Over the past 18 months, Wall Street banks and other big institutions have been trying to muscle their way into the small-balance commercial real estate loan business, a highly fragmented slice of the market that provides capital for small investors. By elbowing out community banks and small private lenders, the newcomers aim to grab their fair share of the roughly $130 billion annual market and to broaden their product, geographic and borrower bases.
Depending on the lender, small balance commercial mortgages generally top out at $5 million. Mom-and-pop investors and small businesses buying apartments, office buildings, retail stores or other income-producing properties are the most frequent users of small-balance loans. The borrowers often provide up to 35% in equity, and in many cases provide personal guarantees.
Why is Wall Street so interested in small borrowers, even as the capital markets continue to experience a high degree of volatility? This financing niche is highly lucrative. Small-balance commercial mortgages can generate internal rates of return in excess of 25%, particularly if debt providers securitize the paper and recycle the cash into more loans, experts say. The big banks also anticipate enjoying wider spreads over U.S. Treasury yields than they have been able to achieve in the highly competitive large-loan arena.
But rising defaults among subprime residential borrowers have spooked buyers of real estate bonds in the commercial mortgage-backed securities (CMBS) market, which has slowed momentum in small-balance activity (see sidebar). Small-balance loan originations declined 16% to $30.7 billion in the third quarter of 2007 from a year earlier, according to preliminary findings by Boxwood Means Inc., a Stamford, Conn.-based research and consulting firm focused on the small-balance loan industry.
Despite the market dislocation, many experts remain convinced that more big banks will enter the space and that more small-balance securitizations are inevitable. “We're really in the early innings of this expansion, and the game has been delayed by rain,” says Randy Fuchs, a principal and co-founder of Boxwood Means. “But we're still talking about a very large market that has a lot of potential.”
The small-balance appeal goes beyond the fat returns that big banks and Wall Street lenders stand to make. Loan underwriting, for example, is generally far more conservative than the underwriting that occurred in the large commercial property markets over the last several years.
Small-balance lenders often require borrowers to accept recourse loans. They take into account a borrower's personal income, credit score and net worth during the underwriting process. Lenders typically cap proceeds at 80% of a property's value, but some offer higher leverage at higher interest rates.
No single lender has any significant grip on the market. Four banks — Washington Mutual, Wells Fargo, Wachovia and Bank of America — rank among the top small-balance loan producers but account for only 10% of all originations, reports Boxwood Means. Generally, those banks don't have any small-balance programs outside of the Small Business Administration initiatives.
The field has opened up even more over the last several months. At least a handful of well known or rising small-balance lenders abruptly halted originations last fall, including two California-based residential mortgage providers that pursued commercial customers to offset mounting non-conforming home loan defaults. Those two lenders are GreenPoint Mortgage, which Capital One owns as a result of its $13.2 billion North Fork Bancorporation acquisition in December 2006, and real estate investment trust Impac Mortgage Holdings. Meanwhile, small-balance lender CBA Commercial in Stamford, Conn. closed its doors.
“There was definitely a period of time where everyone thought small-balance was the sexy new thing,” says Charles Krawitz, managing director of KeyBank Commercial Mortgage Access. The Cleveland-based bank's small-balance commercial lending program provides borrowers with $500,000 to $8 million.
“Today lenders are trying to figure out how to be successful in their core businesses based on market challenges,” Krawitz adds, “and some are putting new initiatives, including small-balance, on the back burner.” Commercial Mortgage Access is aiming to originate between $750 million and $1 billion this year, a roughly 40% increase over 2007.
Lackluster credit conditions have failed to sour officials at big institutions who are determined to grab their slice of the small-balance market. Established lenders and deep-pocketed newcomers suggest the capital-starved environment is the perfect climate in which to strengthen or build business among small borrowers.
“There has been a lot of shakeout among small-balance lenders in the last six months, primarily lenders who were dabbling in residential as well as commercial,” says Cheryl Higley, director of Dallas-based RBC Streamline, a small-balance program launched by RBC Capital Markets in July. “It's very important for borrowers to work with lenders who have a strong balance sheet. They will show up at closing able to deliver the loan.”
Higley declined to provide the fledgling operation's origination volume, but the program makes loans between $500,000 and $5 million on stabilized commercial property, including apartments, mobile home parks and self-storage warehouses.
Principal Financial Group, based in Des Moines, also launched a new small-balance commercial loan initiative last July. Known as Principal Commercial Mortgage Edge, the program provides loans between $250,000 and $5 million with the goal of securitizing the debt.
Principal's program requires that borrowers have a net worth of 25% of the loan amount and liquidity greater or equal to six months of debt service. Borrowers must also have a minimum credit rating of 680; borrowers with ratings below 620 are considered a high default risk.
Yet for newcomers as well as industry veterans, there are challenges ranging from evaluating potential oddball properties accurately to cost-effectively processing loan applications. Sourcing transactions also can be a difficult task.
