New York City – In what seemed to be a sign that conduit lenders were following through on their promises to demand more from borrowers, the lenders substantially trimmed their interest-only loan offerings this spring.

But the reversal lasted only a few months.

The investors who put money into conduit loans are buying more of the bonds backed by these deals than ever before, and that has put rising pressure on conduit lenders to make deals. So it should come as no surprise that, according to loan brokers across the country, underwriting standards are weakening again.

The volume of domestic commercial-mortgage-backed securities (CMBS) sold in the first six months of 2006 is projected to jump 28 percent from a year earlier, to $103 billion, according to John B. Levy, author of the Barron’s/John B. Levy & Co. National Mortgage Survey.

That means conduit lenders must make more loans to apartment properties. It’s a rigid requirement, because most B-piece bond buyers, who purchase the riskiest tranche of bonds backed by CMBS loan pools, will still only invest in pools in which more than 30 percent of the loans are to apartment properties. That’s because apartments are viewed as a more stable source of income than industrial or office properties.

As the CMBS market continues to grow, conduit lenders must increase their volume of apartment lending if they don’t want to be left behind by the growth spurt.

But it’s hard to attract borrowers as interest rates rise and borrower interest in refinancing properties declines. The yield on 10-year Treasury bonds has finally broken the 5 percent level to reach 5.1 percent in May, up from 3.9 percent in June 2005. Worse, many borrowers who might have refinanced their loans now already did so at last year’s lower interest rates.

Rates stay low

To keep business coming in, conduits are offering interest rates as low as 105 points over 10-year Treasury bond yields for typical apartment properties, several loan brokers said. That works out to an interest rate of about 6.25 percent.

“These conduits will still either lose money or break even to make the multifamily deals,” said Nicolas Matt, managing director for Holliday Fenoglio Fowler, L.P., a mortgage banking firm based in Houston.

That shows in the way lenders have beat a hasty retreat on interest-only financing, which allows borrowers to pay only the interest due on their loans for a specified period of time. Six months ago, the interest-only periods commonly offered with 10-year conduit loans could last as long as five years. This spring, as conduit lenders tightened their underwriting requirements, those periods shrank to as short as two years. But lately lenders have reversed course.

“In the last month people are back up to five years,” Matt said.

“Everybody has good intentions about tightening underwriting or increasing spreads, but not much has changed,” said Gary M. Tenzer, executive vice president and co-founder of George Smith Partners, Inc., a commercial mortgage brokerage based in Los Angeles.

Instead, conduit lenders are thinking up new ways to lure borrowers. They have started to offer 10-year conduit loans that are amortized over 35 years instead of the typical 30 years. These loans have smaller monthly debt service payments, so that that borrower can often take out a larger loan.

The lenders in these deals offer the longer amortization instead of an interest-only period for the loan. For the lender, the final result of an interest-only loan and a longer amortized loan is the same. In both situations, the borrower will come to the end of the 10-year term with less of the loan’s principal paid off.

DSCRs decline

The debt-service coverage ratios (DSCRs) demanded by conduit lenders have also declined. That’s especially important because the size of a conduit loan is now usually limited by its DSCR instead of the ratio of loan size to property value, which until recently controlled the amount that could be lent.

That’s because interest rates and the cost to purchase an average completed project have both swollen, requiring larger, more expensive loans, while the rental income produced by typical apartment properties to support this debt has risen only slightly. That makes it difficult for many deals to meet the standard requirement that a property should bring in income equal to 1.2 times the property’s monthly mortgage payments.

Conduit lenders now offer loans with DSCRs of 1.15x and even lower. “They’re doing whatever they can to make the loan pencil out,” said Tom Fish, a senior managing director for Richard Ellis.

Levy reports that some conduits are even consciously making commercial loans with DSCRs of less than 1.00.

Lowered debt service coverage requirements are more prevalent on acquisition loans. These borrowers argue that they will be able to improve the property and raise the rents.

Conduit lenders are now also willing to waive their requirements that borrowers contribute to escrow accounts for taxes and insurance. The payments to structural reserve accounts, usually costing $250 per unit per year, now often only extend for two to three years, rather than the life of the loan, Matt said.

Fortunately, the delinquency rate for CMBS loans has remained relatively stable. But given the pressure on conduit lenders, it seems unlikely that underwriting terms will tighten until delinquencies rise.