For commercial mortgage bankers, the first half of 2002 might best be described as two steps forward, one step back. The momentum of record-low interest rates for borrowers, coupled with an investor flight to real estate, ran head-on into increasingly weak fundamentals in the property sectors. Meanwhile, a reluctance by sellers to lower prices and the uncertainty over terrorism insurance continued to stymie office deals, according to loan originators.

Commercial lending volume remained basically flat during the first six months of this year, concludes the Mortgage Bankers Association of America (MBA). A survey of its commercial members reveals that loan originations totaled $32.8 billion from January through June 2002 compared with $32.6 billion for the same period last year, an increase of less than 1%.

One bright spot during the first half of 2002 was the retail sector, which recorded a 30% spike in loan origination volume, jumping from $3.3 billion to $4.3 billion. Multifamily lending volume increased a modest 4%, rising from $16.2 billion to $16.8 billion (please see chart on page 38).

Meanwhile, the office and hotel sectors took it on the chin. The hotel sector experienced a 50% decline in the dollar volume of loan originations, dropping from $968 million in the first half of 2001 to $483 million through June 2002. The office market didn't fare quite as badly as hotels, decreasing from $7.7 billion to $6.3 billion, an 18% decline.

“We're not going to have a blockbuster year in commercial real estate finance, either this year or next, because any improvement in office occupancy is going to trail the general economy by six to 12 months,” says Lawrence Stephenson, a senior vice president with Minneapolis-based NorthMarq Capital.

The biggest driving factor for loan volume in commercial real estate is the office sector because those are the most valuable properties, and they generate the largest loans, points out Stephenson. But at the moment there seems to be little demand for office space. According to CB Richard Ellis, the national office vacancy rate is still on the rise, registering 14.6% in the second quarter, up from 14.2% in the first quarter.

However, loan volume picked up considerably in the second quarter. According to MBA, nearly $20.4 billion was originated in the second quarter of this year, up from $17.6 billion during the same period a year ago. Among the individual property sectors, multifamily garnered the biggest share of total dollar volume (51.5%), followed by office (19.2%), retail (13.7%), industrial (6.4%), hotel/motel (2%) and health care (1.4%).

“When you look at the second-quarter gain it was primarily due to the larger lenders,” explains Gail Davis-Cardwell, senior vice president of the MBA's commercial/multifamily division. “Medium and smaller lenders did not necessarily fare as well across the board in the second quarter.”

Loan Volume Comparison: 2001 vs. 2002
(in billions)
January-June 2001 January-June 2002 % change
Retail $3.3 $4.3 30%
Industrial $2.2 $2.3 5%
Multifamily $16.2 $16.8 4%
Office $7.7 $6.3 -18%
Hotel $0.97 $0.5 -50%
Total $32.6 $32.8 0.6%
Source: Mortgage Bankers Association of America


Analyzing the Undercurrents

Several mortgage bankers interviewed by NREI indicated that their lending volumes through June dropped 10% or more compared with the first half of last year. They cite several factors for the dip in the volume of originations, including deteriorating real estate fundamentals, a slow sales transaction environment and the lack of terrorism insurance.

“We are not doing deals we would otherwise do because of terrorism insurance concerns,” confirms Gary Nelson, president of Los Angeles-based Churchill Mortgage Corp. “Our transaction business would be 10% to 20% higher if terrorism insurance weren't an issue.”

The U.S. House and Senate have passed separate bills that call for a federal backstop on terrorism insurance, and were expected to iron out their differences in conference following the August recess. If approved by Congress, the bill is expected to be signed into law by President George W. Bush early this fall.

“The difficulty of obtaining terrorism insurance is the most critical issue to face the lending community and the commercial property industry in years,” says David Creamer, chairman and CEO of GMAC Commercial Holding Corp.

Kieran Quinn, president and CEO of Atlanta-based Column Financial, says the projected volume for domestic CMBS issuance this year is expected to range between $55 and $60 billion, down from $74 billion in 2001, due in part to the lack of terrorism insurance. “The fall occurs most dramatically in the office sector in many key urban areas that may appear vulnerable to terrorist targets,” says Quinn.

