First of Three Parts

The commercial real estate market has become a festive place.

At the Mortgage Bankers Association's recent real estate conference, bankers posed for pictures in Wild West gear at one booth and scrambled for free dollar bills at another-one grabbed $8,000 in his allotted 15 seconds.

But a sense of apprehension has crept into the market, too. The ups and downs of real estate are well known, and some observers see signs that the market is accelerating toward the next crash.

In this three-part series, American Banker takes a closer look at the new face of commercial real estate lending: today, how real estate investment trusts and commercial mortgage-backed securities have changed the risks of bank lending on real estate; Thursday, a major developer's view of his changing relationship with the banking industry; and Friday, an examination of one banker's changing role through several real estate cycles.

As 1998 began, occupancy rates were rising, money for construction was abundant, and with new players from Wall Street pumping capital into real estate investment trusts and commercial mortgage-backed securities, optimism abounded.

"Eight years ago we were saying it doesn't get much worse than this," said Tony Pierson, head of research at Cigna Investment Management. "Now we're saying that it doesn't get much better."

Indeed, extraordinary employment growth is fueling demand for property, commercial mortgage loan delinquency rates are below 2%, and interest rates are at historical lows.

But some fear the new money could worsen the inevitable next downturn in property values.

"There's unlimited liquidity, and it's being created as long as people are paying," said a former real estate banker who now trades loans in the secondary market. "It's a feeding frenzy, and these Wall Street bankers believe their own hype."

He said lending standards are eroding dangerously and that many loans have no guarantee from the developer or investors. "There are bridge loans to nowhere, and recourse is going out the window."

As memories fade of the early 1990s nightmare years, when banks had to slog through $400 billion of bad real estate debt, banks' lending machines are in gear again.

And despite talk that securitization has changed things, not all of the risk is being passed along to investors. The industry had $86.1 billion of construction and land development loans on its books as of Sept. 30, 1997, according to the Federal Deposit Insurance Corp., up from $76.4 billion at the same date in 1996 and only $68.7 billion the year before. Construction loans held by banks peaked at $136 billion in 1989.

There is no doubt that the development of a capital market-where commercialmortgage-backed securities and real estate investment trust stock are actively traded-has changed the lending business.

The commercial mortgage-backed securities market took shape in the early '90s when the Resolution Trust Corp. started issuing mortgage-backed bonds collateralized by commercial real estate loans from defunct savings and loans.

Securitization lets lenders-including insurance companies, banks, investment banks, and conduits-move the risk of their loans off their books.

Lenders assemble mortgages and other loans into a pool and issue bond- like securities. The rating agencies assess cash flow, the value of collateral, and the structure of the security, then assign ratings to the various tranches of the pool according to the risk of the properties underlying them.

Thus the risk of real estate losses can be passed to investors with an appetite for higher returns-including investors in traditional stocks and bonds, as well as in commercial mortgage REITs. Investment-grade ratings on the rest of the tranches offer a sense of security to other real estate investors.

Though only 15% of the nation's $1.1 trillion in commercial and multifamily real estate assets have been securitized-or transferred from private to public hands-that share is growing fast.

Issuance of commercial mortgage-backed securities rose to $44.1 billion in 1997, from $4.8 billion in 1990, according to Commercial Mortgage Alert, an industry newsletter. Commercial mortgage-backed securities' market capitalization at the end of 1997 was $133 billion, according to Morgan Stanley CMBS Research.

Today, Wall Street firms and the larger commercial banks routinely originate loans for conduits-subsidiaries that arrange loans and sell them into trusts that finance themselves in the capital markets. Conduits have replaced savings and loans as the main originators of loans from $1 million to $25 million.

With interest rates at historical lows and more conduits coming into the market, bankers predict more than $50 billion of commercial mortgage-backed issuance in 1998, with about $20 billion expected in the first quarter.

As the market has evolved, the pools of loans backing securities have become more diverse in terms of geography and type of loan, reducing the risk to investors from a single property's failure or a regional economic downturn.

Almost half the new deals in 1997 were by conduits, and private-label transactions accounted for nearly one-quarter of new issuance. About 10% of the securities issued were backed by a single large loan, and about 8% were backed by non-U.S. properties, according to Commercial Mortgage Alert.

Real estate investment trusts grew to $146.7 billion in market capitalization by the end of January, thanks in part to a healthy economy and low inflation. Investors, hungry for higher yields, have poured their money into equities of the publicly traded real estate trusts, which have been snapping up properties at a breakneck pace.

Nearly 9% of the $1.5 trillion institutionally owned commercial real estate market is under REIT management.

The trusts are getting easier access to capital than ever before, as they achieve investment-grade credit ratings. In 1997, lenders extended a record $10 billion of unsecured debt to them, more than double the volume of 1996, according to the National Association of Real Estate Investment Trusts, Washington.

Bankers say that the equity analysts who follow REIT stocks and the rating agencies that judge commercial mortgage-backeds are helping maintain discipline in the market-and producing a flow of information about properties and financing packages that never existed before.

"It should dramatically differentiate (this from) other cycles, where lenders have stepped out of the market completely," said Joe Franzetti, a senior vice president at Duff & Phelps Ratings Services.

"The capital markets have not only transferred the risk but also, in theory, ... have more efficiently matched it so that those who want certain risks can take it and price it efficiently," he said.

Patricia Goldstein, division executive of Citicorp Real Estate, noted several differences between today's market and that of the early 1990s. "If there's a downturn in property values," she said, "the market will have liquidity that we didn't have."

"There's so much more information and review, and that has really been very positive" she added. "Previously, everybody had his own black box or crystal ball."

Phoebe Moreo, a partner at E&Y Kenneth Leventhal Real Estate Group, said banks' role has changed. "Instead of acting as individual investors, the commercial banks are now playing the role of facilitators and fee earners, and investors are corporate entities," she said.

But the capital markets may not be the panacea some perceive. Though property supply and demand are currently in balance, many observers fear liquidity and competition to lend are already changing this and that the participation of new investors will only intensify the normal real estate cycle.

"There is no CMBS technology that is going to stop overbuilding," said Mr. Franzetti of Duff & Phelps. "It's not going to stop competitive lending, but what it should do is make it more expensive" to finance real estate "as markets start to deteriorate and more attractive when markets are cooperating."

Arthur Mirante, president and chief executive officer of Cushman & Wakefield, one of the nation's largest real estate firms, also said he is getting nervous. "The potential problem is that properties are not being priced based on their intrinsic values but by what investors are willing to pay for the high-flying stocks of REITs," he said.

Others are concerned that real estate has been thrust into the hands of investment bankers and other capital markets experts with no realty experience.

"Underwriting has clearly weakened over time, and that's inevitable when competition arises," Mr. Franzetti said. When a downturn comes, "the ability to work out loans is going to be tested. As losses happen, which is inevitable, are the subordinated buyers going to hang in there or flee the market?"

Bankers say they are determined to keep up standards.

"We are concerned about the impact that the ongoing competition and drive for market share will ultimately have on underwriting standards," said Clyde Stutts, a senior vice president in NationsBank's real estate banking group.

"We're not going to forget that underlying these securities (is) real estate," he said. "Our hope is that we are viewed as a dependable and credible source of underwriting and, over the long haul, that will make us successful and distinguish us from those in the market who are not."

Andrew Stone, who heads the real estate business at Credit Suisse First Boston, said Wall Street firms will simply have to adapt to the next recession.

"We do a lot of due diligence on our higher-loan-to-value and riskier loans," he said. "We are very careful about knowing the risks. Whether we win or lose is not the issue. It is being a better judge of what the risk is."

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