The DCF Method of Analyzing Income Property Needs to Change

February 25th, 2012

By Bruce J. Coin
Director, Bruce Coin Consulting, Inc.

While much of the focus during the remainder of this year will be on the national election, it is clear that cautious optimism now abounds about an improving national economy.  Many, but not all, of the carefully monitored economic barometers are confirming a continued but modest growth. At their January meeting the “Fed” left interest rates unchanged and commented that “the expectation is that the fed funds rate will remain exceptionally low until late in 2014”. This bodes well for business and the commercial real estate industry that are substantially dependent on financing.  Consistent with their past promises of more “transparency” the minutes of their February meeting included a tremendous amount of additional information and some insight into board members thinking.

As the economy expands and commercial real estate again receives increased investor and lender attention, a real concern is the way that Discounted Cash Flow (DCF) analyses are being used to analyze income properties and estimate their values and internal rates of return or IRR. 

In the mid1980’s, appraisers, analysts and investors started using a 10 year income and expense analysis to estimate the value of an income property and its potential IRR.  The projection process became known as a Discounted Cash Flow Analysis or DCF for short. The 10 year period became the acceptable “norm” and was identified as the “typical holding period”, i.e., the assumed or estimated time period that an owner would typically retain ownership and operate the property before selling.

The ever increasing availability and use of computers and “canned” software programs such as the early Lotus and more recent Argus facilitated increased use of the analysis and permitted the analysts to perform their projections much more rapidly than by hand using a calculator. The problem is that no one has changed how these projections have been done for years.  I submit that it is now time to recognize that “garbage in” produces “garbage out” i.e. the reliability of a DCF analysis is only as good as the assumptions used to generate the analysis and the skills of its creator to properly direct the software to produce a product that is properly customized to the facts and forecasted information for the property. 

The benefit of performing a DCF, as opposed to using a single stabilized year approach known as “Direct Capitalization (using a “cap rate”) and capitalizing a “stabilized” annual net operating income into value, is that a DCF analysis permits its creator to consider and estimate virtually every income, vacancy, expense and capital item on a year by year basis over the forecasted “holding” period.  Typically a ten year forecast is generated although a DCF can be created and applied to longer and shorter time periods. In uncertain times a five year analysis may be more reliable.

One very significant problem associated with running a canned program to create and perform DCF calculations is often the un-admitted but true lack of more than a surface understanding of how to properly use the program by its author.  As a result, many analysts allow the program to perform any number of tasks without giving the amount of individual and meticulous attention and instructions that the case warrants. This is especially true after they have input the information for only the first year or two. When they do that the preprogrammed formulas take over and produce results that often are not truly reflective of the intent. 

In addition, these preprogrammed formulas and calculations often use built in averages, “blends” or standard formulas that have not been overridden by the analyst who is really the “programmer”. They don’t override them because they either do not know how or they don’t want to invest the additional time to seriously and more carefully think about some things that may occur in the 4th or 5th years or thereafter. 

To dramatize the impact of projecting that rents and expenses will all go up by pre-ordained, but hypothecated  percent per year, I have provided a brief and very simple basic example (due to limited page space) assuming that the annual real estate taxes and operating expenses of an income property are initially 45 percent of a property’s annual gross income. In many cases the taxes and expenses are more or less than 45 percent.

Escallation factor 3 percent per year:

Year  3 5 10
Gross Income:    $1,000,000 $1,030,000 $1,060,900 $1,125,550 $1,304,819
Taxes & Expenses:  $450,000 $463,500 $477,405  $506,479 $587,147
Property’s annual net income:   $550,000  $566,500 $583,495 $619,071 $717,147

Wouldn’t it be nice if all investments performed that way? 

The use of an Excel spread sheet, where line by line and year by year figures must be estimated and individually entered is probably a more reliable way to perform a DCF especially when the property is encumbered by multiple leases.  The process takes much more time that cranking out an Argus run after inputting first year or three year’s numbers and then asking the program to apply factors such as increasing the annual income and expenses by a given percent per year forever over the holding period.  

Going line by line in and year by year in an Excel spreadsheet forces the analyst to actually think more about the future actions of individual tenants, lease expiration dates, the impact and viability of any existing renewal options, tenant reimbursements/contributions, base year expense stops (where applicable) as well as annual real estate taxes, operating expenses and capital expenditures for such items as tenant improvements and leasing commissions to brokers to retain or attract new tenants.

I have recently informally reviewed the DCF analyses in the appraisals of over eighty income properties located in twenty seven states with a concentration in multitenant office buildings.  I have been astounded to see many commercial appraisers continuing to estimate that the rents and expenses of multitenant properties will still escalate year after year on a straight line basis over a 10 year holding period by using annual escallation factors of 2.5 to 5 percent in their DCF analyses.  They are obviously ignoring the lessons of the past 4 years as well as the post WWII history of economic recessions and practical economic theory.

Since WWII, recessions have occurred in this country in a range of every two to ten years with two and ten year hiatus periods being atypical.  Most occur every four to eight years and often close to national elections.  When recessions occur, property vacancy rates increase, rents go flat or actually decline while most operating expenses continue to increase. It doesn’t always take a national recession to have the same impact.  Changes in supply and demand can have the same effect in a community or even a region.  Overbuilding, employer relocations, technological advances, social change and other factors can often flatten rental rates and increase the vacancy of a particular property or group of properties.

For the past few years the way that most have been creating these DCFs appear to be merely based on an almost standardized and rote method of thinking but while many properties exhibit similar characteristics many are individually very different.  Accordingly, I submit that it is now time to recognize that how these forecasts have been performed needs to be changed.

My former company, Pro-gressive Mortgage Corp. was a mortgage loan correspondent and loan servicing agent for insurance companies and other institutional investors for thirty five years. Every year a servicing correspondent is required to inspect the property and review the annual rent rolls and income and expense statements for each and every property secured by the loans they service. A written analysis and report must be provided to the lender-investor. At one time we were servicing a portfolio of approximately $500,000,000.  Accordingly, we saw firsthand that;

  • in some years rents went up more than a property’s operating expenses
  • in some years a property’s expenses went up more that the rent increases
  • in some years a property’s market rents actually went down from what they had previously been able to obtain
  • many times the actual vacancy rates of a property changed significantly from year to year
  • no multitenant property’s annual income, annual expenses or net income all increased steadily from year to year

When a DCF is being created, prudence suggests (and I say demands) that it incorporate forecasts that do not simply project everything increasing at a rate of some hypothecated   percentage rate over the next 10 years but should reflect more sophistication that includes consideration of future economic downturns and recessions. Opponents to this intelligent and necessary change cite that when they make such up, up and away forecasts they are only mirroring what investors do and are replicating the actions of the market.  Personally, I don’t believe that excuse as I do not know any investors that would make such an unrealistic assumption over such a long period of time. Maybe that is because it really is their money they are thinking about and how future conditions and projections will impact their own money because they are not just providing an opinion to someone else.

Think about the foregoing and I believe you will agree that the likelihood of rents increasing steadily every year over a 10 year time period is literally ludicrous thinking.  If it were a valid assumption one would think that stock brokers would be telling customers to buy stocks because their dividends would increase every year by a pre-ordained percentage.  We all know how that message would be accepted so why has this past method of doing a DCF simply been accepted?

If you really want to test a DCF that was prepared for a multitenant office, retail or flex-industrial building, just incorporate a reasonable amount of mortgage debt service because they are all typically created without incorporating the annual debt service of a reasonable mortgage. They all assume an all cash (unleveraged) purchase and that all of the imminent and future costs of tenant finish and leasing commissions are paid out of annual cash flows. Depending upon the particular case, in some years they actually show a negative cash flow as the tenant improvement and leasing commissions exceed the annual cash flow. No explanation is given as to where the money to cover those costs comes from. In addition such a loss is not carried forward into the next year to be (potentially) absorbed by the next year’s cash flow. In years where that does not occur, the after improvements cash flow is often low enough that there is not enough to pay the annual debt service or if there is it doesn’t “margin” the loan sufficiently to meet the lender’s debt service coverage requirement.

What is necessary to really do one properly and on a more meaningful basis than the current practice is to incorporate a combination of up-front cash (reserve) to cover the imminent tenant finish and leasing commission costs as well as an annual on-going reserve to reasonably cover those future costs but they just don’t do it.

I guess the comedian W. C. Fields was right when he said that  “ there is a sucker born every minute”.  I have seen many less than truly sophisticated investors accept such DCFs and invest in a property only to lose their money because the property never could have performed to the level estimated by the DCF that was initially used to seduce their investment.

When I see such a forecast it makes me very suspicious and impacts the credibility of the projection and forecaster. Now, when you look at one, you can make your own decision, are you a sucker or not?

