The Father Of CMBS Says We’re In ‘Uncharted Territory’ When It Comes To Valuing Real Estate

enAugust 27, 2020

Odd Lots

Podcast Summary

Identifying Opportunities Amidst Crisis in Commercial Real Estate: The commercial real estate sector faces challenges, but past crises have led to significant innovations like CMBS, and Principal Asset Management looks for opportunities in public and private equity and debt.
Periods of economic crisis can lead to significant innovations in the financial system. Principal Asset Management, a real estate manager, leverages a 360-degree perspective to identify compelling investing opportunities across public and private equity and debt. The commercial real estate sector is currently facing intense challenges, and the question is whether this will lead to new innovations or a reevaluation of the system as a whole. Looking back, the invention of commercial mortgage-backed securities (CMBS) in the 1990s addressed a capital shortage in the commercial real estate sector following the savings and loan crisis. Ethan Penner, the father of CMBS, joins this episode to discuss the current state of the commercial real estate industry and potential opportunities for innovation. The future remains uncertain, but history suggests that crises can bring about meaningful change.
The Early 1990s Real Estate Crisis and the Birth of CMBS: The real estate industry's heavy reliance on debt financing led to a crisis when traditional lenders pulled back. CMBS emerged as a solution, born from the securitization process's success in the bond market. Despite challenges, it brought public market participation and led to the growth of REITs and traditional financial practices.
The early 1990s commercial real estate industry faced an existential crisis when traditional lenders pulled back from financing, leaving many borrowers without a way to refinance maturing loans. This crisis was unique because real estate was heavily reliant on debt financing, and the industry was largely untethered from the public markets. The CMBS structure was born out of this need, as the securitization process, which had grown significantly in the bond market, was well-suited to fill the financing gap. However, introducing a new concept like CMBS was not without challenges, and it required convincing various stakeholders to embrace the change. The crisis highlighted the importance of public market participation in the real estate industry and led to the growth of REITs and more traditional financial practices.
Regulatory reactions exacerbated the financial crisis in the late 1980s and early 1990s: Regulatory reactions caused a sudden withdrawal of capital, leading to a desperate industry and the birth of CMBS. However, CMBS inflexibility can exacerbate borrower payment difficulties during economic downturns.
The financial crisis in the late 1980s and early 1990s was exacerbated by regulatory reactions that led to a herd mentality among lenders. Regulators, reacting to perceived risk, caused a sudden withdrawal of capital from the real estate market, leading to a dramatic unwinding of the bubble and immense losses. This reaction, driven by regulation, abandoned the industry and created a need for new financing methods. Today, a significant portion of commercial real estate is financed through private investors in the CMBS market. While CMBS was born to deliver capital to a desperate industry, its imperfections become most apparent during challenging times, like economic downturns. The unique challenges of CMBS, which are similar to those of bond market financing in general, include inflexibility when borrowers face payment difficulties. These challenges are particularly relevant in times of crisis.
Challenges of Fragmented Bond Financing Ownership: Borrowers face hurdles in negotiating loan adjustments due to fragmented ownership and the incentives of special servicers to prolong issues
In the context of bond financing, the fragmented ownership of loans can create significant challenges for borrowers. Problem number one is the lack of a single point of contact for negotiations and restructuring, making it difficult for borrowers to make appeals for loan adjustments in the best interest of all parties involved. Problem number two is the incentive for special servicers, who represent bondholders, to prolong problematic situations rather than resolving them quickly due to their fee structure. These issues can hinder effective communication and decision-making, potentially harming the value of the collateral and the interests of all parties involved.
Complexities in CMBS market create challenges for valuation: The CMBS market's fragmented ownership and conflicts of interest make it difficult to enforce liens and protect investments, leading to distressed debt opportunities and uncertainty in commercial real estate valuation.
The current commercial real estate market, particularly in the context of CMBS (Commercial Mortgage-Backed Securities), is complex and fraught with challenges. The fragmented ownership of loans in bond form can create conflicts of interest, limiting the ability to enforce liens and protect investments. These issues, while not unique to CMBS, can lead to distressed debt opportunities. The renegotiation of leases and other dynamics, such as overwhelmed special servicers, make it difficult to predict valuation resets and establish values for many commercial real estate assets today. With uncertainty around the viability of many properties and the timing of their recovery, valuing commercial real estate is nearly impossible at this stage.
Retail real estate in a state of uncertainty: Retailers and landlords face renegotiations, legal system to play a role, uncertain future due to pandemic, focus on helping those in need, foreclosures and new ownership for economic recovery
