfight for every deal,” according to the Barron's/John B. Levy & Co. National Mortgage Survey.

Nowhere is the surplus of new capital more visible than in CMBS tranches rated double-B — a highly rated non-investment grade tranche. Earlier this year, newly originated double-Bs, which vary widely in spread, were generally thought to carry a spread of 410 to 425 basis points. Since then, double-B spreads have virtually fallen off a cliff and now trade in the range of 325 to 340 basis points.

To be sure, there's some smart money that seems to suggest that things have fallen too far. Chris Milner, managing director of Anthracite Capital, was a significant buyer in the first half of the year. He suggests that “the combination of lower subordination levels and tighter spreads has put double-B CMBS on the rich side of fair.”

Taking Advantage of Price Gains

Despite the lack of new securitizations in late August, the secondary market was chock-a-block with activity. In one week, traders estimate that more than $3 billion in CMBS securities traded hands. Money managers saw triple-A spreads tighten — a whopping 5 to 7 basis points — and sold to take advantage of the price gains. UBS and BlackRock Inc. were thought to be among the biggest sellers, although they surely had plenty of company.

More than a few individual investors are now seeking to park money in the CMBS arena, an area once totally the purview of insurance companies, money managers and other institutions. And with the Dow Jones Industrial Average down on the year some -2.7%, the returns in the commercial mortgage world can be rather enticing.

For example, Newcastle Investment Corp. (NYSE: NCT) invests in a diversified portfolio of real estate securities, including a heavy weighting of CMBS. The company buys CMBS securities with ratings from single-A to double-B, sprinkles them with a fair amount of REIT debt, and repackages the mix into collateralized debt obligations. The result has led to a stock with a current yield of approximately 8%, according to Don Fandetti, vice president and senior analyst with Wachovia Securities. Year-to-date, it's garnered an attractive 15.1% total return.

Hotels Regain Status

For an extended period after the events of Sept. 11, hotel lenders were nowhere to be found as hotel occupancies and daily rates seemed to be in a freefall. But now that the economy seems to be on the way back, hotels are becoming the “lending choice du jour,” according to Craig Sedmak, managing director with Bear Stearns.

As a result, the market can expect to see securitizations that may have as much as 10% of the collateral devoted to hotels, compared with virtually none in the later part of 2001 and all of 2002. This rush back to the sector has observers confused. After all, hotels have much higher delinquency rates than any of the other major property types. According to Morgan Stanley, hotel delinquencies at the end of July were 3.41% vs. 1.17% for office buildings and 0.93% for retail. But hotel loans do command higher spreads, and in this market when greed meets caution, the former always wins.

Commercial mortgage whole loans in the second quarter continued to outperform CMBS, according to the Giliberto-Levy Commercial Mortgage Performance Index, a $188 billion index of institutionally generated commercial mortgages. Though commercial mortgages showed a loss for the quarter of -2.13%, that was smartly ahead of the Lehman Brothers' duration-adjusted Baa bond index which checked in with a loss of -2.84%.

To no one's surprise, the high-yield component of Lehman's CMBS index turned in a positive 2.57%, perhaps in part due to the performance of the double-B sector mentioned above. For the previous 12 months, commercial mortgages generated a positive 1.64% total return, which was neck-and-neck with the Lehman Baa index, which posted a 1.52% return.

John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va. ³ Dow Jones & Co. Inc., 2004.


Selected CMBS Spreads*
To 10-year U.S. Treasuries
Rating 9/6/04 8/2/04
AAA 75-77 84-85
AA 82-84 91-93
A 91-94 102-104
BBB 131-136 135-140
BB 330-340 350-365
*in basis points, or hundredths of a percentage point

Whole Loans*
Prime Mtge. Range Prime Mtge. Prime Mtge. Range
Term of loan 9/6/04 Rate 8/2/04
5 Years 4.61-4.71% 4.66% 5.15-5.20%
7 Years 4.93-5.03 4.98 5.46-5.51
10 Years 5.42-5.52 5.47 5.88-5.93
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.

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