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Filling the Void

The virtual shutdown in the commercial mortgage-backed securities (CMBS) sector has created a gaping hole in the capital supply for real estate deals. Last year, CMBS lenders accounted for $230 billion in commercial real estate loans in the U.S., according to the Washington, D.C.-based Mortgage Bankers Association (MBA), up from $203 billion in 2006. In all, that was 46 percent of all originations.

For years, debt gushed from these players. With demand for CMBS bonds so high, lenders could barely keep up. They quickly sliced and diced loans, packaged them into securities and sold them off to voracious investors. But that all stopped with the collapse of the subprime housing market. Today, the market for securitized debt has all but evaporated. There is a deep mistrust of rating agencies due to some AAA-rated subprime pools collapsing. So even highly rated CMBS offerings, which traditionally have suffered very low rates of default, are being viewed with heavy skepticism. Compounding the problem is that the lockdown occurred at the peak of activity.

As a result, CMBS lenders and issuers are warehousing billions of dollars' worth of loans originated last year. To date, less than $10 billion in CMBS issuance has occurred in the U.S. in 2008. And no one is sure when the market will pick up again, especially as each week seems to bring a new shock to the system. For the time being, CMBS lenders have been effectively sidelined. Such firms simply have no room on balance sheets for new loans and they won't again until the backlog is worked out of the system.

The loss of that capital source is shaking up the entire industry. There are still borrowers looking for money. In fact, even borrowers that are well capitalized are being judicious and looking to borrow as much as they can. “Everyone realizes there is a real supply-constrained capital market. So they're trying to keep their equity available,” says Don Curtis, senior managing director at Houston-based Holliday Fenoglio Fowler.

The question is: what companies are going to step forward and fill the gaping hole in the market? CMBS Mortgage Alert is predicting a 51 percent drop in U.S. issuance in 2008 from $230 billion to about $113 billion. In addition, some experts are predicting even lower volumes for 2008 with some estimates as low as $60 billion.

If demand for debt stayed the same as 2007, that would leave a $150 billion hole. In reality, there is a slowdown in both investment and development, cutting into the need for debt. So it's likely that other lenders won't need to cover quite that much of the market. Still, traditional lenders such as banks and life companies are doing their best to step up and meet the needs of borrowers; and many industry observers believe that the efforts will ultimately fall short of meeting the market's needs. “We are hearing, anecdotally, that our balance sheet lenders and life company members, as well as the agencies, are busy. But there is a calculated limit to what they can put back into the business,” says Jan Sternin, senior vice president of commercial/multifamily at the MBA. “And when you add that all up, it doesn't fill the hole left by the vacancy of CMBS.”

Picking up the slack

Conduits have not been the only lenders affected by the capital crunch. While CMBS lenders experienced a 31 percent decrease in originations during fourth quarter of 2007 compared to the same period a year ago, life insurance companies reported a 15 percent decline, and commercial banks saw a 6 percent drop, according to the MBA.

Commercial banks are likely to capture a bigger chunk of the available market in the short term due to the fact that they offer the broadest assortment of financing products. They can finance construction, bridge or permanent loans. Rates also remain competitive.

However, there is a question of how deep bank pockets are right now. “The whole marketplace has become more conservative,” says William E. Hughes, senior vice president, managing director at Marcus & Millichap Capital Corp. in Irvine, Calif. A year ago, regulators said that they were going to start looking at bank assets and how they were underwriting deals. That scrutiny is likely to intensify given the current market conditions.

Bank activity is going to differ widely depending on each bank's balance sheet and existing loan portfolio, as well as the health of the local or regional economy where they operate. “Every bank is going to have to look at what's currently on their balance sheet, and make a determination on how much lending they will be doing based on all of their risk criteria and their whole size versus the percentage of commercial real estate and actual composition of that real estate,” Sternin says.

There are a number of banks that are well positioned, and will take advantage of the opportunity to gain market share. For example, St. Paul-based Bremer Bank expects its commercial real estate mortgage volume to be significantly higher this year compared to 2007. “It's a great time for banks to add some high-quality assets to the books because of this significant hole that is in the marketplace,” says Terry Kriesel, senior vice president of commercial real estate at Bremer Bank.

