Financing Focus

Wait and See

Capital market activity hinges on interest rates and job growth.

Last year, the commercial real estate debt market again decreased considerably from the last decade's double-digit growth rates. This slower growth indicates a lower level of transactional activity —buying, selling, and refinancing — taking place as the industry awaits signs of economic strength.

The good news is that the U.S. economy is improving, but job growth continues to stagnate. Low interest rates have helped the market weather the slowdown, but ultimately job creation is needed for commercial real estate activity to increase. Luckily, most economists are predicting positive quarterly employment growth this year. With more jobs and economic expansion, demand for commercial real estate space, and thus transactional activity, should increase.

However, interest rates remain the wild card. If rates rise, how will floating-rate lenders and the fixed-rate market react? Commercial banks may experience problems in their construction portfolios if short-term interest rates rise ahead of demand for commercial real estate space. However, new capital sources should take advantage of this occurrence, which means real estate owners will have more sources available to help bridge these assets until occupancies improve and debt can be refinanced in the permanent loan market. Knowledgeable and experienced investors are focused on this opportunity and are capitalizing entities to provide higher-yielding mezzanine capital and higher-leverage first mortgage loans to fill this need in the marketplace.

Primary Lender Performance

Analyzing last year's commercial real estate debt markets offers some useful clues about how the market will perform in 2004.

Commercial Banks. The industry's dominant debt capital provider, commercial banks have $832.6 billion in outstanding commercial mortgage assets. Their portfolios increased 4.3 percent from second-quarter 2002 to second-quarter 2003, which is modestly above the market's overall growth rate of 4 percent. Although banks have been relatively disciplined in their loan portfolio underwriting, it is unknown how they will handle maturing construction loans in which the underlying properties have not performed well. They could require borrowers to pay down their loans prior to extending them, or they could extend loans at existing balances even if loan-to-value ratios have not increased. This issue is one that banks are forced to face this year as their three-year loans originated in 2001 mature.

Commercial Mortgage-Backed Securities. The CMBS marketplace is the second-largest debt capital provider with $360.1 billion in outstanding commercial mortgage assets. At a 6.1 percent growth rate, asset-backed securities' portfolios once again have increased faster than the overall marketplace, resulting in a larger market share of 16.9 percent. However, their growth is down significantly from the 20 percent rates seen in 2001 and 2002, which is a good indication of the discipline that the public debt markets impose on the commercial real estate markets. Transactional activity should increase this year as the 10-year CMBS loans originated in 1994 mature and need refinancing.

Life Insurance Companies. With $236.6 billion in outstanding commercial mortgage assets, insurance companies continue to be very disciplined in their debt portfolios, which grew only 1.2 percent. As the CMBS market increased in the last decade, life insurance companies consistently took a smaller portion of the commercial real estate debt capital market. In 1992, life insurance companies had 22 percent of the marketplace; most recently that share shrunk to 12 percent.

Savings and Loans. With 8 percent of the overall commercial real estate debt market, savings and loans have $156.9 billion in outstanding commercial mortgage assets. Their 5 percent growth rate continues to be modestly higher than the entire market. The savings and loans have avoided construction lending and added more existing leased commercial real estate assets to their portfolios; therefore, they should be better positioned than the banks to deal with short-term loan maturities.

Government-Sponsored Entities and Federal Pools. More rigorous oversight and recent accounting issues have slowed down the Federal National Mortgage Association and the Federal Home Mortgage Corp.'s growth to 5.6 percent, the lowest rate in a decade and down significantly from their 26.6 percent peak growth rate from 2000 to 2001. As quasi-governmental entities, Fannie Mae and Freddie Mac recently have been in the limelight, which is affecting their business and growth strategies. Congressional leaders are focused on these entities' operations and regulators to make certain that their activities do not present any risk to the U.S. financial system.

A Disciplined Market

Fortunately, plenty of debt capital is available for commercial real estate properties. The public markets' discipline has helped to stabilize commercial real estate debt providers, which are positioned to continue to offer capital to the market. The continued availability of debt capital in slow and expanding markets is important for the marketplace's long-term viability.

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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