It really is time for them to change. If you are preparing one, make sure you change the way you do yours.

Will the Dodd Frank Act Be Watered Down?

January 3rd, 2011

By Bruce J. Coin

To me this year should be one that can be described as a transition year. The Federal Reserve is investing $600 billion to purchase U.S. Treasury notes in a plan, known as QE II, to help keep long term interest rates low to aid economic growth. The national economy should continue to grow slowly and unemployment should decline further. By year’s end we should look back and see that during 2011 we went from a slowly recovering economy to one that has recovered and is well on its way to being strong once again. The wild card that could affect that is any shock from rising oil and gasoline prices. But as much as I watch the economy I am also very concerned about how the requirements of the 2,319 page Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) will be finished, implemented and enforced. All of its aspects and requirements are to be in place and operational within 24 months of its enactment or on or about July 21, 2012. Some aspects are to be in place well before then.

The Dodd-Frank was signed into law on July 21, 2010 just under six months ago. Among other things, it was sponsored as “a bill to promote the financial stability of the United States by improving accountability and transparency in the financial system”. It was supposed to “rein in” the Wall Street firms including the rating agencies: Standard and Poor, Moodys Financial Services, Fitches and the seven other such agencies that are approved by the Securities and Exchange Commission (“SEC”).

Implementation and enforcement of the various provisions of Dodd Frank was left to regulators and thirteen new administrative boards, bureaus or offices. Even before its passage special interest groups and lobbyists were hard at work trying to convince those in power to minimize its impact on the areas they represent and they are continuing to exert pressure. 

In an attempt to protect purchasers of mortgage backed and other Asset Backed Securities (ASBs), Dodd Frank required sellers of ASBs (Wall Street investment banks, large banks and other issuers) to retain a minimum 5 percent interest in the ASBs they sell, i.e., to have “skin in the game” so that they would be somewhat responsible for and at risk, right along with the ASB purchasers, for the quality of what they sell.  The Dodd Frank provision that requires the retained interest has been named the Volker Rule after its advocate former Federal Reserve Chairman and presidential adviser Paul A. Volker.

An early sign that the intent and strength of the Dodd Frank would be watered down appeared when exceptions were negotiated to allow the sellers of “low risk mortgages” to escape the Volker Rule and avoid the need to retain the minimum 5 percent interest. The term “low risk mortgages” (perhaps “prime”) has not, as of this date, been fully defined.  There continues to be ongoing discussion and negotiations between bank regulators and the Treasury department about what will be deemed as a low risk mortgage. Among other aspects, negotiations include addressing how much down payment is required, if an interest only mortgage can be included and how long a borrower’s income must be verified. It appears as if a standard, first lien, amortizing residential mortgage that is the lesser of 80% of the purchase price or appraised value of a residential property (with insurance for amounts above 80%) and with borrowers that have demonstrated income sufficient to support such a mortgage will meet the definition. The majority of the basic residential mortgages in this country will meet that definition including those insured by the FHA.  For the present, jumbo, sub-prime, balloon, no doc and similar mortgages will not meet the definition of a low risk loan.  Apparently borrowers that qualify as a low risk mortgage will receive a slightly lower interest rate than those that do not as the lender/seller will not need to retain a 5 percent interest.  Reciprocally, that means that borrowers that do not qualify will pay a higher rate and lenders may even shy away from providing non-low risk mortgages which will adversely impact the supply of mortgage money.  In addition, and also of major significance, is the yet to be defined “low risk” commercial mortgage.  Remember that one defaulting $15,000,000 commercial mortgage is the equivalent of fifty $300,000 residential mortgages all going into default simultaneously.

Perhaps a more important sign occurred on July 22, 2010 only one day after the president signed Dodd Frank into law, when SEC Chair Mary Schapiro granted an initial six month waiver to the “expert” designation of the rating agencies. 

In earlier writings I explained that the rating agencies were escaping liability for their past improper (bad) ratings based on a pre-Dodd Frank exemption (to the Securities Act of 1933) that permitted them to avoid having their ratings opinions considered as “expert” opinions.  As their ratings were considered just “opinions” as opposed to “expert opinions” many of the law suits filed against them in the last two years have been dismissed.  However, some suits are still ongoing wherein the rating agencies defense has argued that their ratings were protected under the First Amendment to the Constitution (freedom of speech) but some courts have not agreed with that position. Dodd Frank removed the expert exemption making the rating agencies properly liable for their rating opinions. The removal of the exemption was designed to make it easier for harmed investors to successfully sue.

 It is important to point out and understand that immediately upon the passage of the Act, the rating agencies very publicly notified clients and debt underwriters that they were withholding permission to allow their ratings to be published on any debt issues.  Their immediate announcement indicating that they were unwilling to stand behind their own ratings and allow them to be published effectively shut down the multi-billion dollar registered securities debt market. 

That’s when Chair Schapiro promptly gave in to pressure and provided the rating agencies with the initial six month waiver thereby allowing pending and proposed debt issues to proceed. 

When the waiver was issued, Meredith Cross, director of the SEC’s division of corporation finance stated: “This action will provide issuers, rating agencies and other market participants with a transition period in order to implement changes to comply with the new statutory requirement (of Dodd Frank) while still conducting registered ABS offerings”. The SEC’s waiver was set to expire on Jan. 24

It is also important to remember that the Wall Street “Capital Markets”, prior to the financial/credit crisis of 2007-08, had become the largest single source of mortgage capital (RMBS and CMBS) in the U.S.  Consequently, Wall Street firms (for money making purposes), Fannie Mae, Ginnie Mae and Freddie Mac (for purposes of selling their securities) and even the federal government all see a strong return of the Capital Markets as vital and necessary for economic recovery and the best source of providing financing liquidity to the mortgage and other industries including credit cards, equipment financing and student loans.  The Federal Reserve’s Term Asset-Backed Securities Loan Facility, or TALF, sold billions of dollars low-cost asset-backed bonds, as rated securities, through the Capital Markets.

Conscious of the impending January 24th waiver expiration, in a little publicized announcement on November 23rd, the SEC INFEFINITELY EXTENDED THE WAIVER. 

In a letter posted on the SEC’s website and addressed to the Ford Motor Credit Company (issuers of auto loan backed securities), the SEC said it wouldn’t require the ratings information in bond documents “pending further notice.” The SEC said it was waiting for new rules in Dodd Frank for credit raters and ABS to be implemented.

In the letter, Katherine Hsu, an SEC senior special counsel, wrote: “We are doing this to facilitate our consideration of whether and, if so, how those final regulatory actions should affect the Commission’s disclosure requirements regarding credit ratings for asset-backed securities, while permitting registered asset-backed securities offerings to continue without interruption,”

“We are pleased,” said Margaret Mellott, a spokeswoman for Ford Motor Credit. “The SEC recognizes the importance of the public ABS markets, and we are glad the staff is ensuring the public ABS markets remain available.” I guess so.  Can you see the external pressure on the SEC?  But where is any indication or explanation that the SEC and the rating agencies have been working to find a solution?  I haven’t seen or heard anything about committees being formed or on-going negotiations between the SEC and the rating agencies to try to find a way to comply with the intent of the Dodd Frank Act and the expert exemption and it’s been five months.  Do we need to treat them like the employers with unionized workers and require binding arbitration? 

This indefinite waiver extension will allow the rating agencies to continue to behave as in the past with no concern for recourse of their opinions.  Until this ultimately plays out one can’t know for sure but my bet is that this provision of Dodd Frank that was really going to make the rating agencies be legally responsible for their opinions will be tremendously watered down before it is finalized.  I hope not as the Dodd Frank was supposed to rein in these rating agencies and removing the expert exemption was one good way to do that.

What has surprised me a little is that none of the seven other rating agencies has stepped up by providing ratings and assuming full responsibility for their ratings. There appears to be a real business opportunity there that is not being seized. The other seven Nationally Recognized Securities Rating Organizations are:

  • DBRS, a Canadian firm
  • Egan-Jones, a Philadelphia, PA based firm
  • A. M. Best Co, Oldwick, NJ
  • Japan Credit Rating Agency, LTD.
  • Rating and Investment Information, Inc. , a Japanese firm
  • LACE Financial of Frederick, MD was acquired 8/31/10 by Kroll Bond Ratings of NYC.
  • Realpoint, LLC., of Horsham, PA, acquired 5/3/10 by Morningstar Inc. of Chicago, IL
  • Maybe the acquisitions of LACE and Realpoint will lead to one or more of these “stepping up” to offer ratings that they will be legally willing to stand behind.  

    The elections this past November showed that the American public was displeased with the actions or non-actions of national, state and local political office holders. The Dodd Frank was highly touted and took a long time to negotiate.  If it continues to be watered down once again the congressional legislators, while appearing to have done something meaningful, will have put on a show and “passed the buck to others” that can ultimately result in its substance being reduced to having little benefit to the American people.  

