Unquestionably, this is a borrower's market.

And they are making the most of it by taking on huge amounts of debt, even in the face of rising interest rates. During the first quarter of 2006, commercial loan originations jumped 34.2 percent compared to the same quarter last year, according to the Mortgage Bankers Association (MBA). This puts 2006 on pace to surpass 2005's total of $345 billion, which itself was a 49.9 percent increase over 2004. For retail, the numbers have been even more extreme, with volume jumping 55 percent during the first quarter, putting the industry on pace to surpass 2005's total of $60.3 billion in originations.

On one level, the frenetic pace of lending is a positive indicator that there is still a very healthy demand for retail real estate assets. Lenders are flush with cash and investors are seeking the reliable returns afforded by commercial real estate.

Viewed another way, however, the situation raises some troubling questions about current lending practices and the long-term prospects for many borrowers. The current environment has all the earmarks of a late-cycle scramble to get that last dose of cheap money before higher long-term interest rates and rising cap rates put an end to the retail real estate buying spree.

For now, borrowers continue to have the upper hand and are demanding — and getting — unprecedented terms, including interest-only loans. The latest demand is for construction-perm financing loans, which roll construction money and long-term debt into one package, providing construction debt that transitions into a permanent loan after a set time, often with the same rate on both loans. Borrowers want to lock in their long-term debt at the same time they get their construction loans because it's likely that long-term rates will increase, and put the short-term/long-term yield curve back to its historic norms.

“Many lenders are developing new loan programs to distinguish themselves, and loan terms are getting very, very aggressive,” says Dan Trebil, an assistant vice president and producer in Northmarq Capital's Minneapolis office.

Looser lending

“Borrowers have been thoroughly spoiled over the past 24 months — they are not shy about asking for anything and everything,” says David Graves, vice president of real estate mortgages for State Farm Mutual Life Insurance Co. And to Graves, a veteran investor with 33 years in the industry, this provokes an uneasy sense of déjà vu. Once again, he says, we're “starting to see things that got the industry in trouble.”

That means looser lending standards including high loan-to-value (LTV) ratios and lengthy interest-only terms — potentially seeding delinquencies and defaults in years to come. Recently, Moody's Investor Services issued a stinging assessment, blasting lenders for being too accommodating to borrowers in order to get deals done. A red flag, according to the rating agency, is the record level of commercial mortgage debt, reached in last year's fourth quarter. Commercial mortgages, as a percentage of gross domestic product, reached 15.8 percent, topping the record of 15 percent set in 1988 at the peak of the last real estate cycle.

Moody's also cited LTV ratios on CMBS loans, which hit 103.8 percent in the first quarter, the highest on record, and a sign of increased balloon refinance risk. Of equal concern is the growing percentage of conduit loans that have been originated below a 1.30 debt service coverage ratio — a record 53.4 percent in the first quarter of this year. The lower debt service coverage could signal increased default risk.

Despite Moody's fears, this is not 1988: Today's CMBS market will, in theory, cushion the blow if a large number of loans cease to perform. Few lenders hold onto loans once they originate them, and that's why they've been more than willing to meet borrower demand as they clamor to place debt. Many institutions, meanwhile, have raised target allocations for real estate, spurring even more demand.

B-piece buyers supposedly safeguard lenders on CMBS deals. And so far, most CMBS pools are still healthy, posting few defaults or delinquencies. In fact, delinquency rates are likely to remain steady this year at about 0.8 percent, according to Standard & Poor's, which is forecasting that the total delinquent amount on commercial loans will remain at the $3-billion level. CMBS delinquency rates for the first quarter actually declined for all property types except for retail, which ended the quarter at .51 percent, up six basis points from fourth quarter 2005, according to Wachovia Securities.

With so much money available for commercial real estate investments, lenders have little leverage. They are all fighting for a share of the business. Life insurance companies — which used to have a much bigger share of the permanent financing pie before conduits came along — are trying to win back business by growing their construction lending volume. This is encroaching on where banks have historically thrived. Meanwhile, there is continuing pressure from conduits on permanent loans.

