3Q 1998 - getting a healthy dose of Wall Street reality As we all have witnessed first hand, the fast and furious market for real estate capital has undergone major transformations over the past few years. Although Wall Street-dominated lending is currently taking a breather, the heady days seem certain to return with greater attention to underwriting fundamentals and less reliance on structuring creativity. By weathering the convulsions and turmoil of the capital markets, securitization has shown staying power. There can no longer be any doubt that the use of commercial mortgage securities will remain a viable long-term financing vehicle.

It was not that many years ago that commercial financing was stratified based on risk profiles. At the conservative end of the spectrum you had life companies, typically seeking Class-A properties with strong tenancies coupled with low loan-to-values. Also, there were the savings and loans that seemingly lent too much money on anything that could be classed as property. Credit companies engaged in higher risk transactions with private money and a clear directive for achieving high returns. Whereas the credit companies specialized in commercial real estate finance, the S&Ls entered into deals to accommodate relationships, often abandoning prudent underwriting, letting the personal interests of their directors dictate loan terms.

Somewhere among the life companies, the credit companies and the S&Ls, banks existed. Banks focused on local market lending and provided prudent/measured loans on multifamily and commercial properties supported by the personal guarantees of the transaction's principals.

Conduits, filling the financing void left by the S&Ls, initially entered the market seeking high margins on B-/C+ properties. Differing from the S&Ls, conduits conducted stringent due diligence. Rating agencies served as an external overseer of credit, and commercial mortgage securitization rapidly became an entrenched financing source. The conduit industry grew in short order from $4 billion in production in 1995 to upwards of $77 billion last year. Individual securitizations went from $150 million of pooled loans to more than $3 billion in a single offering. With the capital markets proving to be the cheapest cost of capital, lifecompanies started to be squeezed out of the direct lending business instead purchasing the securities generated by Wall Street.

In the conduit world the playing field is much different today from what it was in early 1998. The numbers often cited were that only 15% of all commercial mortgages had been securitized vs. 65% or more of residential mortgages. Looking back, we see that the conduit business not only displaced traditional lenders by offering such attractive returns, led to an artificial financing boom. Industry consensus is that roughly $50 billion in annual production is a sustainable level and that 10% annual growth is more likely the norm; equilibrium between supply and demand being essential in a "commoditized" business. By no means does the retreat of the conduit business from roughly $80 billion to $50 billion mean that there will be a liquidity crisis in term mortgage financing. Instead, financing will revert to the stratification mentioned earlier with life companies serving the upper end, banks providing construction and mini-perm financing on a recourse basis, conduits engaged in non-recourse term lending and credit companies filling out the spectrum.

A much more disciplined lending landscape that looks primarily to property fundamentals to achieve better subordination levels and better profitability will emerge. Gone are the days when deals could be priced at margin knowing that a declining interest rate environment would turn them into money makers over time.

Now that the structural aspects of securitization are better understood, investors will become more concerned with the soundness of the credit process underlying pooled collateral. Regional banks, along with select life companies and the major finance companies, will excel at this and be best positioned as the ultimate survivors in a maturing securitization market. The ability to warehouse loans on balance sheet until such time as a capital market execution is both possible and profitable is crucial. Brand identity will move to the fore as bond investors become increasingly concerned with an originator's credit culture and subsequent collateral quality. This will lead not only to better executions for originators, but increased liquidity for these investors.

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