CMBS is back. Following the debacle of 1998, the commercial mortgage-backed securities (CMBS) markets have not just re-stabilized, they are re-energized. According to Mark R. Jarrell, senior vice president of Greenwich Capital Markets Inc. of Greenwich, Conn., domestic CMBS issues totaled $32.6 billion through the first six months of 2001, compared with $20.9 billion for the same period last year.

What's more, the long heralded theory that the publicly held real estate debt can discipline the traditionally volatile real estate market when the economy turns south may be proving true.

Despite this year's economic slowdown, or perhaps because of it, lending activity in today's real estate markets has ticked up. “The debt markets are extremely well-priced right now,” said Bruce Schonbraun, managing partner with Schonbraun, Safris, McCann, Bekritsky & Co., LLC of Roseland, N.J. “There are still vast amounts of debt available, and we're seeing great activity at all levels as to debt issuance.”

Most of the borrowing activity this year has come in the area of refinancing, according to Schonbraun, who attributes the volume of activity to falling interest rates driven by the Federal Reserve Board's 2001 efforts to blunt the threat of recession.

The CMBS market has benefited from borrowers' interest in refinancing, while imposing increasingly rigorous lending standards.

Representatives from firms that provide debt largely agree that highly liquid, highly disciplined lending has characterized 2001 so far. “I think there is better and more disciplined liquidity for real estate generally on the debt side than at any time I can remember,” said Jarrell. “A borrower, today, has many choices, from traditional portfolio lenders and banks through the real estate capital markets for debt, including CMBS and privately placed debt.

The 2001 CMBS market

As a market leader in the sales and trading of asset-backed securities, Greenwich Capital Markets will likely issue $2 billion in CMBS during 2001, about the same level as 2000. The CMBS industry as a whole, however, may show significantly higher levels of activity for 2001 compared with 2000.

While the first six months of the year produced $32.6 billion in CMBS issues, the second half of a given year typically produce more CMBS activity than the first half, Jarrell said. As a result, Jarrell speculates that CMBS issues for 2001 could reach $75 to $80 billion. That level of activity might equal or surpass the record CMBS year of 1998, when issuers conducted $78.4 billion worth of business.

Even the fulfillment of less optimistic projections, such as a Morgan Stanley estimate of a $60 billion 2001 CMBS market, would represent a strong year.

As a major CMBS lender, Deutsche Bank Alex Brown in New York ended its first half as lead manager of $3.7 billion in CMBS issues, up from $2.7 billion during the first half of 2000. Despite the increased activity, Deutsche Bank fell from second to fourth place in the rankings for lead CMBS managers. “What threw us off was a couple of major transactions that you won't normally see and that we didn't participate in,” says Jon Vaccaro, global head of the real estate debt markets for Deutsche Bank.

Key Commercial Mortgage, a division of Cleveland-based Key Commercial Real Estate, expects to reach its 2001 goals for loans destined for CMBS securitization as well. “Our plan called for originating $1.2 billion of fixed-rate commercial real estate loans in 2001,” said E. J. Burke, head of Key's CMBS lending unit. “We believe we'll be close to that number based on our performance during the first half of the year and current activity in our pipeline. Last year, our total CMBS origination was around $900 million. So overall, we are seeing a 33% increase in CMBS lending.”

Amidst the busy CMBS markets this year, lenders report interesting shifts in volume related to multifamily properties. At Key Commercial, for example, multifamily loans as a percentage of originations related to the CMBS business have dropped from about 30% to 10%. Burke attributes that change to increased agency lending activity fueled by agency interest rates compared with CMBS interest rates.

Indeed, Key Commercial's Dallas-based agency lending operations originated $475 million in multifamily loans during the first half of 2001. “I think we'll do about $1 billion this year between Fannie Mae and Freddie Mac,” said Todd Rodenberg, Key's senior vice president and chief underwriting officer for agency lending. “That will exceed our original budget by about $200 million. I think industry-wide you're seeing an increase in agency lending. Through the end of July, Fannie Mae reported doing $9.3 billion in multifamily business, which is $700 million over that agency's total 2000 business.”

