Banks and insurance companies are back in the commercial lending game, and they're giving other lenders a run for their money, which means good news for those seeking funds.
Hush with capital from securitization as well as traditional sources, the commercial real estate lending market has become increasingly competitive in 1995. Lenders are more aggressively vying for quality deals, enabling borrowers to find credit at better prices and from a larger variety of potential sources.
"Financing has finally emerged from the doldrums of the late '80s and early '90s," notes Arthur Fefferman, president of AFC Realty Capital, New York. "As a result, today's investor faces a wide variety of options."
With many property market indicators reading more positive, and spreads - although tightening - looking more attractive for the long term, many banks and insurance companies have re-established their comfort level with real estate as an asset worthy of investment, making great strides at working out their portfolio problems and determining ways to participate in an arena transformed by the commercial mortgage-backed securities (CMBS) market. Although witnessing a slump this year, CMBS has proven its staying power, especially its conduits.
"If anything, the major difference between the market today and two years ago is that conduits are now an established presence in real estate financing. Their competition helps to define the market, and they must be included with banks and insurance companies as a pillar in the market for commercial mortgage debt," says Jonathan Adams, vice president with the mortgage research group at Prudential Securities Inc., New York. "Conduit activity has increased dramatically this year," says Jacques Brand, managing director at Bankers Trust Co., New York. And it isn't over yet. "Rating agencies will enjoy a lot of fourth quarter activity from them."
On the other hand, many report that the CMBS market is overrated, that conduits are struggling with production and that, despite all the hoopla from Wall Street, "it is obvious they are not going to take over the world," says Gilbert Lorenz, president, Horizon Mortgage, Atlanta.
"Conduits have filled the void of the S&Ls, coming out of CMBS in 1993 when rates were so low," says Stephen J. Pearlman, director, Jones Lang Wootton USA, New York. He explains that, at that time, it made sense for a conduit to go out and do $4 million to $15 million deals at 60% loan-to-value and 1.3 debt service coverage and get 400 basis points over comparable term Treasuries. However, when interest rates went up, a spread of 300 basis points or more "became very rich" and insurance companies, studying the concept of securitization and not wanting to lose share, cut their spreads to compete.
"Conduits are competing with insurance companies for the same A-quality credit, but insurance companies can do deals at 140 basis points over Treasuries as opposed to a 250 spread from conduits," Pearlman says.
Donald Innis, director of loan administration at St. Paul Federal Bank, a Chicago-based savings bank active in multifamily lending in the Midwest, says competition is intensifying for both A- and B-quality property, largely from other financial institutions and insurance companies. Conduits, however, have not adversely affected the business as they are "pricing themselves out of the market with too many layers of fees."
Fefferman says that he sees a shakeout under way among conduits, citing Kidder Peabody and Daiwa as two firms that have exited from the scene.
"It's not a secret that conduit activity is down," says John Beam Jr., president of Insignia Mortgage & Investment Co. Inc., Atlanta. Beam cites a statistic that places CMBS activity, which is the end-product of conduit activity, down about 35% from last year. "At the end of the year, we might end up with $15 billion vs. $20 billion, which is a pretty big difference."
Beam says three major factors have slowed conduit activity.
First, "the RTC is running out of steam," he says, noting that its last big pool - about a $385 million pool handled by CS First Boston - occurred earlier this year. "After this, if there a pools, they're going to be a lot smaller," he says.
Second, like Pearlman and Innis, Beam cites stepped up competition. "The agencies (Fannie Mae and Freddie Mac) and life companies are able to undercut conduits as far as spread is concerned and offer better yields," he says.
Third is what Beam calls "the REIT situation." He says: "Last year there were a number of secured REIT loans; this year, the trend seems to be unsecured. Activity has probably doubled ... but the activity has also been on an unsecured basis, which means they're lending to the REITs and they're not going through the securitization process."
"Those three have combined to press the market," Beam says, "especially in the multifamily area."
But Adams, paraphrasing Mark Twain, says "The death of the CMBS market has been greatly exaggerated," pointing out that conduit transaction volume has risen this year and that the CMBS market has proven it can bounce back from adversity, having survived a period of higher interest rates in early 1995.
Nevertheless, conduits are "proving much more accommodating in their terms", Fefferman says. "Today, for example, they are willing to consider terms and services they once disdained, such as longer amortization, financing of moderate rehabs and financing of student housing."
