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Lost Cause

For now, the bulk of Prudential Financial Inc.'s commercial mortgage holdings remain on its books, but the day is fast approaching when that won't be the case.

In 2006, roughly $5.5 billion of Prudential's total loan originations were on-book while an increasing chunk — more than $3 billion — were issued and securitized as commercial mortgage backed securities (CMBS) or commercial real estate collateralized debt obligations (CDO). The balance included short-term lending products like mezzanine debt and construction loans. In total, the Newark, N.J.-based company issued $11 billion in commercial real estate mortgages (about $1.6 billion was for retail properties).

“Each year, there's the potential for it to go the other way,” says managing director Sean Beggan. “We expect our growth to come from our CMBS and CDO activity, while our portfolio lending activity will stay the same.”

And, it can be argued Prudential is one of the lucky life insurance companies. It's just one of a handful that are involved in both portfolio and conduit lending. So it's been able to make up for its shrinking business of on-book loans by building up activity in other areas. Other life companies — once the dominant force in commercial mortgages — haven't fared as well.

Some of the life company business is being sustained by a core of borrowers that still prefer portfolios to conduits, Beggan says. There's also been an overall steady growth in the commercial real estate lending business. Those factors have helped life companies grow their deal volume a modest amount. But, overall they are losing market share as conduit loans take up a bigger and bigger piece of the senior debt market, says Norm Nichols, a managing director with KeyBank. “The pool of borrowers that are uncomfortable with CMBS is getting smaller every day,” he says.

For its part, Prudential hopes to grow its commercial mortgage volume to $12 billion this year, Beggan says, adding that retail is still one of the company's “favorite” sectors. Beggan's not sure what the breakdown will be, but he's pretty confident that the company will continue to shift more of its business into conduits.

Joe Hegenbart, senior vice president and managing director of NorthMarq Capital's Boston office, thinks portfolio lending may be extinct within a few years. “I doubt CMBS will take over the entire mortgage industry, but maybe I am in denial,” he admits. “It could certainly happen.”

For the first three quarters of 2006, life companies issued $33.4 billion in commercial real estate mortgages, up 9 percent over the first three quarters in 2005, according to the American Council of Life Insurance Companies. In 2005, they doled out $43.17 billion in mortgage debt, a 10 percent increase over the previous year.

But that growth pales in comparison to the CMBS and CDOs. CMBS issuances reached $299.2 billion in 2006 — a $60 billion gain over 2005. CDO issuance grew to $34.3 billion in 2006 — a 62 percent gain from 2005.

Overall, life companies today hold just 9.8 percent of the $2.845 trillion of existing outstanding mortgage debt at the end of the third quarter 2006, according to the Mortgage Bankers Association. Banks still hold the bulk of commercial real estate mortgages — about 44 percent — while CMBS and CDOs have upped their share to 20.5 percent.

“We consider the banks and conduits to be our main competition, and I get the sense that our originators like KeyBank are straining to find good deals for us,” says Scott Stone, vice president of fixed income management and investments for RGA Inc., a Chesterfield, Mo.-based re-insurer that closed more than $100 million of commercial real estate mortgages in 2006.

In the third quarter of 2006, commercial banks saw the largest increase in dollar terms in their originations of commercial mortgage debt — an increase of $36 billion, or 3 percent, which represents 45 percent of the total $79.9 billion increase. CMBS and CDO issuers increased their mortgage activity by $26 billion, or 5 percent, representing 33 percent of the net increase in commercial mortgage debt outstanding.

But life companies aren't giving up just yet. “I'm not aware of any life company that hasn't increased its lending goals every year since 2000,” Hegenbart says. “Some companies haven't met the goals they've set, but they are able to put money out.”

Terms of endearment

One of the major drivers pushing borrowers to conduits rather than life company loans has been conduit lenders' willingness to lend at higher loan-to-value (LTV) ratios.

Today, it's not uncommon to see LTVs of 85 percent or higher in the CMBS market, but most portfolio lenders max out at 70 percent LTV, according to Tom Melody, executive managing director of CBRE|Melody.

Prudential's Beggan agrees: “We're definitely seeing LTVs creep higher where 80 percent is not such a bright line anymore for the conduits. For us, we're still a more moderate leverage lender, and most of our loans are about 60 to 70 percent LTV.”

