Jeffrey Packard, an assistant vice president with life insurance company John Hancock, which does about $2 billion in commercial mortgage lending, has been waiting for this moment for four years. The rise of CMBS lenders has radically altered the scene. CMBS lenders have been driving the terms for all commercial real estate lenders. Life insurance companies — once a dominant player — have moved to the back seat.

But to do so CMBS lenders have gotten more and more aggressive. That left executives at companies like John Hancock — which, admittedly, still got its share of deals — shaking their heads at some of the terms conduit lenders were offering to borrowers. Loans were being made that Packard says his firm could never justify.

“The conduits created a situation where the competitive bidding for deals got really out of hand,” he says. “I think they just got sloppy with a lot of underwriting.”

The big surprise is not that the correction arrived, but that it has not been of the conduit lenders own making. Instead, CMBS lenders have been hammered as a result of the subprime mortgage meltdown. Nonetheless, it's only natural that they feel vindicated by what's happened in the CMBS market.

Portfolio lenders had gotten used to coming up short on almost every aspect of a loan. But with the recent developments stemming from the subprime meltdown (See story on p. 38), the gap has narrowed, Packard says. “We're absolutely happy that the correction has finally occurred.”

Now, though, conduit lenders are bearing the brunt of the beating in the debt markets. Balance-sheet lenders, like life insurance companies and real estate banks, are sitting back and enjoying the show.

“Portfolio lenders are sitting back in their chairs, saying ‘I told you so,’” says Martin Kamm, managing director of Jones Lang LaSalle's Capital Markets Group. (Kamm is also a former executive with Northwestern Mutual.)

Balance-sheet lenders are enjoying the fortuitous turn of events. Such companies can do deals when conduits can't — a shocking reversal. No one's sure how long this situation will last. But portfolio lenders are intent on making the most of this window of opportunity.

“They are looking at this situation as a huge opening because right now they almost have 100 percent market share,” Kamm says.

It's not as if things have been all bad for life insurance companies. They have been hitting their targets. But those targets were much more modest than what CMBS lenders had been shooting for. Overall, market share has shifted dramatically out of their favor in the past decade. No one expects things to fully turn back the other way — CMBS is here to stay — this has given a lifeline to the sector.

“Most of the life companies were still hitting their numbers, but when they were going head-to-head with the conduits, they were losing,” says Mike Wood, executive vice president of NBS Financial Services in Seattle. Wood is advising his clients to consider portfolio lenders during this tumultuous period. “I am not advising them to steer clear of conduits, but I can't guarantee that a conduit deal will stay the same and won't get repriced,” he explains.

Seeing more deals

During the first quarter 2007, $87.5 billion in commercial mortgages were originated, a 37 percent increase over the same period last year, according to the quarterly survey conducted by the Mortgage Bankers Association. Conduits accounted for the bulk of the new loans with $60.85 billion in originations, while non-CMBS issuance reached $20.05 billion, a 55 percent increase over the first quarter 2006.

Preliminary estimates from the Mortgage Bankers Association show that second quarter originations volumes were higher across the board. CMBS lenders, in fact, set a record (see chart below). Expect that to change when third quarter numbers come out.

Even with the CMBS turmoil, portfolio lenders have not pulled back their commercial property lending goals. While many conduits are paralyzed, there's still plenty of debt available from banks and life companies.

“Despite fears that we are facing a liquidity crunch, loans are still getting quoted from both CMBS and non-CMBS lenders,” Kamm says. But, it's not quite the free-for-all it was earlier this year. Portfolio lenders are being more selective, he says. They're not going to be forced into deals they don't like.

Overall, most portfolio lenders are feeling pretty good about the underlying fundamentals of commercial real estate and that's keeping them in the game. “We have life companies calling us, and just yesterday we had one that we hadn't seen in a while stop by and tell us they wanted to see more deals,” says James DuMars, senior vice president and managing director of NorthMarq Capital's Phoenix office.

John Hancock, for example, hasn't changed its lending targets, Packard says, adding that he anticipates closing 10 percent to 20 percent more transactions because of the CMBS turmoil. “We're definitely seeing more deals, and depending on how things shake out, we would expect to see more business for our company and industrywide for portfolio lenders,” he notes.

DuMars estimates that portfolio lenders are now seeing 20 to 25 packages when they were used to just 5 to 10 packages. “In my opinion, this environment is a good cherry-picking opportunity,” he says.

In fact, portfolio lenders are quickly becoming overwhelmed with the volume of loan requests, especially from borrowers they've never worked with, Kamm says. “Most of them are focusing first on servicing existing clients who have stuck with them.”

