In July, the acting U.S. Comptroller of the Currency, Julie Williams, expressed concern about national banks' drift toward making subprime and high loan-to-value loans. Such practices, she said, would lead to risky underwriting and "cutthroat, lowest-common-denominator lending."

The comments, made at a risk-management conference in Washington, preceded release of a report by the U.S. General Accounting Office criticizing the lending industry's underwriting standards in regard to commercial loans being made at an LTV of 125%.

Separately, the Deputy Comptroller of the Currency for the western region, John Robinson, warned that underwriters sometimes appeared to be accepting overly optimistic projections of a prop- erty's future income. Speaking at the Western Secondary Market and Lending Conference in San Francisco, he called the situation in commercial lending "a consistent and depressing picture." He said too much money chasing deals and an overleveraged syndicated loan market have the potential to undermine the "safety and soundness" of the overall lending market.

Earlier, the Division of Banking Supervision of the Board of Governors of the Federal Reserve System issued a supervisory letter cautioning banks not to base loans on the assumption the economy will remain robust. While the letter acknowledged that no downturn is in sight, it cautioned banks to keep the possibility in mind. Good underwriting, it reminded, assumes that a downturn could occur at any time.

These are only a few of the warnings about commercial lending sounded since the beginning of the year. The question is, do the warnings reflect a genuine problem or are they simply cautionary jolts to keep lenders on their toes and ensure against a repeat of the last real estate meltdown?

Borrowers reaping the bounty The attitude among retail lenders and investors is divided. There are no outright Cassandras prophesying imminent doom, but a significant number believe at least some major lenders need to tighten their practices.

Strong criticism comes from Bruce Kaplan, president of Northern Realty Group, a retail leasing, consulting and development firm in Chicago. He considers another real estate nose-dive a real possibility, though probably not soon.

"I think lenders are being too aggressive in terms of some of their underwriting standards. It feels like the late '80s," he says. "Right now, everything is peaches and cream. But I'll tell you this, I'm not putting my kids' college funds into REITs."

Not all critics see lax underwriting as the major issue in today's lending market, however. Thin spreads, high LTVs and poor servicing are cited as equal concerns.

Analysts attribute whatever problems exist to the intense competition among lenders for deals to lend money on. The commodification of real estate via REITs and the securitization of mortgages have produced a flood of capital into the market.

The ready availability of capital has created a borrower's market, and borrowers are, understandably, reaping the bounty while the bounty is there to be reaped.

Kenneth Bernstein, president of New York-based Acadia Realty Trust, thinks some of them might be fooling themselves. "I believe with respect to the fixed-rate, secured loan market that neither the borrowers nor perhaps the bond holders truly appreciate what they've gotten themselves into," he says.

Acadia, a $600 million REIT formed after the recently completed merger between RD Capital Inc. and Mark Centers Trust, often finds itself among the borrowers and obviously benefits from the availability of funds, but Bernstein nonetheless is concerned.

"There's no doubt that there's a tremendous amount of debt in the marketplace looking for a place to go," he says. "That can often result in huge pressure for lenders to make loans. The pressure results in either aggressive pricing, aggressive LTVs or lax underwriting."

Underwriting too lax? While some observers acknowledge the potential for problems due to lax underwriting, few regard the situation as critical at this point. Some maintain underwriting standards in general have not slipped.

"In our shop, if anything we are tightening up on underwriting. We are taking TIs and lease commissions into account and doing an analysis of rollover risk," says Ernie Iriarte, a director for Finova Realty Capital in Irvine, Calif.

At the same time, he notes, not all lenders are taking equivalent care. "Some lenders are doing off-the-wall financing. We can't understand how they're able to market or sell their loans. They're taking no reserves yet still trying to sell loans on a securitized basis," he remarks, adding, "We don't think they'll be around too long."

Failure to take the need for reserves into account seems to be the single biggest shortcoming of underwriting today, observers agree. Few lenders even require them, says Bernstein. "No lenders have been able to be competitive while requiring reserves for reanchoring," he asserts.

Finova clearly believes it can remain competitive despite requiring reserves. According to Iriarte, it impounds from 25 to 65 cents per sq. ft. per year to cover tenant improvements and leasing commissions needed to attract replacement tenants and pay for unforeseen problems.

The mistake some lenders make, says Tim Hawthorne, a regional director in Finova's Irvine headquarters, is to underestimate the potential for credit tenants to go under.

"There are those who question whether those being underwritten as credit tenants really are," he says. "Some apparently sound retailers have fallen very quickly."

