If you're waiting for the sell-off in real estate investment trusts to affect commercial mortgage-backed securities, you had better be patient. REIT shares have dropped from a 33% premium to their net asset value at the beginning of the year to a still-frothy 28%. No one in the CMBS arena seems to have batted an eye, and capital continues to flow into the commercial-mortgage arena at a healthy clip, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

Nowhere was the inflow more evident than in the securitization of a $2.6 billion offering from Greenwich Capital Markets and Goldman Sachs in April. It was the largest single securitization since 1998, and the fourth-biggest CMBS transaction ever.

The sheer size of the deal had some concerned about the market's appetite. The class A-7 tranche alone, rated triple-A, was a tad more than $1 billion — the total size of most recent securitizations.

But the institutional-buying response to this new benchmark transaction amazed even some of the most jaundiced observers. Most tranches sold on the tight side of pricing estimates, despite Freddie Mac's lack of involvement due to insufficient multifamily collateral. The bonds eventually were sold to 75 investors, including 36 who bought the above-mentioned A-7 tranche.

To be sure, some buyers weren't enamored of the transaction, noting that it included seven so-called pari passu loans — unusually large loans that are placed into multiple transactions. But each of the investment-grade tranches was large enough to be included in the Lehman Brothers Aggregate Bond Index — a fact that enticed money managers and others whose bonuses are tied to the Lehman Index. There were no offerings close to that size in May, but eight deals in the pipeline totaled nearly $10 billion.

The Impact of Higher Rates

Interest rates have skyrocketed 70 basis points (seven-tenths of a percentage point) since April 1. Compounding the damage, commercial-mortgage spreads are expected to rise as well, primarily because interest-rate swap spreads, the derivative on which CMBS bonds are priced, are up eight to 10 basis points.

Higher interest rates may affect the number of coming transactions. As rates rise, some borrowers retreat to the sidelines, and so the number of new commercial-mortgage originations could decline.

But on the flip side, higher rates are helpful to the lending community, since some institutions have been unwilling to buy 10-year mortgages when rates are at or below 5%. Look for the supply of capital seeking commercial mortgages to continue unabated.

Not only do higher rates entice lenders, but CMBS also are now perceived by some as offering significant relative value. According to Patrick Corcoran, head of CMBS research for J.P. Morgan, 10-year CMBS are trading 21 basis points wider than single-A corporates and a whopping 29 basis points wider than the average for the past 12 months. That could place more downward pressure on CMBS spreads as money managers flock to the hottest relative-value play.

A Sanguine Outlook

More than a few real estate analysts have argued that higher interest rates will drive up capitalization rates. As capitalization rates (the reciprocal of a price-earnings ratio) rise, they cause real estate values to decline.

Other analysts are more sanguine. According to Susan Hudson-Wilson, founder and CEO of Property Portfolio & Research, capitalization rates over the past several years have been about 400 basis points wider than the 10-year Treasury, compared with the normal spread of 200 basis points.

As Hudson-Wilson puts it, “People who sit around and wait for bad things to happen to over-leveraged people are going to lose the battle and end up with pockets full of cash and no real estate to show for it.” She agrees that capitalization rates will eventually rise, but by then incomes will be up, causing real estate values to increase.

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 5/10/04 4/5/04
AAA 81-82 69-70
AA 89-90 76-77
A 97-98 83-85
BBB 126-131 115-120
BB 375-395 390-400


Whole Loans*
Prime Mtge. Range Prime Mtge. Prime Mtge. Range
Term of loan 5/10/04 Rate 4/5/04
5 Years 5.04-5.14% 5.09% 4.30-4.40%
7 Years 5.40-5.50 5.45 4.75-4.85
10 Years 5.89-5.99 5.94 5.25-5.35
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