Prepare for reorganization in commercial mortgage industry

Real Estate Weekly, March 21, 2001 by Frank Scavone, Joseph Heil

The commercial mortgage industry may be poised to realize a fundamental transformation for the better -- in particular, through key changes in the underwriting and origination processes. These changes will eliminate the glaring inefficiencies that many other fixed-income markets recognized and eliminated long ago.

Today, the commercial mortgage origination process suffers from two structural flaws that undermine value. First, traditional lending practices require lenders to manage the collateral validation and valuation process. Second, the process forces lenders to offer prices long before essential underwriting and due diligence tasks are complete. These process characteristics impose unnecessary burdens on all the participants in the lending process, increasing the cost of investment in commercial real estate debt.

In the first stage of any commercial real estate borrowing, borrowers will typically retain mortgage bankers or brokers to guide them through a complex underwriting process that will vary from lender to lender. These bankers and brokers then shop the proposed deals to a restricted circle of lenders usually obtaining "soft" quotes, which typically represent nothing more than non-binding expressions of lender interest. If a tentative quote is attractive, then borrower and lender proceed to a formal application.

This first stage in the commercial mortgage process constitutes a premature action that is unsatisfactory and inconclusive for both parties. The mortgage banking team is often presenting preliminary deal portraits that do not address issues that could potentially raise the cost of the financing. The lenders, in turn, cannot offer binding prices, because they lack critical information that must be authenticated by exhaustive due diligence arid independent third-party evaluations.

The first stage is also lengthy and expensive. It takes weeks to complete, and frequently alters the terms lenders are willing to offer. To hedge the risk of unaffordable pricing, borrowers sometimes initiate loan applications with several different lenders, and must bear the added costs of pursuing multiple applications. Borrowers must supply the same information in differing forms as they respond to each lender's requests for credit information, appraisals, environmental impact assessments, site and engineering inspections, zoning and building compliance, property insurance, legal issues, and more. And they must endure these redundant costs with no guarantee that they will receive the market's best loan terms and price. Given the current organization of the industry, where mortgage bankers and brokers work through personal relationships with small groups of lenders, loan quotes may be driven more by the limited nature of the mortgage banker/broker relationship than by open and efficient competition. If off ered unsatisfactory terms, borrowers have little choice but to proceed given their high investment in the process or time-sensitive refinancing or acquisition deadlines.

Lenders are in an equally unsatisfactory position. They must maintain large staffs of highly paid professionals to screen the numerous deal inquiries they receive. In addition, they must bear extensive due diligence costs for all the deals they decide to pursue, even though the prospective borrowers are in no way committed to proceed. As a result, overall origination costs are high and success rates are low. Lenders will generally close less than five to ten percent of the deal inquiries they screen. The combined length of due diligence and commitment negotiation is typically four to six weeks. Lenders have committed to pricing terms or take business reputation risk in changing these pricing terms during this period.

Any successful reorganization of the commercial mortgage industry must take into consideration the evolution of mortgage banking and brokerage firms. Historically, the commercial mortgage broker industry has been relationship-drive, and origination practices have placed a premium on the knowledge and skills of individual brokers. Mortgage brokerage firms are experiencing a fundamental transformation in their institutional environments. Individual brokers have historically derived three principal values from their associations within large firms: access to major lenders; access to market information, and the support of a corporate infrastructure (offices, communications systems, computers, analytical support and administrative assistance). Recent advances in information and communication technology, particularly the rapid growth in electronic "distribution channels" and the range and depth of content accessible though the Internet, as well as the rise of non-traditional lenders (in the form of conduit lenders ), have already changed the dynamics of the broker/lender relationship. Access to information is already available and often free. Moreover, advances in personal technology, including the many affordable applications available for personal computers, provide many of the support functions once supplied by the firm.