The calendar shows that it's a new year, but in commercial real estate lending circles it certainly feels like 2003. Persistently low interest rates — the 10-year Treasury yield hovered at only 4.1% in late December — are helping to fuel aggressive and creative lending strategies by a variety of capital sources including Fannie Mae, insurance companies and myriad other institutional and private investors. To pump up volume, lenders are competing on costs and testing underwriting boundaries. Yet, real estate fundamentals in several property sectors are showing clear signs of stress, a trend some industry experts say bears watching in 2004.

“Losses and delinquencies have climbed, and there is a concern,” says Steve Nostrand, director of mortgage and investment finance for the Codina Group in Miami, a full-service real estate firm and mortgage banker.

Indeed, the number of borrowers requesting assistance, or potential workouts, is growing. So too are lender “watch lists,” which identify potential problem loans. According to Fitch Ratings, a credit rating agency that serves the global capital markets, delinquencies on commercial mortgage-backed securities (CMBS) are creeping up: Fitch predicted the cumulative default rate would rise to 3.75% by year-end 2003, up from 2.66% a year earlier. On a dollar basis, health care properties reported the highest default rate in 2002 at 14.4%. Hotels were next at 8.6%.

CMBS losses in 2003, meanwhile, were expected to reach $400 million within a universe of $177.2 billion outstanding loans, according to Fitch. That's a 24% increase over the $305 million in CMBS losses reported for the entire nine years between 1993 and 2002.

Still, on a historical basis, the default and loss rates are extremely low, according to Nostrand, and the fact that they're ticking up hardly constitutes a crisis. How long defaults and losses remain at less-than-critical levels depends on large part on how swiftly interest rates move upward. Late in 2003, prospects that the Federal Reserve Bank would hike interest rates during the first half of 2004 dimmed somewhat after November's disappointing job numbers were released — only 57,000 jobs created vs. the 150,000 forecasted by economists.

The Apartment Attraction

When the final numbers are tallied, the Mortgage Bankers Association of America (MBA) expects volume in 2003 to top out at more than $100 billion, marking a 16% increase over 2002. Actual numbers through the third quarter of 2003 show lenders poured nearly $34.7 billion, or about 55% of all commercial originations, into multifamily properties, according to MBA. That's a 17.6% increase over the $28.6 billion that lenders pumped into apartments during the same period in 2002.

But multifamily wasn't alone. Debt volume across all categories shot up during the first nine months of 2003 compared with the same period in 2002. Retail was up 36.5%; office, 31%; and industrial, 17.3% (please see chart).

On a national level, few experts anticipate multifamily achieving any meaningful rent growth this year, but equity and debt investors alike have been heartened by slowing construction and a 4% rise in rents in select markets on the East and West coasts.

In the third quarter of 2003, apartment construction starts totaled an annualized rate of 306,000 units, a 1.3% drop from a year earlier, according to the National Multi Housing Council. Over the same time period, the annualized rate of multifamily construction permits dropped 8.9% to 307,000 units.

Mortgage bankers also suggest competition from the single-family home market will wane. The home ownership rate among households hit a historic high of 68.4% in the third quarter of 2003 from, up from 67.8% in the same period in 2000, according to the U.S. Commerce Department. Thus, the thinking goes, the core rental population — or the number of people who primarily choose to rent rather than own — has stabilized. Those who wanted to buy a home have already done so.

Forces Impacting Originations

Most debt experts anticipate a dip of about 10% in total loan originations in 2004 because of the drop-off in refinancing activity, which caught fire when the 10-Year Treasury yield bottomed at 3.07% in June 2003. Helping to offset that lost business is $32 billion in 10-year CMBS issued in the mid-1990s that are coming due. But the lion's share of that business is expected to hit in 2005.

The conventional wisdom is that the economy is gradually recovering, which will inevitably lead to higher interest rates. Even so, MBA predicts the 10-year Treasury yield will top out at 4.6% in 2004, only 50 basis points higher than where it stood late in 2003.

“In the past, even if interest rates were low, you couldn't find capital if we were at the bottom of the property cycle,” says Edward Padilla, CEO of Northmarq Capital in Minneapolis, a mortgage-banking firm that acquired Legg Mason Real Estate Services in late 2003. “This time around, real estate is surviving the bottom of the cycle as a favored investment class.”

Why? Clearly part of the reason is low interest rates, he says, which enable borrowers to pay loans with less income derived from a property. Thus, underwriting criteria such as debt-coverage ratios is easier to achieve, even though properties may fall short of best-case financial performances. The other reason: Capital that moved out of stocks and bonds and into property since 2000 generally has sustained the high values assigned to real estate during the peak of the property cycle in 1999 and 2000.

Still, the disconnect between real estate fundamentals and availability of capital hasn't escaped lenders. “In this weak market there are fewer good opportunities to lend money, while at the same time all of your competitors have an extraordinary amount of money they also want to lend,” says M.W. Sam Davis, vice president of The John Hancock Real Estate Investment Group in Boston.

“But that phenomenon is going to change soon, assuming that the stock and bond market continue to perform more consistently. Capital will migrate out of real estate and mortgages to a certain degree.” Relieving some of the pressure that the swell of money is putting on lenders and mortgage bankers to make loans hardly is a bad notion, Davis adds.

Do ‘Whatever It Takes’

Fannie Mae is displaying an attitude indicative of the ambitious lending climate. Last year the company, which funds single-family and multifamily purchases by issuing mortgage-backed securities and buying loans, introduced a “whatever it takes” strategy to its Delegated Underwriting and Servicing (DUS) lenders in an effort to increase its $100 billion apartment loan portfolio.

