PLI: Consumer mortgage issues have dominated the real estate financing news for a year now, which has crowded out reporting on the commercial real estate market. How is that sector faring? 

ROBERT J. HELLMAN: The more things change, the more they remain the same. For those...who have been in the real estate industry for ten years or more, financing real estate transactions today is looking a lot like it did before securitized commercial real estate lending came to dominate the market. But the market took us on a six-month roller coaster ride in 2007 and there's no certainty the ride is over.

PLI: Consumer mortgage issues have dominated the real estate financing news for a year now, which has crowded out reporting on the commercial real estate market. How is that sector faring? 

ROBERT J. HELLMAN: The more things change, the more they remain the same. For those...who have been in the real estate industry for ten years or more, financing real estate transactions today is looking a lot like it did before securitized commercial real estate lending came to dominate the market. But the market took us on a six-month roller coaster ride in 2007 and there's no certainty the ride is over.

Consider: Early in the second quarter of 2007 it was still possible to create a non-recourse capital stack using debt up to 95% or more of an investment's value, with debt service coverage ratios less than 1:1 for as long as three years, at a blended interest rate in the neighborhood of 6%, interest-only for up to 10 years. By the fourth quarter of 2007, the norm was more like a recourse loan at 65-75% LTV, with DSCR of 1.2:1, interest rates well above 6% and a 30-year amortization schedule – kind of like what mortgages looked like before Wall Street figured out how to securitize loan pools and sell off the tranches to investors around the world.

Capital movements are so quick and so global now that what follows is merely a short-term snapshot, but anyone considering an acquisition or new development needs to take into account the current environment. The good news: Real estate has become an accepted asset class for investors worldwide; so today's environment should be viewed as a (relatively) short-term transitional period that may present better opportunities for long-term players whose main focus is the business of real estate. More good news – deals have been closed during this transitional period, although the market is demanding a much higher degree of selectivity in deals that can get done.

It may sound axiomatic, but by the end of 2007 only the most qualified borrowers and soundest properties or developments were getting funded. In other words, if you had no experience, no real liquidity or no reasonable business plan, there was little chance capital was available from any lender other than so-called "hard money lenders" who were making 50% LTV loans at rates around 12% plus 4 points. This is less obvious than it sounds since the CMBS market had grown so big, so fast that it seemed quantity mattered more than quality in order to keep the machine running. How else to explain the explosion of sub-prime mortgages in the residential market or the condo developers who suddenly qualified for hotel loans?

As a result of this new reality, banks and insurance companies are competing more effectively against conduits and other securitized lenders (which is not likely to last forever). Over the last decade, the market moved to securitized lenders because they offered higher LTVs, speedier execution and non-recourse loans. At the end of 2007, many securitized lenders could not guarantee quotes or proceeds, especially for larger deals, mainly because they couldn't sell bonds backed by the loans and were therefore having difficulty pricing their loans accordingly. Nor is this expected to change in the immediate future (one estimate suggests CMBS issuance in 2008 will be less than half what it has been the last two calendar years).

So on-book, or portfolio, lenders have filled much of the lending gap, while applying their normal standards, which include lower LTVs. They are also more conservative regarding to whom they will lend. And, there are capital allocation limits to which portfolio lenders are subject that never seemed to apply to conduit lenders, which seemed able to access a never-ending supply of capital (ironically, often from the same portfolio lenders who also lend direct but were also buyers of rated CMBS debt). There are always exceptions to the rule, but the market is clearly squeezed at the moment.

True equity is back in style. Lenders want sponsors, investors, developers to actually have their own skin in the game, or at least cash from investment structures for which they are responsible. Nominally, this means 25-35% equity (and often does not include improved or inflated land values) -- i.e. to the lender it must look like real cash in the deal. So developers can use all of their own cash or they can take on partners in the form of mezzanine debt/preferred equity and maybe bring the "equity" to 80-85% of the amount required. Although mezzanine debt is plentiful at levels below that because of the depth of the private equity market, getting the debt capital stack to above 85% is either non-existent or prohibitively expensive.

Recourse lending is back as well. Expect full or partial recourse provisions in loans for the foreseeable future. It's not that non-recourse lending has completely disappeared, but for the time being it will be more of the exception than the rule. Where recourse is concerned the borrower must not only show adequate net worth, but must have considerable liquidity as well. There are ways, however, to burn down the recourse, for example based on an increase in NOI and free cash flow. Put another way, as the value of a property increases based on property fundamentals (versus cap rate compression or some exceedingly aggressive rental growth assumptions), lenders might show some flexibility on this issue.

Another key market constraint is the fact that construction lending is extremely limited, as is the rest of the floating-rate debt market. Lenders have pulled back on making large loans (over $100 million) and club deals (i.e. pre-closing syndicates) are increasingly common. Of course, those kinds of deals are harder to craft. Much of the floating rate debt had been bought by large European lenders and SIVs (and we've all heard what's happened to the latter). So without a market into which lenders can sell these loans, availability is highly uncertain. Now, when development loans are getting done, proceeds are usually in the 60-70% loan-to-cost range rather than the 70-80% loan-to-value range (which could often equal 100% LTC).

People also tend to forget that commercial mortgage lending does not operate in a vacuum. We can't overlook the impact of the consumer sub-prime mess or concerns regarding the leveraged loan overhang. No one is suggesting that commercial real estate lending suffers from the same practices some have attributed to sub-prime brokers and bankers, which ostensibly include fraud and high-pressure tactics. But that doesn't change the fact that uncertainty in the residential market has adversely impacted the ability of the capital markets to issue new bonds backed by commercial real estate loans as questions continue to swirl around the reliability of bond ratings;  this, in turn, will continue to constrain the amount of capital available to commercial borrowers. And the constraints are likely to continue through 2008 as more and more homeowners face loan resets or if the economy slows and people begin losing their jobs, thus risking increasing defaults in the residential market.

And let's not forget that commercial and investment banks are long in the leveraged loan market, by some estimates as much as $300-400 billion at the end of 2007. Until they can sell off their positions, or be forced to write down values, this overhang contributes to their inability to lend more aggressively in many arenas, including commercial real estate. Will this correct? Of course. How soon? That probably depends on whether the world's economic fundamentals are as solid as many analysts hope.

The $64,000 question, of course, is when does commercial real estate lending return to "normal"? Arguably, we have already returned to normal in the sense that the aggressive lending practices over the last four years may have been an anomaly leading to a cleansing credit crunch, although it's just as reasonable to consider the recent credit crunch to be a universal reaction to certain sector excesses. The CMBS market is not going away, though it will shrink, at least over the next year. Net-net, securitized mortgage debt is a positive development in commercial real estate finance. Issued and rated properly, it injects tremendous amounts of fresh capital into the real estate industry and allows a great many investors a way to diversify their portfolios. Ultimately, a return to quality is good for lenders and for experienced developers who understand the fundamentals of the industry.