We're not sure that the commercial real estate industry is experiencing bubble-like conditions, but then again describing loan activtiy as merely frothy just wouldn't do it justice. The heated competition for new commercial mortgage transactions, mixed with a seeming complacency about risk, has caused some investors to reach for more than one Maalox tablet, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

The securitization calendar for June reflected a staggering level of activity, with $24 billion in transactions scheduled to come to market. To be sure, a few of those deals may slip into July when the pace of business slackens abruptly. With the 10-year Treasury plunging through 4%, borrowers had a new incentive to refinance existing transactions. The lower Treasury rate also provides fresh ammunition for real estate investors seeking to acquire new properties.

Impact of mega-deals

In early June, the market was asked to digest two monstrous transactions: the first was a $3 billion offering from JP Morgan Chase; the second transaction was a $4 billion offering from Goldman Sachs and RBS Greenwich Capital. The latter was thought to be the largest CMBS transaction ever.

These two transactions will offer what has been described as dueling structures. The JP Morgan Chase deal comes replete with a super-duper senior tranche, rated triple-A and offering a 30% subordination level, while the Goldman Sachs and RBS Greenwich Capital transaction offers the heretofore standard super senior triple-A tranche with a 20% subordination level.

The super-duper senior tranche is a relatively new structure. As one analyst noted, “It's CMBS for dummies, as some 75% of the collateral would need to default before the triple-A tranches would suffer principal loss.” Some buyers have suggested that the super-duper senior tranche is only offered in order to mask the inferior nature of the underlying collateral.

Perhaps a more mainline view is that the 30% subordination level allows buyers who have absolutely no real estate expertise to purchase triple-A securities. According to Citigroup's Managing Director Darrell Wheeler, “a 30% subordination level should be enough to attract the heretofore missing central bank interest in CMBS.” To be sure, that would be a startling change in the CMBS buyer profile.

It's not clear whether CMBS spreads will have to widen further in order to clear the massive amount of supply coming to market. Super-senior triple-A spreads, which were previously as low as interest-rate swaps plus 20 basis points, are now in the range of swaps plus 30 basis points.

Pessimists would argue that spreads will have to reach into interest-rate swaps plus 35 to 37 basis points in order to clear out the current pipeline. The superior performance of CMBS helps attract new and current investors. Right now, triple-A CMBS offers a 20 basis-point pickup over triple-A corporates and a whopping 40 basis-point pickup over agency debentures.

In a yield-hungry market, that may be enough to attract even the most jaded investor. But, then again, in today's hyperactive environment, maybe not. “The risk of a significant market dislocation isn't being priced into structured product spreads, including CMBS,” says Credit Suisse First Boston's Mike Marriott.

Risky business

Inquiring minds might wonder why securitizers are slicing and dicing their offerings into super-senior and super-duper senior triple-A rated tranches when CMBS continues to show superior yields, and delinquencies are falling. In short, major investors don't trust the triple-A subordination levels offered by the rating agencies. There is more than a little logic in their thought process.

Just two years ago, standard triple-A subordination levels were approximately 20% and have since fallen off a cliff to the 13% area. At the same time, loan-to-values have climbed an Everest-like peak, rising from some 77% two years ago to over 96% today, according to data compiled by Moody's Investors Service.

Additionally, debt-service coverage ratios have declined precipitously, from 1.16 to a wafer-thin 1.03. Of course, there's no way to know whether the big rating agencies or their investor clientele are right, but for now the investors are surely taking a more jaundiced view of the market. Fitch Ratings' Managing Director Susan Merrick opined that “given the state of mortgage loan underwriting, subordination levels will be going up.”

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

BARRON'S/JOHN B. LEVY & CO. NATIONAL MORTGAGE SURVEY

Selected CMBS Spreads*
To 10-year U.S. Treasuries
Rating 6/6/05 5/9/05
AAA 70-71 70-71
AA 85-86 82-83
A 95-96 91-93
BBB 146-151 138-143
BB 290-300 280-295


Whole Loans*
Prime Mtge. Range Prime Mtge. Prime Mtge. Range
Term of loan 6/6/05 Rate 5/9/05
5 Years 4.80-4.90% 4.85% 4.97-5.07%
7 Years 4.90-5.00% 4.95% 5.11-5.21%
10 Years 5.10-5.20% 5.15% 5.31-5.41%


*in basis points, or hundredths of a percentage point

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.