Mortgage Bankers Roundtable, Part II: Taking Stock of Today's Financing Conditions
By Keat Foong, Finance Editor
In Part I of CPE’s 2012 Mortgage Bankers Roundtable, “Maturities, Here They Come,” which appeared in the February 2012 issue, top commercial real estate finance executives addressed the question of whether the capital markets will be able to refinance the wave of expiring CMBS loans coming onto the market this year. In Part II, the spirited discussion continues, addressing interest rates, underwriting standards, CMBS and the future of Fannie and Freddie. Participating in the roundtable are Jack Cohen, CEO of Cohen Financial; William Hughes, senior vice president & managing director of Marcus & Millichap Capital Corp.; Eduardo Padilla, president & CEO of NorthMarq Capital; and William Walker, chairman, president & CEO of Walker & Dunlop L.L.C.
CPE: What are your projections for the volume of debt financing this year, and which players will be the leading sources of capital in 2012?
Padilla: All expectations are for continued positive momentum, providing more capital to the commercial real estate market. If you look at new originated loans, it is really life insurance companies taken as a whole that will be the single largest source of newly originated loans. The amount life insurance companies originated in 2011 may be at an all-time record for them. Their typical annual numbers are in the $40 billion to $50 billion range, but expectations are that they are going to exceed that number. There are some banks that provide permanent financing in the five- , seven-year fixed-rate category very regularly. Those would also be sources of (permanent non-recourse debt capital).
As you look at all the players, with the exception of Freddie Mac and Fannie Mae, life insurance companies would be No. 1 as far as new originations over $50 billion. CMBS had a hiccup this summer, so CMBS’s originations are below those of life companies. I think it is possible the CMBS market will look similar to a life insurance market in terms of volume—that is, $50 billion annually.
Hughes: I think the volume of financing is going to continue to improve over what we saw in 2011, when we witnessed significant improvement in our business over that in 2010. In 2010, we saw about a 20 percent increase (in financing volume) over 2009. For 2011, we saw about a 30 percent increase over 2010. In 2012, we think we will see a further increase, although it certainly won’t be quite the increase we saw in 2010 and 2011. So we are looking for our business to grow by maybe 15 or 20 percent this year.
I think the drop in interest rates was what drove a lot of business growth in 2011. We saw rates drop to historically low levels, and it brought a lot of investors into the marketplace. I think the primary drivers to increased activity in 2012 will be two factors: the depth of maturities that are going to hit the marketplace this year and the volume of transactional activities, which will improve. I think those will be the primary drivers to increased activity in 2012.
Walker: 2011 I think will show a significant amount of financing from banks, life insurance companies and agencies: Fannie Mae, Freddie Mac and HUD. The biggest surprise in 2011 will be that life insurance companies came back stronger—and conduits came back in a much less significant manner—than most people expected. As to 2012, it sounds as though banks will be very active again; life insurance companies will be very, very active; the agencies will be very active; and I think CMBS will struggle to find its balance.
Jack Cohen: 2012 will be pretty much a mirror image to 2011. I think we are in a slow/no-growth period. There will be plenty of capital out there, though not by 2006 standards. We are back to more of a market normalization standard, and I think that standard is in a $100 billion to $150 billion range when you consider all the various financing sources. Your perspective is distorted by the fantasy, which many people seem to have, that 2006 and 2007 were reality. The reality in my view is a steady-state marketplace for commercial real estate finance, which is $100 billion to $150 billion of capital, and we are there.
CPE: Will CMBS be able to penetrate the multi-family market this year?
Walker: Clearly, it did in a very big way in 2006 and 2007. However, the bottom line is, CMBS is not competing with agencies, life insurance companies or banks on stabilized properties today, whether it be multi-family or almost any other asset class.
The spreads that investors require for CMBS deals today are almost by design requiring the assets to be unstabilized or to have some type of structural issue to them that allows investors to get greater yields so the bonds can be sold. When you have lenders such as banks, life insurance companies and agencies with such a low cost of capital, by definition CMBS has to go after higher-yield loans.
