We don't suspect that Sir John Templeton had commercial real estate in mind when he noted that “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Nevertheless, while the commercial mortgage market may not be in a state of euphoria, it's clearly moved beyond mere optimism, according to the Barron's/John B. Levy & Co. National Mortgage Survey. As one wag puts it, a good loan now is defined as “any loan I can sell.” Stringent credit analysis appears to be a lost art.

Commercial mortgage volume was on a non-stop tear in 2004, much to the surprise of most observers. Early in the year, commercial mortgage players thought that first-half volume would be robust while the second half would be lackluster due to rising 10-year Treasury yields. Though they were predicted to approach 5%, those 10-year yields lagged far behind and, in fact, spent a microsecond below 4%.

Cause for celebration

Volume in the commercial mortgage-backed securities (CMBS) market continues unabated with no less than five transactions pending, each of which is substantially in excess of $1 billion. Assuming that all of these deals close, which would seem to be a no-brainer, U.S. volume in 2004 will set a new record, perhaps touching $90 billion with international volume setting a record as well. The previous domestic record was set at $78 billion in 2003.

Analysts are now suggesting that 2005 could be robust with conditions in place for perhaps another record volume. Some observers, naturally, aren't so sanguine and suspect that a significant rise in Treasuries will keep a lid on loan production. Marielle Jan de Beur, vice president at Morgan Stanley, disagrees, noting that while Treasuries are expected to increase, even a rise of as much as 100 basis points would have a modest effect on new loan production. She figures that, at worst, loan production would take a $3 to $5 billion hit.

Two months ago, CS First Boston introduced the concept of a super-senior tranche, which came with a subordination level of 20%, substantially higher than the 12% to 15% levels which had predominated heretofore. The super-senior tranche has taken the market by storm and enticed a number of investors to either increase their interest in CMBS or to enter the market, including such well-known players as Capital Research, Ohio Public Employees' Retirement System, and Loews Corp.

While the concept has added liquidity to the market, some would argue that it's having a negative effect as well. With the super-senior tranche, investors seem to be solely concerned about whether CMBS is a good value relative to other sectors and have seemingly totally forgotten about the credit aspects of the real estate business.

Underwriting standards slip

There's virtually no argument that leverage in the commercial mortgage market is increasing. According to Moody's Investors Service, conduit loans are now showing a loan-to-value of almost 95% based on a Moody's stressed loan-to-value concept. In the third quarter of 2004, some 74% of the loans were over 90% of value, and a whopping 22% were over 100% of value. Four years ago, a scant 1% were over 100% of value, and only 22% were over 90%.

Tad Philipp, managing director at Moody's, believes that “we're gravitating to a lower standard and now have market liquidity without discipline.” Given the current underwriting standards, or perhaps the lack thereof, Moody's notes that the CMBS track record of low defaults over the past 10 years is likely not replicable. Larry Duggins, president and COO of ARCap REIT Inc., a major buyer of the riskiest CMBS tranches, is equally concerned, noting that “our capital deployment pace is down, we're holding more cash, and have moved into a defensive position.”

Still, spreads continue to tighten. Developers seeking mortgages on multifamily projects could find spreads as low as 65 basis points over 10-year Treasuries, a nearly identical spread to those commanded by 10-year, triple-A rated securities.

But even at today's low spreads, some commercial mortgage players are suggesting that there's more to come. The commercial mortgage market normally sees a “January effect” where spreads tighten, and conditions seem ripe for that to happen again this year. The market is clearly priced to perfection, but one wonders whether underwriting standards are.

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