The Education Committee of CoreNet Global’s New York City Chapter recently presented a workshop, titled “Basics of Debt Financing: Making Sense of Today’s Market,” that was aimed at explaining to attendees the core concepts of real estate financing. The event was held at Kaplan and more than 30 members attended the lecture.
Lawrence Longua, clinical associate professor with the NYU Schack Institute of Real Estate, gave a detailed synopsis of the manner in which commercial real estate is financed and the genesis of the current turmoil in the global market. “The global capital markets are frozen at this time,” he said. Longua added that, despite his 40 years of experience in the finance sector, “I cannot make sense of today’s market.”
“The purpose of this lecture is to explain to you why what is taking place in the financing markets today is important to you as a tenant, what other tenants are experiencing, and what the landlords and lenders are going through,” he added.
For large-scale commercial real estate lending, borrowers would turn to the portfolio lenders, which mainly comprised major U.S. and global insurance companies. They were called portfolio lenders because the firms would keep the loans they originated on their balance sheets. According to Longua, portfolio lenders as a whole were only ever able to originate about $50 billion in loans annually.
The financial markets turned to commercial mortgage-backed securities, or CMBS, to fill the burgeoning need for increasingly large amounts of capital to finance commercial real estate across the United States. In comparison to the output of the portfolio lenders, the CMBS market currently comprises about $735 billion in securitized loans.
“The global nature of the capital markets was initially a positive development that allowed borrowers to create the kind of liquidity or access to financing that used to come from the large portfolio lenders,” said Longua.
Longua noted the first entity to tap CMBS as an instrument to finance commercial real estate was the Resolution Trust Corp. The RTC was an entity set up by the government to deal with the assets of failed savings-and-loan institutions following the real estate crisis of the late ‘80s and early ‘90s. By law, the RTC had just five years to complete its mission and it came up with the idea of securitizing the loans by selling bonds against pools of commercial mortgages.
“Fannie Mae and Freddie Mac have been securitizing pools of residential mortgages in this manner for decades,” said Longua.
Portfolio lenders, which always kept the loans they originate on their books, have a clearly defined and concentrated risk profile. The executives in charge of the portfolios of loans are well versed in the properties that were financed and the markets in which they reside. They remain in constant contact with borrowers and receive detailed monthly reports. If a problem arises with a borrower, portfolio lenders have some control over the situation and can work directly with the borrower to resolve issues.
Longua pointed out the situation is far more complicated when it comes to the CMBS market. The money that is generated by securitizing loans via CMBS comes from investors who buy bonds. Each CMBS issuance is a separate legal entity that is empowered to issue bonds. These bonds are divided into different tranches that are rated as investment grade — AAA, AA, A and BBB — or as below investment grade — BB or lower — based upon the default risk of the individual loans within the pool.
“Unlike with a portfolio lender, when loans within a CMBS pool go bad, working out a solution can be difficult,” said Longua.
CMBS issuances typically contain more than 100 mortgages in multiple markets and multiple product types. Each CMBS pool is overseen by a third-party organization called a master service, and in the event of a default, the problem loan is then handed over to a separate third-party organization called a special servicer. There is no direct contact with the borrower and obtaining up-to-date information on an individual property can take some time.
When the credit crunch hit, the competing interests of the buyers of the different types of bonds resulted in “tranch warfare,” noted Longua. The owners of investment grade bonds wanted to maximize any possible return on their investment by pushing special servicers to quickly foreclose on problem loans and sell the properties. At the same time, the buyers of the below investment grade bonds — also called B-piece buyers — began pushing for special servicers to extend or change the terms of the problem loans so they have the best chance to boost the return on their investment.