Lenders complain about their eroding margins, but continue to put out money at record rates. Pricing has hit rock bottom, asserts John Fenoglio, a principal with Live Oak Capital Ltd., a Houston-based mortgage banking shop. As of mid-June, 10-year treasuries were at 5.094 percent, and a borrower was able to get a 75 percent loan-to-value fixed rate loan for 100 basis points over treasuries — a very low spread for lenders.

“Pricing has been so tight — especially on the conduit side — that people have said that they're just going to break even or even lose money just to get the deals and do the business,” Trebil says. He adds that many lenders have moved away from smaller deals of less than $10 million, or will tack on a 15 to 20 basis-point premium to do a small deal. (For example, J.P. Morgan Chase and Archon Financial are two firms that have shied away from smaller deals.)

Fenoglio notes that several CMBS lenders have complained that their profit margins are being squeezed. In response, many of them are limiting their activity to more profitable targets such as specific property types or larger loans.

Some experts even suggest that servicing, not origination, is the only way to make money in this intensely competitive marketplace. “Servicing is very sought after because it's another way to make money,” Trebel says. “People aren't ignoring the opportunity that servicing creates.”

But Ken Griggs, an executive VP at Norris, Beggs & Simpson Finance, a Portland, Ore.-based mortgage bank that closed 65 loans totaling $520 million in 2005, and serviced $1.42 billion in loans, scoffs at the idea that lenders aren't making any money.

“Yes, margins have compressed, but to say that they're only making money off of servicing is just not true,” Griggs says. He adds that he recently talked to a colleague on the conduit side who said that his firm gets 1.5 percent on every pool today — roughly half as much margin achieved in 2005 — but still makes money off the deals.

Building business

Conduits, despite their reduced margins, continue to lead the market in originations for all property types, according to industry experts. That's why more lenders, specifically life insurance companies, are getting involved in construction lending in hopes of getting a piece of the permanent debt market back through construction-perm financing.

Construction-perm products combine two separate businesses, according to Frank Petz, senior director with CBRE/Melody. “The construction lending business is a lot more high-touch lending compared to perm deals,” he explains. Moreover, getting a construction loan through a bank and then getting a forward commitment from a perm lender actually consists of two different deals and closing that requires two sets of documents, appraisals, titles and legal fees.

Although most commercial banks cannot offer construction-perm financing because they don't like having long-term debt on their balance sheets, the business is ideal for the life companies because their robust balance sheets allow them to aggressively price permanent loans. “Life insurance companies are trying to stop the bleeding caused by the conduits, and they are trying to capture the perm loan by offering the construction loan,” says Adam Weissburg, partner in the Los Angeles office of Cox, Castle & Nicholson LLP.

State Farm, for example, rolled out its construction-perm financing program about a year ago and has closed about six loans totaling $90 million since. The insurance company partnered with State Farm Bank to provide the construction-perm product, Graves says, noting that the bank had grown large enough to enter into commercial lending. Together, the companies have a natural synergy, with the bank funding the construction loan and the life insurance company providing the perm loan.

Graves and other life company executives contend that their decision to offer construction-perm loans is more defensive than offensive. “Commercial banks are clearly the dominant construction lenders, so I don't think that they're losing sleep over this,” Graves says. He adds: “We're not spending a whole lot of time trying to take customers from the banks. We're trying to keep the customers that we have.”

Recently, State Farm closed its biggest construction-perm loan a $24.5 million construction loan and a $24.5 million perm loan for a 102,000-square-foot grocery-anchored center in Modesto, Calif. The center is 78 percent leased.

“There are more lenders offering [construction-perm financing] today than they did five years ago,” says Mark Burton, vice president of Indianapolis-based 40|86 Mortgage Capital, Inc., which rolled out its construction-perm program in 2000. As of mid-June, the lender has closed $150 million worth of construction-perm loans, which is roughly 50 percent of its total loan originations this year, Burton says. Five years ago, construction-perm loans accounted for just 25 percent of the company's volume.

“Construction-perm lending has really picked up because the yield curve is so flat and short-term rates at banks have increased more than our rates have,” Burton says.

