Although the free flow of capital into the markets shows no signs of slowing, today's tributaries are fewer and more diverse than in the past. For now, at least, borrowers rule. Commercial real estate debt financing, continually fueled by the capital markets, has become increasingly competitive, making it easier for large and small owners of all kinds of property types to find capital from many different lending sources. Wall Street investment banks, commercial banks, credit companies, foreign banks and even some insurance companies are going after the lucrative opportunities that lie in originating loans for the commercial mortgage-backed securities (CMBS) market at a time when most of the country's commercial property markets have rebounded back to palatable performance levels.
Better yet for borrowers, they should have little trouble finding a speedy lender who can commit quickly, as many are anxious to create product for loan pools and meet conduit origination targets. And even better still, interest rates remain low.
In such a competitive environment, lenders may be more willing to stretch underwriting parameters and offera broader range of financial products to satisfy real estate owners' specific needs. Lenders may even be friendly and attentive, knowing that without exemplary customer service their prospective client can easily go down the street or to Wall Street and find funds awaiting them.
While the abundance of capital shows no immediate signs of disappearing, it may, however, come from fewer, though more diverse, sources. While the maturing CMBS market is still seeing some relative latecomers join the lending pack, survival of the fittest is forcing consolidation. Smaller, weaker entities are expected to continue to fall out, unable to meet the rigors of a volume-oriented business.
Conduits gain on investment banking While the world of CMBS remains dominated by Wall Street investment banks, it no longer is their exclusive domain. Among non-Wall Street conduit players who are "originating at a faster rate than in 1996 are Wells Fargo, GMAC Commercial Mortgage and Citicorp," according to Commercial Mortgage Alert, a weekly newsletter on real estate finance and securitization published in Hoboken, N.J.
Conduits have now become the dominate source of CMBS issuance, according to the newsletter, which reported that for the first half of 1997, "conduit transactions accounted for 58% of CMBS volume, up from 34% a year earlier and 12% in the same period of 1995." The newsletter also reported that first-half 1997 volume of conduit issuance of $9.4 billion is close to 1996's full-year total of $10.2 billion.
Besides taking a bigger share of the overall CMBS pie, conduits are more frequently finding a place for larger loans within their transactions. Conduit loan sizes typically range from $1 million to $15 million or $20 million, but Commercial Mortgage Alert reports that "rating agencies will usually give the green light to loans as large as 5% of a conduit transaction's total pool balance." Conduit deals this year from Nomura and Credit Suisse First Boston both included several loans of $25 million or more, according to the newsletter, which reported that these transactions are helping to "blur the line between traditional small-loan conduit deals and large-loan pooled transactions, which generally involve loans of $40 million or more to a relatively small number of borrowers."
The newsletter also reports that the large-loan deals, "which until now has been the sole province of Nomura's mega-deals, is about to expand," as Goldman Sachs, Lehman Brothers and Morgan Stanley are all working on large-loan transactions that will hit the market by the end of the year.
CMBS market continues growth In 1996, CMBS issuance reached approximately $31 billion, a record level that most in the industry expect to be topped this year.
"Because of their superior efficiency, the public markets have assumed a disproportionate, if not dominant, role in real estate finance," according to a recent Nomura Commercial Real Estate Quarterly, produced by David Jacob, managing director and director of research and CMBS structuring at Nomura, New York.
"With interest rates dropping to levels not seen since the first quarter of 1996, we expect a substantial increase in origination volume as borrowers hurry to lock in these low rates. We have revised our projection for CMBS issuance for 1997 to $32 billion," Nomura says.
CMBS issuance in the second quarter of 1997 was $9.2 billion, "the second-largest quarter since the inception of this market, surpassed only by the fourth quarter 1996 ($13.4 billion)," according to Nomura.
Some traditional lenders, primarily life insurance companies, have played a minor role in the real estate financing market since the downturn earlier this decade. But they have not disappeared. Many have changed the way in which they participate in lending, now favoring the securitization route over whole-loan/portfolio lending due to its many advantages in terms of liquidity, its requiring less overhead and staff, and its ability to provide a wider breadth of product with fewer limitations.