The survey also reveals that the share of multifamily loans purchased by government-sponsored enterprises (GSEs) dropped sharply, falling from 52.2% in the first quarter of 2002 to 35.3% in the second quarter. The GSEs include Fannie Mae and Freddie Mac. Richard Lawch, Fannie Mae's senior vice president of multifamily products and capital markets, says the lending pie as a whole has shrunk due to reduced velocity in the number of sales transactions and less borrower activity in general in 2002.

In addition, the pricing by conduits has become extremely competitive, which has allowed them to gain market share. For that reason, Lawch isn't surprised by quarterly swings in market share.

Linda Holmes, director of multifamily marketing for Freddie Mac, believes the investor flight to real estate also plays a role. “It seems that they [life insurance companies, pension funds and conduits] view multifamily mortgages as a safe haven right now compared with corporate bonds, equities and other types of commercial real estate they could be investing in,” says Holmes.

Meanwhile, Davis-Cardwell of MBA says that it's no secret that Fannie and Freddie have enjoyed a significant increase in their share of multifamily loans in recent years. “There's only so long you can keep that momentum up,” he notes.

Ripple Effects of the Stock Market

The volatility on Wall Street cuts both ways. Concerns about a possible double-dip recession, or at least a much slower economic recovery than anticipated just a few months ago, have put downward pressure on interest rates, which is good news for loan originators.

At the close of business day Aug. 26, the 10-year Treasury yield stood at 4.21%. The low interest rates have helped boost the refinancing market to some degree, although that wave is tempered somewhat by the fact that in order to get out of their existing loans early, borrowers must incur hefty pre-payment penalties.

John Pelusi, executive managing director with Dallas-based Holliday Fenoglio Fowler, doesn't expect refinancings to increase significantly until valuations improve along with the general economy. “Really it's not until 2007 and 2008 that you are going to have north of $125 billion a year coming due that needs to be refinanced,” says Pelusi. “Right now there just aren't a lot of opportunities on the refinancing side.”

The beleaguered stock market has become a reflection of weak corporate earnings, which has led to deterioration in real estate's fundamentals. David Twardock, president of Newark, N.J.-based Prudential Mortgage Capital, believes a cloud of uncertainty continues to hang over the economy. “The longer the uncertainty drags out and the weaker the fundamentals get, the more likely it is that we're going to have real estate issues,” he says. Weakening fundamentals affect loan production directly because it's a sign that properties are having cash-flow problems. The underwriting then becomes more difficult and the overall process more arduous, says Twardock.

The malaise in the stock market clearly has driven investors into fixed-income instruments such as commercial mortgage-backed securities. The continued growth of CMBS is helping to pump more liquidity into commercial real estate at attractive borrowing rates, says Twardock. So far, at least, that hasn't led to a sharp rise in loan delinquencies. In July, conduit delinquencies registered 1.69%, up slightly from 1.55% in January.

Ed Hurley, a principal in the Dallas office of Lend Lease Mortgage Capital, says there is no doubt that conduit lenders are much more competitive today than they were 12 months ago.

“Investors have either changed their perception of the risk in those subordinate bonds (non-investment grade) and are willing to accept lower spreads, or investors are looking at fairly unattractive investment alternatives and have decided that CMBS is a good place to be,” says Hurley. Over the past six to 12 months, the investor spreads on the subordinate CMBS bonds have tightened considerably, adds Hurley.

Retail's Resiliency

Despite a rash of retailer bankruptcies and store closings, the property sector continues to shine in the commercial lending arena. One explanation, says Davis-Cardwell of MBA, is that investors have a strong appetite for grocery-anchored and community shopping centers, which comprise the bulk of the retail loan originations. “People will always have to eat,” she says.

Pelusi sounds one note of caution about the grocery-anchored niche, however. He favors markets with high barriers to entry such as the key cities of the Northeast. “I'd be concerned about investing in grocery-anchored retail in places where there are no barriers to entry and land is plentiful,” Pelusi says.

Ironically, in 2000 and 2001, industry forecasters predicted that retail was going to be a hard-hit category, says Pelusi. “I think it's probably held up the best. Why? People have been able to refinance their homes over the past two or three years, in some cases two or three times. Their disposable income continues to increase, even if they're not getting wage increases,” says Pelusi, who is based in Pittsburgh.

Who's Driving the Deals?