Developers typically have turned to banks for construction loans because banks price construction loans off LIBOR. With construction loans in place, developers could then get forward commitments for the permanent loans from a life company.

But, LIBOR isn't as cheap today as it has been over the past several years. As of mid-June, the one-month LIBOR rate was 5.266 percent; just 24 months ago, it was 1.13 percent. For a while, developers were able to take advantage of the low rates and get construction loans that were cheaper than permanent debt. But that has now flipped back to historic norms. Today, an open-ended construction loan priced at LIBOR plus 250 basis points means a developer would be paying an interest rate of 6.5 percent — more than 120 basis points more than a perm loan. This creates an incentive for developers to lock in perm financing as quickly as possible, even before an asset has been stabilized, or even fully built out.

“The ability to lock in a construction loan and perm loan now is an advantage,” Griggs contends. He recently closed a loan with a shopping center developer who was set to get his construction loan from a bank, but got a better deal with a life company's construction-perm program.

Lenders are more than willing to oblige.

“With the rise of short-term interest rates, some lenders — ourselves included — are trying to put together construction-perm programs to take advantage of long-term rates,” Trebil says. Northmarq, which boasts a direct lending group, is working to nail down an agreement with one of the life companies for a construction-perm program. Northmarq would provide the construction money, while the life company would do the permanent loan.

Retail properties are strong candidates for construction-perm loans because a developer more likely has its revenue stream locked in through pre-leasing than through other product types. 40|86 Mortgage Capital requires 60 to 70 percent pre-leasing, which allows borrowers to lock in the same rate for both the construction and permanent loans.

“Usually these lenders want to see a break even pre-leasing hurdle to make sure that there is significant cash flow,” says Lucas Donahue, a loan officer with Johnson Capital, a Phoenix-based mortgage banking firm.

Out with the old, in with the IO

Even conservative lenders have acquiesced to borrower demands, including for risky interest-only (IO) loans.

“Almost everyone agrees that interest-only is a dumb idea, but the marketplace is very competitive, and the way to get customers is to do away with amortization,” says Jack Cohen, CEO of Cohen Financial, a Chicago-based mortgage banking firm. “The minute one guy says that he got one year of interest-only, the next guy will say that he got three years.”

Burton believes that the biggest change in lending over the past 12 months has been the length of interest-only terms borrowers are demanding. Although 40|86 Mortgage Capital says it is more willing to extend the IO period for a quality rent roll, the lender isn't comfortable with a lengthy IO period. “We lost a transaction where a Wall Street firm was offering a 10-year interest-only period,” Burton recalls. “It's hard for us to accept a loan that doesn't pay down any principal.”

Over the past six years, the percentage of securitized loans that feature an IO period has steadily and significantly increased, according to a research report by Wachovia Securities and Intex Solutions, Inc. Titled “Ee-I-Ee-IO: Everyone is Singing It,” the report found that in 2000, only 7.8 percent of securitized loans had IO periods. This year, 68.2 percent of securitized loans feature IO periods.

Moreover, the report found that the average IO period has increased dramatically over the past six years, to 38 months to from three months in 2000.

Indeed, lenders are pushing the credit envelope with long-term IO loans, notes John Cannon, executive vice president at CapMark Finance Inc., a Horsham, Pa.-based lender, servicer and mortgage banking firm (formerly GMAC Commercial Finance).

“It's an evolution,” he says. “A couple of years ago, we had no IO. Then we went to a couple of years of IO on lower leverage and now we're at 10-year IO and not necessarily for low leverage deals.”

Highly levered

Reed Hummel, managing director of the large loan CMBS unit for Wells Fargo, notes that the bank has done some 10-year interest-only loans.

“Generally speaking, we would rather not do IO loans, but the competition has taken us there,” he admits. And State Farm recently closed a 10-year IO loan that had an LTV ratio of 50 percent.

But the Wachovia and Intex Solutions report found that the average LTVs for IO loans aren't really that low, and they have been increasing since 2000. For example, in 2000, the average LTV for a loan with partial IO was 66.5 percent; today, the LTV for the same type of loan is 72.2 percent.

