Why Now Is a Great Time to Become a CRE Lender

What would you do if you won the lottery? My wife and I have speculated about this, and we’ve always been pretty much in agreement (travel, a big loft in a major city, more travel, etc.). We haven’t played this game lately, however, because now I want to buy a bank and specialize in CRE lending, which is a goal I can tell she is not enthusiastic about.

To be clear, now is not a good time to have been a CRE lender. From Jeff Bernstein post on Urban Digs, “Holes in the Dike”:

According to Globe Street, Realty Finance Corp. has sold an original $47 million loan on a Class A office building at 250 Montgomery Street in San Francisco for approximately $25MM. The building was reportedly only 55% occupied, so obviously debt service by the borrower, Lincoln Property Co., was an issue.

I do not want to be Realty Finance – I want to be the bank loaning to the buyer. Jeff continues:

What we have to do is look ahead at how the new owner of 250 Montgomery Street is likely to act. The new owner has not been disclosed in this case, but is said to have been another real estate private equity firm. This firm now has a great new basis cost in the building and lots of incentive to be aggressive in getting it leased up. This is the transmission mechanism whereby lower rents are enabled in a market due to distressed properties being turned over at a much lower prices. It just doesn't take a lot of this kind of activity in a soft market with high vacancy rates to crush rents.

The most secure loans are loans where the real estate has plenty of upside, and the only real estate with upside these days are deals which have a low basis compared to the rest of the market. Those are the loans I want to make.

There are other reasons for lenders who have not previously done CRE lending to jump in now:

• Spreads are really good. Borrowing at 1-2% and loaning at 6-7% is a nice business.
• The most important rule in CRE lending is to loan to people who have experience in the property type and their market. By definition, those people already have lending relationships. However, many of those relationships have been disrupted as lenders have pulled back, and the lenders that remain are generally not known for their customer service. Imagine half the NFL teams disbanded over the summer; there would be a lot of talented players looking for a new home. Now is a great time for a smart, customer-focused bank to pick up some great free agents.
• CRE lending is relationship oriented, and the relationship is between the borrower and the loan officer. Loan officers are in the same position as the borrowers described above; many are twiddling their thumbs because their employers have pulled back. Now is a great time to build a team of high producers who have established client networks. The same is true for other necessary talent (underwriters, processors, etc.).

Of course, I’m not likely to win the lottery, especially since I don’t play (you probably knew that if you follow this blog). My wife does play, but if she wins I’m pretty sure we will not be buying a bank. However, some people are going to take this opportunity to jump into CRE lending and do very well.

After the Honeymoon: Trusting Loan Brokers

Should a loan broker who has established a successful relationship with a lender be trusted by that lender? Not according to research by Mark Garmaise, a finance professor at UCLA Anderson (working paper “After the Honeymoon: Relationship Dynamics Between Mortgage Brokers and Banks”). From a July 6, 2009 Financial Times story on the research:

The financial industry’s vaunted belief in trust and long-term relationships is being challenged by research showing that before the crisis US mortgage brokers fed loans of deteriorating quality to the banks they did most business with.

By questioning the prevailing wisdom that dealing with well-known counterparties is more fruitful and less risky than venturing into new relationships, the academic study puts in doubt one of the banking sector’s most enduring beliefs.

The key findings of the study:

• The quality of the loans submitted by the broker deteriorates over the course of the relationship
• The volume of loans submitted grows even as the quality deteriorates
• The effect is stronger for geographically distant brokers
• Even though the bank’s ability to evaluate the quality of the broker’s loans increases over time, the bank is increasingly reluctant to terminate the relationship.

It’s easy to dismiss this as a problem unique to loan brokers, but what if it’s true in other situations where initial monitoring is high and then relaxed over time? For example, the first few times you use a new appraiser you might carefully scrutinize the work. Do you need to do that every time, or can you relax? It’s a big enough topic for a separate post, but I think the answer (for commercial real estate, at least), is to check the key elements every time, no matter who you’re dealing with. Finley Peter Dunne had the right idea: “Trust everybody, but cut the cards.”

Rising Markets Create Lender Losses

People anticipate the future will be like the past. From a DNA article, “Why Economists Can’t See a Recession Coming”:

Robert J Barbera, chief economist, Investment Technology Group, in his book The Cost of Capitalism -- Understanding Market Mayhem and Stabilizing our Economic Future, writes: "Since the economy is not in a recession 80% of the time, the safe strategy is to predict recessions only when they have already arrived! That means you're right 80% of the time. Simply put, forecasting the recent past is the way to go and it is the dominant strategy employed by professional forecasters…Most of the time, tomorrow bears a close resemblance to yesterday. After all, both industry and economic trends tend to last for years, not for days. Once we acknowledge that we confront a world of pervasive uncertainty, it is quite reasonable to decide until circumstances change, we will plan as if present circumstances are likely to persist."

This approach to forecasting guarantees lenders will take losses. If you don’t say no when markets are rising, you are certain to have significant exposure at the top of the market which will create losses when the market softens. This time around, although everyone knew at an intellectual level that home prices could go down, the long term trend of rising house prices made it easy to justify rating models and lending decisions which didn’t adequately weight this possibility.

“Evidence” on the Foreclosure Crisis

Stan Liebowitz, an economics professor at University of Texas, Dallas, has an op ed piece in the Wall Street Journal touting the results of research he has done using “a huge national database containing millions of individual loans”. His conclusion:

The analysis indicates that, by far, the most important factor related to foreclosures is the extent to which the homeowner now has or ever had positive equity in a home.

My first reaction was, like Barry Ritholtz, “Duh”. If you have equity in your home and can’t pay your mortgage, you sell the home, pay the loan off and pocket the equity. Equity = No Foreclosure.