    Where is the outrage at what is and is not taking place? I hope that our national press corps and other media start watching this closely and reporting as important news the actions of the SEC and the thirteen new administrative boards or agencies that were formed by Dodd Frank that are responsible for finalizing and enforcing respective provisions of the act. The Act requires most of its provisions to be finalized and in place within 24 months, i.e. by July 21, 2012.  With 18 months to go I hope everyone pays attention to what happens to the different aspects of Dodd Frank during the 12 months of 2011.  Think about what has occurred when you enter the voting booth next November.

    The Dodd-Frank Wall Street Reform and Consumer Protection Act and its Potential Impact on Commercial Mortgage Financing and Lenders

    August 22nd, 2010

    By Bruce J. Coin

    On July 21, 2010, President Obama signed into law House of Representatives Bill #4173 commonly known as the Dodd-Frank Wall Street Reformand Consumer Protection Act (“Dodd-Frank Act”). It was sponsored as “a bill to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail’, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.”

    Among other things, the Act is supposed to reign in lenders and Wall Street firms. The press and politicians have touted it as imposing “sweeping change,” but from an early read it does not appear to do all that much or go far enough.

    Much of the Act focuses on consumer protection, residential mortgage companies, “Wall Street” firms and the Federal Reserve. Implementation of the different applications will vary between 6 and 24 months (started July 21, 2010), and finalization and enforcement will be the responsibility of regulators and numerous new boards. Accordingly, it will be some time before it will be possible to understand the Act and its full impact completely known. Despite this, those in Congress that supported it have already called it the greatest “financial services legislation” since the Great Depression. Based on the fact that lobbyist are already working to reduce, eliminate or minimize its impact on their represented area of interest, and as one six-month waiver has already been granted, it may seem reasonable to assume that the statement is true. The average American may feel good that something dramatic has apparently been done, but has it? A closer look says otherwise.

    The SAFE Act

    A precursor to the Dodd-Frank Act was the Secure and Fair Enforcement for Mortgage Licensing Act that was initially passed on July 30, 2008. Known as the SAFE Act ,it was designed to enhance consumer protection and reduce fraud by establishing registration and licensing minimums for residential mortgage loan officers, originators and mortgage companies. But commercial mortgage loan officers, commercial mortgage companies and residential mortgage loan officers that work for an insured depository (a bank) were originally specifically exempted. In addition, no mortgage expertise or licensing of commercial mortgage loan officers was required at any level; there were no such requirements even for Wall Street investment banking firms or rating agency analysts. Remember that these are the parties that analyze, process, rate and/or sell pools of both residential and commercial mortgages. Their past practices all contributed to the meltdown of the capital markets.

    On July 28, 2010, and after the Dodd-Frank Act became law, the agencies responsible for the SAFE Act issued their final rules. The final rules now require residential loan officers of national and state banks, savings and loan associations, Farm Credit System Institutions, credit unions and some of their subsidiaries to meet the registration requirements of the SAFE Act. With exceptions for small institutions and those processing less than 25 mortgages per year,  this basically means that all residential mortgage loan officers of banks, savings and loans and credit unions are now required to be formally registered in a national registry base. However, it does not require residential mortgage loan officers of national banks to demonstrate competency by passing a test to become licensed or take continuing education. The explanation for this exemption is that national banks and their loan portfolios are examined every year by federal regulators. Interestingly though, loan officers of non-Federal Reserve member banks and state charted banks are subject to registration and are also subject to any licensing requirements of their respective states.

    What does registration involve? It involves individual background checks and finger printing. Licensing? It involves passing a test to demonstrate competency. Commercial mortgage loan officers and bankers are still exempt from registration and generally from licensing. Seems to me that if the process of annual examination of national banks had worked prior to the capital markets meltdown, the FDIC would not have needed to close over 250 banks since January 1, 2008 with more to come. In December 2008, I wrote to the heads of the various agencies and sponsors of the Dodd-Frank Act advocating licensure of all financing industry participants. Based on the final version, it appears that even if they listened, they missed the real point by only partially amending and expanding the SAFE Act requirement. 

    The Dodd-Frank Act

    The Dodd-Frank Act creates better protections for residential mortgage customers and card credit “borrowers,” and it addresses some of the items that the SAFE Act missed. However, how it will affect the commercial mortgage industry and Wall Street’s capital markets is the focus of my interest.

    It appears as if the Act will have the most impact on banks, Wall Street “players” and the all important and massive RMBS/CMBS capital markets source for mortgage financing. Here’s why:

      ●  There will be no more taxpayer funded bailouts of financial institutions.
      ● Complex derivatives will be regulated.
      ● New controls to allow the government to seize large failing financial companies are being created.
      ● Hedge funds will now be required to be registered with the SEC.
      ● Interest rate “swap” transactions will be required to be publicly disclosed.● Banking entities’ abilities to engage in proprietary trading or to own interests in hedge funds or private equity funds will be limited.● Banks will be required to have higher capital levels.

      ● With exceptions already negotiated, the sellers of mortgaged backed securities products (RMBS/CMBS) will retain a 5 percent partial liability on risky issues.

      ● It removes a former major exemption by formally designating the rating agencies (so necessary for RMBS, CMBS and other public debt issues to be rated and sold) as experts, and is designed to make them accept responsibility for their actions by making it easier to successfully sue them for bad ratings.

      ● For the very first time, it requires analysts at the rating agencies to pass qualifying exams and have continued education.

    Let’s look more closely at three of the reforms, as they principally affect the all important RMBS/CMBS capital market that “everyone” is pressing for a return, which will happen. The impact of requiring sellers of mortgage securities to retain a minimum 5 percent interest in the securities they sell is designed to require them to have “skin in the game” and be at risk along with the securities buyers for the quality of what they sell. Already, exceptions have been negotiated where “normal” and “low risk” mortgages will be defined, and sellers of securities backed up by such mortgages will not need to retain a 5 percent interest. The FHA, FannieMae and FreddieMac have all at different times imposed similar requirements on their correspondent lender-loan originator-sellers, and that hasn’t helped much. Look at the financial difficulties that Fannie and Freddie are currently enduring. Past history has shown that when an originator-seller has had such a low level of skin in the game, they went bankrupt when called upon to absorb their portion of the risk or to repurchase the defaulted loans. I spoke with one company founder who told me that the risk of such loss was far outweighed by the money they made from fees and servicing even though they knew they could never afford to cover any significant losses. It sounds good, but in reality it hasn’t proven to be worth much protection to the investors that buy the securities.

    What is the impact of formally designating the rating agencies (Standard and Poor’s, Moody’s, Fitch and others) as experts? In order to understand its potential impact, you need to know that agency ratings are used by (Wall Street) debt issuers and underwriters to indicate the quality of the bond or debt security they are selling. Stated simply, the proposed sale of registered securities requires that an agency rating be formally published on the official offering statement (they usually appear in the upper right hand corner of the first page). While they may choose to show a rating, unregistered, or private placement securities are exempt from the requirement. An example of an unregistered, private placement security is a local municipal bond issue. 

    There are two levels of ratings – investment grade and non-investment grade. Letters are assigned to indicate the rating. Typically, investment grade ratings run from BBB (the lowest) to AAA (the highest) and often supplemented with + or – gradations. Non –investment grade ratings range downward from BB to D. Securities with non-investment grade ratings or with no rating are often referred to as “junk bonds” due to their lack of quality in comparison with investment grade rated bonds. Investors substantially rely upon such ratings when deciding to buy the securities and what price and yield they are willing to pay or accept.

    In previous writings I mentioned that the rating agencies were escaping liability for their past ratings actions that contributed to the capital markets meltdown by having law suits dismissed. That was basically due to their exemption from being considered as “experts.” Their ratings were considered just “opinions” as opposed to “expert opinions.” While I think most people always believed that the rating agencies were experts, “buyer beware” appears to have been the unacknowledged watchword for reliance upon such ratings. The capital markets melt down certainly proved that. Now that the exemption is being removed, they become properly liable for their rating opinions just as an attorney or real estate appraiser is liable for his or her opinion. The removal of the exemption now makes it easier for harmed investors to successfully sue.

