Encore Performance?

Mortgage bankers are hoping that 2006 will be a repeat performance of 2005 — a phenomenal year for commercial and multifamily mortgage originations. But whether those expectations materialize depends largely on interest rates.

An unshakable 10-year Treasury yield grabs most of the credit for the incredible run of rising lending volumes in recent years. The 10-year has barely budged in the past three years, rising from 4.05% in January 2003 to 4.37% as of Jan. 23.

“This last year was simply ideal circumstances,” says Ed Padilla, CEO of Bloomington, Minn.-based NorthMarq Capital. “Commercial real estate values generally held, interest rates are compelling and the [loan] maturity cycle is growing.” All of those factors contributed to the increased deal flow in 2005, and those same factors are still in play this year.

NorthMarq Capital arranged more than $11 billion in new production in 2005 — a 15% increase over 2004 and a record volume for the firm. Padilla is projecting even higher volumes for 2006 with a new production target of about $12 billion. “If we could duplicate 2005 and run it a few more times, I would be very happy,” he says.

Padilla isn't the only financial intermediary pleased with deal flow. The level of commercial/multifamily mortgage debt grew by $83.8 billion in the third quarter of 2005 to reach a record $2.5 trillion, according to the Federal Reserve Board of Governors. That volume is up 13.6% from a year earlier. Yet even as mortgage bankers are striving to exceed last year's record lending activity, many in the industry also recognize mounting risks — namely rising interest rates, aggressive underwriting and high-leverage loans. Those factors could not only drag down deal flow, but also shake up existing loan portfolios if delinquencies were to increase.

Reasons for optimism

Several factors are contributing to the record mortgage banking volume: a strong pipeline of refinancing activity, a robust investment market and rates near historic lows. Direct lenders and intermediaries hope those trends will continue to fuel volume. “We think the window is going to remain open for six to nine months, and potentially much longer,” says Christopher Carroll, a director at Chicago-based Cohen Financial. Cohen arranged more than $5 billion in financing in 2005, up from $4.1 billion in 2004.

More than $249 billion in commercial and multifamily properties changed hands in 2005 — a 35% increase compared to the $185 billion in transactions recorded last year, according to New York-based Real Capital Analytics. RCA tracks deals in excess of $5 million. “There is a lot of money all over the world that is chasing relatively risk-free yields that are higher than alternatives such as corporate bonds or treasuries,” Carroll says.

In addition, 2005 also represented a significant year for refinancing activity. In the mid-1990s, after a number of quarters of net decreases in commercial/multifamily mortgage debt outstanding, mortgage debt outstanding started to grow significantly through increased originations. For example, the net change in commercial/multifamily mortgage debt went from being relatively flat in the first quarter of 1995 to an increase of more than $45 billion in the fourth quarter of 1998.

“The refinance volume we are seeing now is driven by the maturing of the leading edge of those loans,” says Jamie Woodwell, senior director of commercial/multifamily research at the Mortgage Bankers Association in Washington, D.C. The projected higher volume in refinancing activity is expected to kick in around 2008, he adds. Rising interest rates will certainly impact mortgage lending to some degree in 2006. More than a dozen interest rate hikes over the past 18 months have clearly had an impact on short-term rates, with the 3-month LIBOR increasing nearly 200 basis points in 2005. The 3-month LIBOR registered 4.63% on Jan. 23 vs. the 10-year Treasury yield of 4.37%.

Yet even though the 10-year Treasury yield is expected to climb in 2006, long-term rates remain near historic lows compared to the mid-1980s when the 10-year was above 10%. “The rates will increase in 2006, but the increase will be gradual. So, we don't expect a significant pushback from borrowers because of the increase in rates,” says Jeff Majewski, chief operating officer at Houston-based CBRE | Melody.

Risk on the rise?

It remains to be seen whether real estate investment activity will be able to maintain its frothy pace, or if 2005 marked the peak of real estate sales activity. Even though there is still so much capital chasing real estate, at some point real estate investors are going to demand higher cap rates, and subsequently lower sale prices.

Buyers may be rapidly approaching that price threshold. For example, cap rates on apartments fell to 5.9% in the fourth quarter of 2005, down significantly from 8% in the fourth quarter of 2002, according to Real Capital Analytics. “If sellers are not willing to accept higher cap rates, then you will have a market that is going to slow down,” Carroll emphasizes.

Nevertheless, huge amounts of capital continue to flow into the commercial real estate industry. “The big question relates to the valuation of commercial real estate,” Padilla says. Although long-term interest rate increases have been slow to materialize, many expect rates to inch higher in the coming months. Economist predictions through August 2006 place the 3-month LIBOR at 4.97% and the 10-year Treasury yield at 4.8%.

“What, if anything, will those rising rates do for real estate values?” questions Padilla. “In turn, what does that mean for existing mortgage portfolios and the health of existing mortgage loans?”

The delinquency rate on bank loans has been steadily falling for more than two decades, and registered 1.05% in the third quarter of 2005, according to the Federal Reserve. However, one concern is that aggressive underwriting on high-leverage loans could push more loans into default.

