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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   February 2014

Ensuring a Lending Lifeline

Life insurance companies are a growing force in commercial lending

Commercial mortgage finance is a field in which several major players have emerged in the past five decades. Traditionally, the banking industry was the first in a series of leading providers of capital that emerged as the commercial real estate industry grew from fledgling to maturity. Until the late ’80s, banks maintained a significant volume of commercial mortgage debt on their balance sheets. When the commercial real estate boom of the late ’70s to mid ’80s collapsed, many banks were left holding the bag, suffering record losses. These events, coupled with other economic factors, led to the first major transition of commercial real estate finance: securitization.

Commercial mortgage-backed securities (CMBS) were the birth of a solution to the credit drought of the early ’90s and drew a major divide between small and large banks. The larger banks seized the opportunity to use CMBS to reduce their balance-sheet commitment to fixed-rate commercial real estate debt. The smaller banks turned their attention to providing debt solutions by in essence “brokering” fixed-rate loans to the CMBS shops. The advent of this powerful new financial tool, combined with the extreme shortage of available capital, created the perfect environment for a new leader in commercial real estate finance to emerge: conduit lenders. CMBS enabled conduit lenders to provide a steady stream of financing until the subprime-mortgage crisis of 2008, when lending was brought to a standstill amid fears that the residential mortgage crisis and impending recession would impact the market negatively.

Enter insurance companies

Mortgage Delinquency Rates of Investor Groups

These events, comparable to the boom and bust of 1980, cleared the way for yet another leader in the commercial real estate finance industry: life insurance companies. Unlike conduit lenders, life insurance companies always have demonstrated more conservative underwriting practices, including high debt-service-coverage ratios and low loan-to-value ratios. Rather than basing their investment strategy on the riskier, higher-yield properties that appeal to many conduits, life-insurance-company lenders focused on financing larger properties with more structure and longer-term stability. This conservative approach, focused on higher-quality properties with low debt and stable income streams, ensured that investment losses were extremely moderate for life insurance companies in comparison to CMBS-based lenders in the fallout from 2008.

This positioned life insurance companies advantageously as market conditions stabilized but credit availability remained largely inaccessible. Once known throughout the industry for their extreme conservatism, life-insurance-company lenders now are virtually unmatched competitors based on their ability to finance massive projects and the broad flexibility of the terms they can offer.

According to the Board of Governors of the Federal Reserve, life insurance companies held about $280.9 billion in commercial mortgages in this past third quarter. This equates to about 12.6 percent of the $2.23 trillion in total outstanding commercial mortgage loans. Although this percentage might seem a small stake when compared to other types of commercial real estate lending, it conforms to the overall investment strategy of life insurance lenders: quality over quantity. Other lenders make significant contributions to commercial real estate finance as well, though their prospective roles have changed notably as the commercial real estate markets began the long journey of regaining momentum.

Although their presence in the field has diminished considerably since 2008, conduit lenders still are considered an important resource for riskier properties that would not qualify for insurance company loans. Often, with a conduit lender, toleration of higher risk comes with an expectation of higher leverage. This approach for properties with no other financing alternatives is helpful, but can be problematic. Underwriting and legal costs for this type of loan are significantly higher than for an insurance loan. If a financed project requires additional funding, an agreement must be reached with a special servicer because a conduit lender is not portfolio-based. This process is more difficult and much more complex than working directly with the lender.

Because of their financial exposure in the 2008 crisis, agency lenders face many of the same handicaps as conduit-based lenders. Displacement of available funding and a more controlled regulatory environment mean that many agency lenders can no longer price their loans competitively. This discourages many well-qualified borrowers from pursuing agency-based financing. Other, less-qualified borrowers willing to endure the higher cost of financing are often ineligible because of more restrictive qualifying requirements, such as the 90-day/90-percent occupancy rule. If they do qualify, these borrowers face many of the same post-closing challenges associated with conduit-based lenders because the loan has been securitized.

Events that led and immediately followed the subprime-mortgage crisis set the stage for a dramatic upheaval and restructuring of the finance industry. Conduit-based lenders lost significant market share as they struggled to regain their footing within the real estate sector, while agency lenders face growing regulatory restrictions. These changes, coupled with the diminishing availability of credit, created a perfect environment for the lender that weathered the storm to take advantage of plummeting property prices and record-low rates. In fact, the traditional benefit associated with life insurance financing has been the ability to lock low long-term rates. Another competitive advantage that life-insurance-company lenders offer is their ability to establish a relationship with institutional-based lenders with the flexibility to offer further financing or restructure the existing agreement. This is a comforting option to many borrowers, considering the recent turbulent history of the real estate market.

