A rising tide?

Does a rising tide really lift all boats? The commercial real estate finance industry has had an unprecedented run over the last decade. Capital markets technology has transformed the business, providing huge inflows of debt and equity to both institutional investors and entrepreneurs. Enormous liquidity, low interest rates and increasing equity values have made commercial real estate one of the most desirable and best-performing asset classes since the Russian debt default and resultant market disruption in the fall of 1998.

Commercial real estate is typically highly leveraged, and borrowers have benefited from widely available and cheap mortgage debt. Commercial and investment banks have built major businesses around the origination and issuance of commercial mortgage-backed securities (CMBS). In 2006, more than $206 billion of CMBS was issued in the United States. This represents an increase of 460 percent over the $36.8 billion issued in 1997.

How have mortgage bankers faired during these halcyon days for commercial real estate finance?

The efficiency imposed by the capital markets has brought brutal competition to the commercial mortgage banking industry. Commercial mortgage capital is essentially a commodity. Mortgage bankers' compensation from origination fees and servicing fees has seriously eroded. Mortgage bankers are battling with direct lenders for many loans originated for securitization. The mortgage bankers are working much harder on behalf of their borrowers. Where borrowers once accepted a few quotes from portfolio lenders, today many want a dozen conduit quotes over multiple rounds of bidding. To make matters worse, the best producers are highly compensated, and some end up making more than the "house."

Historically, one of the biggest advantages that mortgage bankers offered their borrowers was the ability to deliver a relationship for the life of the loan. Servicing the loans that they originated provided a steady, reliable income stream for many mortgage banking firms. Servicing revenue sustained these firms when origination volume was slow. Float from escrows and reserves provided compensating balances to support their corporate bank financing and warehouse lines. CMBS has taken significant market share from the life insurance companies that were many mortgage bankers' bread-and-butter lenders. As the commercial real estate finance product mix has changed, so have the economics of the commercial loan servicing business, and these changes have put most local and regional mortgage bankers at a serious disadvantage.

Once upon a time, portfolio lenders allowed mortgage bankers to retain the servicing on loans they originated. The mortgage bankers received servicing fees ranging as high as 12.5 basis points. Over time, these fees have significantly diminished, and a number of major portfolio lenders have consolidated their servicing away from the mortgage bankers.

CMBS issuers rapidly recognized that conduit servicing rights are very valuable and a major source of securitization deal profit. CMBS servicing rights are either retained by the originator or sold to the highest bidder among a small group of servicers. The amount of capital required to play in CMBS servicing is substantial, with the largest CMBS servicers investing $200 million or more on purchased mortgage servicing rights annually. Many mortgage bankers try to retain the primary servicing rights on the CMBS loans they originate. But in addition to the economic benefits to issuers of selling the servicing rights, increasingly complex investor reporting requirements and lack of scale have disadvantaged the smaller mortgage bankers. Corporate compliance issues such as Sarbanes-Oxley and Securities and Exchange Commission (SEC) Regulation AB further exacerbate the disadvantage for non-institutional servicers. Additionally, small servicers have disproportionately high costs to cover business resiliency and disaster recovery for their operations.

Historically, Fannie Mae and Freddie Mac multifamily lending provided a great opportunity for mortgage bankers to build significant value in their servicing portfolios. The programs were designed to take advantage of mortgage bankers' ability to build strong borrower relationships with multifamily property owners, developers and managers. The qualified mortgage bankers originated program loans and retained the servicing rights. However, this business has become significantly more institutionalized as the government-sponsored enterprises' (GSEs') counterparty capital requirements have been increased. Many of the entrepreneurial owners have sold to commercial or investment banks.

What do the numbers tell us about the changes in the commercial servicing business? The Mortgage Bankers Association (MBA) conducts an annual survey of commercial loan servicers. In 1997, the top 95 firms serviced an aggregate balance of $251.3 billion in commercial mortgages, according to MBA. By 2006, the top 95 firms serviced $1.7 trillion--an average annual increase of 58 percent. However, the market growth has not been distributed equally. The top 10 commercial servicers had aggregate portfolios totaling $146.3 billion in balances in 1997, according to MBA. These ballooned to $1.291 trillion in 2006. Over the 10-year period, the average portfolio for the top 10 servicers increased by almost eight times.

