Until the end of last summer, the quickest route to finance a commercial real estate project or acquisition was straight down Wall Street. In the fast lane of conduit financing, loan-to-value ratios of 80% to 85% were the norm, and some borrowers tacked on second mortgages, mezzanine debt or other financial instruments to achieve leverage equal to 90% or more.

That changed in August, when many lenders reacted to lackluster sales of commercial mortgage-backed securities by applying the brakes on new loans. More deals fell out of contract in September than closed, and sales volume across all property types dropped 25%, reports Real Capital Analytics. In the office arena, September sales fell 26% from year-ago totals.

Today, Wall Street is undergoing heavy reconstruction, and mortgage traffic is being rerouted to life insurance companies and other traditional lenders. Borrowers say financing is available to cover a more conservative portion — say 70% — of a project's value, but the path to funding may lead to a regional bank or to an institutional lender. Even a few CMBS issuers will still provide leverage for high-quality projects, but borrowers must first learn to navigate a dramatically different marketplace that shuns risk and demands a higher price for the privilege of borrowing.

Costly detours

Conduit lenders weren't the only ones who balked in the third quarter, according to Steve Pyhrr, senior managing director in the Austin office of investment services firm Kennedy Wilson Inc. The Beverly Hills-based company acquires properties both independently and in partnership with institutional investors. At the onset of the credit crunch, insurance companies terminated two loans Pyhrr needed for separate acquisitions — an industrial building in Austin and a medical office building in San Antonio.

Pyhrr fell back on existing relationships with banks to salvage the deals. Wachovia's commercial real estate group in Southern California stepped up with $21.3 million in mortgage financing to help purchase One Technology in San Antonio for an undisclosed price. The transaction required a change in ownership structure to a co-mingled fund that was able to post additional equity. “The rates were a little higher and the terms weren't quite as good, but we got the deals done,” says Phyrr, who heads Kennedy Wilson's southern division.

What are the borrower's new challenges in the marketplace? Pricing, for one. Lenders developed an aversion to risk in the third quarter and increased the spread added to U.S. Treasury rates to calculate mortgage rates. A multifamily mortgage from Freddie Mac or Fannie Mae that would have cost the borrower 100 basis points over the 10-year Treasury rate last summer now runs 180 to 190 basis points over Treasuries.

Conduit loans for multifamily acquisitions that would have cost less than 100 basis points over Treasuries now run about 250 basis points over, according to mortgage brokers. Cost has been mitigated by a declining 10-year Treasury yield that dropped below 3.7% in mid January, a four-year low and more than 100 basis points below year-ago levels.

Size matters

A more serious impediment to borrowers than rising cost has been the reduced leverage lenders will provide on a single property, according to Woody Heller, executive managing director of the capital transactions group at real estate services firm Studley Inc. To limit exposure to a single asset, some lenders have set maximum loan amounts of, say, $50 million, which falls short of funding requirements for many deals.

One lender who had agreed to provide $63 million to one of Heller's clients for a $70 million property acquisition before the credit freeze recanted shortly before closing. In light of the credit crunch, the lender had decided to lend no more than $45 million on any property. “The impact of the change in the level of proceeds is quite profound, more profound than what the debt costs,” Heller says.

Studley ultimately saved the deal and was able to identify another lender that provided $40 million as a first mortgage, and then took out a smaller, second mortgage from the original lender to achieve the leverage necessary to close the deal.

Lending caps are a point of frustration for financial intermediaries, who must line up multiple lenders to finance large deals that would have qualified for a single conduit loan a few months ago. “Size is not your friend,” laments Jody Thornton, executive managing director at Holliday Fenoglio Fowler LP. “You can have a great deal on a property that's well-located with great sponsors, but the lender can only loan $50 million and you need $150 million,” says Thornton, who co-heads the financial intermediary's Dallas office.

To fund deals approaching $100 million or more, intermediaries may work with multiple lenders, even pre-syndicating a loan by lining up secondary buyers to acquire the debt after the deal closes. Thornton says the more complicated maneuvering required to arrange mortgage financing today has increased the demand for intermediaries. “People call us to wring inefficiency from their deals, and there is a lot of inefficiency in the market with pricing, proceeds and terms that vary widely,” he says.

