SAN DIEGO — The wind is no longer at their back in a rising interest-rate environment, but you'd never know it by the tenor of the speeches during last month's Mortgage Bankers Association (MBA) convention at the Manchester Grand Hyatt. The consensus among direct lenders and mortgage bankers in attendance was that that the industry has become quite adept at walking the fine line between pumping up loan originations without making nutty deals. The conventional wisdom is that the efficiency of the capital markets, CMBS in particular, instills discipline.

On the one hand, it's difficult to argue with success. The industry posted another record-setting year in 2004. Commercial and multifamily mortgage originations reached $136 billion, up 16% from $117 billion reported in 2003, according to the MBA. The fourth quarter of 2004 also established a record with $42.7 billion in mortgage originations, an increase of about 10%, or $3.8 billion, compared with the fourth quarter of 2003.

Still, such confidence within the lending community today reminds me of the star athlete who begins to believe his own press clippings. While I agree that the industry has refrained from overbuilding, the low interest rates continue to mask some of the underlying problems. The office market, in particular, remains noticeably weak.

The combination of corporate mergers, a decline in the average space per worker and a still tepid job market — the 146,000 new nonfarm payrolls in January fell short of expectations — don't give this sector much visibility. Yet, properties in many major metros are being flipped with great frequency and at record prices (please see related story on page 42). Keep in mind that the national office vacancy rate stands at 16%, according to CB Richard Ellis, so even the most optimistic projections of a 200-basis point improvement in 2005 wouldn't get us close to equilibrium.

When I asked one MBA official at a press conference if the low cap rates and soft real estate fundamentals could cause some pain for some office landlords in a rising interest-rate environment, the response that I received is that the flood of capital shows no signs of slowing down. Translation: Returns are relative and right now real estate has the hot hand, so let's play it for as long as we can.

Contrary to popular belief, interest rates won't have to rise 100 to 150 basis points before the real estate industry takes notice, says Bill Pollert, president of Capital Lease Funding, a net-lease real estate investment trust based in New York. “Last spring, when there was a 30- to 40-basis point pop in interest rates, we saw a couple hundred million dollars in transactions fall out of bed.” In other words, borrowers who were ready to close on a deal suddenly backed off because the terms no longer made economic sense. Cap Lease was able and willing to swoop up about $100 million in deals as a result. Imagine a borrower's reaction if interest rates were to spike even more dramatically.

Meanwhile, evidence that the lending markets are getting frothy is mounting:interest-only loans, reductions in debt-service coverage ratios, and the willingness among some mortgage bankers to surrender loan-servicing fees just to land the deal are all options being exercised today. And mortgage bankers talk about the likelihood of further consolidation in the industry as the competition continues to compress fees.

For the moment anyway, these headwinds haven't put a dent in the pace of lending, but if Pollert's anecdote is a harbinger of things to come, it could be a wild ride up the 10-year Treasury yield.