“It's hard to find volume because so much of the business sits in the hands of little mortgage brokers who have their funding sources but don't tell anybody who they are,” says Barry Bates, president of Reno, Nev.-based Inside Valuation, a 15-month old appraisal firm concentrating on small-balance deals. “Big banks have a tough time finding that volume, but it clearly exists.”
Silver Hill Financial depends on residential mortgage brokers to drive business to its small-balance program. The Miami-based lender is one of three small-balance subsidiaries operating under Coral Gables, Fla.-based Bayview Financial Holdings. Wholesale lender InterBay Funding and Commercial Direct, an originator that works directly with borrowers, are the other two subsidiaries. Silver Hill typically holds hundreds of seminars a year across the country and over the Web to draft and train residential brokers, says Joanna Schwartz, managing director of Silver Hill.
Not surprisingly, those brokers are showing more interest today than they did in the month's following Silver Hill's launch in 2003, she adds, and often writing small-balance commercial loans mirrors the residential process. The lender provides $100,000 to $1.5 million to borrowers with a credit rating of 640 or higher, which was recently raised from 600 given the enhanced perception of credit market risk.
Although Schwartz declined to disclose Silver Hill's annual lending volume, all three Bayview loan operations originated about $3 billion in 2007, a roughly 25% increase over 2006, according to the privately held parent company. Affiliate Bayview Commercial Asset Trust has securitized $10 billion small-balance mortgages since 2003.
Signing up residential brokers to work with Silver Hill is paying off, Schwartz insists. Mom-and-pop commercial property investors “are not necessarily experts on the financial side of the business, ” she points out. “Very often that first call turns out to be the person who got them the mortgage for their house.”
On the other hand, KeyBank's Krawitz avoids residential mortgage brokers, who he refers to as “commercial curious,” because they simply are too unfamiliar with commercial properties. “I need commercial mortgage brokers who understand how to properly underwrite a property's cash flow complexion, and the residential guys don't,” he says.
Still, the customers who walk into KeyBank's branches across 13 states account for many of the loans that Commercial Mortgage Access originates. To capture more customers, KeyBank is installing 200 plasma screens that will air a commercial about the small-balance loan program at some bank locations.
Small-balance lenders with that type of direct retail channel enjoy an advantage when it comes to landing business over those that lack the connection, says Fuchs of Boxwood Means.
“It's difficult to develop proprietary relationships with brokers to the extent that lenders have a predictable flow of business,” he says. “So retail channels to borrowers, as difficult or as expensive as they may be to develop, may be the best way to go in the long run.”
Joe Gose is a Kansas City-based writer.
Small-balance commercial real estate loans created a buzz during the second half of 2006 and the first half of 2007 when they increasingly showed up in the commercial mortgage-backed securities (CMBS) market. Securitizations of the mortgages, typically made to mom-and-pop investors for less than $5 million, grew 70% to $7.2 billion in 2006, reports Fitch Ratings.
Midway through 2007, small-balance CMBS issues totaled $5.2 billion and were on a pace to reach $10 billion. But rising defaults among subprime home borrowers last summer caused panic in the credit markets. Deal volume totaled $8.1 billion in 2007, short of expectations.
Robert Vrchota, a Fitch Ratings director, expects 2007's second-half drop in small-balance activity to continue. “We're still seeing shops stepping forward with new securitizations,” he says. “But when you look at the landscape, you're certainly going to see fewer players.”
Yet experts remain bullish on small-balance CMBS prospects for the long haul. Late last year, Lehman Brothers sold $700 million in bonds backed by 1,207 small-balance loans that had an average principal balance of $580,000. Cleveland-based KeyBank, meanwhile, plans to securitize small-balance loans with an average size of $1.5 million in the coming weeks, says Charles Krawitz, managing director of Commercial Mortgage Access, the bank's small-balance program.
Small-balance CMBS issuers face more challenges beyond the credit market crunch, however. Real estate deal making likely will remain muted because less upside in property income growth exists this late in the cycle, Vrchota observes.
Many of the small-balance CMBS buyers have migrated from the asset-backed securitization (ABS) market and traditional CMBS buyers still are a little wary of the securities, he adds. While CMBS investors receive annual financial data such as occupancy and net operating income on the properties in large-loan pools, investors in small-balance securities don't get that information.
“Typically there are more loans in a small-balance CMBS deal, and it's a more diverse pool, which makes it difficult to collect and process those financials,” Vrchota says. “That's the one hang-up [traditional CMBS investors] have about buying in this area.”
Conversely, diversification could attract investors to small-balance CMBS bonds given the economy's uncertainty, says Barry Bates, president of Reno, Nev.-based Inside Valuation, an appraisal firm focused on small-balance property. CMBS buyers may conclude that large-loan pools with fewer properties make them more susceptible to a recession.
— Joe Gose