As investors in commercial mortgage-backed securities braced for a significant impact on some real estate holdings as a result of Hurricane Katrina, the market prepared for a flood of new issues in September and October, according to the Barron's/John B. Levy & Co. National Mortgage Survey. In August, usually a slow month, a surprisingly high $20 billion in CMBS came to market, and by year's end issuance could total $160 billion. Underwriting remains lax, with leverage on conduit loans averaging 101% in August.
The devastating effects of Hurricane Katrina could impact nearly 2,700 fixed- and floating-rate loans with a current loan balance of just under $30 billion, according to analysts. Perhaps the most visible loser will be the New Orleans hotel market. The city's RevPar in 2005 — a measure of hotel performance — was up 4%, but it was still 14% below pre-9/11 levels. Katrina's damage will cause significant shortfalls for the next few months, and perhaps even years, as tourism to the area suffers. Paradoxically, some hotels may flourish as they fill up with rescue and relief workers.
Damaging effects of mold
While damage to area hotels is expected to be dramatic, one of the biggest concerns could be the growth of mold as windows have been blown out and air-conditioning systems are unable to take the moisture out of the building. Mold is perhaps the industry's leading environmental problem today, far in excess of asbestos. Significant mold could require a total gutting of hotel interiors to eradicate the problem and make it safe for tourists.
Investors are rightly concerned about their New Orleans' holdings because a number of securitizations hold liens on major area hotels, and significant losses could cause losses to the lower investment-grade tranches. But the bigger surprise may actually come in the triple-A tranches where buyers are thought to be immune, according to Manus Clancy, managing director at Trepp LLC, a New York-based research firm.
Prepayments due to casualty or condemnation made are at par, so investors buying bonds at a premium could take some significant hits. As a hypothetical, consider the A-1 tranche of CCMSC 2000-3, a Morgan Stanley offering. Last week, those bonds traded at a yield of 4.8%. If the Le Meridian Hotel — part of this securitization — were to prepay at par in one year, the yield drops a whopping 280 basis points.
The damage brought by Hurricane Katrina has caused many industry players to re-emphasize the diversification needs of each securitization pool. The hurricane hit in an area where there is only one major city and, as a result, many of the affected properties were not major highrise buildings. Some security buyers are running scenarios to look at what would happen if, for example, a major earthquake hit California, an area chock-a-block with expensive real estate and much larger loans. Many of these properties are covered by earthquake insurance, but the devastation could make Katrina look like the minor leagues.
New issuance soars
The beat goes on, and so it does with securitization activity in the CMBS arena continuing to hit record levels. In August, typically a dead month, some $20 billion came to market, and according to Credit Suisse First Boston, $40 billion is on tap in September and October alone. Adding up the numbers leads to a year-end domestic CMBS total, which could well hit $160 billion, a whopping 50% ahead of the record set just last year. Our group of a dozen market forecasters as recently as 60 days ago expected CMBS issuance volume to be $135 billion for 2005.
We'd like to think that underwriting has become a tad more conservative or even realistic. But data from the rating agencies doesn't seem to support that theory. According to Fitch Ratings, leverage on conduit loans in August averaged slightly over 101%, up from 98.6% in July and August, while debt-service coverage ratios in August dropped to 1.14 from 1.17. The magnitude of the changes isn't huge, but it has occurred in a very short period of time.
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
|To 10-year U.S. Treasuries|
|Prime Mtge. Range||Prime Mtge.||Prime Mtge. Range|
|Term of loan||9/5/05||Rate|
|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.