If you're mesmerized by the blockbuster growth in the commercial mortgage-backed securities market and want to jump into the conduit bandwagon - the fastest growing market segment - you may want to rethink your decision. Competition among conduit originators is fierce, their margins are narrowing, and a battle between conduit loans and the whole loan market is just beginning to brew.
"The securitization market has become very competitive. You have to earn your fee today," says Mark Finerman, co-head of the Real Estate Investment Banking Group at New York-based Credit Suisse First Boston. "If you have to enter the market today, it makes no sense. The competition is fierce enough." But don't get scared. Look at the bigger picture - the immense growth potential.
The issuance of commercial mortgage-backed securities, overwhelmingly dominated by conduits, reached near a whopping $19 billion in the first quarter of this year as compared with $42 billion CMBS issued during the entire 12-month period last year. CMBS issuance is set to break another record this year, with some analysts predicting the annual volume to reach the high $60 billion mark in 1998. The annual CMBS volume in 1991 was a mere $4.6 billion.
"CMBS market volume still represents a relatively small part of the debt sector," says George Fantini, chairman of Fantini & Gorga Inc., a Boston-based mortgage banking firm that specializes in the structuring and placement of financing for real estate projects. "There is a huge growth potential."
The total CMBS market volume today stands only at about $200 billion outstanding - a tiny portion of total institutional real estate debt market estimated at $1.13 trillion. With between $100 billion and $200 billion of commercial debt originations each year, the potential for CMBS growth is immense. Of the $1.13 trillion debt outstanding, CMBS accounts for only about 15%, according to industry estimates.
In addition, industry observers say, investors and borrowers now feel more comfortable with conduit deals and quality origination and rating processes.
"We are in one of the greatest financial booms in real estate we have ever seen in this country. And unlike the past when real estate booms went from one state to another, we are seeing it all over the country at the same time," says Hal Rose, executive vice president of Calabasas, Calif.-based ARCS Commercial Mortgage Co., a national mortgage banking firm with strong ties to Wall Street houses. "Why it is happening is because we have not seen interest rates in sevens - and in some cases in sixes - since the '60s."
Driving this real estate financial boom are conduit deals, or multi-borrower securities, as rating agencies prefer to call them, says Galia Gichon, a vice president responsible for CMBS research at New York-based Bear Stearns. "Conduits represented 75% of the total CMBS issuance during the first quarter of this year."
The share of conduit loans - loans that are originated for the sole purpose of securitization - rose from less than 5% of CMBS issuance in 1992 and 33% in 1996 to more than 50% in 1997, according to industry estimates. Large loans, seasonal mortgages and other loans account for the rest.
FASITs likely to boost market Gichon says the recent advent of the financial asset securitization investment trust, or FASIT, is likely to further boost the CMBS and conduit market because of its flexible nature. There has already been a $2.2 billion FASIT deal completed this year, Gichon adds.
FASIT, which became effective Sept. 1, 1997, provides a mechanism of securitizing both mortgage and non-mortgage assets, and allows issuers to substitute collateral, withdraw collateral representing over-collateralization and add assets over its life.
Although there was a lot of initial enthusiasm when this new financing vehicle was introduced last fall, FASITs have been much slower than initially expected. After some regulatory and tax issues are clarified, FASITs still have the potential to provide a dynamic alternative to real estate mortgage investment conduit (REMIC) vehicle that has allowed issuers to pool and securitize commercial real estate mortgages into a variety of financial products.
Many industry pundits say FASITs could add fuel to the securitization industry on two fronts: First, it would attract a new class of investors such as money managers and hedge funds and, second, it will be able to provide a variety of loans including construction loans, bridge loans, takeout loans and other short-term loans. Most in the CMBS industry so far have used the REMIC vehicle.
The best value of FASIT, which is being called a living and breathing vehicle, however, could be seen in its ability to securitize construction loans - an area where traditional lenders especially commercial banks have maintained an edge and conduit originators have failed to make much headway. FASITs could change that.
"All banks offer construction loans, and they are really competitive. Banks have been making construction loans for a long time, and I feel it's localized business. It's difficult to secure a construction loan in Burlington (Mass.) from Kansas," says Fantini of Fantini & Gorga. "Conduits are trying to retaliate by giving out construction loans now. There is a bit of battle going on."
He says CIBC Oppenheimer, a New York-based investment firm, is getting into construction loans and so is Nomura Securities of New York. Conduit originators are also getting into a variety of new financial products that were previously covered by traditional lenders such as commercial and savings banks and life insurance companies.
"Life companies have lost market share," says Fantini. "They once dominated the permanent loan market (five- to 25-year loans). Banks also had big share of it, but banks also tended to be short-term lenders - three- to seven-year loans. While insurance companies competed in terms of spreads and price, banks relied on their relationships."