Value questions

Now that insurance companies have become the lender du jour for commercial mortgages, borrowers are adjusting to the conservative loan-to-value ratios those providers have generally clung to all along. CMBS lenders may have been comfortable providing 95% financing, but life insurers have typically stayed below 75% loan-to-value on loans.

“Insurance companies are pretty much doing what they've always done and the market has had to adjust to that,” says John Morran, principal at Texas Realty Capital LP, a commercial mortgage company in Austin that originated 90% of its loans in 2007 with insurance companies.

In addition to learning to accept 70% loan-to-values, borrowers must come to grips with today's conservative underwriting that eschews projected cash flow. Wall Street lenders have been chastised for underwriting asset values on projected income, so the practice in 2008 is to focus on current rent rolls in determining a property's worth. That creates a problem for value-add projects or those with substantial vacancy, which previously could qualify for loans based on a higher asset value that reflected future rent growth.

This emphasis on hard numbers is easiest to see in construction loans. A year ago, a developer planning to spend $70 million to $80 million constructing an office building might expect to sell it for $100 million after completion and lease-up, according to Larry Vogler, president of The Prime Group, a Chicago-based developer. The lender on such a project might provide a loan to cover the entire construction cost, treating the additional 20% of future, or imputed, value as the developer's equity in the project.

Today, the same lender is more likely to offer a loan covering just 70% to 80% of the development cost. “They're looking at the same ratio, but it's loan-to-cost, not loan-to-value,” Vogler says.

Land is the most challenged property type due to a lack of cash flow during project development and lease-up. Lenders have grown so disinterested in land deals that one Chicago developer, Higgins Development Partners LLC, is buying development tracts with equity alone. “I don't really even ask anymore” for land acquisition loans, says Dietrich Knoer, chief investment officer at Higgins Development, which is a merchant builder of office and industrial properties.

The mortgage trickle

On average, lenders were barreling along in the first half of 2007 with originations that were 38% ahead of the previous year's pace. But in the third quarter, mortgage volume fell by 4% over the same period in 2006, according to the Mortgage Bankers Association. Mortgage origination volume for the fourth quarter wasn't available from the MBA at press time in late January, but will inevitably reflect a continued slowdown.

The slowdown in new mortgages was chiefly driven by the credit freeze that virtually halted conduit lending toward the end of the third quarter. In the first half of 2007, conduit volume was running 70% ahead of the first half of 2006; in the third quarter, CMBS originations were down 28% from a year earlier.

What has kept the door to mortgage financing open, and continues to provide leverage to qualified borrowers, are the legions of insurance companies and other institutional lenders that keep loans on their balance sheet rather than packaging them into securities.

In fact, life insurance companies surveyed by the MBA reported an 11% increase in origination volume in the third quarter over the same period a year ago. Originations for Fannie Mae and Freddie Mac also helped fill the mortgage void in the third quarter by cranking out loan volume 61% greater than the pace a year earlier.

Would-be buyers and sellers have been understandably inclined to wait on the sidelines until the mortgage market regains some of its lost liquidity. Greater availability of capital would pressure interest rates downward as lenders compete for deals while giving borrowers better access to leverage and boosting the prices sellers are able to fetch for their properties. Yet a growing number of existing mortgage holders will be compelled to seek refinancing this year and next as their loans mature (see chart p. 40).

Waiting to bounce back

The sooner financial institutions acknowledge all of their losses from subprime and any other bad loans, the sooner market participants can get a better grip on asset values and lenders can loosen credit constraints, says attorney Adrian Zuckerman, who heads up the real estate practice in the Northeast for law firm Epstein Becker & Green. “We can't go forward until there has been some sort of watershed event. All the non-performing stuff has to come out — the markets have to settle.”

A potential economic recession is compounding the lethargy in mortgage originations by clouding the outlook for job growth, real estate demand and property cash flows, says Zuckerman. That's why he expects the credit malaise to drag into summer — or even fall — before the industry begins to bounce back.

Even those investors and developers who have succeeded in acquiring mortgage financing lately would prefer a more liquid, confident lending environment. Knoer of Higgins Development Partners will be glad to augment his company's land purchases with leverage that has grown too troublesome to pursue since last August.

“We need to get through this phase,” says Knoer. “For the time being we can digest the corrections that are happening, but the uncertainty needs to go away.”

Matt Hudgins is an Austin-based reporter.