The Changing Paradigm in Commercial Real Estate

Despite unprecedented declines in commercial real estate (CRE) fundamentals, the nation's insured institutions have weathered the storm of the recent downturn with remarkably strong performance in their CRE portfolios. The rapid growth of public ownership of CRE loans through commercial mortgage backed securities (CMBS) is a significant change that has influenced CRE performance since the last cycle.

In order to assess these and other related issues, the FDIC convened a September 12 roundtable of industry experts including Stacey Berger, Executive Vice President, Midland Loan Services; Sally Gordon, Vice President/Senior Credit Officer, Moody's Investors Service; John B. Levy, President, John B. Levy & Company; and David Worley, Managing Director, Wachovia Securities, and Chief Risk Officer, Capital Markets Real Estate. FDIC Chief Economist Richard Brown moderated the discussion. The roundtable was followed by a lunchtime presentation by Bret Wilkerson, Director, Property Portfolio Research.

Provided below are a few highlights from the roundtable discussion and lunchtime presentation.

The creation of the RTC in 1989 facilitated the growth in CRE securitization:

John Levy: "The RTC really made all of this possible had there been no RTC, we would be where we were in the early 1980s, which was in the whole loan business, where you made a loan, you banked it or brokered it to a life company or other institution and they held it for the term, and that was it."

Stacey Berger: "We got our start in the commercial loan servicing business as one of the national servicers for the RTC. We also acquired over $1 billion of non-performing loans in the first structured transaction with the RTC."

Sally Gordon: "Yes, I'd like to underscore that, and maybe flesh out ways in which the RTC was really critical in jumpstarting our industry. there was this critical mass and volume of mortgages that we knew were going to be securitized once that was the chosen disposition course. That means that as soon as there's this much business out there, you can justify the expenditure in developing the analytical models, the software, the structural processes. And since you have some guaranteed volume, it supported the investment in developing all of the analytical tools which could then later, with minor tweaking, be adapted to private label securities. The second sense in which the RTC was critical was to absorb the loans that had been on the books of failed savings and loans. Those were also the institutions that were heavily involved in lending to relatively small commercial real estate assets. With them out of the market, something else took their place functionally in the commercial real estate lending environment, and those were conduits. Conduits are businesses, as well as legal structures, that permit the pooling of many small loans and rolling them up into securities."

The CMBS market is public and thus relatively transparent to risk exposures:

David Worley: "I think the transparency from the rating agencies and the distribution of risk has brought new investors in. Now when you have firms like PPR and Torto Wheaton Research, you can go click on a website. You know what's going on with a particular market or sub-market with job growth, with construction supply...with vacancies. That helps the underwriting. And this is where the banks, in my opinion, need to get better technologically with their own portfolios. In the CMBS market, everything is transparent. If you want to know delinquencies, [or] what's going on with a particular loan in a pool, it is very easy to get that information. Debt service coverage, whatever you want to get, it is out there."

Sally Gordon: "Our loans are different. They are a different composition of the total portfolios, of the pools. And they are, in fact, also managed differently when they're under stress. As David said, transparency is essential in a securities environment in a publicly-traded instrument. So if a loan in the CMBS pool is 30 days past due, the whole world knows it. Sixty days past due, everybody knows. Ninety days past due, it's on everybody's radar screen. Let me reinforce that, again, don't weep for the B-piece buyers. But to return to the point that Rich made earlier, is risk being buried somewhere in this process that nobody knows about and [if] it's going to sneak up on us...The B-piece buyers buy into that risk up front. They know about it. It's clear. This does not come as a surprise to them."

CRE losses are expected to be lower this cycle than in the last one:

Sally Gordon: "The amplitude of the cycle will be shallower. That is, shallower peaks and troughs, less big profits, less big whacks, but we will see more short-term volatility. Little blips as things move up and down, because of Criimi Mae, because of Russian bonds, because of Y2K, because of things that, via the bond market, now affect the cost and availability of capital. And we will always be a capital-intensive asset class."

The recovery in CRE markets will occur after hiring commences:

John Levy: "Right now we have a jobless recovery which makes it difficult to forecast. If we don't have a jobs recovery, there is not really a whole lot of chance that people are going to need more space, because space has a strong relationship to the number of people you employ."

Bret Wilkerson: "You have to have profits before you can start to hire again. And companies are very reluctant to do what, in our economy today, is the number one expense - increase jobs. Employers are currently 'squeezing productivity' from their employees before they begin hiring again."