Banks have an incredibly cheap cost of capital today; banks can be lending on anything they want. They just don’t like the dynamics of longer-maturity and fixed-rate debt, so they are not really a competitor on the 10-year fixed-rate loan. But if you are talking about cost of capital, insurance companies, banks and the agencies all have a much cheaper cost of capital today. As a result, for CMBS to effectively compete with stabilized multi-family deals, it is very, very difficult.
CPE: Will CMBS ever be able to adequately finance the CRE market, or are other financing sources adequately filling the financing gap that has been left by CMBS?
Cohen: It was never supposed to. Securitization is not an industry. It is a tool. It is a way to attract investors who have a particular opinion about a specific risk they are willing to pay for. The fact is that we got carried away manufacturing bonds, stealing business from the life companies and corporate finance. That has no place in our industry. Nice, solid CMBS issuance in the $50 billion to $100 billion range is very healthy because it represents a balanced option for the borrower seeking well-placed capital across the financing landscape—life companies, GSEs, pension funds, banks, finance companies and securitized lenders. My view is that somewhere around 2015 or 2016, we’ll get to $100 billion in CMBS issuance, so I hope we will have slow growth between $30 billion in 2012 and $100 billion max in 2016.
These loans will not be 100 percent replaced by debt. They will be replaced by debt, equity and loss. So what has to happen is lenders and borrowers alike are going to have to accept they are not going to get bailed out. They are going to have to write a check, write (it) off, refinance it and move forward.
CPE: Everyone is saying underwriting is more disciplined today. Is that a short-term change in response to current economic weakness or more of a long-term structural shift?
Walker: CMBS was the big driver to changes in underwriting standards. CMBS came out of the block at the beginning of 2011 and did a significant volume of business, but the financing was all very well underwritten, low leverage and high DSC, with very, very high subordination levels in all of the issuances. And then all of a sudden, they started to go back to trying to securitize loans, if you will, under what was done in 2006 and 2007, and the market said, “No.” Or more important, the B-piece buyers said, “If you want me to buy this, you are going to have to pay me a lot more.” And as a result of that, I think the market has shown some discipline in a very, very rapid fashion in not allowing CMBS to move back to old underwriting standards.
Hughes: I can see how some of our debt providers will start to compete beyond interest rates—and particularly if the CMBS arena does start heating up a little. But at the $30 billion level, (CMBS players) are really not going to have to compete on their underwriting prowess. I think they can compete and fill their buckets by underwriting pretty conservatively and just move into B-minus or C-plus quality assets in some of the smaller, non-primary markets. I think they can fill their buckets today (without having to loosen underwriting standards).
Padilla: I don’t think anyone really expects to see $200 billion-plus CMBS volume level (as we saw in ‘06-07). To execute that kind of volume, CMBS was probably pushed to do deals they really shouldn’t have been doing—10-year interest-only, break-even or below-DSC loans—properties that were not stabilized, that were still in lease-up or lease-improvement stages. The net result is that the delinquency performance of CMBS is much, much worse than the life insurance companies or Freddie Mac, Fannie Mae, and worse than the banking industry dealing with construction lending and all types of properties.
CPE: When do you think mortgage interest rates will start to trend up again?
Hughes: I just don’t think there is enough pizzazz in this economy, both domestic and global, to really push interest rates up much right now. I am a firm believer that interest rates are going to go up, and I stick by that. The question is, when and by how much. … I just don’t see a whole lot happening ‘til you get to 2014. Then it will be interesting to see what the federal government does. The (Federal Reserve) has already announced we are going to keep interest rates low through 2014. They have got to let interest rates go (up) at some point in time.
Cohen: I think interest rates have to go up, but they will not in an election year. I do think we have inflationary risk. As a matter of fact, I am rooting for inflation because that is good for real estate as an asset class. That will drive value up.