The current economic situation, particularly in retail real estate, is filled with uncertainty and tension. Retailers are struggling to renegotiate with landlords, while landlords are trying to renegotiate with lenders. The future of retail real estate is uncertain due to the impact of the pandemic and the lack of a vaccine. The legal system will play a role in resolving these issues, and there may be heightened litigation and bankruptcy filings. Historically low interest rates and easy monetary policy are providing some stability, but a bailout of corporate entities or wealthy individuals is not a viable solution. Instead, government resources should be focused on helping those most in need. The world should continue to function with foreclosures and new ownership, allowing for economic recovery.
Uncertainty in real estate valuations leads to market for transactions with price gap: Uncertainty in real estate valuations causes a price gap between sellers and buyers, but the availability of capital keeps a market alive.
Despite the uncertainty in real estate valuations, there is a market for commercial real estate transactions. However, there is a significant gap between sellers' asking prices and buyers' willingness to pay. The Fed's role as a backstop for various assets has resulted in limited selling activity, with only a few notable transactions occurring. The senior-most CRE bonds, which are considered reasonable credits, tend to be less affected during liquidity tightening. The tug of war between being imprudent and investing versus waiting for prices to drop continues, with sellers hoping for March prices and buyers seeking at least a 20% discount. Ultimately, the availability of money waiting to be invested and the desire of managers to deploy it creates a market, despite the high uncertainty.
Triple A spreads offer trading opportunity despite risky junior classes: Widened Triple A spreads present a trading chance, but junior classes with retail, office, and hotel risk remain wide and uncertain, influenced by money availability. Potential government debt increase could widen private sector credit spreads, impacting debt owners and potentially shifting losses to lenders.
Triple A spreads, which had widened significantly, presented a good trading opportunity due to their expected snap-back. However, junior classes with concentrated credit risk, particularly in retail, office, and hotel properties, remain wide and risky. Money availability is a major factor influencing spreads, with little loan money available for office, retail, and hotel projects. Looking ahead, the potential increase in government debt could lead to wider spreads for private sector credit as banks shift towards buying government debt. If this trend continues, it could result in significant losses for debt owners and a potential shift in the allocation of those losses between equity and lender parties. Overall, the real estate market's recovery trajectory and the impact on debt holders remain uncertain and worth monitoring closely.
Government Intervention during Economic Crises: During economic downturns, the government's role is debated, with some advocating for a free market approach and others believing significant intervention is necessary to prevent anarchy and mitigate societal consequences.
During economic downturns, lenders often face losses and may need to recreate value rather than enforcing their liens and taking over borrowers' properties due to their limited capacity to own and manage real estate. The role of the federal government during economic crises is a topic of debate. While some advocate for a free market approach, others believe that given the current societal dependence on government intervention, a significant federal response is necessary to prevent anarchy and help society avoid the worst consequences of a depression. The speaker argues that the massive government response during the 2008 financial crisis masked some of the natural symptoms of the depression but was the only viable choice given the societal dependence on government intervention.
Economic bifurcation: Boom vs. crash areas: The economic landscape is dividing into winners and losers due to regional responses to the crisis, leading to resource competition and potential societal changes
The economic landscape is undergoing a significant bifurcation, with some areas experiencing boom conditions while others face crashes. This situation, exacerbated by the anarchy of different regions responding differently to the crisis, is leading to a massive competition for resources and opportunities. Companies and wealthy communities are already moving to places with better physical safety and lower taxation, creating a downward spiral for struggling areas and an upward one for recipients of these movers. The future could bring dystopian cities and big questions about the role of the federal government in the United States. Ultimately, this competition will result in winners and losers, making it an intriguing time for those who enjoy playing the economic game. The government's response, along with the ongoing competition, will shape the economic and societal constructs of the future.
Understanding the complexities of urban real estate markets: Landlords navigate tenant relief and price discovery in a complex real estate market, with CMBS and private bondholders influencing lending decisions.
The current state of the real estate market, particularly in urban areas, is complex and requires a deep understanding of the various incentives and motivations of all the players involved. Ethan's insights into CMBS and the differences between traditional lending and having a group of private bondholders provided valuable perspective. With tenants needing relief during these uncertain times, landlords must navigate renegotiations with lenders to keep their tenants afloat. Price discovery is also complicated due to the lack of transactions. The new Money Stuff podcast, featuring Matt Levine and Katie Greifeld, promises to delve deeper into Wall Street finance and related topics, making it a must-listen for those interested in the financial world.

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