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“Divergent” is the tactful way Michael Weiser, the president of GFI Realty Services in New York City, describes underwriters' approach to commercial real estate lending at this particular point in the cycle.

“Capital sources are becoming more accepting of risk relating to certain types of assets, while becoming more risk averse with others,” he says.

He points to two recent deals to illustrate the gap. “On one occasion, we were tasked with arranging acquisition financing for a vacant, underutilized asset with no cash flow located in a prime Manhattan area. In the past, this was the domain of hard money; however, in the current lending climate, we were able to secure a competitively priced loan at a 90% LTV.”

Then he tells of a single-tenant asset in a strong retail corridor in New Jersey. It had a new 10-year lease with a publicly traded company, and the tenant also provided a corporate guarantee. “Although we were looking for relatively low leverage, the New Jersey deal was outright rejected by several lenders, on the basis that they can't accept the single tenancy risk, and that the debt yield was still relatively low,” Weiser says.

An economy that seems to be running more on fumes than fuel these days, if various economic indicators are to be believed, most notably the March unemployment numbers released by the US Labor Department at the start of April. A Federal Reserve Bank that is still coy about its interest rate plans. Oil prices. A strong US dollar. Dodd-Frank financial regulations that, five years after the fact, are still being promulgated, leaving institutions and borrowers to wonder and wonder what the end result will finally be. Traditional metrics, such as cap rates, that are no longer very telling about a project's health. (It is no accident that Weiser's lender in example No. 2 was examining the debt yield of the prospective deal).

Then again, the US economy is undeniably the envy of the world at the moment. If it has slowed in the last quarter, economists are overwhelmingly confident it is a short-term development. The slow drip-drip of new regulations could arguably be considered a good thing, giving the market time to adjust. And there is little doubt that lenders want to lend. To cite just one survey released earlier this year, CRE Finance Council members expect CMBS issuance to exceed the 2014 volume of $94 billion by some 25%. In addition, banks and life insurance companies predict more balance sheet loans to be made to commercial real estate owners.

This, basically, is the mishmash of economic trends and developments borrowers and lenders are navigating at the moment. Therefore, it is little surprise that players such as Weiser find decisions and judgments in the capital market to be a mixed bag of conservatism and aggressiveness.

Or here is another way to view the current environment, says Shahram Siddiqui, a partner at Berger Singerman in Miami. Right now we're at a point in the real estate cycle where lenders have gotten over their low-hanging fruit syndrome, he says. They are ready, willing and able to compete for value-add deals where structuring flexibility is the determining factor in winning a loan assignment.

“The easy refinancing deals have, for the most part, closed,” he says. The end of Siddiqui's low-hanging fruit syndrome also means lenders are not willing to go to the ends of the earth for that rare best or very good deal, as they were a few years ago. “The 100% LTV days are gone,” he says. “Some skin in the game is required.”

But how much LTV is the norm now? How much skin? These are questions that lenders and borrowers are feeling out as the recovery enters what some believe will be its final stretch. Much of the answer depends on the lender. Is it an opportunistic bank that, at the same time is aggressively managing its real estate capital exposure? Is it an insurance company that is willing to be flexible to win the deal but is resigned to losing the best apartment transactions to the agencies? Or a CMBS provider that, as always, prides itself on offering the cheapest money of all—but has an eye on upcoming regulations that will increase costs?

These are the players in the CRE capital markets today and like everyone else, they're making many decisions in real-time, based on events in an ever-changing economy.

For the most part, both lenders and borrowers have become adept at this process. As one example, consider Gramercy Property Trust, a New York City-based REIT. The company is pushing into Europe, it told shareholders in an earnings call earlier this year. “There's a very large opportunity set for our single-tenant business in Europe,” CEO Gordon DuGan told listeners.

