Market's undulations make a topsy-turvy ride

For those who closely watch the commercial mortgage market's undulations, the past few weeks have been a topsy-turvy ride.

Before the release of November jobs data, most market participants were betting on rates soaring.

The weak employment numbers, however, put some backspin on rates, and combined with the high loan demand, commercial mortgage rates have stayed low. Five-and 10-year rates are now in the 4.9 percent to 5.5 percent range, according to the Barrons/Levy Commercial Mortgage Survey, with more aggressive pricing for lower-leverage transactions.

Mortgage volume has increased and will set a record this year while pricing has fallen off a cliff.

As an example, in November 2003 a borrower searching for a loan on an unanchored retail center would have expected to pay 1.7 percent over the 10-year Treasury yield. Four years ago, the borrower would have expected to pay 2.55 percent over the 10-year Treasury, and today that same transaction would price at 1.3 percent over the 10-year Treasury.

The pricing differential is only a portion of the story. According to a recent study by Moody's Investors Service, leverage in the commercial market is increasing.

Using Moody's conservative approach to value, in the third quarter of this year, 74 percent of the loans sold as commercial mortgage-backed securities, called CMBS, were over 90 percent of value. This is up from just 22 percent a short four years ago.

Besides pricing and proceeds, borrowers will find fertile negotiating ground when asking for interest-only payments. According to research by Citigroup, 38.7 percent of CMBS loans this year have had a period that was interest-only. In a recent offering from Bank of America, 67.8 percent of the loans had an interest-only period, and more than 24 percent were interest-only for the entire term.

The almost euphoric optimism has some basis in a fantastic CMBS delinquency track record since 1997. The most recent delinquency data indicate that loans secured by retail properties have the lowest delinquency rates - 1.16 percent as of October.

Hotel and health-care property secured loans are the worst performers, with 4.36 percent and 3.18 percent delinquencies, respectively. The good news is that these levels are down tremendously from October 2003, when hotel loans registered an 8.5 percent delinquency and health care was 8.4 percent.

Interestingly, lenders have taken notice. Hotel loans are sought-after again, and pricing is quite attractive, even for roadside limited-service hotels. Lenders are now willing to lend up to 75 percent of acquisition costs on existing limited-service hotels at 1.6 percent to 1.7 percent over 10-year Treasuries.

Although financing the construction or rehabilitation of a proposed hotel is more difficult than financing an existing hotel, the market is clearly willing to stretch on deals that make some sense.

As development of the parking lots and streetscapes around the Greater Richmond Convention Center accelerates, it has become clear that the proposed hotel at the Miller & Rhoads building is still just a plan. Miller & Rhoads is now looking like Bugs Bunny's home in that famous cartoon where new development went up all around Bugs' hole.

According to Mike Laing, the executive vice president for ECI Development Services, who is managing the Broad Street project as well as the Miller & Rhoads redevelopment, ECI has met all its obligations and is in compliance with its contract with the Broad Street Community Development Authority (for the Broad Street work that is progressing) and with the Richmond Redevelopment and Housing Authority for the purchase of the Miller & Rhoads building.

Although we were unable to confirm this with RRHA, the larger question is whether the deal can move forward as it is currently structured. Does the project make financial sense? Do we have the right developer? What can the city do if the answer to either of these questions is no?

Although this may not be the first thing Mayor-elect L. Douglas Wilder focuses on, someone better organize the answers to these questions before Wilder walks into their office.

Andrew Little is an investment banker with John B. Levy & Co. He can be reached at alittle@jblevyco.com

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