Sponsors used to be able to pick and choose their lenders but the last few months have seen the tables turned. Stephanie Schwartz Driver reports on developments in the US
Now that the commercial mortgage-backed securities (CMBS) market in the US is in a logjam, the investment banks that dominated commercial real estate lending for the past two years have been forced to take a step back to regroup. Balance sheet lenders, including banks, life insurers, and even some pension funds, have been stepping in to fill the gap, reclaiming a market where they had once been strong.
Although commercial real estate fundamentals remain sound in most markets, the sub-prime debacle has put a damper on the market and transactions are markedly down, compared with 2006. There is even a distinct
split between the first half and the second half of the year.
These trends are all apparent in the figures for 2008 loan originations. According to the Mortgage Bankers Association, commercial and multi-family mortgage originations ended 2007 on a down note. They were down overall by 16% in the fourth quarter of 2007, compared with the same period the previous year. While this reduction was true across property types, some sectors showed more dramatic declines than others: office was down 73%, industrial by 50%, retail by 38%, multi-family by 7%, health care by 3%, and hotel by a whopping 349% owing to several large portfolio sales booked in the fourth quarter. Most of the negative performance took place during the second half of the year: while the first half of 2007 showed a 38% increase over the first half of 2006, the second half of the year showed an 11% drop compared with the previous year.
Although the market has slowed, deals are still being done and loans are still being made. But rather than turning to Wall Street, buyers are looking to US regional banks and to foreign banks based in the US for funding.
Bank of Ireland is a case in point. While some lenders might shy away from a volatile market, last July, Bank of Ireland committed to doing $1bn (€0.67bn) of business in the US, concentrating on the Boston-Washington DC corridor, although its remit is national in scope. Even in a slowing market, the bank estimates that it will be more than halfway to its target by 31 March, said Matthew Galligan, managing director and head of US property finance. Around 25% of the business is with Irish buyers, with American buyers making up the bulk of activity.
Galligan stressed that Bank of Ireland is relatively conservative, focusing on low loan to value deals. "In general, the only projects that can get financed are those with low leverage," he says. "The pressure is greater on sponsors - the deals have to have greater return potential."
This is true across the board. "We've seen a return to the underwriting standards that were prevalent five years ago," says Adam B. Davis, senior managing director, Wells Fargo Commercial Mortgage.
US regulators are well aware that some investors, after being denied by bigger and stronger financial institutions, may be looking to community banks and other not qualified to judge deals. According to the Office of the Comptroller of the Currency, the overseer of national banks, the ratio of commercial real estate loans to capital has nearly doubled in the past six years, to 285%. To avoid an early 1990s-style boom and bust, regulators have been stepping in to scrutinise real estate lending.
For quality sponsors, tightened standards are not an obstacle, says Galligan. "From the sponsor's perspective, there is less competition for deals so, even if the equity requirements are more onerous, they can manage. It's challenging but not impossible."
He compares today's environment with the conditions of the last three to five years, when it was "absolute insanity," saying "today you cannot push the lender - there is not the multitude of options there once was." Galligan emphasises that Bank of Ireland only works with quality, national sponsors, by virtue of the equity they have to be able to put into the deal.
Davis at Wells Fargo notes the same change in sentiment. "As we were moving out of the last downturn, the economy was growing, vacancy rates were tightening, and rents were increasing, so it made sense to be more aggressive. Today the consensus is different because the economy is slowing and may be recessing, so it is prudent to underwrite more conservatively," he says.
Wells Fargo is an interesting illustration of current market conditions. A portion of the bank's broad commercial real estate lending business was devoted to the CMBS market. "It is very hard, as a CMBS lender, to make a loan today - AAA spreads more than doubled in January, and the market is very volatile," says Davis, who runs the CMBS group. However, now that the CMBS market is locked up, the bank has diverted efforts to closing long-term fixed-rate loans that would have previously been originated for securitisation on their balance sheet. By shifting its strategy to balance-sheet lending, the bank is able to maintain its relationship with its clients in changing market conditions. "It's a great time to have a balance sheet," says Davis.
In Davis's view, the lending universe is in the process of an evolution of sorts. The investment banks began lending more than 10 years ago, "When lenders were confident in the economy, confident that rents were increasing, with lots of money flowing to the sector, capital markets lending entered the space traditionally occupied by banks - floating rate with value added lending," he explains.
The situation is changing now as the economy is a question mark, and capital markets have locked up. "Will CMBS come back in its original form, lending against stable assets with cash-flow in place? Or will be it be a product that can finance value-added transactions, competing against banks to provide transitional lending?" Davis asks.
While Davis does not know the answer himself, he says categorically that, "nobody expects the real estate capital markets to come back the way it left. Real estate expertise and discipline will be imposed through this next cycle."
Galligan agrees that CMBS lending is likely to rebound, albeit returning in a different form. "I think CMBS will rebound, but I do not think it will be as frenzied, as frankly irrational, as it was," he says. He reckons it will take more than 12 months for the market to right itself. "What we are trying to do now is get enough market share so we are in a good position when CMBS does rebound."