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A challenging year ahead; many commercial and multifamily lenders are hoping 2004 produces volume not too much less than 2003. But realistically, with rates rising, most concede it will be no walk in the park.

THE BUSINESS OF ECONOMIC FORECASTING is somewhat akin to reading tea leaves and often about as accurate. No matter how immersed in a particular industry one is, it is still difficult to gauge even the near future when markets change so quickly.

Peter Donovan, chief executive officer of Boston-based Berkshire Mortgage Finance, for the past two years has predicted year-on-year slowdowns for commercial/multifamily finance, but volume continues to be solid--nationally and at Berkshire Mortgage.

As an example, last year commercial mortgage-backed security (MBS) volume hit $90 billion, about $65 billion coming from the United States. Although total commercial mortgage-backed security (CMBS) issuance is expected to decline in 2004, U.S. totals will hold steady, according to Lend Lease Real Estate Investments Inc., Atlanta.

Berkshire Mortgage saw its business activity remain level last year. In 2002 and 2003, the company's origination volume held stable at close to $3.5 billion. Undaunted, Donovan again predicts "next year's" volume will be down. "One of these years I suppose I will get it right," he says.

On the other hand, Clifford Hardy, CMB, president and chief executive officer of Tampa, Florida-based First Housing, was right last year--and probably wishes he'll be wrong for 2004. When asked last year at this time what he thought 2003 would look like, Hardy quickly and without hesitation responded, "2003 will be a better year than 2002."

Hardy, chair of the Mortgage Bankers Association's (MBA's) Commercial Real Estate/Multifamily Finance Board of Governors, better known as COMBOG, is not so sanguine about 2004. "Looking down next year's pipeline, I am a little concerned about continuation of that pipeline," he says.

The problem for First Housing is that, unlike most lenders, most of its business is new construction and not refinance. Florida, which is First Housing's primary market, remains overbuilt in a number of key sectors. "We are even seeing overbuilding in affordable housing, which I never thought I would see," says Hardy. "We are seeing some developers return their allocation back to the issuing agency rather than build."

Lenders that have some dependency on new construction should be wary. The numbers for 2003 haven't been totaled yet, but a report entitled Construction Outlook: Midyear Update 2003, by McGraw-Hill Construction Dodge, part of New York-based The McGraw-Hill Companies Inc., forecasts a slight decline in the value of all new construction for 2003 as compared with 2002, which was up just 1 percent over the prior year. In individual sectors for 2003, McGraw-Hill Construction Dodge estimates office construction numbers will be at -8 percent, warehouse -13 percent, hotel +13 percent, retail +2 percent and multifamily +2 percent.

In 2004, McGraw-Hill Construction Dodge expects all construction (including residential, nonresidential and nonbuilding--highways, bridges, etc.) to rise 1 percent, with institutional building (including schools, health-care facilities and public buildings) declining but the income-property market making a rebound.

For 2004, a lot depends on the economy and employment trends and, unfortunately, there is not a great deal of consensus in this regard.

"The health of the real estate finance market is directly dependent on jobs creation, and we anticipate significant jobs growth in 2004 and into 2005," says Douglas Duncan, MBA's senior vice president and chief economist.

That compares with the Expectations & Market Realities in Real Estate: 2004 booklet published jointly by Principal Real Estate Investors, Real Estate Research Corporation (RERC), Chicago, and Torto Wheaton Research (TWR), Boston. The study states, "We expect the U.S. economy, in terms of GDP [gross domestic product] and income growth, to continue to strengthen throughout the remainder of 2003-2004, while the job market will likely continue to experience a delayed and only gradually improving recovery."

A number of contradicting cross-currents continue to impact the real estate industry, both to the benefit and detriment of those firms involved in the sector, observes Kenneth Riggs, RERC's chief executive and managing principal. "People suspected the economy was growing in 2002, but jobs were not there. The math fundamentals were poor for real estate in certain sectors such as office and warehouse, while retail properties did well. Single-family housing was robust, and that hurt multifamily."

Riggs is hesitant to invoke the word "disconnect," but to some extent it still best describes the real estate markets going into 2004.

While operating performance, especially in the office and multifamily sectors, has been poor, there is still tremendous capital flow into real estate. Due to a fundamental issue of risk/return, this may not change all that much even if interest rates rise in 2004, says Riggs.

"Yes, there is more capital in the market than people believe there should be. And the short-term capital that has been chasing returns will go away, but there are long-term reasons for institutional capital to be in real estate. There won't be a full-fledged exodus from the markets once interest rates pick up," he says.