As GPT moves in this direction, it is also taking steps to hedge against the strong US dollar. Dugan explained it this way: the company is planning to borrow in euros and in fact is in the process of exercising a euro-borrowing option on a credit facility in the US. The debt, meanwhile, will come from local lenders. “So we'll hedge the investment and then swap out future cash flows to minimize any effect on our core earnings,” he said. “We don't expect it to be a material number for this year either way, even if we didn't hedge it. But we're planning to hedge our future cash flows.”

Lenders, too, are moving in tandem with developments in the market. For instance, it is widely believed that the easy money for the single-family rental home market is past, at least for large portfolio purchases that equity funds were making a few years ago. But there is still enough distressed product in the pipeline that the market needs to absorb.

The Blackstone Group, Colony Capital and Cerberus Capital Management, therefore, are shifting their focus slightly by providing financing indirectly to smaller investors that are buying these properties, according to news reports.

And so it goes with all the CRE lenders. 

“WE ARE THE LOW-RISK GUYS”

Life insurers are inherently conservative investors, due, of course, to the nature of their business and regulatory model. Still, they too are finding it necessary to stretch to compete for the better deals.

“We are the low-risk guys,” says Marcia Diaz, managing director and head of originations for Prudential Mortgage Capital's Los Angeles office. “The CMBS group are the ones that take on higher leverage or tertiary markets or value-add property types. We look for moderate leverage and for borrowers that are very experienced and have traditional assets.”

Prudential is lending more aggressively in response to competition in the market, Diaz says, but those deals are usually acquisitions or trophy products—meaning the risk is still limited. “For instance, in 2010 we were underwriting great loans and getting a 10% debt yield on an industrial property,” she says. “Now we are going below 9% and, for infill core trophy low loan-to-cost office we are going to an 8% debt yield.”

Prudential started using debt yields as a metric around the downturn, Diaz adds. At that point, cap rates went so low they no longer were meaningful metrics, so Prudential switched to debt yields, she explains.

On the apartment side, life insurance companies may take on higher leverages of up to 75%, Diaz says, speaking generally about insurers. They might take on lease-up risk, doing a pre-stabilized deal with a guarantee to get to a stabilized number, primarily in order to compete with the agencies.

Often, though, in the end the agencies win out anyway as they underwrite at low acquisition cap rates, and life companies are not willing to follow suit, Diaz says.

However, life insurance companies will compete in other areas, she continues. “Generally speaking, a lot of life companies have coupon floors, and as Treasuries have dropped you may have to waive coupon floor to win business,” she says.

Relationships are also key to Prudential's strategy, Diaz says.

“We stick with borrowers we know and work with them. For example, we have industrial borrowers that have done business in Southern California and are now moving to Phoenix or Portland.”

Life insurers are also known for their flexibility, especially in the current market environment, Siddiqui says.

They can be downright creative in giving a borrower the ability to release individual collateral, and granting the right to substitute collateral, he says. “We have seen insurance companies give 30-year loan terms, with 65% leverage, and future advance provisions.”

As an example, Siddiqui points to a large loan his firm recently secured with an insurance company for the repositioning of a regional mall. The loan included a large line for improvements to the property, flexibility on payment terms and had a term that totaled 30 years with all of the extensions are exercised.

BANKS' CALCULATED AGGRESSION

Other lending sources are even more aggressive, such as bank lending, according to Chandan Economics' Q4 2014 Bank Lending and Default Report.

Banks' net lending on commercial and multifamily real estate and construction projects jumped $103.7 billion during 2014, the report found, following an increase in net lending of $71.4 billion in 2013 and a decline of nearly $8 billion in 2012. This compares to the pre-crisis peak, when net bank lending increased by more than $200 billion in 2005.

It is clear banks have a robust appetite for CRE loans as aggressiveness in the underwriting continues to increase, CEO Sam Chandan says. Of course not all banks are uniformly eager to embrace the risk that typically accompanies a CRE deal, he goes on to note. There are also areas to watch with caution, Chandan says. For example, “we are watching closely for any change in momentum as more onerous regulatory capital treatment of construction loans come into force,” he says. “It is not clear at this point that it will materially reduce construction activity, but it demands monitoring.”

