The capital markets in the United States are bulging with cash and a willingness to supply debt to the real estate industry. However, so far this year, few real estate developers have come to the market asking for money.

Rising interest rates and a relatively new pricing factor affecting the commercial mortgage-backed securities (CMBS) market have combined to restrain industry enthusiasm for new debt, most experts agree.

The real estate industry, nevertheless, continues to bring new product on-line. According to the U.S. Department of Commerce, non-residential construction put in place by July 2000 reached an annualized total of $215.5 billion, 10% higher than the annualized figure of $195.3 billion through July 1999.

Interest rate watch "There's been plenty of new product built," says Larry Hadley, president of Novi, Mich.-based Hadley and Associates, a mortgage banking company. "But a lot of borrowers seem to be sitting on their construction loans, waiting for permanent loan rates to come down."

While projects started in the past have come on-line this year, new activity appears restrained. "There hasn't been a lot of new development activity," confirms Stacey Berger, executive vice president for Washington, D.C.-based Midland Loan Services Inc., a PNC real estate finance company. "PNC tends to be selective about who its borrowers are and continues to work with its existing customer base," he says.

Since a series of global currency crises in 1998, interest rates have risen beyond the comfort level of developers, according to Hadley. Following the crash in the bond market in 1998, spreads nearly doubled overnight, moving from 125 to 175 basis points over Treasuries to 250 to 350 basis points. Throughout 1999, concerns about inflation led the Federal Reserve Bank to push interest rates up further. In response, lenders reduced spreads somewhat, but not enough to overcome rising rates produced by the Fed.

In the first quarter of 2000, the 10-year Treasury rate reached 6.5%, up from 4.75% the year before. "Spreads in the first quarter were 200 to 250 basis points, and costs for deals were bumping up against 9%, compared with 7% two years ago," says Hadley.

Hadley explains that during the second quarter of this year, both the Treasury rate and spreads softened. By August, Treasuries stood around 5.7% and spreads had moved back to 200 to 225 basis points.

At that point, whole-loan rates had declined to below 8%. As a result, third quarter borrowing activity has begun to inch up, as some construction borrowers have moved to lock in their rates.

In an effort to generate interest among borrowers, some institutions have developed new programs. This year, General Electric Financial Assurance, the life insurance arm of Stamford, Conn.-based General Electric Co., introduced a convertible loan program that allows borrowers to pay on a floating rate for up to three years. At any time during that period, the borrower can convert to a fixed rate.

Conduit or CMBS lenders, faced with similar problems in attracting borrowers, have also attempted to inject some flexibility into their offerings. "Some conduits have introduced what amounts to bridge-loan programs," says Hadley.

"The investment bank will make a three-year floating rate loan, usually priced over LIBOR (London Interbank Offered Rate), on its balance sheet. When the borrower is ready, the first loan converts to a securitized loan. Borrowers have to go through two closings, but they do get their money upfront, adds Hadley."

While these programs may attract borrowers, a lot of cash remains unemployed. "Portfolio lenders and conduit lenders still have more capital to lend than borrowers to lend to," says Sam Davis, second vice president of Boston-based John Hancock Life Insurance Co. "Today's market is one of the most competitive lending markets I've ever seen. The evolution of the CMBS market has brought a whole new world of lenders into the business."

Davis says that another factor contributing to the drop in demand involved the lengthy period of low interest rates from 1996 through early 1999. During those years, many borrowers refinanced existing loans and remained content with the rates they were paying. "Commercial mortgage finance is a cyclical business," notes Davis. "When you have boom years with a lot of financing and refinancing activity, you are going to see a slowdown afterward. We're in that slowdown period today, and higher interest rates are exacerbating it."

The CMBS factor The reasons for the slow pace of borrowing during 2000 extend beyond interest rates and business cycles. As a general rule, any trend in the real estate capital markets is linked to the CMBS market.

"From a pricing standpoint, today's overall market tends to follow the securitized market," says Tim O'Connor, executive vice president and regional manager for the Orlando, Fla., office of Baltimore-based Legg Mason Real Estate Services Inc.

"Even though the life companies don't necessarily securitize their loans, they do follow the CMBS market and frequently price off of it," says O'Connor.

Despite the increased flexibility of some CMBS lenders, activity in loans destined for securitization remains at levels much lower than the record year of 1998. "In 1998, conduits issued $78.3 billion in CMBS," says Berger of Midland Loan Services. "The number fell to $68.8 billion in 1999. Through August of this year, CMBS volume was $34 billion. The expectation is that volumes will continue to lag through years' end. Industry estimates for 2000 are approximately $50 million to $55 billion."