On the mortgage banking side of the industry, the same type of cross-currents are occurring. Mortgage banking has been very fluid because interest rates are at generational lows, says Riggs. "I don't think that will continue. Job expansion, which could happen in 2004, will trigger interest rates to move up. That will affect mortgage banking," he says.

How much remains to be seen.

"There will be a 20 percent drop in originations in 2004," predicts Shekar Narasimhan, managing partner with Beekman Advisors LLC, Vienna, Virginia, a real estate investment and advisory firm. The reason for the downbeat prediction? Everything that could be refinanced has been refinanced at least once since interest rates declined, and there won't be a lot of new construction coming out of the ground.

As to the investment sales market, it has become very stratified, according to Narasimhan. Good A-quality projects in A markets are going to sell quickly, as they have been over the past year. Anything below A is almost unsellable.

"You are going to see companies with a lot of capacity in the finance market, and there is not going to be enough business," says Narasimhan.

The odd thing, adds Berkshire Mortgage's Donovan, is that the continued oversupply of capital along with low interest rates have propped up the real estate sector and will continue to do so through 2004. "We do expect interest rates to adjust upward in 2004, though not right away, and so it is hard to guess the effect it will have on volume. Most people I'm talking to are expecting volume to be down, but not necessarily dramatically," says Donovan.

Flat in 2003, less in 2004

Berkshire Mortgage attained a record level of volume back in 2001, at $3.5 billion. In 2002, originations dropped by about $100 million, the company reported. When numbers are finally tallied, 2003 should be "in the same range" as 2002 and, as noted, Donovan expects volume will drop just slightly for 2004. Essentially, Donovan is saying his company's business will probably remain fairly flat over a four-year period--not that he's complaining, because this period of stability has occurred at a high-volume level.

Other mortgage bankers are observing the same phenomenon with their own companies.

In 2001, PW Funding Inc., Mineola, New York, scored a record production year, reports William Hyman, executive vice president of the mortgage banking firm. Then in 2002, production dropped about 10 percent, to $750 million. "We will do a similar amount this year [2003]," says Hyman. He is not very optimistic about 2004.

"We are primarily a multifamily shop," Hyman explains. "In that market, occupancies have slid, rents are flattening and development pipelines [are] slowing. We see a slowdown coming. In 2004, we will do less in the way of financing new construction."

In past years, PW Funding has been much less involved in refinancing than in the type of new business that will grow its servicing portfolio, such as forward commitments on new construction. (When the property is built out and stabilized, PW Funding will make the permanent loan).

Multifamily thrives when job creation is strong, and Hyman doesn't see that happening before the end of 2004--making the first part of the year a "challenge," he says.

As a result of expected trends not favorable to its core business, in 2004 PW Funding is focusing on other things, such as credit-enhancing bond issues. Also, it will be doing credit facility transactions. "We are going to thrive in 2004 by going after those kinds of niches as opposed to traditional bread-and-butter, one-off, multifamily financing," says Hyman. "We need to focus in niche areas, because the flow business is down."

The fiscal year for Pacific Southwest Realty Services, San Diego, ends on June 30, so when fiscal year 2003 ended all the stars were still aligned for the company. Pacific Southwest reported a little more than $1 billion in financing, up from $670 million in fiscal year 2002.

Business won't be so robust in fiscal 2004. Those numbers will slide, says Daniel Phelan, Pacific's president and chief executive officer and vice chairman of MBA's COMBOG.

The big question for next year is interest rates. If they rise just 100 basis points, Phelan doesn't expect that would affect his firm's business (mostly refinancing) very much, but for real estate owners it could be a problem.

"Capital is readily available, especially CMBS capital, and my sense is that underwriting guidelines are going to get more stringent," Phelan says. "Not because lenders are experiencing a number of defaults now, but because they perceive interest rates are going to rise and with that comes defaults. There are a lot of properties out there that are financed through LIBOR [London interbank offered rate] kinds of transactions for the low interest rates, but they are experiencing vacancies--so if interest rates rise, they could be in trouble.

"People are looking hard at the risks and individual markets," says Phelan. "There is a lot of potential for defaults."

L.J. Melody & Co., Houston, expects to do $10 billion in originations in 2003; that would be up from $8.3 billion in 2002, says Brian Stoffers, executive managing director of the real estate investment banking firm. Multifamily financing was huge for the company in 2003 as compared with office deals, which greatly declined, says Stoffers.

