Monitoring Risk in Uncertain Times: Commercial Real Estate Finance Has Become a Much More Volatile Business in Recent Times. Tools and Policies to Monitor Exposure to Risks Have Become Increasingly Important to Both Lenders and Regulators

Article excerpt

With 2007 now behind us, some nagging concerns continue to dominate discussions about the entire business landscape associated with commercial real estate.

Those lingering sources of worry include these developments:

* Subprime defaults are at historic highs, and there are growing concerns about the ripple effect on commercial real estate-related (CRE-related) interest rates, property values and liquidity.

* Rating agencies have announced concern about the continued decline in underwriting standards and the operational risk of managing complex deal structures on spreadsheets, and the rating agencies' business practices are coming under growing scrutiny.

* Congress is looking at changing the tax laws related to hedge funds and private-equity firms that have channeled a lot of liquidity into the market, as well as those related to the use of tax havens that have contributed to the dramatic growth in the collateralized debt obligations (CDOs) market.

* Banks are wondering about the impact of the interagency CRE regulatory guidance issued in December 2006 and their ability to continue to make CRE loans under current market conditions.

According to America's Real Estate 2007: An Agenda for a Strong Economy, published by the Washington, D.C.-based Real Estate Roundtable, 25 percent of the inputs to the $10.2 trillion U.S. gross domestic product (GDP) are generated by commercial and residential real estate. Combined with the fact that there is currently more than $3 trillion in CRE debt outstanding, commercial real estate is now considered a legitimate fourth asset class for investment purposes--along with equity, bonds and cash.

Not only is CRE debt at historic highs, but the net change in commercial and multifamily mortgage debt is rising dramatically on a quarter-to-quarter basis (see Figure 1). Figure 1 also shows this increased volatility in the market, which may create additional concern for investors and regulators alike. For example, with recent reports of more than $40 billion in write-offs related to subprime loans, and an estimated $300 billion more to come, financial institutions are struggling to get their hands around their exposures, assess the breadth of the impact on the economy and their commercial loan portfolios, and the credit and monitoring process and technology changes they need to restore investor and customer confidence.

Moreover, the distribution of commercial and multifamily mortgage debt demonstrates the pervasiveness of CRE debt in today's economy (see Figure 2). CRE debt is no longer primarily confined to just the banking industry. According to the Mortgage Bankers Association (MBA), more than 60 percent of the growth in commercial and multifamily mortgage debt in the first quarter of 2007 came from the commercial mortgage-backed securities (CMBS), CDO and asset-backed securities (ABS) markets. The point is that any hiccup in the CRE market now has wide-ranging ripple effects on the entire U.S. economy--not just on the banking industry.

For all these reasons, regulators are putting increased pressure on financial institutions to invest in more-sophisticated portfolio-management capabilities and to have greater transparency and better data quality across the entire CRE lending, servicing and securitization process.

Increased uncertainty

Some in the industry hold that the broader distribution of risk via securitization will mitigate the effects of any downturn. That belief may or may not bear out, in my view, as the market has entered uncharted waters in a number of ways:

* With average London interbank offered rate (LIBOR) rates higher than the 10-year Treasury historically used to benchmark CRE lending rates (as shown in Figure 3), there is a clear anomaly in the market. CRE rates are not being properly priced for risk. When this disconnect ultimately corrects itself, what will be the negative impact on CRE rates and values? …