Who are the top commercial mortgage servicers? Seven of the top-10 are owned by commercial or investment banks, two are institutional specialty finance companies and one is an insurance company.

As noted, commercial mortgage-backed securities have transformed real estate finance. The dramatic growth of CMBS also has significantly changed the commercial servicing industry. Outstanding CMBS has grown from $134.9 billion in 1997 to $769.5 billion in 2006. Fannie Mae and Freddie Mac have also contributed to the change in industry dynamics. Their combined multifamily portfolios have grown to $294.9 billion in 2006. All of the top 10 servicers have significant CMBS and multifamily GSE portfolios.

As commercial servicing portfolios have grown, the local and regional mortgage bankers have been disintermediated by institutional players. Both CMBS and multifamily GSE servicing portfolios generate significant interest income from the float on debt-service payments, payoffs, and escrow and reserve deposits. Banks can optimize the value of these deposits, whereas mortgage bankers typically use them as compensating balances that reduce their cost of financing. It is cheaper for banks to buy the deposits associated with commercial servicing than building and staffing new retail branches.

Larger servicers have experienced economies of scale as their portfolios have grown. Many have upgraded their technology platforms, gone "paperless" through digital imaging, and implemented automated business-process-management systems. Most large servicers outsource or offshore processing activities and data-entry functions. Smaller servicers typically don't have the scale, expertise or resources to consider these alternatives. A number of local and regional mortgage bankers have formed consortiums like the Zurich, Switzerland-based SAM Group or Brentwood, Tennessee-based Q10 Capital LLC to gain the scale and expertise to pursue these alternatives. But their independent ownership and multiple servicing operations have been an impediment to realizing the benefits of their combined scale.

Is there hope for the smaller mortgage bankers? As the Council to Shape Change states in its Outlook for the Real Estate Finance Industry report, "Mortgage bankers have shown a remarkable ability to adapt quickly to changing market conditions." Mortgage bankers still retain superior local market knowledge and strong ties to their borrowers. Being smart, nimble and responsive still adds value to borrowers in developing solutions to their financing needs. And controlling borrowers still makes mortgage bankers relevant to CMBS issuers, the GSEs and portfolio lenders.

Innovative mortgage bankers are using advanced technology and other solutions to compete with the institutional servicers. Web-enabled technology platforms provide new opportunities for mortgage bankers to retain their customer relationships while outsourcing their technology and certain processing activities on a private-label basis that is transparent to their borrowers and investors. These mortgage bankers maintain the responsibility for the customer-facing activities, such as customer service, asset management and credit administration. The outsource provider is responsible for billing, payment processing, tax and insurance administration, and other scalable activities. New servicing systems can provide integrated loan accounting, servicing, asset management and investor reporting in a single technology platform. Additionally, digital document imaging and business continuity/disaster recovery can be delivered as part of the package of services. These technologies can be delivered to the mortgage banker on a hosted basis.

Through these new shared servicing relationships, mortgage bankers can get the economic benefits of a large-scale servicing operation without the direct investment in information technology hardware and software. Benefits include increased capacity and the conversion of fixed costs to variable costs. In some cases, the outsource provider can also provide treasury management services to maximize the benefits of the interest earnings on float, providing an additional economic benefit to the mortgage banker.

Fannie Mae and Freddie Mac have both issued guidance that allows their seller/servicers to utilize these type of outsourcing relationships. A variation of this model has been adopted by some CMBS originators. The mortgage bankers retain the responsibility for managing borrower customer service, performing annual site inspections and collecting financial statements. They maintain their relationship with their borrowers and collect a servicing strip for their activities.

Through their relationships with borrowers, mortgage bankers create value and remain an integral component in the commercial real estate finance business. The implementation of capital markets technology has made the deployment of capital somewhat of a commodity. In commodity markets, the lowest-cost provider usually wins. However, mortgage bankers remain a valued intermediary through their ability to deliver the end user--borrowers. Forward-thinking local and regional mortgage banking firms are finding opportunities to utilize new business models to remain competitive in a challenging and dynamic environment.

Stacey M. Berger is executive vice president of Overland Park, Kansas-based Midland Loan Services Inc., a provider of loan servicing and technology solutions to the commercial real estate finance industry. He can be reached at [e-mail].