Commercial mortgage rates at May's end were up fractionally from the levels of 30 days ago, according to the Barron's/John B. Levy & Co. National Mortgage Survey. Mortgage rates briefly flirted with slightly lower levels but jumped back after the Federal Reserve announced that it might seek to tighten rates in an effort to stem inflation.

This year is turning out to be an all together different market from the record setting 1995. The commercial mortgage market is presently quite uneven with some survey members reporting more than adequate pipelines, while others are having a hard time finding enough volume. Although there are plenty of transactions around, most are highly sought after and as one survey member succinctly put it, "there is more noise out there than substance." The sputtering market is quite a contrast to last year when the summer was absolutely "red hot." Although it's too early for the traditional "summer doldrums," some survey members are acting as if they have already begun.

The culprit without a doubt is higher interest rates. Although rates just north of 8% can't be considered excessive when viewed from a historical perspective, they are up over 1.25% from their low point earlier this year. This has caused many borrowers to sit on the fence assuming that rates will retreat to lower levels.

In order to attract these fence sitters and to encourage more transactions, several sophisticated survey members have designed programs to entice the borrowing community to accept offers now and not wait for rate declines. Perhaps the most interesting approach is an offer of an adjustable rate transaction which can be fixed at some late point when rates are theoretically at lower levels. For example, one survey member has offered to let property owners borrow money today at LIBOR plus 1.5% to 2% (LIBOR is a frequently used adjustable rate index). Three month LIBOR today is 5 1/2% so the borrowers are paying a total rate of 7% to 7 1/2%. If rates decline in the next 12 months, the borrower can convert this loan to a fixed-rate transaction at the lender's then prevailing rates. For borrowers who sense that rates are at a peak, this program is surely a godsend.

In another version of this same approach, another survey member will allow borrowers to, in essence, "shelf register" their deals. The lender will approve the loan now and will allow the borrower up to six months to fix the rate based on the lender's rates then in effect.

This sputtering market has not unleashed a full-scale "borrowers' market," but there are signs that that might not be too far off. Most lenders despise negotiating their prepayment penalties since the standard formula allows them to collect the difference between the mortgage coupon rate and the Treasury rate for the remaining term of the loan. When the loan is prepaid, they can buy Treasuries with the principal amount of the loan plus the prepayment penalty and receive the same yield that they would have had the mortgage paid to its normal due date. Today, a number of survey members are willing to assume that the proceeds of the mortgage are reinvested at the Treasury rate plus 50 basis points, which significantly reduces the amount of penalty they collect. To be sure, this is not a loosening of underwriting standards in the pure sense, but it does suggest that lenders in many cases are receiving less value than they may have in the past.

Spreads are another example of how aggressively lenders are competing for business. For low-leverage transactions, those below 60% loan to value, lenders are sometimes willing to reduce their spreads below 1% -- though that is surely the exception. Additionally, some lenders are adding a year or two on to their amortization schedules in order to attract borrowers.

It's becoming clear that the "conduit market" and the "institutional market" are coming closer together. When the conduit market began, no institutional lender worth his salt would admit that he had anything to do with this market for properties that were described as B-grade and C-grade. But conduits have become more efficient and in many cases can offer spreads down to 1.75% for the right deal. Institutional lenders, on the other hand, have found that they can often produce more business than their own cash flows demand and have adopted a "if you can't beat them, join them" strategy. A number of life insurers -- including John Hancock, General American and Union Labor Life Insurance Co. -- are now originating business directly for conduits led by J.P. Morgan and other Wall Street firms.

Institutional lenders have also learned a thing or two from Wall Street. Not too long ago, no life insurer wanted to "share" a mortgage loan with another lender. The most common justification was that they wanted to "control their own destiny." But now, especially on larger transactions, insurers are teaming up to syndicate deals and compete directly with Wall Street. For the most part, this has occurred on large office buildings and regional malls, but there is surely nothing to stop it from spreading to other property types. Insurers such as Principal Mutual, Northwestern Mutual, Prudential, CIGNA and American General have all been active in this arena.

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