As it faces new competition, the conduit component of the commercial mortgage-backed securities (CMBS) market continues to develop and refine itself.
Many in the industry say they expect more loans to come into the CMBS market through conduits, which originate smaller commercial real estate loans (anywhere from $150,000 up to $15 million) that are pooled and then securitized. Others point to an inevitable consolidation of conduit originators as CMBS faces increased competition from many conventional lenders who are back in action, stepping up activity and grabbing their share of loans.
Nonetheless, as conduits continue to come of age, the process shows signs of maturity and increased efficiency. Large financial institutions such as banks and insurance companies are becoming new sponsors. As another sign, sponsors are forming strategic alliances that can better respond to specific financing needs and that help reduce the costs of the conduit process. And sponsors are more frequently specializing, originating loans to different property niches, thus broadening the market by lessening the dominance on multifamily properties. This helps reach a broader array of potential borrowers and could also attract more investors to securities that are backed by more diverse property types, which are, therefore, potentially less risky.
Added to all of this are advancements in information technology, such as electronic processing, that reduce operating costs, just as standardization and increased tracking of data makes for easier analysis for investors.
Conduit volume to rise
The overall dollar volume of conduits is expected to increase in 1995, just as it has for the last two years, according to Carl Kane, managing director and head of the capital markets group at Kenneth Leventhal & Co., New York. Kane estimates $4 billion to $6 billion of loans coming into the market via conduits this year, up from $2.2 billion in 1994 (out of a $20 billion total CMBS issuance last year). Kane also views conduits as healthier than the overall CMBS market. But some players may be squeezed out this year.
Securitization is a process that the commercial real estate industry needs, says Stan Cheslock, president of Cheslock, Bakker & Associates, a Stamford, Conn.-based investment banking firm. "There has to be a secondary market for commercial real estate loans to better place the credit risk," he says. "But it's very competitive because the volume was not there to support all the conduits. Now conduits are diversifying their product."
The conduit business is "more competitive," says Steve Wendel, vice president at ContiFinance, New York, a subsidiary of Continental Grain Co., mainly because of the return of banks and life insurance companies. "I don't expect the market share (of CMBS) to shoot up, he explains, adding that he is skeptical of real expansion of true loan-by-loan conduits.
"Lots of people come out with a product and make a big splash," says Raymond M. Anthony, a director in the real estate division of Nomura Securities International Inc., New York. "But a lot of people come and go."
In many cases they go because they do not have the financial resources, manpower and long-term commitment required to aggregate the critical mass of loans necessary to make conduits work, Anthony adds.
"It is not a quick in-and-out business," notes Robert M. Greer, senior director at Cushman & Wakefield, New York, and national manager of the National Mortgage Conduit Program, a venture between C&W and Fidelity Bond & Mortgage Co., Blue Bell, Pa., which serves as loan underwriter and servicer.
Greer says some conduits are "dropping out fast," be they mortgage bankers or Wall Street firms, because "some don't have the resources to do the due diligence, originating and underwriting that's required."
Jeffrey Davis, chairman of Cambridge Realty Capital, a Chicago-based merchant banking firm, has seen competition from conventional lenders cut significantly into conduits' lending on senior housing loans. He says conduits provided $1 billion in financing for senior housing, but now Wall Street has put a tremendous premium on these properties. In addition, they are the target of whole loan lending by conventional lenders.
"Banks and insurance companies are back in the market feet first, and the financing is more attractive than conduits," Davis says.
"There's clearly a place for conduits, but I think there will be consolidation," he adds. "It's hard to know what is necessarily a conduit deal today."
Banks are big sponsors
Some of die earlier conduits were sponsored by investment banks and mortgage banks "with limited capabilities," Kane says. Nevertheless, he believes that conduits are operating more efficiently because large financial institutions such as commercial banks and life insurance companies are moving in as new sponsors.
Unlike many previous sponsors, these institutions can do the entire conduit job - originate, underwrite and master service - under one roof, Kane says. This overall shift in sponsorship will produce a better-capitalized, better-managed business, and these one-stop sponsors benefit from being able to keep rather than share the profit, as they can make originations as well as master service fees.
