Large loans and mushrooming CMBS issuance drove commercial real estate financing levels to an all-time high last year, but lenders say a slowing pace of transactions could temper loan volume as 2006 unfurls.

NREI's annual ranking of the top 40 direct lenders and financial intermediaries confirms that 2005 was indeed a banner year. Bank of America led all direct lenders, financing $75.9 billion in commercial real estate loans, up nearly 30% from the previous year's tally of $58.6 billion.

Meanwhile, the Mortgage Bankers Association (MBA) reports that total originations for the year exceeded $201 billion and outpaced the previous year's record of $136 billion by 48%. However, the total number of loans increased only 14%, an indication that the size of loans climbed substantially.

Volume in the fourth quarter alone reached $67.5 billion, the most volume ever in a single quarter and more than the $62 billion origination total for all of 2000. “It was a tremendous year across the board in terms of property sales, mortgage originations and security issuances,” concludes Jamie Woodwell, senior director of research at MBA.

Conduit loans, or loans made and placed into commercial mortgage-backed securities (CMBS) and sold to investors, accounted for the lion's share of originations in 2005. The issuance of CMBS loans rose 82% to $169.2 billion, up from the previous year's record volume of $93.1 billion, according to trade publication Commercial Mortgage Alert.

“Everybody was surprised by the enormous increase in CMBS lending,” says Brian Stoffers, president of financial intermediary CBRE/Melody (formerly LJ Melody). The Houston-based company arranged $18 billion in commercial real estate loans, placing third on NREI's ranking of the top financial intermediaries.

CMBS delinquencies remained low despite the surge of deals, and that solid performance attracted even more capital to real estate, Stoffers says. At the same time, shrinking capitalization rates and higher prices for properties fueled bigger deals and larger loan amounts.

Nearing the peak

There are indications that the frenzied pace of lending in recent years is beginning to calm. Bank of America's origination volume in the first quarter of this year was roughly equal to, or slightly below, its volume of a year ago, says Eugene Godbold, president of commercial real estate banking at the Charlotte, N.C.-based financial services giant.

After several years of smashing records, commercial real estate lenders may fall short of setting a new record in 2006. “There may be fewer transactions than last year,” Godbold acknowledges.

“But you have to compare that to what a record year 2005 was to put it in perspective,” adds Godbold. “I wouldn't read a negative into that.”

For the moment anyway, larger loan sizes may be keeping origination volumes on an upward track while masking a reduction in the number of loans. “If you go back three years, an average loan was $5 million to $7 million; now it's $13 million to $15 million, so the dollar amounts have gone up tremendously,” says Bill Green, managing director at Wachovia.

Banking experts say borrowers are taking out bigger loans for a number of reasons, but some of the largest deals involve acquisition financing to take public real estate companies private. “As a result, there are a lot of $300 million to $3 billion transactions out there,” Green says.

Rising construction costs and acquisition prices have been a contributing factor to high loan values, although recent increases in interest rates may halt the rapid escalation of acquisition prices by forcing buyers to demand higher cap rates, reducing the amount they are able to pay for properties.

After 15 consecutive hikes in overnight interest rates by the Federal Reserve, the 10-year Treasury yield breached 5% in April, up 100 basis points from June 2005. Correspondingly, cap rates have ceased to shrink and have even come up a quarter point in some markets.

The number of loans is slowing at Wachovia, although the proliferation of large loans has kept origination volume high, Green says. Wachovia ranks as the No. 2 direct lender with $66.9 billion financed in commercial real estate loans in 2005, up from $46.8 billion the previous year.

Much of that volume came from a handful of loans valued at $500 million or more, including a deal financed in partnership with Bear Stearns for The Blackstone Group's $2.8 billion purchase of Wyndham International.

“(But) in terms of just core, $5 million to $20 million loans on shopping centers and office buildings, that business is flat to slightly down for us,” Green says, referring to Wachovia's volume in the first quarter of this year.

Pivotal factors

If demand for financing has reached a peak — or at least a plateau — then what has stemmed the tide of borrowers clamoring for commercial real estate loans?

For one, demand to refinance existing loans is down since most owners have already refinanced in the past two or three years and are unable to refinance their new mortgages any time soon due to prepayment penalties or defeasance requirements.

But many lenders say a refinancing wave of a different sort is imminent. Loans dating back to the commercial real estate boom of the late 1990s are starting to mature and require new financing. That will fuel demand for financing beginning this year and extending through 2008, according to Stoffers of CBRE/Melody.

The question is whether that pent-up demand for refinancing will be enough to offset the damper that's been thrown on the borrowing party by rising interest rates. The high demand for acquisition loans could drop, if interest rates continue to climb.

“Where you'll start seeing [reduced demand for loans] is on value-added, opportunistic purchases,” says John Pelusi Jr., executive managing director of Holliday Fenoglio Fowler (HFF). “If cap rates move up, the owner may not want to sell because he can't get the price he wants.”

Houston-based HFF took the No. 2 spot on NREI's survey of financial intermediaries by arranging $24 billion in commercial real estate loans last year, up 7.6% from $22.3 billion in 2004. Bank of America's intermediary business took first place with $69.3 billion in arranged loans.

Straightening the curve

Although long-term interest rates have begun to rise incrementally, the yield curve is nearly flat: The difference between the three-month and 10-year Treasury yields was only 29 basis points in mid April. Lenders say demand for short-term financing has largely evaporated except for bridge loans or other short-term needs.

The flat curve contributed to refinancing volume in 2005 by bringing down the cost of defeasance and prepayment penalties, says Stoffers at CBRE/Melody. He anticipates at least one more rate hike by the Fed this year and expects the 10-year Treasury yield to reach 5.5% by year's end. That's still an attractive rate that should generate continued high lending volume, particularly if lenders absorb some of the impact on rates.

“Some of the increases in interest rates have been offset partially by further compression in spreads,” he says, referring to the margin lenders add to benchmarks to achieve offering rates. “It's a very aggressive lending market, and lenders are working on a very thin margin.”

The prospect of fewer properties requiring financing in 2006 means competition to place loans will be even greater this year, and lenders' profit margins are already being squeezed, according to Pelusi of HFF. “You've got to be very competitive on the fees, and you have to be always adding value, or you're not likely to win the deal,” he says.

The flat yield curve has enabled lenders and intermediaries to add value through creative financing, thanks to similar pricing for short- and long-term debt, according to E.J. Burke, executive vice president of commercial mortgage lending at Cleveland, Ohio-based KeyBank Real Estate Capital. KeyBank financed $22.17 billion in commercial real estate loans in 2005 to place seventh on NREI's direct lenders ranking.

“Our success in 2006 is going to be directly correlated to our ability to create innovative financing structures,” Burke says. “For example, we might do a construction loan with a mezzanine piece and maybe even a forward commitment.”

Contrarian point of view

Not everyone expects the growth of lending volume to slow in 2006. Burke says the cooling housing markets will send even more investment capital to the commercial real estate world for placement. He also expects increased demand for construction financing — a category that dominated KeyBank's lending program in 2005.

Even if rising interest rates lure some investors away from commercial real estate, much of the capital invested in the industry will remain indefinitely because many institutions have increased their allocation to real estate, says Barry Gersten, executive vice president at Capmark Finance Inc., formerly GMAC Commercial Mortgage. Gersten shares oversight of the company's North American lending with Jerry Earnest, another Capmark Finance executive vice president.

Capmark Finance doesn't expect interest rates or cap rates to spike this year, either, Earnest says. “This is very much a steady-as-she-goes year that could be down a touch on overall volume.”

Matt Hudgins is a writer based in Austin.