FEATURE ARTICLE, OCTOBER 2007

Large Lenders Looking for Small Loans
In today’s climate, large lenders offer small balance borrowers and brokers two things: a blessing and a curse.
Daniel J. Smith

Daniel J. Smith, RBC Capital Markets — Real Estate Mortgage Capital

The landscape for small balance loan financing in Texas has changed considerably in recent months. Numerous large national lenders announced plans to actively pursue small balance multifamily and commercial loans (typically $500,000 to $5 million) that were once the purview of local and regional banks. Yet some have reconsidered due to capital markets volatility.

Commercial real estate capital markets experienced a perfect storm this summer, as rating agencies began to comment on aggressive underwriting, the subprime residential market collapsed and many investors stopped buying CMBS securities, which increased origination spreads for multifamily and commercial mortgages by 70 to 100 basis points.

Today, many lenders are holding billions of dollars in multifamily and commercial loans that either cannot be sold in the capital markets or can only be sold at a huge loss. This reflects a mismatch between the loans’ origination and execution spreads, not widespread delinquencies and defaults like those experienced in the residential sector.

Given today’s commercial real estate lending environment, what are large lenders offering small balance borrowers and brokers in Texas and nationally? A blessing and a curse.

The blessing: Some lenders are still actively pursuing small balance lending in Texas, providing access to global capital markets and loan features previously restricted to large loans. The curse: Taking advantage of those opportunities exposes small balance borrowers to capital markets’ volatility, which today includes wider spreads and stricter underwriting standards.

Nonetheless, many aspects of Texas’ small balance loan market are still appealing. However, national lenders that are new to this market — or that fail to recognize its unique needs — may find successfully serving small loan borrowers in Texas more challenging than expected.

Enter the Large Lenders

The small loan market has been strong nationally — valued at approximately $130 billion in 20061  — and particularly robust in Texas, thanks to consistent population growth, a resilient economy and interest from out-of-state developers.

In the last several months, a number of large lenders have either begun offering small balance loans in Texas or announced plans to do so. All intend to securitize the loans and sell them to investors.

As a result, these large lenders can offer small balance borrowers features typically limited to large CMBS loans — non-recourse, 80 percent LTV, fixed-rate financing with a 10-year term, a 30-year amortization schedule and the option for 2 to 3 years of interest-only payments. Hybrid loans, which have flexible maturity dates, are also available.

Some large lenders are pursuing the small balance market because they see these clients as excellent prospects for additional commercial real estate financing and/or retail banking products.

For other lenders, the move is defensive; some banks that offered floating-rate small balance loans are adding a securitized product to help keep clients who would otherwise look elsewhere for long-term, fixed-rate financing.

The Texas Challenge

Although the small loan market in Texas is extremely attractive, large national lenders moving into it face a number of potential pitfalls in addition to capital markets volatility.

Many appealing lending opportunities are located in secondary or tertiary markets such as El Paso or Abilene; national lenders are typically better acquainted with major markets. A lender that does not understand smaller markets and fails to thoroughly examine their dynamics, diversity and economic drivers may find its loans in trouble and unacceptable to investors.

Major markets in Texas also can present hurdles. For example, there are pockets of weakness in Dallas’ multifamily markets. Similarly, the aftermath of Hurricane Katrina may be artificially inflating Houston’s occupancy rates. Whether these tenants will stay in Houston — and how long they will receive government rent subsidies or create significant vacancies by returning to New Orleans — remains to be seen.

In addition, immigration is fueling demand for smaller commercial properties across the state. Considerable changes to immigration laws are likely to impact Texas disproportionately and could affect the market for small multifamily and commercial properties.

Juggling Volume and Service

Small balance borrowers and the brokers who serve them need the same speed, reliability and predictability as large loan borrowers, along with a healthy dose of education, communication and support. However, delivering so much service while processing hundreds of loans can quickly tax a lender’s origination, underwriting and closing capabilities -— especially if the lender uses the same infrastructure for large and small loans.

Investing in technology designed specifically for small balance loans is a critical component of efficiency, productivity and a smooth internal loan process.

Diligent underwriting also is essential to successful small loan originations and securitization. A lender accustomed to making recourse loans may need to review and strengthen standards for smaller properties’ reserves, tenant credit, turnover and net operating income.

Bringing decision-makers into the process early is extremely valuable to every borrower. Yet many lenders will find it difficult to provide early credit decisions on small loans because their committees are primarily focused on large CMBS loans. 

Lenders that hope to succeed at small balance lending in Texas also need a team of originators, underwriters and closers who are dedicated to serving this market, understand CMBS and work closely together. Expecting employees who are responsible for large loans to also process small loans is unrealistic; small loan originations and service will suffer as staff overlooks them in favor of larger loans. 

Capital markets volatility aside, today’s small balance lending market in Texas offers new opportunities for borrowers and lenders alike. National lenders that understand the market and invest in technology, staff and processes to meet the unique needs of small loan borrowers and brokers may find promising returns.

For borrowers, the access to global capital markets, which national lenders are making possible, creates appealing new financing options for smaller multifamily and commercial properties. For the first time, small loan borrowers can tap a robust international market in which capital is always available. Yet they also face potential volatility caused by unpredictable circumstances such as residential subprime lending affecting commercial real estate’s stronger collateral base. Balancing these opportunities and challenges will be critical to borrowers’ choice of a lender.

Daniel J. Smith is managing director of Texas-based RBC Capital Markets — Real Estate Mortgage Capital, which recently introduced RBC Streamline for the small balance loan market.


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