MORTGAGE LENDING: SMALL LOANS

APARTMENT FINANCE TODAY • NOVEMBER/DECEMBER 2007

Banks Strike Back

Banks haven’t had to raise their interest rates for small loans in the wake of the financial crisis. That, plus flexible underwriting, is giving them an edge over Fannie Mae and conduit lenders.

By Bendix Anderson

Commercial banks are back. The crisis in the capital markets robbed conduits and Fannie Mae lenders of their ability to offer low interest rates— their best weapon to challenge balance sheet lenders like banks in the competition to make apartment loans of less than $5 million.

That put the rates offered by banks on par or even ahead of their conduit lender competitors this fall, giving them an edge when borrowers take into account their other advantages, like better prepayment terms, flexible underwriting, and interest-only options.

“The capital markets really shook out and aligned in our favor,” said Kendon Studebaker, senior vice president in the income property lending department at First Federal Bank of California.

Interest rate spreads, which express the markup over the yield of an underlying security such as Treasury notes, hardly changed throughout the capital crisis for the small five-year, fixed-rate loans offered by many commercial banks, experts said.

For example, since June the typical spread over five-year Treasuries offered by First Federal to apartment borrowers hasn’t budged at all from 155 basis points. In early October, that equated to a rate of about 6 percent for loans covering 80 percent of the value of a property— within a few basis points of the rates offered by some Fannie Mae lenders.

As rising defaults threw the market for bonds backed by commercial real estate into chaos this summer, the interest rates offered by conduits and Fannie Mae lenders climbed by as much as a full percentage point in some cases, to around 6.5 percent.

In early October, rates offered by some Fannie Mae lenders were just beginning to drop back toward 6 percent.

Now that banks can match or even beat the interest rates offered by conduits and Fannie Mae lenders, their other advantages put them in a strong position to win back market share.

Bank loans are relatively easy to prepay. First Federal charges prepayment penalties that start at 2 percent for the first two years and then step down to 1 percent in the third year, with no penalty for prepayment in the fourth or fifth year. In contrast, the 10-year loans usually offered by conduit and Fannie Mae lenders require borrowers to go through the expensive and complicated process of either yield maintenance or defeasance to get out of a loan.

Banks still offer longer-term “interest-only” loans, in which the borrower pays only the interest and none of the principal of the loan for a period that can last for the entire five-year loan term, experts said. Fannie Mae and conduits now offer interest-only for shorter periods of a year or two, if at all.

The documentation required for small bank loans is also minimal compared to other lenders, some of whom have taken action in response to the competitive pressure.

“We have really loosened our requirements again. We cut them in half in response to the local banks,” said John Barbie, vice president for ARCS Commercial Mortgage, a Fannie Mae lender. Despite these efforts, banks still charge the least for the reports needed to close a loan: as little as $2,000 compared to $3,500 for ARCS.

To realistically compete with these benefits, conduits and Fannie Mae lenders need to offer borrowers interest rates that are more than 15 basis points lower than the rates offered by banks, said Barbie.

Before the capital crisis, conduits and Fannie Mae lenders often offered rates that low and lower. But during the credit crisis, many conduits raised rates so high that loan originations slowed to a trickle. In early October, bond buyers were still unwilling to purchase some tranches of commercial mortgage-backed securities (CMBS), including Arated and AA-rated bonds backed by conduit loans.

Even conduits like Clevelandbased KeyBank, which has bold plans to expand its small loan business, had to raise rates. KeyBank plans to originate more than $300 million in small loans to securitize once the bond market revives in the first quarter of next year. Until then, KeyBank plans to hold new loans on its balance sheet.

In early October, KeyBank’s rates started at 6.57 percent and rose as high as 7.65 percent for small 10-year loans amortized over 30 years. That works out to a spread starting at roughly 180 basis points over the yield on 10-year Treasuries. These loans typically cover 80 percent of the value of an apartment property with a debt service coverage ratio of at least 1.1x, according to Charles Krawitz, managing director of KeyBank’s small loan unit.

A year ago, many conduit lenders were offering small loans at much lower rates of 100 basis points over Treasuries or lower.

Fannie Mae lenders have also been hurt by the crisis on Wall Street, though investors are at least buying and selling Fannie Mae bonds, experts said.

For example, ARCS boosted the interest rates it charged on its typical 10-year small apartment loans from 5.63 percent, or 109 basis points over Treasuries, in mid- March to a 168-basis point spread in mid-August. By Oct. 12, as market volatility lessened, the spread shrank to about 133 basis points.

Both conduit lenders and Fannie Mae expect to eventually regain the ability to offer low rates. “Spreads will continue to contract,” Barbie predicted.

That’s because investors will eventually realize that small loans to apartment properties have experienced very few defaults, unlike the home mortgages that sparked the credit crisis, he said. “ARCS has never had a default on a small loan,” said Barbie. Conduit defaults are low, with far fewer than 1 percent of all loans 30 days late.

Also, conduit and Fannie Mae lenders offer non-recourse loans, unlike bank loans in which a lender could potentially seize a borrower’s personal assets in the event of a foreclosure.

Fannie Mae is expanding its small loan program. “We are committed to growing this business,” said Richard Wolf, vice president with the Housing and Community Development Division at Fannie Mae. “We haven’t backed off even with the market disruptions.” Since August, Fannie Mae has increased its volume of small loans, according to Wolf, though Fannie Mae was unwilling to release exact volume numbers.

To expand its small loan business without low rates, KeyBank’s conduit is offering flexible prepayment penalties that step down from 3 percent over three years and disappear in the fourth year, just like a bank.

KeyBank also offers borrowers a fast, certain execution, closing loans in just 35 to 45 days, compared to up to 60 days for banks. That’s helped it pick up business from other conduit lenders that have slowed originations.

“We are in a hiring mode,” said Krawitz. “Volume is up.”