Two headlines in Standard & Poor’s Ratings Services’ “Structured Finance Research Update” caught my eye this week.

The first, “U.S. Office: Trend to More Efficient Space Use Continues,” noted that “the long-term trend to more efficient use of space is [a] negative for office commercial real estate demand. . . . Office furniture makers are increasing sales to companies modifying floor plans to encourage collaboration and cut space usage. Firms are replacing large conference rooms with spaces for small groups. We [S&P’s analysts] have estimated that these trends will keep the office vacancy rate as much as 3 percent higher than otherwise would be.”

Having exacted revenge on retail space, e-commerce and generation Y now turn their attention to the office market. Next we’ll have industrial properties ordering directly from manufacturers, thereby improving “just-in-time” strategies. All kidding aside, how many of us were factoring this type of analysis into our projections?

The second headline, “U.S. Commercial Real Estate: Mortgage Rates Fall Below 3 Percent,” noted that a mall real estate investment trust had recently closed two loans secured by major mall properties at rates of 3 and 2.94 percent, respectively.

Certainly from the borrower’s point of view, the loans were “priced to perfection”; but what about from the lender’s view? Were they priced to perfection or will they turn out to have been priced to disappoint due to a combination of factors, including aggressive underwriting and a lack of stress testing of the loan to see what would happen to the value of the collateral in the event interest rates spiked when the property was due for refinancing. It is certainly reasonable to ask if lenders are getting ahead of themselves due to the current highly competitive lending environment. Are we headed back to the days when everyone was willing to lower their underwriting standards to compete? Maybe with 3 percent mortgages for trophy-type properties and only for “best of breed” borrowers we are.

Equally troublesome were a number of quotes that appeared in one of the lead stories in this week’s issue of Commercial Mortgage Alert in which banks easing underwriting standards were discussed, as follows:

  • “It looks like 2006 again”;
  • “I spend a lot of time lately coming up with details of loans we lost. . . we need to loosen up, or we’re going to be in trouble in terms of our production goals”;
  • “We’re all sitting here going, ‘I gotta win. I lost the last couple—I’ve got to win this one’ ”;
  • “I’d say overall there [are] more prudence and more equity in deals than we’ve seen before, so we’re not in the ninth inning. But it’s definitely approaching the middle of the game”; and
  • “Borrowers are coming back and telling us, ‘We’re getting quotes where there are no covenants.’ ” 

We’re not crying “bubble,” but we are concerned and watchful and think you should be as well. History reminds us that when lots of equity combines with low-priced debt, good things do not necessarily follow. 

Monday’s Numbers

This week’s Trepp survey showed spreads unchanged, indicating that loan pricing appears to have reached a floor. With an average spread of 164 basis points and ten-year U.S. Treasury bonds coming in 10 basis points, “all in” pricing of 3.5 percent or less for low loan-to-value loans is more than a little attractive from the borrower’s point of view and warranted from the lender’s perspective. 

Asking Spreads over U.S. Treasury Bonds in Basis Points
(Ten-Year Commercial and Multifamily Mortgage Loans with 50% to 59% Loan-to-Value Ratios)

12/31/09

12/31/10

12/31/11

12/31/12

3/29/12

Month Earlier

Office

342

214

210

210

174

180

Retail

326

207

207

192

164

174

Multifamily

318

188

202

182

156

165

Industrial

333

201

205

191

161

165

Average Spread

330

203

205

194

164

171

10-Year Treasury

3.83%

3.29%

1.88%

1.64%

1.72%

1.98%

The Cushman & Wakefield Equity, Debt, and Structured Finance Group’s monthly survey of commercial real estate mortgage spreads for the period ending April 1, 2013, showed spreads for ten-year, fixed-rate mortgages secured by Class A property, widening 5 to 10 basis points while spreads for Class B property came in similar amounts.

It would appear that the pricing wars have reached the secondary and tertiary markets, with financing for Class B property now available at the 4 percent level.  

Liquidity, regardless of source—commercial bank, insurance company, or securitized (conduit) lender—remains abundant and priced aggressively as lenders compete for business. 

Ten-Year Fixed-Rate Commercial Real Estate Mortgages (as of April 1, 2013)

Property

Maximum
 Loan-to-Value

Class A

Class B

Multifamily (Agency)

75% – 80%

T +175

T +180

Multifamily (Nonagency)

70% – 75%

T +175

T +180

Anchored Retail

70% – 75%

T +200

T +210

Strip Center

65% – 70%

T +220

T +230

Distribution/Warehouse

65% – 70%

T +205

T +215

R & D/Flex/Industrial

65% – 70%

T +220

T +235

Office

65% – 75%

T +190

T +205

Full-Service Hotel

55% – 65%

T +255

T +280

Debt-service-coverage ratio assumed to be greater than 1.35 to 1.

Year-to-Date Public Equity Capital Markets

DJIA (1): +11.15%
S&P 500 (2): +8.91%
NASDAQ (3): +6.11%
Russell 2000 (4): 8.70%
Morgan Stanley U.S. REIT (5): +9.56%

(1) Dow Jones Industrial Average. (2) Standard & Poor’s 500 Stock Index. (3) NASD Composite Index. (4) Small Capitalization segment of U.S. equity universe. (5) Morgan Stanley REIT Index.

U.S. Treasury Yields

12/31/11

12/31/12

4/5/12

3-Month

0.01%

0.08%

0.07%

6-Month

0.06%

0.12%

0.10%

2-Year

0.24%

0.27%

0.24%

5-Year

0.83%

0.76%

0.68%

7-Year

1.35%

1.25%

1.12%

10-Year

1.88%

1.86%

1.72%

                                                 

Key Rates (in Percentages)

 

Current

One Year Prior

Federal Funds Rate

0.16

0.17

Federal Reserve Target Rate

0.25

0.25

Prime Rate

3.25

3.25

U.S. Unemployment Rate

7.60

8.70

1-Month LIBOR

0.20

0.24

3-Month LIBOR

0.28

0.47