Landlords are piling the most debt onto commercial properties in five years as Wall Street banks bundle the loans into bonds to meet rising demand from investors seeking high yields amid record-low interest rates.
The size of mortgages bundled into bonds will surpass 100 percent of building values for the first time since 2007, before the market shut down amid the worst financial crisis in seven decades, according to Moody's Investors Service. That measure of leverage on loans tied to everything from skyscrapers to strip malls is poised to climb 4.3 percentage points this quarter, the New York-based ratings company said in a July 11 report.
Lenders are offering larger loans to win business as borrowers look to pay off a wave of debt taken out during the real estate bubble and as yield-starved investors are pushed toward riskier assets. More generous mortgages, a boon for landlords who need to refinance debt, may fuel concern that banks are reverting to practices that led to record defaults as late payments rise above 10 percent.
"I wouldn't say we are in a danger zone, but we are leaving the comfort zone," Moody's analyst Tad Philipp said in a telephone interview. "The margin of error has been diminished."
Wall Street has arranged about $16.8 billion in commercial mortgage-backed securities this year, compared with $28 billion in all of 2011, according to data compiled by Bloomberg. Wells Fargo & Co. increased its 2012 forecast to $35 billion from $25 billion last week, and Credit Suisse Group AG projects as much as $45 billion in issuance this year. A record $232 billion in commercial-mortgage bonds were sold in 2007.
Forecasts Increased
Investors are buying the debt as the Federal Reserve keeps interest rates at record lows for a fourth year. Relative yields on top-ranked bonds linked to commercial mortgages dropped to 180 basis points more than Treasuries on July 13, down from 261 basis points on Dec. 30, according to a Barclays Plc index.
Elsewhere in credit markets, the cost of insuring European corporate debt declined on speculation Fed Chairman Ben S. Bernanke will hint at further stimulus measures when he addresses Congress today. A benchmark index of leveraged loan prices rose for a 13th day yesterday, the longest winning streak in 20 months.
The Markit iTraxx Crossover Index of credit-default swaps on 50 mostly junk-rated European companies fell 11 basis points to 662 basis points as of 12:53 p.m. in London, prices compiled by Bloomberg show.
Credit-default swaps typically rise as investor confidence deteriorates and fall as it improves. Contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
Leveraged Loans
The S&P/LSTA U.S. Leveraged Loan 100 index added 0.06 cent to 94.16 cents on the dollar, the highest since May 16. The measure, which tracks the 100 largest dollar-denominated first- lien leveraged loans, has climbed from a five-month low on June 5 and has risen every day since June 27, the longest stretch since the 13 days ended Nov. 9, 2010.
Leveraged loans and high-yield bonds are rated below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's.
The U.S. two-year interest-rate swap spread, a measure of debt market stress, widened for a third day, increasing 0.45 basis point to 24.06. The gauge, which ended July 12 at an 11- month low of 22.5, increases when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.
Unemployment Rate
Bernanke delivers his semi-annual report on the economy and monetary policy before lawmakers amid deteriorating signs of growth, with data yesterday showing a contraction in June U.S. retail sales. He's under pressure to unveil a strategy to combat an unemployment rate that has stalled above 8 percent for 41 consecutive months.
Bonds of New York-based Goldman Sachs Group Inc. were the most actively traded dollar-denominated corporate securities by dealers yesterday, with 128 trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
In emerging markets, relative yields narrowed five basis points to 353 basis points, according to JPMorgan Chase & Co.'s EMBI Global index. That's the least since May 8.
Commercial Mortgages
Late payments on commercial mortgages packaged into bonds reached a record 10.1 percent last month as bubble-era loans failed to refinance at maturity, according to Jefferies. More than $23 billion of the debt issued in 2007 is currently categorized as delinquent, the most of any year, Jefferies analysts led by Lisa Pendergast said in a report yesterday.
Underwriting in commercial-mortgage bonds is still "generally superior" to the prevailing standards of 2006 and 2007, the Moody's analysts said in the report last week. When loans similar to those from the bubble years appear, it will be time to "sound the alarm," Philipp of Moody's said.
"But by then it's too late," he said. "It's a good time to take stock of where we are."
Occupancy levels and revenue for U.S. commercial property have been rising, though a stalling economic recovery and concern that the European debt crisis will escalate may crimp demand for office space, according to Wells Fargo & Co. Retail vacancies are just 0.2 percentage point lower than the 2010 high as U.S. unemployment holds at more than 8 percent and the housing market struggles to recover, Wells Fargo analysts led by Marielle Jan De Beur said in a July 12 report.
Uneven Recovery
Commercial property values are staging an uneven recovery, with large cities on the coasts regaining the most value as investors seek stable tenants in active areas. Prices in major markets climbed 41 percent in May from the January 2010 low, according to the Moody's/RCA Commercial Property Price indexes. That compares with an 18.7 percent gain for smaller cities. Values declined as much as 39 from the peak of December 2007.
Lenders use a different formula to calculate a property's value relative to loan size than Moody's, resulting in a lower leverage ratio. On a $1.35 billion offering from Morgan Stanley and Bank of America Corp. sold last week, the issuers estimated the average office loan in the pool to be equal to 65.5 percent of a building's value, compared with Moody's 109.7 percent, according to the rating company's assessment of the transaction.
Unlike the banks, the ratings company accounts for the potential that interest rates will rise during the life of a loan, which can erode a property's value.
Ratio Increase
The gap between where Moody's and lenders peg that ratio will probably grow to 37.7 percent during the third quarter, the largest difference since 2007.
Leverage has been rising consistently in recent commercial- mortgage bond deals, likely leading to higher safeguards being put in place by the ratings companies, said Christopher Sullivan, who oversees $2 billion as chief investment officer at United Nations Federal Credit Union in New York.
"We've declined the recent deals," Sullivan said in an e- mail. "We will continue to review and consider others that may be brought."
Moody's is requiring banks to boost investor protections on the lowest-ranking investment-grade portions of new deals to offset the higher-leverage loans. Deals scheduled for this quarter will need to boost loss cushions for those securities to 7.3 percent, compared with about 6.5 percent in the first quarter.
Rising leverage in new transactions isn't cause for "excessive concern," according to Alan Todd, a commercial- mortgage debt analyst at Bank of America in New York. Mortgages contained in recent deals are typically underwritten based on the income buildings are actually generating, rather than optimistic projections of potential revenue that were common during the boom period, Todd said.
"Having leverage increase is an unavoidable side effect of the increased competition that everyone is seeing," Todd said. "Everybody is fighting over the same toys in the sandbox. A lot of assets are already encumbered. When something becomes available, you have to bring more to the table than somebody else would."