    It is most interesting to note, however, that immediately upon the President’s signing of the Act, the rating agencies publicly notified clients and underwriters that they were withholding permission to allow their ratings to be published on any debt issues. This immediate refusal to stand behind their own ratings effectively shut down the $1.4 billion registered securities debt market (of which CMBS, and RMBS are a part) until, on July 22nd, the SEC gave into pressure from large debt issuers and Wall Street underwriters by promptly providing the rating agencies with a six month waiver thereby allowing pending and proposed debt issues to proceed. The pressure came from a number of Wall Street Firms and debt issuers that had major issues pending.  It often takes months and a significant investment of time and money to structure and assemble large debt issues and they could not be marketed without agency ratings. For example Glodman Sachs had a $778.5 million registered issue pending that was comprised of traditional, multi-borrower CMBS. They successfully sold the entire issue on August 2nd just 10 days after the waiver was put in place. It is also very important to note that Goldman (with no requirement to register or have specially licensed mortgage loan officers or loan underwriters) originated 69 percent of the portfolio itself. Without the waiver Goldman’s CMBS issue could not have been sold. it was business as usual with no changes imposed by Dodd-Frank  from the pre-meldown days.

    So what is the impact?

    The words LET THE BUYER BEWARE should continue to apply to any new debt issues rated by these agencies while the waiver is in effect. If an acceptable alternative is not found in six months, the agencies will again withhold their ratings and shut down the market. If the SEC backs down on their expert designation, the Dodd-Frank Act will have done nothing, other than licensing analysts, to reign in the credit rating agencies.

    How this plays out will have a major impact on the capital markets, including on future (post waiver period) RMBS and CMBS issues. So what should be done? One solution could be creating a “rating agency insurance fund” in combination with mandated cash reserves and professional liability/malpractice insurance to compensate investors harmed by a bad rating. We have the FDIC insurance to protect bank depositors. Some states have similar funds for parties harmed in real estate transactions. If the idea has merit, it will probably take the federal government or the SEC to help start such a fund.

    Concerning the licensure of rating agency analysts, no guidelines have been issued. It is another aspect that requires refinement and completion. Remember that the rating agencies were supposed to be the gatekeepers of the mortgage backed securities market, and they failed miserably. The lack of world wide investor confidence in their MBS ratings is the major reason for the capital markets collapse. In my opinion, investors should demand that their analyst’s licensure and continuing education requirements include mandatory education about prudent mortgage loan underwriting as well as a basic understanding of real estate appraising. It may be prudent to create separate licensing and requirements for the analysts responsible for analyzing and rating mortgage backed securities portfolios. I have sent a letter to SEC Chairman Schapiro advocating such an educational requirement. If you agree perhaps you’ll send a similar letter.

    Just for the record, the new administrative boards and agencies and sub-entities to be created by the Dodd-Frank Act include:

      ●  The Consumer Financial Protection Bureau of the Federal Reserve
      ●  The Financial Services Oversight Council●  The Office of Credit Ratings at the SEC

      ●  The Federal Office of Insurance within the Treasury Department

      ●  The Office of Financial Literacy and Research within the Treasury Department

      ●  The Office of  Minority and Women Inclusion

      ●  The Office of Housing Counseling within HUD

      ●  The FDIC’s

      –  Office of Complex Financial Institutions

      –  Division of Depositor and Consumer Protection

    In summary, depending upon the outcome of the expert status of the rating agencies and the educational requirement that will or will not be imposed on rating agency analysts, it appears as if not much has changed to reign in Wall Street and its potential impact again on the capital markets as it relates to mortgage backed securities. It was a multi-billion dollar industry that was initially a secondary market and then became a primary market for all types of real estate financing. Investor confidence was lost, but time and the yields currently available are bringing investors back to the market. Will we see a return of the halcyon days of the mid 2000s?  Not for awhile, but the Act’s safeguards concentrate on making the individual (residential) mortgage originators and loan officers responsible for doing a better and more prudent job of underwriting mortgage loans than in the past but not much appears to have been done to prevent the Wall Street firms and underwriters from again becoming overly aggressive and abusing the capital markets source.

    Because no real adverse impact has been seen now that the Act has been passed, and in anticipation of the much desired return of the capital markets as a major mortgage financing source, more companies are again planning on selling major amounts of mortgage backed securities. Cantor Fitzgerald (had major 9-11 employee losses), a traditional bond house with no real mortgage experience just partnered with CIM Group, a Los Angeles Fund Manager (also apparently with no real mortgage experience), to become mortgage originators and pool assemblers. They have announced a target of creating and selling $5 billion of MBS product. No required registration or licensing of mortgage loan officers and underwriters. Can you see a trend?

    History has demonstrated that those that do not learn from its lessons are doomed to repeat them.  Were regulators and legislators really paying attention to history? You decide.

    Accordingly, while it should not be, sadly the words let the buyer beware continue to be the best advice for investors.

    Should Lenders be Licensed Before Being Allowed to Make or Purchase Commercial Mortgages?

    June 10th, 2010

    By Bruce J. Coin

    America’s real estate lending community is comprised of approximately 8,000 FDIC insured banks, approximately 8,100 Credit Unions (insured by NCUSIF), over 200 insurance companies and well over 300 Pension Funds.  Then there are the Wall Street firms and the numerous mortgage broker-pseudo lender-seller conduit companies that profess to be mortgage lenders. They all process, place, sell or invest in stocks, bonds, mortgages and/or real estate and many treat Commercial Mortgage Backed Securities as bonds.  As of December 2008 the 300 largest pension funds had over $10 trillion invested in stocks, bonds, mortgages and real estate.

    In light of the recent capital markets melt down and loss of confidence in the major rating agencies, that led to and caused the great recession does anyone really think that collectively these institutions and companies were or are all properly staffed with skilled, experienced and knowledgeable loan officers and underwriters or that they invested the proper amount of time and money in training their staffs?  The evidence strongly indicates that such institutions were really not very good at underwriting acquisition, development and construction (ADC) and commercial real estate (CRE) mortgage loans while failing to simultaneously keep an eye on changing economic conditions. They also invest in stocks and bonds and some were caught badly with large investments in Fannie Mae and Freddie Mac stocks when those institutions were taken over and their stock became virtually worthless. Also note that banks consider RMBS and CMBS investments to be bonds as opposed to actual mortgages and many invested heavily in those as well.

    According to the FDIC’s data (, excluding banks in Puerto Rico, between January 1, 2008 and May 28, 2010 the FDIC has closed 243 commercial banks or a simple average of about 8 closures per month.  52.3% of the closed institutions were located in just four states: Georgia (38 closures-15.6%), Illinois (33 closures-13.6%), Florida (29 closures-11.9%) and California (27 closures-11.1%).  Tied for 5th place are Missouri and Washington with 9 closures each or 3.7%.   As of May 28, 2010 the FDIC also had a list of 775 “problem banks”. Also, since January of 2008, more than 48 Credit Unions have been closed.

    Case studies of recently failed banks are posted on the FDIC’s Office of Inspector General’s web site ( The case studies provide detailed explanations of what led to each bank’s closure.   I reviewed eleven recent case studies looking for common causes.  While, to its credit, the FDIC often admits a failure to respond earlier and/or with stronger measures to banks with developing problems the case studies indicate that most if not all of the bank closures were caused by bad real estate lending practices especially in the ADC and CRE arenas. While the lending community can try to point to the great recession as the primary cause of declining demand for and values of real estate, they cannot deny that it was bad lending practices that led to the current great recession.

    The following are direct quotes selected from the various FDICOIG’s case studies:

    “Poor management and inadequate Board of Directors oversight, a high concentration in ADC lending, poor loan underwriting, weak credit administration and reliance on volatile funding sources”

    “…..Board and management implemented a high risk business strategy that included rapid growth, with the focus on earnings, by investing the majority of the bank’s assets in higher-risk CRE and ADC loans while maintaining limited liquid assets”.

    “…management, led by a senior bank official, pursued an aggressive growth strategy focused on acquisition, development and construction lending that coincided with declining economic conditions…”

    “inadequately supervising lending units…”

    “Aggressive underwriting during periods of hyper real estate market growth”

    “…a high concentration in ADC lending, poor loan underwriting, weak credit administration…”

    “…risks included the bank’s concentration in ADC and CRE lending and weak underwriting and credit administration policies…”.

    “…the (FDIC’s) 2008 examination questioned whether the lending staff had the expertise…”

    “….loan underwriting and administration practices became extremely lax…”.

    “The Chief Lending Officer’s (CLO) lack of experience in ADC lending, the CEO/President’s lack of lending experience…”

    “…a lack of due diligence pertaining to loan purchases and weak credit administration and loan review practices…”

    “…weak oversight by management, inexperience and turnover in key positions…and concentrations in CRE and ADC loans.”

    “…the bank failed to conduct proper due diligence and implement prudent underwriting of the loan participation credits”.

    “…Insufficient staff resources – in need of training and/or replacement to enhance employee skill sets and experience levels necessary to implement change.”

    “…lacked the personnel, depth and resources to properly monitor, assess, and manage a large portfolio of complex CRE/ADC loans….”

