Stability of Spreads Spurs Deals

Commercial mortgage players experienced few Maalox moments in May, as spreads on both Treasury rates and interest-rate swaps stayed stable. But the market was awash in loan originations and new securitizations, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

Spreads for commercial mortgage-backed securities (CMBS) have showed remarkably low volatility. Since April 1, the market has digested 12 CMBS offerings from conduits — firms that aggregate and securitize loans — totaling $14 billion. In 10 of them, the 10-year tranche, rated triple-A, traded in the narrow range of interest-rate swaps plus 30 to 32 basis points (0.3 to 0.32 of a percentage point).

At the triple-B level there has been more volatility; prices have ranged from interest-rate swaps plus 75 to 85 basis points. Taking advantage of the stability are two transactions. The first is a $1.2 billion offering from Citigroup and Wachovia, while the second is a slightly smaller deal backed by J.P. Morgan Chase and PNC. CMBS buyers have been uncomfortable about the number of pari passu loans in recent offerings — pieces of large loans that are placed in multiple securitizations. Neither the Citigroup nor the J.P. Morgan deal has pari passu loans, so underwriters expect a wave of aggressive buyers.

Despite extraordinary competition among lenders for new business, the returns for institutions seem to be holding steady, even doing better than expected. Some insurers and pension funds have been unwilling to “price below the box” — that is, offer spreads narrower than what their pricing formulas indicate.

Whole Loans Hold Their Own

The whole-loan commercial mortgage business continues to perform well. In the first quarter of this year, according to the Giliberto-Levy Commercial Mortgage Performance Index, commercial mortgages posted a total return of 3.17%, outpacing the duration-adjusted Lehman Brothers' Baa bond index's 2.95%.

The whole-loan performance was right in line with the investment-grade performance of CMBS, which had a total return of 3.28%. But for the trailing 12 months, the total return for commercial-mortgage whole loans was only 6.63%, while Baa bonds showed a return of 10.13%.

CMBS credit losses continue to rise, but at a slower pace. According to Merrill Lynch Director Roger Lehman, the Merrill Lynch credit-impaired rate — embracing delinquencies and liquidated loans — experienced a rise of only four basis points in April, the smallest gain since October 2002.

Major Hotel Offering Served Up

The CMBS market is playing host to a $1.95 billion hotel offering by Bear Stearns and Bank of America. The deal is intended to finance the purchase of 485 extended-stay hotels bought last month by the Blackstone Group for $3.2 billion. Money managers are unenthusiastic, but insurers were attracted by the offering's rich yield — swaps plus 35 basis points on the A3 tranche. But high yield generally means high risk. Besides the $1.95 billion of securitized debt, there is $712 million in subordinate debt, for a total of $2.7 billion, which, according to Moody's Investors Service, is 113% of the value of the mortgaged hotels.

One large investor complained that “you're not getting paid enough given the full leverage and interest-only nature of the loan.” But another analyst called the offering “a play on Corporate America.”

Indeed, according to Smith Travel Research, the extended-stay sector is in fact improving. Through April, comparable hotels were 63.4% occupied, versus only 61.5% in the similar period last year. Rates are also on the rise. The average daily room rate (ADR) is running almost $48 this year, versus $47.55 a year ago.

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 6/7/04 5/10/04
AAA 80-81 81-82
AA 87-89 89-90
A 94-96 97-98
BBB 129-135 126-131
BB 375-390 375-395

Whole Loans*
Prime Mtge. Range Prime Mtge. Prime Mtge. Range
Term of loan 6/7/04 Rate 5/10/04
5 Years 5.22-5.32% 5.27% 5.04-5.14%
7 Years 5.51-5.61 5.56 5.40-5.50
10 Years 6.02-6.12 6.07 5.89-5.99
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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