Commercial rates don't follow Fed's lead

If Alan Greenspan intended to increase the average rate on commercial mortgages by over 0.60 percantage points with the Federal Reserve's latest cut, he could not have done a better job.

In a somewhat baffling reaction to the central bank's move, commercial rates zigged when the Federal Funds rate zagged and now range from 4.35 percent to 5.35 percen, according to the Barron's/John B. Levy & Co. National Survey.

What's amazing is that the yield on the 10-year U.S. Treasury, even after moving up by more than 60 basis points (0.60 percentage points) in the past month, is still over 110 basis points (1.10 percentage points) lower than it was at this time last year!

Even at today's anorexic rates, commercial mortgage performance has lenders smiling. Many institutions have proudly pointed to their commercial mortgages as evidence that a diversified investment portfolio is intelligent.

For borrowers, things couldn't be rosier. In fact, the low rates have allowed investors to pay extremely aggressive prices for real estate simply because a smaller amount of cash flow is used to pay debt.

Of course, with interest rates, all things are relative. The past month's powerful uptick in rates left some investors flat-footed. Commercial real-estate investors who contracted to purchase real estate based on an interest rate that no longer exists may be in for a rude awakening at closing. The higher rates mean lower returns on the project.

One way to avoid the risk of swiftly moving interest rates is the increasingly popular rate-lock agreement. Most insurance companies and pension funds making loans on commercial real estate are willing to offer rate-locks with a 2 percent "good faith" deposit and a fully negotiated loan application. If the transaction fails to close, the lender generally gives back the good faith deposit unless the borrower has defaulted.

On the other hand, borrowers seeking a rate lock from a Wall Street conduit can expect to get treated roughly. (A conduit is a investment bank that bundles commercial mortgages and sells them as bonds.) While worthy exceptions exist, the vast majority of conduits offer rate locks only when a 2 percent deposit is posted and the borrower agrees to post additional dollars if the yield on the 10-year U.S. Treasury goes down.

In this quasi-margin-call situation, for every 13 basis points (0.13 percentage points) that rates decline, the borrower has to post (in cash) another 1 percent of the loan amount.

As if the margin call wasn't enough, the borrower loses the deposit if the loan fails to close for any reason. There are now several conduits offering "insurance-company locks" but, as always, the devil is in the details.

The volatility in interest rates did little to dampen loan volume and demand. Greenwich Capital recently floated over $1.2 billion in commercial mortgage-backed securities (known as CMBS).

Included in the offering was an $85 million loan secured by Central Park and Waverly Village on Interstate 95 in Fredericksburg. The loan was priced at 6.25 percent and carries a 10-year term with a 30-year amortization.

Based on information supplied by Standard & Poor's rating agency, the well-located property was more than 90 percent leased to a large number of national tenants when it closed.

Andrew Little is an investment banker with John B. Levy & Co.