According to the normal rhythms of the real estate industry, the first years of this decade should have been a slow period for lenders. This should have been a trough — the low point of the business cycle between a huge wave of underwritings during the mid- to late-1990s and the refinancings that would naturally occur a decade later.

To the delight of the mortgage industry, it hasn't worked out that way: 2003 brought a record year in U.S. commercial real estate lending, with originations hitting $116 billion, the first time originations topped $100 billion and a huge, 34% jump from the $86.4 billion reported for all of 2002.

And, according to the Mortgage Bankers Association, when all the deals are counted, 2004 could surpass the 2003 record. Through September, originations tallied $88.2 billion, up from $78.1 billion for the first nine months of 2003. The third quarter was particularly productive — MBA members originated $34.1 billion in loans, a 15.2% jump over the same period a year earlier.

“Under normal circumstances, these years would have been much slower for us,” says Ross Berman, president and CEO of Chicago-based iCap Realty Advisors. Instead, the company saw loan originations jump by 28% in 2003 to $3.6 billion and was on track to slightly exceed that amount in 2004.

Robert Feller, CEO of GMAC Commercial Mortgage Corp., is equally surprised that a lending trough never materialized following the real estate boom of the late 1990s. “The level of volume that has occurred in 2004 would not have been forecast based on loan servicing,” Feller says, referring to the number of loans reaching maturity and in need of new financing. GMAC Commercial Mortgage's total origination volume for 2004 was expected to surpass $20 billion, similar to 2003. Feller predicts the company's originations will increase 10% in 2005.

Market Drivers

What's behind this happy anomaly? There are several reasons, not all of which are related to low interest rates that continue to be a borrower's best friend. Most important, capital continues to pour into commercial real estate, which is looked upon as a favorable alternative to other fixed-return investments.

“Real estate has really outperformed across the board,” says Mary O'Rourke, senior director of New York-based Fitch Ratings. “It has performed better than the stock market, and real estate bonds have performed better than corporate bonds, for example.” A recent Fitch study found commercial mortgage-backed securities from 1990-2003 had an overall cumulative default rate of only 0.2%, compared with an 11% default rate for corporate bonds during the same period.

The feverish pace of investment sales activity also is helping boost loan originations. The estimated value of sales transactions in 2004 ranged between $160 billion and $170 billion, an increase of more than 30% over the $120 billion recorded in 2003, according to Real Capital Analytics, which tracks deals $5 million and higher.

That sales momentum is expected to continue in 2005. “At least the beginning of the year is going to start off with a bang,” forecasts Bob White, president of Real Capital Analytics. Indeed, mortgage bankers anticipate that a sizable chunk of their business in 2005 will stem from property purchases. Acquisitions and new development accounted for 25% of NorthMarq Capital's mortgage banking business over the past two years, says CEO Ed Padilla, who anticipates that activity to account for fully one-third of the Bloomington, Minn.-based firm's origination volume in 2005.

Another boon to the loan origination business: A slew of loans made in the 1990s are reaching maturity. Mortgage bankers expect a cycle of refinancings to begin in late 2005 and peak in 2007 and 2008. Many borrowers are still sitting on 10-year loans that, in some cases, carry interest rates that are twice as high as today's rates.

Why haven't those borrowers already refinanced? The pre-payment penalties can be costly. “The make-whole provisions in these loans are very prohibitive,” says John Pelusi Jr., executive managing director of Holliday Fenoglio Fowler in Pittsburgh. Holliday Fenoglio Fowler's records show interest rates on 10-year loans averaged 8.17% in 1997 and 7.56% in 1998, compared with a current rate of 6.66%.

While that bubble of maturing loans coming due won't occur until 2007, Pelusi believes that some pension funds and life insurance companies are eager to retain the better loans in their portfolios. Consequently, these lenders may offer to refinance the loans early, extending discounts on the prepayment penalties or rolling the make-whole payments into a new loan.