Commercial mortgage originations either completed or in the pipeline at Bremer Bank as of March 1 totaled about $100 million — the same volume Bremer originated in all of 2007. So far, Bremer doesn't have a cap on the commercial real estate lending it expects to conduct in 2008. Deposits at the $7.2 billion bank are up, and the delinquency rate on existing commercial real estate loans is 0 percent.

Depending on demand and the quality of deals, commercial real estate lending in 2008 could be $100 million, $200 million or $300 million, Kriesel notes. “We don't have any issues with how much business we do,” he adds.

Tapped out?

Yet both banks and life insurance companies will eventually max out the dollars they can allocate to commercial real estate loans, and many industry observers are wondering how quickly lenders will reach those limits.

The larger life companies such as Met Life, New York Life and Prudential all seem to have a very good supply of capital for the year. Still, some industry observers are predicting that life companies will run through allocations by as early as third quarter, and almost certainly before year-end.

“We do not like to be out of the market, so we are pacing ourselves and investing judiciously,” says Thor Orndahl, managing director at Prudential Mortgage Capital in Newark, N.J. “We are picking our spots and originating product that we find very attractive right now.”

Prudential originated $14.5 billion in new commercial real estate mortgages in 2007, which represented a record year for the company. Prudential is forecasting a less active year overall in 2008, with deal volume projected to reach $11 billion. The decrease is largely due to the decline in CMBS activity. Prudential originated $3.9 billion via capital markets in 2007 compared to $6.9 billion in financing that originated from its general fund.

“The concern I have is whether we start to see some liquidity issues in the commercial banking industry,” Hughes says. “Their pockets certainly are not deep enough to absorb the loss of Wall Street.” That said, commercial banks are still at the table in full force. Right now the top 10 lenders Marcus & Millichap Capital is using are all commercial banks, which account for about 60 percent of the intermediary's financing activity. A year ago, banks represented about 40 percent of activity, Hughes adds.

Banks do need to be mindful of risk management and regulatory requirements as it concerns balance sheet lending. Complicating matters further is the fact that bank regulatory agencies issued guidance on commercial real estate lending concentration at commercial banks at the end of 2006. Based on a bank's asset base, regulators said that if a bank met certain “thresholds” in total commercial real estate loans, which included land and other construction loans, then regulators would take an extra look at banks' risk management techniques.

Regulators that review the composition of a bank's portfolio and find it too heavily weighted in commercial real estate loans can require the bank to reserve additional capital. “I think everybody's risk management staff is taking a good, hard look at their existing commercial real estate portfolio and breaking that down — whether its community banks, regional, superregional or the large national banks,” Sternin says.

Weighing the impact

Borrowers are already feeling the squeeze from the capital crunch. The biggest change across the board is a higher equity requirement. Life companies in particular have tightened purse strings. The 75 percent to 80 percent loan-to-value ratios that were typical a year ago have been replaced by ratios of 60 percent to 65 percent.

There are other issues as well. Even if the conduit lenders wanted to ramp up activity, such firms have lost the pricing edge they previously enjoyed. Conduit lenders came to gobble up such a large part of the market because of how aggressively they priced debt — offering lower rates and higher loan-to-value ratios than balance-sheet lenders could offer. That's because CMBS spreads to 10-Year Treasuries and 10-Year Swaps have both widened massively from a year ago. Even though Treasuries have dropped south of 4 percent, the widened swap makes CMBS debt more expensive.

In addition, lenders are exhibiting a flight to quality for class-A properties and quality borrowers, while it is harder for weaker deals to capture lender interest. “There are transactions that we were financing a year and a half ago that are having a huge amount of trouble financing today,” Hughes says. Those deals involve borrowers with poor credit and lesser-quality properties.

“We're telling our guys that if you have a transaction in a tertiary market, and it's something other than a quality borrower and quality asset, you better find a local lender,” Hughes says. The potential capital constraints later in the year will undoubtedly impact deal flow. “A lot of the active lenders have a program and a set budget, and once they're done, they won't get any more money to allocate,” Curtis says.

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