Prudential Mortgage Capital has benefited by a significant increase in refinancing activity among institutional investors, namely pension and investment funds, reports Twardock. “The pension funds have decided that this is a great opportunity to achieve a positive spread between the income they're getting on the property and the borrowing rates,” Twardock says. “If I'm earning 9% on a portfolio of assets and I can borrow at under 6.5%, I've got to take advantage of that opportunity.”

Case in point: In May, Prudential announced that it had closed a $246.5 million package of seven commercial mortgage loans for the General Motors Pension Plans portfolio. With $6.5 billion in real estate equity, this venerable institutional investor is one of the largest U.S. corporate pension funds of its kind. The funding included multifamily, office and industrial properties in California, Texas and along the East Coast, and includes a combination of single-asset and multi-asset portfolio loans.

All the deals but one were 10-year loans amortized over 25 years. Though the interest rate was not disclosed, the borrower indicated that it was more than pleased with the loan terms. Twardock says the GM pension deal was particularly large, given that average loan size at Prudential ranges from $8 to $10 million.

Through June, Prudential Mortgage's loan origination registered $2.05 billion, down from $2.1 billion a year ago. For all of 2001, the company originated $4.5 billion in loans.

Twardock notes that while the volume of large institutional deals has risen, the core bread-and-butter deals have dried up because there's less new construction to finance. Additionally, the pace of property sales transactions has not gained momentum in 2002 due to a bid-ask gap between buyers and sellers, though Twardock anticipates the abundance of equity capital to spark more deals in the latter half of the year.

For the debt or equity deal that's in the strike zone, it's a feeding frenzy in the lending community, says Pelusi. Conversely, borrowers may find themselves waiting for quite some time for a deal outside of a lender's criteria. “In the past, borrowers could say, “I'll pay you 50 basis points to do the deal. Now lenders are saying, ‘You can't pay me enough to do a deal that isn't in my [zone].’”

So, what's attracting lenders? Apartments with strong occupancy rates are highly coveted. In July, Holliday Fenoglio Fowler arranged a $14.1 million refinancing for the Lodge at Kingwood, a 312-unit apartment community in the Houston suburb of Kingwood. The borrower, The Hanover Co., obtained a three-year, adjustable-rate loan through Nationwide Life Insurance Co. The project is 98% leased.

The term “adjustable-rate” is popping up more often in loan origination announcements these days. In August, Holliday Fenoglio Fowler arranged $29 million in acquisition financing for Retreat at the Heights, a 394-unit multifamily community in Aurora, Colo. The adjustable-rate loan is for three years. Greenwich Capital was the lender, and the Laramar Group was the borrower.

Stephenson of NorthMarq Capital says the number of borrowers who have opted for short-term, floating-rate loans is surprising.

“It surprises me because fixed-rate, 10-year loans also are at very low interest rates from a historical perspective. I would think that more people would take a longer-term view and say, ‘This is really cheap, long-term money that I can lock in today.’ Apparently, borrowers feel that the political and business environment is such that these very low floating rates are going to hold for a long time,” says Stephenson.

Spreads over Treasuries for attractive multifamily properties range from 140 to 150 basis points, he adds. For higher-risk properties such as unanchored retail, the spreads can range from the low to mid-200s. “You're talking about an interest rate to the borrower of 6% or 6.25%, even for unanchored retail-type properties. That's just unheard of,” says Stephenson. “It's a historic opportunity to borrow money if you've got a property that can be financed.”

MBA Commercial Mortgage Banker Origination Survey*
(Second-quarter 2002 results)

TOTAL COMMERCIAL ORIGINATIONS, A COMPARISON
Second quarter 2002 First quarter 2002 Second quarter 2001
Number of Loans 2,174 1,649 2,085
Dollar Volume ($ Millions) 20,379 12,439 17,664
Average Loan Size ($ Millions) 9.37 7.54 8.5


SECOND-QUARTER 2002 BY PROPERTY TYPE
Dollar Volume ($ Millions) Percent of Total Number of Loans Percent of Total
Office 3,919 19.2 305 14.0
Retail 2,795 13.7 317 14.6
Multifamily 10,498 51.5 1,004 46.2
Industrial 1,296 6.4 220 10.1
Hotel/Motel 402 2.0 19 0.9
Health Care 277 1.4 79 3.6
Other 1,192 5.9 230 10.6
*Totals reflect survey of 45 mortgage bankers, including all major third-party originators and a cross section of medium and small firms.