Appetite for Debt Increases, But Conservative Underwriting Remains

Fall 2012

Even if the volume of new commercial mortgage lending originations dips in the second half of the year, the first half of 2012 has been robust. According to the latest figures available from the Mortgage Bankers Association (MBA), the level of commercial and multi-family mortgage debt outstanding increased by $8.1 billion, or 0.3 percent, between 1Q12 and 4Q11.

Three of the four major investor groups: commercial banks, CMBS, insurance companies and government-sponsored entities, increased their holdings and lenders put out more in new loans than they paid-off or paid down. Given this net increase in debt issuance, Development magazine asked two of the industry’s biggest direct lenders to talk about how they view the market now and what they see ahead.
That view is fairly rosy, with a few caveats: underwriting is still conservative and the larger lenders are sticking to their preference for high-quality, stabilized assets in primary markets. Increasingly, too, they are looking overseas, mainly to the United Kingdom, for new opportunities.

Robert Little

Robert Little

A member of the MassMutual Financial Group, Cornerstone Real Estate Advisers LLC, provides core and value-added investment and advisory services, including debt, equity and securities expertise and services, to institutional and other investors around the globe. Robert Little, Cornerstone’s chief investment officer/finance, reported that the firm invested $6 billion in debt in 2011 and is on track to match that in 2012. Cornerstone and its subsidiaries have more than $33 billion in assets under management.

“This is one of the most interesting markets I’ve seen in my 25 years in the business. There has never been a better time for stabilized, quality assets. Equity and debt rates are especially attractive, new supply is very constrained and markets are improving.” Little has observed an increasing appetite for debt among the firm’s institutional clients, who are seeing it as an attractive investment alternative for the first time. Because the impact of over-leveraging is likely to increase over the coming year, as five-year loans initiated at the market peak in 2007 come due, opportunities will present themselves in re-pricing and acquisitions.

Earlier in 2012, Cornerstone raised $546 million in capital for the Cornerstone Real Estate Fund VIII (CREF VIII), which will target property types and markets that the company expects will experience above average growth, with a focus on markets with high concentrations of employment in the technology, energy and health sectors. CREF VIII has closed nine acquisitions representing a little less than 40 percent of the capital raised. All of these have been equity investments. The acquisitions have been in Raleigh, Tampa, Dallas, Phoenix, Denver, San Francisco and Orange County, Calif. The firm also raised $315 million from domestic and international institutional investors for the Cornerstone Enhanced Mortgage Fund LP, which is designed on the club concept of fewer, select investors. The fund will invest in first mortgage debt, secured by real estate that has undergone an ownership change or other transition as a result of recent financial conditions. The fund seeks assets with strong sponsors, locations and business plans over a two- to five-year period. Little will serve as portfolio manager.

Cornerstone has been expanding in other ways as well: seeking out high-profile transactions and expanding to Europe, starting in London. “Europe is farther behind the United States in healing,” he said.

The company has focused on commercial properties in six gateway markets in the U.S., but has been avoiding the suburbs, particularly office properties. Needless to say, other major lenders are targeting the same markets. According to Little, Cornerstone’s competitive edge lies in its long-term, repeat relationships and certainty of execution. It may also “stretch” on pricing, if it seems necessary, but he noted, “We haven’t changed our underwriting; we’re fairly steadfast on that. It’s been a big enough sandbox.”

Cornerstone likes borrowers that are large high-quality sponsors with good reputations and financial capability — in short, those who have “deep pockets and long arms.” 

Little expects that rates and yields will probably not be too different six months from now, although “long term, rates have to go up,” he said. His advice for prospective borrowers? “It’s a great time to be a long borrower. Insurance companies have a need for 10 to 20-year transactions. Don’t get too smart about getting the optimal rate on the optimal day. If the rate works for you, pull the trigger,” he noted.

The Quest for Yield

According to the MBA, whose analysis is based on data from the Federal Reserve Board’s Flow of Funds Account of the United States and the Federal Deposit Insurance Corporation’s Quarterly Banking Profile, of the various types of mortgage lenders, including commercial banks, CMBS, insurance companies and government-sponsored entities, insurance companies are the third-largest category. In percentage terms, insurance companies saw the largest increase in their holdings of commercial and multi-family mortgages in the first quarter of 2012, an increase of 5.3 percent.

Mark Wilsmann

Mark Wilsmann

But if MetLife Real Estate Investments is any indication, insurance companies are tweaking their lending strategies in response to market conditions. Mark Wilsmann, managing director, MetLife Real Estate Investments, commented, “We continue to see good lending opportunities and have been reasonably active in the marketplace. MetLife is still feeling good about real estate lending in the United States. However, we are beginning to limit our appetite for longer-term, fixed rate loans.” In the first half of 2012, 90 percent of MetLife’s business has been short-term (five years and under) and floating rate loans. Its sweet spot comprises high-quality assets in primary markets.

Thanks to the tepid economy and a continuing low interest rate environment, Wilsmann expects that volume will decline in the latter half of 2012. MetLife is also focusing on its senior mezzanine program, expecting to increase volume in that program by year-end. These loans would also be on high-quality assets in major markets, in the 50 to 70 percent loan-to-value tranche, where yields are better than they are for first mortgages. MetLife is providing more permanent construction financing, and is still recapitalizing overleveraged assets, with maturing 2007 loans representing good opportunities for senior lending. “MetLife is looking for financially stabilized properties, with institutional-grade owners, in major markets and can tailor financing to the client’s needs.”

The quest for higher yields also has led MetLife overseas, where it has become very active in the United Kingdom. Wilsmann said there has been a dearth of commercial bank capital available in the U.K., particularly on commercial properties in central London and the Canary Wharf area. Of the $5 billion in new MetLife loans committed in the first half of 2012, 20 percent represented financing in the U.K.

“Most of what we do is investment-grade quality and lending,” he said. At what rate? Wilsmann remarked that if banks are lending at 200 points over Libor and CMBS loans are 300 points over Treasuries, then life insurance companies are “somewhere in between.”

Assessing the investment horizon, Wilsmann commented that “Buy-and-hold investors probably are not going to be doing as much as they did in 2011. Commercial banks are getting healthier, but there is a lot of pressure from regulators, and they are sensitive to real estate risk. The CMBS world continues to be choppy and those deals are priced with a good amount of margin. Rates will continue to be low, but there will be a little upward pressure.”

Generally, lenders are not sizing loans based on pro forma, and debt yield is analyzed with current income in place. “Underwriting is not ahead of itself, although multi-family is the sector where lenders have been more aggressive,” said Wilsmann, meaning that competition among lenders has been intense, resulting in higher pricing and lower expected initial returns.