Conduit lenders are competing for investors’ business, offering progressively lower interest rates and larger loans to commercial real estate borrowers, according to worried bond underwriters at Moody’s Investors Service.
“Spreads have come in … some lenders are offering more leverage,” says Tad Philipp, director of commercial real estate research for Moody’s and co-author of a report “U.S. Q1 2012 Review: Q2 Poised to See More Highly Leveraged Collateral Pools, Increased Subordination Levels.”
In the second quarter, Moody’s expects to rate CMBS backed by loans with a weighted average interest rate of 5.53 percent. That’s down from 5.70 percent in the first quarter.
Those higher-interest loans suffered from anxieties over the European Union as Greece wobbled on the brink of chaotic default, which would have pushed the capital markets back into crisis. Europe is still making negative headlines today, though disaster no longer seems to be just around the corner.
Calm in the capital markets means lower interest rates for conduits. Spreads have tightened to within 50 basis points of the lower interest rates offered by portfolio lenders like life insurance companies. That’s down from a spread of more than 100 basis points two quarters ago, according to Moody’s.
Sharp-elbowed competition between lenders has had a major impact on the types of loans that appear in CMBS loan pools. Nearly half rated by Moody’s in the first quarter were made to retail properties—a relatively less desirable asset class, aside from the best properties. Fannie Mae and Freddie Mac lenders compete fiercely to lend to apartment properties, which account for 10 percent or less of the loans in CMBS pools. Portfolio lenders compete to lend to industrial properties, high-quality offices and top-quality malls, luring some of these borrowers away from conduits.
“Tighter conduit origination spreads bode well for the credit quality of CMBS deals in coming quarters, as they will be more attractive to higher quality borrowers with higher quality properties,” states the report.
Interest-only conduit loans are also making a comeback. Roughly one-in-five conduit loans in the Moody’s pipeline are interest-only for at least part of their loan terms, meaning that the borrower pays only the interest and none of the principal. That’s similar to the percentage of interest-only loans in 2004. However, interest-only loans are much less common today than they were at the peak of the conduit boom in 2007, when more than 90 percent of loans included interest-only, according to Moody’s data.
Rising leverage
Moody’s loan underwriters are beginning to worry about the amount of leverage offered by conduits lenders. These lenders say they are making loans that cover between 60 and 65 percent of the appraised value of a property, as they have been doing since the conduit market restarted in 2010.
However, Moody’s computes value in a different way than most lenders and appraisers, using historic ratios of operating income to sales prices. Today these ratios, called capitalization rates, are at rock-bottom lows that may not last for 10 years, when conduit loans will reach the end of their terms and need to refinance. “We tend to use cap rates that have been sustainable over time,” said Moody’s Philipp.
The average conduit loan rated by Moody’s in the first quarter of 2012 covers 94.8 percent of the value of the property, according to Moody’s Loan-to-Value computations–and leverage keeps rising. In the second quarter, Moody’s expects to rate loans that cover 97.6 percent. And in response, Moody’s plans to increase subordination levels so that fewer bonds receive the highest AAA rating.
“Conduit underwriting appears poised to transition from a level consistent with 2004 underwriting to one consistent with early 2005,” according to the report.
Moody’s also increased subordination levels in the summer of 2007. Conduit loan leverage peaked that year at 117.5 percent, according to Moody’s math. “Credit erosion today is minor in comparison,” says Philipp. “We want to immediately and fully address it.”