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2008 Commercial Mortgage Banking Forecast

The commercial mortgage banking industry kicked off 2008 the same way a lot of people did - resolved to make some changes and hopeful of better times to come.

"This year is not for the meek or inexperienced or the operationally inefficient, but it does provide a real opportunity for growth and the capture of market share for those properly positioned to do so," says Eric Meadow, chief operating officer of St. Louis-based American Equity Mortgage.


Commercial real estate professionals who expected the capital markets to stabilize by the end of 2007 were disappointed. Instead, the whole industry is still wading through the mess created by the subprime mortgage meltdown, and throughout the first quarter of 2008, the commercial real estate industry will have to deal with liquidity issues, says Scott Lynn, director/principal of Dallas-based Metropolitan Capital Advisors.

Beyond availability of capital, the greatest concern for the industry is the cost of capital (and whether it's overpriced), says Susan Branscome, principal and executive vice president of the Cincinnati-based commercial mortgage banking firm Q10Triad Capital Advisors.

"It will be tough to finance properties," she says. "It will be more expensive than it has been in recent years. Banks will be more cautious and more conservative in their approach and require more equity in deals."

A lot is riding on the economy and whether the United States ends up in a recession. Interest rates also are a concern: if the 10-year Treasury rate rises to the 4.5 or 5 percent level, then mortgage rates will reach the same level spreads were at the end of 2007, Branscome points out

Most institutional lenders will deal with any risk of recession in 2008 by applying more conservative underwriting, says Todd Everett, head of real estate/fixed income investments for Principle Real Estate Investors, which has over $43 billion in commercial real estate assets under management. He believes that there will be slowing rental growth even without a recession.

"I think investors are going to conduct more extensive risk analysis when they are looking at a property and not just assume that the most likely scenario is that of high rental growth and low cap rates," Meadow says. "Investors are going to be tempted to stay up in quality and that's a strategy we're applying for most of our clients. Also, assets are no longer priced for perfection and that's created some very good buying opportunities."

A tough year
Ryan Duncan, president of Florida-based Backwater Mortgage, likens the commercial mortgage lending industry in 2007 to the movie The Perfect Storm. "You had multiple storms on the horizon converging: financial slow down in the housing market, weak U.S. dollar, extraordinarily high energy costs, and a tightening credit environment," he says.

After the turmoil in the subprime markets permeated through the capital markets, most of the fixed rate markets collapsed in the latter part of 2007, causing volatility in CMBS offerings.

"2007 was a tale of two halves," reports Jamie Woodwell, senior director of commercial & multifamily research for Mortgage Bankers Association (MBA). "In the first half, commercial and multifamily originations were running about 38 percent above last year's levels. We saw an overall drop in the third quarter and one of the key drivers was the CMBS drop."

During the third quarter 2007, commercial mortgages originations were four percent less than the third quarter 2006, according to a quarterly survey conducted by MBA. Conduit lending during the third quarter was down 28 percent, while originations by life companies were up 11 percent over the previous year.

"There's been a sudden shift in terms of investor risk tolerance, with the subprime sectors as the trigger for that change in risk assessment and tolerance," Everett says. "Also, debt spreads have increased back to levels that we probably haven't really seen since 2003."

With the CMBS market essentially resetting underwriting in the last half of the year, the current credit climate is a boon to life companies. "Many borrowers are on the sidelines now because they think spreads are too high and that it will stabilize," Branscome notes. "Conduits will continue to play a role but not dominate the debt capital markets as they had in the past several years."

Indeed, life companies are back in the game, says Jeffrey Packard, an assistant vice president with life insurance company John Hancock, which does about $2 billion in commercial mortgage lending.

"In the past, if you compared the life companies to CMBS, conduits were able to offer spreads that were much lower, and proceeds and loan amounts that were much more aggressive," he says. "The worm has turned. The ratings agencies have tightened down on some of the underwriting criteria that the conduits have used. It's created a situation where life companies are more competitive."

Scary spreads
Spreads on CMBS have blown out to record levels, says David Rosenberg, managing director of Meridian Capital Group, which closed more than $17.1 billion in mortgages in 2006 and about the same amount in 2007. The firm did several CMBS transactions during the third and fourth quarter 2007 including a large loan in Manhattan for $295 million.

"AAAs and BBBs were trading at record levels and an enormous spread in early December," he says. "The spread on a typical loan went from 80 or 90 over Treasuries just a few months ago to 250 to 275 over Treasuries for those who would even make a loan."

Jeff Weidell, executive vice president of NorthMarq Capital, says the firm recently closed on an apartment complex at 65 loan-to-value (LTV) with a 200 basis point spread over Treasuries. "Earlier in the year, we may have gotten that as a 70 LTV with a 100 spread," he notes. "The big change in the last few months has been in the spreads. Lenders are more conservative, which means finding more equity."

Chicago-based The Prime Group has experienced the credit crunch firsthand as they've accessed the debt markets. "Typically we would borrow 75 percent LTV," says Larry Vogler, president of the Chicago-based investment and development firm The Prime Group Inc. "Today lenders are down to 60 to 65 percent LTV. So we've had to go back and raise more equity from our partners or from new sources."

The recent turbulence in the capital markets also means less money to lend and banks are likely to be more constrictive and restrictive in development deals. "We're going to look to lend money to people who want to buy income-producing property or refinance an income-producing property," says Craig Young, vice president of the commercial real estate financing division with The International Bank of Miami.

Real estate players contend that the liquidity crisis is not here to stay, and many expect the CMBS market will calm down in mid-2008, primarily because real estate fundamentals are still sound.

"I think that the conduit lenders will come back but will not come back with any significant strength until the latter part of the year," Rosenberg predicts. "Life insurance companies and non-traditional conventional sources of real estate capital, as well as hard money lenders, banks and other mortgage players that have been sitting on the sidelines will start to enter the market, and we will see a reshuffling of the deck amongst the active players providing commercial real estate capital."

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