JOHN BITNER
‘In a recession’

It’s not as bad as the early 1990s, but ask lenders and developers what the future holds for Massachusetts commercial real estate lending and you’ll get a mixed bag of answers.

“What you have is a gathering storm for commercial real estate lending,” said Jim Jones, owner of First Wellesley Consulting, a Wellesley-based firm that advises lenders.

There are several reasons, he noted, all stemming from the residential subprime crisis. For example, commercial mortgage-backed securities – which last year captured some 20 percent of the commercial lending market nationally, according to Federal Reserve Flow of Funds Release data – are no longer an option for most developers needing a loan.

Jones said the word at industry conferences is that regulators also are intensifying their examinations of commercial portfolios at banks.

“I think it’s a direct reaction to the subprime crisis. They want to ensure that commercial lending doesn’t go down the same path of [residential] subprime,” he said.

Jones predicted that life insurance companies, which made approximately 10 percent of commercial loans last year, will be as cautious as banks, which made about 60 percent, partly because both are regulated entities.

Other industry observers say pension funds – which also are regulated and some of which invest in commercial real estate – will follow the same road.

Jones said a recession also slows down the economy and, in turn, commercial lending, because lenders will be more cautious about how easily a property will sell or rent. He’s reluctant to say whether the nation has reached that economic stage – but others aren’t.

“We are in a recession and we probably entered it in December,” said Eastern Bank Chief Economist John Bitner.

Bitner said a shaky economy will put pressure on building landlords, who won’t be able to maintain total rent income as companies suffer and office vacancies rise.

It also increases the perception of risk, meaning investors will want higher returns for their money. Rising fuel costs are a third factor contributing to owners’ overall expenses.

Bitner predicted those combined factors will bring property values down.

Flat or declining property incomes pitted against “risk-averse” investors’ demand for higher profits means investors will pay less for the properties to ensure they do profit, he said.

Bitner’s advice to lenders: Use a “conservative” capitalization rate in valuing properties. In other words, set the value lower, so investors will get a greater return for their money.

Lenders also should be certain their borrowers have enough staying power to get through “a rather protracted and sluggish recovery in the next year or two,” he suggested.

‘Pretty Remarkable’

Tim O’Donnell, a principal at commercial mortgage broker Fantini & Gorga, an Eastern Bank affiliate, said he expects capitalization rates will increase.

“There isn’t enough evidence yet from [recent] sales that they’ll go up,” he said, because there simply weren’t that many sales in the last two quarters. “But everyone expects they will.”

O’Donnell declined to make a prediction about real estate taxes – another factor in the equation that also includes rents and utility prices. But he noted that if capitalization rates go up, property values will go down even if other factors stay constant.

Today’s capitalization rates range from 5.5 percent for “good quality apartments” to 8 percent for a 25- to 30-year-old, multi-tenant commercial property, O’Donnell said.

That compares favorably with March 1990, when cap rates were in the low teens, he said.

O’Donnell said borrowers today tend to have more equity than they did in the early 1990s, and loan underwriting has been more conservative in recent years than it was in the late 1980s.

More equity comes from the fact that more borrowers are institutional as opposed to individual today, he explained. For example, real estate investment trusts own plenty of properties today compared to 20 years ago when they were just getting started.

Bank and life insurance company underwriting practices are stricter now because lenders and regulators are concerned both about falling property values and general weakness in the economy, O’Donnell added.

“Falling property values will mean some existing [CRE] loans will get put under stress, and we can also expect fewer sales,” he said.

O’Donnell said the CRE delinquency rate is quite low today, around 1 percent, but it’s going to rise to some degree.

Mark McCarthy, an attorney with McDermott, Will & Emery in Boston, who advises lenders and borrowers in commercial markets, said lenders are paying attention.

McCarthy said he’s noticed that the percentage of CRE lenders deciding to tighten their standards for borrowers shot up at the end of 2007 to its highest level since 1990.

The change and speed with which it happened “was pretty remarkable,” he added.

Securitized lenders that got into the game in the mid-1990s did some “crazy” underwriting between 2004 and 2007, O’Donnell said, but it wasn’t very widespread.

Today, securitized lenders are largely out of the picture and have an uncertain future.

“The consensus is that we’re going to have a difficult year or two in capital availability,” largely for that reason,
O’Donnell said. “But we don’t expect a major credit crisis.”

McCarthy predicted that with securitized lenders at least temporarily gone, banks’ opportunities in CRE lending will increase.

“They perceive that the deals are now adequately priced for risk,” he said.

That’s just fine with Fairlane Properties President Michael Grill.

“I’ve always dealt with only savings banks and insurance companies,” said Grill, whose 11-year-old Boston firm buys and manages commercial properties in the $5 million to $20 million range. “I haven’t worked with conduits [securitized lenders]. They always sell their loans so I don’t know who will end up servicing them. I prefer to deal with people I know will be there.”

To Grill, today’s message in commercial real estate finance is that “funds are still available for lending” – from local savings and commercial banks.

Peter Smollett, vice president and senior lending officer at the $710 million Hingham Institution for Savings, said banks and some credit unions have been “aggressively” positioning themselves to do more commercial lending.

“You have three times the lenders participating today, compared to 1990,” he said, as well as more investors and fewer properties. “It’s healthier now.”

Smollett said he doesn’t have to look any farther than his own backyard to see the trends.

When he joined Hingham Savings in 1993, he said, the bank had three competitors. Today, there are 20 – and they’re mostly banks.