Magazine article The Journal of Lending & Credit Risk Management

It's Back to the Future for Real Estate Lending

Magazine article The Journal of Lending & Credit Risk Management

It's Back to the Future for Real Estate Lending

Article excerpt

The U.S. real estate depression of the early 1990s shocked the foundations of the institutional real estate investment community and sent many institutions into permanent hibernation. Even as occupancies stabilized and rents increased midway through the decade, many traditional portfolio lenders were slow to see the developing opportunities and refused to reenter the market.

In 1993, a small number of prescient investment banks created the CMBS market to fill the liquidity void. These institutions infused billions of dollars of liquidity into the market by making conservative, intermediate term, fixed rate, first mortgage loans to refinance stabilized properties. These loans were pooled, securitized, and sold to bond investors, including many of the same portfolio lenders that had exited the direct real estate finance market. It seemed the best of all worlds for investors. The securities were rated by independent agencies, were significantly more liquid than direct mortgage or property investments, and provided cautious investments to fill real estate investment allocations without significant in-house origination and underwriting staffs. Word of profits spread, causing other institutions, including money center and regional banks, to enter the CMBS market. The rise of the CMBS distribution system coincided with a massive expansion of liquidity in the debt markets.

During this same period, many astute investors who had purchased discounted properties during the real estate recession benefited from the improving property valuations and realized significantly increased equity. The market's illiquidity restricted their ability, however, to leverage this equity to fuel further growth. The U.S. stock market's bull run offered a new way for investors to access this equity by putting a new twist on an old idea: REITs. By tapping into a hungry stock market, REITs, fueled by positive spread investment opportunities, created an illusion of growth. Newly formed REITs were able to access capital with which to invest in additional purchases.

Illiquidity in the first mortgage market was not an issue for REITs for two reasons:

1. REIT debt was seen by lenders as corporate, not real estate debt, and there was no lack of corporate debt during the initial phase of the bull market.

2. The yield requirements of REITs were lower than that demanded by private or syndicated real estate equity investors.

Consequently, REITS could generate adequate returns using less leverage. The unprecedented proliferation of REITs during the mid-1990s drove an insatiable hunger for new acquisitions, which, in turn, resulted in rapidly increasing property prices. Increasing property prices caused REIT stock prices to balloon, which, in turn, spawned the formation of more REITs.

Emerging Problems with the CMBS Market

Even though the CMBS market brought added liquidity into the market, it was still far from perfect. Borrowers and originators alike were often frustrated by loan parameters that were driven by independent rating agencies and pricing that was driven by bond traders. Documentation was static, unforgiving, and expensive. Service and personal relationships, long a distinguishing characteristic of many portfolio lenders, took a back seat to efficiency and market forces.

Also, although there was a seemingly endless stream of buyers for the highly rated tranches of CMBS certificates, the lower-rated and unrated strips had a more limited market. To the rescue came a newly created security, born of the marriage of the REIT and CMBS boom: The Mortgage REIT Most of these new, nonregulated entities were formed to originate securitizable loans, issue CMBS certificates, and purchase high-risk tranches of CMBS certificates. Acquisitions of these high-risk tranches, with yields of 15-25%, were financed with high-leverage repurchase agreements (meaning that the buyers were essentially collateralized borrowers) and provided tremendous returns to equity. …

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