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Commercial real estate finance: The present day “Gordian Knot”

Louis Mirando
Mar 22, 2010

I left the commercial mortgage-backed securities (CMBS) origination industry four years ago when some concluded that that any income-producing property with a just a mere rumor of cash flow could qualify as a candidate for a loan securitization. Do not misread the motive for my departure … I am not that altruistic. I assumed it would be better to be a borrower than a lender in that scenario. Truth be told, the vast majority of professionals in the conduits were highly disciplined and their detractors have always exaggerated the alleged abuses. In fact, a new and improved form of securitization program is still is our best hope out the mess we now find ourselves in. The early CMBS pioneers got it right; its role can best be described as the prime force that rescued the industry shortly after the last commercial real estate depression of the late 1980s. The early vintage securitizations were primarily comprised of smaller- to mid-sized 10-year fixed-rate mortgages. Because most mortgages were originated at the bottom of the trough, they have performed well. Had we remained more focused in perfecting the conduits, much of the existing commercial finance crisis today could have been minimized. Of course, the industry would still be coping with a natural down cycle. In fact, back in 1998 shortly after the Russian default crisis, the CMBS business snapped back much faster than predicted. Ironically, during this temporary lull, would have been the ideal the time to perfect and nurture the traditional conduit business. For example, in 1998, my company, Transatlantic Mortgage (aka, Deutschebanc Mortgage), was the first loan origination conduit to purchase a significant interest in the “B Piece” off the securitization in which it contributed loans to. The theory was to align the profit incentive of the loan originator with the performance of the bond issue. Unfortunately, it was a practice not picked up on a then recovering industry. As many of the CMBS platforms recovered and became highly profitable, there were probably more than 30 of them by 2005, we turned over greater control and authority of the balance sheet to these operations. As global investment demand pressed further for products, the internal pressure built for expanding the scope of investment beyond the traditional fixed-rate loans. The goose that was laying the golden eggs, namely the conduits, were neglected. A once good thing that only needed timely oversight and incremental innovation became vilified as to be slow and marginally profitable. At best, it was a feeding gateway for larger exposures in the form of bigger and more complex transactions. As an industry, we unwittingly entered into practices we were ill advised to be in, such as bridge financing, construction lending and condominium developments, to name just a few. The need for investment distribution called for the invention of complex structures, such as collateralized debt obligations (CDOs), special investment vehicles (SIVs), highly structured syndicated participations in B notes and bifurcated mezzanines and preferred equity. Unlike the traditional fixed-rate conduits whose third-party industry organically grew to support the practice, these new investment endeavors far surpassed the industry’s capacity to support them. Unintended consequences resulted in a downturn of the market, thus dragging everything with it. The traditional fixed-rate CMBS business became a “baby drowning in the bath water.” The new battle cry … create volume, sell volume and it unfortunately resulted in structures that no one can understand how to unwind in the current meltdown. This carnage, which now seems irreparable and dire, may be the number one obstacle to the recovery of the commercial real estate market. A true Gordian Knot has resulted. The industry seems paralyzed and is left with a confluence of dysfunction: A special servicing industry in near collapse, a myriad of lender liability lawsuits, minimal liquidity, a demonization of developers and owners (who are probably one of our best hopes out of the mess), deteriorating assets, a ticking time bomb of losses that is only growing, a collapse of ancillary industries that have supported commercial real estate for the last 100 years. Namely, real estate attorneys, mortgage and real estate brokers, title examiners, appraisers, engineering firms, construction personnel, accountants and diligence firms continue to wilt and are the real human tragedy. Perhaps the most egregious result is an unwillingness to recognize that a continued status quo policy of putting off losses may cause a 21st Century Great Depression. The solution is clear, albeit a painful one. The Gordian Knot cannot be methodically untied or legislated away. A bold swoop of the sword is necessary. The way out: Quickly rebuild a new and better CMBS industry with emphasis on aligning interest and performance. There is no debate that CMBS was an effective weapon in ending the Resolution Trust Corporation (RTC) mess of the 1980s and 1990s. Embrace the entrepreneurial forces of profit. First, there must be an industry consensus that bold action is called for; those clinging the status quo should be at least, at a minimum, prevented from being obstacles to the new incarnation of CMBS. The federal government must stop propping up institutions, get out of the way and let them fail, thus resulting in the emergence of better capital stewards. Allow orderly liquidation of underwater loan assets, including special servicers stepping up their foreclosures and also allowing discounted payoffs from existing borrowers, as this will all lead to a flourishing transactional business again, creating tens of thousands new jobs through a multiplying effect. Early CMBS was the embodiment of “The Mother of Invention,” as in competent hands, it can become the sword we need. Its role in creating liquidity in the days of the RTC cannot be denied. The sooner this happens, the sooner things will recover. I still hold these truths to be self evident: Value equals income divided by cap rate. A safe loan can be underwritten at a 1.25 times debt service on actual income. A well-underwritten commercial mortgage is still a good asset and plays an important part in a capitalist society. This doesn’t require bond math. There are thousands of fine and competent professionals ready in the industry who can swiftly design the sword necessary to cut the Gordian Knot. Let’s get on it while there is still time. Louis Mirando is co-founder of TransAtlantic Capital Advisors LLC based in New York, N.Y. Louis has more than 25 years of commercial real estate finance, acquisition, disposition, brokerage and development experience in $10 billion-plus worth of real estate transactions nationwide.
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