Nomura points out that "commercial mortgage-backed securities are at a premium to the value of the underlying whole loans," although that premium has declined by 2% to 3% in the last few years. The reason being "quite obviously the increased competition in originating commercial mortgages and securitizing them on Wall Street. One of the implications of the narrowed commercial mortgage premium is that traditional lenders who want to play the old-fashioned game of investing in whole loans have much less room to do so. Since it costs substantially more to originate and manage the whole-loan assets than typical management costs on the public side, only the most efficient originators can benefit by investing in whole loans relative to CMBS. And, of course, these efficient originators are the same ones who would likely use their capital more profitably by originating for the public market."
One of the biggest issues in real estate finance today is the gradual and general exodus of insurance companies from the real estate market, says M. Leanne Lachman, managing director at Schroder Real Estate Associates, New York.
"First, it was happening on the equity side and continuously on the mortgage side as well. Those insurance companies who are set up as stock companies are being more aggressive about it while those that are mutual companies are dragging their heels but, in the long run, insurance companies will not be significant real estate players," she says.
Yet she is not talking about CMBS, because she points out that in terms of risk-based capital, a CMBS is not real estate but a rated bond, which insurance companies are eating up as "voracious buyers," having switched from being originators to being "devourers of securitized product," she says.
Lachman says she doubts that CMBS is the most cost-effective financing methodology "because it wasn't needed years ago." But now it is. "There is not enough origination money with insurance companies out of the market," she adds.
The commercial real estate financing market is going the way of the residential market in more frequently relying on a capital markets approach. "By the year 2000, about 20% of the commercial market will be securitized," Lachman predicts. This represents approximately $200 billion in assets, she says, which "could be an understatement."
Lachman mentions three reasons why she believes that, over time, insurance companies will stop originating loans and be content to function only as CMBS buyers. First are the risk-based capital requirements imposed by the National Association of Insurance Commissioners (NAIC), "which have taken insurance companies a while to understand in terms of how they work and how they must put up significant reserves, which means the need for high returns that real estate does not provide." A second factor is that "rating agencies hate real estate," she says. Rating agencies demand that insurance companies must have a high rating to sell their insurance products, Lachman says, and if real estate investment brings it down, the life companies simply won't invest in it. The third reason involves life companies' boards of directors, who "think life is too short to jeopardize the rating and say, 'If the rating agencies are going to be this absolute, let's not risk it.'"
All of this is why "a huge chunk of money is leaving the mortgage market," Lachman says. "Banks and other conduits are stepping in to fill the void."
The downside of new lenders While securitization is purring along quite nicely -- thanks to currently strong real estate fundamentals -- there is some risk attached to the fact that new people, who may not yet have experienced a downcycle in their careers, are making the mortgage loans, Lachman says.
Lachman says she sees another risk coming from some conduit lenders passing loans on to securitizers and not having to live with the loans they originate. They can therefore be more cavalier in terms of what they lend against. "At the moment, it is not a problem because of the place of the cycle and because of good loan-to-value and underwriting standards," she says. "But if the market heats up a bit, there is a good chance of seeing irresponsible lending. Perhaps the key will be to see if rating agencies really understand real estate," Lachman says.
Securitized lenders counter by pointing out that it is portfolio lenders who historically could be more careless because they had fewer people looking over their shoulders and could therefore more easily stick loans in files and forget about them. Lenders' reputations weren't as publicly on the line as they are now that CMBS results are more quickly analyzed on the bond market.
Lachman mentions another market risk coming from the dominance of large volume securitized loan pools, which could mean that rating agencies and buyers are not paying as much attention to each underlying loan and asset.
Lachman questions, too, whether there is not an investment bank mentality that believes CMBS "is just another product, and they don't care about the underpinning. It is just another bond, and the asset backing it could be car leases as opposed to real estate."
