Talk about a 180-degree turn. The once turbo-charged commercial real estate financing market stands now largely idle. Lending volume plummeted 80% in the fourth quarter of 2008 from a year earlier, according to the Mortgage Bankers Association (MBA).

The reasons for the falloff are many. For starters, the recession has put the brakes on developers' plans for new construction and renovation. Meanwhile, acquisition financing has dried up along with commercial property sales, which fell 84% year-over-year in the first quarter, according to Real Capital Analytics.

The only steady demand is for long-term mortgages to refinance maturing debt. The chief source of that funding — conduit loans — is on hiatus until the commercial mortgage-backed securities (CMBS) market stabilizes.

While life insurers are filling a portion of that long-term demand, many of these institutional giants are dealing with their own capital constraints. Financial intermediaries have found an unexpected ally in community banks, which have been largely unscathed by the balance-sheet issues that haunt national lenders. Yet there simply isn't enough long-term debt available to refinance all the loans reaching maturity.

The last action lenders want to take at this stage of the game is to foreclose on hundreds of properties and attempt liquidations in a market where few assets are selling and dispositions may not recover the amount still owed on a mortgage.

In fact, lenders are committing most of their time and capital to staving off a potential wave of foreclosures. For borrowers who are unable to obtain permanent financing to replace mature debt, lenders are attempting to extend loans until market conditions improve.

Time to recover

A case in point is KeyBank Real Estate Capital. The direct lender is extending many of its short-term loans coming due by up to three years. In exchange, KeyBank is asking its clients for more conservative underwriting terms to reduce the risks associated with short-term deals.

Through extensions, the bank is helping its commercial real estate borrowers avoid foreclosure and stay in business until they are able to pay off their loans, explains Clay Sublett, national production manager at Cleveland-based KeyBank.

Three years may seem like a long extension for acquisition, bridge and construction loans that may have carried only two-year terms originally. But KeyBank executives reason that shorter extensions might not be enough to carry their borrowers through the credit crunch. “We're saying, ‘Let's give them a more meaningful maturity so we can see them past the current market upheaval,’” Sublett says.

KeyBank provided $7.7 billion in financing to the commercial real estate industry in 2008 after lending $21.9 billion in 2007, a drop of 65% year-over-year. The bank continues to originate financing for health care properties, including seniors housing, and government agency loans for multifamily projects.

Without significant demand for acquisition and development loans, it's no surprise that originations decreased in 2008 for most lenders and intermediaries. While the MBA doesn't break out dollars borrowed for new deals as opposed to refinancing or loan extensions, the anecdotal evidence suggests that renewals of existing mortgages make up the bulk of lending activity today, says Jamie Woodwell, vice president of commercial real estate research at the MBA.

At Bank of America, which ranks No. 1 on National Real Estate Investor's 2009 Top Lenders Survey, a brisk loan origination business masked a decline in loans to new borrowers.

The Charlotte, N.C.-based institution's direct lending volume swelled to $129.2 billion in 2008, up 41% from $91.5 billion in 2007, but loan extensions and refinancing activity made up the lion's share of those results.

“You see a big number there, but the fact of the matter is that new credit being extended in the real estate space is down considerably,” says Eugene Godbold, president of commercial real estate banking at Bank of America.

No conduits

The conduit loans that drove mortgage originations to record highs in 2006 and 2007 won't become a significant source of debt financing again for several years, observers say. CMBS loans have fallen out of favor with investors, and lenders won't initiate new conduit loans until the bond market recovers.

In the meantime, life insurers remain a finite source of long-term financing and are offering mortgages ranging from 50% to 60% loan-to-value (LTV). Mortgage rates offered by life insurers average 7.25% to 8.5%, depending on property type and market, and come with 25- to 30-year amortization schedules.

Unfortunately for borrowers, life insurers have less capital to lend for commercial real estate these days, says Enoch Lawrence, senior vice president at CBRE Capital Markets' debt and equity finance office in New York.

That's due to the so-called denominator effect, which forces a life insurance company to reduce the amount of capital allocated to commercial real estate when the value of its total investment portfolio declines in order to keep everything in proportion. “That's going to limit a lot of life companies from having aggressive lending going forward,” Lawrence says.

Commercial banks offer an alternative for borrowers looking for permanent financing, according to John Pelusi, executive managing director at financial intermediary Holliday Fenoglio Fowler (HFF).

Banks will make two- to five-year loans at interest rates ranging from 6% to 7.25%, provided the borrower has 40% to 50% equity in the deal. While that interest rate is slightly more attractive than what life companies are offering, many commercial banks demand anywhere from 25% to 100% recourse on their loans.

HFF recently arranged a $40 million loan for mall real estate investment trust Glimcher Realty Trust to refinance Morgantown Mall in Morgantown, W. Va. The five-year loan, which closed late last year, is 50% recourse with an interest rate of 350 basis points over the 30-day London Interbank Offered Rate.

Who provided the financing for Morgantown Mall? Not one, but a half dozen community banks came up with the necessary financing to close the deal. “The life insurance companies couldn't really quote it, given their issues, and the major banks were dealing with balance sheet issues,” Pelusi says. “The best way to get the deal done was to go to the local, community banks.”

Local lenders step up

Experts say community banks emerged as an important source of financing in 2008, probably because those banks had less exposure to the asset-backed securities that are now weighing down the balance sheets of larger lenders.

Consequently, financial intermediaries have had to expand their relationships with smaller lenders, according to Bill Hughes, senior vice president at Marcus & Millichap. “We've spent a great deal of time sourcing lenders, some of which we'd never heard of before, let alone done business with before,” he says.

Regardless of the expected source of funds for a borrower's loan, mortgage negotiations today are complex and lengthy. Experts say any borrower with debt maturing before the end of 2011 should begin working on the problem now.

During negotiations, it's important to respond to the lender's questions quickly in order to close the deal as soon as possible, Hughes says. “The marketplace isn't getting any better, so we're hell-bent on shortening the process wherever we can.” Marcus & Millichap arranged $1.1 billion in loans last year compared with $1.5 billion in 2007.

Borrowers with maturing loans face an uphill battle to refinance today, says Sublett. Three years ago, a borrower who received financing at 75% LTV with an interest-only period may have made little headway in paying down the principal owed. Declining asset values compound the problem. A deal originally struck with a 75% LTV may now be 80% or greater.

That's why KeyBank and many of its fellow direct lenders have chosen to work with borrowers and extend loans rather than pursue foreclosures on a large scale. “You can't count on the market to solve your problems,” Sublett says. “You've got to take control of your own destiny.”

— Matt Hudgins is a Austin-based writer.

BORROWER COSTS ARE CLIMBING

Fixed rates on commercial mortgages remain low by historical standards but are rising at an accelerating pace, according to the American Council of Life Insurers.

Fixed-Rate Loans
Mortgage rate (%) Gross spread (basis points)
1Q08 5.72 254
2Q08 6.11 296
3Q08 6.29 292
4Q08 6.90 446
Sources: Commercial Mortgage Commitments Bulletin, ACLI