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At the height of the tech boom, investors were tossing money at anything with .com attached to the name. Earnings? Profits? Revenues? Who cared? Everyone was getting rich and didn't want to stop. For the past three years the retail real estate market has been posting double-digit returns in an otherwise lackluster economy. It's making fortunes for real estate investors and they can't get enough of it. That pressure extends to the lending side of the equation as well. Competition to do deals is getting so fierce that lenders are tripping over each other to provide developers and owners with cash on increasingly friendly terms.

Are lenders, like Internet investment bankers, sowing the seeds of a bust — throwing capital at a product that, in other times, they would avoid? Retail real estate industry observers — and some lenders — are starting to grumble about the growing risk that the quality of deals is dropping, spelling trouble for investors and developers as interest rates rise. “There's a slow erosion of credit standards,” says Tad Phillip, a managing director at Moody's Investors Service who monitors commercial real estate debt. “It's beginning to concern us, but we don't want to push the panic button.”

That concern is understandable. New players are jumping into the lending markets for not just senior debt, but for riskier mezzanine pieces, too. Pricing on loans is becoming more favorable for less attractive deals. And loan conditions, from recourse and pre-leasing to amortization and insurance, are all being relaxed in order to get deals done. There's also pressure to get loans approved faster, creating a greater margin for error.

The numbers show how much the market is still growing. Total retail lending for the third quarter of 2004 was $6.1 billion, up 21.8 percent, compared with the $5 billion figure posted during the third quarter of 2003, according to the Mortgage Bankers Association. For the year, through the third quarter retail lending volume was $16.8 billion, up 27 percent over 2003. Looking back a little further, the figure through three quarters in 2004 is nearly $4 billion more than the full-year figure for 2002.

As the market continues to sizzle, the line between different types of lenders has blurred. In the past, investment banks and financing companies were the only lenders that offered credit across the life of a retail development, but now seemingly everybody is doing it. Banks, which traditionally originated short-term construction and interim loans, now offer permanent loans. And life insurance companies and conduits whose business was securitizing permanent loans are originating construction loans or testing the waters on bridge and mezzanine loans. And new players are entering across the financing spectrum.

For example, Countrywide Financial Corp., traditionally a residential mortgage bank, in April branched into commercial real estate when it formed Countrywide Commercial Capital Markets Inc. Criimi Mae Inc., which owns $14.9 billion of subordinated CMBS loans, has restructured its balance sheet so that it can once again originate loans. And inexperienced players from other sectors of the real estate market and from overseas are joining the fray, says Susan Winston Leff, Key Bank's real estate capital district manager for New England. “We're seeing some foreign banks that haven't been real estate lenders here before that don't know the playing field.”

British financial giant Barclays Bank Plc., through subsidiary Barclays Capital, has been building a staff since March as it launches its U.S.-based real estate lending business. And Eurohypo AG, an entity formed through the 2002 merger of Deutsche Bank, Dresdner Bank and Commerzbank, is also building a U.S. CMBS business.

At the same time, lenders agree that there's no shortage of new entrants into the mezzanine debt market willing to take on the riskier pieces of loans. “Generally the capital flowing to mezzanine loan funds and borrowers is continually increasing, and the number of mezzanine lenders is growing seemingly on a weekly basis,” says Marc McAndrew, manager of real estate lending for PNC Real Estate Finance. “What's happened is people are giving borrowers more proceeds at better pricing and requiring less equity.”

Losing the Safety Net

With so many players competing for a piece of the pie, lenders are becoming hard-pressed to meet their annual deal targets. As a result, safeguards are eroding.

While the loan-to-value ratio for most deals has remained at a fairly constant 75 percent since 2002, lenders say inflated property values and record low interest rates disguise a much greater use of leverage. “There's no question that on a risk-adjusted basis a lot more people are using other people's money than a few years ago,” says Tom MacManus, president and CEO of North American Operations for GMAC Commercial Mortgage.

Lenders have squeezed more money into deals while maintaining the 75 percent LTV ratio on their books through looser underwriting. If a property is worth $100 million, for example, the underwriting could bump the value up to $115 million through projecting rental increases or new leasing. Then the lender can get $86 million of cash into a deal rather than $75 million but not appear to be pushing the LTV barrier too far.

