After two years of falling net operating income in commercial real estate, the lending community has begun to tighten its underwriting standards. Yet the competition among lenders to win deals is so intense in this high-velocity market that yield spreads over the past year have contracted by as much as 50 basis points across the property sectors, making the cost of debt financing for borrowers extremely cheap.
“The last four months of 2002 were probably the busiest months I've experienced in my 10 years in the business,” says Kieran Quinn, president and CEO of Atlanta-based Column Financial, a lender specializing in commercial mortgage-backed securities. “The first four months of this year were almost as busy.”
Column Financial is a subsidiary of New York-based Credit Suisse First Boston, which ranked No. 6 on NREI's Top Lender Survey with $6.5 billion financed in 2002, up a hair from $6.4 billion in 2001. The company's portfolio includes retail (35%), multifamily (30%), and office properties (25%). The remaining 10% is industrial, senior housing, hotel and mixed-use properties.
CMBS Market Proves Resilient
The statistics show that Column Financial and the rest of the CMBS industry have powered through the recession and slow recovery of the past two years. In 2002, new CMBS issues in the U.S. reached $66 billion, according to Lend Lease Real Estate Investments. That was lower than $74 billion recorded in 2001, but still the third highest CMBS total on record.
Quinn attributes the drop in volume in 2002 to the shock of the terrorist attacks of September 2001, not economic and real estate fundamentals. “Loan production shut down in the fourth quarter of 2001,” he says. “We thought the world had stopped. We didn't know if the stock market would open or if bonds would trade. At the same time, we were all worried about the possibility of recession.”
So far this year, CMBS providers are outpacing 2002, according to Lend Lease. Through the middle of April, U.S. issues totaled $20.2 billion, well ahead of the $11.3 billion issued by April of last year. That brisk business is largely the result of historically low interest rates. The 10-year Treasury yield, the benchmark for long-term, fixed-rate financing in commercial real estate, registered 3.4% on June 20. With spreads ranging from 150 to 250 basis points over Treasuries, that means borrowers are paying an interest rate of 5% to 6% — substantially lower than a year ago.
“At this time last year, we would have made comparable loans at 180 to 300 basis points over Treasury rates,” Quinn says, adding that yield spreads are tightening across all property types, particularly for apartments and well-anchored retail properties.
However, the pervasive weakening in real estate fundamentals has forced lenders to impose strict underwriting standards on deals by taking into account future market conditions, which are expected to deteriorate further, says Quinn.
For example, a borrower who applies for a loan today on an office building purchased two years ago with leases in place at rents of $40 per sq. ft. and an occupancy rate of 95% can expect to encounter more stringent underwriting standards.
“We might believe a particular market has gone down to $35 per sq. ft.,” Quinn says. “So we'll underwrite the property at that lower market rent. Second, we'll assign a lower occupancy rate. We'll still use a 75% loan-to-value, but the higher vacancy rates and lower market rents we've assigned will reduce the value we are lending on.”
Future Looks Prosperous
While attending to the current surge in demand for loans, Column Financial and other CMBS lenders are looking for even more business a few years down the road. In 2007, borrowers will begin to refinance 10-year CMBS loans written in 1996, the year CMBS lending took flight.
According to New York based Trepp, LLC, a CMBS research concern, about $14 billion in CMBS loans will come up for refinancing this year. Refinancing will grow slightly through 2006. Then in 2007, maturing CMBS loans will balloon to $28 billion, followed by $49 billion in 2008. “We're all thinking about getting to 2007 and 2008,” Quinn says. “Refinancing will increase CMBS business potential from $70 billion to $100 billion a year, and we'll be in a business that will prosper for a long time.”