Growing pains in conduitland

With any new foundling, there are growing pains - especially with something barely 7 years old. Thus it shouldn't be surprising that the nation's conduit industry, considered a relative newcomer in today's rapidly changing real estate financial markets, is experiencing such maturing pangs.

Once the darling of the real estate sector, conduits were rattled by last fall's unexpected capital crunch, followed by the double whammy of higher interest rates and lower borrower demand.

"The industry was only developed in the 1990s, so it's been finding its footing," says Brett Ersoff, senior vice president of Lehman Brothers in New York. "If handled correctly, conduits can be a very profitable business, but like any business, if companies are reckless, it's going to fall apart. I think we're going to see an expansion of business, but it's going to be fairly conservative. Generally, standards are becoming more acceptable and pitfalls are becoming more obvious."

Conduits are a good, long-term business, adds Ron Wechsler, managing director of PaineWebber based in New York. For those in the business who can endure a volatile time like last year, Wechsler says, it's good, "because it shows they have staying power. Originations are obviously off from the first half of 1998, mostly because of interest rates."

Borrowers are playing a wait-and-see game, Wechsler adds, while lenders are saying, "let's go, let's go. We'll eventually have borrowers who need to refinance, and who will do so if rates stabilize," he says. "We should see some increasing demand for conduits as we get to the end of the year."

A maturing market The conduit sector has matured over the past 10 months, agrees Steve Jones, managing director of client management for real estate capital markets at First Union in Charlotte, N.C.

"From a new origination standpoint, this year started a bit slower, but it has gained steadily for us throughout the first seven months," says Jones. "Our company has just recently begun to achieve last year's run rate. The market will not reach the levels of last year when some $78 billion in CMBS was issued. Like most, we believe CMBS issuance will be off by 20% to 25% this year vs. last."

Recently, Treasuries are generally up, swap spreads are higher and thus yields for CMBS have increased, continues Jones. That translates into higher rates. "People say, 'Is this the best time to refinance or should I sit back?'" he adds. "Real estate fundamentals are good and the projected supply of CMBS would normally seem manageable - resulting in spread movement within range. However, liquidity concerns stemming from Y2K and overall debt market supply could certainly push spreads wider in the coming months.

"I guess, if we had to summarize what to expect for the rest of the year, it might be plenty of lenders continuing to compete in a market that is not as big as last year's and - we hope - not as unpredictable," Jones says.

Jones's colleague, Brett Smith, director of national accounts for First Union, says changes are occurring in the conduit market. "After seeing the run-up in Treasuries, some borrowers are looking at a floating-rate alternative, hoping the market and Treasuries work in their favor later when they look at a more permanent financing," Smith says.

Borrowers are taking a while to adjust to the current market, he adds. "It depends on your perspective. When you look at the 10-year Treasury component of your rate, the pricing looks higher," says Smith. "On the other hand, the spread for multifamily might have been 285 basis points last fall, but now is in the 200 range, depending on the property. Borrowers will have to continue to adjust expectations because the market will change. But, if they can afford to sit on the fence, there are certainly multiple alternatives to assess."

Changes since August '98 Simon Milde, chairman of The Greenwich Group, an international real estate investment banking business based in New York City, says there is no question that the conduit business has changed "since the implosion of last August, when everyone was caught by surprise.

"More recently, the problems in the capital markets seem to have worked themselves through," he says. "People are selling again and pricing has come back. But for six to nine months, there were real disruptions caused by overzealous lenders and buyers. Most of the lenders are now being much more cautious in underwriting standards."

Kieran P. Quinn, president of Column Financial, an Atlanta-based conduit lender owned by New York-based Donaldson Lufkin & Jenrette, adds that there is still too much capital chasing a smaller supply of lending opportunities in the conduit market.

"The market fluctuates periodically, but that's the price you have to pay for one of the most efficient capital markets in the world," says Quinn. "Funds are still very affordable, for the most part, and a borrower might be facing a note rate of 8%, but that could be higher for certain retail properties or hotels. That's not bad. Nobody has lost a property because their debt was 8%. People have made a lot of money in the real estate business with loans of 8%."