Conduits are one way some banks are again participating in lending - this time with an exit strategy. Jim Naumann, director at NationsBanc Capital Markets Inc., Charlotte, N.C., which has two sizable conduit programs up and running, explains that the bank made a strategic decision to become a pre-eminent real estate lender by establishing ways to not only originate product but also place it in the capital markets.
"Now that the CMBS market is developed, we are trying to take advantage of it and still be in the real estate business. Like a lot of other companies, we want to limit our exposure to real estate," he says. So instead of making whole loans and keeping them on their books, the bank is originating its own conduits and selling them in the public markets, thereby spreading the risk. But not every bank can do it, Naumann points out. Such a structure requires not only Section 20 investment bank status but also an ability to originate loans.
"We are one of the largest originators of any bank in the country, and the real strength of our program is that we can originate loans internally," he says, adding that the bank's own franchise can make loans from Baltimore to El Paso, needing only a limited amount of supplementation from outside originators. This is the key to speed, independence and survival which is lacking in many other conduits on the market today and which exists "in only a handful of banks," Naumann says.
NationsBanc has a two-part multifamily conduit program that contains both conventional and Section 42 low-income housing loans. It also has a commercial property conduit of loans in the $1 million to $10 million range with a focus on retail and industrial properties, with a smattering of hotel, office and health care included up to the extent that rating agencies allow.
A conduit provides the bank with a product it never had before, Normann says. He cites the example of a borrower wanting a $2 million loan on a strip center. "The trend is that larger banks are taking less and less portfolio risk. They don't want to do permanent lending or even mini-perm lending. If that customer came to us and wanted a seven-to-10-year loan, we would say we are not lending for that length of time but that we do have an alternative in the conduit."
The internal origination capacity at NationsBanc eliminates some of the costly fees that occur when going through a mortgage banker or intermediary, although unavoidable third-party costs associated with necessary appraisals and environmental and engineering reports do make the conduit loan more expensive than a straight bank deal, Naumann says. "Borrowers have to look at the options and the benefits. If it costs a little bit more to get the deal done and it avoids their having to roll it every three or four years, the savings over the long-term is worth it," he says, adding that the big conduit loan advantage is that it is non-recourse.
"It has become apparent that the survivors in the conduit game are those who can act as principals with their borrowers," says E. J. Burke, program director at Midland Commercial Funding, Kansas City, the mortgage banking arm of Midland Loan Services, L.P. A lot of conduits were not capable of making underwriting decisions in the field and instead were relying on investment banks, Burke says. "We have capital, and we are different in that we have the highest-risk piece, so when we negotiate a loan, it is as if the borrower is working with a traditional lender. We also service the loan, so the borrower is not affected by the securitization process."
Burke is confident that "conduits are here to stay. It is a relatively new industry that will see more shake-out, but those who are well-capitalized and innovative will survive," he says. "We have worked hard to overcome the conduit stigma and are now seeing repeat business as borrowers appreciate the traditional lenderlike relationship."
Competition comes from other conduits for multifamily loans and from banks and insurance companies on other property types, Burke says. Mortgage REITs and credit companies are involved in health care and mobile home properties and, while many other conduits specialize, Midland's strong suit is in creating solidly underwritten pools of loans with both geographic and property diversity. Its first securitization was a pool of 66 loans totaling $106 million and including 63 different borrowers. A second offering of 85 loans totaling $200 million is due for December.
Beam of Insignia cites several active new programs in the market. He says that Nomura has a direct program gaining momentum "where they're really bypassing the conduit lenders in the marketplace and going directly to investors and brokers." Likewise, he says, "the ability of the Fannie Mae DUS lenders to access directly their MBS program will also be something that will allow for lower rates and, probably as the program gains momentum, will do a sizable amount of business."
Insignia's own main program is PruExpress, a life company conventional lending program. "I see the PruExpress program continuing to try new niche markets," Beam says. "We already are in affordable housing, we have a senior living program, we have a conduit program, and I see that next we'll have access to an agency program, either Fannie Mae or Freddie Mac.
"With Prudential as our partner," he continues, "we'll try to cover the various aspects and levels of the lending markets with the different loan product types."
Insignia's newest program in conjunction with Prudential, through J.P. Morgan and with AMRESCO doing due diligence, is called Prudential Capital Markets Express. Beam says this program takes in all property types. "It is Prudential's goal to put other programs into Capital Markets Express," he says. "AMRESCO/J.P. Morgan is just the first. They will be having other programs that are tied to Wall Street or the capital markets."
