Despite expected hikes in permanent mortgage rates and scant remaining leeway on underwriting standards, the 2006 lending environment is shaping up to be another windfall for proven market-rate apartment owners and buyers.

Today’s primary multifamily lenders can’t control general interest-rate movements, but they can still strive to emulate each other’s competitive advantages on multifamily mortgage coupon rates and other deal terms.

For example, yet another major commercial bank is following the conduit lenders’ lead in reducing capital costs by securitizing loan pools through Wall Street. And at least one of the government-sponsored enterprises (GSEs) may well adopt the same strategy.

U.S. Bank is hooking up with institutional giant Principal Real Estate Investors in a venture securitizing pools of loans originated by both institutions. The new program, dubbed Principal Commercial Funding II, furthers U.S. Bank’s efforts to supplement its bread-and-butter construction and short-term portfolio lending activities with the permanent mortgages many of its clients also need. The venture already has some 175 originators sourcing deals across the country, with its inaugural securitized pools slated to go to market in 2006’s first quarter.

Likewise, at press time Freddie Mac, which retains the vast bulk of the mortgages it buys from its delegated lenders, was also discussing prospects for securitizing multifamily mortgages through one or more of the big Wall Street investment banking houses. Freddie officials are even exploring arrangements through which the agency would buy long-term loans from various regional banks, allowing traditionally short-term lenders more opportunities to meet client demand for permanent mortgages.

Today’s conduit lenders are responding to GSE and portfolio-lender competition as they explore ways to offer greater flexibility when it comes to Wall Street’s necessarily rigid prepayment provisions. Ultra-competitive rates and borrower-friendly loan-to-value ratios (read: total loan proceeds) have won conduits a rising share of the income-property lending business – as 2005’s record-setting originations volume dramatically illustrates.

Conduits have little choice but to devise innovative prepay policies in response to competitive moves by the GSEs as well as banks and life insurers. That would include offering “declining-balance”-type alternatives to the commercial mortgage-backed securities (CMBS) arena’s standardized defeasance or yield-maintenance requirements – but would also require higher coupon rates to accommodate bond-buyer interests.

Funneling the capital flow

All of those efforts fundamentally reflect a continuing flood of multifamily debt capital chasing opportunities in today’s mortgage arena, said E.J. Burke, executive vice president at mega-lender KeyBank Real Estate Capital.

The implication for 2006 is that borrowers will continue receiving exceptionally attractive quotes on terms even while coupon rates rise as expected with the 10-year Treasury rate, Burke and other experts predict.

For example, it appears that most finance professionals doubt the already-tight spreads between the relevant indexes and apartment mortgage coupon rates will widen much if at all. Some say further tightening is more likely.

Experts suggest that competitive conditions should allow creditworthy borrowers to achieve total leverage (including mezzanine layers) of 90% from conduit lenders, and 85% from others. Likewise, lenders should continue to offer interest-only (IO) structures – though the marketplace is already backing away from long-term IO periods.

Some lenders will continue lengthening the rate-lock periods before loans fund. On the exit side, pressures should also drive many to make the 12-month maturity extension a standard option.

The commercial mortgage market remains awash in capital, with little hint of any near-term let-up, said David Baird, national director of multifamily at Sperry Van Ness (SVN). “There’s just a lot of money in the market trying to find a home.”

Indeed, more than 80% of respondents surveyed for the 2006 edition of the widely read Emerging Trends in Real Estate report are expecting income-property markets to experience an oversupply of debt capital in the coming year.

Continued globalization and growth in asset-backed instruments are major factors feeding today’s multifamily mortgage market, Baird explained. More and more offshore capital continues targeting investments backed by U.S. real estate – including commercial mortgages and CMBS. “Foreign investors tend to understand U.S. real estate more than U.S. stocks,” Baird said.

Accordingly, many capital markets professionals are expecting the Wall Street conduit lenders to continue to be aggressive.

“The conduits are really driving the market today” with exceptionally tight loan spreads and higher leverage than the GSEs and portfolio lenders are willing to offer, said Andy Weiss, managing director at Meridian Capital Group, a high-volume income-property lender. Wall Street conduits just can’t offer the creative deal-term flexibility of the GSEs and portfolio lenders, so it’s pricing and proceeds that win the deals for them.

No wonder the likes of U.S. Bank and Freddie Mac are looking to tap into Wall Street’s proven efficiency. As more diversified banking companies follow examples such as Bank of America and Wachovia Corp. into conduit lending preeminence, some analysts expect them to become more formidable competitors with investment bankers and GSEs.

Term limits

Experts suggest underwriting is already about as loose as the relevant watchdog-types will allow. Indeed, Fannie and Freddie’s public-sector scrutiny has been front-page news, while banks and insurers answer to federal and state regulatory bodies.

Meanwhile, credit ratings agencies along with the lowest-priority (or B-piece) bond buyers play similar roles looking out for investor interests in the conduit arena.

With many deals already structured at near break-even pricing for lenders, there is little room for competition based on interest rate spreads, Weiss said. As he and others noted, however, some lenders are willing to step up and take some warehousing risk to win deals under today’s intense competition and Wall Street’s appetite for CMBS (which tightens spreads).

If loan spreads move at all in coming months, they’re more likely to narrow than widen, predicted Michael Melaugh, executive managing director of capital markets with Trammell Crow Residential. That’s because conduit producers are pressured to win deals, thus they “rationalize” the risk of a decline in demand for CMBS, which would tend to boost the yields that bond-buyers require.

Linwood Thompson, managing director overseeing Marcus & Millichap’s multi-housing group, expects competitive pressures to keep spreads on “bread and butter” 10-year mortgages in the vicinity of 100 basis points over the Treasury rate at least for the near-term.

Even if upward movement of long-term interest rates pushes multifamily coupon rates modestly higher, they’ll still generally be a welcome change for the huge wave of borrowers with 10-year mortgages maturing over the coming months, noted Michelle Paretti, managing director with Credit Suisse First Boston.

Meanwhile, however, the multifamily mortgage marketplace is seeing some hints of higher loan distress levels. A recent CMBS study by Standard & Poor’s indicated nearly 14% of the loans in the surveyed bond issues are on servicing agents’ “watch-lists” for potential repayment issues.

Another analysis by CMBS data provider Realpoint found that more than 1.5% of all apartment loans were delinquent at the end of October.