In general, Fannie Mae has worked with its lenders to tweak its loan products, making them more competitive. Fannie Mae also is giving its lenders more flexibility to execute loans by waiving certain escrow and capital reserves requirements.

“All indications are that there is going to be plenty of capital available for multifamily in 2004 but fewer deals,” says John Powell, vice president of customer management at Fannie Mae. “You've got to do what it takes to be competitive, but you've got to maintain some level of credit standards, or else some major mistakes will come back to haunt you somewhere down the road.”

Fannie Mae's Extended Maturity Option Loans product is one example of how the company and its DUS lenders have collaborated to improve loan programs. The product adds a year of floating-rate debt to the end of an 8- to 10-year, fixed-rate loan.

The product gives borrowers flexibility two ways, says William Hyman, CEO of New York-based PW Funding, a mortgage-banking firm that specializes in multifamily assets. Borrowers get a 12-month window to refinance their debt, and in this steep, yield-curve environment, deals that don't quite underwrite for a 10-year loan sometimes can work with a 9-year loan. Typically the floating rate generally is 240 basis points over the 30-day LIBOR (London Interbank Offering Rate).

At the end of 2003, the 9-year loans carried an interest rate about 25 basis points less than the 10-year loan, he says. In late December, a 10-year loan generally was running about 100 basis points over the 10-Year Treasury, which was about 4.2%. “We've found that to be a very effective technique and a very effective tool to win business,” says Hyman, who expected PW Funding to complete 2003 with $700 million in originations.

Does that kind of aggressiveness pose potential default problems down the road? Hyman and other mortgage bankers don't think so. Fannie Mae continues to closely scrutinize underwriting assumptions about revenues and expenses, Hyman says.

Today's underwriting standards are nothing like those applied prior to the real estate crash of the early 1990s, emphasizes Scott McMullin, a managing director in Holliday Fenoglio Fowler's Los Angeles office. In fact, a survey of insurance companies showed that the loan-to-value ratios on apartment loans actually fell to 64.4% in the third quarter of 2003 from nearly 71% at the end of 2002, according to the American Council of Life Insurance Cos. in Washington, D.C.

“There's a level of conservatism and required equity in every deal, and that wasn't the case in the last crash,” McMullin says. “Even though everybody's more aggressive, the underwriting fundamentals are sound.”

Aggressive is the operative word at ING Investment Management in Atlanta. Skip Foley, vice president, says ING has made loans that it would have rejected 18 months ago. For example, it agreed to finance a 200,000 sq. ft. office building in downtown San Francisco at a little more than $100 per sq. ft., despite the fact that the structure is some 40% vacant. The building may lose even more tenants in the next two years, which could send cash flow into the red.

But today, with the flood of capital searching for real estate, such deals make sense across all property types, Foley says. It costs $300 per sq. ft. to construct a new office building in San Francisco, and office buildings in similar or worse shape are selling for about $200 per sq. ft. ING also liked the fact that the borrower had 40% to 50% equity in the building.

“We'll make some loans by the pound that we think are very attractive, even though the economics of them may be a little nerve wracking,” Foley says. “We realize there may be negative cash flow for a period. But with the level of equity in those deals, we're comfortable that the sponsors will continue to maintain the property and move forward with it.” Typically, the insurance company will make a five- or 10-year loan on such deals at no more than 120 basis points above five-year or 10-year Treasury yields, respectively.

Shop Talk: Volume Projections

Mortgage bankers expect capital sources to keep the debt pipeline jammed for the foreseeable future. Banks still consider a construction loan of $10 million or $20 million safer than lending money to a 5-year-old small business, says George Smith, chairman of George Smith Partners in Los Angeles, a mortgage lender.

Meanwhile, Wall Street can't get enough CMBS deals. “Everybody's got an appetite greater than the amount of production available to them,” says Smith, who expected to end 2003 with $2.2 billion in originations compared with 2002's $1.8 billion. The company provides construction, mezzanine and permanent financing for commercial properties as well as large-scale, single-family home developments.

McMullin of Holliday Fenoglio says commercial mortgages in 2004 could easily rival 2003's volume. Holliday Fenoglio anticipated originating as much as $15 billion in 2003, compared with $12 billion in 2002. This year could be even better because a lot of borrowers have three-year floating-rate debt coming due. “Going into the year, our pipeline is as full as we've ever seen it,” he says. “Typically the first quarter is slow for us, but we see the first quarter as being one of the best quarters we've ever had.”

This year, the John Hancock Real Estate Investment Group wants to at least match, if not exceed, its more than $2 billion in debt volume in 2003 through its general account and conduit channels, according to Davis.

For its part, ING Investment Management Americas plans to allocate $2.5 billion in commercial real estate debt for its general account this year. That's the same amount it placed in 2003, which was up $500 million over 2002. “We'd like to put out more, but there will be fewer transactions and the ability to underwrite them is going to be tougher,” says Foley. “We'll be very happy if we're able to maintain it at $2.5 billion.”

Joe Gose is a Kansas City-based writer.

An Appetite For Apartments: A Comparison of Lending Volume Year-Over-Year Through the 3rd Quarter
(In Millions)

2002 2003 Change
Multifamily 28,603 34,676 17.6%
Office 11,428 16,659 31%
Retail 8,055 12,678 36.5%
Industrial 3,902 4,719 17.3%
Healthcare 1,080 1,686 36%
Hotel/Motel 837 1,972 57.6%
Source: Mortgage Bankers Association