Burke says that it appears life companies have been very aggressive in 1995, and that he believes interest rates will play a key role in determining how much volume is out there. "As yields on Treasuries drop, spreads from life companies tend to widen, which helps us," he says. He mentions another plus for the future of conduits and the CMBS market is that it now has a history. "Rating agencies and investors are now better able to draw on more accurate data regarding loss history and performance, and that should bring spreads down relative to other lenders," he says.
"As they see markets have stabilized, and specifically as they see that values have bottomed out and inched upwards a bit," investors are more comfortable with the underlying securitized loans, says Adams. "Our expectation is - and history has shown that - loans originated at the bottom of the cycle will perform the best. As returns on income grow larger, there comes a point when investors are willing to pay more for the equity in the property because returns are competitive on a risk-adjusted basis compared to other types of assets." At some point, an investor will step up and pay more for the increased income stream, which is an important indicator in the turnaround of the securitized market, he says.
While 1995 began slowly for CMBS, Adams says he expects acceleration from now until year's end. Although traditional lenders are back, "so far, there is no indication of their willingness to undercut whatever offering is in the market to get deals done, as they did in the mid- and late, 1980s, when they were driven by origination fees and willing to commit to spreads that did not reflect the risk of real property. There is nothing like that today," he says. "The increase in their activity is incremental at best, which is not surprising given the history and general tenor of commercial banking. They have too many other things on the fire to focus in an all-consuming way on commercial property."
As for conduits, Adams says they are evolving into a more efficient origination system, which takes time. "If you want to make bad loans, you can do it pretty quickly, but an on-going system of volume and high quality takes considerable time, especially in terms of working out a transfer system between originator and underwriter, which is happening," he says.
CMBS has seen good news and bad this year, Brand says. While traditional lenders are back again, interest rates have declined dramatically. Since many banks and insurance companies have minimum thresholds for both spreads and absolute interest rates and are not able to go below a certain level, it creates a gap that investment banks are very willing to fill.
"Many life companies and financial institutions are not yet out of the woods and have not turned the comer in terms of dealing with their problem real estate loans, so CMBS offers an attractive alternative as a means of rationalizing their balance sheets in terms of NAIC-imposed risk-based capital guidelines," Brand says.
One example of how a life company is turning to the capital markets is a securitization of more than $200 million that Bankers Trust is arranging for a performing loan portfolio. The offering effectively takes the place of bulk sale and should result in a higher price to the insurance company, Brand says.
Brand also points out that securitization is making gains in foreign markets and is working effectively for large mega-million dollar transactions where the process offers a better economy of scale in terms of structuring and placement costs.
"We are exporting the securitization technology from the U.S. market into Canada, Asia and Europe," he says, mentioning that Bankers Trust completed a $1.8 billion CMBS transaction last year in France and is at work on a $125 million multifamily securitized deal in Hong Kong. "The pricing is more competitive than their traditional sources," he says.
Capital chasing deals
An excess of capital from all types of sources is chasing deals, Lorenz says. Banks are the most dramatic entrant into the market, and time will tell whether their appetite remains healthy, he says. "Banks have abdicated some corporate
Capital providers are back, but can they find enough quality deals?
An overwhelming number of real estate capital providers say they are back in the market, but a majority of that same group indicates that the biggest problem in the industry today is the lack of quality deals.
More than 80% of the respondents to a survey of over 1,500 capital providers and 3,500 capital users conducted by Chicago-based real estate investment services firm Cohen Financial Corp. (CFC), indicate that they will continue to increase commercial mortgage holdings during the next 12 months.
At the same time, 57% of the respondents to the same survey say that a lack of quality deals is the biggest problem facing the industry today. A year earlier, only 29% of the capital providers said deal availability was a major problem.
The intense competition among lenders to corral what little business is available has caused spreads - the difference between mortgage rates and Treasury yields of the same term - to drop significantly over the past year and a half. However, results from the CFC survey suggest this downward trend may soon be coming to an end.
Nearly half the lenders responding feel that spreads have reached their floor and will either stabilize or possibly even increase before year's end. This is up considerably from only 28% who were predicting that spreads would stabilize a year ago.
With their ability to compete on the basis of spreads quickly disappearing, these capital providers have been forced to move the battle to the underwriting field - a fact that the survey indicates has not gone unnoticed by those in the borrowing community. Over the past year, the borrowers' perception of lender underwriting has grown steadily more favorable, rising from 3.31 last year to 4.70 today (on a scale of 1 to 10).
Lenders indicate the greatest flexibility will continue to be experienced in areas of amortization and borrower recourse.