Refinancing is driving the surge in multifamily lending. Rodenberg estimates that approximately 70% of Key's agency business this year involves refinancing. “People are getting off the fence,” Rodenberg said. “They don't believe interest rates will drop too much more. In addition, I think these owners want liquidity. They don't believe that the economy will begin to improve soon, so they are taking out equity.”

Another trend related to increased agency refinance lending involves the numbers of loans approaching the end of their terms. As multifamily CMBS loans approach term, they “come out of yield maintenance” and expensive prepayment penalties no longer apply. Borrowers can then refinance at lower rates through Fannie Mae or Freddie Mac.

The rise in multifamily agency business has restructured Key's CMBS lending portfolio. As multifamily CMBS originations have declined from 30% to 10% of the firm's business, retail has increased to about 32% and office has grown to 20%. The balance of Key's CMBS lending goes to a mix of industrial, self-storage, manufactured house, and mixed-use properties, according to Burke. “The pie has changed,” he said. “We're making more loans overall, but fewer multifamily loans for CMBS.”

Another pie has changed as well: the kinds of businesses that hold commercial mortgages. In an article titled “New Rules for an Old Asset Class,” Sally Gordon, senior anaylst with Moody's Investor Services, writes that more commercial mortgage paper than ever is flowing into the CMBS market, while insurance companies have not kept pace.

In 1995, writes Gordon, commercial banks held 42.5% of all commercial mortgages. Life insurance companies held 19.7% of the total. CMBS held 5.5% of this business.

In 2000, commercial banks held 40.6% of all commercial mortgages, not much of a change. On the other hand, the CMBS share of the market had risen to 13.8%, while life insurance companies had ratcheted down to 13.5%.

Imitation is best form of flattery

Have insurance companies pulled back on commercial real estate lending? Not in absolute dollars. According to figures collected by the American Council of Life Insurers, life insurance company commercial mortgage volumes from 1997 through 1999 ranged from $36 billion to $40 billion, not much different from the 1986 figure of $38.9 billion. Larry Hadley, a mortgage broker and president of Hadley and Associates in Novi, Mich., said that whole-loan lending among insurance companies has risen this year compared with 2000. “The reason is interest rates,” said Hadley. “Rates are down about 100 basis points this year, thanks to the Fed's cuts and the slowing economy.”

On the other hand, CMBS lenders can seize the initiative and grab traditional insurance company lending targets these days. In June, for example, Key Commercial Mortgage closed a $19.5 million loan on the corporate headquarters of Modern Continental Cos. in Cambridge, Mass. “Normally, such a high-quality property with a high-quality tenant would be financed by an insurance company,” said Burke. “But we financed it in our conduit.”

As CMBS encroaches on traditional insurance company lending territory, insurance company lenders have begun to forego competition with CMBS. Over the past several years, insurance company lenders have made it a point to conform their documentation to the CMBS markets, to accommodate the possibility of selling loans into the CMBS market.

At one time, of course, insurance lenders promoted their products by selling the less rigorous documentation procedures related to portfolio lending.

While insurance lenders continue to make this pitch, some, Prudential, for instance, have created securitized lending departments that work side by side with portfolio lending departments. “In these operations, insurance companies can originate for either their whole-loan portfolio or for CMBS securitization,” said Hadley.

Life companies have begun to mimic CMBS lenders and mitigate risk by requiring borrowers to set aside reserves for tenant improvements, according to Hadley. “This is probably one of the most significant influences that CMBS has had on life company lending,” he said.

Smaller life insurance companies that typically originate $1 million to $3 million in whole loans per year have begun to question the wisdom of continuing to offer such loans, Hadley said. “Is the cost of maintaining a mortgage department worth the yield they can get originating whole loans?” he asked. “Given the competitive pressures of that business, might it not be better to hire a small staff of one or two people to buy B-piece or triple B-piece CMBS issues. The company might get the same yield for the same risk. These companies have not yet really answered this question for themselves yet. But they are asking the question more loudly.”