But when the real estate market collapsed in the late 1980s and the industry faced its worst credit crunch in recent memory, it did not take a long time for Wall Street to jump in as a new source of financing for the commercial real estate industry.
Going head to head with traditional lenders "That gave birth to the conduit industry. People say it will never be like residential, but it has worked remarkably well," Fantini says. "There are a lot of smart guys on Wall Street." And these "smart guys" are competing head-to-head with traditional lenders by offering various financing programs ranging from smaller loans to construction loans.
ValuExpress, a New York-based Wall Street mortgage conduit, for instance, is originating fixed-rate, non-recourse mortgage loans ranging from $250,000 and higher secured by multifamily, anchored and unanchored retail shopping centers, office buildings, warehouses, hotels, manufactured housing communities and self-storage facilities.
In addition to providing smaller loans, conduits are also offering very competitive packages that include a cap on legal fees, environmental reports and other third-party reports. Furthermore, while banks are charging half to one point fee on loan originations, conduits are not taking any such fees.
"Also, conduits are not asking for personal guarantees on loans. There are no personal guarantees required in conduits. Banks, on the other hand, cannot give up on personal guarantees. Many people are going to move to conduits," Fantini says. "Banks are considering partial guarantees, and I would predict that we are moving in a direction where we are going to find banks surrendering on personal guarantees."
The competition is also fierce in terms of spreads. Insurance companies still remain competitive in the first place, with conduits second in line and banks in third place. Spreads in life companies' loans remain at about 100 basis points over U.S. Treasury as compared with between 150 and 200 bps for conduit loans and between 200 and 250 bps for bank loans.
ARCS and Credit Suisse First Boston, for example, recently provided conduit mortgage funding of a downtown Los Angeles property that included a historic movie theater and an office building with 60 retail shops on the ground floor, 31 retail shops in the basement and upper floors with 192 jewelry offices. The loan was priced at a 180 pb spread with a final interest rate of 7.75%. It was structured for a term of 15 years with a 30-year amortization. "Even with 150 and 200 basis points, conduits are saying there is enough profit. They are shifting to smaller loans because they are very effective," says an industry source, who asked not to be identified. "What is the rationale behind conduits getting into smaller loans of up to $2 million? Profits. Spreads at smaller loans are ranging between 250 and 300 basis points above Treasury."
Insurance companies and banks, which have not been hungry in the origination business traditionally, are now also inching their way into the conduit business - directly or indirectly. KeyBank and Wells Fargo have been particularly aggressive on getting into the conduit business. Some insurance companies such as Confederation Life of Canada and Penn Mutual Life of Philadelphia, however, have either closed down their loan origination units and securitized their commercial real estate debt portfolios or have significantly cut down permanent loan originations.
Banks and insurance companies are fighting back Many banks and insurance companies, along with a new group of investors such as money managers, pension funds, real estate funds and mutual funds, are emerging as major buyers of these commercial mortgage-backed securities.
"Even though banks are competing against Wall Street firms, they are also big buyers of securities," says John Gorga, president of Fantini & Gorga. "Big buyers of CMBS are banks and insurance companies. Clearly, banks and insurance companies are fighting back."
Charlotte, N.C.-based First Union National Bank, for example, has launched a very aggressive small loan origination process. It originates and finances commercial mortgages of $2 million and under and then securitizes them. The bank has also introduced a small construction loan program for securitization.
"The program started about nine months ago. It's very new to us and has been a tremendous success," says Barry P. Reiner, managing director of First Union Corp.'s Commercial Real Estate Finance group.
Gorga says the institutions that are not directly involved in the underwriting process and are not well-capitalized are getting hurt in the cut-throat competition in the CMBS market.
"Their margins are being squeezed. For the most part, intermediaries are disappearing or already gone because they cannot effectively compete," says Gorga, adding that some CMBS players may get out of the market because of tightening competition and narrowing margins.
Given a large and still-growing list of CMBS originators, industry insiders are predicting a wave of consolidations in the CMBS industry in late 1998 and 1999. They say the impending consolidation would result in a small number of big players, especially on the conduit side.
"You are going to see consolidations," says Finerman. But large and service-oriented originators of conduits, the mainstay of CMBS market, will continue to dominate the market, he adds.
"Conduits are more efficient. It segments the risk and is more effective than the whole loan market such as life companies and bank market. But if you want to be in the conduit business, you need client loyalty," Finerman says. "In order to maintain not only margins but also client loyalty, you need to offer a wide variety of mortgage products. Clients want a one-stop shop. The permanent market is getting extremely competitive, and the only way to get a margin is to offer other products."
He says Credit Suisse First Boston, for example, has a pipeline of permanent mortgages that are holding for six months to a year or longer before they are securitized.
