With life companies lending again and conduits also on board, the money market wave is continuing to gain strength but, this time, at a more sensible pace.

Nearly every type of commercial property -- from triple-A malls to mobile-home parks -- is benefiting from a flood of liquidity in the market. "It is a golden time for borrowers," says Curt Glaser of Glaser Financial, Minneapolis.

Life companies arc again actively lending to top-quality properties, and conduits are largely taking care of the remainder.

"It is a more accommodating market," says Hal Holliday, president of the commercial mortgage harking group at Holliday Fenoglio Dockerty & Gibson, Houston, a wholly owned subsidiary of Dallas-based AMRESCO Inc. Deals are getting done "as long as the lender is being paid for whatever risk is associated with the deal and as long as the underwriting is sensible," he says.

Key word: sensible

As the capital markets have become more accepted in the industry, their standards "should help put the breaks on any predatory pricing" that was evident when traditional lenders re-entered the market a year or two ago, says Carl Kane, national director of real estate and hospitality consulting at KPMG Peat Marwick, New York. "Commercial mortgage-backed securities (CMBS) provide consistent benchmarks for all types of lenders. Exit is key, along with mark-to-market principles and liquidity," he says. "The impact that securitization has had on the market is the common reckoning of: 'Can I sell it today?,' 'Would I take a hit?,' 'If so, I don't want it,'" Kane says. "People are backing off a bit if they can't make a deal work at sensible levels."

While such caution should help keep the industry in equilibrium, it cannot completely erase the fact that real estate is inherently cyclical, says Michael Coster, managing director and co-head of real estate capital markets at the Bank of Boston. "The peaks and troughs are not as wide, hut the cycle is shorter," he says, referring to how, in just a few years, commercial real estate has gone from recession to a period "with so much money sloshing around."

Equity capital focuses on private REITs

Equity capital is especially plentiful. Pension funds are looking at ways to pump more money into real estate "knowing that the 1980s' way is not the way they want to do it today," Coster says. Their current focus is in the private real estate investment trust (REIT) market, which comprises 81% of all real estate equity and represents a different mindset from public REITs, Coster says. Pension funds find a number of advantages in investing in a company, "entity capital," rather than a property. "It represents an alternative to direct investment or commingled funds" and provides increased control, a closer alignment of interests with management, improved risk diversification over a portfolio of properties, and better risk adjusted return on capital, Coster says.

"There is a value pendulum that swings between private and public REITs," Coster says. "In 1993, implied market cap rates were extremely low, and real estate owners realized value by selling to Wall Street and forming REITs."

Now the pendulum has swung hack toward Main Street, sector by sector, starting with apartments and then retail, he says, adding that it is 'a true capital markets phenomenon for all corporations, once you cross the line to investment grade, you find better pricing in the public markets and if you are below investment grade, better pricing comes from the private market."

As the optimum public REIT size continues to grow (Coster says Bank of Boston recommends $500 million), it presents "a barrier to entry" and will result in more merger and acquisition (M&A) activity rather than additional initial public offerings (IPOs). "Given the market and pricing execution of today, we do not see a rush of IPOs as in the past," Coster says. "The market is covered geographically and by property type. There may be a niche play here and there, as there are some portfolios yet to be converted that are in institutional hands."

Coster says the market has become more sophisticated in terms of developing "a better understanding and pricing of the risk/reward relationships," as well as learning from the 1980s, "that real estate is a separate industry, hut it must he able to compete with other assets" and not be viewed as merely a 10% hedge by institutional investors. "Institutional investors are starting to see that you can apply corporate finance valuation techniques to entities easier than individual assets," Coster says.

"Real estate is no longer a four-letter word," says Matthew E. Galligan, recently appointed head of the new real estate investment branch at Fleet Financial Group. "There is a tremendous resurgence of old players in the market as well as new nontraditional players." It is increasingly difficult to say what is traditional, as players' roles and behavior continue to broaden and evolve, largely due to the maturation of the CMBS market. Conduits are working hard to lower their spreads and make their loan documentation reflect that of portfolio lenders. Life companies, besides returning as top-tier lenders, have also become the leading buyer of investment-grade CMBS.

Noninvestment banks are issuing their own shelf registration for CMBS. Niche lenders are becoming a part of the scene, using capital markets techniques to create transactions for properties net leased to investment-grade tenants.

The end result is that "the re-liquidation of real estate is in fruition," Kane says. "Financing is available at any risk position, for any property type, any geography, any flavor, any grade, any size. It's there," he says. Besides various new equity sources, in the debt arena, "conduits are increasing their loan sizes up to $50 million, and other larger loans are singularly financed from other sources. Any parameter is covered."

