The past year has been one of the most aggressive markets for underwriting and pricing of commercial mortgage-backed securities in several decades. Questionable practices and an unprecedented amount of liquidity in the marketplace available for investment pushed commercial real estate lending to new highs over the first two quarters as increased leverage and lower yields stimulated the investment market.
So, what has happened over the last quarter? The past 90 days was a roller-coaster ride with lenders using words such as "capital crunch, meltdown, re-trade" and "difficult." As a reaction to the increase of delinquencies in the residential subprime loan market, buyers of asset-backed paper -- whether backed by residential mortgages or not -- began to readdress pricing in relation to risk. In short, bond buyers are no longer accepting loosely underwritten or thinly priced debt.
Where are we today? The commercial mortgage-backed securities (CMBS) market has been in the process of selling approximately $30 billion of securitized loans since the roller coaster ride started in early July. Bond buyers have slowly returned to the marketplace during the past two months, although they are requiring more return for taking certain levels of risk, creating an availability constraint that has increased spreads by much as 100 percent. A spread of 100 basis points several months ago is anywhere between 150-200 basis points today depending on the lender, asset type, leverage level and structure. However, several lenders have recently shown signs of renewed strength.
CMBS/Wall Street conduit lenders
A majority of the Wall Street lenders are still in the market for making commercial real estate loans. However, a small group of conduit lenders are staying on the sidelines until they can sell the existing loans they have not been able to sell in the past several months. Those lenders are still cautious of making loans, as the demand for CMBS paper still is scarce. Although some are not lending, most have adjusted to the market with higher spreads and increased lending constraints and are making loans to borrowers. Additionally, all CMBS lenders are pricing transactions with higher profitability levels in case the market deteriorates further.
During the last week of September at the Commercial Mortgage Bankers Association Conference, most conduit representatives were hopeful of a recovery late in the fourth-quarter 2007 as the majority of the aggressive commercial loans still in the market get sold. Spreads, which were above 200 basis points on average a few weeks ago, have continued to decline in recent weeks. There were in fact several that have been bullish on the market again, quoting creative structures and pricing below 175 bps.
Life insurance companies as lenders
Life insurance companies and balance sheet lenders are not as impacted by the capital crunch in the CMBS world. However, many have held off on issuing new quotes until they can assess where the market is for new business. Additionally, many life insurance companies have recently been able to purchase CMBS bonds at a discount. Others have taken advantage of the current market conditions to take back market share and make loans on good quality real estate at higher yields.
Life insurance companies have continued to stay disciplined over the past several years as CMBS lenders have gained market share with lower yields, higher loan proceeds and less structure. They have stayed relatively firm on loan structures and leverage and many are taking advantage of the current market conditions. After the turn of the New Year, when new allocations of capital are given to the real estate departments of life insurance companies, many industry experts expect these lenders to be the leaders in the market.
Currently, spreads from life insurance companies differ greatly depending on their appetite for making business. Based on the general tone and specific meetings at the Commercial Mortgage Bankers Association Conference, spreads can start as low as 135 basis points, depending on the lender's position in the market.
Agencies: Freddie and Fannie
Agencies such as Freddie Mac and Fannie Mae were created for times of credit issues in the market. The agencies continue to have a lower cost of capital than most institutions, which bodes well for certain investment sectors like multifamily borrowers. Multifamily owners can still borrow capital below a 6 percent interest rate with interest-only payments.
For good quality real estate, spreads from Freddie Mac can be as low as 130 basis points. For acquisitions with hard equity capital being contributed to the transaction, agencies will still size the loan amount with a 1.05 times debt-service-coverage ratio and allow for the entire term to be interest-only. Freddie Mac, in anticipation of the return of the Wall Street conduit lenders, has recently come to market with a more aggressive secondary financing initiative and a new program for properties in need of rehabilitation.
Impact on the market
The capital markets have been at ease for the past several months, as buyers, sellers and owners determine where the debt market is moving. Additionally, the economic uncertainty of continued growth or recession is keeping buyers conservative.
Borrowers are more concerned today about their lender's sources of funds and how they are proceeding forward with loans in process. Many buyers have been tentative to put a property under contract without knowing their capital structure or cost of capital.
As stabilization for lenders continues to occur into the holiday season, many borrowers will likely begin to become more active. As long as the treasury bonds remain relatively low and spreads stabilize, the cost of capital for commercial real estate owners will remain relatively low. These facets will continue to revive both the debt and equity markets, particularly as new allocation requirements are set for both lenders and buyers for the 2008 fiscal year.
Peterson is a producer with CBRE Capital Markets' San Diego office, a source provider of debt, equity, structured finance and loan servicing for all property types.