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Out of Equilibrium

Debt markets are facing a costly problem - a shortage of deals. "Requests for financing this year are down fairly significantly over the previous year," says Sam Davis, vice president at Boston-based John Hancock Financial Services Inc.

Everyone in the lending business is in much the same boat, explains Davis. "We're in a market where there are more lenders than deals to be had."

Borrowers are finding a generous supply of capital chasing a shrinking number of debt-financing transactions. "Commercial lenders seem to have re-entered the market this year aggressively and enthusiastically," observes Sheridan Schechner, managing director and co-head of the real estate department at New York-based Goldman Sachs & Co.

The increasingly crowded field of lenders is discovering that the number of debt-market transactions is down in 2000 compared with previous years.

CMBS issuance during the fourth- quarter 1999 was $16.5 billion - down about 25% compared with the $21.9 billion reported during the same period in 1998, according to the Mortgage Bankers Association of America in Washington, D.C.

Both institutional lenders and conduits are feeling the pressures arising from lack of product. Large-scale conduit operations have been built up over the past several years to support loan volumes that were generated in the boom years of 1996 through 1998.

"But between life companies, which want to do long-term, fixed-rate loans, and conduit competitors, there is clearly an overcapacity of lenders for the flow of deals that are out there right now," says Davis.

Consequently, competition is fierce for quality mortgages today. The intense competition is compressing spreads and profit margins for lenders. "We find ourselves in frustrating situations competing with lenders that don't seem to appropriately price for risk due to the competitive market," says Davis. "Often, we have to pass because we feel that we are not being paid for the risk."

Some lenders are winning deals by loosening underwriting standards. In some instances, lenders are not underwriting tenant improvement or leasing costs so that more proceeds can be lent on a particular transaction.

Such lax practices are reminiscent of activity prevalent in the late-1980s. "That became a problem for a lot of lenders in the early-1990s," recalls Davis. So far those instances have been rare. But if underwriting continues to be more aggressive, it could present problems that those lenders will pay for in the next recession, he adds.

Drop in demand Demand for borrowing is way down and has been throughout the early part of 2000, says Davis. That drop in activity is due to a variety of factors, including rising costs of capital and a general uncertainty in the capital markets. "When conditions are volatile, borrowers tend to sit on the sidelines until there is more stability."

A decline in refinancing activity as well as rising spreads and interest rates are two key reasons for the slump in transaction volumne. Commercial real estate has always been a cyclical business, and lenders have just been through a five-year period of very high activity for refinancing properties. So the United States is at a low point in mortgage rollover schedules.

Also, because there were very few new fixed-rate, 10-year mortgages put on the books during the early-1990s, the actual number of loan maturities is lower, says Davis.

In addition, interest rates have risen significantly during the past year. "Therefore, borrowers' desire to refinance has dropped off," says Schechner. Interest rate hikes traditionally have a depressed effect on real estate activity. Interest rates are still favorable, but many borrowers had been spoiled by a period of extremely low rates. The borrowers are less apt to lock into long-term deals at the current rate.

One result of rising rates has been a significant shift to floating-rate debt. Borrowers are opting for floating rates because they offer greater flexibility on terms such as pre-payment. Additionally, many borrowers are optimistic that rates will drop in the short term.

Meanwhile, lenders continue to find favorable profit margins with floating-rate deals. At this time last year, Goldman Sachs was executing 80% of its transactions as fixed-rate deals and 20% as floating-rate loans. "This year it's a reversal, if not 90-10," says Schechner.

It may be several months before conditions improve and lending activity picks up. Some industry observers expect that the mortgage rollover rate will stay at low levels through 2001 and possibly until 2002.

Debt capital continues to be a viable source of money for expansion-minded REITs. An uptick in REIT stock prices would give a lift to highly-leveraged REITs in order to pursue new debt-financing opportunities.

"While REIT stocks have performed well, I don't think they're at a point where they're going to be issuing more equity," says Schechner, referring to the relatively flat stock prices.

