REQUIRED READING: From The Securitized Lending Model Back To The Portfolio Mindset

ost daily, I read reports predicting that commercial property values will decline anywhere from 20% to 40% by the time the capital crisis ends.[/b] But to see where we actually may be headed (absent all the fear and uncertainty), think back to the era of pre-securitization – say, early 1996, and look at the lending landscape. Based on my observation, back then, about 50% of professionals now working in the commercial real estate business were in another field or had not graduated from college at that time. For the rest of us, this memory is a window into the near term of what lending and borrowing may once again be like after tenant markets stabilize. Picture the February 1996 Mortgage Bankers Association commercial real estate finance conference: I brought to the conference a stack of loan packages that I was showing to the 20 or more life companies with which I planned to meet. Some of these packages were for retail, and others for office, multifamily and industrial. When it came to retail, the life companies were very conservative, as this was the product type they had had problems with in the downturn of the late 1980s and early 1990s. They offered feedback on my 1996 retail and office property submissions as follows: 8.25% to 8.50% interest rates, 60% to 65% loan-to-value (LTV) ratios, 20-year to 25-year amortization and perhaps recourse. Rates were about the same for apartments and low-finish industrial, but the lenders were a bit more aggressive in their LTVs offered for these more favorable property types. At the time, lenders tended to dislike cash-out, and they loaded the expenses with $1.00 per square foot for tenant rollover before capping the net operating income. Cap rates were in the 9% to 10% range, which is commensurate with interest rates and debt constants. [i][b]Conduits are born[/b][/i] Meanwhile, Wall Street was in the process of rolling out the first conduits at this time. Interest rates were higher – say, 9%. But the programs offered longer amortization and a higher LTV – perhaps 75%, compared to life companies' 65%. The conduit would originate the loan and then slice and dice groups of loans for sale to institutional investors. Life companies started to buy the less risky slices of the pools in lieu of making whole loans. There was pent-up demand from borrowers who wanted to highly leverage their retail and office product, and they were willing to pay 9% interest. Even though they offered lower rates, the life companies could not get to the proceeds the borrowers wanted. Many of the retail and office assets chasing commercial mortgage-backed securities (CMBS) debt were leftover loans from the downturn of the late 1980s – when the savings and loan crisis occurred – or assets purchased from the Resolution Trust Corp. that either were held free and clear or had recourse bank debt. Over time, the early investments made in these pools paid off. Defaults were minimal, and the industry matured. This asset class became widely accepted, as money managers were able to beat the published corporate bond index by buying CMBS, which had a higher spread than corporate bonds did. Wide acceptance meant a narrowing of required yields, and thus, even more life companies began to purchase billions in these assets. The market became very liquid. There was even talk by some life companies and CMBS originators that portfolio lending was archaic and would someday be eliminated. Securitization is much more efficient and liquid, these industry players claimed. Who wants file cabinets full of whole loans that you can't quickly sell in a liquidity crisis, anyway? We're in a new era! [i][b]Current state[/b][/i] Fast forward to 2007. As one life company executive explains it, ‘The 28-year-old Ivy League MBAs in the bond departments began loading up on CMBS when spreads widened from 90 to 125 for super-subordinate AAA paper.’ This was the least risky layer of the loan pool, and billions were purchased before the market collapsed in the fall. Now, in order to gain liquidity or raise cash, the life companies were forced to sell these super-subordinate AAA investments for 900 over – or 12%. But because that arrangement works out to a tremendous discount on what they originally paid, they avoided selling. Then, some of the life companies stopped lending and began accumulating cash, as they believed they were not liquid enough. Their once-liquid paper was no longer liquid. Some others lent what little cash came in the door, but they did so at extremely conservative terms, as everyone feared that values were going to collapse now that securitization was dead. Even worse, some life companies were forced to sell their whole loans to raise cash. Considering the current landscape, it is hard to argue against a return to valuation models pre-securitization. Real estate investors and developers now have to borrow from life companies if they want long-term fixed rates. Matching up interest rates with cap rates, using a simple band-of-investment technique, it is easy to arrive at a 9%-plus cap rate. Add in all the pending CMBS maturities, negative news on the economic horizon and lack of activity by life companies (due to circumstances such as annuity guarantees, credit default swaps and being overweight with illiquid CMBS) and a 10-plus cap is not out of the question. As I arranged a recent life company loan, it occurred to me that this transaction was similar to loans we would have negotiated in 1996. We were closing an $8 million loan on a dock-high distribution warehouse property. The rate was 7.25%. The amortization was 25 years, and the term was 10 years. The life company offered a 65% LTV at an 8% cap rate after inputting a 18% vacancy rate. We wound up putting two 150,000 square-foot buildings together to mitigate the tenant rollover. The tenants were national, and the sponsor was extremely financially strong and liquid. The life company believes the loan made sense at $23 per square foot. The firm also said it believes it will get paid back, and if it does not, it would not mind owning the real estate at that level. Welcome back to portfolio lending. [i]James DuMars is a senior vice president and managing director at NorthMarq Capital. He oversees the daily production and servicing operations of NorthMarq's Arizona office, including $1.1 billion in serviced loans. DuMars can be contacted at (602) 508-2206 or jdumars@northmarq.com.[/i