Q|10 Quest Commercial Capital’s Branscome: Lenders ready, willing and able to lend again

Susan Branscome

Guest post by Susan Branscome, Q|10 Quest Commercial Capital

It is a good thing 2009 is behind us. In that year, a hand grenade was thrown into the commercial real estate market and lending activity all but ceased entirely.  Several years have passed and today there are many lenders in the market ready, willing and able to lend, but it is not 2006 again either.  That’s a good thing, too.

In the peak year of 2006, aggressive underwriting by mostly CMBS (conduit lenders) set up the beginning of the collapse in the commercial real estate market.  Lenders were aggressively underwriting future rents, providing years of interest-only versus amortizing loans and offering imprudent leverage levels on properties. Controversial discussion ensued in later years about who was at fault for the overly zealous commercial mortgage loans, the borrower who accepted the terms or the lender who offered them.  It was a very frothy market at the time and in order to originate mortgage business, lenders had to do so by underwriting aggressively and offering exceptionally aggressive loan terms.  No one saw the sheer magnitude of the downturn coming in 2007-2008.

How are properties being financed today?   All types of lenders are in the market. The predominant lenders originating are commercial banks, life insurance companies and CMBS/conduit lenders, Freddie Mac and Fannie Mae.   The range of offered terms probably differs as much as it has in years, depending upon the lender and property.  While in larger cities lenders will utilize aggressive underwriting standards and offer better pricing, in the Midwest, because growth has been generally steady, conservative underwriting and moderate pricing govern loan proposals today.

The demand for debt capital is still greater than the supply.  Competition for the highest-quality deals is fierce, and lenders prefer to compete on interest rates and loan monetary terms versus more aggressive underwriting and leverage.  Since property values declined 40 percent during the downturn and there has been some appreciation, lenders seem to feel comfortable that values will not decline further in the near future and most probably will increase in value.  Vacant space continues to absorb and the economy continues to improve.  Providing leverage in the 65 to 75 percent range on lower property values makes a lot of sense for lenders.

Without exception, other than the lowest leverage properties and strongest credit tenant loans, the most favored property type among lenders is multi-family.  Demand and supply fundamentals for rental housing are quite strong in most markets, and with increasing rental income lenders are optimistic that values will continue to increase.

In the Midwest, while markets vary, lenders are comfortable using cap rates in the 7.0’s and even in the high 6.0 percent range given good location and newer properties.   Freddie Mac and Fannie Mae continue to be dominant lending forces in the multi-family lending world. And with some Midwest markets continuing to be in pre-review states for Fannie Mae, Freddie Mac is offering low rates and high leverage for the best multi-family properties.  One of the most competitive lenders in the country is HUD for existing properties or new construction/renovation.  While the loan terms are excellent, the approval process through the HUD bureaucracy is only for the most patient of borrowers who can expect to endure at least nine months of aggravation before approval.

Grocery-anchored retail properties, industrial portfolios and medical office also command attention by lenders that offer the most competitive loan terms and pricing.  Tougher properties to finance include unanchored retail and office properties.  The market for these properties is driven by economic growth so lenders continue to be cautious as the economy trundles along.

Life insurance companies have enjoyed an extraordinarily low delinquency rate of .4 percent during the last several years.    These portfolio lenders like the current comparative yields of mortgages to corporate bonds so are originating large budgets of mortgage debt.   The edict coming from senior officers of life companies to mortgage managers? Originate more mortgages …. But … do not make mistakes.   So the pressure is on lending staffs in life companies to originate secure, well-structured loans with excellent spreads above corporate bonds.

Life companies cannot fill the entire universe of commercial mortgage demand as they did in the ‘80s and ‘90s.  Commercial banks primarily fill this gap, with CMBS/conduit lenders attempting to capture some of the business.  Because there are plenty of great deals to finance, ‘story’ deals have fewer lenders that will consider them, creating a void of financing choices for borrowers except commercial banks that require recourse.  Interest rates on 10-year loans can be as low as in the 3.50 percent range, five-year rates being lower.  Typical interest rate range is 3.75 to 4.75 percent.

During stronger economic years, such as 2002-2007, CMBS (commercial mortgage backed securities) lenders dominated the permanent lending market.   CMBS 2.0, which sounds like a new software product of some type, is the most recent version of how conduit loans are being originated today.  Expected CMBS origination volumes this year are estimated between $35 billion and $45 billion, a fraction of the peak in 2006 of $230 billion.

