As published in Scotsman Guide's Commercial Edition, January 2007.
Tumultuous is the best word to describe the current credit markets. Lenders are re-evaluating risk and tightening their underwriting, and easy money for commercial properties is gone. This all means fewer loan dollars, higher interest-rate spreads and a flight to higher-quality properties and borrowers.
During the past few months, trading of commercial-mortgage-backed securities (CMBS) has experienced rapidly widening spreads, fewer buyers and in some cases, no buyers for the riskiest pieces. In turn, widening spreads are causing CMBS lenders' break-even interest-rate-spread -- the lowest spread at which they can write a loan and make a profit when they securitize it -- to increase daily.
From late July through August, markets were so tumultuous that many lenders ceased quoting interest rates. Others stayed on the sidelines, not yet quoting loans. This turmoil reportedly caused four major conduit lenders to delay scheduled securitizations until the CMBS market regained some stability and liquidity.
What was the cause? The much-publicized residential nonprime mortgage fallout that began late last year caused investors to scrutinize the credit analyses behind loans that act as CMBS collateral. Investors worried that the excesses of the nonprime market were seeping into the commercial arena. Buyers of AAA-rated CMBS bonds criticized rating agencies that assign CMBS-bond-risk ratings, saying they were too lax in their analyses.
This past February, Fitch Ratings issued a statement criticizing lenders for underwriting future property cash flows prematurely. In April, Moody's Investors Service announced it would increase subordination levels on future CMBS transactions.
This means a greater portion of CMBS deals will have a lower credit rating than before. Because lower-rated credit trades at a lower price and at a higher yield, conduit lenders may lose money on securitizations.
Upon the rating-agency pronouncements, CMBS bond buyers immediately started requiring higher yields on their investments. Consequently, certain CMBS securitizations found some lenders unable to sell some tranches of their loan portfolio. Buyers of unrated tranches got rid of loans they deemed too risky.
What does this mean for commercial mortgage brokers? More conservative loan underwriting, for one. Ten-year, full-term, interest-only loans aren't in the cards, unless you have a low-leverage loan. It's also no longer acceptable to calculate today's net operating income by underwriting potential future rent increases.
Choosing your lender is especially important now. Portfolio lenders can keep their loans on their books; they don't need to sell. So once the lender fixes an interest rate, generally the borrower can close that loan without facing potential repricing caused by volatile capital markets.
Conduit lenders, on the other hand, have clauses in their applications that give them the ability to reprice or pull a loan because of a material adverse change in the capital markets. We are now experiencing this adverse change, and securitized lenders cannot confidently fix rates until the market volatility quiets. As such, some conduit loans are being repriced or turned down.
This turmoil should subside and the markets should settle, but it's hard to predict when. Ultimately, a move toward more prudent underwriting will help prevent overbuilding and loan delinquencies in the commercial property markets -- a good thing for everyone.
Cynthia Hammond is president, CEO and owner of Churchill Commercial Capital Inc., an income-property mortgage banking company based in Phoenix.
Churchill Commercial Capital is a loan correspondent for major life-insurance companies, as well as for select Wall Street investment banks, domestic banks and pension-fund advisers. Hammond is a past national director of Commercial Real Estate Women (CREW) Network and past president and current member of an Arizona chapter of CREW Network. Contact her at email@example.com.