Reproduced with permission from Real Estate Law & Industry Report, 4 REAL 580 (Aug. 9, 2011). Copyright 2011 by The Bureau of National Affairs, Inc. (800-372-1033)
When Stephen R. Blank left investment banking in the late 1990s to the become a senior resident fellow at the Urban Land Institute, he brought with him his expertise in and his respect for real estate finance, but he also brought his impatience. In a recent conversation with BNA’s Richard Cowden, Blank airs frank concerns about what he considers a tendency in the real estate sector to disregard warning signs when the economy and property fundamentals begin to soften. Here he offers some candid views on policies designed to curb excessive risk and on the industry’s reluctance to ‘‘get rich slow.’’
BNA: As I recall, you came to the Urban Land Institute from Wall Street, isn’t that right?
Blank: Yes, I had been in investment banking from the early 1970s to 1998, when I retired, and during my career, I focused on real estate finance.
BNA: Do you now have a more neutral view of the issues surrounding real estate finance than you did when you were in the investment banking business?
Blank: I don’t know if it’s neutral, but the one great benefit I have in being a senior fellow is that I have a little more time to think about issues. I look at them on a longer-term basis rather than being on the firing line. You had to deal with problems much more quickly [on Wall Street]. There was less time to focus on the issues. That said, what investment bankers have proven themselves to be really good at is focusing an incredible amount of resources with laser like precision on a problem and developing some unique financial solutions.
BNA: You seem to have a certain respect for their talent, right?
Blank: Absolutely.
BNA: Do you think the real estate sector caused its own problems in the most recent downturn, or was it inevitable, given the larger context of the recession?
Plenty of Blame to Go Around.
Blank: That’s a really tough question. You know, when you look at the financial crisis, I think there’s enough blame to go around and it doesn’t matter whether you start with the mortgage broker who sold somebody the wrong product or the speculator who thought that he could basically flip condos like a day trader during the dot com period, or the financial institution that allowed that person speculating in single-family homes—to have as many as 12 mortgages—to accumulate those mortgages, do no due diligence and sell them to a commercial bank or some other financial institution. And those institutions certainly did no due diligence before selling them to Wall Street, which sliced, diced, and priced them and gave them to the rating agencies, who obviously didn’t do a substantial amount of due diligence. And then there were the eventual buyers who basically said if it’s got a triple A or a double A wrapper, it’s okay. You know you’ve got a responsibility if you’re an end buyer to do some homework. The buyers of these securities are not individuals; they are institutions.
Now, that is the single-family subprime side of the ledger. Certainly, if you look at the commercial side, the tipping point was those 34 days from hell between September and October 2008 when you had Lehman Brothers, AIG, Merrill Lynch, Countrywide, Wachovia, and Fannie Mae and Freddie Mac. You had seven 1,000-year floods in 34 days. All of the rules kind of got thrown out.
Some people might say it was inevitable. You had the combination of huge amounts of equity trying to get into the real estate space, incredible amounts of debt finance available in a very low, highly competitive market. You had underwriting standards that were—I won’t say misapplied—I’ll say being underapplied in a competitive environment so that 70 percent loan-to-value became 75 percent; 75 percent became 80 percent loan-to-value. You had all this mezzanine financing so that you could see a structure where the owner had only 5 percent of the money in the deal, the mezzanine guys had 10 percent, and the securitization model or the commercial bank had the other 85 percent.
Any time you divert from the long-term, historical norm in the real estate business, you have trouble. I was always told real estate was a get rich slow business. Any time someone tries to do it too quickly, they’ll have a problem.
BNA: That’s really what was going on, wasn’t it?
Blank: I’m saying there certainly was a combination of a whole group of issues.
BNA: Should the public have been able to expect more integrity in the way the real estate finance sector operated during the mid-2000s?
Blank: I’m not an expert on who’s licensed and who’s not licensed in the real estate sector. But people were being paid to produce volume. It’s very hard to assess blame in these types of things. That’s why I say a little bit of a pox on all their houses. Everybody did something wrong.
BNA: All right, let’s fast-forward to the Dodd-Frank Wall Street Reform and Consumer Protection Act. On the face of it, did Dodd-Frank legitimately address the factors that needed to be dealt with in commercial real estate finance?
Dodd-Frank’s Unfinished Business.
Blank: I don’t know if we know that yet. There is so much of Dodd-Frank that is unwritten and undiscovered. I don’t know the exact number of studies and rules to be done, but there was a huge amount of work to be done to create the infrastructure that would become the Dodd-Frank legislation. I think a lot of that has not been completed. I think the Volcker Rule is probably a good rule. I think separating proprietary trading from other parts of investment banks is probably a good deal. It would be smart to say you have the high-risk, or principal, side; you can have the agency, or lesser risk, side.
BNA: Were the changes in accounting and capital requirements warranted as it regarded real estate finance?
Blank: It’s hard to know how far you need to go to strengthen the banking system. I think anything you can do with the financial system that allows it to absorb stressful events and the risk of a systemic collapse is a good idea. I always wonder when everyone protests that this is going to reduce business or make it more expensive to get credit. The private market seems to adjust to these issues. I think people are protesting a bit too much.
BNA: They are being asked to change the kinds of behaviors that got us into trouble in the first place and they don’t like it. Right?
Blank: Right. It’s like the risk retention discussion on CMBS [commercial mortgage-backed securities]. On one side you have those who say the originators should keep 5 percent of the deal—vertically, horizontally, mix and match—I have my thoughts as to which is better. But at least they should have 5 percent skin in the game. Having the risk with the B-piece buyers I don’t think satisfies the requirement in my view. I think the guy who wrote the deal—who is getting the fee—should take some of the risk. Now there are accounting issues. There are all kinds of things that come up, but I believe in trying to leave some risk in the hands of the guy who made the profit.