Examining interest rate swaps While interest rate levels have surely helped dampen CMBS lending, another factor has worked to raise CMBS prices: swap rates. The 1998 upheaval in currency markets magnifies an essential weakness in the CMBS lending concept.

During the time between loan origination and the sale of CMBS bonds containing that loan, lenders take an interest rate spread risk. To hedge the interest rate risk, lenders quote a spread over a U.S. Treasury instrument, typically a 10-year bond. During the holding period, if interest rates go up, the lender suffers no loss. The spread remains the same over whatever rise may have occurred in the Treasury instrument's rate.

Prior to 1998, no one thought about spread risk. During the 1998 currency crisis, spreads widened significantly. CMBS loans suffered the consequences. Buyers wanted CMBS bonds with higher spreads and higher returns. The lower spread CMBS issues remained unsold and created huge losses for their issuers.

Since 1998, conduit lenders have come up with various methods of hedging spread risk. One of these hedges is an interest rate swap. In an interest rate swap, two parties exchange floating- and fixed-interest rate payments on an agreed principal amount. No principal changes hands; each party simply pays the other's interest rate.

At the beginning, one party pays a floating interest rate on its money, and the other party pays a fixed rate on its money. For whatever reason, both parties would prefer to pay the other's rate. A CMBS issuer, for example, borrows at a fixed rate against Treasuries to fund the loan origination. To hedge against spread risk, the issuer would prefer to pay a floating rate.

The CMBS issuer then buys a swap contract from the party with the floating rate and passes the cost of the contract through to the borrower in the form of a higher spread.

The issuer calculates income from the CMBS issue by tracking four cash streams: the issuer receives interest rate payments from the borrower; the issuer pays interest to investors; the issuer receives interest rate payments from the swap counter-party; finally, the issuer pays interest to the counter-party. The sum of these inflows and outflows is the issuer's income.

In the end, CMBS borrowers pay the cost of the swap contract. By doing this, they reduce the issuer's spread risk to an acceptable level.

How much do swaps add to a borrower's costs? "Swap costs went up dramatically through late 1999 and early 2000," says Charles Krawitz, first vice president of the real estate capital markets group with Chicago-based LaSalle Bank. "In the second quarter of this year, those costs have come back down. Ten-year swaps peaked at approximately 170 basis points. They have since fallen to the middle 120s as interest rate fears have subsided."

Three years ago, no one talked about swap spreads affecting real estate mortgage spreads. Today, everyone talks about swaps.

"Swaps are a Wall Street issue, and the emphasis on swaps shows you how much Wall Street has inserted itself into the mortgage business," says Hadley. "It shows that Wall Street's influence on the commercial mortgage business is not transient, but is indeed permanent."

Where do we go from here? What happens next? "The real proof of the pudding will come with the next true downturn in the economy and in real estate," says Hadley. "What happens when the [loan] pools don't perform or when they start to have losses? Conduits will price the risk and spreads will go up. At that point, the question is, will the liquidity that we believe is there really be there when it counts? I think so."

Institutional equity investors bring a much less arcane set of concerns to their seat at the capital markets table. Unlike lenders, equity investors will take risks with their equity partners without sowing fear about spreads, swaps or what the Federal Reserve might do.

Equity investors also know what they want. If a pension fund doesn't want to own a property or a share of a property, no market-based hedge will make the deal more palatable.

On the other hand, institutional investors tend to work with a highly pruned list of real estate products and partners. Capital may be available but only for certain undertakings and conditions.

The TIAA approach "Real estate is a pretty basic investment," says Joseph W. Luik, senior managing director and division manager with New York-based TIAA-CREF. "Joint ventures along with 100% ownership are the methods our company uses. It manages to keep 5% of the general account portfolio, which totals about $104 billion, in equities, explains Luik. "This has been consistent over several years, even though the company manages the equities actively. TIAA-CREF buys and sells anywhere from $500 million to $700 million in real estate annually."

According to Luik, TIAA-CREF's mortgage portfolio contains paper on all property types, but the equity side of the business focuses primarily on ownership and joint venture participation in office and industrial properties, with a smattering of retail.

"Our feeling is that as the market has evolved, many real estate sectors have become more of a business than a real estate player," says Luik.

"Hotels, regional malls, apartments - these are businesses where managing economies of scale has become important. We believe that the larger REITs, in each of these sectors, can do a better job with those properties than we can. This is not to say there are not individual assets owned by individuals or small real estate companies that are not very successful, but it seems less common today," adds Luik.

The GE philosophy GE Capital Real Estate prefers to avoid so-called one-off equity deals in all property categories. "We focus on doing equity deals with repeat customers in a programmatic way," says Frank Marro, managing director for leveraged equity [joint ventures] with the GE subsidiary.