Changes in loan underwriting and structure include requiring cash flow sweeps for larger loans in the case of declining debt coverage ratios and requiring funded tenant finish and leasing reserves.  A new measure of loan security is primary in underwriting: the debt yield. This is calculated by dividing the net cash flow (net operating income minus underwritten capital expenditures and tenant finish and leasing commissions) by the loan amount.  Universally, the acceptable debt yield on most property types is 9.0 percent, yet can be lower based upon the quality of the property or market, or higher for properties like hotels or those located in smaller markets.

CMBS pricing has been volatile lately with spreads between 250 to 350 over swap rates yielding interest rates between 4 to 5 percent.  Besides new underwriting guidelines and higher pricing than life companies, another challenge to CMBS lenders’ success in originating as previously is servicing issues borrowers have experienced.  Once originated, the servicing of these pools is bid on, with the cheapest bid winning.  Responses to special requests are met with not only inexperience but indifference to treating borrowers as customers.  Many borrowers have experienced delays in response by CMBS servicers and unexpected fees.

Within the legacy CMBS lending world, those originated between 2000 and 2008, delinquencies are hovering around 10.16 percent for all property types.   This number includes maturing loans, within which are a number of five-year loans this expired this year, originated in 2007.  Maturities of legacy CMBS loans begin in earnest in the year 2015. This isn’t surprising; 10 years ago CMBS volume accelerated.  It is still unclear as to how many of these loans could be refinanced.  It will depend upon the strength of the debt capital market in 2015 and the state of the properties and markets at that time.  There are equity and mezzanine funds having begun in recent years that could bridge the gap between the loan balance and the new loan.  More discounted payoffs are expected as well by these lenders.

Commercial banks are actively lending. A few banks are leading the way in taking more risk than others.  Banks have few new construction loan requests to consider and the strongest transaction requests by borrowers are competitively bid among banks.   While loan officers are being given the green light to lend and are being urged to do so, they are expected to underwrite loans and borrowers thoroughly and cautiously.  Banks are offering five-year fixed-rate transactions often through offering swap contracts.   Floating rates range in the 30-day-LIBOR-plus-250 range.  Assuring that they will be paid off through permanent debt or sale, banks will use a more normalized interest rate, 6.0 to 7.0 percent with a 30-year amortization and a reasonable debt coverage ratio to protect against future rising rates when the loan is expected to pay off.

Few sales have occurred, so banks are having difficulty assessing what appropriate capitalization rates to use in terms of potential sales in the future to pay off their loans.  Commercial banks are wise to keep assets short-term to match their liabilities/deposits.  Interest rate swap contracts are offered to borrowers allowing them to fix rates for an interim period of time.

All lenders are underwriting borrowers more closely than ever.  Requests for global portfolio cash flows are often requested.   Lenders understand that the magnitude of the last downturn has caused borrowers to have issues with some properties.   Attitudes differ among lenders regarding borrowers giving properties back to lenders, discounted payoffs and foreclosures. In these cases, questions are asked about the property and market, how the borrower interacted with the lender and how long the borrower paid the shortfall between income and debt service.   Some lenders find these situations more acceptable than others.

Borrowers have more lending choices today than they have had in several years.  Interest rates have been sustained at extraordinarily low levels.  Loan terms are not the only factor in choosing a lender, of course; how the lender handles the relationship in good times and tough times should be considered.  Borrowers need to understand that they should manage not only their interest rate risk by locking interest rates when they are this low for long periods, but by managing their recourse risk, too.   Loan assumption provisions are available for borrowers should they decide to sell, and with interest rates at these levels could enhance property prices.  For properties that are self-supporting, long-term, fixed-interest-rate, non-recourse debt is the best choice to finance commercial real estate.

Susan Branscome is president and founder of Q|10 Quest Commercial Capital in Cincinnati. She has more than  32 years of experience in commercial real estate lending and mortgage banking.

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2 Responses to Q|10 Quest Commercial Capital’s Branscome: Lenders ready, willing and able to lend again

  1. michael kelly says:

    Susan, excellent article and provides an up to the minute snapshot of what is happening in our industry right now. Great article; i will likely use this in our next Newsletter…

  2. Pingback: Susan Branscome of Q|10 Capital Guest Posts On The REJ Blog About Lender’s Being Ready, Willing and Able to Lend Again. | Q10 Capital

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