CFC's survey found 35% of the lenders indicate their institutions plan to lengthen amortization schedules over the next 12 months - up from 22% one year ago. Similarly, 23% of the lenders indicate they will continue to place less emphasis on borrower recourse in the year ahead - vs. 9% last year. Other criteria mentioned as targets for future loosening include loan-to-value, where ratios will once again exceed 70% and debt coverage.
Find a replacement enhancer now or you could lose tax-exempt status
Lenders active in refinancing tax-exempt bonds for multifamily projects are seeing a window of opportunity that has kept them busy for the last few years and should continue through at least 1996. This specialized market involves tax-exempt bonds issued in the 1980s to induce development of multifamily projects where a component (generally 20% of the project's units) was set aside as affordable housing. These bonds, which some estimates put at $29 billion, with approximately 60% expiring before 1998, were often credit enhanced by a thrift institution or commercial bank and are reaching maturity at the same time that the original lenders, if still in existence, are for the most part shying away from renewing the letters of credit, wanting to avoid making a long-term real estate lending commitment.
But such niche lenders as Banc One Capital Corp., a wholly owned subsidiary of Banc One Corp., Columbus, Ohio, and CentRe Mortgage Capital, New York, an entity formed by CentRe Trading Holdings Ltd., a subsidiary of a Zurich-based insurance group, and the Related Cos., LP, a New York-based real estate company and large owner of apartments across the United States, are actively filling what Ed Marron, president of CentRe Mortgage Capital, calls a "substantive void," by offering replacement surety for enhancement of the expiring letters of credit.
Owners risk loss
Without such lenders in this market, owners of many such multifamily projects are risking the loss of their tax-exempt status and could end up with a taxable prime-based loan with a short amortization period, a balloon maturity or both, and, in some cases, would still have to comply with original low- or moderate-income tenant targeting requirements, according to Banc One Capital. Unless a replacement enhancer is found, owners would have to turn to such a taxable loan or sell the project to a buyer who can provide such enhancement.
Adding to the factor that some of the thrift issuers are no longer in business is that some of the real estate involved was overvalued or overleveraged, or both, according to William E. Roberts, vice chairman of Banc One Capital Corp. and chairman of BOCC Funding Corp. "At the time it may have appeared as if the values and cash flow were there, but it soon became clear that they weren't. The projections weren't realized, the values weren't there, the rental markets deteriorated, something happened. There were a number of defaults and a lot of properties that didn't default were carried by their general partners. So there may be situations where the institution still exists and where there might be a willingness to renew a letter of credit at some level, but not at the level necessary to refund or to replace an expiring letter of credit. A write down of the debt, a subordinated credit facility, an infusion of subordinated capital, or some combination thereof is required in these cases," Roberts says.
Similar to any debt, the credit enhancements can take a variety of forms, says John W. Adams, managing director of Banc One Capital Corp. "There are a wide range of situations, and there is no cookie-cutter way of doing this," he says. He and Marron both say that problems usually arise with former issuers and a myriad of tax issues, and that solutions vary.
Marron says CentRe can provide 10-year enhancements with up to 90% loan-to-value (LTV) and also has the ability to float the transaction over a tax-exempt index, which provides extremely aggressive pricing. Marron says he expects increasing competition from credit companies and a few conduits who are already in the market. "It requires taking an owner's point of view and taking a 90% advance. There are a lot of people who don't want to play in that sector but we are willing," he says, adding that it requires a specialized understanding of both bonds and the underlying property. CentRe has recently provided approximately $110 million of such substitute credit enhancements, has an additional $35 million under contract and expects a year-end total of approximately $600 million, according to Marron.
Banc One Capital Partners IV (BOCP IV), a $100 million housing and health care investment fund managed by BOCC, can provide additional credit enhancement, guaranties or subordinated taxable financing in connection with the refunding or refinance of a property and in some cases can provide mezzanine financing, according to Roberts.
Adams says that Banc One Capital has completed more than $200 million in such transactions this year, and he explains that credit enhancements can come through Fannie Mae, Freddie Mac or FHA programs, which generally allow 85% LTV, as well as from letters of credit from banks or any other ratable institutions, such as life companies.
Several option plays are available, Adams says, such as a custody receipt transaction, where a borrower can convert a fixed-rate bond to a floater and take advantage of lower short-term interest rates or an advanced refunding where an issuer sells a tax-exempt bond prior to the original bond issue call.