With an allocation to domestic real estate equity investments of approximately $1 billion, GE Capital's equity investment programs might take many different forms with different partners. The company wants to establish an approach to deals in the first go-round with a partner and then continue to roll out that approach on subsequent deals.

For example, GE Capital recently inked a commitment to invest approximately $100 million in equity with Memphis, Tenn.-based Storage USA. Assuming that equity represents 20% of most deals, the GE Capital commitment to Storage USA could end up fueling an estimated $500 million in developments and acquisitions over time.

"People seem very interested in talking to us," he says. "Since the beginning of July, we have had a lot of interest in our programmatic approach from investment bankers searching out equity for their customers."

In fact, Marro says GE Capital has signed a roster of approximately 50 partners since the program's inception last year. All partners plan to execute long-term programs.

"We focus on five main areas: self-storage, multifamily, retail, industrial and office," says Marro. "Roughly 60% of our portfolio is multifamily, and the remainder evenly divided among the other property types."

Annual gathering of executives to focus on the future, from CMBS to technology Mortgage bankers are dusting off their crystal balls to take a peak at what the future might hold.

Okay, crystal balls aren't all they're cracked up to be. But the 2000 Fall Commercial/Multifamily Executive Forum is the next best thing when it comes to finding out what's in store for the mortgage banking industry.

The Mortgage Bankers Association of America (MBA) is expecting approximately 200 mortgage banking executives to attend the Fall Forum to hear about the future of the commercial mortgage banking industry. The Fall Forum is part of the MBA's 87th annual convention.

"I think there is no question that we're all beginning to worry about the future," says Shekar Narasimhan, managing director, agency & funds manager at the Vienna, Va., office of Prudential Mortgage Capital Co. of Newark, N.J. Narasimhan will moderate the MBA's "State of the Industry" panel discussion.

Mortgage bankers have experienced an incredible eight-year run. But now many in the industry are beginning to think the ride might be over due to volatility in interest rates and uncertainty within the economy, notes Narasimhan. "One thing people have on their minds and want to talk about is: What is the future going to look like, what is my role, and how do I plan for it?" he says.

A variety of topics will be addressed during this year's Fall Forum at the San Francisco Marriott. The condensed convention schedule begins Monday, Oct. 30, and concludes Tuesday, Oct. 31, with a special luncheon. MBA members also are encouraged to attend the open commercial/multifamily committee meetings held on Sunday, Oct. 29.

The Fall Forum kicks off with its annual "State of the Industry" general session on Monday afternoon. "We're adding a slightly different twist this year with the opening general session," says Bronwyn Morgan, director of the Commercial/Multifamily Business Group at the MBA in Washington, D.C. One difference is that the MBA hopes to gain some insights by addressing innovations that have occurred in the single-family sector.

The MBA opted to bring in a leader in the single-family sector to deliver the keynote address. Angelo R. Mozilo, chairman of Calabasas, Calif.-based Countrywide Credit Industries Inc., will present his perspective on innovation in the business that has brought real estate finance to the year 2000.

"Most of us believe that while the residential business is not exactly the same, it does precede the commercial business by a few years," says Narasimhan. "So what happens there will happen to us." Mozilo is considered to be a visionary in the single-family business, and he will talk about trends in his industry, and hopefully commercial and multifamily mortgage bankers will be able to draw some parallels, adds Narasimhan.

Some of the issues Mozilo will discuss include consolidation, standardization, use of technology and the Internet in originating and servicing loans, and emerging partnership opportunities. "Angelo is going to give his perspective on innovations in business and talk about what commercial and multifamily can learn,"says Morgan .

The Monday afternoon panel is "E-commerce: Who Is Doing What and Why?" Industry experts will explore the impact of e-commerce on commercial and multifamily real estate, the Internet's impact on the commercial/multifamily mortgage banker's business model, and the avenues to pursue for building a Web-based strategy to promote a mortgage banker's strengths in the marketplace.

E-commerce panelists include Henry Schwendinman, president and CEO of Salt Lake City-based Bonneville Mortgage Co., and Wes Hall, CFO at Little Rock, Ark.-based UNIVEST.

The primary topic will focus on what is in the technology pipeline, particularly Web-based systems. Web-based software is already in place on the single-family side that allows mortgage bankers to go to the Internet to find the tools they need to originate, process, close and administer a loan.

That same Web-based software is in the process of being developed for the commercial and multifamily industry. "The purpose of the panel is to introduce this concept," says Edward T. Byrd, president and CEO of Orlando-based Edward T. Byrd & Co., and moderator of the e-commerce discussion.