Overly optimistic projections about future income streams can also be a problem. Using today's rosy economy as the basis for tomorrow's returns is a serious error, says Richard Kaplan, president of Syndicated Equities Corp., a net lease lender in Chicago.

"We've had several years of increasing rents and returns. It becomes dangerous when you project out several years based on these same rates. The likelihood of having some kind of downturn is high, and you need to take this into account," he says.

Spreads, LTVs, pricing In the opinion of several commentators, the combination of too low spreads and too high LTVs is more common than lax underwriting.

Spreads dropped to near historic lows this spring, says Robert Schneiderman, executive vice president of Parallel Capital Corp., a New York-based conduit lender. Spreads of a little more than 1 basis pointover 6-month Treasury bills are not uncommon, and Schneiderman admits that his company has been "cutting spreads to the bone."

While this has some people worried, Robert Schonefeld, CEO of Bridger Commercial Funding, a Mill Valley, Calif.-based firm that acts as an intermediary between banks and the CMBS market, insists low spreads are positive rather than negative.

"Low spreads also result in a lower mortgage payment, which allows the borrower to service the debt more easily," he says. "In my mind, low spreads are the result of a more efficient capital market, not risky lending practices."

In any case, spreads appear to be growing. "Spreads are widening due to the risk bond buyers are willing to take. They're saying they don't feel comfortable with the spreads we've been seeing," says Hawthorne.

As for LTVs, Schneiderman says Parallel has done numerous loans at LTVs of 80. He mentions the company recently introduced new mezzanine loan programs that will allow LTVs "well past 80%."

Bart Tabor, Northern California manager in the San Francisco office of Houston-based L.J. Melody & Co., reports that 75% is the standard at his company but Melody has gone higher. Some lenders have gone above 80%, he adds.

Another area of concern is rising prices. Virtually everyone interviewed agrees the flood of capital has driven prices up, sometimes dramatically. Not everyone is confident that today's high prices are justified.

Jay R. Lerner, president of The Lerner Co., a shopping center development and retail brokerage firm in Omaha, points out that higher acquisition costs will ultimately result in higher rents. Existing leases, of course, will not be affected, but new ones will.

He questions whether landlords will be able to pressure anchor tenants into paying the higher rents needed to service the debt. He further questions whether retailers who sign at substantially higher rents will be able to increase sales sufficiently to cover the bump-up.

"Suddenly they're paying $19 per sq. ft. in areas where they've been paying $14 per sq. ft. I assume they recognize the impact. Time will tell," he says.

What particularly gives him pause, he adds, is the way some retailers appear to be taking sites to keep competitors out of a market rather than because the market justifies it.

"Sometimes they already have market saturation, so adding another store can only dilute sales at each location. Yet the rent is substantially higher at the new store. How can they pay and still make a profit?" he asks.

Poor servicing Whether lenders are too lax or not, the development of the CMBS market has created a serious problem for borrowers. According to Iriarte, more and more loans are being sold by their originators on the secondary market. "Lenders typically hold loans only 90 to 120 days before they securitize them," he says.

As a result, when borrowers face a difficult situation, they discover they cannot go to the original lender for help. Unfortunately, some say, conduits provide minimal servicing of loans they have bought.

"The servicing in today's conduit world is really a payment collection and a billing service. There are accounts that need more than that," says Dave Rogers, also a partner with Finova in Irvine. Rogers says Finova continues to assist the borrower even after the loan is sold, but he calls the firm the exception rather than the rule.

According to Bernstein, the shortcoming in service is especially evident with secured loans. "The ability for a borrower to navigate through an unforeseen problem in the future is much more difficult in the context of a secured loan. The way the (conduits') services are currently staffed, there's virtually no one to talk to to work through any significant issue," he says.

Bernstein uses Acadia's recent merger as an example. "The process we went through to get simple lender consents with respect to increasing the equity of our company was more difficult than closing the loans in the first place," he says. "If we're having a hard time during a positive transaction, I pity the people who are involved in difficult situations."

Rogers says getting approval even for simple actions can be difficult. "We've had borrowers tell us they had an anchor that wanted to expand - at the anchor's own cost - and they couldn't get anyone to approve it as the loan required. So they did it without approval," he says.

Role of REITs Not surprisingly, REITs seem to get most of the blame for pushing prices up. Many question whether the prices being paid are justified.