And there is no shortage of lenders eager to up the ante. “Sources of capital are coming from many directions,” says Lisa Pendergast, managing director at RBS Greenwich Capital. “There's no one category of lender out there holding the line.”

The slipping line can be seen in everything from the pricing of deals to the leniency of terms. “There's been tremendous compression in the pricing of spreads in the past 12 to 18 months,” says PNC's McAndrew. He points out that unanchored credits that would have been priced at 180 to 200 above 10-year Treasuries a year ago, are paying just 130 to 150 basis points over Treasuries today.

For example, a local tenant in an unanchored center is receiving the same deal as one with a signed Publix would have gotten four months ago, says Andrew Little, a partner at CMBS analyst John B. Levy. Or an Office Depot, which makes up only one-quarter of a property is getting the same pricing as a Kroger supermarket, which would typically would be twice as big. “Grocery has always been perceived to be the best quality retail,” says Little. “Lesser deals are now getting those prices. There's very little price differentiation for the quality of the real estate and that is indicative of a market where you can sell virtually everything at a good price.”

Lenders are also requiring less and less of the two primary protections on origination loans: pre-leasing and recourse provisions. “Five years ago, a lender might have to have an anchor signed and 50 percent of the small space in the middle, and the borrower would have to fully guarantee the loan,” says McAndrews. “Now lenders are willing to accept a lot less.”

Key Bank's Winston Leff says she has seen the competition offer construction loans on retail projects that require as little as 10 to 20 percent recourse, a fund required to compensate the lender in case the borrower goes bankrupt or can't otherwise repay the loan. “Eighteen months ago, we were seeing 50 percent reserve levels for a top-tier client,” she says. “Now we're seeing some of that for second-tier clients and developers with slightly less than credit quality.” Making matters worse, she adds, reserves are often held in some kind of anonymous entity or fund. “We're moving farther and farther away from the personal guarantee system we're used to.”

Weakening standards can be seen across the board. Pendergast says interest-only loans have increased 14 percentage points, to 34 percent this year from 20 percent of retail loans last year. In a rising interest rate environment, interest-only loans could be particularly troublesome when interest rates rise more and the balloon loans come due. “You could have more refinancing risk in a pool than you think, loans could be due in five years instead of ten,” she says.

And on average, reserves for both taxes and insurance have dropped five and nine percentage points respectively. Tenant improvement and leasing commission reserves, which help cover the cost of replacing a tenant who leaves, have dropped from 64 percent to 50 percent.

On the CMBS side, B-piece buyers, who acquire the riskiest tranches of securitized loans and provide the greatest scrutiny, have traditionally provided the CMBS business with its safety net. In the past, when the field was limited to handful of such players, B-piece investors exerted discipline on the market by refusing to take on loans that didn't make the grade. But now “demand has increased to the point that if one investor doesn't want to purchase a particular CMBS transaction, somebody else will,” according to a recent report by Standard and Poor's credit analyst Kim Diamond

Furthermore, she notes that “the growth of the collateralized debt obligation (CDO) market has encouraged subordinate and mezzanine investors to lay off risk into CDOs instead of embracing a buy and hold strategy.” Worried about your debt? Just sell it off to another eager investor.

Is the Sky Falling?

How foreboding all this is depends on who you talk to. Morgan Stanley Managing Director Jim Flaum, who works on the CMBS side, argues that considering the juicy increases in equity, concerns about lending standards are like fleas on an elephant's back. “There's always increased risk when there's less structure in a loan,” he says. “However it's a small risk compared to the equity valuations. Someone buys a property that has doubled in value; are you concerned about the escrowing taxes or the doubling of the property?”

Still, most observers believe a market that has been outperforming this long is headed for a fall. MacManus predicts, barring event risk, a gradual increase in delinquencies in the next 12 to 18 months. “The pendulum has swung well into the borrowers' favor today relative to leverage and price point,” he says. “It's a little difficult not to believe that it's just a matter of time before it goes back in the lenders' favor.”

