In the financial world's version of “All Dressed up with No Place to Go,” investors — especially insurers — find themselves flush with cash these days with few places to comfortably invest. Commercial mortgages, and especially the commercial mortgage-backed securities (CMBS) world, have been major beneficiaries of this as commercial real estate still looks relatively attractive, according to the Barron's/John B. Levy & Co. National Mortgage Survey.

Interest rates continue to decline — the 10-year Treasury is now at a 45-year low — which has fueled both a flood of new loan originations and given lenders cause for concern at the same time. On the loan origination side, it appears possible that 2003 will set yet another record. According to Richard Parkus, head of CMBS research for Deutsche Bank, global CMBS origination this year is estimated to be $108 billion, vs. the previous record of $97 billion in 2001. Between $8 billion and $9 billion in new CMBS was expected to reach the market in June, according to analysts.

CMBS Buyers Remain Cautious

Meanwhile, low interest rates are giving more than a few investors reason for pause. Based on interest rates in late May, 10-year triple-A rated securities were carrying a coupon of approximately 3.95%. Andy Parower, vice president of New York Life Investment Management, notes, “I'm dabbling, but I'm not buying with conviction.” And UBS Director Steve Finkelstein thinks that “there will be better buying opportunities down the road.”

A $794 million floating-rate origination, styled KSL 2003-1 and offered by Deutsche Bank, stepped into this yield-starved environment in late May. The pool consisted of five large resort hotels, golf courses and spas, including La Quinta Resort and Club in Southern California and the Grand Wailea Resort in Hawaii.

To be sure, hotels have been troubled lately, but you'd never know it from the response to this moderately leveraged offering, which Fitch Ratings pegged at a conservative 58% loan-to-value. The Class-A tranche rated triple-A was originally expected to price in the area of LIBOR (London InterBank Offered Rate) plus 0.60% but tightened to LIBOR plus 0.55% when the transaction was finished. Analysts suggested that because triple-A rated tranches on non-hotel properties normally price in the range of LIBOR plus 0.30% to 0.35%, more than a few investors saw this as an excellent opportunity to garner additional yield without taking significant risk.

Through May, CMBS performance has been strong with triple-A CMBS garnering a total return of 6.0%, almost 1.50% more than comparable Treasuries. Down at the triple-B level, the song is the same. Triple-B CMBS showed a total return of 6.35% year-to-date, some 1.90% more than comparable term Treasuries. While CMBS was strong, triple-B corporate bonds blew the lights out with a return that was 2.91% higher than similarly rated CMBS, according to Jeff Mudrick, senior vice president of Lehman Brothers.

Are Borrowers Too Leveraged?

A nearly $1 billion floating-rate transaction known as Whale 2 offered by Wachovia Securities and Banc of America Securities is circulating in the market. Even though the transaction wasn't expected to price until mid-June, investors early in the month were poring over the numbers and a few expressed some concern with their findings. As one large pension fund manager put it, “There's been a run-up in the amount of overall leverage in this and other similar transactions, which has barred us from participating.”

A close look at the numbers reveals that there is, in fact, substantial leverage. According to Moody's Investors Service, total debt on the properties is almost 91% of the properties' value, although only 62% is inside the trust. The remaining debt is held in the form of either junior note participations or mezzanine debt. In fact, according to Moody's, four of the assets have total debt which is at 100% or more of the assets' value, causing a few shrewd analysts to wonder whether these loans will be paid off in time or will be the subject of extensions and possibly workouts.

Meanwhile, real estate fundamentals don't seem to be improving. Nevertheless, as one buyer said, “Fundamentals are weak, but not alarmingly so.” Despite the real estate weaknesses, CMBS spreads are continuing to tighten and are as tight as they've been since 1997.

John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va. © Dow Jones & Co. Inc., 2003.

BARRON'S/JOHN B. LEVY & CO. NATIONAL MORTGAGE SURVEY