CMBS market lull The CMBS market has been much less active in 2000 than in recent years. "There is still a lot of capital, but the pipeline has diminished dramatically," says Joe Sweeney, vice president at Philadelphia-based Legg Mason Real Estate Services Inc.

At the height of the CMBS market, about 25% to 30% of the activity at Legg Mason Real Estate Services was related to CMBS transactions. In 1999, that activity level slipped to 15%, and in 2000 volumes have declined even further to about 10%, says Sweeney.

The CMBS market was expected to kick off a strong start once worries about Y2K were put to rest, but that has not been the case. "As equity markets have grabbed more capital, CMBS and the overall fixed-income markets have had a tough time in the last quarter," says Mark Finerman, managing director at New York-based Credit Suisse First Boston.

CMBS rates are up, so the cost of borrowing is higher. "Any time rates kick up, it takes some time before clients decide to use long-term financing," says Finerman. The flow of deals is already starting to show some signs of improvement after a slow first quarter. However, those volumes are still down from levels recorded in previous years, he adds.

Another reason for the dip in transaction volume is that some borrowers are realizing that while the upfront rates of a CMBS deal make it appear to be a great transaction, they're finding out that two to three years into a transaction it is a lot of work, according to industry experts. Getting leases approved and dealing with back-end operations after the deal closes is a lot of work. "Borrowers are coming back saying the [lower] rate isn't worth the extra work," says Sweeney.

Swap spreads Swaps refer to the cost associated with swapping from fixed to floating- rate terms or vice versa. Swap spreads have historically ranged from 25 to 35 basis points, but have recently increased to about 115 to 135 basis points. That increase has added to the rising cost of capital for borrowers, and it has reduced profits for CMBS dealers.

"Early on, when the CMBS market was first developing, there didn't appear to be as much correlation between the interest rate swaps market and the CMBS market," says Schechner. "Therefore, there was not much opportunity to hedge." But now there appears to be a one-to-one linkage, which means when swap spreads widen, CMBS spreads widen. The result is that competition with life companies is out of the securitized market's control, adds Schechner.

CMBS outlook Although volume in the CMBS market has declined and dealers' profits are down, commercial real estate securitizations remain attractive for major commercial and investment banks.

"People will always want to borrow money on real estate. It ebbs and flows," says Finerman. "At some point in time, the investors in the CMBS market will see a relative value that is so strong that they buy. Sometimes it takes time for those things to settle."

The CMBS market is a $1.4 trillion market, and the sizable market will produce more refinance product in future years. "It's not a function of if the market will come back, it's when will the market come back," says Finerman. T he CMBS picture is not likely to improve dramatically in 2000, but some relief could arrive in 2001 as mortgage rollovers increase.

In addition to an increase in financing opportunities, a surge in investor interest would help boost the lagging CMBS market. "We're already seeing more interest coming from the investor side because conduit paper offers a good relative value compared with other products," says Finerman. "While we have seen investor demand increase, there are more dealers fighting over fewer deals."

One of the factors that makes the CMBS market work is demand from higher-risk investors willing to buy into sub-investment grade bonds. That demand is becoming a bigger issue because there are a limited number of such investors.

"I think many market participants feel like there needs to be more competition among these investors to make this market work efficiently," says Davis. That has been one of the most difficult issues for sellers of securitizations, he adds.

A positive shift for the CMBS market has been greater caution among conduit lenders. During the height of the CMBS market in the mid-1990s, conduit lenders were aggressively pursuing all types of properties, ranging from hotels and restaurants to marinas and golf courses.

"After the capital market blow-up in late-1998, capital investors didn't want to see those high-risk property types in securitized pools," says Davis. Consequently, conduit lenders became more focused on mainstream lending.

Institutions vie for deals Institutions are struggling to hit targets amid a competitive whole-loan market. "A high percentage of institutions are slightly behind budget because there is not a lot of product," says Sweeney. "What product that is out there is being chased by six, seven, eight institutions."

