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Small-Cap Attraction

Even though small-cap commercial real estate transactions often involve investors who are not institutional players, these assets certainly attract institutional-scale lenders. Defined by most lenders as transactions of $3 million or less, these deals represent assets ranging from small owner-occupied apartment buildings to retail pad sites that may be home to small stand-alone stores or mini retail centers.

While these assets — commonly called “small-balance” transactions by lenders — account for the greatest volume of deals recorded by lenders, title companies and municipal deed offices, they had been shunned in the past by institutional financing organizations.

Until real estate's up cycle of the early 1990s, lenders considered these deals to be unattractive. The transactions did not merit the attention of lenders because they generally require higher touch from lenders than their larger loan counterparts. And the inherent risks were more than conservative underwriters were willing to bear.

The business of buying, managing and trading smaller commercial properties has now become a favored target market of both portfolio and conduit lenders. To be sure, even the business of issuing commercial mortgage-backed securities (CMBS) with small-balance loans as the underlying assets has become quite competitive. So, it's no surprise that most Wall Street investment banks today either have, or are actively seeking to build, a small-balance commercial real estate finance and securitization platform.

Identifying small-cap deals

Fannie Mae and Freddie Mac — the powerful government-sponsored enterprises (GSEs) that actively pursue small apartment buildings — have increased their loan limits for small-balance transactions to $5 million in larger metropolitan statistical areas. Now, the industry has also raised its limits on what it considers small transactions.

Some lenders such as Irvine, Calif.-based Impac Commercial Capital Corp., a publicly listed lender that specializes in small commercial real estate loans, has identified its financing program as encompassing transactions of up to $10 million.

Until recently, however, only selected small-balance loans had been financed, and they were traditionally done through local and regional deposit bank branches. These lenders avoided the more risky loans, such as cases where borrowers had weak credit histories. This has changed in recent years, according to research conducted by Stamford, Conn.-based Boxwood Means Inc., a quantitative real estate lending analytics firm that focuses on the small-balance space.

While the firm finds that a handful of top commercial and savings banks accounted for some 15% of such deals in the previous year, it also finds that non-bank lenders such as private investment funds, pension funds, and Wall Street investment houses are battling for a niche in the splintered small-balance real estate finance space (see chart).

Variety of borrowers

Still, the borrowers who seek small-balance commercial loans in this fragmented marketplace are as diverse a group as any. Ranging from owner-occupants who often rent out part of their facilities, to investors seeking to specialize in portfolios of small properties, lenders enjoy some level of inefficiency in the small commercial marketplace.

The loans generally carry higher interest rates than their large-loan counterparts as a result of the risk in lending to often less sophisticated borrowers. The loans and borrowers also require more involvement from lenders and loan administrators, and are more likely to need special underwriting considerations.

Loans to small-balance borrowers are generally priced higher than larger deals. Lenders report that small-balance borrowers tend to have low resistance to higher rates. But lenders also report low instances of default among pools of small-balance loans.

These findings have been demonstrated in the pools of loans analyzed and rated for CMBS transactions. Nevertheless, by their very nature small-balance loans are often made to less-experienced real estate investors, posing a significant amount of lender risk.

This is the very reason these loans carry higher interest rates and less favorable underwriting terms. Since many transactions are tied to the operations of an owner/occupant's business, the dynamics of a small business can often figure largely into the underwriting and loan administration processes.

Small-cap commercial real estate is a dynamic marketplace for which major financing institutions are competing fiercely. Once considered a business only for local bank branches, these transactions now command the attention of national players and the capital markets. And the incrementally higher pricing of these loans makes them as attractive to the lenders as they are to the loan investors who pursue them.

W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance consultant.

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