    “Weakness in …loan underwriting, credit administration, and risk analysis and recognition practices were contributing factors in the asset quality problems that developed…”

    The common threads are concentrations in ADC and CRE loans combined with a lack of skilled senior management, loan underwriters and personnel, aggressive underwriting and lack of oversight by management.

    When a large private industry fails to act prudently to police itself, there has usually been a public outcry that lead to government intervention in the name of protecting the public.  Among others it’s happened to the auto, food, airline and pharmaceutical industries and don’t forget all the environmental laws since 1969. It happened to the financial industry after the great depression and it’s going on now as the House of Representatives and the Senate negotiate the differences between their versions of the planned Financial Services Reform Act to try and pass new laws regulating the financial industry.

    After the great depression of 1929 there was government intervention and regulation of the financing industry that covered the activities of Wall Street firms, banks and real estate companies.

    In 1933 the Federal Deposit Insurance Corporation (FDIC) was formed to provide insurance up to $2,500 per individual savings account to restore confidence in the banking system.

    Also in 1933 the Glass-Steagall Act was passed to:” separate investment and banking activities” citing that banks had become too greedy by taking big risks (in the stock market) seeking big rewards.  In 1956 it was amended to prevent banks from underwriting insurance.

    In 1934 the Securities and Exchange Commission (SEC) was formed to: “regulate the stock market and prevent corporate abuses relating to the sale of securities and corporate reporting”.  It was given the power to license and regulate stock exchanges, the companies whose stock was traded on an exchange and the brokers and dealers that conducted trading.

    Between 2002 and 2007 weren’t the investment banks and commercial banks doing the same with real estate lending that that pre-depression era banks were doing in the stock market?  Seems obvious to me.

    Over time, and particularly during the Reagan and Clinton administrations, many of the post depression regulations were diminished or were even repealed such as the 1999 repeal of the Glass Steagall Act.  It was replaced by the Gramm-Leach-Bliley Act which repealed part of the Glass-Steagall Act and opened the market between banks, investment banks, securities firms and insurance companies and facilitated the legality of mergers between them that were previously illegal. The banking industry was cited as trying to have the Glass-Steagall Act repealed since the early 1980s. They obviously succeeded.

    To look a little deeper into possible bank failure causes I investigated what it takes to start a bank.

    In order to start a bank a sponsoring group usually starts by applying to their local state initially requesting approval to become a state chartered bank. Later, based on growth and success they can apply to become a federally chartered national bank.  The requirements to become a bank vary by state, especially the initial minimum capital requirements needed.  That currently appears to be in the range of approximately $6,000,000 to $10,000,000 noting that I did not investigate the requirements of the 50 states. The state requirements I reviewed reference meeting the minimum federal requirements and require application to the FDIC for insurance.  The application process I reviewed for three states (among other requirements) all basically stated that the initial stockholders and/or board of directors of the proposed institution had to include experienced bankers.  The requirements did not elaborate or say that including experienced real estate mortgage lenders was a requirement, commercial or residential.   I then reviewed the FDIC’s insurance application. Among its numerous other requirements those that I found that could be germane to mortgage lending are directly quoted below:

    “Provide a list of the organizers, proposed directors, senior executive officers, and any individual, or group of proposed shareholders acting in concert, that will own or control 10 percent or more of the institution’s stock. For each person listed, attach an Interagency Biographical and Financial Report, a fingerprint card, and indicate all positions or offices currently held or to be held…”

    “Describe each proposed director’s qualifications and experience to serve and oversee management’s implementation of the business plan”.

    “Describe each proposed senior executive officer’s duties and responsibilities and qualifications and experience to serve in his/her position”.

    “Discuss any plans to engage in any subprime or speculative lending, including plans to originate loans with high loan-to-value ratios”.

    “Describe the institution’s plans to engage in any secondary market/mortgage banking activity, including loan participations.  Discuss any plans to use forward take-out commitments or engage in loan securitization.  Describe any plans to use hedging activity to mitigate the risks of this activity. Also discuss plans to retain recourse and servicing.”

    “Describe the loan review program, addressing independence, scope, frequency and staff qualifications.”

    “Discuss how the institution will identify and measure interest rate risk”.

    According to DSC’s (Division of Supervision of Consumer Protection)  Risk Management Manual of Examination Policies: “the quality of management (of a bank) is probably the single most important element in the successful operation of a bank.” Despite that statement there appears to me to be no formal requirement for a founder, director or even a senior officer to possess real estate lending knowledge.

    I was unable to find any detailed guidelines concerning what the FDIC would consider acceptable qualifications and experience. There are very few programs that “certify” real estate loan officers. Personally, in my 40+ years experience I have never met a “certified” commercial mortgage loan underwriter.   So when it comes to a group’s application to become approved for FDIC insurance as a bank, it appears that the FDIC can apply a subjective standard to determine if the founders and officers of a new bank are qualified.

    So why have so many of these institutions proven to be very poor at underwriting and investing in ADC and CRE loans?

    Greed, competition, earnings pressures, changing economic conditions and mortgage fraud can only partially explain what happened.  There are greater reasons.  I personally believe the main reasons they fail is a combination of four things:

    • Not having truly highly experienced mortgage loan officers and underwriters
    • Failing to invest in ongoing education for mortgage loan officers and underwriters
    • CEOs, Presidents and senior management not being knowledgeable mortgage loan officers, investors or underwriters themselves and imposing imprudent lending and investment decisions on subordinates
    • The institution not being required by law or by the FDIC to have and maintain truly highly experienced loan officers and underwriters and on-going education programs

    Despite losing billions of dollars in bad ADC and CRE loans and investing in RMBS and CMBS without performing proper due diligence many of the larger banks are now making major good profits while still writing off and selling their bad loans and bad RMBS and CMBS investments. While more rating agencies may be coming on to the scene the three major firms; S & P, Moody and Fitch continue to be allowed to rate mortgage issues and appear to be escaping damages from law suits that are being dismissed by the courts.  Many of the Wall Street firms led, by Goldman Sacks and Bank of America’s Merrill Lynch, are again ramping up to sell pools of RMBS and CMBS.

    On July 30, 2008 the federal government passed the Secure and Fair Enforcement for Mortgage Licensing Act of 2008, aka, The SAFE Mortgage Licensing Act of 2008. Among others the act required states to pass licensing standards for residential mortgage loan originators by July of 2009. State licensure is to be based on national standards, require passage of a qualifications test and include registration and continuing education. Can you guess who is exempt? BANKERS ARE EXEMPT, i.e. any individual (that originates residential mortgages) that is an employee of; a depository institution; a subsidiary that is owned and controlled by a depositor institution (e.g. a bank owned mortgage company) and regulated by a Federal banking agency or an institution regulated by the Farm Credit Administrator.  They are not innocent purchasers that need to be protected from unscrupulous “sellers” (mortgage brokers, wall street brokers and mortgage bankers) they make or purchase commercial mortgages every business day and in many cases originate the business themselves.  Remember that one bad $9,000,000 commercial mortgage is the equivalent of having thirty, $300,000 residential mortgages all go bad at the same time.  You do the math.

    The industry continues to fail to police itself.  Many banks still lack truly highly experience mortgage loan officers and underwriters.  Many still employ or are re-hiring those that were involved in the bad loan decisions that led to the capital markets collapse. The Safe Mortgage Licensing Act does nothing to change that. The act principally targets mortgage brokers and mortgage companies that originate residential mortgages but not those that ultimately actually lend the money or buy the loans. Mortgage brokers do not lend money.  Privately owned mortgage companies may close a loan in “their own company’s name” but always with the concept of pre-selling or selling the loan shortly after loan closing.  While they can be at risk they are not true lenders.

    The government fails to see the need to require bank and investment bank loan officers and underwriters be certified and licensed and take continuing education like numerous other professionals.  Nothing in the proposed Financial Reform Act currently being negotiated addresses that.

    Realtors must take classes, pass an examination to be licensed and then in most states take continuing education in order to renew their licenses.  In 1989 most of the existing appraisal organizations got together and formed the Appraisal Foundation that, with the support of the government, established education and experience requirements for appraisers, required them to pass an examination to be licensed and take continuing education to renew their licenses.  The SEC requires securities dealers to pass an examination to be licensed and take continuing education to renew their licenses. All of these actions and requirements were implemented in the name of “protecting the public”.

    I could not find any formal requirements for bankers or investment bankers to have any amount of formal commercial mortgage underwriting and appraisal knowledge and education, meet minimum experience requirements, pass a test to be licensed (as no such licensing exists) or take continuing education to renew such licenses.  In addition, while there are a variety of licenses that securities dealers and their brokerage licensed firms can hold, there appears to be no requirement for them to have expertise in mortgage loan underwriting or appraising or a separate level of licensing because when packaged into pools mortgage loans are sold as securities and their existing licenses permit them to do that.

