It's a battle of the heavyweights — technicals vs. fundamentals. And right now, technicals are the clear winner, according to the Barron's/John B. Levy & Company National Mortgage Survey. Commercial mortgage whole loans and CMBS bonds are performing extraordinarily well, despite the fact that real estate fundamentals are continuing to deteriorate, especially in the office sector.

According to the Giliberto-Levy Commercial Mortgage Performance Index, whole loans registered a total return of 15.26% for 2002, about on par with investment-grade CMBS at 15.45%, but dramatically ahead of the Lehman triple-B Bond Index, which weighed in at 8.28%. In the fourth quarter, however, corporate bonds came to life with a 3.51% return versus a 1.22% return for whole loans.

Meanwhile, CMBS was the best performing sector in the Lehman Brothers' Bond Index in 2002. These performances, when added to the Dow's recent 1,000-point decline, have made the commercial mortgage business look more attractive.

Consistency is Key

Nowhere was the value of consistent performance more evident than in two recent CMBS securitizations. The first, a $1 billion offering from Morgan Stanley known as TOP9, attracted spreads for the 10-year triple-A tranche at interest-rate swaps plus 0.42%, at the tight end of expectations. But this wasn't a surprise. The TOP series with commercial mortgage paper, largely contributed from insurance companies, has always traded well.

In January, underwriters led by Wachovia Securities and Nomura Securities brought to market a $937 million generic conduit offering comprised of 130 separate commercial loans. Many investors complained that the collateral was mediocre — and highly leveraged.

Additionally, Fitch Ratings reports that 22% of the pool was composed of properties that did not have an extensive operating history. But the market didn't agree with the naysayers: There was surprisingly strong demand for the transaction in virtually every part of the credit curve.

The long-term triple-A tranche, A-2, priced at interest rate swaps plus 0.42%, caused secondary trading in TOP9's triple-A tranche to tighten from 0.42% to 0.39% over swaps. The Wachovia triple-B tranche, G, sold at 1.25% over interest rate swaps. Investors familiar with the transaction noted that there were a number of new investors in the deal, including significant interest from Asian investors in the mezzanine classes.

Property Values Stabilizing

Loan demand in January, usually a tepid affair, was surprisingly strong. Low interest rates continue to be a driver, as do firming property values. Given the strength of the market, second- and third-quarter CMBS issuance volume could be stronger than anticipated.

At present, analysts expect first-quarter CMBS volume in the U.S. to register between $16 billion and $18 billion, with the majority of that coming in March. In the past, investors have bet on increased volume to widen spreads and have generally been wrong. But with spreads at levels evidenced in recent transactions, the volume may bring spreads back to the mid-40 range.

Prudential Mortgage Capital President Dave Twardock remarked in late January that “real estate markets are as weak as they've been since the early 1990s.” But despite weak cash flows, property values are firming. Is this a disconnect or rational pricing?

According to Tad Philipp, managing director of Moody's, it's a disconnect. He argues that declining capitalization rates — the inverse of a P/E ratio — are primarily caused by low interest rates. According to Philipp, an example of this phenomenon is playing out in the office arena, where office cap rates have dropped 0.4% from their norm.

Nevertheless, since the national office vacancy has risen from less than 10% to almost 17%, office cap rates should be up. But Pat Corcoran, vice president of J.P. Morgan, doesn't see it that way. He argues that cap rates are declining because investors regard today's decline in income as merely temporary. Since the declines are temporary, Corcoran advises rating agencies to underwrite toughest at the top of the real estate cycle and ease up at the bottom, where we are today.

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

Selected CMBS Spreads*
	To 10-year U.S. Treasuries
Rating	2/03/03	1/13/03
AAA	86-87	92-93
AA	95-97	105-107
A	107-108	119-123
BBB	169-174	180-185
BB	450-475	450-475

Whole Loans*
Term of loan	Prime Mtge. Range 2/03/03	Prime Mtge. Rate	Prime Mtge. Range 1/13/03
5 Years	4.89-4.99%	4.94%	5.05-5.15%
7 Years	5.46-5.56	5.51	5.44-5.54
10 Years	5.82-5.92	5.87	6.00-6.10
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