While the real estate community ponders the impact of the rising cost of capital and flattening cap rates, lenders and borrowers appear unfazed. Commercial and multifamily mortgage debt outstanding in the first quarter of 2006 climbed to $2.7 trillion, up 3% from the fourth quarter of 2005. Lending sources invested $76 billion in mortgages during the first quarter alone.

Loan originations rose 34.2% in the first quarter of 2006 compared with the same period last year, according to the Mortgage Bankers Association. Three factors — the widespread availability of capital, relatively low interest rates and a robust property sales market — led to the soaring volume, says Jamie Woodwell, senior director of commercial and multifamily research at MBA.

“Property sales is one area where we are starting to see some decline in year- over-year volume,” Woodwell says, “but that's a decline over absolute record levels, so it's still strong activity.”

The hotel sector recorded the biggest gain in origination volume year over year (166%) followed by health care (123%) and retail (55%), reports MBA (see chart). Hotel owners and operators have benefited by strong demand from corporate and leisure travelers and a relatively limited amount of new room supply.

The availability of capital across all property types is, in fact, so large that it's forcing lenders to be highly aggressive and putting pressure on margins, says Norman Nichols, senior vice president at KeyBank Real Estate Capital.

Case in point: KeyBank is in the hunt to provide both a senior loan and a mezzanine loan for a new apartment development in Phoenix that would account for 90% of the capital in the multi-million-dollar project. “We think that in order to win that business, the mezzanine portion will have an all-in return of 13%. Two years ago, that deal would have returned 15% to 17% on the mezzanine portion,” says Nichols. KeyBank ranks No. 7 on NREI's list of Top 25 Direct Lenders with financing transactions totaling $22.2 billion in 2005.

Borrower strategies shift

While capital remains plentiful, higher interest rates and flat cap rates require real estate owners to be far more strategic today, says Thomas Melody, vice chairman of CBRE/Melody, the real estate investment banking division of CB Richard Ellis.

“We're spending a lot more time with owners who want to make more informed decisions on how to recapitalize their property.” CBRE/Melody ranks No. 3 on NREI's ranking of the Top 25 Financial Intermediaries. The mortgage banker arranged $18 billion in financing in 2005, up from $13.2 billion in 2004, a whopping 36% increase.

The decision of whether to sell, refinance or bring in a new capital partner isn't as clear-cut for owners as it was a few years ago when interest rates were at least 100 basis points lower than today and cap rates were falling.

“Back then, you would buy a property and hold it, then cap rates would go down and you would sell it, and everyone was a winner,” Melody recalls. “Investors who have bought properties the last couple of years can't just win by the market bailing them out,” Melody emphasizes.

The best opportunities for lenders and mortgage bankers today, Melody believes, can be found in properties that provide some upside potential to boost rents or occupancy.

Given the increasingly sophisticated investment landscape, CBRE/Melody is striving to become a financial advisor to owners as opposed to operating as a traditional mortgage banking shop, Melody says. CBRE Realty Finance, a mortgage REIT sponsored by Melody, was launched last year to originate and acquire a diversified portfolio of commercial real estate-related loans, structured debt securities and investments.

Short-term outlook

MBA anticipates that economic growth for the remainder of the year will remain steady. Real GDP is forecast to register 3.1% in the fourth quarter compared with a blazing 5.3% in the first quarter. MBA also forecasts the 10-year Treasury yield to finish the year at 5.2%. As of late June, the 10-year yield was already 5.22%, but MBA is holding firm on its prediction for now.

While Nichols of KeyBank acknowledges that rising interest rates will inevitably lead to higher cap rates and cool off a red-hot sales market, financing remains relatively inexpensive at the moment. “You can still get a lot of long-term, fixed-rate financing below 6.5%. I can see the economics of transactions starting to become more substantially affected when the financing starts to move over 7%.”

Matt Valley is editor of NREI.