    When questioned about past practices, many of the bankers and investment bankers that cost the public billions of lost dollars continue to espouse that they did nothing wrong. To borrow a line from Shakespeare; “The lady doth protest too much me thinks”.  What do you think? In furtherance of again protecting the public isn’t it time for more to be done?

    In December of 2009 I sent letters advocating implementation of a program of educating, requiring experience, testing, and licensing of mortgage loan officers and underwriters followed by continuing education for license renewal purposes to the following:

    • Federal Reserve Chairman, Ben Bernanke
    • SEC Chair, Mary Schapiro
    • FDIC Chair, Shelia Bair
    • Treasury Secretary, Timothy Geither
    • Senator Frank Lautenberg-D. NJ (e-mail)
    • Senator Robert Menedez-D.NJ (e-mail)

    The letters were timed so that the concept could be incorporated within the Financial Reform Act now being negotiated. I can personally see no reason other than a lack of wisdom or intestinal fortitude by the legislators and undue influence from the banking and investment banking industry why these members of the financial community that are the primary analysts, processors and often approvers, buyers and sellers of mortgage loans are not required to meet and live up to the same standards as other industry professionals.  There is no excuse, not even the cost of creating such a program.  Such a requirement would not inhibit the flow of capital or retard economic expansion or growth. The cost of implementation would pale by comparison with the losses it may have prevented.   I submit that had such requirements been in place on or before the post 911 runaway capital markets, much of what happened to cause the financial meltdown would have been avoided.

    If you agree with the forgoing write to all of the above, your local Senators and members of the House and even President Obama.

    A Creative Method To Refinance A Highly Leveraged Property

    February 8th, 2010

    By Bruce J. Coin

    One of the major problems confronting the commercial or income property financing industry is finding a way to finance many of the highly leveraged existing properties that were financed 5, 7 and 10 years ago and their loans are now coming due. Last fall in separate statements issued by both the Mortgage Bankers Association and by Deutsch Bank predicted that approximately $400 billion of existing commercial mortgages will expire and need to be refinanced. Just at the end of January, the Fitch Rating Service predicted that default rates on commercial mortgages could reach 12 percent by 2012 and that those insurance companies that invested in CMBS bonds could lose $20 billion.

    Of most concern are the loans that were written by banks or CMBS conduit originators. Many were written at 80% loan to value ratios, with no amortization or with low amortizing 30 year schedules. The interest rates of many of those mortgages are about the same or nominally higher than today’s rates but with appraised values based on much lower capitalization rates and often with appraised values based on assumed higher rents. During the last two years, vacancy rates have increased substantially across all property types as have capitalization rates while loan underwriting standards have become more conservative.

    In combination with the substantially reduced dollars available in the market place to finance commercial properties and the more conservative underwriting standards currently being applied by those lenders that are active, prospects for refinancing are currently “dim” for many commercial property owners and has led to more than one professional describing the situation as a potential time bomb of default.

    The problem is that it is difficult to find lenders today that will make new loans at more than 70% loan to value ratios and with more conservative underwriting that includes the use of higher vacancy allowances and overall capitalization rates. The lending community sees this and the federal government sees this. All are thinking and hoping that given time more investors will return to financing mortgage product while vacancies decline, existing loans can amortize further and property values will again increase. The fed offered the use of TALF funds to effectively refinance maturing highly rated CMBS product. To stave off defaults some banks are using the “pretend and extend” method of pretending that there is not a current loan to value ratio problem and are extending the loan with the same hopes.

    Depending upon the circumstances and with a little aggressive attitude there is a method from the early 1970s that can be employed in the right situation today to refinance some of these properties. By providing a combination land purchase-leaseback and leasehold mortgage transaction collective amounts of up to 85% (and higher if desired) of current property value can be offered as a financing package. It will take a positive attitude by existing lenders and help from their legal staff but an abundant number of similarly structured transactions were successfully used by many of the insurance companies in the late 1960s and early 1970s. Some used the method as a pseudo joint venture structure.

    The concept is simple but the mechanics can be complex. The borrower conveys the land of their project to the lending institution or to a subsidiary or holding company if required to meet legal requirements and leases it back at a fixed rent. Simultaneously the lender provides a leasehold mortgage up to its comfort limit of the appraised value, presumably 75% (not 70% or 80%) of the leasehold estate it just created. Remember this is intended to be a “help” not a punish program.

    While lenders holding loans from such borrowers may think that the borrower is “stuck” and will accept most any solution that isn’t always the case and the bankruptcy courts are always an option. Taking unfair advantage of a borrower in this market could lead to more trouble than it is worth. Using my suggested idea, a fairness standard should be employed and if “everyone” believes that over time, vacancies will diminish and values will increase (which is highly likely) this is a solution that can allow a deserving borrower to keep equity and earn their way out of difficulty by a combination of good management and an improving economy. It will also give the lender more control and options in the event of a default as an eviction action can be used when the ground rent is defaulted in addition to normal foreclosure procedures on the mortgage.

    As an example:

    If a property was financed 5 years ago for $4,800,000 as an 80% LTV with a 30 year amortization schedule and 6.75% interest rate the balance of that loan today would be about $4,575,000. The initial appraised value would have been approximately $6,000,000. A 1.25 times debt service coverage ratio indicates that the N.O.I. would have been approximately $467,000 indicating that the overall capitalization rate applied at the time was probably 7.75% or less.

    Now let’s assume that between increased vacancy, some tenant rollover and increased operating expenses the property’s N.O.I. declined by 5% to a current level of approximately $ 443,650. Applying an overall capitalization rate today of say 8.0%, the appraised value would only be about $5,545,000 making the current balance equal to about 83% of value which is much higher than is customary or available today.

    However, if we say that the land under the building(s) is worth in this example say $1,000,000 (18% of current total value) and do a purchase lease back where the rent is based on say 6.25% for up to 10 years (see below) or $62,500/year the picture changes. After deducting the $62,500 from the $443,650 N.O.I., the income to the leasehold estate is now $381,150 but you only need to provide a leasehold mortgage of $3,575,000 to provide the total of $4,575,000 needed to refinance, notwithstanding fees and closing costs. Applying a 75% LTV ratio to the $3,575,000 indicates that the appraised value of the leasehold would need to be approximately $ 4,767,000 which would be supported today with an overall cap rate of 8.0%. Applying a fixed rate of say 6.75% to that for 7 or 10 years and with a more conservative 25 year amortization produces an annual debt service on the $ 3,575,000 of approximately $296, 403. Including the land rent of $62,500 the overall “debt service” would be approximately $358,903. The N.O.I. of $443,650 reflects an overall d/s coverage ratio of 1.236 times.

    The ground lease must contain a repurchase provision that gives the borrower the right to repurchase at any time for the same price. The ground repurchase option can contain a provision that the ground can only be repurchased simultaneously with the prepayment of the leasehold mortgage. Neither the ground lease, purchase option or leasehold mortgage can be assumed by anyone. No “reasonable approval” clause allowed. If a lender is concerned that the 6.25% and 6.75% rates suggested above are too low they may be able to incorporate rent or rate “up-ticks” after say 5 years but only if the property is showing increased income less you again increase the possibility of default, i.e., based on performance. As a “hammer” to force the borrower to ultimately sell or refinance to repay this financing in 10 years or less, the purchase price of the land would be structured to then escalate significantly year to year after that. It is important to note that if such a transaction is structured as above that over 10 years the mortgage, in this example, would amortize by about 21.7% down to about $2,800,000 or $3,800,000 total would be owed including the $1,000,000 for the land. That’s more than ¾ ths of a million dollars less than is owed today.

    Obviously, depending on the type of lending institution, there may be some legal hurdles to be overcome but they can be and if a mortgage lender or a borrower is looking for a way out of an impending default situation and they believe that time will ultimately cure the problem this can work but not for every transaction. The numbers need to be studied on a case by case basis as well as the perceived prospects for future success property by property, borrower by borrower before deciding to do this. I’m sure, once this idea is brought to their attention, that some of the CMBS entities that are ramping up and not constrained as are the banks and insurance companies, will quickly find a creative way to employ this technique. All fees and closing costs should be paid by the borrower. In some states transfer taxes on the ground transfer may be an issue but I believe that if such a program can be offered to a borrower that “basically avoids potential for default and gets them out whole” except for the fees and closing costs, they will take such a financing deal as it lets them keep heir property avoid default and earn their way out.


    December 2nd, 2009

    Since the 1930s, when the F.D.I.C. first started requiring insured banks to secure independent appraisals to confirm the value of a property they planned to secure with a mortgage, the problem of “undue influence” being exerted on appraisers to “make the number” has existed. During periods of economic decline, increased mortgage defaults and foreclosures, loan officers most often blame mortgage losses on “bad” appraisals with overstated values.