Portfolio lenders continue to be interested in retail, although there are some concerns about the sector's ongoing health and fundamentals. John Hancock, for example, is still interested in providing debt for retail properties, but Packard admits the firm has a higher level of vigilance when reviewing retail deals. “We do have some concerns on retail, and they relate primarily to what's happening in the housing market,” Packard says. In particular, he expects increased foreclosure rates and a weak housing market to put a damper on consumer spending.

Pricier loans

While portfolio lenders aren't the only game in town, they certainly are the only ones that can provide any kind of confidence that a deal will close on time with the agreed upon terms, says Todd McNeill, a senior director with Metropolitan Capital Advisors, a Dallas-based mortgage banking firm. “Certainty of execution is the main thing in our business, and the conduits can't offer that now — portfolio lenders can so they actually have the advantage over the conduits,” McNeill says.

“I have borrowers who have told me that they don't want to waste time on a conduit,” says Michael Derk, a senior director at Marcus & Millichap Capital Corp.

Certainty of execution isn't the only advantage that portfolio lenders have over the conduits these days. McNeill says they're disturbing the waters in a market that is causing even the most seasoned professional to get a little seasick. Balance-sheet lenders, though, are operating like business as usual. And that's become a distinct advantage.

In fact, underwriting has remained largely the same for portfolio lenders, experts say. Although conduit lenders have been forced by credit ratings agencies and bond buyers to modify their underwriting standards, portfolio lenders have not changed their underwriting standards. Their loans rarely included riskier terms such as 10-year interest-only loans and debt service coverage below 1.0 x. “We've maintained a pretty good discipline over the years, so now we're just doing what we've always done,” Packard says.

But, volatility in the bond market has pushed up the cost of commercial real estate debt — not only for CMBS loans, but also for whole loans. The big difference is that portfolio lenders' pricing is actually better than CMBS pricing now even though it has increased from six months ago.

“The tables have completed turned over in the past month,” Derk says. “Previously, portfolio lenders just sat there and lost deal after deal to conduits because they couldn't compete. But the difference of pricing and volatility in CMBS is giving portfolio guys a leg up.”

DuMars says that even though life insurance companies are still less aggressive than CMBS, their spreads were lower as of mid-August. A typical life company deal offers 65 percent loan-to-value, 25-year amortization, and 150 to 190 basis point spread over 10-year Treasuries. In contrast, CMBS quotes are coming in at 200 basis points over 10-year Treasuries, he says.

Pricing on John Hancock's mortgage loans had increased as of mid-August, according to Packard, but he declined to say by how much. “Our pricing has trended up along with everyone else in the industry,” he explains.

Even at spreads of 180 basis points over 10-year Treasuries, mortgage loans are still at historically low levels — below 7 percent. But, borrowers have been so spoiled by the conduits that they are balking at these more expensive terms. And some mortgage brokers are advising them not to make long-term loans right now.

“Borrower expectations are based on what was occurring just two months ago,” DuMars says. “We're forced to do a tremendous amount of expectation correction with our borrowers.”

And he's not only managing borrower expectations, but lender expectations too. Dumars is warning portfolio lenders that higher prices are going to be a hard sell to borrowers for a while.

Many of Wood's borrowers are pretty vocal in their frustration as well. “I tell them to just look at the coupon rate instead of looking at the spreads because the all-in rate is not that much different. Treasuries have come down,” he says.

Nonetheless, Wood has had a couple of deals fall through because of the increased coupon rates. He had borrowers walk away from the table because their cost of debt had increased by 25 basis points or more from what they were expecting.

Neil Efron, senior vice president of commercial mortgage banking for BankAtlantic, a $7 billion Fort Lauderdale, Fla.-based bank, has seen a lot of deals blow up too. That's why BankAtlantic has created a new mortgage loan product — a three-year to five-year fixed-rate loan with partial recourse and no prepayment penalty.

“Some borrowers can't wait for the market to settle down, and this loan solves the problem because they refinance or acquire their property now and can come back and get a new loan once spreads have gone down,” he explains.

Right now, no one has any idea of when spreads will come back down because it's not just the competitive environment that is determining pricing for portfolio lenders. Many have increased their spreads because of internal pressures, DuMars says, pointing out that mortgage lending is just one investment vehicle for most portfolio lenders.

Many life insurance companies are active buyers of CMBS paper and corporate bonds, both of which are being sold at very cheap prices. That means that mortgage lending groups have to compete with other investment vehicles.

“Life companies can still go out and buy a AAA corporate bond at a 140 basis point spread,” Wood says. “When you compare corporate bonds to whole loan mortgages, it's only fair that you be compensated for taking on the additional risk from mortgages. That's a big reason why borrowers who get portfolio loans can expect to pay more.”