With the tremendous amount of capital, Quinn continues, there is also an excess supply of lenders. The ranks of lenders will thin eventually, he adds, not so much from consolidation as from people simply losing interest in the business. "People will say the returns aren't there, particularly when they need to build an expensive infrastructure to originate $1 billion or $2 billion in conduit business a year," says Quinn. "CMBS lending has become a mature business. Margins have shrunk. There are no opportunities for quick money. You have to slug it out day in and day out. You have to be a low-cost provider and have the infrastructure in place."

Conduits turn cyclical Don MacKinnon, managing director at Donaldson Lufkin & Jenrette, notes that overall conduit product flow is down. "There are several reasons for that," he says. "First and foremost, interest rates have been higher over the past couple of months than they were during almost all of last year. The capital markets disruption last fall has given borrowers pause in returning to the capital markets. And finally, there are fewer transactions on the equity front, such as acquisitions and mergers, that require financing."

Explaining that the future is always hard to predict, MacKinnon says he thinks the lower product flow this year could result in fewer capital markets originators. "The strong will survive, and the weak will finally go away," he continues. "Originators with strong balance sheets, good origination capabilities and investors who believe in what they're doing will survive. I think we'll see some people toward the end of this year who will lose their stomach for the business. The conduit business is cyclical, and it is risky. It takes a lot of work, commitment and attention to risk management."

Ersoff of Lehman Brothers agrees conduit fever has subsided. "As far as we are concerned, there is less product out there, less insurance company roll overs from 10-year loans, less financing from opportunity funds and less refinancing activity from RTC loans," he says. "Bankers say things are slower because there is not much product out there. Last year, Lehman did $29 billion in real estate activity. Of that, $3.5 billion was conduits. This year, we'll probably do $2.5 billion worth of conduit business."

The high conduit volume in 1998 was due to a number of factors, Ersoff explains. "What you saw last year was more prepayments than ever as borrowers began repaying early to take advantage of low rates," he says. "Also, there were still a lot of RTC and early conduit deals that were rolling over.

"But if you look to see what's going to be rolling over, 1989, 1990 and 1991 were not significant transaction years," he continues. "So the roll over in 1999, 2000 and 2001 is not going to be momentous. Several years out, we'll see the next wave of balloons come due and we'll see things pick up rather substantially. But we don't expect enhanced volume in the next few years."

Conduit loans remain lukewarm Robert J. Walter, senior vice president and managing director of LaSalle Bank NA of Chicago, a full-service subsidiary of ABM Amro with some $30 billion in assets, agrees that conduit loan demand is tepid.

"Acquisitions are down, interest rates have kicked up," he says. "We've had a fair amount of optional refinancing in 1997 and 1998, and we see some results of that in 1999, because there are a lot of people on the sidelines. But I don t see any big increase in volume in the second half of the year that is going to turn up demand substantially."

Higher interest rates are having an effect on the market, he explains. Some borrowers are feeling that they don't have to act because they don't know where interest rates are going.

"I think, clearly, we're seeing some consolidation starting," says Walter. "There are a lot of companies out there that really staffed up because they thought loan demand would continue where it has been. A lot of those folks are going to have rationalizing where they are staffing-wise. We're staffed very lean, and it's good to be that way in this environment."

Milde of The Greenwich Group adds that most of the conduits have adopted conservative underwriting, concentrating on lending no more than 70% of value.

"Because of this conservatism, there is less unrated paper to sell," he adds. "At the same time, the ability to get loans in excess of 70% of value through conduits has been severely reduced. I think that is the major effect of what happened last August and, quite frankly, I think it's better for the industry because it creates more stability."

Consolidation among conduits The country's economic fundamentals are strong, the real estate market is healthy and employment is good, says Carmela Anderson, Bank of America's managing director of the commercial mortgage lending business based in San Francisco. "We're beginning to see bond-holders base investment decisions on real estate credit quality and the track record of the originator more now than in the past. It's the whole notion of flight to quality," she says.

