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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   December 2012

Where Are All the Specialty Lenders?

An absence of unconventional lenders may be a boon for new nonbank entities

Over the past two years, the core  commercial real estate market has been recovering. One sign of this recovery easily noted by active commercial mortgage professionals is the return of equity investors. These investors have begun to seek out stabilizedproperties with performing locations, high occupancy rates and strong cash flow. 

Commercial real estate lending volume, however, remains at a fraction of its pre-crash levels. Most lending from traditional lenders — namely major banks, life-insurance companies, the resurgent commercial mortgage-backed securities (CMBS) market andagencies — has been consolidated.

c_2012-12_chart_yoncho

These lenders have been focused on core assets, thus creating a highly efficient market. Specialty lenders, including mortgage real estate investment trusts (REITs), industrial credit companies and finance corporations,increasingly have taken a backseat in the past few years, however.

By some estimates, the financial crash had a greater impact on commercial real estate specialty lenders than traditional lenders. Many specialty lenders have been forced to leave the market after their originations plunged, and some have been pricedout of the core markets by traditional lenders.

Although specialty lenders, by some estimates, hold less than 10 percent of commercial real estate debt, their market presence remains critical for investors, especially with today’s heightened credit underwriting and the rigid standards of traditionallenders. If distressed assets are going to continue to come to market seeking recapitalization, the presence of specialty lenders is vital to meeting the financing needs of these properties.

With that in mind, the situation today creates a strong opportunity for new lenders armed with capital that have the ability to underwrite this type of business. In return, lenders are being compensated with spreads that are higher than market pricingfor conventional commercial mortgage lending.

Background

With the commercial real estate market boom in the mid-2000s, the lending industry became more diversified. Specialty lenders relied heavily on short-term borrowing through unsecured or secured-term facilities, commercial paper, and/or collateralizeddebt obligation (CDO) financing, which led to a classic case of asset/liability duration mismatch — where borrowing is short and lending is long.

The financial crash of 2008 hit every part of the commercial real estate industry, and specialty lenders were no exception. Because borrowing costs surged, available credit was curtailed sharply, and loan losses triggered negative covenants on outstandinglines or term facilities.

As a result, specialty lenders were hit on both sides of the balance sheet with nonperforming assets creating losses and a nonexistent financing market to match their liabilities. In many cases, the losses were higher than those experienced by traditionallenders, because many loans made by specialty lenders were for nonstabilized real estate and development. The aggregate commercial real estate loan balance among specialty lenders shrank by 21 percent, or $30 billion, from 2008 to the second quarter of2012, according to figures from the Federal Reserve.

Unsurprisingly, some specialty lenders went bankrupt or ended up close to bankruptcy. Others embarked on a massive balance-sheet reduction.

Some mortgage REITs saw their stocks drop to zero, effectively shutting them out of the equity markets. With theclosing of the CDO market and precipitous drop in stock prices, mortgage REITs lacked the ability to raise new capital for lending. Total commercial real estate debt held by mortgage REITs dropped from $42 billion in 2008 to $32 billion as of this pastsecond quarter, according to the Federal Reserve.

"If distressed assets are going to continue to come to market seeking recapitalization, the presence of specialty lenders is vital to meeting the financing needs of these properties."

The only source of capital for new lending was from CDOs, which typically have a five-year reinvestment period, allowing recycling of funds to originate new loans. With the last CDO issued in August 2007, the last reinvestment period will end in 2012,spelling the end of CDO-backed originations.

Current status

Finance companies are largely still out of the market, with at least one making a slow comeback. The overall lending capacity is pretty much limited across specialty lenders. Three new mortgage REITs launched in 2009 to raise public capital for new commercialreal estate loan originations. It has taken years for them to complete secondary offerings and reach their initial fundraising goals, however. 

Despite a dividend yield higher than their equity counterparts, these mortgage REITs rarely trade above book value, which would allow them to expand more rapidly. The lack of new entrants into the marketplace since 2009 clearly means that a public-equitysolution to the lack of capital in the specialty-lender market is unlikely. The legacy mortgage REITs still are sorting through assets and have been unable to raise new equity or expand their business

Further compounding the lack of debt capital in the market has been the slow recovery of the CMBS market and continued distress experienced by the top commercial banks because of their exposure to the residential housing market, in addition to commercialreal estate exposure.

What about the highly publicized CMBS rally that started this summer and has continued into the fall? Even with a surge in fourth-quarter issuance, the 2012 total is projected at $46 billion, according to Commercial Mortgage Alert. This is only about20 percent of 2007’s peak issuance, and the market faces significant challenges related to federal regulations, rating agencies and market volatility. 

The pricing of the bonds has improved, allowing for lower coupons, which will allow CMBS lenders to get more market share from life-insurance lenders. Continued growth in the CMBS market will offer some relief, but this will only be for stabilized commercialreal estate and will not be a source of capital for lending on distressed assets. 

In addition, a return of the CDOs that previously fueled many specialty lenders isn’t on the horizon at this time. With more than $50 billion in loans in special servicing and similar amounts of nonperforming loans on the bank’s balance sheets, thereis a clear need for lenders that can lend on distressed assets.

• • •

From a lending perspective, the absence of specialty lenders provides a tremendous opportunity for nonbank lenders with ample cash reserves and an existing balance sheet to generate high-risk adjusted returns. To capitalize on this opportunity, severalnonbank balance-sheet lenders funded by private equity and hedge funds have been capitalized. These companies have been set up as closed-end funds, joint ventures or privately capitalized debt platforms. Targeted returns typically are between 7 percentand 8 percent unlevered for a senior loan that has 65 percent to 75 percent loan to value and at 300 basis points to 400 basis points higher than a typical bank loan on stabilized commercial real estate. 

Many of these companies aim to originate new commercial real estate loans directly into the marketplace rather than being a passive participant that buys them from other lenders. Because many banks and special servicers continue to work out and liquidateproblem assets, the demand for specialty lenders will continue to increase.

Without the legacy workout issues that the banks, finance companies and mortgage REITs have, these newly capitalized lenders may be in a position to respond to lending requests and add value on distressed assets with the speed, flexibility, and structureneeded to fit the business plan of the asset.

From an equity perspective, nimble investors and mortgage brokers with the ability to navigate today’s marketplace for specialty lenders can act with confidence in helping clients make new investments or refinance existing ones.


 
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