Commercial banks have scaled back balance-sheet lending in the second quarter of 2008, while steering customers to Fannie Mae and Freddie Mac permanent loan programs.

Even those banks that are actively originating balance-sheet loans are doing so much more conservatively than they were at this time last year. Short-term “interim” and construction loans are still available from most commercial banks, though the credit standards on those loans have made them much more difficult to get. But for longer-term loans, there are really only two games in town as of mid-June: Fannie Mae and Freddie Mac.

“The capital markets broadly speaking have been shrunk to just the agencies,” said Martin Meagher, a director at Citi Community Capital. “Balance-sheet lenders are priced off of the capital markets, which makes them price-prohibitive relative to the agencies today.”

Citi last originated a market-rate balance- sheet loan last fall, when rates offered through that program were below agency executions. Spreads on balance-sheet loans have grown since then, and the group decided to funnel most of its business to the governmentsponsored enterprises.

The volume of loans made for commercial bank portfolios fell 56 percent in the first quarter compared to the fourth quarter of 2007. Commercial banks made just 228 commercial real estate loans in the first quarter, the lowest number recorded since the second quarter of 2004, according to a Mortgage Bankers Association quarterly survey.

KeyBank Real Estate Capital’s Income Property Group is still actively originating balance-sheet loans for multifamily borrowers, but in a much more cautious way than it did a year ago. The lender offers interim loans of three to five years for new construction or acquisition-rehab deals, with full term interest-only.

The division has a strong multifamily concentration—about 40 percent of the group’s portfolio is in multifamily. And that preference is even stronger now, since multifamily construction loans have the agencies to provide a permanent-loan “exit strategy,” as opposed to other real estate sectors such as retail or industrial.

“We’ve just become much more selective,” said Christa Chambers, a senior vice president with the Income Property Group. “Multifamily is probably the most favorable for us, given that we have an exit strategy on it through the agencies.”

The pullback by commercial banks is most evident on construction lending, which, as of mid-June, was the most difficult type of multifamily loan to get, industry watchers report.

“The construction loan is the least compatible with capital markets; it is balance-sheet driven lending, and that’s where we’re having a lot of constraint,” said Meagher. “All of the banks are having difficulty managing their balance sheets.”

Many banks today are only willing to lend up to a certain threshold, maybe $15 million to $25 million, before seeking to syndicate a loan, a process that allows them to share risk with other banks.

When a loan is syndicated, two or more different lenders are involved in providing different portions of the loan. But this process can be a headache— each lender has their own approach to construction lending, and the borrower sometimes doesn’t know what terms and conditions will be in the loan until closing.

KeyBank traditionally tries to find syndication partners for loans of more than $35 million. But the company has found the loan syndication market to be much more conservative this year.

“In today’s market, we have to have our co-lenders in place and closing with us,” said Chambers. “In the past, we’d give the client a deal, fully underwrite it, and sell it after the fact.”

Spreads for KeyBank’s balance-sheet loans have grown about 100 basis points or more over the last year, following the pricing trend of longer-term loans.

Spreads are now averaging between 200 and 275 basis points over the London Interbank Offered Rate (LIBOR) for construction loans. “But even for the strongest developers, we just don’t have the appetite to book a LIBOR (plus) 200 (basis point) construction loan right now because our cost of capital has gone up so much with the current credit crisis,” Chambers said.

Underwriting has grown more conservative this year, with leverage maxing out at 75 percent rather than the 80 percent broadly offered in the first half of 2007. Debt-service coverage ratios have been raised by at least five basis points in the last year as well.

Equity requirements have also changed dramatically. Last year, a 10 percent equity requirement was commonplace, but KeyBank has seen a range of between 15 percent and 30 percent equity on construction loan deals this year.

Many banks are also stepping away from providing credit facilities for large transactions for real estate investment trusts (REITs), another area where the agencies are dominating.

“The banks have pulled back. They were providing a lot of lines of credit for REITs and for larger institutional borrowers,” said Heidi McKibben, Fannie Mae’s vice president of multifamily production. “We’ve certainly stepped in and seen a lot more interest in credit facilities, both with the larger REITs and also with regional REITs and large owners.”