Commercial lending volume is bursting at the seams, the result of competitive, deal-savvy lenders willing to relax underwriting standards to get money out the door — a practice unheard of a year ago. Even mortgage servicers are waiving pre-payment fees for securitized loans in some specialized cases. That's good news for borrowers in search of more flexible loan terms and lower fees, but loan approval committees have their hands full these days trying to balance flexibility with prudence.
Some lenders are even willing to underwrite properties that are 20% vacant, says Charles Krawitz, director of real estate capital markets for LaSalle Bank in Chicago. Why? They're banking on the theory that the market has bottomed.
A fairly dramatic reversal in lending practices has occurred over the last year, according to D. Michael Van Konynenburg, president of Los Angeles-based Secured Capital Corp., a real estate investment bank. “Last year we saw a tightening of underwriting standards as lenders became more conservative. Many lenders now think they have seen the worst (market conditions) there will be.”
Life insurance companies, for example, are doing deals today at 70% loan-to-value for multifamily product vs. 65% a year ago, says Van Konynenburg. The size of loans also is growing. For example, a multifamily property that received a maximum loan of $60 million a year ago would receive $70 million today with the same loan terms.
“Valuations are stable and with interest rates so low, lenders are lending more this year,” Van Konynenburg explains. He expects his business this year to top $3.5 billion, up 25% from last year.
By the Numbers
Nationally, loan originations increased 34% to $18.8 billion in the first quarter of 2003, up from $14 billion during the same period a year ago, according to the Mortgage Bankers Association of America (MBA), which anticipates that figures for the second quarter will be equally as strong for loan production. (Statistics for the second quarter were not available at press time.)
Multifamily properties were the high-flying sector with $7.5 billion originated during the first quarter of 2003, compared with $6.8 billion for the same period in 2002, the MBA reports. The only obstacle to even higher loan production could be rising interest rates. The 10-year Treasury yield, the benchmark for long-term, fixed-rate financing in commercial real estate rose rapidly from 3.10% in early July to 4.4% in mid-August. Still, interest rates are very low by historical standards.
Yet, the abundance of capital chasing deals puzzles Art Rendak, a senior loan originator at Oak Brook, Ill.-based Inland Mortgage Corp. “It doesn't really make sense since fundamentals in real estate are still weak,” says Rendak. For example, the national apartment vacancy rate in the top 50 U.S. markets rose to 6.8% in the second quarter of this year from 5.9% during the same period a year ago, according to Reis Inc., a New York-based research firm. The vacancy rate is expected to top 7% by the end of the year.
Still, there's pent-up demand to invest. “There's more activity this year than last year. It's a more competitive environment as the marketplace is full of money,” confirms Holli Leon, executive vice president of loan production at ARCS Commercial Mortgage of Calabasas Hills, Calif.
The Fannie Mae Factor
Housing agency giant Fannie Mae, a government-sponsored enterprise, also has played a pivotal role in the trend toward more relaxed underwriting standards. The agency routinely tweaks its Delegated Underwriting and Servicing (DUS) program, which establishes guidelines for mortgage brokers and bankers. But over the past year, rising vacancy rates and a slowdown of economic growth in some of the hardest hit areas prompted Fannie Mae to loosen the reins on underwriting policy and give lenders more delegation authority.
Through its nationwide network of lenders, Fannie Mae provides 93% of affordable housing in the U.S. The agency says it will work with borrowers in situations where the property may not meet all of its specified guidelines for lending. Seem too good to be true? Fannie Mae says the quicker turnaround time on the deals achieved via the increased flexibility has resulted in a higher loan volume, yet it stressed that it is careful in selecting properties on which to lend. Fannie Mae's business volume is on track to surpass last year's totals. Through June of this year, Fannie Mae's business volume totaled $746.4 billion vs. $848.9 billion for all of 2002.
Stuart Davis, director of multifamily production at Fannie Mae, says that the agency's goal is to remain the number one mortgage lender and provide liquidity in soft markets as well as growth markets. With a multifamily portfolio of $96 billion compared to about half that at rival Freddie Mac, the strategy appears to be working.
Leon of ARCS Commercial Mortgage recently took advantage of Fannie Mae's newly created Extended Maturity Option, which offers borrowers the flexibility of extending their loan term for an additional year. With Fannie Mae's new option, ARCS Commercial Mortgage was able to arrange refinancing for a $12.7 million mortgage loan last July for the Beaver Ridge Apartments, a 350-unit property in Beaverton, Ore. The borrower's ability to extend its loan anywhere from a month to a year to capture the best interest rate available to refinance the property helped seal the deal.
Hal Kendrick, principal of Lend Lease Mortgage Capital LP, a DUS lender in Dallas, also touts the benefits of Fannie Mae's decision to allow lenders to lower floors, or the minimum interest rate borrowers have to pay on their loans. He emphasizes, however, that lenders should have a stringent policy in place that ensures floors won't drop below a minimum threshold of 5.5% or 6%.
Fannie Mae also has empowered lenders to originate, underwrite, commit, close and service loans without its prior involvement. DUS lenders have the freedom to waive or reduce some underwriting criteria on distressed properties. Otherwise, a lender adhering to the original underwriting standards could be in the difficult position of having to force a property into foreclosure, says Davis.
