Life Insurance Companies
Life insurance companies are the second biggest source of commercial
real estate loans. In the past, life insurance companies offered
lower interest rates than most other types of lenders because of their
low leverage. Today, however, the opposite holds true. Life insurance
companies are now charging rates 2 to 3 percentage points higher
than usual rates, thanks to the subprime mortgage crisis and the
ensuing global financial crisis that plagued the world’s economy
starting in 2009. Credit and loans for commercial real estate nearly
dried up during this period, and most life insurance companies
raised their prices to compensate them for the risk.
Life insurance companies make loans using the money they collect
from the premiums they receive for the life insurance policies,
fixed-income annuities, and other financial products they sell.
Unlike banks, life insurance companies are not regulated by state or
federal banking oversight agencies and can make loans without any
restrictions. However, despite this lack of oversight, they are
extremely conservative underwriters and lend only on high-quality
commercial real estate properties, usually limiting loans up to a maximum
of 75 percent of the appraised value.
Life insurance companies are extremely risk averse, and thus
they tend to look for brand-new or well-located properties in major
metropolitan cities. There are small life insurance companies that
lend as little as $500,000 and large life insurance companies that
lend up to $100 million per transaction. Life insurance companies
can be very creative and offer many types of loans for many different
types of properties, which is why mortgage bankers and brokers rely
heavily on life insurance companies. As mentioned earlier, there are
many small and medium-size life insurance companies whose
names you may not know that use exclusive correspondents for
sourcing and originating loans. Larger life insurance companies that
are still actively making commercial real estate loans, names that youmay recognize, include Allstate, New York Life, MetLife, and John
Hancock.
Conduit Lenders
A conduit lender is typically a New York Wall Street investment bank
like Morgan Stanley, JPMorgan Chase, or Goldman Sachs, which
through a distinct and separate division of the bank originates,
underwrites, and funds commercial real estate loans the same way
that residential mortgage bankers or commercial banks do for residential
loans. Investment banks fund conduit loans using their own
money or borrowed money from large commercial banks, like Bank
of America, Citigroup, and Wells Fargo. Conduit loans are individual
commercial mortgages that are pooled and transferred to a trust
for securitization (the process of taking a pool of commercial mortgages
and converting them into fixed-income securities called commercial
mortgage-backed securities or CMBS). This is almost identical
to the way that residential loans are pooled by Fannie Mae and
then converted to mortgage-backed securities (MBS). These securities,
also referred to as bonds, are separated into different bond
classes according to a grading system that factors in yield, duration,
and payment priority. Credit rating agencies like Fitch, Standard &
Poor’s, and Moody’s then assign credit ratings to the various bond
classes, ranging from investment grade (AAA through BBB–) to
below investment grade (BB). Once bonds are classified and given a
credit rating, they are packaged and sold to institutional investors
such as banks, foreign governments, and life insurance companies.
Wall Street investment banks primarily make their money from
underwriting, creating, and selling fixed-income securities, which
are then sold by bond dealers on the open market. These securities
or bonds are secured and backed by the commercial mortgages, and
the commercial mortgages are secured by the property such as an
office building or retail center. The best way to explain how a conduit
loan works is by working backwards. A conduit lender begins by
using its own cash or borrowed money, for example, from a line of
credit from a big commercial bank like Citibank. The conduit lender,
which can be a Wall Street investment bank or an unrelated independent
mortgage bank, then loans the money to a borrower who
needs it to purchase an office building. The term of the loan is ten
years, meaning that there is a balloon payment at the end of ten
years. The investment bank or mortgage bank is now the owner of
that promissory note (the note). However, the investment bank cannot
keep the note for ten years because it borrowed the money from
Citibank using a loan with a very short term of two years. The conundrum
for the investment bank or mortgage bank is that it will take
ten years to get its money back from the borrower, but in the meantime
Citibank wants its loan paid off within two years. To solve that
problem, the investment bank then creates a fixed-income security or
bond that is secured by the commercial mortgage. The fixed-income
security is then sold to a long-term investor who doesn’t mind holding
a ten-year bond. The money from the sale of the bond is then
used to pay back the loan from Citibank. The investment bank makes
its money when the bond is sold. Let’s say that the value of the original
commercial mortgage was $5 million, which was the face
amount of the loan given to the borrower. The investment bank in
turn sells that same mortgage, packaged as a long-term bond, for a
higher price of $5.1 million, thus making a profit of $100,000. The
higher price represents a 2 percent premium paid by the long-term
institutional investor. Selling bonds at a 2 percent premium, along
with other underwriting and securitization fees, is how conduit
lenders make their money.
You may be wondering why a long-term investor would pay more
for the bond than the face amount of the mortgage. To be able to
answer that question, one needs to understand the nature of bondmarkets. Simply put, bond investors are after yields, regardless of
price. Higher demands for securities mean higher prices. Paying a
higher price lowers the yield to the bond investor, but that is how the
bond market works. This process is what provides liquidity to the
mortgage industry and competition among commercial real estate
lenders. Higher competition among conduit lenders translates into
lower interest rates. The advantage of conduit lenders is that their
loans are typically nonrecourse. Nonrecourse loans do not require personal
guarantees, thus releasing the borrower from personal liability.
In addition, they offer very low long-term fixed interest rates,
longer amortization, and higher loan-to-value ratios. The disadvantage
is that these loans are extremely rigid and expensive to originate.
It is also very difficult to pay off a conduit loan early, and even when
the loan can be prepaid early there are huge prepayment penalties.
In fact, most of these conduit loans have lock-out periods for years
before the loan can be prepaid in part or in whole.