Mike Greco, former senior vice president of New York-based Donaldson Lufkin & Jenrette, moved to lead First Union Bank's conduit business last summer. "I saw the business moving to depository institutions," says Greco, who is managing director of Charlotte, N.C.-based First Union Capital Markets. "Banks have the ability to do this business more efficiently than Wall Street. We have a lower cost of funds, a better origination base and every service in-house. We can make more money on the carry (of loans)."
Rising interest rates hurt the first few months of the bank's conduit business, but it closed on $100 million of loans in the fourth quarter, followed by an active first 60 days of 1995, vice president Steve Jones says. It has loan programs for multifamily, retail, industrial, congregate care, nursing homes, hotels and office properties. "We're taking this business and offering it as a bank product," Jones adds.
First Union expects to aggregate $400 million to $500 million in loans in 1995. While it hasn't securitized loans yet, it expects to this year.
Charlotte, N.C.-based NationsBank Capital Market inc., a subsidiary of NationsBank Corp., also started its multifamily conduit a year ago and expects to offer two $200 million, private-label multifamily securitizations by year-end, vice president Rob Schweitzer says. The first is planned for the end of April. The bank also expects to have health care, retail and industrial conduits in place during the second quarter.
"These sectors will become more competitive, but that won't have a bearing on whether we're in or out of the business," Schweitzer says. "We are in this to make money, but the programs also serve the needs of the corporation in terms of balance sheet management (by reducing the amount of much of the real estate it holds)."
Because of competition, NationsBank's multifamily conduit has become a more aggressive originator, underwriting more Class-C-plus and -C properties and fewer Class-B properties. Bank-sponsored conduits may be more adept than Wall Street and their correspondents at tapping these markets.
"The B- and C-property market is vast, (but) it takes more coverage to identify the borrowers and produce the volume, Jones says. "We're probably in a better position to do this than Wall Street."
Banks also say their ability to do everything in-house is a plus for borrowers since owners deal with just one contact instead of separate originators or servicers.
"It still comes down to product," adds Neil Cullen, vice president of AMI Capital, a Bethesda, Md.-based Fannie Mae DUS multifamily lender that's working on securitized deals with New York-based First Boston and First Union. "The First Boston/First Union marriage may be a model in terms of getting volume. There are a bunch of players out there that are holding $200 million in loans, but they can't hold forever," says Cullen.
There will be a huge shakeout in conduits this year, at least in multifamily, Cullen adds. Some Wall Street firms will survive and there will be six or eight banks in the business. In the meantime, Cullen says it will be difficult to quote pricing to borrowers, particularly as conduits will likely account for a growing share of apartment lending as the stock of multifamily product ages. The majority of business he is interested in underwriting now is between 15 and 25 years old. And conduits have to figure out how to create a vehicle for low-income housing, since 60% of all multifamily business in recent years has used the low-income housing tax credit.
But Todd Schuster, president of Continental Wingate Financial Services, Boston, the parent company of Continental Wingate Mortgage Group, says the conduit market is witnessing an influx of capital from sources that haven't had a strong presence in the last few years. "Just when you thought the conduit market was consolidating, it appears that capital sources are reaffirming their commitment to the business," he says.
Schuster is bullish about the state of conduits in the coming year, and he expects more business concentrated with fewer mortgage bankers. "The real issue is which of the mortgage banks are going to be providing the service to this business," he says. "I believe there are only a handful of mortgage bankers that have closed more than $250 million worth of conduit business, and only those that have will gain market share.
"Last year was difficult, as we ran into a buzz saw," he explains, citing bond market troubles and increased competition from insurance companies and banks. "The competition will continue to increase in the next six months, and the bond market should be more cooperative this year."
Through its commercial loan program, Continental Wingate expects to generate $400 million to $500 million in loans in 1995 in refinancing or acquisition financing for all types of commercial real estate, Schuster says.
He is also looking for insurance companies to invest more in securities as opposed to direct real estate. "Just like the equity side, where big institutions have replaced real estate ownership with REIT stock, I think we will begin to see them displace their mortgage portfolios into mortgage-backed securities," he says, mentioning that the day will come when real estate will find its place among, instead of outside, the asset classes of (public) debt and equity.