This lending leniency, he says, has actually worked to lower the overall delinquency rate for its multifamily loans to 0.15%, compared with a level of around 2% when the program originally started in the late 1980s, says Davis. Vacancy in general, though, is still a problem for all multifamily development.
A combination of low economic prosperity, reduced job growth and an oversupply of new construction has left some markets more vulnerable to property performance issues. Austin, Texas, still stands out as a depressed area for lending, but the absolute worst combination of property type and location is the hotel sector in Orlando, Fla., according to Tad Philipp, managing director of commercial mortgage-backed securities (CMBS) at Moody's Investors Service in New York.
Still, lenders in today's market are more inclined to avoid a specific market rather than an entire state or region as once was the case. “A year ago, you just looked at the Texas market for vacancy data as opposed to just the North Austin section,” says William Hughes, senior vice president of Marcus & Millichap Capital Corp.
Ronald Halpern, COO and president of Berkshire Mortgage Finance, a commercial and multifamily lender based in Boston, says “there has been flexibility by lenders on a deal-by-deal basis in continuing to do business in those markets (the hard-hit areas like parts of Texas).”
Leon, of ARCS Commercial Mortgage, agrees. “If we have an ability to lend in certain markets of the country, we go in very cautiously,” she says, pointing out that even in weak markets some individual properties perform strongly due to location or other factors. “Many markets see significant occupancy issues. You can't ignore this,” she says.
In economically challenged areas, Fannie Mae also has given lenders more authority to calculate rental income of multifamily housing projects based on collections for one month, for example, rather than projections for a 90-day period. This way a really hot property or one not performing well is more accurately depicted. “Now there's more discretion to modify on a case-by-case basis,” says Kendrick of Lend Lease.
Non-Traditional Lenders Weigh In
Secondary mortgage lenders and intermediaries also provide greater flexibility in today's financing market. Over the past two years, Old Standard Life Insurance Co. in Spokane, Wash., recorded a 250% increase in volume for short-term financing, including bridge loans, development loans, renovations and land deals. Gregory Weed, vice president of Old Standard Life Insurance, expects to complete $750 million in financing in 2003, up from $565 million last year.
Flexibility was the key reason Old Standard's $13.7 million refinancing of a convenience store operation throughout Utah got off the ground. The borrower already had secured a six-month, $6.5 million loan earlier this year to be used as a down payment to purchase several convenience stores from a company in bankruptcy, but it needed additional capital.
In a less competitive market, Old Standard may not have entered into such a complicated refinancing because the deal involved 17 separate properties as collateral. By using a combination of collateral between the properties, the lender ultimately was able to provide refinancing for each property. The deal was based on a 70% loan-to-value with interest-only payments for 12 months.
Weed maintains that in many cases “it's not a matter of total financing but how to get from here to there. Without us, many properties would struggle and would end up going to foreclosure, or it wouldn't get refinanced.”
Over the past few months, some mortgage servicers have waived prepayment fees on conduit loans — or loans that are originated, pooled and securitized — without charging penalties. To those borrowers who remember the capped fee formula, which included lenders charging fees up to 10% of the value of the loan, the idea seems preposterous. Yet it's happening.
Statistics reveal that servicers are showing a greater willingness to allow borrowers of distressed loans to pre-pay without penalty, says James Stouse, vice president of CMBS research at Bank of America Securities in Charlotte, N.C. A survey of all conduit loans as well as those loans that blended a portion of conduit loans with other loans in the last 22 months revealed 76 loans prepaid without penalty and 821 loans prepaid with penalty, according to Bank of America.
“Because these pre-payments are usually a product of some property distress, an alternative way to view the phenomenon is as a type of default,” says Stouse. In one recent example, the pre-payment penalty fee was waived on three separate loans to the same borrower.
But whether or not the trend of waiving fees continues at a rapid pace, the early return of principal inherent in these loans has detrimental implications for the investors in the packaged securities. Pre-paying early prompts a decrease in yield for the first investors in these securities — those investors buying the interest-only portion of the CMBS and those buying the A1 or first tranche of the security, Stouse explains.
In its review, Bank of America found that if the pre-payments were waived without penalty, default rates actually increased by 8%. This stands to reason since these properties were obviously in trouble prior to any waivers being considered. “It is a gray area,” says Stouse. “Servicers are trying to balance minimizing losses with honoring the pre-payment stipulations. It is becoming a bigger topic.”
However, Philipp of Moody's says that waiving pre-payment penalties is not a widespread trend, adding that lenders have other options. “We expect servicers to hold borrowers to the deal,” he says.
So far the waiving of pre-payment penalty fees is not having much impact on the number of CMBS loans that are downgraded vs. upgraded. Following several quarters where downgrades exceeded upgrades, the first quarter of 2003 saw upgrades and downgrades evenly matched, according to Philipp.
The consensus of industry experts is that as long as interest rates remain relatively low, the intense competition among lenders will not abate any time soon. There are no absolutes in the lending arena, however, and some of the concessions could begin to wane if real estate fundamentals don't show significant signs of improvement in the near term.
The key for lenders is to be aggressive without making a deal that will come back to haunt them. As Rendak of Inland Mortgage puts it, “when you lose deals, you think the other guy is making a mistake.”
Kathleen Fitzgerald Hoffelder is a New York-based writer.