There is a tremendous amount of capital in the market, Anderson adds. "In the early part of the year, we saw many lenders really stretching loan to value (LTV) to 80% with debt coverage of 120 to 125 on more volatile property types," she says. "The investor community usually likes to see 70% to 75% LTV, and debt coverage more in the 125 and 135 range."

Anderson says investors are demanding good-quality, well-underwritten loans. In addition, multifamily pricing is now competitive with Fannie Mae aggregation, she explains, and, "We are starting to see some of that business come back to us. During the first part of the year, Fannie Mae DUS programs were competitively priced and a lot of multifamily business began flowing into the agencies. We're seeing a trend back into conduits."

Bank of America is also experiencing a significant amount of business locally. "Bank conduits benefit from our incredible client base," she continues. "We see a large number of product coming from our own customers."

At the same time, there will be further consolidation in the conduit industry, she says. "In order to succeed, you not only have to have a very efficient origination capability, but you have to be able to securitize and be a full-service provider of CMBS products from the cradle to the grave,"Anderson says. "Those institutions that are able to do it are going to be the institutions that, over time, stay in this business and flourish."

Wechsler of PaineWebber agrees, saying that because the conduit market has slowed, he expects to see fewer firms in the conduit industry. "Today, there are fewer conduit players because there is not enough business to sustain everybody," he says. "There will be others leaving because a lot of new players came into the market expecting a certain amount of business and have been disappointed. Those firms with senior management who understand the business and have a long-term objective will be here."

Alternatives to conduits The decline in business is forcing some conduit firms to reassess their business plan. Shekar Narasimhan, chairman and CEO of WMF Group Ltd. of Vienna, Va., a commercial mortgage financial services company, adds that many firms are no longer focusing on conduits as the all-purpose origination vehicle for real estate. "Firms in the industry originated an extraordinary amount of business over the past three years and everyone showed dramatic growth during that period," he says. "Rates are up and there is less activity. Everyone is scrambling to find ways to increase business. Some of the normal ways have become less easy or involve more risk, such as using more leverage."

As demand for conduits eases, he adds, those in the industry have begun to look at other types of financing. "We're seeing more activity in bridge financing, a kind of precursor to conduits," Narasimhan explains. "Some people today don't want to lock into a fixed rate. They don't like where rates have gone, so they opt for a floating-rate loan and wait."

He adds that Fannie Mae and Freddie Mac are still aggressively competing for multifamily business, making it even more difficult for some conduit companies. The impact of such aggressiveness, he says, may increase subordination levels because rating agencies like to see some multifamily mix in conduits.

"It's a very competitive market," Narasimhan adds. "There is lots of capital still out there, although the market has experienced a substantial change in complexion, competition and volume. I think every person in the business is re-examining their conduit business right now. There will be fewer players, less crazy competition, less ability to manage risk and more branding. The long-term players are still going to be around three to four years from now, but others will change business strategies or just go out of business."

The conduit crossroad That's one of the reasons flexibility needs to return to the conduit market, adds David M. Jackson, president and CEO of First Security of Chicago, the holding company of First Security Commercial Mortgage (FSCM), First Security Com-mercial Servicing and First Security Investor Reporting.

"I think the conduit industry is at a crossroads," says Jackson. "Conduit underwriting has become very 'in the box.' What used to be an advantage for conduits - flexibility - is not any more. Some of the biggest names known for flexibility have been hurt the most. The new people who replaced them are more cautious because they don't want to be stuck with an unsalable product."

Jackson thinks borrowers are sitting on the sidelines because conduits do not have enough flexibility. Those fears of borrowers will ease, Jackson predicts, and ultimately six months down the road, conduits will have re-invented themselves, allowing for greater flexibility and confidence. "Maybe it will be looking at real estate values as opposed to debt service coverage ratios, or prepayment flexibility as opposed to default risk or the value of interest-only strips," says Jackson.

The residential market has seen constant innovation, but the CMBS market has seen little, Jackson continues. "Conduits will not go away, but if they really want to be the front player on the scene, they're going to have to be redesigned for the capital markets," he adds. "The new people who have entered the business have wanted to be strictly in the box. What I'm saying is that, over the next six months, they'll have to come out of the box if they want to play a major role in real estate finance."

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