Financing Focus

Low Rates Help Insulate Commercial Markets from Unstable Economy

Last year, the commercial real estate debt market slowed considerably from the double-digit growth the industry experienced the past three years. Overall, at the end of second-quarter 2002, the debt market had grown 3.7 percent from the end of 2001 to $1.8 trillion, an increase of $64.2 billion. This slower growth is an indication of the market's discipline and bodes well for the commercial real estate industry in light of an unpredictable economy.

In mid-2002, the 10-year Treasury was at 3.6 percent, near its all-time historical low, and the 30-day London interbank offered rate was at 1.8 percent. These low rates also have helped the commercial real estate market counter the softness in demand due to the continued economic slowdown.

However, the economy is expected to begin improving this year, which could cause both interest rates and demand to rise. What effects will rising rates have on existing floating rate lenders and on the fixed-rate market? Analyzing last year's commercial real estate debt markets offers useful clues to this year's performance.

Lender Performance

Let's evaluate the activity of six sources of commercial real estate debt capital -- commercial banks, commercial mortgage-backed securities, life insurance companies, savings and loans, governmentÐsponsored entities, and pension funds.

Commercial Banks. Commercial banks are the industry's dominant capital provider with $766.3 billion in outstanding commercial mortgage assets. Their portfolios have increased 4.9 percent, which is in excess of the market's overall growth rate. Increasing short-term interest rates could have a negative impact on the performance of commercial banks' mortgage assets, since most of their portfolios are floating rate loans. Additionally, commercial banks' portfolios are 88 percent invested in properties other than multifamily; these properties are experiencing occupancy problems due to weak demand, which could present a challenge if interest rates begin to rise prior to an increase in occupancy.

CMBS. The second-largest debt capital provider to the commercial real estate industry is the CMBS marketplace with $307.5 billion in outstanding commercial mortgage assets. Asset-backed securities portfolios have increased 4.4 percent -- faster than the market overall but significantly slower than their historical growth rates. Increasing long-term interest rates could reduce the volume of new activity but shouldn't negatively affect the portfolios' existing loan performance, since the majority are fixed-rate loans with longer durations.

Life Insurance Companies. Insurance companies are very disciplined in their debt portfolios with $228.3 billion in outstanding commercial mortgage assets. Following the recent trend, their growth rate is slower than the overall market. Insurance companies' portfolios grew 1.1 percent, which is significantly slower than their competitors' growth rates.

The majority of life insurance portfolios are focused on properties other than multifamily, which composes only 16 percent of their commercial real estate debt portfolios. Increasing long-term interest rates could reduce the volume of new activity; however, the life insurance companies' portfolios are match funded and therefore should not be affected by long-term interest rate increases.

Savings and Loans. Savings and loans maintain their market share at 8 percent of the overall commercial real estate debt market with $142 billion in outstanding commercial mortgage assets. At 3.6 percent, their growth rate is almost identical to the overall market.

The savings and loans' portfolios are relatively balanced between commercial and multifamily mortgage loans with 46 percent of their portfolios represented by multifamily properties, which may prove to be less of a challenge for them than for the commercial banks if short-term interest rates rise. Increasing short-term interest rates could impact savings and loans' mortgage portfolios if interest rates rise prior to increases in the cash flow of the underlying properties, since their interest rates usually are tied to their cost of funds.

Government-Sponsored Entities and Federal Pools. These two investor classes are expanding at rates significantly higher than the overall market's growth rate. They almost have doubled their investments in commercial real estate debt since year-end 1998 and now account for $118 billion of the total commercial mortgage debt. The Federal National Mortgage Association, known as Fannie Mae, and the Federal Home Mortgage Corp., or Freddie Mac, continue to be the top low-cost mortgage debt providers to multifamily properties nationwide, growing from 20 percent of the multifamily market at the end of 1998 to 27 percent at the end of second-quarter 2002. Rising interest rates may slow down their origination activities as fewer owners rush to lock in the historically low rates that existed last year.

Pension Funds. At $18.1 billion, pension funds remain a modest provider of commercial real estate debt capital; however, the public pension funds' growth rate at 11 percent is significantly greater than the overall market. Pension funds are very active in the commercial real estate equity markets and are beginning to look at the commercial real estate debt markets as a part of their fixed-income investment strategy. Their real estate allocation has increased as a percentage of assets due to underperformance in the other investment asset classes.

A Cautious Outlook

The best advice for the coming year is to proceed with caution in the commercial real estate financing arena. Commercial banks may be vulnerable to short-term interest rate increases if they occur before the economy picks up. Banks may experience problems in their commercial real estate portfolios if short-term rate increases occur ahead of commercial real estate demand increases, which may limit the amount of new capital they commit to commercial real estate. Borrowers may be unable to pay the increased interest rates if their properties' cash flows have not increased, thus causing the banks to experience more loan defaults.

In the coming year, sophisticated and knowledgeable capital providers who are aware of the lag between increasing interest rates and the coming improvement of the real estate market should be able to benefit from the opportunities that are presented.

Thomas Jaekel

Thomas Jaekel is manageing director of the Merchant Banking Unit at Cohen Financial in Chicago. Contact him at (312) 803-5885 or


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