Economy spooks retail investors

When the Federal Reserve speaks, the commercial mortgage market responds, and April's surprise rate reduction was no exception. According to the Barron's/John B. Levy & Co. National Mortgage Survey, the market's tone improved remarkably following the announcement. The fear of general economic weakness still pervades the real estate market, and nowhere is that more visible than in the retail sector. Investors worry that slacking consumer confidence will lead to lower retail sales and, inevitably, more retail loan defaults.

Fear of retail was evident in late April when Morgan Stanley led a $280 million CMBS offering backed by the Potomac and Gurnee Mills. The two properties are value-oriented, super-regional malls in the greater Washington, D.C., and Chicago areas. Securitizations offered by a single borrower are not generally a cakewalk and, in this case, it was complicated by the retail collateral. The F and G classes, rated BBB and BBB-, priced at 2.70% and 3.75% over comparable Treasuries, respectively, which was 0.40% wide of where a more traditional conduit transaction would price. Higher-rated tranches priced some 0.20% wide, which clearly reflects the buying public's fear of shopping centers. As one Wall Streeter noted, “It was a tough sale.”

Meanwhile, life insurance companies and pension funds don't seem any more excited about retail mortgages than do their securitized counterparts. As Bernie Freibaum, CFO of General Growth Properties puts it, “loan committees are reactionary, not proactive, and in the current environment they may be reluctant to do retail.”

On a more positive note, GE Capital recently brought a $1.1 billion conduit securitization to market, with underwriters led by J.P. Morgan and Bear Stearns. The security consisted of 153 loans and, for the most part, was well received, especially the class A2-rated triple-A. The $703 million class priced at interest-rate swaps plus 0.49%, which was at the tight end of the expected range and a whopping 0.10% tighter than the high water mark set by PNC Bank in late March. To be sure, the thin spread at the A2 level was aided by Merrill Lynch Bank. The bank, an extremely active CMBS buyer, reportedly bought some $300 million to $400 million of the class. But the offering wasn't as heavily subscribed in all tranches. In fact, the triple-B rated tranches struggled a bit before finding a home.

First-quarter volume was up 25% from the similar period last year. The lower interest-rate environment, aided by four rate cuts, gets most of the credit for the increased supply. Higher volume may continue, as the pending CMBS calendar is chock-a-block with large transactions. Coming soon will be a $1.2 billion offering for Rockefeller Center, as well as a $1.3 billion offering by TrizecHahn. Additional transactions in excess of $1 billion each are expected from Lehman/UBS and First Union/Merrill Lynch.

Commercial mortgage whole loans turned in a respectable 2.94% total return for the first quarter, according to the Giliberto-Levy Commercial Mortgage Performance Index. But that just couldn't compete with duration-adjusted BBB corporate bonds, which registered a significantly better performance with a total return of 4.36%. Credit losses on commercial mortgages are on an uptick. Apartments continue to show virtually no losses, while the office and retail sector are showing somewhat higher losses. Despite the recent higher loss levels, current losses would have to increase by five times to merely equal the average loss for commercial mortgages during the past 30 years.

It looks as if the ongoing hubbub about the FASB Statement No. 140 issued by the Financial Accounting Standards Board may just be a chapter from Shakespeare's “Much Ado About Nothing.” The financial engineers at Credit Suisse First Boston (CSFB) have determined that only a modest change in verbiage is necessary to keep CMBS transactions recorded as a sale and not a financing. Although there's been no formal acceptance of the CSFB proposal, the market is clearly acting as if this potential issue is a “has been.” According to John Scheurer of Allied Capital, “We don't expect FASB 140 to impair our ability to work out a troubled mortgage loan.”

John B. Levy is president of John B. Levy & Co. Inc. (www.jblevyco.com) in Richmond, Va. © Dow Jones & Co. Inc., 2001.

Barron's/John B. Levy & Co. National Mortgage Survey