Lenders Raise the Bar
For Commercial Real Estate

NEW YORK (Dow Jones)--Commercial real-estate lenders, spooked by the collapse in residential housing, are reining in riskier loans on fears that underwriting standards were too loose.

During the last few months, lenders have been requiring significantly more equity to get projects rolling, while the cost of obtaining debt continues to shoot higher. Meanwhile, banks are avoiding making loans to commercial real estate on concerns about the quality of construction and development loans.

"Six months ago, it was money chasing deals. Now it's deals chasing money," said Larry Vogler, president of Prime Group Inc., a Chicago-based commercial real estate developer.

"We have to rethink our capital structure. At the same time, there is adequate capital, it's just more expensive," Vogler said. He said his organization has experienced some minor delays in projects, but nothing has been canceled yet.

Commercial real-estate developers are having to provide about 25% of equity financing, up substantially from the 10% to 15% range permitted before a severe credit crunch compelled lenders to adopt a more conservative posture a few months ago. The higher equity requirements also come as developers face dwindling opportunities to raise funds from the commercial mortgage-backed securities market.

The tighter standards mark a departure from the loans that were offered from mid-2006 to mid-2007 when Wall Street banks were underwriting interest-free loans and debt based on future revenue, not current cash flow.

"In the last couple of years, they were providing 10-year interest-only loans where borrowers never had to pay principal," said Scott Rechler, chief executive and chairman of RexCorp Realty LLC.

"Those types of investments may run into problems when the loans come due in the next three to five years," he said. The market, he said, "has shifted back to requiring principal and having to demonstrate that you have the cash to cover debt service."

Developers face tighter underwriting conditions amid early signs that a correction in the commercial real-estate market is underway.

"We're currently in a period of low loan delinquencies and property fundamentals are still generally good. However, if you make increasingly fragile loans, when a downturn does come, it will result in more defaults," said Tad Philipp, managing director of commercial real-estate finance at Moody's Investors Service.

Moody's in April made a bold and controversial announcement that it was seeking higher subordination levels for bonds from all rating categories due to an ongoing decline in underwriting standards. The move was seen as a key catalyst for tighter loan requirements.

"While there are no signs of imminent major credit distress, we rate these deals to last 10 years," Philipp said. He noted that is the time when investors get their money back.

Developers are coming up with the additional equity from their own wallets or securing more from investors such as private-equity firms, individuals with high net worth and pension funds. In addition, developers are doing more deals with traditional lenders in lieu of Wall Street conduits.

Many think the tighter standards will foster a healthy correction in the industry, given the previously lofty terms created artificially high prices for properties. In addition, some experts anticipate that debt markets will be more fluid in 2008 if the new requirements and pricing reflect long-term norms.

"It's definitely healthy to have the rating agencies change the rules to reduce risk," said Hugh Hall, chief operating officer at Gramercy Capital Corp. (GKK)

"All specialty finance companies like Gramercy are being more conservative in their underwriting in order to appeal to investment-grade bond buyers," he said. "Bond buyers need to start trusting Wall Street banks and ratings agencies again. It's as much a question of confidence."

An August survey by the Federal Reserve found that about 25% of U.S. banks and 40% of foreign banks have tightened their commercial real-estate lending standards. It was the latest in a string of Fed surveys that documented the trend, after a period in which many banks had been easing terms.

The trend isn't confined to the regional and community banks that were the most aggressive lenders; some of the nation's biggest banks also have clamped down.

JPMorgan Chase & Co. (JPM) has dramatically reduced its construction lending in the past two years, according to CEO James Dimon. And Wells Fargo & Co.'s (WFC) giant portfolio of commercial real-estate loans continues to perform well, thanks to the San Francisco lender resisting the trend toward ever-easier lending standards, according to Chief Financial Officer Howard Atkins.

"Many of our competitors had loosened their standards over the past two or three years," Atkins said in an interview Tuesday. Today, with real-estate prices dropping in many parts of the U.S., "it doesn't surprise us that they're pulling back."

Although the market is starting to make better loans, Moody's Philipp says, there is still a multi-billion-dollar backlog of weaker loans in issuers inventories that have yet to come to market.

-- David Enrich contributed to this report.

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