New York City – 2004, investors bought $128 billion in commercial mortgage-backed securities (CMBS), breaking all previous records. At the time it seemed like a lot of money. But by Dec. 2, 2005, CMBS issuance had already broken $208 billion and was reaching toward $220 billion, according to Commercial Mortgage Alert

The implications for anyone looking for a conduit loan are tremendous. If conduit lenders seemed eager to close deals last year, they are now desperate. Conduit lenders need to make apartment loans because many CMBS buyers won’t purchase bonds that aren’t backed by loan pools in which at least 30% of the loans are apartment mortgages.

“The conduits obviously have a lot of money to invest,” said Janet Krolman, a director for Holliday Fenoglio Fowler, L.P., based in Boston. “They are very, very hungry.”

That hunger eased only slightly at the end of the year, after many CMBS investors had bought as many of the bonds as they had ready money to spend. The price CMBS investors paid for the bonds dropped, pushing the yield on the bonds up 12 basis points, ranging from 87 to 88 basis points over the yield on 10-year Treasury bonds at the beginning of December, according to the Barron’s/John B. Levy & Co. National Mortgage Survey.

But the prime mortgage range for whole loans actually dropped at the beginning of December to 5.64% to 5.74%, from 5.67% to 5.77% a month before. At press time, however, the interest rates offered by conduit lenders for 10-year loans to Class A apartment properties had finally risen a few points to about 110 basis points over the yield on 10-year Treasury bonds. Experts think rates will drop again in January to a little over 100 basis points as the pressure renews to make loans in the new year.

Conduits are also being forced to tighten their underwriting and are being pushed away from the most expensive apartment deals. That combination should drive conduits to focus even more strongly on their core multifamily business of financing and refinancing Class B properties.

Underwriting tightens

At the same time, the buyers of B-piece CMBS have started to flex their muscles. These investors are the first to lose money if any of the properties in a CMBS loan pool default. If B-piece bond buyers refuse to invest in a property, that property gets kicked out of the loan pool.

Recently, B-piece buyers have focused their skepticism on Class C apartment properties in peripheral markets like Tennessee and North Carolina. “B-piece buyers are getting a little bearish on Class C buildings,” said David Rosenberg, a managing director for Meridian Capital Group, based in New York City. “Several properties have been kicked out of loan pools.”

Interest-only loans are also more difficult to come by than they were 12 months ago.

Conduits less useful for most expensive deals

But rising prices for apartment assets make it even more difficult to provide conduit loans to the priciest properties.

A high sales price usually equals a low capitalization rate. A cap rate is the net operating income of a property represented as a percentage of its sales prices. So if a property’s cap rate is significantly higher than the interest rate on the property’s financing, then the property should be able to pay its own debt service every month, plus produce a little income for the owners in addition to any appreciation in the property’s value.

The average cap rate for apartment properties nationwide sank to 6.4% in the third quarter of 2005, down from 7.6% the year before, according to data from Real Estate Research Corp.

If a property’s cap rate is much less than the interest rate of its financing, then the property may suffer from what brokers call “negative leverage,” so that the project’s debt service every month would be more than the income produced by the property.

Unfortunately, most conduit underwriters usually ask a property to maintain a debt-service-coverage ratio of 1.20x, further limiting the size of a loan.

“There’s not enough cash flow,” Rosenberg said.

Borrowers have found ways to make conduit financing work for expensive properties, if they mix in significant equity. A 10-year conduit loan that only covers half of a property’s value typically wins an interest rate of less than 100 basis points over the yield on 10-year Treasury bonds, Krolman said.

Even for a property with a low cap rate, this financing should please the underwriters, but it also gives up the possibility of high leverage, which is one of the main motives for choosing a conduit loan.

With Class C properties falling into disfavor and with it becoming more difficult to make the numbers work on Class A properties, experts predict that conduits will focus even more on their traditional market niche of Class B properties in 2006.