    The original concept of requiring an appraisal was good as all lenders “held” their loans “on book” as the loans were typically located in their local market and there was no secondary market. The requirement was designed to protect lenders and ultimately the F.D.I.C. against potential losses due to foreclosures. With the advent and explosion of the secondary market (RMBS/CMBS) lenders, and especially mortgage company/conduit lenders made loans outside their local markets and sold most of them before or shortly after loan closing. The process pushed the importance of a good appraisal to the background making only the “right number” to properly margin the loan as its sole importance to enable the loan to be sold or put into a pool for sale in the public debt markets. It is time to change that and bring the appraisal back to the foreground as one of the most important pieces of the mortgage loan underwriting process.

    Until the late 1970s, when some national real estate firms established national appraisal divisions, the appraisal industry was totally a “cottage” industry comprised of numerous small and regional appraisal firms. Many appraisals were performed by realtors. Today, the industry is still substantially comprised of numerous small appraisal shops. Most strictly perform residential appraisals. The larger firms are usually commercial appraisal oriented and there are far more residential appraisers than commercial.

    For many years, a number of professional appraisal societies have existed. For membership purposes they imposed the only educational, experience requirements and codes of ethics that existed. Prior to late 1980s there were no national appraisal standards or licensing for appraisers. Any licensing or experience requirements were decided by individual states with many requiring no licensure.

    The majority of appraisals performed in the U. S. are for financing purposes. For years appraisers have complained about undue pressure from lenders and mortgage brokers to “make the number” or lose business from the institution or broker. Accordingly, there have been many attempts at creating solutions to avoid appraisers providing appraisals that (principally) overstated the property’s value or (occasionally) understated the property’s value due to undue pressure.

    A major step occurred toward the end of the 1980s. With the on set of the Savings and Loan crisis, and knowing, as in the past, that appraisers would be blamed for the massive losses of the S & Ls, 9 major appraisal societies acted collectively to “tighten up” their industry, to avoid drastic federal government action. In 1986 they formed an “ad hoc” committee to create the first Uniform Standards of Professional Appraisal Practice (aka U.S.P.A.P.- generically- Use-pap) to provide standards for appraisal preparation and appraisal practice, nationwide. In 1987 they formally established The Appraisal Foundation and its subsidiaries, The Appraisal Standards Board and the Appraisal Qualifications Board. The first version of U.S.P.A.P. was copyrighted in April of 1987. Its purpose is to promote and maintain a high level of public trust in appraisals. It was formally adopted by the Appraisal Standards Board in January of 1989. It has been revised numerous times. Also in 1989, the federal government adopted the Financial Institutions Reform, Recovery and Enforcement Act (AKA FIRREA – generically- Fire-re-ah) that required appraisals for federally related transactions to conform with U.S.P.A.P.

    Many states subsequently adopted U.S.P.A.P. as the standards they require appraisers to conform with. Virtually all went on to form certification or licensing acts that required appraisers to pass examinations for certification and to take continuing education classes. Two classes of certification or licensure were created; a strictly residential certification and a more expansive “general” certification. The latter allows such certified appraisers to appraise both commercial and residential properties.. Once certified appraisers are subject to reprimand, censure, state board/judicial review, fine, loss of certification and similar.

    The current “credit crisis” wave of foreclosures has fingers again being pointed at the appraisal industry with the industry again complaining loudly about undue pressure from lenders and mortgage brokers to “make the number”.

    It is important to remember that appraiser’s typically rely on recent market sales, rents and histories to arrive at their opinions of value. Prior to U.S.P.A.P.(which requires appraisers to factually support their conclusions), appraiser’s could render opinions based on their knowledge of the market that may not have been supported by tangible evidence. While that was a problem as it allowed for some truly unsupportable value opinions and lawsuits, when a market is on the precipice of rapid incline or decline, absent recent sales (which can take as long as 90-120 days to formally close and be recorded) to evidence the changes, an appraiser can’t help but over or under state value due to U.S.P.A.P. constraints even though they are aware of the substantial market change occurring.

    The two most recent attempts to try to eliminate undue appraiser pressure are the development and use of “Appraisal Management Firms” (AMFs) and the most recent creation of the Home Valuation Code of Conduct or H.V.C.C. In my opinion, both are weak attempts at assuring appraiser independence and reducing undue pressure.

    AMFs are really “middlemen” between their lender clients and the appraisers they hire. While the use of AMFs might reduce undue influence, their use has increased the cost to the consumer while simultaneously reducing the fees paid to individual appraisers. The difference goes to the AMF. Reducing the fees to residential appraisers has already reduced the number of appraisers willing to perform residential appraisals for AMFs and reduced overall appraisal quality.

    Does anyone seriously think that the use of a middleman will really reduce undue influence? If an AMF delivers too many appraisals that don’t “make the number” they will no longer be used by that lending institution. When an AMF approved appraiser fails to “make the number” on too many appraisals they will be removed from the AMF’s list. Does the industry really believe that the AMFs and individual appraisers haven’t recognized that? All they have done by requiring an institution to use and AMF is to remove the direct contact between the lender or the originating mortgage broker and the appraiser. The process has been lengthened but not changed.

    The H.V.C.C is really only a code of conduct designed to restrict lenders and brokers from directly ordering appraisals and having some control over the appraiser. It is not truly a code of ethics. Ethical appraisers already abide by the codes of conducts of the societies to which they belong.

    It’s time to make a bold and significant change to the process because here’s what is amazing;

    Appraisers, realtors, attorneys and numerous other professionals must be certified or licensed and must take continuing education but…


    While bankers can argue that they are examined by “regulators” every year, and some actually have in house appraisers that formally review appraisals, that system obviously has not prevented the problem of bad lending, bad appraisals or undue appraisal influence. There is no direct recourse. Think about it. If someone was actually responsible for formally accepting responsibility for approving an appraisal do you think that many “made the number” appraisals would get accepted and worse, passed along to the secondary market?

    Under the current structure, a lender still does not need to grant a mortgage even if the appraisal “comes in at the number” but if they do, ultimately foreclose and take a loss on the property they generally blame the appraiser I submit that the loan process is now broken. Time to put the true responsibility where it belongs, on the loan officer or underwriter

    In my opinion, the best way to now fix it and to virtually eliminate undue pressure on appraisers to “make the number” is to now also make loan officers (like appraisers, attorneys, realtors and other professionals) at banks, credit unions and especially at Wall Street Brokerage Firms be educated, take and pass an examination to demonstrate a level of knowledge to be licensed or certified and take continuing education to maintain their licensure or certification. Their education would include basic appraisal knowledge. One of the semi-annual CE courses would need to be an appraisal class. All mortgage loans would then require that a certified loan officer formally sign off and approve the appraisal they have accepted for purposes of the loan they have approved. Loans sold in pools would require the pool buyer/Wall Street Underwriter to also have a licensed/certified loan officer sign off on each appraisal and so on.

    When you think about it, how can a loan underwriter truly structure a loan based on appraised value (and all real estate mortgages are) if they don’t have a good understanding of what constitutes a good appraisal and it’s not just “the number”.

    Armed with better knowledge of what is and is not a good appraisal, if they still accept a bad appraisal (either because they still wanted to make the loan or because they were incompetent or worse) they would then be subject to the same type of censure, fine and/or loss of certification or license (and job) that applies to appraisers and other professionals. It would substantially put an end to loan officers applying undue pressure on appraisers to make the number and then hiding behind the appraiser’s value when a loan goes bad. It would bring back the importance of having and knowing what a good appraisal is as part of the underwriting process.

    Structured properly and perhaps with a new entity (similar to the Appraisal Foundation), formed by the F.D.I.C and S.E.C or other appropriate agencies, that would establish national education and certification guidelines, the F.D.I.C and S.E.C would more oversight and power to address bad loan officers. If we all agree that bringing back the secondary market is very desirable and if we all agree that confidence in the system needs to be restore to re-attract both American and foreign investors, this would be a major and visible step in that direction.

    This seems like a logical solution to me. Opponents will argue that the cost or timing issues make this impractical and those are not supported by history. Appraisers have been forced to do all of this, absorb the costs and lost time and have not been able to pass those costs along to the consumer. When one acts in haste one often regrets their action at their leisure. Slowing down the loan process a little can help avoid the financing fiasco we just came through that brought our economy to its knees.

    Time for a bold new change. If you agree, contact your Congressman, the President, the Chairman of the S.E.C. the head of the F.D.I.C and all others in positions of power and question why loan officers are not certified, licensed and required to take continuing education and insist that they be certified.


    September 4th, 2009

    The average person knows that the economy is in recession.  They see that unemployment and mortgage defaults increased.  They are aware of the difficulty of obtaining a mortgage to buy a home, let alone one that can be secured with little or no down payment. They see the number of bankruptcies and curtailed retail sales. They believe that the current recession occurred due to those economic factors and a “crisis of confidence” that led to a meltdown of the financial markets. But where is the blame for this one?  It wasn’t the economy that caused the recession it was the lending community.