The only area basically untouched by the capital flow is new construction, which Kane calls "the last frontier." Capital markets don't lend on development. Insurance companies are scared, and banks have a limited involvement, Kane says, adding that the only real activity he is beginning to see is equity participation from high-yield hedge funds that aren't finding returns elsewhere.

But, Kane says he believes that eventually capital markets' characteristics will carry over into construction, with lending programs devised that look like securities, "layered debt programs that segment the risks of a development scheme."

As for now, new speculative development continues to be limited by "a good re-balancing of priorities," as the risk-return advantage now rests in favor of the capital rather than in the 1980s when a developer with little equity could get all of the upside and then walk away, Kane says.

Holliday says most construction lending is being executed by REITs through bank loans or internally generated funds, and others report that hanks continue to be active as they remain "the best suited for short-term, floating-rate loans with full recourse," says E. J. Burke, program director of Midland Loan Services L.P., Kansas City.

Some life companies who have been aggressive lenders all year may he backing off of the market until year's end as they reach their 1996 targeted lending levels, according to Galligan. Many of them have stretched further outside of their quality-level parameters than they did a year ago, says Brian F. Stoffers, executive vice president at L. J. Melody & Co., Houston, which was acquired by CB Commercial in July 1996 and serves as an originator for both conduit and life company loans. "Conduits are sharpening their pencils, too," he says.

Conduits

Some conduits are cutting their spreads to be able to compete with portfolio lenders on investment-grade properties. Burke says Midland has started a program to introduce investment-grade loan pricing. "We are willing to dramatically cut our loan spreads for high-quality properties with low leverage where we feel they will get investment-grade treatment," he says.

The reason is because he believes "there are a lot of borrowers who are more rate conscious than concerned with leveraging out the last dollar." Burke says Midland has also raised its maximum loan size from $5 million up to $15 million, believing that it is well enough established with both rating agencies and investors to take bigger risks and because "biggest securitizations seem to receive better pricing, with a perception of more liquidity on bigger deals," he says. In July, Midland became one of the first noninvestment banks to file its own shelf registration for future CMBS, called Midland Realty Acceptance Corp., which is expected to securitize all of its loan production and "further the idea of Midland as a brand leader," Burke says.

Burke says he sees an upcoming convergence between the spreads of life companies and mortgage conduits. He says life company spreads for A-quality properties are in the 150 to 190 basis points range, while conduits have lowered their spreads in the last year on multifamily properties from the 235 to 270 range down to the 170 to 225 range and for offices, down from the 300 range to the 200 to 250 level. He says that as the backend of the CMBS market becomes more liquid, he expects the numbers to go down even further. "Life company spreads are moving up a bit in response to their being under pressure for liquidity in their portfolio, which is a direct result of the CMBS market. We will meet in the middle somewhere," he says.

Stoffers says that it remains easier to close a life company loan, while a conduit loan often continues to be a more painful process. "Conduits still have maturing to do," including simplifying their "incredibly time-consuming loan documentation process," he says.

Burke says Midland and others are already working on it and admits that "a few years ago borrowers were required to jump through hoops to get a conduit loan, whereas documentation requirements from life companies were not as cumbersome." Now, conduits are dropping special purpose entities and eliminating replacement and rollover reserves to help ease borrowers' burdens, Burke says.

"The biggest rap against conduits was that a borrower would sign an application and spend money on appraisals and environmental requirements and then find out 60 days later that they end up with a loan commitment that did not look like the application, in contrast with life companies, where there was a high probability the loan would close in accordance with the application," Burke says. "What we and our competitors are striving to do is end up with loans that look like the initial applications," he says, adding that conduits also have made gains in closing loans faster than they did a year or two ago.

Stoffers says that "a huge step toward maturity" is that some conduits are now offering a rate-lock procedure, which stabilizers the interest rate for a period either 30 to 60 days before funding. This was especially important in upward-rising interest rate periods, such as last spring, and helps to eliminate what was a built-in conduit risk factor of circling the spread but not the rate, Stoffers says.

According to Holliday, the real challenge in making a conduit loan is to make sure the loan is not inferior. In other words, "to make an `A' loan on a `B' or `C' property," he says. "For almost any deal that comes into the shop, we know right away if it is a conduit deal or traditional life deal, generally speaking," he says, mentioning that that conduit flow business, usually loans under $15 million, "are generally on properties of lesser quality and command a higher spread so that all of the people who need to be paid in the conduit from the originator to the seller can be compensated,"

"Conduits have brought liquidity to the `B' and `C' properties and off-beat property types. Life companies are willing to invest in that product, but only in the senior tranches," he says. Securitization can be more competitive for deals of $100 million or more, Holliday says, part of the reason being that "the fixed cost is spread over more dollars. You can have a situation where a half dozen life companies are bidding and competing with securitized lenders." But in what he called "blue-collar mortgage banking," he says he sees "no head-to-head combat."