Beggan also notes that in the past Prudential did not try to compete with conduits on interest-only (IO) loans, but has plans to be far more aggressive in the future. The best deals it is prepared to offer will give terms close to what conduits are offering, but Beggan doesn't think Prudential can ever be as aggressive. Some conduits are doing IO loans with LTV ratios up to 70 percent or 80 percent and that is more aggressive than Prudential is willing to go.

“For the best assets and the best borrowers, we'll compete head-to-head on interest-only,” he says. However, he notes that Prudential's IO tolerance is tied directly to the LTV. “If we get to a 70 to 80 percent LTV, three years IO might not be something that we want to do,” he notes.

Indianapolis-based 40|86 Mortgage Capital Inc., on the other hand, finds it easier to meet higher LTV requirements than it does longer IO periods, says senior vice president Wayne Nelis. “We are eager to meet the higher leverage LTV like the conduits are offering rather than going with IO,” he says. Nelis says the company just isn't comfortable with the risks inherent in IO loans and will only go three years on such loans.

Surprisingly, though, pricing has become almost a non-issue when comparing portfolio lenders to conduits, Northmarq Capital's Hegenbart claims. Life companies had tried to hold the line on price and were unwilling to accept thinner margins just to meet target loan quotas.

“The conduits have pressured portfolio lenders to compress their spreads, and they're all matching the market,” he notes. “They're making a spread, but it's a pretty thin spread.” Prudential, for example, is doing 10-year, fixed-rate loans in the 5.5 percent to 5.8 percent range. That is just about 25 basis points above what conduits are offering.

Touting flexibility

Aside from pricing, LTV and IO, there are still some major differences between conduits and portfolio lenders, says Hegenbart. In fact, he has created a checklist that compares conduits to other lenders to help point borrowers in the right direction. Flexibility is at the top of the checklist.

“We can make little tweaks here and there that the conduits can't,” says RGA's Stone, who hopes to increase loan volume by 10 percent this year. The company, which has an average size loan of $6 million to $10 million, has boosted its allocation of commercial real estate loans over the last few years. Today, about 6 percent of the re-insurer's invested assets are commercial real estate mortgages.

In particular, portfolio lenders are known for their flexibility with pre-payment terms, says KeyBank's Nichols, which doesn't do any portfolio lending for itself. However, it does originate senior debt on behalf of several portfolio lenders including RGA.

Nichols notes that pre-payment terms have become a real hot button with borrowers — one that the conduits continue to push on a regular basis. Borrowers want the flexibility of being able to get out of their loans early to refinance. They don't want to pay a price to do that.

Also, unlike for residential mortgages, pre-payment penalties aren't normally waived in the event of a property sale. Portfolio lenders have consistently been shortening the length of time that a borrower is subject to a pre-payment penalty, as well as decreasing the amount of the penalty.

Also, portfolio lenders' willingness to lend on unstabilized properties is another hallmark of their flexibility, Nichols says. For example, the conduits are notorious for being unable to finance properties that don't have a stable tenant roster or a steady cash flow. Moreover, mortgage banking experts have always advised any borrowers who think they may need to make modifications to their properties to avoid conduits.

Melody notes that retail properties, particularly lifestyle centers, tend to require more lender flexibility. That's why life companies have been able to compete very aggressive for lifestyle center deals.

“Life companies are good options because it's hard to go back to the conduit and find someone who can approve changes,” he explains.

CDOs cast shadow

But, portfolio lenders may not be able to hang their hats on flexibility for much longer, Nichols warns. “CDOs have opened up the capital markets to borrowers that would otherwise be forced to use other lenders,” he says. “CDOs were designed for deals that didn't fit in the CMBS box, and they're emerging as yet another pressure point on portfolio lenders.”

Nelis agrees that CDOs are going to impact portfolio lending. “The more flexibility that is put into the capital is going to squeeze us,” he says.

Today, about 50 percent of 40|86 Mortgage Capital's $1.6 billion loan portfolio is senior debt. The Indianapolis-based company hopes to reach $2.5 billion eventually and has a 2007 production goal of $700 million including construction-permanent financing, Nelis says.

Over the past four years, 40|86 Mortgage Capital has significantly decreased its concentration in retail real estate, dropping from 86 percent in January 2003 to 61 percent today. “We made a conscious effort to diversify,” Nelis says.

Despite those efforts, retail remains 40|86 Mortgage Capital's second highest loan type behind multifamily. “With so much competition, we're not going to turn down good deals,” Nelis says.

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