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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   January 2007

Small–Balance Conduits: The New Era

Former stepchild of the securitized-loan market now has a seat at the big table

c_2007-01_Reiner_spotWith the advent of securitized lending in the 1970s came pools generally characterized by big, sexy, sophisticated assets or trophy properties and large portfolios of loans. Smaller loans or loans on smaller-sized real estate assets were all-but-absent from the securities market.

These smaller loans — generally ranging from $500,000 to $3 million, with exceptions on both ends of the spectrum —  today are commonly referred to as “small-balance conduit loans.”

This former ugly duckling of conduit loans is now finding acceptance among mainstream commercial-mortgage-backed securities (CMBS). Indeed, there is now a seat at the table for the small-balance lender when CMBS issuers are crafting the optimal CMBS pool to bring to market. Today, if you look in any pool of commercial-securitized loans, there will generally be a healthy dose of small-balance conduits sprinkled throughout the standard fare of regular conduit assets.

The nature of the loan

In order to understand why there was resistance to small-balance loans by the capital-markets community, it helps to understand the nature of these loans. A small-balance conduit is exactly the same as a standard conduit loan, with one primary difference — the loan amount is smaller.

The common features of all conduits are that they generally have 10-year terms and are nonrecourse with a fixed rate. The closing process between small and large conduits is the same. The due-diligence process is similar, legal issues are addressed in the same manner, loan documents mirror one another and credit-committee review and approval occurs in the same manner.

The negative predisposition toward smaller conduit loans developed largely because of economies of scale. A CMBS pool containing small-balance loans increases the loan count. Bond-purchasers found that their due-diligence costs were higher as a result of the larger loan count. The cost of performing an appropriate review was more expensive.

The economic issue was addressed the old-fashioned way — with money. Conduit lenders offered small-balance conduits with significant spread premiums to compensate for the higher due-diligence costs. The spread differential during the early evolution of these loans varied between 20 and 40 basis points above the loan spread or pricing that would be available for a comparable large conduit. In other words, a loan with the same attributes, the same asset quality and the identical loan structure was priced with a large premium to compensate for its small size.

Growing acceptance

Small-balance conduits are now being scooped up by conduits and slated for securitization for several reasons. First, the quality of the smaller assets is now consistent with the asset quality of regular conduit deals. In the past, small-balance programs were viewed as a dumping ground for inferior assets. But because of sound policing of CMBS pools by rating agencies and bond-buyers, that is no longer the case.

In addition, conduits are constantly hungry for more loan product and are continuously striving to bolster their annual loan production. Further, even though conduit lenders are actively originating record volumes of conduit loans, large and small, profit margins have contracted. To offset lower yields, greater volume is required. Conduit lenders realize that many smaller loans that had been ignored can be securitized to help achieve these objectives.

Because small-balance loans bring the loan count up in a CMBS pool, rating agencies and bond buyers view this as a benefit. It increases loan-pool diversification, which investors like.

Accordingly, small-balance loans are now courted for inclusion in CMBS pools without draconian spread premiums.

The details

Historically, before a conduit execution became an option, small loans would be funded at a local bank. The problem, of course, was that at some point a repeat borrower would run up against constraints on loans to individual borrowers and could do no more business with that particular institution. The bank loan would be short-term and recourse to the borrower.

Today, small-balance conduits are typically longer term, and unless they’re owner-occupied, they will be nonrecourse like their larger loan counterparts.

Conduits give more favorable treatment to the borrower. For example, a typical small-balance conduit might have terms along these lines:

  • 10-year term
  • 20- or 25-year amortization
  • Fixed rate for the life of the loan, with no interest rate reset or adjustment 
  • An available interest-only period 
  • 80 percent loan to value and 1.20  debt-service-coverage, depending on the property type

What’s too small?

So how small can a loan be before it is ineligible for conduit execution? Many programs state a minimum loan size of $500,000, but there is no real science to that number. Exceptions will be made for the right deal or a favored client.

Of course, sometimes even deals that are $1 million may be turned away simply because that particular conduit lender cannot be bothered with such a small loan. After all, it takes as much time and trouble to close a smaller loan as it does to close a multimillion-dollar loan.

Obviously, the profit on the larger loan is higher. And profit is often the driving force behind a decision.

Regardless, there is no magic number for what is considered too small to be a small-balance conduit. In reality, it usually depends on just how hungry the lender is when a loan is presented.


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