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Commercial servicers respond to dynamic market conditions.

COMMERCIAL MORTGAGE SERVICERS have been challenged by the downturn of the real estate finance markets coincident with the Great Recession beginning in 2008. These challenges are both operational and financial. [paragraph] Servicers have responded to shrinking portfolios and reduced profitability using a variety of different strategies and tactics. Outsourcing has been an effective tool to allow commercial servicers to improve efficiency and transform fixed costs into variable costs.

The third-party commercial mortgage servicing business developed in the 1990s. The catalyst was the formation of the Resolution Trust Corporation (RTC) as a vehicle to manage and liquidate the commercial real estate loans from failed savings-and-loan institutions. The RTC hired third-party contractors to service loans acquired from failed institutions.

The RTC also used securitization as a mechanism to resolve both performing and non-performing commercial real estate loans, which established the commercial mortgage-backed securities (CMBS) master and special servicing market.

As the RTC successfully wound down in the mid 1990s, the commercial real estate finance markets heated up and created new opportunities for qualified master and special servicers. Mortgage bankers originated CMBS loans and retained the primary servicing. Fannie Mae, Freddie Mac, the Federal Housing Administration (FHA) and Ginnie Mae also provided approved mortgage bankers the opportunity to originate permanent loans and build servicing portfolios as seller/servicers.

As the commercial and multifamily debt outstanding grew dramatically, so did servicing portfolios. From 1994 to 2008, the commercial and multifamily debt outstanding increased from $970 billion to $3.4 trillion--a 251 percent increase or 9.4 percent compound annual growth rate.

Over the same 15-year time frame, CMBS and the resultant primary and master servicing grew at an even faster pace, from $70 billion to $811 billion--a more than tenfold increase or 19.2 percent compound annual growth rate. Multifamily agency debt also demonstrated very strong growth.

Commercial and multifamily servicers expanded their portfolios and operating platforms to accommodate this growth. Improved commercial servicing technology and process improvements resulted in operational efficiencies and economies of scale, which improved servicing profit margins. Servicing provided long-term, durable revenue streams for mortgage bankers as well as the opportunity to build significant servicing businesses for financial institutions and specialty finance companies.

In 2008, the good times ended and commercial mortgage debt outstanding started to decline. From 2008 to 2012, the overall market contracted by 10 percent and CMBS outstanding balances declined by 18 percent.

For the first time, commercial mortgage servicers were faced with shrinking portfolios. Servicing operations that were built for growth were now faced with the prospect of reduced scale. Profit margins suffered as servicing fees declined and fixed expenses could not be proportionately reduced.

As a result of economic conditions, servicers also faced increased operating expenses associated with large increases in delinquencies and defaults. Further compounding these problems were historically low interest rates that resulted in reduced interest income or float revenues.

Some commercial mortgage servicers were under an existential threat. How would they respond?

Commercial mortgage servicing operations were built for efficiency and growth. The commercial servicing business model is based on receiving a combination of fixed and variable revenue. The fixed revenues are primarily associated with servicing fees. The variable revenues include a variety of borrower-paid fees and interest income or float from monthly debt service, escrows and reserves, and payoffs. Many fixed-rate permanent commercial and multifamily loans have prepayment lockouts that protect the duration of servicers' revenue streams.

Improving operational efficiency is the lifeblood of successful commercial mortgage servicers. As servicers have grown and evolved, they have utilized advanced technologies and process management to improve their operations.

Digital document imaging and indexing has been a boon to servicing operations. Document imaging can be integrated into servicing systems and workflow-management tools to improve productivity and efficiency. Automated payment processing and bank account reconciliations are other activities in which servicers can improve efficiencies.

Personnel costs and associated overhead are the single largest servicing expense. Some commercial servicers have offshore operations that utilize lower-cost personnel to reduce costs. Significant scale is required to justify a captive offshore operation, but vendor relationships provide an alternative. Offshore operations require expert management and oversight to realize the efficiencies associated with lower personnel costs.

Many servicers outsource selected activities, such as property site inspections, real estate tax administration, property insurance reviews, Uniform Commercial Code (UCC) administration, financial statement collection and review, and a borrower-requested consent analysis.

The outsourcing or contracting of these types of discrete activities is standard operating procedures for high-volume commercial mortgage servicers, utilizing dedicated service providers on a variable-cost basis. The selection, management and oversight of third-party vendors is crucial to realizing the full economic benefits of these relationships.

Many servicers have chosen to outsource their servicing technology platform on a hosted or application-services-provider basis. This results in a reduction of in-house technology support costs, increased capacity and realization of the benefits of variable costs for this critical servicing infrastructure.

Additional economic benefits can be gained through sharing the cost of business continuity and disaster recovery across multiple users. Again, the selection and management of a servicing technology vendor is critical, given the cost, disruption and effort associated with changing platforms.

As the commercial real estate finance markets and associated servicing portfolios have grown and contracted over the past decade, mortgage servicers have explored new options to remain economically viable and competitive. In some cases portfolio lenders and mortgage bankers combined their servicing portfolios and built dedicated new servicing operations to realize economies of scale and reduced costs.

Similar strategies have resulted in CMBS servicers consolidating their primary servicing activities and eliminating redundant activities and the associated personnel. Insurance companies and other portfolio lenders have used one or a few large servicers to more efficiently manage their commercial mortgages instead of having servicing distributed over a network of many traditional mortgage banking correspondents.

Non-cashiering subservicing has emerged as an alternative commercial loan servicing construct that has been effectively utilized for both CMBS and portfolio lenders. The scalable payment processing, loan accounting and administration functions are consolidated with a master servicer, while the mortgage bankers or subservicers maintain the borrower customer service, asset management and credit-related activities. This provides the ability for the loan originator to maintain borrower relationships and receive ongoing compensation through a servicing fee. The lender realizes the economic benefits and financial controls associated with haying payment processing and loan accounting consolidated with a single master servicer.

A bifurcation or sharing of certain servicing activities is another alternative in which portfolio lenders or mortgage bankers can outsource their servicing technology platform and selected processing activities to realize the benefits of a large-scale servicing platform while retaining all of the borrower customer-facing activities, asset and portfolio management and credit-related decisions.

This type of relationship requires dedicated resources and coordination to be effective, but the economic benefits have been significant. An additional benefit is the ability to ramp up capacity to support a merger or large portfolio acquisition without a significant increase in staffing, further reducing marginal servicing costs. Successful relationships require the service provider and client to collaborate with common goals and objectives.

As the commercial real estate finance markets have evolved, servicers have responded to the challenges of a dynamic environment through a variety of means. Subcontracting, offshoring and outsourcing have all been successfully utilized to help servicers improve operating efficiency and productivity and increase profitability.

These tools allow commercial servicers to transform fixed to variable costs, increase capacity and respond to changing market conditions. However, these types of relationships require strong vendor-management and operational capabilities, and are highly dependent on selecting the right service providers.

Stacey M. Berger is an executive vice president of Midland Loan Services, a PNC Real Estate business. Midland is a leading provider of loan servicing, asset management and technology for the commercial real estate finance industry, including commercial mortgage-backed securities (CMBS) special servicing. The views expressed by the author are his own, and this column was prepared for general informational purposes only and does not purport to be comprehensive. The information and views in this publication do not constitute legal, tax, financial or accounting advice or recommendations to engage in any transaction. The views expressed in this column are subject to change due to market conditions and other factors.
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Title Annotation:SERVICING
Comment:Commercial servicers respond to dynamic market conditions.(SERVICING)
Author:Berger, Stacey M.
Publication:Mortgage Banking
Date:May 1, 2013
Words:1371
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