Market forecast

The Money Race

Borrowers benefit as lenders chase commercial property deals.

Today's real estate finance market remains very active, as owners continue to capitalize on historically low interest rates by refinancing properties and converting their debt from floating-rate to fixed-rate loans. Acquisitions also are generating significant financing activity.

Having learned some lessons from Wall Street, commercial real estate investors are better informed than in previous years. Lenders also gained valuable insight: They must exercise more-stringent lending criteria to mitigate risk. This point is particularly important in light of weak market fundamentals. At the same time, lenders have become more aggressive in their rates and spreads to reach production goals in the face of heightened competition among the players.

In many markets, commercial real estate prices still are climbing to new highs, more due to the availability of capital than because of solid economic fundamentals. Despite high prices, the cost of money remains near an all-time low, creating extremely favorable market conditions for borrowers, owners, and investors that now find themselves in a unique situation as more money chases fewer deals.

While acquisition and financing activity remains fast paced, the lending arena and the players have changed considerably. Boundaries among lenders have shifted, creating a vast pool of financing suppliers that vary by size and capital sources. Although traditional savings and commercial banks historically held the majority of the mortgage business, Wall Street conduits, insurance companies, and other nontraditional sources, such as mezzanine and bridge financing providers, are grabbing a greater share of the market, creating competition beneficial to borrowers.

Nontraditional Lenders Speed Ahead

The current commercial real estate market is crowded with unstabilized properties, most often financed by interim or bridge loans. Sometimes requiring personal guarantees and typically featuring one-year to three-year terms, bridge loans offer rates 2 percent to 3 percent over London interbank offered rates and typically allow borrowers to finance 80 percent of their acquisition and construction/development costs on a nonrecourse basis at very attractive spreads.

Commercial banks, regional savings banks, and credit companies are the most common bridge loan sources. Interim or construction loans ideally are suited for local lenders because of the localized knowledge that is often necessary to make such loans.

However, lenders such as life insurance companies and Wall Street conduits also are competing to finance unstabilized properties as an entree to making future permanent loans. By structuring incentives for borrowers to take out permanent loans with them (such as steep penalties for not doing so), these new entrants are securing a competitive edge over regional banks and more-traditional commercial lenders.

For example, in an effort to satisfy borrowers' needs and become long-term full-service providers, life insurance companies now offer both securitized lending and balance-sheet lending for properties in transition.

The conduit business also has joined this growing pool of funding sources for unstabilized properties. No longer viewed as commodities, conduits often feature high maximum loan amounts, low rates, competitive spreads, and low reserve requirements to differentiate themselves from the more-established lenders in this arena. Other nontraditional financing sources such as mezzanine lenders also have emerged, actively meeting needs often overlooked by traditional lenders with tighter underwriting criteria. As a result, mezzanine lenders are in high supply and are a source of higher leverage for unstabilized properties. While they still adhere to sound underwriting principles, mezzanine lenders often are willing to reduce their profitability in exchange for volume because they need to put their money to work.

In addition to properties in transition, banks typically hold the dominant permanent financing for stabilized properties with strong cash flows. But in the current market, nontraditional lenders are encroaching on this terrain as well. In particular, mezzanine lenders, which often are asked to finance the capital structure above 80 percent loan to value - the traditional maximum amount for a first mortgage - are even more competitive on stabilized properties than unstabilized properties.

Traditional Lenders Respond

To compete with nontraditional lenders, many banks have created flexible lending programs to satisfy unstabilized property owners' financing needs. For example, with balance-sheet lenders, borrowers may be able to lock in interest rates at the loan application stage, complete with flexible prepayment options and the ability to borrow additional loan proceeds as net operating income increases. The flexibility that balance-sheet lenders offer is more attractive to long-term owners than the marginally tighter spreads they might achieve with less-flexible conduit or securitized lenders.

Earlier this year U.S. Treasury rates dropped, allowing borrowers to lock in seven-year to 10-year fixed-rate loans below 5 percent. Now lenders must accept tighter spreads on their loans and rely on volume to make up the difference.

Traditional financing sources also have learned that they need to compete more assertively and, in many cases, more creatively. For example, they are doing deals with higher leverage - above 80 percent LTV. Waived reserves, interest-only loans, and more-negotiable prepayment penalties are just a few methods these lenders are using to attract borrowers' attention.

In the current lending environment, the lines among various lender types have blurred, and new capital sources are entering this profitable industry. These new players have fostered a sense of competition, leaving borrowers in an enviable position when shopping for loans.

Michael Brown and Andrew Weiss

Michael Brown is managing director of Meridian Capital Group\'s Florida office and Andrew Weiss is managing director of the Maryland office. Contact Brown at 516.367.0005, ext. 305, or [email protected] and Weiss at 301.652.6000 or [email protected]

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