Will Bond Plan Have Teeth?

By LINGLING WEI Demand is expected to be strong Monday for the first sale of commercial-mortgage-backed securities under a government rescue program designed, in part, to ease the mounting stress in the commercial-property sector. But the strong demand is partly a reflection of the conservative underwriting of the $400 million in bonds backed by 28 Developers Diversified Realty Corp. shopping centers, in terms of the quality of the assets underlying the loan and the loan amount relative to the value of the properties. While the deal may help reopen a vital funding source for some commercial-property investors, it will likely provide little solace to owners of tens of billions of dollars of office buildings, shopping centers and other commercial real estate that are now worth less than their mortgages. The deal is the first issue of commercial-mortgage-backed securities under the Federal Reserve's Term Asset-Backed Securities Loan Facility, or TALF, program. Under the program, investors can borrow from the Fed as much as 85% of the CMBS bonds' value by pledging the securities as collateral. By taking advantage of that leverage, investors will be able to boost their returns. The sale of the real-estate investment trust Developers Diversified bonds is more than three times oversubscribed, according to price talk among investors who are considering buying the paper. The healthy appetite enabled Goldman Sachs Group Inc., the underwriter of the issue, to lower the unleveraged yield of the top-tier class of the bond issue to about 4%, those investors said. Many analysts and investors had expected the yield to be above that amount. A Goldman spokesman declined to comment. "It's a great execution for the borrower," says Scott Simon, managing director and head of mortgage- and asset-backed securities portfolio manager at Pimco, a leading bond house. "If other real-estate investors can borrow money at that rate, it would be a real game changer for the commercial real-estate market that has been so devoid of financing." Mr. Simon declined to comment on whether Pimco would buy any of the Diversified Realty bonds. Bids for the securities are expected to come from many mutual funds, insurance companies and other institutional investors. Firms that are considering the deal include Babson Capital Management, the investment-management unit of Massachusetts Mutual Life Insurance Co. and Principal Financial Group, according to people familiar with the matter. Babson Capital declined to comment. A representative at Principal Financial didn't respond to requests for comment. Institutional investors are attracted to the deal because it is viewed as a low-risk investment with relatively healthy returns when compared with five-year Treasurys, which are yielding about 2%. Investors buying the triple-A slice of the deal, totaling $323.5 million, can get an unleveraged return of about 4%, according to price information distributed to possible investors by Goldman late Friday and reviewed by The Wall Street Journal. If they finance their purchases with TALF funding, their returns can rise to about 6%. The credit-starved real-estate industry and federal regulators are hoping that Developers Diversified's debt sale will pave the way for other CMBS deals and help uncork a market that had been one of the most important funding sources for commercial real estate in the past decade. They are worried that unless financing sources can be resurrected, the pain in the industry will get worse, threatening to unhinge the nascent economic recovery. The deal reflects the high bar the Fed has set for loans eligible for TALF financing. The 28 shopping centers in 19 states securing the bonds have stable cash flow because they often are occupied by discount retailers that tend to attract business even in a recession. For instance, one of the properties is Hamilton Marketplace, near Princeton, N.J., a 957,000-square-foot property whose tenants include Wal-Mart Stores, Lowe's, BJ's Wholesale Club and supermarket ShopRite. According to Fitch Ratings, the property has maintained an average occupancy of 96.7% since 2006 and is 95.1% occupied. The $400 million loan represents about half of the value of the underlying properties. By comparison, in the years before the financial crisis erupted in 2007, banks were willing to lend more than 70% of a property's value because the debt could be easily sold as CMBS. Even under a "stress" scenario, according to Fitch, the Developers Diversified properties would produce a cash flow of about 1.44 times what is required to service the debt. Back when credit was easy, the ratio for stress scenarios would even fall below one for many CMBS offerings. The Developers Diversified deal also differs from past deals because the offering has been carved up into only three slices, with the Triple-A class representing about 80% of the deal and the rest consisting of Double-A and Single-A classes. Past deals often had more than 10 classes from investment grade to noninvestment grade. "The market appears willing to accept very conservatively underwritten commercial mortgages backed by strong sponsors," says Thomas Zatko, managing director of the real-estate finance group at Babson Capital. "The availability of TALF financing is icing on the cake." Developers Diversified, Beachwood, Ohio, announced in early October that it had borrowed the $400 million first mortgage from Goldman. The investment bank, which converted the five-year mortgage into CMBS, is expected to select buyers for that paper on Monday and close the deal Nov. 25. CMBS offerings are considered one of the key tests for the TALF program, introduced by the Fed in March. Since then, TALF has been viewed as a moderate success, helping borrowers from auto companies and credit-card issuers raise capital. The Fed has made more than $40 billion in TALF loans to investors buying these securities, which has sparked a market rally and reduced the cost of borrowing. The Fed extended TALF to include newly issued CMBS in June. In addition to the deal by Developers Diversified, a dozen or so other new CMBS deals also are hoping to take advantage of the program. Other CMBS deals in the pipeline include those by Inland Western Retail Real Estate Trust Inc. and Vornado Realty Trust. J.P. Morgan Chase & Co. is working on both deals. Not everyone is going to benefit from the TALF program. Tight restrictions will bar thousands of small developers and commercial-property owners with heavy debt loads from participating.