Increased securitization, standardization, and consolidation expected to lower small-loan borrowing costs

Investors looking to buy or refinance small apartment properties can’t expect quite the tight interest rate spreads and generous loan terms their institutional counterparts might command for $50 million financings through Wall Street conduits, government-sponsored enterprises, or life insurers.

But as an increasingly competitive “small-balance” lending arena in 2007 should demonstrate, things are definitely moving in that direction.

With one noteworthy exception, however: Unlike the $5 million-plus loans securitized into giant mortgage-backed bond issues, small-balance loans will for the most part continue to carry personal recourse collateral.

The better news is that the forces of standardization, securitization, and consolidation are bringing greater efficiency to the small-balance arena. While experts agree these trends will gradually lower borrowing costs, they also say borrowers probably shouldn’t count on dramatic declines in 2007.

For the time being, as small-balance apartment lending continues to attract all sorts of capital sources, this niche remains quite fragmented compared to the larger-balance arena. The relative absence of dominant players or true marketplace efficiency is a key factor keeping loan spreads quite a bit wider than for larger properties.

The 15 most active small-balance lenders account for hardly 20 percent of the niche’s production, according to a recent report from Boxwood Means, Inc., and Scotsman Guide. In contrast, the top three conduit lenders alone accounted for more than 25 percent of commercial mortgages securitized through Wall Street during the first nine months of 2006.

That helps explain why spreads in the small-balance market are generally 50 to 75 basis points wider than averages for larger, nonrecourse loans funded through conduits, calculated Jim Going, a managing director specializing in small-balance lending at Principal Real Estate Investors. He and others also stressed that small-balance spreads vary widely depending on many factors, and can be much tighter than the overall average for favored properties and borrowers.

But even as securitization is being rapidly introduced to the small-balance market, Going agrees with the expert consensus that intensifying competition throughout 2007 probably won’t affect the spread levels, fees, and structures in practice. Once securitization becomes a more regular practice, small-balance spreads should tend to narrow eventually, he said.

Meanwhile the movement toward securitization should push standardization of small-balance application and underwriting processes, which should in turn reduce related costs, said Scott Rielly, executive vice president with pioneering small-balance lender and securitizer CBA Commercial, LLC.

Rielly added that “seamless” Web-based originations and processing should bring better efficiency as CBA Commercial and a growing roster of lenders securitize collateral pools composed specifically of small-balance mortgages. Other active peers include Bayview Financial, Imperial Capital Bank, LaSalle Bank, Washington Mutual, Hometown Commercial Capital, and Lehman Brothers Small-Business Finance.

Unlike the larger-balance conduit marketplace, the vast majority of small-balance loans continue to require pledges of personal assets. According to Boxwood Means, some 82 percent of small-balance mortgages written today are recourse loans.

Echoing his peers, Jonathan Morris, president of small-balance lender BMC Capital, said he expects full recourse to remain the standard in the small-balance market. “Our borrowers are generally comfortable with it.”