Another area about which Chandan sounded a possible alarm was the increase in the use of interest-only structures, which he called “problematic. This is especially the case in the apartment sector, where current underwriting offers little room for weaker fundamentals coinciding with higher interest rates.”

Again, though, not all banks are loosening their underwriting standards to that great of a degree. KeyBank, for example, wants to make loans, but it is staying committed to its underwriting standards, says Dan Baker, EVP of KeyBank's Real Estate Capital Markets Group in Chicago. The bank's idea of an “aggressive” transaction is a $36 million acquisition/renovation loan it recently made on a mixed-use property in the San Francisco Bay area for an equity fund in Chicago and its JV partner in Portland. The loan was committed within 30 days and closed within 45 days.

Baker is sympathetic to the pressure that borrowers are under. “There is a tremendous amount of equity dollars chasing deals, which is driving prices up,” he says. “It is natural for borrowers to push on their lenders for more aggressive loan terms at this point in the cycle so that they can hit their return parameters.”

KeyBank, he says, “will always compete on pricing for deals with the right sponsorship that meet our underwriting standards. However, we will not compromise our underwriting standards in exchange for more pricing.”

The upside of banks is that they generally can be counted on to offer a good—albeit not the best—rate because their cost of capital is lower than most other lenders aside from CMBS, Siddiqui says. “Virtually all of this debt is funded on a recourse basis,” he says. Also, as is always the case with banks, flexibility in non-monetary terms is limited due to regulations. However, Siddiqui continues, banks can be flexible in such ways as giving a borrower the ability to substitute collateral, longer maturity dates and future advance provisions. 

CMBS CONTINUES TO GROW

CMBS continues to grow after its near-death experience during the crash and most participants second that CRE Finance Council member survey that projects a 25% increase in issuance over 2014 for this year.

There are several reasons for the robust health of this piece of the lending community, says Paul T. Vanderslice, co-head of the US CMBS group at Citi and the head of its commercial mortgage distribution. Buyers are back in force, including investors from the fixed-income side. There is a wave of maturities coming due, with $300 billion from rollovers alone. Also, interest rates will remain relatively low, even with the Fed poised to begin increasing them. This, in turn, will keep cap rates low and push investors to look to real estate for the yield they won't be getting from Treasuries.

Perhaps the most telling indicator is that demand is strong for CMBS right now, including from institutional investors on the fixed-income side.

Indeed, demand for CMBS could almost be described as frothy, says Berger Singerman's Siddiqui. “Due to competition, LTVs have increased dramatically,” going as high as 75%. He adds, “Some borrowers have been able to also obtain mezzanine financing rights, so overall leverage can go as high as 90%.”

Ground lease and OpCo/PropCo deals are returning, Siddiqui says, and so are transactions with significant amounts of upfront interest reserves, and thus a bet on the ability to reposition an asset. “Underlying credit quality of the tenant is not so much a focus today; so long as the proposed payment fits within historical financials there is very little forward underwriting going on,” he reports.

As an example, Siddiqui tells of a portfolio deal he worked on, in which the sponsor was a REIT managed by an offshore investment fund. “The guarantor had limited US assets, the collateral is located in non-major markets, and the cash flow relies on local tenants with limited operating histories.”

How lax is underwriting getting? Siddiqui reports there is a growing willingness to lend to borrowers and sponsors who previously went through the foreclosure process with a CMBS servicer.

None of this is to say that the CMBS space is worry free. There are concerns on the horizon for the industry, Vanderslice says. The risk retention rules for CMBS are coming into effect and they will increase the cost to borrowers, making CMBS less competitive than portfolio lenders. In addition, the liquidity coverage ratio will be another burden for issuers.

How this will affect supply-demand fundamentals remain to be seen, of course. For now, Vanderslice says, the CMBS community is focusing on its usual overarching goal. “We want to create bonds that investors want to buy and we want to provide loans that borrowers want to take out on terms that are favorable for us and them.”

Which, actually, sums up the CRE capital markets in general.