Impact of Rising Rates

The Federal Reserve continues to raise short-term rates to ward off inflation. In mid-December, for example, the Fed raised the fed funds rate a quarter-percentage point to 2.25%. So, what's the impact on loan originations? “We do think the (high) volume will continue as it is,” Fitch's O'Rourke says. “The CMBS sector's ability to attract capital and competition for both debt and equity product will likely be undeterred by interest-rate hikes so long as they do not increase dramatically.” The 10-year Treasury yield hovered around 4.2% in mid-December, which is still quite low by historical standards.

As the Fed's rate hikes continue, lenders expect the spread between long- and short-term rates to flatten. This will encourage borrowers to swap floating-rate, short-term debt for fixed-rate, long-term financing, experts say.

NorthMarq Capital projects that short-term rates will increase by at least 100 basis points over the next 12 months, which should open the floodgates for borrowers with floating rates to seek fixed-rate financing.

“We're going to be looking this year at all-time record profits,” predicts Padilla. “Everyone that we've talked to is looking for more commercial mortgage opportunities.” Business is already brisk for NorthMarq. The firm's originations rose to $9 billion in 2004, up from $7.5 billion in 2003. Padilla forecasts that in 2005 volume will top $10 billion, an 11% increase.

Overheated Market?

The intense competition to place loans is squeezing lenders' profit margins. Additionally, mortgage bankers are under pressure to charge lower service fees. The bottom line is that mortgage banking is increasingly becoming a high-volume, low-margin business.

Industry observers worry that the surge in loan volume could lead to lax underwriting standards. Purchase prices continue to rise even as fundamentals, particularly in the office market, remain weak. Relaxed underwriting standards could set the industry up for a rash of defaults, if the economy falters.

That doesn't appear to be an imminent problem, however. The CMBS loan delinquency rate of 1.29% in October 2004 marked the lowest delinquency rate in a year. “The increased competition has invited some lessening of (underwriting) standards,” explains Fitch Ratings' Senior Director Mary O'Rourke, “but those kinds of increased risks that might be there in underwriting have in fact been taken into account in our ratings.”

Standard & Poor's in November cited lax lending standards as a danger for CMBS debt holders. “A lot of the reason for the deterioration is competition,” says Kim Diamond, a managing director in S&P's Global Real Estate Finance Group. “Standards are being relaxed not only to compete against their peers in the CMBS industry, but also to compete against non-securitization lenders.”

Leslie Lundin, senior vice president of Inland Mortgage Corp., says lenders on retail projects sometimes provide long-term financing based solely on signed leases, rather than waiting for tenants to move in. On apartment deals, some lenders have provided loans based on initial leasing trends, rather than occupancy.

S&P's Diamond also has encountered some eyebrow-raising practices. Some loans have been made against the speculative value of a property, which may never be realized. Lenders have also lowered requirements for funded reserves, or cash management systems to safeguard their deals. And, she says, there is an increasing volume of interest-only loans, which creates a heightened risk if interest rates are not favorable when the balloon financing is required.

“It's not endemic or widespread at this point, but we need to monitor the situation to make sure it doesn't become a broader trend,” Diamond says. “If it continues in this vein, it's not headed in a positive direction.”

Optimism Reigns

Overall, however, mortgage bankers and lenders say the positives in 2005 outweigh the negatives. Most reason that interest rates have been so low that there is room for gradual increases without severely crimping lending volumes. The flattening yield curve suggests that intermediate- and long-term interest rates will remain comfortably low for those borrowers seeking a conversion to long-term, fixed-rate debt.

“By any historical standard, a 10-year loan at a 4.2% rate is very attractive for a borrower,” says Feller of GMAC Commercial. “In my lifetime, this is as good as it gets other than a brief period last year when it was in the 3s.”

Certainly, rising rates can trigger that other cyclical phenomenon — rising defaults. But as Feller points out, the Fed has been raising rates in response to an improving economy, which ultimately should help to improve real estate fundamentals. “As long as the economy is improving, at least the loans we've originated are going to do very well,” he says. “And the increased economic activity is going to mean more deals getting done, including acquisitions and refinancing.”

Matt Hudgins is based in Austin, Texas.