The commercial mortgage industry polished off 2000 in remarkably strong style, according to the Barron's/John B. Levy & Co. National Mortgage Survey of more than 30 participants in the whole-loan and CMBS markets. Mortgage rates continued to fall, putting a holiday smile on the faces of developers and borrowers. The Federal Reserve's rate cut at the beginning of January, though injecting optimism into the market, had virtually no effect on commercial mortgage rates. In fact, the yield on the 10-year Treasury, the benchmark for most commercial mortgage prices, actually rose some 0.20% after the announcement.
On the institutional lending side, 2001 looks to be a good year. Many survey participants indicated that their allocations to commercial mortgages were up, and increases in the 15% to 25% range were not abnormal. Despite their interest in new deals, more than a few expressed caution about the state of the economy, with retail properties heading the list of concerns. As one large institutional lender put it, "I'm only interested in triple-A malls in major markets." Another warned that though defaults and delinquencies were at record-low levels, he noted some "stress cracks" in his portfolio that might temper his enthusiasm for new investments.
While the lending community is clearly focused on the upcoming recession, many borrowers believe that credit already has been throttled back, especially for construction loans. Commercial banks want substantial preleasing on new loans and are offering significantly less leverage than they were just 60 to 90 days ago. But borrowers sense that there's been an overreaction to the economic slowdown. As Monument Realty's Jeff Neal succinctly puts it, "There are a bunch of grandmothers on investment committees drawing parallels between now and 1989 that just aren't legitimate."
The CMBS market finished the year with incredible strength, sporting a year-end volume of $60 billion, according to Salomon Smith Barney's Darrell Wheeler. Last July, our panel of market forecasters predicted that CMBS volume would total only $49 billion. We've impaneled a new group of experts and asked for their volume and spread predictions as of June 30, 2001 (see Industry Insider, p. 10). Their volume estimate of $30 billion is 15% ahead of the same period last year. The panel expects volume in the first half of the year to be stronger than in the second half, primarily due to the abnormally low rates that are now available. With respect to interest rate spreads, buyers and sellers are virtually unanimous in their agreement that spreads will tighten in the next six months, albeit modestly.
While low rates are clearly good news for the borrowing community, they are creating a liquidity problem in the CMBS market. Interest rates have fallen so quickly that most CMBS bonds now trade at a premium. Further, investors have been consistently unwilling to invest in premium bonds, especially those super-premium bonds where the price is $105 or higher. These premium bonds trade at an increased spread to bonds that are priced at par and, in some cases, at such attractive spreads that Wall Street sees a buying opportunity. Indeed, in a recent research report, Bear Stearns noted that it believes these premium bonds "...represent the best relative value in the triple-A CMBS market today." But investors still aren't convinced and, as a result, liquidity in the premium priced bond market has been severely impacted.
Despite the softening economy and threat of a further downturn, CMBS investors do not appear to be nearly as spooked as those in the corporate bond world. While junk bond yields have skyrocketed, below investment-grade double-B CMBS have shown fair stability with current yields in the 5.25% to 5.40% range, virtually unchanged from last summer. A recession could clearly cause these bonds to have losses and, as one trader put it, these bonds trade "by appointment only," so there's scant liquidity. Nevertheless, investors don't seem to be forming a line at the door to exit the market.