The commercial mortgage business in 1995 will be a "Standing Room Only" crowd, as traditional lenders continue to rediscover the discreet charms of commercial real estate. That was one of the overarching themes of a high-level conference co-sponsored by the E&Y Kenneth Leventhal Real Estate Group and Commercial Property News. In addition to the discussion on traditional lending activity, Wall Street executives, ratings agency representatives, conduit originators, and investment advisors gathered to offer a progress report on single- and multiple-asset commercial mortgage securitization. In this article, we summarize the key observations and prognoses made by this impressive group of real estate industry players.
Part IThe Life Insurance Companies' Perspective
Life insurance companies hold $1 trillion in commercial mortgages, nearly one-quarter of the market. Last year, over $150 billion in commercial mortgages matured and this figure should increase by $10 billion per year through 1998.
But life insurance companies face a variety of pressures, including growing competition from other traditional and non-traditional sources. rising interest rates, and the possibility of regulatory pressures increasing reserve requirements. The challenge is to confront these pressures and find a way to continue to pursue mortgage finance opportunities.
Today's competitive and rapidly moving investment environment begs the question: are we likely to see a repeat of the mistakes of the '80s? Steve Graves. senior vice president of Principal Mutual Life Insurance Company, pointed out how underwriting has changed dramatically since 1985. Among the differences:
Macroeconomic fundamentals. In the late '80s, Principal set up an independent research arm, separate from production, to monitor the real estate market and analyze the supply/demand environment, which lenders had largely ignored in the '80s.
Underwriting standards. Underwriting was "overly simplistic in 1985," he said, adding that there had been insufficient focus on what would happen over the term of the loan. In other words, the potential downside was ignored.
Debt service coverage. The '80s were also characterized by a lack of focus on the quality and duration of the income stream. For its part. Principal has developed its own rating system which it uses to determine a loan's potential risk and "stress points," much as it does for bonds.
Position in the real estate cycle. When a property's value is significantly lower than its replacement cost and the market is still unreceptive to new construction, lenders see upside potential in commercial mortgages, Graves observed. But loans are now priced differently; what would have been priced as "A" in '85 would be triple-B now.
Management of portfolio risk. There is more diversification to protect against credit risks, as well as more accuracy in pricing and more aggressive reserving for risk.
Better information systems. Graves noted that Principal has the ability to examine a portfolio with a more active and disciplined approach than in '85.
In 1980, Principal Mutual Life Insurance had $2.5 billion invested in commercial real estate. Now it has $13 billion--investing approximately $2 billion annually, even through the real estate recession of the early' '90s.
There are new and different players in the market today," Graves observed. "Will they be good students of the '80s? That remains to be seen. One risk going forward is that there is no standard underwriting."
Focus on Service
One keen student of the '80s is Teachers Insurance and Annuity Association (TIAA), which currently holds $20 billion in mortgage investments and $7 billion in equity investments. It closed $2.7 billion in new investments in 1994, and is aggressively looking at new opportunities this year, including multi-family, industrial, suburban office, and retail.
Tom Garbutt, managing, director, explained that TIAA revamped its investment operation in 1993, in part because "we are in a different market from what we were used to." Now, with a national accounts group, an international group, and an internal securitization group, there is more emphasis on service. Investments ranging from S5 million to $25 million go through a national network of correspondents. This is an important segment of the market, and the process is streamlined, Garbutt said.
TIAA has an active conventional loan program in the $25 million to $150 million range. It seeks portfolio plays as well as fixed-rate and participating loans. Maturities for fixed-rate loans range from seven to 12 years.
TIAA also will forward-commit up to six months with no rate increases, which has proved to be a strong marketing tool, he said. It will even forward-commit for up to 36 months with participation.
Continuing Regulatory Pressures
Tom McCardle, vice president of New York Life Insurance Company, stressed that regulatory issues are of paramount concern to life insurance companies. Currently, a tug of war is taking place between the life insurance companies and regulators. Life companies face the prospect of being more accountable for liquidity, asset risk and meeting new requirements at state levels. Risk-based capital investment reserves, now three percent for commercial mortgages, could range from 1.5 to 9 percent.
Another complication, he pointed out, is that regulators don't understand small mortgage pools and single-property mortgage-backed securities. and demand higher reserve levels for them.
Timothy Welch, executive vice president of Equitable Real Estate Investment Management Corp., pointed out that double-and triple-A rated securities represent an alternative to whole-loan investments, and offer a promising opportunity for institutional clients seeking diversification and liquidity.
Part II Mortgage Pools and Restructuring Portfolios: New Trends in Securitization
The growth of the Commercial Mortgage-Backed Securities (CMBS) market has proven less dazzling than some industry observers had predicted last year, but even after a steep learning curve, it has continued to attract notice as a powerful finance vehicle.
The prognosis made by the participants of the E&Y Kenneth Leventhal Real Estate Group/Commercial Property News conference was generally optimistic, with some predicting a volume of $20 billion this year. CMBS yields have proven highly attractive, and even the below-investment grade tranches have found champions in unexpected quarters because of their returns.
But the current market is not without its drawbacks, as industry observers outlined them:
* a lack of uniformity in documentation;
* the difficulty some conduits have faced in becoming viable;
* the difficulty in analyzing the strengths and weaknesses of individual assets in a pool;
* the importance of continuing surveillance by ratings agencies of already-issued securities; and
* the overwhelming need for more comprehensive, reliable, and easily disseminated information.