There is a blurring of designations between commercial and investment banks and a continually broader source of origination of CMBS, Lachman says. European banks are being more aggressively active in the market here than domestic banks, "many of whom were badly burned in the last downcycle and still have memories." Those U.S. banks who spent the early part of the decade doing clean-up work on defaults in their portfolios are probably overcautious, she says. European banks, on the other hand, have spotted the uptick in U.S. markets, have a natural interest in investing and are taking over and getting a head start on many U.S. banks, she says.
Some insurance firms stay in the game Despite the risks, the heightened competition and the general disappearance of many insurance companies from lending, one stalwart source intends to be in the market for good.
In August, Prudential Insurance Co. of America, Newark, N.J., created a wholly owned subsidiary: Prudential Mortgage Capital Co. LLC, the first capital markets initiative by the huge real estate lender, who had up until now functioned only on a portfolio basis.
The new company will consist of a securitization conduit for the origination of commercial real estate loans from $1 million to $20 million that may extend outside the types of loans (less than institutional quality) that would be appropriate for its general account. In addition to the conduit, Prudential Mortgage Capital will administer a large loan program for transactions larger than those handled by the conduit.
Clay Lebhar, formerly a managing director in Prudential Securities' Investment Banking Group, is president and chief executive officer of the new company. Lebhar says he expects the conduit program to generate approximately $1 billion in loans by the end of 1998 and between $500 million and $1 billion for the large loan program.
Lebhar will report to Matthew Chanin, senior managing director in charge of The Prudential Capital Group, Pru's $50 billion private placement investment unit. Chanin calls the move "a reaffirmation of Prudential's substantial commitment to the commercial mortgage sector, as well as a recognition of the rapidly growing role of the public capital markets in this sector."
The new formation follows Pru's disclosure late last year that it would sharply reduce its direct property holdings over the next three years, while at the same time pursuing more liquid and high-yielding investment opportunities in REITs, real estate operating companies, participating debt and other vehicles on behalf of both its general account and its institutional clients.
Pru officials report that they expect to double the firm's annual origination volume from $2 billion to $4 billion once the conduit is fully operational. The increase would be split between Pru's direct origination activity and loans originated by its nationwide network of PruExpress commercial mortgage loan affiliates, 12 advisory mortgage brokerage firms who feed the Pru network.
Lebhar admits that Pru is entering an extraordinarily competitive conduit market. "There are a lot of conduits out there, but few from life companies," he says. "The largest life companies are evaluating the appropriate strategic adjustment to a vastly changed and largely capital markets-driven arena. Small- and medium-sized life companies are determining whether or not they want to be or should be direct portfolio lenders or instead participate as CMBS investors," he says.
The new conduit marks a broadening of product line for Pru, which has long had the experience and infrastructure in place for loan origination, but can now offer borrowers the advantages of a conduit loan. "We want Prudential to capture more business, whether in the portfolio or the conduit. We want to loan on not everything, but nearly everything -- from A to T," he says. That means a broad array of nearly all widely recognized commercial property types.
Lebhar says he believes one of the important keys to success for the new conduit comes from PruExpress. "Having that affiliated quasi-dedicated network is something only a few conduits have," he says. Another big strength is the obvious affiliation with Prudential Securities, which has been active in CMBS business and who Lebhar says he sees as a "very strong 'partner' to help us get the business off the ground."
"Prudential has a long-term strategic commitment to get into this business and the wherewithal to stay with the game plan during what is bound to be a challenging market environment over the next few years," Lebhar says. "I believe we will be one of the major players and one of the long-term winners when the dust settles."
That may not be the case for all the participants in the market today. "Because of the ownership and structure of some conduits, one could make a reasonable bet that they won't make it through the next few years," Lebhar says. "It is a high-volume, low-margin business, and you have to operate in very large scale, originating billions of dollars a year for it to make sense as well as to be efficient."