Walker: (Regarding spreads), I think it will have a lot to do with how the equity markets move, how the high-yield corporate debt market moves, and quite honestly what types of spreads make commercial real estate loans attractive to investors.
When you are looking at Treasury rates that are below 2 percent, you have a lot of investors seeking yield. So are they happy with a 4.25 first-trust, 60 percent LTV commercial loan? Maybe. Now that might move out during the year to the point where they are only happy with a 4.75, and obviously that is all based on the Treasury staying static, which it will not.
Right now, we see spreads staying quite tight because it is a very desired asset class, and there is a bunch of capital trying to chase the deal flow.
CPE: There has been talk about doing away with Fannie Mae and Freddie Mac. Do you believe Fannie and Freddie should be eliminated?
Padilla: On the single-family side, you have got a $5 trillion portfolio. Ninety percent of the new residential loans that are generated go into Freddie Mac or Fannie Mae. You can’t just shut off the light and say, “Hey, we are out of that.” Who is going to pick it up? What is going to happen? Housing values would plummet if you could not get a loan to buy a house. So it is a much more complicated discussion than simply a statement that says, “I believe we should shut it down.” It is just irresponsible (to say that).
On the multi-family side, it is just crystal clear that, fundamentally, there has been nothing wrong about what Freddie Mac and Fannie Mae have done. … The worst thing I can see happening there is that rather than a constructive discussion about what should be done and the steps forward, we see this continual political saber rattling about freezing bonuses and shutting down Fannie Mae and Freddie Mac altogether. …
I have always said it is not so much about structure as it is about people. Fannie Mae and Freddie Mac have been lucky. They have had terrific people, and that is why they have made very sound choices on the multi-family side. If you want to kill that industry, simply make it very unattractive for those people to stay there. Have investigators threaten to arrest them, freeze their bonuses, discussions about just simply closing it down. The hilarious thing about it is some of the people who are saying those things have no understanding of what the Freddie Mac multi-family side means to rental housing in America and how well in fact they have performed all these years.
Walker: There are plenty of people who talk about trying to do away with Fannie Mae and Freddie Mac. There is nobody—and I mean nobody—who has come up with a viable replacement for what Fannie Mae and Freddie Mac do in our housing industry. None of the proposals that were put forth as far as alternatives in the Administration’s white paper exist in any material way today. The covered bond market does not exist today in the U.S., and in Europe it had an extremely difficult 2011. The white paper also proposed private mortgage insurance coming in and replacing the mortgage insurance that Fannie Mae and Freddie Mac place behind single-family mortgages. The private mortgage insurance industry in the U.S. is in complete disarray today—complete disarray. The third is, many people who would like to see Freddie Mac and Fannie Mae go away have talked about the hope and desire that the private-label residential mortgage-backed security market would come back and start to take market share from Fannie Mae and Freddie Mac. That market did two or three issuances in all of 2011—we are talking in a trillion-dollar market. We can say there is not a single proposal on the table that’s a viable alternative to what exists today. Until Congress puts together a road map, it is an economic impossibility that Fannie Mae and Freddie Mac go away anytime soon.
Hughes: I think certainly Fannie Mae and Freddie Mac have a longstanding role in supporting the housing industry. I think the multi-family arena is the way that the government through the GSEs has helped create low-cost housing and would continue to do so. Fannie Mae and Freddie Mac have both been profitable organizations when it comes to the multi-family arena.
Clearly, Congress is looking to restructure Fannie Mae and Freddie Mac. Will they ultimately sell them to a private firm or go through a privatization of those agencies? They might, but I suspect that there will be some continued government involvement, if only in the multi-family arena, and that may be the appropriate place for that to happen.
The impact of privatizing Freddie Mac and Fannie Mae is really an increase in cost of homeownership, because if you don’t have the implied guarantees by the agencies you are going to have interest rates go up in those sectors.