Investor demand drives market
But, according to Ron Wechsler, executive managing director in the CMBS group at Fitch Investors Service, Inc., a New York-based rating agency, much of the underlying commercial real estate that comprises conduit pipelines does not seem to be the Class-A product that many institutional investors want.
"Conduit product is the old S&L, B-quality product," Wechsler says. "It is not the top-tier real estate, which life companies are making loans to at low spreads." Since product is B- or even C-quality and originators don't keep the mortgages on their books, Wechsler says "investors should be very cautious and look to the rating agencies for help in scrutinizing the collateral - which isn't all pretty."
And, he adds, with conduit product "getting worse, it tells me they (originators) will stretch due to increased competition from each other as well as from life companies and other lenders."
But Greer says the appetite of B-piece buyers is much larger than the supply. "With today's underwriting standards, the B-piece is considered a safe junk bond, with yields between 14% and 17%," he says. "It's very attractive paper."
In fact, Greer and others report a trend in subordinate debt investors coming into the conduit process at origination, which all but ends the later risk of placing die B-piece debt. This translates into tighter spreads and happier borrowers that pay less for capital. For the sub-debt investor, it means "you don't have to wake up every morning like a chicken and find new deals," Kane says.
"Sub-debt investors like the certainty of coming in to fund the debt from the start and making sure they get the specific property they want," Greer says. "B-piece players are sophisticated institutional investors that will help grease the skids for everyone. These players will make alliances with product originators, and the net effect is that they become conventional whole loan lenders."
Greco agrees, adding that "the barrier (to growth of CMBS) is not demand, but supply. There's a lot of interest, even in the lower-rated paper. There's an expanding list of buyers for investment-grade and non-investment-grade pieces, and a steady list of buyers for BB- and B-rated paper."
Overall, securities investors, having shied away from Third World debt and looking for alternatives to corporate bonds and troubled derivatives, are looking at CMBS.
The investors include pension fund advisers, Greer adds.
One of the strategic alliances in the conduit business is between Continental Grain's conduit/merchant banker/owner of loans, ContiTrades, and real estate partner Parallel Capital. Wendel says, "We have a number of correspondents that bring loans to Parallel, which originates the loans. We then run the funding or loan sale or securitization and own the assets."
Similar to the evolution of many other conduit sponsors, the ContiFinance/Parallel team started as a multifamily conduit and branched out into mini-warehouse and self-storage properties. It then offered loans on property types that included retail, office, assisted-living facilities, and mobile home parks, among other types of commercial real estate. And the team continues to expand its horizons with different property types, Wendel says.
"One of our strengths is that we are different from Wall Street institutions in that we can hold loans. Continental Grain is happy being the B-piece holder. We will sell, but we don't have to if the economics aren't correct," he says. "We allied with Parallel because we chose to operate differently than the rest of the street," he says, explaining that ContiFinance found it better to form a joint venture with experienced real estate professionals rather than support the structure in-house - which would drive up loan origination costs.
Wendel says the advantage of being the B-piece holder is that "it obviates going to the rating agencies on a loan-by-loan basis. We have had extensive dealings with Fitch as a B-piece holder. We had been involving the rating agencies up front, and it was unwieldy. Now we know how they think with much less involvement. It cuts time, which is an important ingredient."
Wendel says rating agency models are driving conduits toward larger pools that include more deals. It makes sense to have combinations of conduits, with a double-sized pool to help decrease risk. He adds that he would not be surprised to see some informal or case-by-case alliances formed where a conduit with $100 million of loans teams up with an investment banker that puts in an additional $100 million.
"It takes six to eight months to get $100 million of loans," Wendel explains. "You have to originate fast and have to be prepared for a six- to nine-month holding period. Not everyone has the capital allocation to do it. But conduits with good origination systems can be just as efficient as traditional lenders."
Efficiency rises
Cheslock Bakker & Associates, which also buys the B pieces of the securities, is aggregating office, industrial, retail and hotel loans and expects to securitize two or three deals this year. By the end of this year, Cheslock, who says consolidation of the business will continue, expects to announce a new relationship that will lead to his firm securitizing "a deal a month next year."