Credit Suisse First Boston recently completed a $2.48 billion conduit transaction and hopes to do another $3 billion to $3.5 billion in fixed-rate permanent conduit financing by the end of the year.
"Moreover, we are securitizing floating rate products in addition to fixed-rate financing," says Andy Stone, a manager and principal in the transactions group of Credit Suisse First Boston. "Historically, we have not done floaters."
Of the projected $8 billion floating rate products to be issued by Credit Suisse First Boston in 1998, about 50% will be securitized, company officials say.
"The conduit market has been terrific. There are huge number of buyers of securities," Stone says. "In this interest rate environment, there are also a lot of borrowers who want to lock in."
He says REITs, which were gobbling up properties all across the country, have now slowed down their acquisition spree because they are no longer able to meet their yield requirements due to skyrocketing real estate prices. REIT shares are down about 9% so far this year.
With deals being priced more efficiently and greater involvement of rating agencies in real estate mortgage-backed securities, a large number of investors are flocking to the market to buy real estate securities.
Finerman says there is huge demand for B and below grade securities. "There is a lot of liquidity in the marketplace. There is an excellent risk-reward if you are confident that the real estate market is still improving," Finerman says. "Return is very high compared with the corporate equity market, and multiples are very cheap."
The CMBS market has grown and diversified dramatically over the past five to six years in addition to achieving tremendous efficiency. The sizes of mortgage pools have also become bigger.
There is also a new trend of "fusion" conduit deals these days, says Reiner of First Union, which recently offered the industry's most geographically diverse commercial mortgage securitization package to date. (See box.) In fusion deals, large loans of more than $50 million on institutional quality real estate are put into conduit deals where average loan size remains at about $4 billion.
Industry experts say the commercial mortgage-backed securities market and conduits will continue to grow in the near future because of superior and still-evolving public market scrutiny and checks and balances.
Despite an abundance of capital in the marketplace, underwriting standards remain quite high, Rose says, adding that underwriters today remain concerned about cash flow of the properties they are underwriting.
"I cannot say we will have a big bust because of the increased cash flow and low interest rates and the reserves lenders are requiring today. Borrowers are getting loans on the basis of their properties," Rose says. "This is what we did not have in the '80s."
Some industry analysts, however, remain cautious.
"There have been no significant defaults that have caused CMBS buyers to think twice, but there will be an episode that will force people to reassess the pricing of the securities," says Fantini of Fantini & Gorga. "I think Wall Street is doing a terrific job. They are very disciplined, and they are doing a better job than the banks did in the '80s."
What is hot in the conduit market today? "Fusion deals," says Barry P. Reiner, managing director of First Union Corp.'s Commercial Real Estate Finance Group.
"Fusion" deals consist of a typical conduit loan component - loans that are originated for the purposes of securitization - as well as a large loan component that generally exceed $50 million on institutional quality real estate. More and more financial institutions these days are combining conduit loans with larger loans, industry officials say.
"People are mixing large loans with small loans," says Richard Levine, a senior analyst at the New York office of EY Kenneth Leventhal Real Estate Services Group.
He says the industry wants bigger deals in order to be more efficient and cost-effective, and "fusions" are the way to do it.
First Union Capital Markets, a division of Wheat First Securities Inc., a separate non-bank affiliate of Charlotte, N.C.-based First Union Corp., and New York-based investment house Lehman Brothers recently pooled 664 loans in the latest commercial mortgage securitization package that was priced at more than $3.4 billion. The pool is the industry's most geographically diverse offering of commercial mortgage-backed securities to date, comprising 729 properties from 43 states and the District of Columbia.
Known as a "fusion" deal, the package is also the industry's second largest offering of CMBS. The securities are backed by loans originated or acquired by First Union National Bank, Lehman Brothers and Bank of America. In addition to the conduit loan and large loan component, the mortgage pool also included a credit tenant lease (CTL) portion valued at approximately $232 million. First Union contributed 271 loans to the mortgage pool representing approximately $1.35 billion of mortgage loans. Included in this figure are CTL loans valued at about $163 million as well as a number of loans from the bank's Class-A program - which offers institutional quality assets from institutional quality borrowers. Lehman Brothers contributed 273 loans valued at approximately $1.73 billion, including $496 million in large loans and $62 million in CTL loans. In addition, Bank of America contributed nearly $332 million in conduit loans to the package.
"We are very excited to be offering a collateral pool of this magnitude as investors will benefit from the tremendous diversity of the components in property type, loan type and geographic distribution," says Reiner, whose firm is ranked as the nation's leading originator of securitized commercial mortgage loans.
Multifamily housing represented 31% of the securitized loan pool, followed by retail properties at 27% and office properties at 20%. The package also included hotels with 7%, credit tenant leases with 7% and industrial/warehouse at 4%.