Increased underwriting discipline

In short, as new money flows into the debt markets today, it is flowing ever more strongly in the direction of the CMBS sector.

And a lot of capital is searching for a home these days. “There is no place to get any returns,” said Rodenberg of Key Bank. “No one wants to be in the stock market today. If you look at the amount of cash on the sidelines right now, it's at record levels.”

In contrast to practices of the late 1980s and early 1990s, however, lenders of all sorts are managing oceans of debt capital with more discipline, thanks perhaps to the highly structured lending approach characteristic of CMBS lenders.

Take, for example, a marquee deal recently made by Deutsche Bank. In August, the bank refinanced the 28-story AT&T Building in New York, providing a fully amortizing $225 million loan to 32 AA Associates LLC, the owner of the building. The cash refinanced existing debt of $172.4 million, funded capital improvements of $20.1 million, paid the closing costs, and repaid $29.5 million in equity to the owners.

The 64.3% loan-to-value (LTV) of this transaction stands out as highly conservative. Similarly, the transaction's 1.24 debt-service level seems quite safe. Deutsche Bank plans to securitize the loan.

As CMBS loans have increased their share of real estate debt, the number of CMBS players has declined. “This is a dramatic change,” said Vaccaro of Deutsche Bank. “In 1997, there were probably 50 firms underwriting and originating loans for CMBS. Today, that number is down to about two dozen. And there is a lot more business for CMBS loans in the marketplace.”

Even so, earning a living on CMBS loans is tougher today. According to Vaccaro, a CMBS securitizer typically earned margins between 3% and 5% in 1997. Today, however, margins have fallen to .5% to a maximum of 2%. Thinner margins generally mean more stringent LTV underwriting by lenders.

“Many lenders will say that they have always been a 75% LTV lender,” Hadley said. “But have they? Lenders underwrite a property's income stream and come up with a net operating income figure, to which they apply a capitalization rate, determine value, and come up with a loan-to-value loan amount.”

But lenders use different figures to calculate value every year, Hadley explained. For example, this year, for an office building, a lender might use a 10% vacancy figure and 50 cents per sq. ft. for tenant improvements, while last year the same lender looking at the same building might have applied a 5% vacancy rate and 25 cents per sq. ft. during the underwriting process.

“Two different income streams for the same building produce two different values,” Hadley said. “Seventy-five percent of those different values gives you two different loan amounts. So this year's 75% loan-to-value might be last year's 70% loan-to-value. That's an important change.”

But can borrowers still get the loan dollars they want? For a refinancing deal, sometimes; for a new building, perhaps not. “Frankly, we've probably seen the top of the cycle,” Hadley said. “Today, we're somewhere in a downward part of the cycle.”

As a result, lenders are starting to evaluate properties with considerations that go beyond LTV.

For example, Hadley has noticed lenders in the Midwest drilling down to loan dollars per square foot when it comes to underwriting permanent loans for new office buildings.

“You're seeing new office buildings in the Midwest with loan requests for $150 to $175 per sq. ft., with equity left in the deal,” Hadley said. “This is scaring lenders. I've seen 75% LTV lenders derive a loan amount and check it against square feet and say ‘no.’ They say they don't want to lend that amount per square foot, no matter how good the building and the market.

“What these lenders are really saying is that the current rental rates will probably fall during the next renewal cycle,” Hadley continued. “That prospect makes lenders uncomfortable enough to cut the size of the loan.”

Deals continue to come to fruition, according to Hadley, but what started out as a 75% LTV may often end up as a 70% LTV or less.

Conclusion

A decade ago, when the economy was weakening and cash was plentiful, the analyses of many lenders apprently ignored the warning signs. Today, lenders are factoring those warnings into loans.

What's different? The share of the real estate debt market held by CMBS has more than doubled, while portfolio lenders have begun to underwrite with CMBS standards in mind.

For some years now, CMBS proponents have contended that applying the discipline of the public securities markets to real estate will prevent the real estate busts characteristic of past recessions. Will it?

The answer to that question may be just around the corner.




Mike Fickes is a Cockeysville, Md.-based writer.