Commercial mortgage backed securities riding for a fall?

Real Estate Weekly, May 18, 1994

In the past 18 months, dozens of companies have rushed to set up commercial mortgage conduits, feeding mortgages to the Wall Street investment banks that are now packaging them into Commercial Mortgage Backed Securities (CMBS). These securities have found unprecedented favor, particularly with institutions hungry for securitized real estate investment. But as the pace of this securitization increases, so does the danger to investors.

"The problem is there isn't enough high quality mortgages to satisfy the demand," says Jerry Swartz, a principal in Pergolis Swartz Associates, one of the best known commercial mortgage brokerage firms in New York. "Mortgages of lesser quality are being packaged as though there were no substantial difference."

The root of the problem, Swartz argues, is that neither the Wall Street investment banks nor the rating agencies understand the underlying real estate well enough to make the distinction. Yet the fees involved in securitizing and re-packaging the loans as CMBS's are sizable, making them an extremely popular product to sell.

"Those of us who have been around long enough to remember the debacle of mortgage REITs of the 1970s and the S&L crisis of the 80s have all too clear an understanding of what can happen when a market like this overheats," added Richard Pergolis, also a principal in Pergolis Swartz Associates.

"Because huge fees are generated up front, the issuers are hot to find ever more product to package," he continued. "The rating agencies are willing to put their stamp of approval on the newly minted securities and investors plunge in head first. Then the inevitable happens. There simply aren't enough good properties to fill the demand, so Wall Street, never scrupulous about understanding the underlying real estate, accepts ever lower quality mortgage product into the conduits and pushes it into the hands of investors. It can't be long before the house of cards comes tumbling down."

Pergolis notes that the commercial mortgage market has, in fact, become relatively healthy in the last year, with more loan money available for commercial real estate than has been the case since before the recent recession. But a new debacle in commercial mortgage backed securities could derail the general recovery of the debt market, making it harder for properties to obtain the financing that is essential to a more normalized real estate market.

"I would be wary of this fad for CMBS's," summed up Swartz. "It has taken us a long time to see the debt market recover from the abuses of the past. No real estate investment, whether in bricks and mortar, mortgages, REITs or securitized vehicles of any sort, can be looked at without an understanding of the basic underlying economics of the real estate. Investors who recognize this have always done well. Ones that don't, well, they've paid a stiff price."