Lebhar also stresses the importance of borrower relations as an integral part of successful lenders today. "We are committed to developing a user-friendly product and have reliability and consistency in the marketplace in conjunction with competitive pricing," he says, mentioning that he is aware of "conduit horror stories," in which disconcerted borrowers had a difficult time getting a loan. "Having borrowers' trust is very important in this competitive business," he adds.
Prudential Securities will serve as investment banking adviser and underwriter and handle the execution of the CMBS in the bond market, while Prudential Mortgage Capital Co. will "originate, price, underwrite, fund, help manage the pipeline and jointly manage warehousing with the help of Prudential Securities," Lebhar says, adding that Pru will handle servicing temporarily during the warehouse period, but then intends to sell off that business.
Capital markets create new product Another new program on the CMBS scene comes from the real estate capital market wing of a commercial bank and further opens the securitization process to construction loans.
First Union Capital Markets, a part of Charlotte, N.C.-based First Union Corp., has launched a new institutional-quality, Class-A loan warehousing program for short-term construction loans, according to Mike Greco, senior vice president and managing director of the Capital Markets Group.
Traditionally, First Union has provided short-term construction loans for Class-A properties but placed the permanent loans with insurance companies and other institutional investors, a practice it intends to continue. But the new program will allow it the capability of securitizing the loans in First Union's existing commercial loan conduit and distribute them through First Union Capital Markets Corp. Greco explains that it is easier for a bank than Wall Street to warehouse such loans. "It is a good bank/capital markets fit in that we are comfortable not selling the construction loan but holding it for three to six months once the project is completed," Greco says. "We still use the capital markets for an exit and have the intention to sell the loans. We will handle the servicing in all cases."
The program is a customer service-driven expansion of First Union's mortgage lending business, Greco says. The bank created a conduit in June 1994 which was designed to make off-the-balance-sheet loan products available to its customer base. Greco says that more than 70% of First Union's total commercial mortgage lending has been through the conduit, which Greco says is expected to generate $1.4 billion in loans this year. "But we were missing construction loans, so in the last six months we developed a way to offer this in addition to the regular conduit," he adds. "It is a vehicle to accommodate Class-A institutional developers and owners."
The new program will offer various types of commercial mortgages, including immediate funding fixed-rate permanent loans, forward fixed-rate permanent loans and construction/permanent combination loans. The loans will be originated from First Union's East Coast franchise and through three new Real Estate Capital Markets offices in Houston, Chicago and Irvine, Calif., which opened earlier this year. Three additional offices are expected to be open next year, Greco says.
First Union has originated more than $2 billion in securitized commercial loans in the last three years. Its Real Estate Capital Markets Group was formed earlier this year as part of the bank's expanded focus on commercial real estate finance. Besides the commercial conduit operations, the group provides credit tenant lease finance, REIT lending, affordable housing debt and equity finance and off-balance-sheet lending products for corporate real estate clients.
Changes take place in the industry Product lines are expanding for most lenders, Greco says, driven largely by the need to provide a one-stop shopping capability for the borrower. This, in some cases, takes the form of banks working in conjunction with insurance companies, i.e. banks may offer construction loans in affiliation with an insurance company who will do the take-out financing, which banks traditionally avoid.
Underwriting and origination alliances are also being formed because, besides providing increased volume, they also delight CMBS buyers, who generally prefer team transactions. "They like bigger deals and like that there are two entities making a market in their bonds," Greco says. Team deals can also result in more geographical diversification, which generally pleases rating agencies and investors and are cheaper to execute, with two firms splitting the expenses. "It makes a heck of a lot more sense to do bigger deals with a partner," Greco says, mentioning that First Union has worked on securitizations with Wall Street investment banks including Lehman Brothers, Merrill Lynch and Credit Suisse First Boston. "Nothing on the horizon makes us want to stop that," he says. "It can always be successful as long as everyone leaves their ego at the door."
The CMBS market is seeing a great deal of competition for new product types and services, Greco says. "Bridge funds, mezzanine financing and equity funds have been added to the CMBS product mix," he adds. All of this forces lenders to "stay ahead of the curve," he says. First Union's major competition is from credit companies and insurance companies, he adds.