    Since the early 1960s, recessions have come along periodically about every 6 to 8 years. Each has generally been started by a different initiating cause.  Amazingly, not many seem to anticipate them, particularly real estate developers, real estate lenders and those in government. When there is an economic boom they act and plan as if it will continue forever. Ultimately a recession occurs, the availability of credit is restrained, mortgage defaults, unemployment and bankruptcies rise, tax revenues and retail spending declines, and confidence in the economy is lost. When credit begins to ease confidence slowly rebuilds and the economy rebounds.

    Economic collapse and restoration are all about confidence. It is interesting to note that if you look at the word e-c-o-n-o-m-y. “Con” implying confidence seems to be implied right there in the middle.

    The financial collapse that led to this current, deep and lengthy recession was principally caused by financing abuses created by the lending community. Rising unemployment, declining tax revenues, reduced retail sales and tighter credit are by-products of this recession, not the causes. The “Wall Street” Investment banks (really stock and bond brokerage firms that in the early 1990s decided to become “lender-sellers” or “conduits”), the commercial banks, Fannie Mae, Freddie Mac, the Securities and Exchange Commission, the rating agencies, (Standard and Poor, Moody and Fitch), appraisers, as well as American, European and other Foreign investors all played a role and at some level are all to blame.

    Approximately 52% of all debt in the U.S. is currently held by commercial banks. Another 10% is held by insurance companies.  However, by 2006 the mortgage backed securities/ capital market (MBS), which included Fannie Mae and Freddie Mac residential and multi-family mortgages, had become the lender of choice for most mid and long term mortgages.  The Wall Street investment banks had grown the MBS market to about 30% of the entire financing market.  Investors from all over the world were buying American MBS. Commercial mortgages were being provided at up to 85% of often all to often grossly inflated appraised values.  Many were written for ten year terms on an interest only basis that did not require any amortization.

    The problem arose due to a lack of accountability.  The rating agencies set the guidelines of what they would and would not accept as individual loans that would go into a pool of MBS that they would rate.  What started out as a “secondary market” also became a “primary lending” market.  Investment banks, inexperienced brokers, mortgage companies and even banks suddenly became “lenders’ but were actually “conduit” lenders originating loans.  They could originate and supply residential mortgages to Fannie Mae and Freddie Mac as well as residential and commercial mortgages to the investment banks that bundled them into pools, had them rated and then sold the MBS.  None of the parties along the way in that process had any recourse responsibility unless they committed a fraud.

    All each party in the process cared about was the loan’s ability to be qualified to go into  an approved pool and be sold. Each entity would then receive a fee for their role in the process with no responsibility whatsoever if the loan went bad.  The fee income and servicing revenue to the investment banks was incredible.  Over time, the investment banks that had the necessary relationships with the rating agencies kept pushing the rating agencies to allow more and more liberal loan underwriting.  The capital markets were efficient and became like a Horn of Plenty to the real estate financing industry. The supply of cheap and liberally underwritten mortgage money appeared unending. To meet the demand for this money, more and more inexperienced and ill-trained employees were hired by the various companies.  Car salespersons became mortgage brokers. With no recourse, “prudence be damned” and it was. “Caveat emptor-let the buyer beware” became industry standard as lenders gave loans that the borrowers could not afford. Prudent lenders were often pushed to the sidelines as they could not and would not compete with the Wall Street MBS financings.  They were often ridiculed as being too conservative. Experienced mortgage professionals only shook their heads at what was occurring but said nothing.

    Based on the then perceived success and durability of the MBS market many lending institutions reduced or eliminated their in-house mortgage departments and seasoned staff.  They turned to purchasing MBS to fill that portion of their investment portfolio. e.g. stocks, bonds and mortgages. Some ventured into purchasing the non-investment grade portions of MBS to secure a higher yield.  The investors all relied upon the ratings of the rating agencies and had no way to independently perform due diligence to see if what they were acquiring was the quality they were being told.  Many, but not all, insurance companies, banks, credit unions and other lenders were all “in the game”.  But the dam was about to burst.

    Very early in 2007 residential mortgage defaults were on the rise.  Many of those mortgages had been given to borrowers on a “NO DOC” basis requiring little or no equity money invested or proof of the ability to pay.  Many borrowers accepted loans at below market “teaser rates” for six to twelve month periods and when the subsequent higher rate was required they defaulted. Some were given mortgages that exceeded the price of the home and fees and closing costs.  Due to the availability of such ultra liberal and imprudent mortgage financing numerous inexperienced buyers became “investors” hoping to flip their purchase for even more dollars before ever having to make many mortgage payments.  All such loans became known as “sub-prime”.   Also due to liberal underwriting too many residential sub-divisions were created and being financed by banks leading to a gross over supply of new housing. When home prices stopped rising due to the over supply additional defaults started to occur.

    An investment grade or higher rating from a rating agency signifies the lowest risk assigned to a debt security, whether it be a corporate bond or a residential or commercial backed mortgage bond (RMBS-CMBS).  Highly rated is highly rated-less than investment grade rated is junk and junk is junk. As the residential mortgage defaults rose, it had become obvious that the rating agencies had been way too liberal with their ratings of this product.  They even rated pools of CDO’s that were comprised of the less than investment grade rated portions of other MBS pools. Accordingly, investors stopped buying residential MBS.

    In the April 2007 edition of the MidAtlantic Real Estate Journal, I questioned; “While those (sub-prime residential) mortgages were not secured by commercial real estate, as virtually all of these loans were ultimately securitized (i.e., as MBS rated by S & P, Moody and Fitch) in the capital markets, will a serious magnitude of defaults in that arena impact investor confidence in the capital markets for commercial mortgages?”

    The answer was a resounding “yes”. As investors recognized that the rating agencies had been too liberal with their ratings it did not take long for their lack of confidence in the rating agencies to cause them to also back away from investing in CMBS product. By the fall of 2007 they had stopped investing altogether in any MBS product.  This led to the “crisis of confidence” and by early 2008 the collapse of the entire (non-government insured) capital debt market.

    Lacking the ability to sell existing or new MBS securities, the values of existing MBS fell dramatically. Absent buyers, there was no way of accurately “pricing” the value of the existing MBS. As the prices of their MBS holdings were being reduced from quarter to quarter, for proper reporting purposes, commercial banks and Investment banks became insolvent.  Even the rating agencies began downgrading some of their previously highly rated MBS.

    Fear gripped the market.  Existing lenders (many of whom, to compete, had been way too liberal granting financing) stopped lending or severely tightened underwriting and credit requirements.  The availability to obtain credit became virtually frozen. Business managers found it difficult to roll over existing debt or to borrow to expand.  The headlines in the media advised the populous at large that we were in a recession.  Businesses started cutting back and laying off.  Consumers cut back on spending.  By the latter part of 2008, the crisis had become so large that the federal government created its “bail out” funding package to restore reserves and inject fluidity into the banking system.

    Much of the blame for the abuse of the MBS capital markets lies with the Investment Banking firms that pushed for more and more liberal financings to be accepted in MBS pools. They exerted tremendous financial and timing pressures on the rating agencies.  Greed influenced the market at every level of the MBS process. As much, if not more of the blame, lies with the rating agencies. They were supposed to be the “gatekeepers” of the industry.  They had initially developed very detailed and conservative guidelines of what constituted a “good loan” e.g.; LTV ratios, DSCR ratios, tenant and lease diversification, amortization, etc.  They also had established guidelines for what constituted a “good pool” e.g.; individual loan size limitations, geographic and property type diversification, etc. They dictated the amount of subordinated non-rated debt required (typically 22% to 28%) to be held in creating a loan pool in order for them to issue investment grade or higher ratings to the balance of a loan pool.  They issued the ratings that convinced investors that the “Investment Grade” or higher rated portions were just that, reasonably safe.  As the Chairman of the SEC, Chris Cox (who is also responsible for oversight of these entities) stated” When there was not enough staff to do the job right the (rating) firms cut corners” HOW PROFOUND!

    With about 30% of all mortgage debt being held or funded in the MBS capital markets and as the MBS had become the single largest source of non-government insured mid and long term real estate financing, its collapse brought down the liquidity of the entire mortgage market, banks, investment banks, hedge funds and even some insurance companies.  We can all thank the members of the Wall Street firms, the rating agencies and similar market participants for the collapse of the capital markets, loss of investor confidence that has not yet significantly returned and for causing the restraint of the credit that caused the economy to spiral into the current severe recession.

    My conclusion: It wasn’t the economy that tanked, it was this lending community that tanked the economy. Return to