Lenders are already backing away from risky condo conversions because of concerns of overbuilding. “Financing for condo conversions has become pretty limited,” Carroll says. In early November, investment bankers began moving to the sidelines as far as condos are concerned, and much of that Wall Street money has yet to return to the market, he adds. Lenders are being very selective in the condo deals they are willing to finance, and the deals that are getting done are requiring more equity and bigger yields.

The apartment sector also has been the target of some of the most aggressive underwriting due to strong investor demand. Typical loan-to-value ratios have jumped from 75% to 80%, with mezzanine capital pushing deals to 85%, or even 90%. There is nothing wrong with those high levels. Some lenders are clearly willing to take the risk, Padilla notes. “The question is whether lenders are being compensated for that risk.”

A lender making an apartment loan at 80% loan-to-value today typically requires a spread of 95 basis points over the 10-year Treasury yield. “That spread is probably a record low for that much leverage,” Padilla says. Five years ago, the same deal would have commanded a spread of 150 basis points. Essentially, lenders are placing more leverage on the same asset and getting paid less, which is a strong indication of how much demand there is for apartment properties.

Borrowers wield clout

Competition for loans promises to be equally stiff in 2006 as lenders continue to woo borrowers with low rates, high leverage and flexible terms. “The challenge is making sure that we know what each of the lenders is doing in the marketplace,” says CBRE | Melody's Majewski. “Because the market is so extremely competitive, our producers need to know what 100 different lenders are doing versus five. Our success is dependent on our producers being very in tune with what's going on in the capital markets.”

Commercial banks continue to be fierce competitors, particularly on smaller transactions less than $10 million. Banks hold the largest share of commercial/multifamily mortgages with $1.1 trillion, or 43% of the total. The CMBS market also has been gaining momentum in recent years. CMBS issuance in the U.S. totaled $169 billion in 2005 — an 81% increase over the $93 billion in 2004, according to Commercial Mortgage Alert. Part of that surge is due to aggressive lending at loan-to-values ranging from 80% to 90%.

“The commercial bank market and the CMBS market have both had a very strong appetite for commercial and multifamily mortgages this year,” says Woodwell of the MBA. “Particularly in the CMBS market, it has become a very effective means of getting capital to borrowers.”

Although life companies can't compete with CMBS on leverage, they are more flexible on pre-payment terms or deferred funding of reserves. Life companies supplied $33 billion in capital through September 2005 and are on pace to exceed the $39 billion provided in 2004, reports the American Council of Life Insurers. “Life companies have the ability to offer flexibility in terms and structure that CMBS, just by the nature of the market, can't offer,” Majewski says. “Life companies are not winning business because they are giving that last dollar, but they can be competitive on pricing and structure of terms.”

Projections for 2006

There is some debate about whether the economy will continue chugging along or whether the inverted yield curve is a sign of a lurking recession. So far, the demand for investment real estate remains high and owners are expected to continue to cash in on premium pricing.

“I don't know if the market can match the $200-plus billion in sales that occurred in 2006, but there is still a lot of capital that is attracted to real estate,” says John Fowler, executive managing director at Houston-based Holliday Fenoglio Fowler. The CMBS market also continues to attract more capital to the mortgage banking arena. The U.S. CMBS market has grown from a $16 billion market in 1995 to a $169 billion market in 2005.

There's other good news for the mortgage banking industry: Most property sectors are exhibiting stable or improving fundamentals. Although concerns persist regarding a slowdown in the retail and condo markets, other property sectors are on the upswing. Those improving markets eventually will lead to further development and create added demand for both short- and long-term financing.

One factor that could have a significant impact on the mortgage banking industry is the ability to securitize construction loans and condo conversion loans. “If someone figures out how to do that profitably and efficiently, that will change things dramatically,” Carroll says. The inclusion of construction loans in CMBS would certainly bring a lot more capital to the construction arena and create added opportunities for borrowers.

In the past, securitizations have focused solely on long-term, fixed-rate financing. But as profits have been squeezed by tighter spreads, the CMBS market is searching for new ways to make money. Construction loans represent an attractive niche because, along with higher risk, they offer higher returns.

The fear is that a flood of construction capital would unleash a building boom. Traditionally, banks have controlled the bulk of construction lending, and in theory, have wielded disciplined lending practices to keep development in check.

If and when that CMBS expansion occurs has yet to be seen. What is apparent is that 2006 is shaping up to follow a course similar to last year. The factors that have been fueling mortgage banking activity in recent years — namely low interest rates, refinancing activity and strong demand for real estate — still exist and are clearly a positive for both borrowers and the mortgage banking industry, Woodwell of the MBA says. “What we can expect for 2006 is probably the continuation of most of these trends.”

Beth Mattson-Teig is based in Minneapolis.


Commercial banking accounted for the biggest share (21.1%) of the $641.6 billion in multifamily mortgage debt outstanding in the third quarter of 2005. Federally related mortgage pools finished a close second (20%).

$Billions % of Total
Commercial banking $135.5 21.1%
Federally related mortgage pools $128.0 20.0%
Savings institutions $96.6 15.1%
CMBS issuers $83.7 13.0%
Government-sponsored enterprises $64.8 10.1%
State and local government $57.1 8.9%
Life insurance companies $41.5 6.5%
Federal government $14.8 2.3%
* Figures do not add up to 100% because not all lending sources are listed
Sources: Flow of Funds Accounts, Federal Reserve Board of Governors

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