"The market is very diverse now, with different players and different levels of activity," Cheslock says. "There's enough spread to be in this business, but spreads on commercial deals are getting tighter every day."
While the conduit business is becoming more and more efficient, Cheslock says it is not quite "efficient" yet. "You have to lend at spreads that compensate for all of a conduit's levels, but when you have life insurance companies that are flush with cash lending whole loans at low spreads, it's tough for conduits to compete."
Efficiency continues to be a key concern for Nomura Securities, which in 1994 ranked as the No. 1 lead manager for all private-label CMBS with $1.7 billion represented in six deals. The firm has made a conscious effort to refine and engineer the conduit process, getting rid of the bugs that frequently make originating small loans cumbersome and confusing, says Kathleen F. Corton, who heads Nomura's small loan program as vice president in the firm's real estate division.
"When people started doing multifamily loans, there were originators that were responsible for soliciting, pre-screening and underwriting the loan. Then the loan went to Wall Street, where it would be underwritten again," says Corton. "There were too many parties with overlapping responsibilities." That frequently meant pain and confusion for the borrower. The process needed to be condensed and better resemble the scenario of working with a local lender in a competitive environment.
Nomura has tried to modify the process, largely by being in constant communication with originators on each specific loan, Corton says. Furthermore, in order to reach as broad a base of small borrowers as possible, Nomura, which commits its own capital, recently launched a marketing program called Nomura Direct, where borrowers seeking loans in amounts of $1 million to $15 million can access Nomura directly. The program is not intended to eliminate Nomura's originators but to reach borrowers that may not come through those channels. Nomura expects to complete between $550 million and $700 million of small loans through both of these distribution methods in 1995.
Cushman & Wakefield's national network of 40 offices has helped Greer keep conduit product in the pipeline for the National Mortgage Conduit Program, "despite seven rate increases," he says. The program is focusing on deals in the $4 million to $5 million range, and is particularly interested in portfolio deals.
Another national alliance has formed a conduit to concentrate on the smaller end of the loan scale. Prudential Securities, New York, has aligned with Midland Loan Services, L.P., Kansas City, and established a conduit called Midland Commercial Funding, which focuses on smaller loans (from $150,000 up to $5 million) in smaller towns, "a relatively underserved portion of the market," says Midland program director E.J. Burke.
"When we started the program with Midland, we had strong feelings that conduits don't work," Peter Riemenschneider, a director at Prudential Securities and head of its commercial mortgage group, adds. "The difference in our arrangement is that Midland is holding the B-piece equity in loans, which they originate, and puts them in a different decision-making position. As opposed to taking loans to Wall Street for underwriting, Midland will underwrite and live and die by their loan decisions." Prudential Securities will advise on pricing and be the take-out source for securitization.
Burke says the conduit already has closed $50 million, with an additional $ 100 million ready to close, recently approved or being committed. The conduit will loan to all income-producing properties except special purpose recreational properties and hotels, although the decision to lend on the latter may change in the future.
"It's more time-consuming doing small loans," Burke says. "But we are not only the originator but the servicer, and we can underwrite these loans and absorb the cost. What you give up up front in terms of underwriting efficiencies you gain in the credit quality of the pool. If the average loan size is smaller, the less impact it has on the overall pool compared to a large loan," he notes.
Both Burke and Riemenschneider say their long-term strategy is for conduits to dominate the smaller loan niche. They expect better subordination levels from the rating agencies by having pools with more diversity and less risk, where investors will recognize the value and buy bonds at lower spreads, with the savings passed on to borrowers.
"The problem with conduits is that they are not really underwriting," Davis says. "They are doing what rating agencies say, and the agencies have strict guidelines," which adds both time and cost to deals.
"The secret of the business is origination, not processing or trading," concludes First Union's Greco. "We see Wall Street backing away from the business. Spreads have come down, and Wall Street firms need bigger profit margins than we do.
"We're pumping out the volume and trying to figure out the bond market," he adds.