Aggressive. Innovative. Creative. Those are all fitting words to describe today's lenders as they stretch underwriting terms in ways that were unheard of just two years ago. It's part of an all-out effort to beat competitors. In fact, borrowing money hasn't been this fun since the late 1980s, when lenders lost the underwriting rule book and doled out capital for 110% of asset value.
Portland-based ScanlanKemperBard Cos. (SKB), a real estate firm with a $600 million office, retail and industrial portfolio, has discovered the joys of the current lending environment. The company acquired five business parks in Salt Lake City last summer from General Growth Properties for nearly $71 million. Combined, the properties include 1.3 million sq. ft. of industrial, office and flex space.
SKB wanted the ability to sell two of the business parks but avoid pre-payment penalties. Of several lenders competing for the deal, the U.S. arm of Japanese investment bank Nomura Holdings came up with the solution: The conduit lender gave SKB enough financing to buy all five business parks, but it placed the debt on only three of the parks. Thus, SKB received two business parks free and clear of any debt obligations.
How did Nomura do it? Instead of funding five parks with a loan-to-value (LTV) ratio of 72%, the bank ratcheted up the LTV for three business parks to 80%. The financing featured a 5.1% fixed interest rate and two years of interest-only payments over the seven-year term.
The funding structure is the first of its kind that SKB Principal Todd Gooding has come across since joining the company in 1996. “Much like I'm doing whatever I can to get a seller to sell us a building, lenders are taking the same approach with borrowers,” he says. “They're getting more aggressive.”
Too many lenders chasing too few deals is how Riaz Cassum, senior managing director in the Boston office of financial intermediary Holliday Fenoglio Fowler, describes the situation. “Everybody is trying to differentiate themselves to win the deal.”
But is trouble brewing? In early January, Fitch Ratings discussed how competition between capital sources is weakening underwriting standards in a report entitled “U.S. CMBS: Where Have All the Good Loans Gone?” Fitch analysts Daniel Chambers and Mary Mertz discovered that properties in many cases are being underwritten at future values.
What's more, the analysts warn that default rates on commercial mortgage-backed securities (CMBS) will climb as capital providers continue to “chip away” at lending standards.
Fitch's stress model indicates that LTV ratios on fixed-rate loans contained in CMBS pools rose to 86.8% in the fourth quarter of 2004, up from 81.7% in the first quarter of the year. The model also shows that among “fusion” deals — a hybrid mix of many small conduit loans and a handful of investment-grade loans rolled into one CMBS offering — LTV ratios among conduit loans rose to 89.5% in the fourth quarter, up from 86.9% in the first quarter of 2004 (bottom chart).
Similarly, debt service-coverage ratios in the conduit portion of the pools dropped to 1.22 in the fourth quarter of 2004 from 1.28 in the first quarter. A debt-service coverage ratio of less than 1.0 means that there is insufficient cash flow by the property to cover debt payments.
“We're seeing a lot more declining structural features than in the past, and it really heated up in the second half of 2004,” says Chambers, a managing director for Fitch Ratings. “Borrowers have become very savvy, and lenders know that if they want to win the business they have to keep up with the competition.”
The blossoming creativity among capital sources is occurring even as property prices have skyrocketed and real estate yields have dropped. To some industry professionals such as Jack Cohen, CEO of Chicago-based mortgage banking firm Cohen Financial, the trend indicates a permanent shift in lower real estate yields. It used to be that real estate investors could expect to acquire assets at capitalization rates ranging between 9% and 10%, but that's dropped to between 6% and 8%, Cohen says.
Why? Securitization has made the pricing of brick-and-mortar assets less risky than ever before, he says, and real estate as an investment class has performed quite well in tough times compared with the equity markets.
Still, Cohen and others acknowledge, capital providers are making riskier loans in the race to place money. Financing experts fully expect the CMBS market to eventually reject the riskier structures. “It's always been believed that the CMBS market would provide the sort of discipline to prevent this kind of behavior,” says Charles Krawitz, national director for small balance originations with LaSalle Bank in Chicago. “In the short run, it hasn't. But over a longer period of time, it will.”
To date, however, the CMBS market has yet to shows signs of duress. In fact, CMBS loan delinquencies decreased 42 basis points in December, dropping to 1.27% from 1.69% a year earlier, according to the Fitch Ratings' CMBS Loan Delinquency Index. Cumulative defaults in the CMBS market, which at the end of 2003 were 3.95% of the dollar balance of all CMBS, were expected to rise about 1% annually, according to projections made by Fitch last year.
Purging Principal Payments
Given the historically high prices that real estate is fetching today, borrowers increasingly are taking out interest-only loans to enhance yields by capturing income that would otherwise go toward the principal. A buyer purchasing a $100,000 property at a 7% cap rate and a $70,000 interest-only loan at 5%, for example, could generate an annual return of 11.7%. The same financing amortized over 30 years would provide annual returns of 8.3%.
Plenty of lenders are willing to make such loans. In 2001, interest-only loans accounted for 2.9% of Fitch-rated, fixed-rate CMBS pools. But by 2003, interest-only loans accounted for 7% of the CMBS pools, a 141% increase over two years.