This softening of credit standards, and possibly of credit quality too, could be a ticking time bomb that eager investors are reluctant to acknowledge. “We seem to be priced to perfection and there's not a lot of room for credit loss,” says John B. Levy's Little. “The pricing we see today doesn't anticipate measurable delinquencies in the next 10 years and that's a pretty unsafe assumption.”

As yet there is no sign of trouble in delinquency rates. On the contrary, the delinquency rate on CMBS loans has actually declined 70 basis points in the past 12 months. Having peaked at about 2.5 percent in October 2003, delinquencies dropped to 1.77 percent this fall, according to RBS Greenwich's Pendergast. She attributes the drop to improving fundamentals at the property level. “There are increased rentals and occupancy for the first time in awhile, so a number of new delinquent loans have come down.” But, she warns, “let's look at this picture a year from now or two years from now with loans today that were issued more aggressively.”

No one expects sudden, wrenching changes to the lending landscape. For one thing interest rates are still so low, they have room to continue to creep up for awhile before slowing down the pace of real estate activity and drawing liquidity back into stocks and bonds. And for at least another year, it's likely that the retail real estate market will remain every investor's darling.

“If long term interest rates stay moderate, the 10-year Treasury remains at less than 6 percent, and the economy continues to grow at healthy but not overheated pace, capital will continue to flow,” says McAndrews. “We think that's fairly likely.” Moreover, if consumers continue to spend as they have been, that too will continue to help prop up the retail real estate market.

Nor does anyone expect a reversal to be as bad as the one that hit after the late 1980s real estate boom unless the economy is plunged into another recession. Back then, liquidity dried up in the face of oversupply of properties. But the CMBS market didn't exist yet to help keep the financial wheels greased. In the 1980s, you “didn't have the CMBS market and the transparency in the market because of the rating agencies,” says MacManus. “It's likely that there's sufficient liquidity and transparency and less likely to be as severe a disruption.”

Still, there's no telling when the market will turn. Then, owners enjoying miniscule interest rates will have to run for fixed-rate cover. Builders who have relied on inflated values to borrow extra financing will be holding loans they can't repay if weakening financial conditions drive down the value of unleased shopping centers or less-than-creditworthy projects — and investors will be stuck paying the tab.

When the balloons on all those interest-only loans start coming due, center owners who don't have the cash to repay them could be squeezed into default. For sure, there will be some disasters, but unlike the dot-com crash, as long as shoppers keep spending, most of the assets in play have real earnings and revenues to back them up. Still, in real estate as in all business, one can't forget the all-powerful cycle. “We've had a powerful tailwind of credit, and a lot of people were able to refinance their properties,” says Moody's Phillip. “But now, we're facing into a headwind.”

Changing Landscape

Two similar deals arranged by George Smith Partners on Southern California assets spread 18 months apart illustrate how lending terms have loosened. Both properties were in good shape. But on the more recent deal, a property with 74 percent occupancy ended up with similar loan terms to a property that had a 91 percent occupancy. The newer deal also involved an older center while the 2003 loan was on a new property. The drop in spreads to Treasuries has offset the rise in Treasuries, giving both loans similar pricing. Both loans have 30-year terms.

8/22/03 12/06/04
Location Southern California Southern California
Size 219,000 500,000
Loan $42,300,000 $79,500,000
Occupancy 91% 74%
Rate 10yr Treasury + 160 (5.16%) 10yr Treasury + 110 (5.25%)
LTV 80% 80%
Source: George Smith Partners

Leaking Conduits

Spreads on CMBS loans have dropped considerably during the past 12 months on both anchored and unanchored retail projects, further evidence that lenders have gotten extremely aggressive with their terms.

Shopping Center Average Spread 10/2003 Average Spread 10/2004 10-year Treasury 10/2003 10-year Treasury 10/2004 Average Coupon 2003 Average Coupon 2004
Retail-Anchored/Community 144.6 116.5 4.34 4.02 5.79% 5.19%
Retail-Unachored 199.5 135.5 4.34 4.02 6.03% 5.38%
Source: John B. Levy & Associates
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