$205M loan offering secured by Kmart leases.

Highland Funding Group, Inc. of Westport, CT, recently performed the loan origination and packaging function for the public offering of a landmark $205 million pool of commercial mortgages backed by leases to Kmart or Kmart subsidiaries. It is believed to be the first commercial lease-backed securities transaction using the new SEC registration rules pertaining to asset-backed securities.

William J. Cavagnaro, managing director of Highland Funding Group, said "This transaction achieved some additional |firsts.' This was the first time that Standard & Poor's has rated the so-called |semi-gross' Kmart lease, which imposes certain obligations upon the landlords. This was also the first time that a securitized financing has been executed to cover the full 25 years of the Kmart leases, despite a clause in the lease that permits Kmart to terminate during the last two years upon a nominal loss occurrence."

DR Securitized Lease Trust Pass-Through Certificates, Series 1993 K-1, underwritten by Dillon, Read & Co. Inc., used a REMIC structure with a short-term and a long-term tranche. The certificates bear an overall blended rate of 7.103 percent consisting of the Class A-1 Certificates, in the amount of $110,927,000, maturing in 2010, and priced at a rate of 6.66 percent, and the Class A-2 Certificates, in the principal amount of $94,037,000, maturing in 2018, and priced at 7.43 percent. The Class A-1 and Class A-2 Certificates were rated "A" by Standard & Poor's Corporation, on the strength of the underlying long-term debt rating of Kmart corporation, which was either the primary obligor or the guarantor of all lease payments. The financing involved a pool of 28 leases on properties located in 17 states.

Thomas P. Zarrilli, vice president at Dillon, Read, said, "This transaction allowed us to introduce a new product into the public market at pricing levels significantly more efficient than would be available in the private placement market. We hope that spreads will narrow even further as the market becomes more familiar with the structure that we have devised for protecting the investor against landlord and tenant defaults."

The Boston-based law firm of Brown, Rudnick, Freed & Gesmer served as issuer's counsel and assisted Dillon, Read and Highlahd Funding in structuring the transaction to an "A" rating level. Ronald S. Borod, chair of the firm's Public and Structured Finance Group, said, "This transaction was significant in that it forced us to devise solutions to a number of problems inherent in lease-backed securities which can be applied in other situations. The transaction made financing available to private borrowers at rates and on terms not currently available in the conventional loan markets. The structuring innovations that were applied in this transaction can also be used for other lease-backed securities offerings involving tenants less highly rated than Kmart."

In order to make 25-year financing available to the borrowers, this transaction used a new type of insurance product which was specially designed to cover any interruption of lease payments during the last two years of each respective lease term.

In this transaction, the securitization process was used not to liquidate an existing mortgage loan portfolio but to originate and fund new mortgage loans. Consequently, the loans were structured and closed simultaneously with the offering of the securities.

Highland Funding Group is currently processing new applications for loans in its forthcoming pools, which will also consist of leases to Kmart and its affiliates, and which will also utilize the structural features of the 1993 K-1 transaction. Highland is also working on other securitized loan programs involving other credit tenants as well as tenants with below investment-grade ratings.