Kane says conduits are now recognized by many people as an integral part of "the new infrastructure for real estate finance." He points out that in only three years they have become larger and more efficient and represent more than one-third of the CMBS market. He says he sees increased conduit efficiencies in the advent of sub-debt funds, better information technology, and a more convergent regulatory and guideline environment for loan documentation and due diligence.

Paul McDowell, vice president and general counsel at Capital Lease Funding L.P., New York, says he believes that the capital markets will garner an evergrowing portion of the financing market, largely because of "sticktoitiveness." "The capital markets will have money available for appropriately structured transactions without limit," he says, adding that he believes that securitized lenders "will in the end become the most dependable lenders," in contrast with portfolio lenders who move in and out as yields move and their strategies change. He admitted there have been some bad experiences. "Capital markets have not always had the best reputation, which was driven by inflexible demands of CMBS investors and rating agencies, which life companies could ignore," he says. But, he thinks the gap between the two types of lenders is narrowing rapidly. "We in the capital markets business understands where we can be more flexible, and the developer market is starting to understand that if you can comply with the capital markets, it is cost effective and efficient," he says.

McDowell says that Capital Lease Funding (CLF) was formed at the end of 1994 "to fill a niche as a specialized borrower to properties net leased to investment-grade tenants in cases where leases did not fit into the capital markets type of net lease deals," Essentially, CLF takes various net credit leases and adds some lease enhancement mechanisms. "Once the loans have closed, we can take an existing lease and make it look like a bond lease," McDowell says, explaining that a bond lease is one "where the tenant has virtually all of the risks and obligations normally associated with the owner of the real estate but does not have residual ownership interest."

The result is a discounted cashflow loan that is more concerned with the lease that the underlying real estate. Typical DSC ratios are as low as 1.0, McDowell says, adding that LTV constraints "are generally not a concern to us," which allows them to compete with life companies and maximize borrower proceeds at competitive interest rates.

McDowell says these types of transactions are "the next tier of CMBS" and that they fill a gap in the capital markets by addressing the needs of many small borrowers in the $1 million to $23 million range that had not seen much liquidity.

While available to all types of triple-B or better properties, the bond lease program expects to do a lot of business with box retailers such as Walgreens, Home Depot and Wal-Mart, McDowell says.

To get increased capacity for funding loans, the firm has a $350 million warehouse line of credit with NationsBank, Charlotte, N.C. McDowell says CLF has funded $100 million and expects its first securitization later this year, which will represent "a diversified pool of credit."

"Even with significant retail exposure, it is not dependent on any one retailer and represents diversification in terms of geography and across the credit spectrum," McDowell says, adding that he expects CMBS investors such as life companies to find the offering to be a more palatable investments than taking the risk of making whole loans to a retailer.

* Total return: Equity REITs produced a 4.5% return in the second quarter, maintaining the consistent, if not dramatic, gains that they have generated over the last year. This performance matched almost exactly the S&P 500, which finally decelerated below the 5.0% total return level for the first time since fourth quarter 1995 (when it actually lost a little ground). Long-term bond indices were essentially flat for the quarter and remain down about 7% year-to-date.

* Sector performance: Not-leased properties topped the performance list for the second quarter (+8.9% on capitalization-weighted basis) as easing interest rates and pretty good earnings helped the group.

* Yield: The capitalization weighted average yield for equity REIT's was 7.28%, down slightly from 7.35% last quarter and down 35 basis points from midyear 1995. However, over the last year, the median REIT payout ratio has dropped about five percentage points (to 85% of FFO) while the average dividend grew by 3.6%, providing investors with both bigger dividends and better coverage. Equity REITs' yield advantage vs., the S&P 500 remained just over 500 basis points, where it has been for over a year. The spread widened to 150 basis points vs. the Dow Utilities during the quarter, near the high end of this range in recent quarters. Conversely, it narrowed to the low end of its range vs. 30 year Treasuries, to about 40 basis points at the end of the quarter, although the gap was essentially zero in midquarter. By sector, median yields this quarter (vs. last quarter) were as follows: diversified, 6.66% (6.03%); office, 5.99% (6.46%); self storage, 6.84% (6.95%); industrial, 6.98% (7.55%); residential, 7.90% (7.75%); hotel, 8.46% (7.76%); healthcare, 8.55% (8.56%); and retail, 8.65% (9.13%).

* Valuation: Equity REITs median price-to-FFO ratio was 10.8 at midyear. This is based on annualized first quarter results following adoption of NAREIT's more conservative definition of FFO, making prior period comparisons somewhat imprecise.