Current trends in real estate banking.

Commercial bankers have been backed into a corner by an aggressive new wave of commercial real estate lending dominated by Wall Street. The increased demand for real estate product, now that the real estate depression of the early 1990's is behind us, has made for a borrowers market for debt products that few lenders could have foreseen. And if it had been foreseen, no one could have predicted the market would move this fast. The increased level of capital available to real estate may be its eventual undoing.

Banking activity depends on transaction volume, driven by favorable interest rate movements, construction and development opportunities, and sales. Lenders came back into the market, attracted to high yields and conservative valuations. Real estate, however, is a cyclical business and it is inevitable that this cycle will eventually trend down. As the markets have improved, the traditional lenders have raised their own origination targets, increasing the funds available for financing to levels not seen since pre-1990.

All this money in the marketplace, together with the reduction of NYS transfer gains tax and possible future cuts in capital gains taxes, has grown the volume of transactions. Supply and demand would indicate that as institutional real estate investment targets increase (funding a fresh supply of capital, both debt and equity) the demand for whole loans will increase accordingly,

This increased demand has lowered the pricing on debt and increased valuations. Real estate yields vs. the 10-year US Treasuries have tightened up, and as they do, valuations have become more aggressive on a risk-adjusted basis. Today's favorable lending rates (average 10-30 year treasuries between 5.5 and 7.25 percent) and reduced spreads, from 300 basis points down to 150 bp for comparable product over the last two years, have drastically improved the real estate climate from an investor's perspective.

Publicly financed real estate debt appears to be the way for a majority of commercial mortgage originations. Since 1995, the volume in Commercial Mortgage Backed Securities (CMBS) has increased approximately 30 percent. The secondary market for CMBS offers liquidity not found in whole loan originations, while still allowing the portfolio diversification into real estate that most institutions crave. Not every loan is securitizable, however.

Since only a small percentage of the $3.2 trillion real estate market is institutional, as opposed to small "mom & pop" operations, that means either the borrowers will have to become more institutional or the lenders less so. The market demands more mortgage debt to feed the CMBS, as well as traditional institutional requirements. The mortgage market has built-in rollover "bullet" and maturity turnover, leading to refinancings every 5, 7 or 10 years. Given the increase in CMBS since 1993 and their unforgiving pre-payment terms, it is unlikely the market will see any of the loans underlying the securities become available for refinancing before 2003. The first floating rate pools are only now coming to market, while construction and/or mini-perm lending is not quite ready for the street.

Some traditional lenders have met the market head-on, delivering debt at prices that barely exceed corporate bonds. Other lenders see the fee business generated by conduits and mortgage bankers and are angling for a piece of the action. Still others appreciate the benefits of off-balance sheet lending and have started their own trading desks to underwrite, issue or trade CMBS. Wall Street appears to have the jump on these "me-too" lenders, but the possibility that investment bankers aren't relationship lenders may eventually dawn on borrowers and mortgage brokers, leaving them stranded when the securitization train starts to slow down... If it slows down.

Where does all this leave the traditional lender? In a more competitive market than ever. The lenders staying in the market will look toward whatever competitive advantages they may have. The need to put money out into the market (increasing supply) may not necessarily reduce credit or underwriting standards, but open up credit to areas that have been cash-starved.

Commercial real estate banking needs to focus on new product types, wider geographic areas, or lower its margin expectations to meet the supply of cheap money entering the market from Wall Street. A more aggressive lending style is required in order to meet these challenges. Prospecting for new business and marketing becomes more important, as do more creative financing vehicles. Construction loans and forward commitments, taboo products for more than 10 years, are now cropping up in many areas. Unique combinations of recourse and non-recourse blends can help differentiate product offerings, as do mezzanine participations and other options.

The increased availability of mortgage financing in the marketplace has forced lenders to become more creative, combining debt and equity into new mezzanine and participating "B-piece" transactions, extending their lending beyond the traditional 75 percent loan-to-value. Principals can raise money in the debt and equity markets in many different ways, with some institutions offering combination debt and equity in one-stop shopping. Commercial lenders will be looking to enter the new markets with these revamped products. Unfortunately, the traditional lenders are not the only ones pursuing new products, property types and geographic areas. Every lender has increased its targets, raising the bar for originations.

Real estate economic fundamentals are as strong as they have been in years, and possibly stronger than they were 10 years ago. Valuations and underwriting for all property types are conservative enough that most lending may not deserve the level of reserve that is traditionally applied to the loans, which may reduce spreads even further. It is conceivable any possible equilibrium for the industry has long since passed, and we are now headed toward a speculative bubble. And when the loans start to turn bad, as some are bound to do, many of these products and lenders are bound to disappear, or at least scale back their expectations.

Real estate has seen Wall Street enter the market before, but perhaps this wave of involvement is different. Rating agencies have become as important to appraisers as a check on value, while national accounting firms have increased staff to perform underwriting due diligence on behalf of the securitization issuers. Third-party servicers are an additional level of control over the process. Given the amount of oversight in lending today, defaults on whole loans should be far lower than the default rate was in 1990-1993.

As a track record of lower defaults gets absorbed into the marketplace, the appetite for commercial real estate banking will get more voracious. Knowing when to slow down the money flow before markets start to turn and deals go bad will be all but impossible while fees continue to be generated from loan production. As lenders in this marketplace, we have our work cut out for ourselves to both meet the competition, and find new ways to step around it.