Still, as Richard Clotfelter, president of CB Commercial Capital Markets Group, asked rhetorically, "Is the mortgage conduit the securitization vehicle of the future? Yes. Is it an easy process? No." He outlined several "shake-out issues" inherent in handling mass-volume securitization:
* Guidelines for loans are changing because of Wall Street and ratings agencies trying to get comfortable with each other.
* Debt coverage ratios continue to move around.
* The processes are designed for larger loan sizes and more sophisticated borrowers.
* Zoning and title issues--where a property owner is at the whim of local ordinances - and subsequent mounting legal costs.
* Becoming a single-borrower entity adds to legal costs.
Clotfelter predicted that with several real estate organizations working for standardization of documents, some uniformity and stricter procedural processes are likely to result.
He also pointed out that "we will have to see computerization in sourcing packaging and in the review process." And, he concluded. "I still think Wall Street is in it for the long term."
Like Triple-B Corporate Bonds
Ross Keeler, president of Berkshire Investment Advisors, offered these observations about the CMBS market:
* CMBS currently comprise six percent of the mortgage market, "a smaller segment than people believe." The average maturity is under seven years, a decline from 25 years typical in the '60s. From a buyer's perspective, it's a yield-driven market.
* Commercial mortgages have similar characteristics to Triple-B corporate bonds in risk. The default rate is twice as high as corporate debt, but losses are half as much. Commercial mortgages perform well in a rising interest rate market, and outperform corporate debt in those circumstances.
* The lack of standardization in determining risk/return ratios is a big problem. Keeler pointed out that "with debt service coverage below 1.20, there are sharper losses. Losses rise above an LTV of 80 percent. Risk doesn't go up in stair-step fashion. It's geometric. The market is trying to figure out risk/reward."
* CMBS are most attractive on a risk/reward basis. But, he warned, "the toughest part is analyzing [portfolios] because they throw so much junk in them. The market hasn't been tested yet. There is a lot of wariness by investors and there should be, but CMBS will represent the best value and they will do well over time."
What About Below-Investment-Grade Tranches?
Robert Greer, Jr., senior director of Cushman & Wakefield's conduit program, noted that "B" pieces are "far from toxic waste" because they have passed rigorous underwriting and typically have a 70 percent LTV. "Cash-rich developers are buying them, and are getting a 13 to 14 percent return," he said.
Richard Gunthel, managing director of BT Securities Corp., noted that a growing number of investors are bringing money back for below-investment-grade vehicles, he added, for the simple reason that the returns on a risk-adjusted basis are "extraordinary--too big not to pay attention to."
But Richard Kately, executive vice president of Heitman Financial Limited, Inc., advised that, particularly with the unrated tranches, "you're taking a real estate risk. You're only as good as your weakest loans."
Long-Term Market Potential
An indication of the breadth of the market is that the conduit program of Cushman & Wakefield. introduced last year in a joint initiative with Fidelity Bond & Mortgage Company, has already raised its loan minimum from $1 million to $5 million, according to Greer, who refers to the program as a way of linking "Main Street" with "Wall Street."
This is not a short-term phenomenon," he said. "It is a long-term, structural change." A big potential market, he said, consists of good properties that had been overleveraged in the '80s and need refinancing now.
The key to conduits, he pointed out, is making them as user-friendly as possible. To the borrowers, the process should look and feel like a conventional loan; borrowers need not deal directly with underwriting firms or ratings agencies.
Looking Ahead
John Westerfield, principal of Morgan Stanley Realty, Inc., sees the future market of CMBS at $200 billion in five years. He also sees:
* The advantage is swinging to the borrower's side, because the market has many alternatives. That will lead to a further lowering of spreads, and better terms for the borrower.
* The financial gap--or the difference between leverage on properties and their marked-to-market equity--will be filled by fixed-income investors. Transactions will become easier to do.
Tools such as mezzanine equity, escrow partnership, and rated-preferred equity will emerge.
* The distinctions between entities such as insurance companies and Wall Street will continue to blur, he said, and "we will see underwriters acting as principals, with Wall Street firms originating bigger and whole loans, at too-tight spreads to be securitized."
* There will be more international deals and deals involving non-traditional collateral, such as properties in Hong Kong, student housing, hotels, pubs, fast food outlets, and nursing homes.
Robert Ruess, director of Northwestern Mutual Life, gave a quick "tour" of the commercial property world from Northwestern's perspective:
Office properties. The good news in the office sector is that about a million white-collar jobs were created in the U.S. in 1994, which impacts demand for space. On the other hand, absorption is likely to continue to be lopsided. "The tenants have voted; the suburbs are the place to be," he said. Looking particularly attractive are low-rise buildings with surface or one-deck parking and efficient floor plates.
Multifamily. As long as new construction is at an annual level of 300,000 units or fewer, there is little danger of overbuilding. Ruess sees good opportunities in infill properties, particularly for empty nesters.
Retail. Competition has heated up for investment in the top 25 percent of shopping malls. Ruess gives higher marks to centers that have a "fashion-forward shopping experience with three anchors." He sees a shakeout coming in power centers, and suggested that lower-rung malls may have to convert to discount centers.
Industrial/Warehouse. This sector is "coming back nicely," aided in part by new build-to-suit construction. Outdated facilities with low ceilings, flat floors, and inadequate turning ratios for today's trucks are "non-starters even at attractive rents."
All of the comments in this article were made at a conference entitled, "Turning on the Spigot: Current Trends in Commercial Mortgage Financing, "hosted by Michael P. Buckley, a member of the E& Y Kenneth Leventhal Real Estate Group, and Mark Klionsky, publisher of Commercial Property News.