Cautious growth

As the demand for life-insurance-company-based lending has increased within the commercial real estate arena, insurance companies continue to explore ways in which they can grow their commercial real estate portfolios successfully while adhering to the conservative principles that protected them from the backlash of the 2008 meltdown. Insurance-company lenders finance a variety of commercial properties including retail, office, industrial, multifamily, mixed-use and hospitality. Although their investment seems concentrated on these specific asset classes, they tend to veer away from less desirable “scratch-and-dent” properties, focusing instead on well-positioned trophy properties in major metropolitan markets.

Historically, the retail and office sectors have been the property types of choice for insurance-company lenders. Many major retailers and other businesses expanded in the favorable economic climate of the ’90s. This translated into high office and retail occupancy rates, prompting development growth. These properties, many of which were secured long-term with multiple anchors, were an ideal match for life-insurance-company lenders seeking stable investments. Although these two property types still currently make up more than half of insurance companies’ mortgage-loan holdings, the changing credit climate since 2008 enabled them to extend their horizons and explore other property types that meet their conservative lending requirements.

Industrial properties are increasingly desirable to life insurance companies, because of their lower-risk model and lower-capital demands. The multifamily space also has opened up recently to these lenders because the once-dominant agencies in the niche face a post-recovery credit crunch that prevents them from pricing their loans competitively.

As life insurance companies seek to diversify their portfolios with property types not traditionally associated with them, the markets they’re investing in also are changing. In the past, the majority of their mortgage portfolios were concentrated within a few select metropolitan areas on the East and West coasts. Life insurance companies now are reconsidering their past over-concentration on major gateway cities such as New York and Washington, D.C., and shifting to secondary and even tertiary markets. This transition opens up the door for these companies to establish new relationships with property owners seeking to take advantage of the final wave of historically low interest rates.

Although certain property characteristics are always key considerations in the approval process regardless of what type of lender is selected, it’s important to keep in mind that a life insurance lender’s overall approach to the financing process is entirely different than that of an agency or conduit-based lender. Life insurance companies keep the majority of their commercial real estate investments within their portfolios. For that reason, unlike short-term dealmakers like agencies or conduits, life insurance companies focus on building solid, long-term relationships with property owners. A property’s geographic location and market position are contributing factors in this equation. Properties with established, effective leadership and strong operating histories are much more desirable to a lender focused on the long term than a property that merely looks good on the books.

Advantages for borrowers

Just as major transitions within the commercial real estate market have prompted life insurance companies to redirect their attention to new niches, changes within the finance industry are compelling property owners to veer away from agency and conduit-based lenders and establish relationships with institutional-based lenders like life insurance companies. As more borrowers pursue this form of financing, it’s important to understand the key differences in lending processes.

The underwriting process is comparatively the same with an insurance company loan as with any other lender: The property type and market are examined carefully. Prospective economic growth, barriers to entry and competing properties are investigated. Although this process is essentially the same among all lenders, the level of scrutiny is much higher by insurance companies than by conduit-based lenders. As institutions that view properties as additions to their own portfolios, life-insurance-company lenders are less willing to consider riskier investments and only focus on properties that are viewed as safe investments; hence they are not selling them off to the secondary market.

Although this qualification process is more burdensome, life-insurance-company loans offer a multitude of benefits for borrowers. If they’re seeking to lock in low interest rates, life-insurance-company lenders can extend fixed rates farther than their competitors can, and they are generally nonrecourse. The only potential drawback to this benefit is yield maintenance. A necessary evil of sorts, yield maintenance enables the lender to provide long-term funding at a fixed rate by ensuring the maturity of the loan or a prepayment penalty equal to any loss occurred to replace its investment with the U.S. Treasury. But if interest rates go substantially higher, yield maintenance on a loan originated today may not be much of an obstacle. This strategy gives borrowers the long-term fixed rate they seek by ensuring the lender collects the long-term interest.

Another advantage of life-insurance-company loans is that legal and underwriting expenses are significantly lower for the borrower. Because life insurance companies are portfolio-based lenders, they conduct a large portion of the upfront due diligence and underwriting in-house. In addition, they rely on third-party reports to verify information and outside legal counsel to prepare loan documents. This removes a significant financial burden from the borrower at the time of origination and is the “cherry on top of the sundae” benefit associated with insurance-company lending.

• • •

As the dust from the crisis of 2008 has settled, it’s strikingly clear that an established, stable leader in commercial real estate finance is healthy and eager to expand its presence in the niche. Life-insurance-company lenders offer property owners access to the funding they need to build a stronger, more vital commercial real estate industry, and the stability to do so not with CMBS, but with a portfolio-based lending model that considers each property an individual investment.

Life insurance companies have been lending for decades under the typical correspondent system, so access can be limited and funneled through select companies in select markets. This value-oriented lending philosophy is rebuilding the bridge between the real estate and finance industries, where the investment in property once again is considered valuable enough to keep on the books.


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