This is the fourth of six installments of my notes and comments from Institutional Real Estate, Inc.’s Dealmakers Summit (Sept. 14 – 16, 2009). This section regards the state of commercial real estate lending.
COMPETITION
Supply and demand factors have a very large affect on the debt markets. During the last cycle, there was an enormous supply of debt capital and competition was fierce fueled in large part by the growth and abundance in the CMBS market. Today, not only has CMBS dried up, but the other more traditional sources of capital have problems of their own / and or have abundant opportunities outside of commercial real estate. Therefore, it should not be a surprise to anyone that supply of debt capital has all but disappeared.
In order for debt markets to return, competition on the capital side of the equation must first return.
SECURITIZATION
After listening to a number of experts, I think the question is when securitization gets resurrected versus if there is ever securitization again.
There are many positive arguments for loan securitization. Many in the public have a current perception that leverage is bad, however, we know leverage is not bad. It is simply a bifurcation of the risk and allows the most efficient use of capital. One presenter at the conference astutely pointed out that “the goal of any functioning financial system is to bring to bear the most efficient capital to the user.” Not only does debt itself do that, but to have a healthy securitization market, complete with tranching, further accomplishes that. So, while it is hard to say if tranching is gone, but there is a valid reason to have it.
Too much leverage comes as a result of out-of-whack perceptions of risk. For example, a first mortgage of 85% priced as though there is little to no risk, is clearly out of touch with the reality of economic and fundamental cycles. But if the 85% was tranched to different parties with an appropriate risk-reward distribution, then the same loan may make sense.
This brings up the notion that loan originators need to have skin in the game, that is, the should be required to keep the most risky first loss position. This would align the interests of the syndicating group with the investors. As a result, securitization may be very profitable, attracting more players back into the market.
There was also a great deal of speculation that securitization may be further solved by a regulatory ‘standardized blue-print’ for inter-creditor agreements and securitization agreement. Right now, owners of these pools have found themselves in a confusing environment with little or no documentation and lawsuits to unfold the mess will likely take the better part of a decade to work through.
At the end of the day, the argument can be made that securitization is good because it took an illiquid business (traditional lending model) and created a liquid market. The problem was that the industry, just like all fledgling industries had not run a full cycle yet. One commentator compared it to running a marathon. Where an individual who typically runs short distances who tries to run marathon, typically finds their weakness (bad knee, toe, etc.) over the long haul. Now that securitization has run a full cycle, many believe it can be fixed and come out stronger and better than before.
BANK LENDERS
The consensus is that banks need to earn their way out of their balance sheet stress. How long that will take varies greatly bank by bank. Many banks are in denial or simply haven’t devoted resources to deal with CRE yet, most are still focused on their residential real estate problems.
Again, the experts say, while banks appear to be better capitalized now than before, don’t look for them to be aggressively quoting loans until (a) they have cleaned up their own mess, (b) there is competition among lenders and (c) the fundamentals of commercial real estate rebound.
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