Moreover, when only the conduit loans in the CMBS pools were examined, interest-only loans accounted for 35.8% of deals rated by Fitch in the fourth quarter of 2004, up from 11.5% in the first quarter.
The amount of leverage is increasing, too. Interest-only lenders will make loans with an 80% loan-to-value today, while a few years ago that ratio would range between 65% and 70%, says Brett Smith, the head of mortgage origination for Wachovia's Real Estate Capital Markets Group. Lenders previously restricted interest-only payments to the first one or two years on a 7- to 10-year loan, he adds. Now, the money providers are accepting interest-only payments for the entire term.
Case in point: In late March, Minneapolis-based Welsh Investments acquired 435,342 sq. ft. of industrial and flex properties in three Minneapolis suburbs for $25 million. Dallas-based Archon Financial financed the purchase with a $19.3 million loan — about 77% of the deal's value — at an interest rate of 4.83%. The kicker — interest-only for the full seven-year term.
What's the danger of interest-only loans? A bad economy, sour property fundamentals or higher-than-expected interest rates will make it impossible to refinance properties when the note matures. Thus, interest-only lenders put a premium on markets with improving fundamentals and on properties with all but guaranteed rent hikes in the near term.
“In the past, borrowers wouldn't have been able to get that aggressive on an interest-only loan, but now they can,” says Michael Kavanau, a senior managing director in Holliday Fenoglio's Chicago office, who worked on the transaction. “Lenders will take the risk, if it means they'll get the deal.”
Pay Now, Lease-Up Later
Lenders also are increasingly making permanent loans on new projects that are weeks or months away from stabilization. In September, for example, portfolio lender New York Life Investment Management provided South Florida-based San Lucia Inc. with $26.5 million in financing for the 356-unit Palm Gardens Apartment complex in Doral Park, Fla. At the time of the loan, the newly opened community was a few occupancy percentage points shy of stabilization, which is generally considered to be around 90%.
To win the deal, New York Life Investment reduced its debt-service coverage ratio on the 10-year, fixed-rate loan to 1.0, which meant that the property's net operating income was just enough to cover the debt service.
Normally New York Life requires coverage of about 1.2, says Jonathan Rice, a director with Houston-based financial intermediary L.J. Melody, who worked on the loan. But the property's location helped convince the lender to make the loan, which includes one year of interest-only payments, he says.
“The project was in a strong, well-developed area, and the borrower wasn't looking for a huge amount of leverage,” says Rice, who is located in L.J. Melody's Atlanta office. “New York Life is very conservative, but it got very creative to win the business.”
Typically, lenders receive a letter of credit or other guarantee from borrowers in such deals to hedge the lower debt-service coverage. Additionally, executives at life insurance companies and Wall Street investment firms have become more comfortable using their balance sheets to make such loans, says Brian Stoffers, COO of L.J. Melody. Some lenders hold the loans until they stabilize, and then move them to the CMBS market, while others keep the loans, he adds.
Government-sponsored enterprises (GSEs) are getting more aggressive, too. In fact, last year McLean, Va.-based Freddie Mac introduced its capped adjustable-rate mortgage (ARM) program and watched its ARM volume explode to more than $2 billion, says Mitchell Kiffe, vice president of loan production. In 2003, Freddie Mac's standard ARM product generated only $400 million in volume.
What's the difference? Freddie Mac's standard ARM loans require borrowers to buy an interest rate cap from a third party as part of the origination process. That costs borrowers more money upfront. Under the new program, Freddie Mac caps the loans itself and builds the cost into the overall financing. Today, borrowers can secure a loan with an initial interest rate of about 4% and a cap of between 6.25% and 6.5%. But that's a pretty healthy jump from the first half of 2004, when borrowers could get an initial rate of some 3% and a cap of about 6%.
In fact, Kiffe says, the flattening of the yield curve — or the narrowing of the spread between short-term and long-term rates — will make the new capped ARM product less attractive. “The program was a very big contributor to our success in 2004,” he says. “We hope the volume this year will be comparable to last year, but it all depends on the interest rate path.”
Still, debt experts don't expect rising short-term rates to slow borrowing. Indeed, rising short rates may pressure floating-rate holders to refinance with long-term debt — which means more loan business.
The long and short of it is that nobody expects the competitive battle among lending sources to abate anytime soon. “I think we'll just keep slugging it out with one another,” says Wachovia's Smith, “with everybody trying to get their fair share of business.”
Joe Gose is a Kansas City-based writer.
RESERVES IN REGRESSION
The percentage of loans that include reserves in Fitch-rated, fixed-rate CMBS pools has declined over the past four years.
|At Loan Closing||35%||32.1%||25.9%||31.3%|
|From Cash Flow||50%||54.1%||42.7%||40.7%|
|* Funded either at loan closing or from cash flow on ongoing basis||** Reserves for broker commissions, tenant improvements and other costs related to leasing space|
|Source: Fitch Ratings|
In deals “stressed” to reflect refinancing at higher interest rates, weighted average debt-service coverage ratios fell while loan-to-value percentages rose in 2004.
|1Q 2004||2Q 2004||3Q 2004||4Q 2004|
|* Conduit-only loans in Fitch-rated, fixed-rate CMBS pools; figures do not include investment-grade loans|
|Source: Fitch Ratings|