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Small-Balance Lenders 'Relatively Oblivious' To Rate Hike

The last couple-three months have been particularly perplexing for commercial/multifamily investors tapping bond-market-driven lenders to finance mid- and large-sized properties. Ditto for folks looking to buy or refinance single-family homes, for that matter.

But it appears the small-balance lending arena has been spared such dramatics - at least for the time being.

The market's nervousness about a potential slow-down in the Fed's voracious bond purchases pushed the benchmark 10-year Treasury yield up 100+ basis points from just early-May to early-July. And Wall Street conduits, dominant multifamily financiers Fannie Mae and Freddie Mac and other capital-markets-dependent lenders necessarily followed suit - generally pushing fixed-mortgage coupons up a full percentage point for mid- and large-sized transactions.

It's an increasingly popular strategy that's helping credit unions collectively boost CRE and other business lending. It's also attracting more CU members seeking small-balance loans, which tend to come at rates and terms at least a bit more borrower-friendly than quotes from community and regional banks that need to generate profits for shareholders.

Even money-center banks and big life insurance companies - which tend to hold loans within their investment portfolios rather than sell into the capital markets - have boosted their permanent fixed-rate quotes notably for deals of $10 million or more.

And the rates these lenders quote for mid- and larger-sized transactions have for the most part remained at elevated levels during the month since the T yield stopped its dramatic climb at 2.734 percent on July 5 - settling into the 2.5s and 2.6s since.

Predictably the quick uptick has cratered, delayed, repriced and otherwise morphed at least a few pending transactions for which quoted rates weren't formally locked. And it has raised realistic concerns about the direction of market capitalization rates - and in turn property values.

In fact a lot of savvy property finance pros are conceding that the general 100-bp hike in rates for mid- and large-cap properties is ushering in a sustained higher-rate period in the cycle - with further upward movement to follow as the economy continues to improve.

But the rise in Treasury yields has played out far differently (so far) in the small-balance space, where balance-sheet lenders attract the bulk of the business, and shorter loan terms are the norm.

While quotes from some lenders did temporarily rise maybe 50 basis points or more as the 10-year yield kept climbing toward that 2.7+ peak, small-balance rates at many if not most balance-sheet lenders have generally reverted back close to where they were in April, notes veteran small-balance executive Charles Krawitz, who directs Fifth Third Bank's Commercial Real Estate Correspondent Products Group.

"Some deals that were previously being quoted at 4.75 (percent) were suddenly up to 5.25 - but they moved back down to 4.75 pretty quickly" once the T yield plateaued, he recalls in reference to typical five-year term loans.

While the five-year Treasury yield rose by roughly the same 100 basis points as the 10-year over that two-month period, it has also remained around 120 basis points lower than the longer-money rate - keeping five-year loan terms at quite attractive rates for many small-balance borrowers.

"I've been pleasantly surprised that so many lenders have avoided over-reacting" to the Treasury yield volatility, continues Krawitz, who connects Fifth Third clients with wide-ranging CRE capital sources when the bank isn't the optimal match.

Again, conduits and others that are comfortable funding and pooling small-balance, non-recourse loans may quote rates a bit higher than before the rapid T yield rise - they risk losing money on securitizations otherwise. The same often applies to the Fannie and Freddie small loan programs as well, given the scores of billions worth of apartment MBS they've been issuing.

Krawitz cites some fundamental reasons for the contrast in T-yield impact among loan-size categories. Perhaps most significantly, balance-sheet lenders playing major roles in the small-balance space - banks and credit unions, and life companies to a somewhat lesser degree - have a lot more flexibility than the Wall Street-tied lenders when it comes to quoting a rate they can live with for five to 10 years (or more).

Indeed while banks and life companies originated more commercial mortgages during the volatile second quarter than they did in the year-ago period, conduit originations were down 14 percent, the Mortgage Bankers Association reports.

In Krawitz's words, the portfolio lenders playing the small-balance space are "relatively oblivious" to the day-to-day movement in benchmark indices, focusing instead on returns they need longer term given their costs of funds and other variables.

That in part explains why the small-balance arena generally doesn't quote coupons using a relevant index plus a risk-based spread calculation - standard practice with eight-figure (and larger) loans.

"The rate is the rate," Krawitz relates, adding that balance-sheet lenders typically don't request deposits to lock small-balance rates before closing.

But borrowers seeking larger loans have had to absorb both the index hikes and gradually widening spreads. Mortgage broker-types report that spreads today for standard transactions are roughly 35 basis points wider than they were at the beginning of the year (generally putting them in the mid- or high-200s over the corresponding index).

Logically the small-balance approach tends to minimize the scramble to reprice and otherwise restructure pending unlocked deals when indices move dramatically. In fact much of the efforts Krawitz has witnessed in the small-balance space to boost rates sharply in response to T yield movement has been not by actual lenders, but by fee-based originators perceiving short-term opportunities to boost compensation amid the volatility.

Meanwhile the only pending small-balance transactions Krawitz has come across that ended up being modestly restructured have tended to be the more aggressively priced deals from capital-markets-driven lenders.

For the near-term, Krawitz wouldn't be surprised if T yields and, in turn, fixed interest rates generally, witness additional temporary spikes in response to unexpected events and/or statements from influential parties - "such as if the government does indeed get out of the bond-buying business sooner rather than later."

Meanwhile the consensus among property finance pros is that rates in coming years will feel more upward pressure than downward - at some point affecting investor yield requirements, and in turn adjusting income-base valuations.

So if you're thinking of exiting an investment over the next year or even two, it might be wise to think about pulling the trigger sooner rather than later - unless micro-market fundamentals suggest NOI improvement ahead will outweigh a looming cap-rate hike.