When Tishman Speyer plunked down $1.8 billion to buy the 41-story 666 Fifth Avenue building in Midtown Manhattan in December 2006, the transaction not only set the record for the highest price ever paid for an office property at $1,200 per sq. ft., it also symbolized the frenzied lending markets that elevated 2006 to a pivotal year in commercial real estate finance.

“All of these deals now are mega-deals,” says Boyd Fellows, comparing today's big transactions to the activity during the late 1990s. Fellows is managing director for Calabasas, Calif.-based Countrywide Commercial Real Estate Finance, a division of Countrywide Financial Corp. Fellows was with Nomura Securities in the '90s and helped coin the phrase “mega-deal” to describe Nomura's large-loan program. “That's what the world has become in many ways, with a twist or two.”

Liquidity for everyone

Both one-off assets and portfolio plays were popular with investors in 2006. The year was marked by the two largest portfolio deals in history — the $39 billion privatization of Equity Office Properties by New York-based The Blackstone Group, and the $5.4 billion purchase of Peter Cooper Village Stuyvesant Town in Manhattan by Tishman Speyer.

But the year also was marked by seemingly less significant transactions that told a deeper story. Consider the December 2006 sale of a 252,000 sq. ft. office building in downtown Allentown, Penn. A group of foreign investors paid Liberty Property Trust a record $327 per sq. ft. for the eight-story structure. What concerned analysts was the high loan-to-value level on the $82.5 million deal, which included 90% debt financing totaling $75 million.

“That's the type of thing I'm seeing more and more, and smaller buildings trading at $250 to $300 per sq. ft. in secondary markets is a bit alarming,” says Robert White, president of New York-based Real Capital Analytics. By comparison, Atlanta's tallest office building, the 1.2 million sq. ft. Bank of America Plaza, sold for $436 million, or $348 per sq. ft., in October 2006.

Many big lenders also are raising caution flags. “We're all watching the amount of leverage being put on properties, which is increasing,” says Gene Godbold, president of commercial real estate banking for Charlotte-based Bank of America. The bank ranked No. 1 in NREI's annual Top Lenders survey with commercial real estate financing totaling $78.5 billion in 2006, up from $75.9 billion in 2005. Meanwhile, Countrywide Commercial ranked No. 20 with $5.7 billion in financing.

Mounting pressures

Many pundits believe that the five-year financing hot streak may be in the final throes. Ongoing woes in the national housing market, along with interest rate worries and a flock of new lenders itching to make commercial real estate deals, has some investors skittish. Many owners, meanwhile, are still hoping to reap the last few drops from the lingering euphoria over increased property valuations.

Case in point: In April, Tishman Speyer listed the former New York Times headquarters it owns on West 43rd Street for $500 million, more than three times what it paid for the building in 2004.

Another cause for concern is the possible spillover effect from the mounting subprime debacle in the residential housing sector, coupled with deteriorating loan underwriting standards in the commercial sector. In April alone, Fitch Ratings and Moody's Investors Service issued warnings about the levels of potential problem loans with pools of securitized commercial loans in the CMBS market.

Fitch warned that aggressive underwriting on securitized loans issued in 2007 will lead to increased defaults over the next decade. Moody's followed up with its own warning shot, requiring higher capital cushions on commercial mortgage bonds it rates as a result of loose underwriting standards and slowing property appreciation.

“Today's deals have become increasingly fragile,” wrote analysts Jim Duca and Tad Philipp of Moody's in a recent report. “The parallels between underwriting developments in the subprime and CMBS market are striking and indicate that acting now should help mitigate potential CMBS losses in a future downturn.”

While 2006 saw an undeniable rush of capital from both traditional and nontraditional sources into the commercial real estate arena, it's not time to panic, says White. “The rating agency actions are evidence of the internal controls that would keep the boom and bust cycles from being as deep and as rapid as they used to be. The wind is still at everyone's backs.”

Bank of America is trying to move with the markets on its deals. “Transactions are occurring much faster today than they used to, and our clients are telling us that we have to be able to run on their timeline. We deliver a comprehensive capital stack — A note, B note, and mezzanine note — and we're doing more of that as a company,” says Godbold.

Financial intermediaries like CB Richard Ellis Capital Markets are enjoying the times. “Lenders are still very aggressively quoting commercial real estate loans at very attractive levels to borrowers,” says Brian Stoffers, president of CB Richard Ellis Capital Markets, which ranked No. 4 on NREI's list of top financial intermediaries with $20.7 billion in commercial real estate loans arranged in 2006.

But Godbold admits that competing for business in 2007 will be tougher, noting that increased construction is looming on the 2008-2009 horizon. “There is too much capital in the system today. It's been very positive for our industry, but at some point the question is: When will that capital gravitate to another sector, and when will supply catch up with demand?”

Time for a breather?

At least one major lender says the subprime crisis will clearly dampen investors' appetites for commercial property. “I am in the spillover camp, and I don't know how anybody could say otherwise,” says E.J. Burke, group head of KeyBank Real Estate Capital, No. 8 on NREI's survey with $22.8 billion financed in 2006.

“Clearly in commercial real estate, and especially in CMBS, some of the underwriting rules have been bent. If you look at the flood of capital, a lot of those investors are also buying residential paper and subprime paper. So, when there is an explosion in that market, it absolutely affects our markets because we have many of the same investors.”

The impact might not be pronounced, argues David Hendrickson, executive vice president of capital markets with Chicago-based Jones Lang LaSalle. “There is probably as much capital going out the door this year as last year,” he says. “I've had lenders tell me they will be putting out just as much or more money for several years to come.”

The challenges facing today's regulated lenders also are escalating. The world's largest bank, New York-based Citigroup Inc., announced 17,000 layoffs earlier this year in a major corporate restructuring.

Banks also may face pressure from private equity firms. The recent $25 billion purchase of student-loan provider Sallie Mae by a private equity group led by J.C. Flowers & Co. and Friedman Fleischer & Lowe LLC, plus banks J.P. Morgan Chase and Bank of America, could make commercial banks themselves acquisition targets by private equity firms.

If recent deals are any indication, competition for assets will continue to increase in the short term as private equity players sell off their portfolios to reduce their debt. For example, in April, Lakewood, N.J.-based Lightstone Group agreed to acquire Extended Stay Hotels from The Blackstone Group for $8 billion.

“It's eye popping,” says Jim Merkel, head of Columbus, Ohio-based Rockbridge Capital, which arranges financing primarily for the hospitality industry. “The capital markets have gotten efficient enough that there is no longer an advantage being public for a lot of these companies. If the market stays healthy, these will be good deals for everybody.”

Will one of next year's top lenders be a division of Blackstone, or some other private equity firm? Stay tuned.

Ben Johnson is a Dallas-based writer.