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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   March 2006

Reality Check

Nontraditional lenders that have been pushing the barriers soon may be forced to re-evaluate their guidelines

Until the early 1990s, it was commonly believed that commercial real estate loans posed a greater risk than residential loans. As institutions hedged the potential risk of an early payoff with tools such as prepayment penalties and lock-out periods, however, Wall Street became more interested in these loans. The relatively low default rate in conjunction with the traditionally higher spreads made commercial loan packages increasingly more desirable.

As the commercial market began to grow, many nontraditional lenders were enticed to move into the market. Today, many of these commercial lenders offer products that in the past had primarily existed in the residential market. No-doc, low-doc and interest-only programs are now common in the small- to mid-balance commercial loan market.

With the arrival of this new breed of lenders, high loan-to-value (LTV)/low debt-service-coverage-ratio loans have become commonplace, allowing investors to venture into dangerous territory. With more of these lenders jumping into the fray, some in the industry believe it is creating an overabundance of exceedingly aggressive products.

Some investors, consequently, have overextended themselves. Those lenders that have thrown common sense out the window will likely see increased rates of investor default as the market slows.

The role of secondary markets

The high-LTV products offered by some sources have been blamed for allowing investors to purchase properties at overly inflated prices, thus artificially driving up prices in some markets. Often, these prices aren’t justifiable according to the valuation principles typically used in banking.

Why might an institution work with a borrower who has a questionable credit profile? The answer lies in the often misunderstood world of the secondary markets. The secondary market — with its desire to purchase pools of commercial real estate loans and its ability to defuse risk between groups of investors — enables these nontraditional funding sources.

In most instances, a traditional lender will service a loan, which allows it to enjoy the returns realized from servicing its portfolio. A nontraditional lender, on the other hand, typically will sell off a commercial loan within 90 days of closing, moving onto the next deal.

As the secondary market has grown, traditional banks have been forced to re-evaluate their underwriting and credit policies to stay competitive. Nontraditional-lending underwriters often follow relaxed credit guidelines that omit or ignore the credit practices used by traditional funding sources. These credit practices customarily act as a safety net for overly aggressive or novice investors. A number of these nontraditional lenders also have adopted the same lax underwriting principles sometimes used in residential lending.

Although many banks have liberalized their guidelines, however, they have not pushed the limits as far as nontraditional lenders. It is still rare to find a bank willing to extend beyond an 80-percent LTV.

A market slowdown

The tide may be changing. Many nontraditional lenders that previously pushed the barriers also have to re-evaluate their underwriting guidelines and credit policies in this slowing market.

Some of the larger players in the secondary market have slowed their rapid acquisition of small- and mid-balance commercial loans. This has forced many nontraditional lenders to change their lending guidelines. As a result, they have fallen back in line with the traditional lenders that stayed steady amid the rapid growth. These changes have been essential for nontraditional lenders to protect themselves from the looming slowdown.

In addition to being at the mercy of the secondary markets, nontraditional lenders often require substantial nonrefundable upfront fees to proceed with a deal. Borrowers are often at the mercy of Wall Street for pricing. Given the onerous process involved in securing a loan from a nontraditional lender, time can become a serious issue. The borrower may wait more than 60 days to close, at which point the rate would lock.

Because they often are borrowing from themselves, traditional banks that service their own portfolio have greater control over the process and can better control the cost of funds. In addition, they can be more creative in their lending. Their ability to entertain other collateral for the transaction or to extend more-favorable rates can help borrowers attain their goals.

The potential implications

In recent years, regulatory bodies have focused primarily on residential lending. State-by-state banking guidelines and regulations vary in regard to commercial lending. Many state banking departments have a gunslinger mentality regarding the regulation of commercial lenders. But the limited oversight the commercial industry has come to enjoy could come to an abrupt halt.

Nontraditional lenders that made aggressive loans not in their borrowers’ best interest might see more borrowers beginning to default. As the market cools, many borrowers who believed they were receiving a terrific product may find themselves overextended and exposed to the changes in the real estate market — unable to absorb the losses on their overextended properties.

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The first half of 2006 should reveal the short-term future of the commercial-lending industry. This year likely will prove to have a different market than we have enjoyed over the past several years. Many lenders will fall victim to their overly aggressive lending policies. Other lenders who have followed good business practices will be well-positioned to excel.


 


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