Compressed pricing has reached the point where insurance companies and conduits are offering the same price in the multifamily market, Greco says, which is one reason why insurance companies are creating conduits. "The circles are no longer a foot apart," he adds. "It is now a partial eclipse coming together, and the conduit market is merging with the traditional lending market."
All of the competition brings pressure to maintain underwriting standards. Rating agencies and CMBS buyers are busy re-analyzing parameters and players. "The discipline is there," Greco says. The market is maturing to the point that "those who are doing a good job will be pointed to. There is finally some brand identity that is beginning to occur. B-piece buyers know who they (reputable, disciplined lenders) are and will stand in line for some deal but won't touch others," he says.
Commercial Mortgage Alert points out that the rising share of conduit volume is "providing a crucial element that had been absent from the market: repeat issuance."
Lending boundaries for securitized loans have not ventured outside what Greco calls "the true underwriting box." But, he admits, benchmarks are heading to the edge of that box.
"I haven't seen a slackening in underwriting," Greco says. "There is a bit higher loan-to-value (LTV) ratios, but nothing beyond 85% and no debt service coverage ratio (DSCR) of less than 1.0." Amortization periods may be stretching up to 30 years, "but no one has gone through the box at 35 years," he adds. "It's more a question of pricing and underwriting risk appropriately."
Greco says he believes that if interest rates "continue in the mid-sixes," CMBS will see a record year, perhaps as much as $35 billion in new issuance, he says, the limit depending largely on "how much rating agencies and investors can handle."
While life companies and money managers continue to be major buyers, Greco says that many life companies are saying that the price of CMBS is so close to corporate bonds that they are not buying as much as they were. Banks and mortgage REITs, however, have increased their appetite for CMBS since the early 1990s.
Stacey Berger, executive vice president in the Washington office of Kansas City, Mo.-based Midland Loan Services L.P., one of the largest servicers of CMBS portfolios, agrees with Lachman that the consolidation trend in the commercial lending arena is very similar to what has happened in the residential lending industry over a longer period of time.
The same events that took place in the residential field in the 1960s are happening in the commercial sector as "local producers are originating product and larger national players are pooling, purchasing and securitizing," he says.
Portfolio volumes increase The maturation of the market is making volume an important issue to servicers as well as originators. "Five or six years ago a $5 billion portfolio was huge," Berger says. "Today, there are three or four $20 billion servicers. In three or four more years or less, we will see $50 billion servicers. The reasons are economics and that there is only a marginal cost involved in adding new loans once a servicer has an infrastructure in place. The barriers of entry are now very high."
Earlier this year, Midland announced the formation of a strategic alliance with NationsBank, Charlotte, N.C., in which the two firms would jointly securitize commercial mortgages originated by each party. Midland reports that in 1996 it originated or acquired and securitized $883 million in commercial and multifamily loans, while NationsBank, through its capital markets subsidiary NationsBank Capital Markets Inc., issued $997 million in securities. NationsBank acquired a 5% equity interest in Midland in conjunction with the alliance, and Midland acquired the servicing rights to a large NationsBank mortgage portfolio, with principal balances of approximately $4.2 billion.
Competition at the origination level of the CMBS business is "clearly pushing underwriting standards to the limit," Berger says, adding that 75% to 80% is still the norm for LTV. "The rating agencies are the market arbiters in the sense that you can't push beyond their standards without getting a hair cut. It's a question of the magnitude of the haircut," he adds.
While Berger says he has seen a definite increase in amortization periods, with "tremendous pressure to push out to 30 years on virtually everything," he does not believe that doing so will have much of an influence on increasing default levels. "If you look at the difference between 25-year and 30-year amortization schedules, the effect is not really significant," he says. "Rating agencies are not giving significant credit to amortization periods, so people are pushing it as far as they can."
Nomura Credit Suisse First Boston Lehman Brothers First Union Heller Financial
Source: Commercial Mortgage Alert
James B. Frantz is a New York-based business writer specializing in commercial real estate.