BNA: It does sound like the industry does have some legitimate concerns about the new proposed rules, doesn’t it?
Kicking Cans of Loans Down the Road.
Blank: Look, the private market got way out ahead of itself in that 2005 through 2007 period. We are going to be dealing with a lot of that for a long period of time. We are going to have legacy refinancing, which everyone estimates at $300 billion per year through the middle part of this decade. Some of the articles have talked about it being substantially higher because that doesn’t include all the loans that have been rolled over. The can has just been kicked forward and those problems may or may not resurface, depending on where fundamentals, cap rates, and interest rates are in three or four years.
You could easily build a model showing that something that was financed in 2005 to 2007—assuming it’s going to come due from maturity or extension in 2015—could have a rent roll that’s possibly lower when it was originated while cap rates have nowhere to go but up. How are you going to roll over that loan? That’s the big question going on here.
BNA: We’re sort of in uncharted territory here aren’t we, as far as how to respond to these liquidity issues. We’ve never had this kind of situation facing us, have we?
Blank: Right. And what we’re not doing is making real progress on reaching a systemic solution.
BNA: Such as?
Blank: Getting these things done—not being in a position where we’re talking about solving these problems from 2008, 2009, 2010. We’re now into year four.
BNA: So we’re four years into this and we still have no clear strategy for refinancing all of these legacy loans plus making room to finance new growth, right?
Blank: Right. And we’re back financing at very historically low rates and we’re seeing some creep in financing proceeds.
BNA: When you say creep, are you talking about risk?
Blank: Yes. I mean what started at 60 to 65 percent loan-to-value in securitization 2.0 is probably up to 70 to 75 percent. What started as only income in place is now giving some credit for leases that are being papered. I’m not saying we’ve lost our way; we’re not quite as cautious as we were or should be.
Strong Rationale for Investing in Real Estate.
Blank: I can look at the future and see the rationale for investing in real estate today—relative value compared to other investments in terms of producing cash flow. Plus, people think inflation will eventually come back and real estate is a really good hedge against inflation. Fundamentals are finally starting to improve. You are able to invest at below reproduction costs in many instances.
And I can see the other side. Interest rates have no place to go but up. Interest rates go up, cap rates go up. The economy is recovering slowly. So, we need a substantial number of jobs before we start to move lease vacant space. Therefore, it’s hard to make projections of what income will be in a couple of years when these loans that you’ve had to push forward come due. You could certainly build a case that it’s going to be difficult to refinance these loans.
Right now, I just don’t see us making as much progress as we should in getting things solved. Look, I’m impatient. I probably still have an investment banker mentality, so I get nudgey.
BNA: It does appear that the CMBS market is recovering. I think you said recently that at least we know the plumbing still works.
Blank: When they started again in 2010 with some single borrower issues, it was a test. Then they started with some relatively small multi-borrower issues that were very conservatively underwritten. So I think that took the temperature of the market and checked to see that things were working correctly. But here’s my argument for why I say I think we’re getting a little ahead of ourselves. Supposedly there are 25 companies writing CMBS loans. Doesn’t that sound like a lot of companies for a business that this year is expected to produce $40 billion in gross volume. A, how can you be profitable? B, how do you win business? You know that financial institutions like JPMorgan and Wells Fargo are going to get a larger share of this business. One might argue that means people have to become more aggressive.
BNA: And that could set off the cycle we saw a few years again all over again, right?
Looking for Signs of Learning.
Blank: I don’t know. Part of my job is to raise the questions and put them out on the table and try to give a balanced view. You would like to think that some rational voices in the industry are going to join the discussion and speak up.
BNA: I know there are some people in the industry that are introducing a bit of perspective on the process. Don’t you think some of them have learned something from the last downturn?
Blank: I don’t think there is a question, but we’re not going to know the result of this imponderable for a while.
BNA: It sounds like you think this could go either way. We could either go right back into a troubled situation or we could right the ship.
Blank: I think there are a lot of things that are going to be in play. Everything is going to depend on jobs and the economy. When the guy said, ‘‘It’s the economy, Stupid,’’ I don’t think he knew it was one of the most prophetic things you could say.
BNA: Would you say that even when they get the Dodd-Frank rules all wrapped up, we are still going to be scratching our heads about this?
Blank: Yes, I would say so. And another thing—what have we done to solve the Fannie/Freddie problem?
BNA: I wasn’t going to get into that, but it’s hard to avoid, isn’t it?
Blank: Well, you know, there are three plans they’ve talked about. But there is actually a ‘‘fourth’’ plan; I call it the stealth plan because they are just going to kick the can down the road until after the next election. Unfortunately, that’s where it seems we’re going. I’d like to say we’re going someplace else, but I just don’t see a solution. I think the private markets are fully capable of developing the underwriting metrics to deal with it and substantially reduce the need for Fannie and Freddie.
Home Ownership Possibly More Expensive.
Blank:
It may be more expensive. Maybe it should be more expensive. Maybe not as many people will be able to have single-family homes. I’m not saying it’s not a great dream, but you’ve got to qualify people to get into the dream, and to make sure they have the right resources. You’ve got to have them buying things that make sense. Foreclosure is not a fair solution.BNA: Is it your sense that we have learned something from the mistakes of the mid-2000s and that we can at least avoid repeating the worst of what happened then?
Blank: I hope so. I don’t think you can say what we’ve learned and what we haven’t learned. We’ve got to practice it a little bit. Look, this was a much more confusing period than we’ve ever seen before. We’ve got economic issues in the United States. We’ve got financial problems in Greece, in Spain, and in other countries in Europe. This is a huge, global problem and our problems are interrelated with all of the others that are having trouble.