Another factor adding to the competitive environment is that many institutions have raised their whole-loan goals for 2000. In some cases, institutions are looking to boost real estate asset allocations because they are below their maximum standards. "So they have room to grow," says Sweeney.

Institutions also have enjoyed growth in the robust economy, and as those premiums and cash flows continue to pour in, they need to get the money back out. So while allocation ratios may remain constant, business growth simply means more money needs to be invested in all asset classes.

The competitive market is forcing institutions to offer attractive rates and loan structures. For example, one borrower approached Legg Mason in search of a lender that would be flexible in financing a potential expansion on an industrial property. A tenant at the property had expansion rights in its lease. "The borrower wanted to make sure if the expansion came to fruition, the financing wouldn't be an issue," says Sweeney. The institution that ended up landing the deal didn't offer the lowest rate. It clinched the deal by writing a loan with tremendous flexibility to account for financing the potential expansion, he says.

"Borrowers are becoming more sophisticated," says Sweeney. "They know there is lot of money chasing their deals." Borrowers are leveraging that demand to secure competitive rates as well as a more flexible loan structure. Some common borrower requests call for greater flexibility to pre-pay loans, as well as the ability to obtain a second mortgage if the asset increases in value, he notes.

Because of the intense competition, some institutional investors are even eyeing deals in tertiary markets that they would not have considered in the past because of less favorable demographics, or a lower employment base. "Now institutions are considering those markets if it's the right deal," says Sweeney. Positive attributes relating to location, tenant mix and loan value per square foot are some of the factors persuading institutions to accept deals outside primary and secondary markets.

The emergence of "club transactions" is another trend becoming more prevalent among life insurance companies.Club transactions occur when multiple life insurance companies team up to make a large loan to a borrower. Club transactions have not been popular in the past because they were viewed as time- and labor-intensive, says Schechner. But the extreme competition for deals has prompted life companies to pursue the more laborious transactions.

Typically, life companies have not competed on loans upwards of $75 million, notes Schechner. So the more expensive deals for higher-quality properties were often out of reach. Now life companies are feeling the pressure to place money, and they are becoming more aggressive in competing in the large loan market, he says.

Bank interest Despite the many obstacles, lender interest remains strong among financial institutions. "It is extremely competitive right now because - among the deals that are out there - only so many of them are attractive to the banks," says Jim Mendelson, senior vice president at PNC Financial Services Group in Pittsburgh. Currently, PNC has about $9 billion in loan commitments in real estate.

Although refinancing activity has clearly lessened, demand for construction loans remains strong among publicly traded companies, says Mendelson. "I think we've seen as much demand from borrowers today as we saw six to 12 months ago," he says.

The increase in interest rates has not curtailed construction activity. "In terms of new development activity, we have not seen much of a slowdown," says Mendelson. Capital markets have done an effective job in keeping development from getting out of control.

However, some banks have become more conservative in underwriting practices. "I think banks are less inclined to take on significant market risk on their deals," says Mendelson. That caution is due in part to the fact that the economy and the real estate market are at or near peak levels.

"Everyone is anticipating at some point that the economy will slow down," he says. "So I think for that reason people are being cautious."

Banks such as PNC are beefing up lending requirements. For example, the bank is requiring greater equity contributions and higher levels of pre-leasing.

Most office building loans require at least one-third pre-leasing. But in some cases, lower pre-leasing levels can be offset by other factors such as favorable market conditions or larger equity contributions to the deal.

"We're not seeing spec deals being done. When they are done, they're few and far between," says Mendelson.

The toughest properties to finance are hotels. "By its nature, it is essentially spec financing because you can't pre-lease a hotel," says Mendelson. In addition, the volume of hotel development activity across the country in recent years has many lenders wary of overdevelopment, he says.

Aside from the hotel industry, the commercial and multifamily markets remain strong. And despite the decline in borrower demand, there are no imminent signs of credit deterioration, says Davis. "The good news is that we're still dealing in a strong real estate market."

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