But, (as Barry also notes), the piece is weird:

A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures.

Time out; that means 53% of all foreclosures are on homes that have equity. Does that sound right to you?

The accompanying figure shows how important negative equity or a low Loan-To-Value ratio is in explaining foreclosures (homes in foreclosure during December of 2008 generally entered foreclosure in the second half of 2008).

I think these are all legitimate contributing factors, but I question some of the conclusions Liebowitz draws. For example:

To be sure, many other variables -- such as FICO scores (a measure of creditworthiness), income levels, unemployment rates and whether the house was purchased for speculation -- are related to foreclosures. But liar loans and loans with initial teaser rates had virtually no impact on foreclosures, in spite of the dubious nature of these financial instruments.

Anyone involved in the crisis can tell you the liar loans and low teaser rate loans were the first to default. You wouldn’t expect to see many of them left by the second half of 2008 (survivorship bias at work).

Also, this a very mixed bag of contributing factors. Negative equity is a factor at the time of default (do I sell the property or allow it to be foreclosed?). A low down payment and a low FICO score are factors at origination. The unemployment increase in 2008 and rate resets happen after origination and before foreclosure. If I’m a low FICO score borrower with a low down payment, a rate reset, no equity, and I lost my job, what caused my foreclosure? Regression analysis can parse out the first four variables if done correctly, but how does the fifth variable enter into the equation? I suspect Liebowitz’s analysis is flawed, especially since he concludes more than half of foreclosed properties have equity.

Hoping for some answers, I checked out Liebowitz’s home page. There’s no reference to this research, and precious little on real estate at all (mostly copyright stuff). If one uses the word “evidence” in one’s title, shouldn’t the evidence be available?

I agree with many of Liebowitz’s conclusions, but it would be nice if they were coherently supported. Also, it’s depressing that some many bloggers have uncritically endorsed the piece without question.

Mortgage Modification Blues

The New York Times article "Paper Avalanche Buries Plan to Stem Foreclosures" documents the logistical nightmare of processing single family mortgage modifications. An excerpt:

A note in the system shows that the bank confirmed receiving documents on April 29 — pay stubs, tax returns, a letter disclosing her hardship, bank statements. Since then, the company has been waiting for WaMu to review the file.

But when Mr. Lavi calls, a representative coolly discloses that the application has been rejected because one document, a proof-of-insurance form, is missing. He must start over.

“The file had been submitted properly, and you didn’t put the pieces together,” Mr. Lavi says, his body quivering with anger. “I’m not going to stand in line again for another six months.”

He demands to speak to a supervisor, but the representative says none is free. He hangs up and redials, hoping to land in a different call center. Eventually, he reaches Chase’s executive offices, where Becky takes over the call.

“We’re not taking cases now,” she says calmly.

“Why was I transferred to you?” Mr. Lavi asks. Becky does not know. He implores her to keep the file open while he faxes in the lone missing document.

“Impossible,” she says, warning of “the sheer amount of papers coming in.”

So, to get a modification on a WAMU (now Chase) loan, you need pay stubs, tax returns, and bank statements? Contrast that with the process of getting the loan in the first place, as reported in the New York Times piece, “Saying Yes, WAMU Built Empire on Shaky Loans.” An excerpt:

As a supervisor at a Washington Mutual mortgage processing center, John D. Parsons was accustomed to seeing baby sitters claiming salaries worthy of college presidents, and schoolteachers with incomes rivaling stockbrokers’. He rarely questioned them. A real estate frenzy was under way and WaMu, as his bank was known, was all about saying yes.

Yet even by WaMu’s relaxed standards, one mortgage four years ago raised eyebrows. The borrower was claiming a six-figure income and an unusual profession: mariachi singer.

Mr. Parsons could not verify the singer’s income, so he had him photographed in front of his home dressed in his mariachi outfit. The photo went into a WaMu file. Approved.

Proper underwriting (of new loans and modifications) is labor intensive. Most servicers never had the proper underwriting infrastructure in place to originate the loans, and they certainly don’t have it now that those deals need modifications.

More at my post, “Why Did WAMU Abandon Underwriting Standards?”

Five Underwriting Issues Which Kill CRE Deals

I have an article in the July, 2009 commercial edition of Scotsman Guide which talks about five underwriting issues CRE lenders are focusing on, and which frequently kill deals in this environment:

• Upcoming loan maturities on the Sponsor’s other deals
• Sponsor liquidity
• Sponsor exposure to distressed loan types (e.g. condo construction loans)
• Lack of Sponsor experience in the market and/or property type
• Project dependence on tenants in a weak industry.

The link may take you to a free registration page…

The Commercial Real Estate Landslide

Disasters are interesting, as evidenced by the success of shows like Destroyed in Seconds (30 minutes of one disaster after another, courtesy of the Discovery channel). A while ago the show aired this video of a landslide in Japan:

The images have stuck with me, and I think there are some strong parallels to what is going on in commercial real estate:

• First and most obviously, a disaster is going on, and if you’re in its path it’s a very bad thing.
• As bad as it is for those to be caught in the path, it’s important to realize the whole mountain is not involved. The landslide affects only a portion of the exposed area of the mountain – most of the mountain remains unchanged.
• The earth in the landslide moves from an unstable position to a stable position.

I was reminded of these facts while visiting with a very experienced real estate investor last weekend. I’m guessing he was in his 70’s, and had some money in a development deal that has a poor prognosis. In this CRE landslide he is going to lose a small portion of his net worth in an unstable deal which was exposed. But, he is confident he will buy other people’s exposed deals at stabilized, lower prices which will recover his losses and more over time.

It’s easy to forget that most CRE is not actively traded, is not fully leveraged, and is owned by people with substantial resources who are looking forward to buying busted deals.