At the halfway mark of 2007, leveraged investors are saying goodbye to the lowest commercial mortgage rates in 40 years and are coming to grips with increased capital costs. Fixed mortgage rates rose an average of 50 to 75 basis points from early April through June to approach 7%, increasing debt service on loans and decreasing loan-to-value ratios.

The higher borrowing costs are at least partially responsible for the flattening sales volume of non-institutional grade properties and could force cap rates to widen later this year, experts say.

“We're seeing a number of acquisitions that are falling apart because the investors cannot get the leverage they could previously,” says Gary M. Tenzer, principal at real estate investment bank George Smith Partners Inc. in Los Angeles.

The pendulum has swung quickly. At the beginning of the year, for example, an investor could expect to finance 85% to 90% of an unanchored strip shopping center for 10 years with an interest-only loan. “That deal would be very difficult to get done today,” says John H. Pelusi Jr., executive managing director of lending intermediary Holliday Fenoglio Fowler in Pittsburgh. Today, an investor in that same retail deal would likely be required to pay principal plus interest, with financing at 80% or less of the purchase price.

The underwriting has tightened to reflect investors' concerns over risky loans. “The 85% leveraged conduit loans are few and far between now, and they were plentiful,” says Tom Sherlock, managing partner of Newport Beach, Calif.-based lender Buchanan Street Partners. “Interest-only deals, and accepting less than break-even debt-service coverage ratios — most of that got washed out the window.”

The debt-service coverage ratio (DSCR) on a stabilized office property five years ago was about 1.1. In recent years that average dropped to about 1.05, with some loans at 1.03 or lower, reducing the cash flow required for debt service.

Horror stories

Even if coverage ratios don't change, debt service has increased because most borrowers must now pay amortization, or principal plus interest. That increased demand on a property's cash flow will limit available loan proceeds.

While borrowers and lenders are reluctant to discuss specific loans, it's clear that deals are suffering. In a recent example, a non-institutional buyer hit by increased capital costs asked to renegotiate the purchase price of a mid-rise office building developed by The Alter Group, a Skokie, Ill.-based firm. The two parties are negotiating, but Alter Group CFO Ron Siegel says the buyer's reduced purchasing power will likely kill the deal.

Lender Philip Carroll, southeast regional manager of KeyBank Real Estate Capital in Miami, says clients have told him “horror stories” about other lenders reneging on previously negotiated terms to impose higher mortgage rates and underwriting requirements. “They've tightened the screws on the origination shops,” he says.

In response to the changing interest-rate environment, owners will need to execute a real estate strategy to increase the value of their holdings, says Earl Webb, CEO of the capital markets group at real estate services provider Jones Lang LaSalle in Chicago. “There is still value to be created in real estate, and lots of it, but it will be value created through improvement of properties, leasing, redevelopment, aggressive management and expense control,” Webb says.

Markets re-price risk

Much of the climate change in lending is traceable to a single event. On April 11, Moody's Investors Service declared that lax underwriting on CMBS loans had increased investors' risk, so the rating agency vowed to increase subordination levels in future transactions.

The spread on BBB-rated bonds has spiked 44 basis points above its 52-week average as of late June, while spreads for B-rated bonds soared 85 points for the same period.

The cost of capital for CMBS issuers increased in order to pay a higher yield to investors at each tranche. CMBS bond buyers, shaken by rating agencies, grew more conservative and even began to kick out undesirable conduit loans from CMBS pools deemed too risky. In turn, conduit lenders began to increase mortgage rates.

As rating agencies had intended, lenders reacted almost overnight by tightening underwriting standards, shunning interest-only periods, boosting equity requirements and effectively reducing the proceeds available on senior loans. As a result, loans that would have provided 80% financing in the first quarter are down to about 70%.

However, repricing of risk only accounts for a fraction of today's higher mortgage rates. A more significant factor is the benchmark 10-year Treasury yield, which climbed more than 50 basis points from 4.50% on March 13 to 5.16% in late June (see sidebar p. 28).

Floating-rate fallout

The one-month LIBOR (short for London Interbank Offered Rate), a benchmark for short-term lending, has remained stable for the past year at about 5.3% with competition among banks keeping floating-rate mortgages low. Nevertheless, investors who use construction loans and other short-term financing report that less loan proceeds are available to them.

Borrowers say lenders are reducing loan amounts to ensure owners can refinance later and supplementing the smaller loans with costlier mezzanine debt. TCB Development Co., based in Tinley Park, Ill., is still landing construction financing for its projects, but company CFO John Atkenson expects to see some reduction in the availability of loan proceeds for individual projects.

Atkenson says amortization requirements on fixed-rate loans create a ripple effect through construction lending. Fixed-rate lenders are cutting back on loan proceeds because borrowers must pay more to cover principal and interest payments, rather than interest alone. In turn, short-term lenders don't want to approve loans that will be too large to refinance in the permanent market.

TCB Development is navigating the more restrictive financial landscape by working with lenders with which it has established relationships. “Lenders are just working harder along with us to address this issue on take-out financing,” Atkenson says.