Roberts points out that timing is crucial. "We have seen a number of deals that should have been just problems but that have turned into crises because of the point at which people started to work on them. The bottom line on these transactions is you can't start too early, but you can sure start too late." Roberts adds that he expects to see continued volume throughout next year as long as interest rates remain low.
Lenders adjusting to climate of renewed activity
Institutions and real estate organizations are adjusting to a climate of renewed activity, according to a recent survey of the top real estate financial executives by Price Waterhouse LLP's New York Metro Real Estate Industry Services Group shows that. Among the findings:
All categories of investors saw a decline in their percentage of underperforming assets, the turnaround is especially significant for life insurance companies, which cited a decline of 5%, as opposed to an 11% increase last year. Commercial banks still reported the largest percentage of underperforming real estate assets, but also reported the largest decrease in that category.
Commercial banks and insurance companies are beginning to become concerned about the multifamily market and anticipate funding more transactions in retail and office as they see these markets recover.
For lenders, real estate fundamentals will dominate investment considerations, including debt service coverage, loan-to-value ratios and property quality.
Equity sources were picked overwhelmingly as the likely sources of new capital in the coming three years. In view of their focus on markets that are currently "down" perhaps this is a further reflection of the belief that "opportunities come to those who look for them."
Geographically, equity sources appear to be targeting the West Coast, the Rockies and the Southwest as areas most ripe for investment. This is a likely reflection of a desire by opportunity funds to take advantage of a changing market. Interest among other respondents tends to be more generally distributed.
Commercial banks still favor multifamily properties (26%), but at a level virtually equal with retail (29%) and office (23%) properties.
Insurance companies favor office (28%), retail (25%) and industrial (20%) property over multifamily (15%).
Commercial finance companies are about equally interested in office (29%) and retail (28%) properties, with multifamily (18%) as runner-up.
Equity sources continue to favor multifamily (43%) properties; retail property (26%) is also gaining more attention.
The Price Waterhouse survey, Perspective '95: Survey of Leading U.S. Real Estate Financial Executives, covered 56 institutions providing capital to the commercial real estate industry. By percentage of respondents, 16% were commercial banks, 25% were insurance companies, 30% were equity sources (pension funds, REITs and other funds), 9% were commercial finance or other investment companies, and 20% identified themselves as "other" (mainly mortgage banks). have no concentrate on even further restructuring, or, an exit. "There is tremendous pressure on Japanese banks with U.S. operations to adhere to the same regulatory environment as U.S. banks. They are no longer exempt and they will have to acknowledge their problem loans," Pearlman says, adding that many of the Japanese banks are more highly leveraged than their U.S. counterparts.
The volume of rollovers in the market "clearly has an impact but has been overblown," says Adams. Without the rollovers, the market would be in bad shape, he says, considering there is virtually no new construction or take-out lending going on. Yet these rollovers are not creating a wave of demand for credit that will boost volume significantly for securitization or even increase real estate exposure for traditional lenders. Conduits are competitively grabbing up some of these loans, with banks remaining equally competitive in trying to keep them, he says.
The resurgence of life companies into real estate lending has been taking place for the last two years, Lorenz says. "Some entered early and others are coming lare to the dance for a variety of reasons." The early birds were largely long-term lenders who were already comfortable with real estate as an asset class. Later arrivals were straightening out their portfolios.
Horizon Mortgage serves as an originator for 14 life companies and one bank, and Lorenz says he has seen all but one of the life companies increase their funds in 1995. Some reached their quotas for the year by summer, which brought on a lull until production picks back up for next year. While all of the participants may appreciate real estate's long-term propositions, "as spreads are more pressed and underwriting is more aggressive, the parameters are reaching the upper limits of acceptable risk and may now not be as attractive," he says.
Shekar Narasimhan, president of Washington Mortgage of Vienna, Va., a major Fannie Mae/DUS lender confirms that insurance companies have increased and already met their real estate allocations for 1995. "We continue to see competition from insurance companies for Class-A and Class-B properties, but we also see spreads holding at their tightest levels in five years. In some multifamily products - even considering that rates are higher than in 1993 - the actual rate to the borrower is equal to or lower than 1993. This is apparently no surprise as borrowers are increasingly requesting financing. "Borrower interest is extremely high," he says, attributing it to a combination of falling interest rates and stabilizing real estate values.
Narasimhan says he is glad he persevered. "With all the competition in the market, borrowers are shopping around more. But they are paying attention to those who remained in the market and those with credibility who stayed in during the bad times are now seeing the pay off," he says.
James B. Frantz is a New York-based freelance writer.