Commercial Real Estate, CMBS and the Free Market

In the early 1990’s I created the CMBS industry to fill the single largest unmet need in the history of the U.S. real estate market. Literally all lenders had abandoned the business simultaneously, thus threatening every single owner with the risk of massive if not total loss.

The idea was simple: apply the same securitization technology to real estate as had already been applied to the residential mortgage industry. The challenge involved persuading all of the skeptics who needed to come aboard; including bond buyers, whose capital would effectively fund loans, and the rating agencies, who were the gatekeepers to the bond market.

CMBS took off and grew to become an important part of the landscape of the real estate finance marketplace, growing to a peak of more than $700B outstanding. It’s contributions to the industry and the overall economy exceeded even its size as it moved the previously arcane real estate lending industry straight into the mainstream capital markets, which facilitated rational pricing based upon relative value considerations. It also bolstered the consistency and depth of capital availability for real estate owners, which helped to cushion the industry’s historical dependence upon regulated pools of capital that can come and go quickly and in herd-like fashion.

There were some fault lines in the structure that was introduced back in the 1990’s, but that moment of complete systemic breakdown required a speedy response. Over time, as cyclical downturns occurred in the capital markets and the CMBS model was tested, its flaws became apparent for all to see — at least all who were paying attention. The most severe test came in 2008, as the Great Financial Crisis unfolded. At that time, it became clear that many loans were included in these pools of securitizations that were just not that good. The loan originators — with no skin in the game — had included loans they probably would not put their own money behind, and the rating agencies failed in their role as the credit risk safety net for bondholders. But this flaw proved to not be CMBS’s most fatal one.

There was another structural problem having to do with how the CMBS system resolves non-performing loans, that has continued to shrink the CMBS borrower pool, making CMBS smaller each year and with generally diminishing credit quality that is the result of adverse selection. The issue has to do with how borrowers and lenders resolve problems. For real estate borrowers who borrow from portfolio lenders, say banks or insurance companies, or private credit funds, if something goes wrong with the property the borrower knows exactly who to call. In these instances, the borrower deals with a party who has a similar incentive to get the property performing again as best and as soon as possible. While the lender clearly has the ability in such cases to foreclose, most lenders understand the benefit of avoiding friction costs and of dealing with matters rapidly, rather than quarrel, during which time a property typically decays as a result of neglect. Nothing is more harmful for the value of a property and the ultimate financial outcome for all constituents than uncertainty and the passage of time in these distressed and challenging moments. Sadly, because the CMBS process involves carving up loans into many disparate interests, CMBS borrowers have no “lender” to talk to in these situations.

As it turns out, the party they must speak with is a company called a Special Servicer, who generally also operates a fund which might have acquired and owns the junior-most portion of the securitization, also called the “B-piece.” There are a small handful of companies involved in this business of Special Servicing/B-piece ownership. In most years, with few defaults to deal with, these companies are rather thinly staffed. However, in the troubled years like 2008 or 2020 when many loans turn bad, they must ramp up their staffing quickly in order to simply field the calls from troubled borrowers. This scenario inhibits their capacity to be appropriately responsive. Further, they get paid a fee for as long as loans are in “Special Servicing,” therefore a quick resolution means a shortened fee stream for them. This places them fundamentally at odds with the parties they find themselves in the middle of — bondholders and borrowers.

The point of this is not to demonize the Special Servicers, who are just playing by the rules of the game. Perhaps the rules ought to be changed, but that can be a discussion for others at a later date. Today there are many hotel and retail property owners in default on their CMBS loans, and there is a bi-partisan bill in front of Congress that, if passed, would provide special aid to these borrowers. It is bad legislation and wrong, plain and simple. The real estate industry learned very well in the GFC that if you borrowed through the CMBS format and ran into problems you’d have no one to deal with and you’d be very frustrated and impaired.

Over the succeeding decade, many would-be CMBS borrowers shunned that path in favor of portfolio lenders, often paying a higher price or borrowing less in proceeds and thus forced to invest more in equity in their deals. Borrowing from the CMBS system became a forum for mostly the greedy and risk-loving, or the clueless, none of whom deserve a bailout. Commercial real estate is a game for professionals and governmental aid ought to be reserved for segments of our society that are in real need. CMBS borrowers are corporate entities or wealthy individuals who should have known better and who took risks they must now pay for. These businesses should be allowed to fail.

This is the nature of a free market — it rewards and punishes. The employees of these companies can also learn a valuable lesson to be more scrutinizing as to with whom they invest their trust. These citizens can be better supported by direct aid from the government rather than channeled via to their (failed) employer.

Capitalism works when our government can maintain discipline and does not intervene to rescue failures. I think it is important to make it clear that I write this not as an opponent of CMBS, but as a huge proponent. A healthy and functioning CMBS industry bolsters our real estate industry, provides strong investment opportunities for investors, and buttresses our nation’s economic stability. The CMBS industry of the past must be reformed properly in order to fulfill this potential. Masking over its systemic weaknesses by rescuing borrowers with taxpayer capital, as the current legislative proposal recommends, would surely undermine the long-term of CMBS.


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