The advantage of Web-based technology is increased mobility and automation. "We want to have information at our fingertips wherever we are," says Byrd. "As long as you're connected to the Web, you virtually have your office in front of you at all times." Although the Web-based systems will by no means replace traditional mortgage bankers, it does provide a more efficient delivery method, much the same way fax machines and overnight delivery have done in the past, he adds.

A discussion on "Outsourcing Trends" starts off the Tuesday panels. "That is something new that has not been addressed at the fall or annual convention," says Morgan. Panelists include Stacey Berger, executive vice president at Washington, D.C.-based Midland Loan Services Inc., and Young Hong, president of Irvine, Calif.-based Strategic Realty.

The panelists will describe the business strategy that has led them to outsource - consolidation, technology, relative value of whole loans vs. CMBS and cost reduction. Panelists will discuss whether outsourcing leads to challenges or new opportunities for the smaller mortgage banker.

"The key issues will be what's behind the decision-making process when companies make the decision to outsource," says panel moderator Charlie Knudsen, managing director and principal at Madison, Wis.-based QuadCapital Advisors LLC.

Consolidation has had a significant impact on the mortgage banking industry, and that trend is likely to continue due to ongoing merger and acquisition activity.

The panel also will discuss the nature and scope of the functions that are currently being outsourced, and those that might be considered for outsourcing in the future. "I think it runs the gamut, from payment processing through asset administration - even including new loan origination," says Knudsen. The second Tuesday panel is "Securitization: Past, Present and Future." The meeting features a discussion of market, volume, servicing issues, benchmarking, interest rate movement, trends in fixed-income markets and new products. Panelists include four key industry leaders - Diana Chazaud, managing director and senior advisor at Credit Suisse First Boston in New York; Richard D. Jones, Esq., a partner at Philadelphia-based Dechert, Price & Rhoads; Nathaniel I. Margolis, Esq., associate general counsel at Boston-based John Hancock Real Estate Finance Inc.; and Shane Tucker, managing director at Prudential Mortgage Capital Co.

"I think we will devote the most time to why securitizations have fallen so dramatically in the last 12 months, and what it will take to increase them," says Ann Hambly, managing director at Prudential Mortgage and panel moderator.

"There is definitely a link between the decline in the number of subordinate bond buyers and the market volume," says Hambly. The panelists will discuss how to increase liquidity by bringing more subordinate bond buyers to the marketplace.

The Fall Forum closes with a Tuesday luncheon featuring the annual "Emerging Trends in Commercial/ Multifamily Real Estate." Lend Lease Real Estate Investments Inc. and PricewaterhouseCoopers will share their research on the rapidly-changing commercial real estate landscape. The two firms offer projections for 2001, which are based upon the opinions and insights of more than 150 leading real estate investors, property executives, developers, analysts, economists and planners.

For more information, contact: Bronwyn Morgan, director, Commercial/Multifamily Business Group, Mortgage Bankers Association of America. Phone: (202) 557-2748. E-mail: bronwyn_morgan@mbaa.org. Web site: www.mbaa.org.

While spreads over interest rates vary from lender to lender, they also vary by property type, according to Matthew Rocco, vice president of Naples, Fla.-based Laureate Capital.

As of August 2000, Rocco estimates the institutional lending spreads over Treasury rates on different kinds of real estate as follows: multifamily, 190 to 200 basis points; office buildings, 200 to 235 basis points; retail properties, 215 to 240 basis points; industrial, 220 to 240 basis points; and hospitality properties, 285 to 300 basis points.

During 2000, Rocco says Treasury rates have softened and produced better overall interest rates. In addition, spreads have narrowed thanks to intense competition among institutional investors for a limited supply of real estate lending business.

When an insurance company goes public, the real estate industry often loses a source of equity capital.

Take the case of Boston-based John Hancock Life Insurance Co. It went public with a January 2000 initial public offering. In preparation for that move, the company sold off most of its portfolio of real estate equities in 1998.

Properties sold include several well-known Class-A buildings such as the 100-story John Hancock Center in Chicago and one of the Watergate office buildings in Washington, D.C. Most of the properties that went to the market were located in major metropolitan areas, such as Southern California, San Francisco, and the Northeast. The sale did not include any of John Hancock's home office properties, including the John Hancock Tower in Boston's Copley Square.

According to the company's news release, the sale has not affected John Hancock's commercial mortgage operations or other real estate-based initiatives in securitized lending, affordable housing or equity investment activity.

The move represents a strategic decision to change the company's investment asset allocation mix to meet the needs of "internal lines of business looking for more stable earnings than equity typically offers," according to Sam Davis, second vice president with John Hancock.

Even so, the company will continue to hold some direct ownership in real estate. In addition, the company's real estate investment group continues to provide a full range of portfolio management and asset management services to institutional clients.