"Something's got to give on the REITs," asserts Bruce Kaplan. "Prices have spiraled so high that rents are going to have go higher and higher. If we get a slowdown in the economy, suddenly these REITs are going to be sitting with unrentable space or rents so low they can't pay their debt. It appears to be very tenuous."

Schonefeld defends the REITs, calling their willingness to pay high prices a response to the strong economy. "REITs have capital to deploy as equity. I don't see that it necessarily means they're paying too much," he argues.

"What they're really buying is a yield, and if they're willing to buy at an 8% cap, while their competitor is asking 8.5%, it means they believe the yield will satisfy their investors."

Actually, REITs themselves appear to be pulling back. Poor returns have prompted many of them to reassess their strategies.

According to the National Association of Real Estate Investment Trusts in Washington, D.C., all four retail REIT categories - regional mall, strip center, single-tenant and specialty - registered average returns of negative 3 to 4% for the first quarter.

"With the stock market treating REITs rather badly, they're not able to go back into the capital market for equity. Right now the prevailing wisdom is REITs ought not to have more than 42 or 43% debt-to-capital ratio," says Lewis Sandler, president and CEO of United Investors Realty Trust in Houston.

"If you're capped out, you're going to have a hard time raising additional capital and a hard time buying properties."

As a result, the market is in a state of flux. "It's been overheated and it's starting to ease up a bit," he says. "But there's a lag time. It's going to take six months before sellers realize they have to bring their prices down."

Like Schonefeld, Sandler does not believe lenders have been lax on REITs. "The Wall Street Journal and the government indicate some concerns about lenders putting too much money out to the REIT community," he says.

"I don't know that I'd agree with that. If you look at how much lenders have put out to REITs compared to five years ago, it looks like a lot. But that's comparing apples to oranges: There are far more REITs today, so of course there's going to be more money loaned to them."

Whatever problems may or may not have occurred, most, though by no means all, observers believe the market is correcting itself.

As Hawthorne puts it, "What we're going to see is that the market is going to keep itself in check. We don't think the lending abuses that have taken place are going to tank the market. You're just going to have some players that won't make it."

Borrowers, he emphasizes, have little to fear from this. "We don't think they'll have any problem," he says. "If their loans get bought at loss, all the better for them because the new owner of the loan can be more flexible about laying out for improvements."

Performance Tests, Carve-outs Create Headaches for Borrower Over the past five to 10 years, loan documents have become increasingly complex. Even large loans used to require only a deed of trust, promissory note, assignment of leases and a few other pieces of information.

But that has completely changed since the real estate downturn earlier in the decade, according to Richard Kale, a partner with Greenberg Glusker Fields Claman & Machtinger, Los Angeles.

"Loan documents today contain many more loan covenants and ongoing performance tests that need to be met in order for the loan to remain in good standing," he says. "Documents can run on and on."

Lenders exercise leverage Performance tests are probably the most disputed elements. The tests work by establishing specific dates by which a property must meet predetermined standards or thresholds.

What makes the tests controversial, says Kale, is that failure to meet the standard or threshold by the specified date technically constitutes default.

"Previously, default meant monetary default. As long as the borrower made timely payments, the loan was good," Kale explains. Today, however, a long list of nonmonetary matters can also trigger default.

Kale points to debt-coverage ratios, leasing thresholds and predetermined net worth as examples of typical performance tests written into today's loans. Lenders may insert any number of such criteria into a loan.

>From the lender's standpoint, says Kale, the tests make sense. "It creates >a situation where the lender has leverage to bring the borrower back to >the table. The idea is that the lender can force the borrower to correct a >problem before a monetary default occurs," he explains.

Up to now, Kale says, the tests have not been problematic, apart from the additional time and effort needed to put the loan document together. As far as he knows, no lender has forced a borrower to default under the new criteria. He attributes that to the good economy.

"We haven't seen what effect this will have in a downturn," he cautions.

Some observers are questioning whether default for nonmonetary reason is legal. Because no lender has attempted it, the courts have had no reason to rule.

Stipulations on nonrecourse Another significant divergence from past lending practices is that lenders are making exceptions to the nonrecourse nature of their loans.

"Previously, the only exceptions related to things like fraud, misappropriation or environmental problems," Kale says. "Now, the list of exceptions - what we call carve-outs - has been growing. The last loan I worked on, there were 27 exceptions in the first draft. It went on for pages. In the past, it took one paragraph."

The carve-outs in the loan mentioned above were so extensive, Kale says, that "when you took them all together, it sounded a lot like the loan was a full recourse."