In the early '90s, mortgage conduits began to replace traditional lenders as a source of capital, filling the void that financial institutions left when they decided not to further invest in debt or equity for commercial and multifamily real estate. In today's market, more sources of capital have become available from life companies, pension funds, banks and credit companies, resulting in less business for conduits. Conduits are also suffering the effects of rising interest rates and declining spreads from traditional lenders, without offsetting declines in the MBS market.
When interest rates rise and competition becomes fierce, institutional lenders can assume greater risk by dropping required debt service coverage ratios. They are able to season the loan in their investment portfolio and bank that the property will experience some appreciation by the term of the loan. Some conduits do not have that option, because they carry inventory under floating rate lines of credit tied to the London Interbank Offered Rate (LIBOR) and cannot hold the asset long enough to experience any degree of appreciation. Other conduits that warehouse fixed-rate loans do not experience any potential upside in property values because current hedging strategies do not allow them to season the loans.
There are currently more than 50 conduits in various stages of activity, plus Fannie Mae and Freddie Mac chasing the same deals in the market. According to E&Y Kenneth Leventhal Real Estate Group, commercial mortgage conduit volume was projected to be in the $5 billion to $6 billion range in 1994 and it finished with just under $4.2 billion in issues. Conduit volume is far below early expectations, but it should be noted that volume in 1994 almost doubled from the 1993 level of $1.2 billion. The top six issuers in 1994, comprising 84% of market activity, are shown in the table below.
The conduit market has begun to consolidate due to a contraction of spreads that do not allow enough room to execute a profitable Fannie Mae swap or profitable securitization. Many conduits are sponsored by established institutions with existing portfolios that have comprised the jumbo conduit pools securitized in late 1994. Unfortunately, there is still some conduit product that has not been securitized, with spreads too tight to make a reasonable profit. Spreads are being offered by conduits and traditional lenders which will lead to further consolidation of the conduit industry.
Competitive conduit spreads are based off a tiered pricing structure tied to the underlying quality or class of the asset. Some conduits are now in a position to compete with spreads from life insurance companies and local banks for higher quality properties; it is very competitive and in many instances these spreads do not allow a profit to be made. Often placing of the loan comes down to which lender or mortgage broker has the better relationship with the borrower. The track record of the conduit is also vital to the prospective borrower. Conduits in general have developed a reputation for increasing spreads and lowering loan amounts once the commitment has been signed. This generally occurs after a considerable amount of time and money have been spent on closing the loan.
Another hurdle involves all of the mechanics of the securitization and the role of the parties involved, specifically the lending entity, investment banker, correspondent, rating agency, lawyers and senior and subordinate investors. The role of these parties becomes confusing to the potential borrower and in many cases the borrower begins to question who, at what level, makes the final decision on the loan. The conduits that have a strong reputation for delivering exact terms and dollars for quoted deals will be the survivors when consolidation of the conduit industry is completed.
Although the quality of loans that conduits are making has increased, the bulk of new originated loans generally fall short of traditional lender guidelines. The majority of the conduit loans are generally a refinance of balloons from banks, S&Ls or RTC discounted payoff loans.
Mortgage conduits must originate and underwrite multifamily loans according to Fannie Mae and rating agency requirements to further minimize the risk of higher levels of subordination upon the rating and sale of the security in the secondary market. Recent rating agency changes requiring tenant improvement and leasing commissions being deducted prior to calculating net operating income have caused the downsizing of retail, office and industrial loans. Reserve requirements tied to age, construction quality, whether it's student housing or an all senior apartment complex, have impacted the loan size of many apartment properties.
As a conduit that either closes the loan with a lender who has offered a line of credit or a warehouse lender who purchases the loan from the conduit at closing, it is instrumental that the conduit stay abreast of all rating agency requirements including underwriting requirements and the use of standardized non-negotiable documents that conform to rating agency requirements. Through standardized documentation and quality underwriting we should start to see consistent levels of subordination being assigned by the rating agencies.
Numerous sources of capital for multifamily and commercial loans have surfaced over the last nine months. Competition for product is fierce. 1995 will prove to be the year of conduit repositioning and consolidation.