Borrowers like IO loans because they can get a higher yield versus amortization. Moreover, the incentive to accept a loan with amortization no longer exists, says Charles Schreiber, CEO of KBS Realty Advisors.

Without the discount (and faced with low cap rates), borrowers are clamoring for even longer IO periods. Nonetheless, many industry experts aren't concerned about the growing popularity of the financing structure.

“Even though interest-only loans aren't as safe as those with amortization, I don't think lenders are stupid because they're doing interest-only on higher quality assets with lower LTV,” Cohen notes. Moreover, he points out that the lenders that are originating IO loans are not planning to hold the loans for the long term. “Ultimately the risk is held by the bond buyers,” he says.

Schreiber, for his part, contends that while some investment advisors believe it's not “prudent” to have IO debt, he thinks it's just fine. “If I buy a $10-million building with $4 million of equity and I finance it with an interest-only loan, I can get a 7 percent return,” he explains. “That sounds pretty good to me.”

And what about concerns that the building may be worth less money in a few years? Schreiber says: “In that case, you shouldn't be buying it anyway.”

INTEREST ONLY CONCENTRATIONS BY SECURITIZATION YEAR

Year IO% Full-Term IO% Part-Term IO% Weighted Average IO Term (Mos.) Weighted Average Term to Maturity (Mos.) IO% of Term
2000 7.80% 1.20% 6.70% 3.00% 116 2.30%
2001 11.9 2.9 9 4 114 3.8
2002 11.1 2 9.1 3 112 3
2003 23.9 8.1 15.7 10 110 9
2004 43.7 14.1 29.7 18 107 16.8
2005 64.3 26.2 38.1 36 106 34.5
2006* 68.2 20.9 47.3 38 110 34.8
Source: Wachovia Securities and Intex Solutions Inc.
*2006 numbers year-to-date through first quarter

LTVS ON CONDUIT LOANS BY SECURITIZATION YEAR

2000 2001 2002 2003 2004 2005 2006
No IO 68.2 67.8 68.5 67.9 68.6 67.4 65.5
Partial IO 66.5 67.3 68.3 63.7 70 73 72.2
Full IO 52.2 47.8 52.5 57.2 60.1 65.1 61.1
All Loans 67.9 67.1 68.2 66.4 67.8 68.9 67.8
Source: Wachovia Securities and Intex Solutions, Inc.

Shrinking Pool

Mortgage banking M&A activity increases

In the commercial mortgage banking industry, bigger must be better. At least, that's what all the recent consolidation seems to be signaling. “The industry continues to consolidate with the big getting bigger,” acknowledges John Cannon, executive vice president at CapMark Finance Inc., which was GMAC Commercial Mortgage Corp. until March was when it acquired by Kohlberg Kravis Roberts & Co., Five Mile Capital Partners, and Goldman Sachs Capital Partners. “The small- and middle-market players are finding it difficult to compete against the larger operators.”

Over the past year, a number of lenders, finance REITS, mortgage banking shops and commercial banks have been acquired by larger firms or have merged into existing organizations to expand their presence within the industry. Wells Fargo & Co., for example, recently acquired Reilly Commercial Mortgage Group, a McLean, Va.-based multifamily specialist. The firm will become part of Wells Fargo Wholesale Banking's Specialized Financial Services Group.

And, just last month, specialty finance companies RAIT Investment Trust and Taberna Realty Finance Trust announced that they agreed to merge in a $606 million deal. Once the merger closes in fourth quarter 2006, Taberna, which provides long-term subordinated debt and trust-preferred securities, will become a subsidiary of RAIT and will operate under the name RAIT Financial Trust.

“The fight now is to acquire more origination channels,” explains Jack Cohen, CEO of Chicago-based mortgage banking shop Cohen Financial. “Most of the deals that have occurred recently are what I call channel acquisitions — they give lenders a way to reach more customers.”

Cohen Financial was recently acquired by FirstService Corp., an Ontario, Canada-based property services company that owns Colliers Macaulay Nicolls, one of the largest commercial brokerage firms in the world. “Our business is a distribution channel of capital for commercial real estate, and FirstService saw the synergy between us and Colliers,” Cohen says.
JP