Stoffers wasn't specific about 2004 other than to say he didn't expect another large increase in volume. "I think we are going to take a breather next year," he said, in an interview in late 2003. Since there is still the possibility of a spike in interest rates, 2004 is hard to predict, he adds.

Although refinancing is still the bulk of everyone's business, says Stoffers, there is money available for new construction. "In some of the stronger regions such as Florida, the condominium market is still very strong. If you are looking at retail, money is available, but I wouldn't be building a spec office building today. That would be very difficult to finance. Multifamily is overbuilt in a lot of markets, although in some places such as San Diego, dollars are available," he says.

As to the finance side of the business, Stoffers says investors and lenders are both doing well.

"As an asset class, real estate debt is looking good for fund managers because they have taken a bath in the corporate bond portfolios and other investments," says Stoffers. "Despite the softening economy and jobless recovery, they look at their real estate portfolios and know they are doing well."

As for lenders, Stoffers adds, "the GSEs [government-sponsored enterprises], despite all the negative publicity about Freddie Mac, will have a near-record year [in 2003]. Their structured finance will exceed the prior year, but they'll be flat to slightly up on core business. Conduits will have a record year. Life companies are all moving up."

Life companies adjust to market conditions

"We had a good year in 2003," says James Stolze, president of Woodmen Services Inc. and manager of the securities department for Woodmen of the World Life Insurance Society, Omaha, Nebraska.

Woodmen's objective in 2003 was $200 million in commercial lending, which it met. It had the same allocation for 2002. As for 2004, Stolze comments, "Insurance companies are going to want to keep their allocations similar [to 2003]."

It's a tough market to navigate because there are good trends and bad trends going on at the same time, says Stolze. While all real estate sectors deteriorated over the past two or three years, Stolze says the bottom has been reached and markets should see an upward swing going forward. On the lending side, however, there's a lot of product and competition, creating pricing that has gotten very "thin," he says.

"We are trying to hold the line the best we can on spreads," says Stolze. "If you want production, you are going to have to reduce spreads--but even so, that still beats the alternative of putting that money in a bond portfolio."

While most life companies "seem to be getting all the business they want, it has not been easy," says Mike Prior, vice president of investments at Protective Life Corporation, Birmingham, Alabama. "This year [2003] has had a lot of ups and down with rate volatility. Everyone is getting what they want, but it has taken a lot of effort," he says.

Protective Life Corporation set an initial target of $600 million in commercial lending for 2003. Later in the year it boosted the goal to $800 million. "Hopefully, we will be in a position to repeat that $800 million again next year [in 2004]," Prior says.

Like most executives who oversee lending for commercial and multifamily real estate, Prior expects the biggest factor in 2004 to be interest rates.

"Interest rates will be higher both in the short term and long term due to a number of factors, including the budget deficit and an improving economy, so people that have been in the real estate market will probably shift their money to other forms of investments," he says.

That could be a problem for some investors. "If we have rising interest rates, especially at the short end of the curve, you could see a lot of properties that are performing now at 200 [basis points] over LIBOR, not performing if LIBOR went up 400 basis points," says Prior.

If this situation occurs, Prior adds, it will be a lot scarier for banks that life companies, because bank borrowers tend to be short-term, and on an inverted yield curve properties belonging to short-term borrowers would be stressed.

The rise of mezzanine

The low-interest-rate environment appears to be very fruitful for lenders that have a mezzanine finance program.

With senior loan positions underwritten at 60 percent to 80 percent loan-to-value (LTV) a lot of investors add mezzanine loans to bring the capital structure up to 90 percent, reducing the amount they have to contribute to just 10 percent. Mezzanine is in some regards expensive money, but with dramatically lower interest rates a lot of mezzanine deals start to make sense that didn't before, explains Robert Kilroy, chief investment officer for Mountain Funding Inc., Charlotte, North Carolina.

"With the lower rates, a lot of people have pursued projects that in a higher interest rate environment wouldn't necessarily be underwritten," says Kilroy.

Kilroy estimates originations for the domestic real estate mezzanine market could eventually tally $25 billion in 2003. Mountain Funding will have a small part of that--about $60 million. Still, that number more than doubles the company's originations in 2002.

Yet last year wasn't exactly as smooth as that might sound for the firm. For Mountain Funding, the first part of the year was very busy with four or five major transactions, then still waters for the third quarter before a mad rush of activity in the fourth quarter.

