A Little Perspective, Please, On Today’s Lending Market

by Jeff Wilder

For H&MM’s 11.2.98 Issue

There’s been a lot of hand-wringing over the past several months about deteriorating lending conditions for the real estate industry. Suddenly, there’s a rate spike in the enormous commercial mortgage backed securities market (CMBS’s) serving us and a corresponding tightening of credit availability. That precious commodity called confidence has been buffeted by the winds of uncertainty as a heightened sensitivity about capital preservation takes center stage, pushing riskier lending to the side (thank goodness!) The question, then, is whether the CMBS market is simply tracking the uncertainty of the current equities market as it searches for equilibrium? To me, the answer is "Yes."

By way of example, in June our company closed a $ 5M hotel mortgage refinancing at

7 ¼ % interest. At 180 basis points over the corresponding 10 year Treasury, that spread was thinner than I had seen in many years and we were delighted to close the deal for the borrower. The lender’s business model called for increasing its market share against many other mortgage originators who had eaten into its lending business. So, offering low rates was certainly one way to get the job done. Of course, others followed suit and profit margins predictably got squeezed for everyone. But, realistically, how long could that continue before the carousel stopped ? Well, by early September, stories began circulating on Wall Street about lenders taking serious beatings as they went to re-sell the low rate mortgage paper they’d created.

What with razor thin profit margins, world-wide financial uncertainty, and a flight to AAA quality paper, lenders lost billions of dollars in non- U.S. Treasury bond markets during the third quarter of 1998. Is it any wonder, then, that when I spoke to the same lender in October, he told me that the hotel loan we closed in June would now carry a rate in excess of 8 %, and that the interest level was now uncoupled from a quoted spread over the Treasury. Frankly, those interest rates are currently justified given the weakening appetite for riskier credits by end-loan buyers. Of course, it is also fair to observe that the spread now demanded to lend money into the hotel industry has experienced a truly breathtaking increase, doubling in just 90 days. One would think that those levels are simply not sustainable, given the intrinsically competitive lending market and our low inflation environment.

On reflection, it was just a matter of time before lenders began pricing their money more in line with the risk it carried. Certainly, lenders who focused on low American inflation levels looked favorably at locking in 10 year interest rates in the 7 to 7 ½% range. After all, that represented a delicious 450-500 basis point spread over the expected inflation range—really quite high by historical standards—especially for rated, pooled, mortgage paper. However, the lenders paid less attention than was warranted to the risk component of the equation. That all changed when Russia defaulted on its bonds, imported deflation began sapping the profits of American companies, and an over-supply of mortgage backed assets (such as hotels) led to the obvious conclusion that the lender’s risk quotient had escalated. While low inflation drove interest costs down, the perception of increased risk caused loan rates to begin rising on many classes of real estate assets, including hotels. And, there was a good case to be made for that increase. After all, we are talking about non-recourse long term debt backed by property, such as hotels, whose markets are being impacted by competition virtually everywhere. Shouldn’t lenders look with a jaundiced eye at such developments and escalate their interest demands given the increased risk of lending into markets such as the lodging industry? You bet they should !

While the rate spike of the past 90 days may be around for a while, I believe it is not sustainable in a world of low inflation and prudent lending. The solid underwriting being done today by major debt capital providers to the real estate industry tends to mitigate risk, which should moderate interest costs. After all, Standard and Poor’s and Moody’s have set up universal underwriting criteria for the CMBS market. The criteria take into consideration conservative cash flow coverages in the 1.4 range, and an 8 % of gross sales "set aside" for supervisory management fees and replacement reserve escrows meant to keep the mortgaged assets in good repair. Given worldwide dis-inflationary trends, I am confident that market forces will eventually apply downward pressure on rates unless some unforeseen financial or political calamity causes an even more serious credit squeeze to occur.

Today, it is true that some hotel borrowers may be forced to accept higher current interest rates in order to access more limited capital pools and get good acquisition deals done. However, if the borrower gets an equity yield commensurate with the risk of taking on higher long-term debt costs, it probably makes sense for him to do the deal. After all, it’s still non-recourse debt that many would have kissed the ground to have had available, at all, just a few short years ago.

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