The commercial mortgage market stayed hot in January as spreads over comparable Treasuries plunged to incredibly low levels, according to the Barron's/John B. Levy & Co. National Mortgage Survey. As one major buyer of commercial mortgage-backed securities remarked: “There's a feeding frenzy for each new deal, and there were three in January alone, normally an abysmally slow month.” Market observers say February could set a record for CMBS offerings; 13 deals totaling $15 billion were scheduled.

One of the most interesting transactions is among the smallest Wall Street has floated in years — a $52 million offering of so-called mezzanine loans, or “B” notes, from Merrill Lynch. The pool consists of 86 loans, with the largest just $2 million. These are subordinate to existing first mortgages and, therefore, stand to take the first loss in the event of default. Loans on the underlying properties can amount to as much as 85% of value — 80% represented by the first mortgage, 5% reflecting the “B” note.

And to entice buyers, Merrill Lynch has indicated that the $21.3 million Class A-2 notes, rated triple-A, will be priced half a percentage point above typical commercial-mortgage offerings by Wall Street firms, and that the triple-B-rated Class D tranche will price around a full percentage point above standard securitizations. With investors scouring for yield, analysts expect this transaction to sell well and for future offerings to be priced more cheaply.

Securitizations in Demand

Wall Street firms often cut up large loans and place them into multiple securitizations. For example, a $150 million first mortgage on an office building may be split into three $50 million tranches and put in three separate offerings, each having the same seniority. This has been necessary because, since 9-11, investors have refused to buy any CMBS issue secured by a single asset or those involving solely large loans.

On the surface, it looks as if these large loans are conservatively leveraged. For example, RBS Greenwich Capital placed a $72.5 million tranche from Chicago's 311 South Wacker Drive in one of its offerings last June. The loan was rated Baa3 by Moody's and, according to the underwriters, it was a warmly conservative 51% loan-to-value.

But the property actually carried significantly more debt, including junior notes totaling $87 million. Including the subordinate debt, the underwriters viewed the total loans as 82% of value, while Moody's deemed it almost 97%.

Buyers today seem to be unconcerned by such leverage. But, observes Citigroup Managing Director Darrell Wheeler. “If any of these large loans ever defaults, the credit committees will have more attendees than the Super Bowl, guaranteeing a long and expensive workout.”

A Pure Play

The CMBS market isn't just for big guys. Many mutual funds have a sprinkling of CMBS offerings in their fixed-income and high-yield funds.

But for individuals seeking a purer play, there's a closed-end bond fund from Pimco (whose chief, Bill Gross, is a member of this year's Barron's Roundtable). The fund, Pimco Commercial Mortgage Securities Trust, invests chiefly in commercial mortgage-backed securities, which range in quality from triple-A to below investment-grade. Its current yield is a sizzling 7.67%, and the total return for the past 12 months is 8.64%.

A high-quality alternative is Anthracite Capital, a real estate investment trust focused on the CMBS market. It sports a one-year return of 12.63%, with a dividend of 10.3%.

Although the economy seems to be improving, Fitch Ratings announced in late January that delinquencies on commercial mortgage-backed securities in the fourth quarter were up some 5% from the previous quarter's level. The main culprit: a 38% increase in office delinquencies.

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	2/2/04	1/12/04
AAA	67-68	66-68
AA	74-76	74-76
A	82-84	83-85
BBB	120-125	123-128
BB	395-410	410-425

Whole Loans*

	Prime Mtge. Range	Prime Mtge.	Prime Mtge. Range
Term of loan	2/2/04	Rate	1/12/04
5 Years	4.78-4.83%	4.78%	4.86-4.91%
7 Years	5.15-5.20	5.15	5.24-5.29
10 Years	5.70-5.75	5.70	5.80-5.85
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