The problem for Mountain Funding during the middle of 2003 was competition. "There appears to be a fair amount of added liquidity looking for real estate," Kilroy notes. Although 2004 won't be any less competitive, Kilroy tries to be optimistic. "When there is a lot of capital looking for opportunities, the market should grow," he says.

Lenders doing much more mezzanine financing are a diverse group that includes mortgage bankers such as Berkshire Mortgage; L.J. Melody; and NorthMarq Capital Inc., Bloomington, Minnesota.

"We do mezzanine in cooperation with a variety of sources," says Edward Padilla, NorthMarq's president and chief executive officer. "In 2003, we probably did $500 million in either mezzanine or some sort of structured finance vehicles," he says.

Optimists and pessimists

NorthMarq's mezzanine numbers are on a combined basis, as the company acquired on Sept. 30 the mortgage banking business of Legg Mason Real Estate Services, Philadelphia. On a combined basis, NorthMarq's total production numbers are about $7 billion ($4.5 billion from NorthMarq and $2.5 billion from Legg Mason).

"Our production is consistent with the MBA survey [results] indicating that 2003 has been one of a steep increase in commercial real estate refinance," says Padilla. "Everyone that had the capacity to refinance in the summer of 2003 pursued it, and at some point in the market refinance will slow down."

That's one reason why NorthMarq diversified into mezzanine and structured finance products. Also, about one-third of its business goes to acquisition finance, and that, Padilla says, remains active.

As for 2004, Padilla, now in charge of a much larger firm, wears his rose-colored glasses with pride. "We expect multifamily to recover faster than office. We still view retail and industrial as solid. For the lending industry, there is a lot of capital available, and cap rates are being driven down. This means lenders will be looking more closely when underwriting commercial real estate. At the same time, lenders are going to be looking at a phenomenal mortgage portfolio performance," he says.

Another lender going through some changes in 2003 is Coastal Federal Credit Union, Raleigh, North Carolina. The former IBM credit union that changed its name in the 1990s also altered its lending mandate in 2003. In March 2003, the company hired Peter VanGraafeiland, former senior vice president at Atlantic Mortgage & Investment Co,, also in Raleigh, to be in charge of its newly formed commercial and residential lending operation. In just nine months, Coastal ramped up production to the $100-million level.

"Our budget was $40 million to $45 million, and we exceeded that. We have been overwhelmed," says VanGraafeiland. In its first year, the company has been doing refinancing and take-out loans.

"Our pricing is a little bit more like an insurance company's pricing," VanGraafeiland adds. "We don't securitize, so we actually have a human being you can talk to if you have questions. We have no prepayment penalty on our loans, which is huge."

If Coastal were more established, VanGraafeiland says, 2004 could be another $100-million year, but it will probably end up in the $60-million-plus range. "Our ability to continue producing business revolves around us being able to participate out our loans to free more capital. We could do the $100 million if we could get participation lending down to a better science," says VanGraafeiland.

Despite the second-best year in his company's history, Howard Levine is not a completely content executive. "[The year] 2004 is going to be a challenge," he says.

Back in 2001, ARCS Commercial Mortgage Co. LP, Calabasas Hills, California, chalked up origination numbers of $3.3 billion. In 2002, production drifted lower to $2.3 billion, but 2003 looked slightly improved at better than $2.4 billion. At best, Levine guesses production levels in 2004 will be flat (most of his business is in multifamily).

There are two things happening in the market now, according to Levine. First, a lot of loans are with conduits and GSEs. Second, borrowers are looking for relief on existing loans because interest rates are higher than prime and there is no room for negotiating (due to prepayment penalties).

"My guess is that some developers are going to have to go deeper into their pockets to cover the negative cash flows, and others that are marginally capitalized will get rid of their properties," says Levine.

Second, a significant number of people who had an opportunity to get out of their adjustable-rate mortgages did so, and with interest rates a little bit higher that opportunity is now gone.

Here's what 2004 will look like, says Levine: Especially for multifamily, there will be "less demand; reliance on job formation which has not happened yet; and with interest rates up even 100 basis points, we don't have the wind at our backs anymore."

The market isn't going away, says Levine, "But it will be slower in 2004."

Steve Bergsman is a freelance writer based in Mesa, Arizona.
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Author:Bergsman, Steve
Publication:Mortgage Banking
Article Type:Cover Story
Geographic Code:1USA
Date:Jan 1, 2004
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