While inflation may be abating, the capital markets are in a period of discovery. Many commercial mortgage lenders have significantly pulled back in the wake of the Silicon Valley Bank, First Republic Bank and Signature Bank failures earlier this year. What made these collapses unique was the speed at which their deposit runs occurred. Now, unsurprisingly, there are growing concerns from regulators that are exploring new and better ways of monitoring lender balance sheets and liquidity.

As an example, the Fed is now considering the implementation of “reverse stress testing.” This approach would evaluate the conditions needed to break a financial institution, rather than creating an artificial stress scenario and its projected impact. Institutions with assets of $100 billion or more already receive more scrutiny and are under more regulatory obligations at the federal level. While these banks tend to make the most loans tied to commercial real estate, they also have fewer effective options for loan risk management or balance-sheet optimization. Recently, many of these lenders have looked to the insurance industry for a possible solution.

Similar in concept to private mortgage insurance on residential loans to consumers, commercial property loan insurance (CPLI) is an investment grade-rated loan guarantee product designed to serve as an effective risk transfer and mitigation strategy. By leveraging this option to insure the most risky portion of a commercial mortgage, lenders can gain significantly better access to liquidity, balance-sheet optimization and risk management when financing a real estate project. It’s something that mortgage brokers and borrowers should understand as they work with lenders to structure safe and cost-effective financing.

Prudent approach

The Federal Reserve requires banks with more than $250 billion in assets to be stress tested each year. (Institutions with at least $100 billion in assets are evaluated in even-numbered years.) Importantly, these rules now cover a large portion of prime commercial real estate lenders.

The enhanced scrutiny impacts these institutions’ balance sheets and liquidity. Although a lender could possibly raise more debt or equity to address this, doing so is expensive and dilutive. Another option is to curtail commercial real estate lending activities, and many institutions have already met (or are exceeding) their concentration limits, meaning that they’ll receive additional regulatory scrutiny. Many lenders are even selling their commercial mortgage notes, especially for certain office and retail properties, at significant discounts.

Regardless of size, focus or geography, all commercial real estate lenders need to ensure they are employing best practices when it comes to risk management. The recent and relatively quick collapses of the three previously respected banks are harsh reminders of what can happen if these measures fall short.

Constant due diligence is a requirement for all types of risk — and not only for an institution’s loan exposure. The banks that failed this year had some things in common: Their loan portfolios were reasonably solid and up to date, but they improperly managed interest rate and deposit risks. These events also serve as reminders that the industry-ingrained stance of “waiting until others go first” has proven to be a faulty if not fatal approach.

Insurance basics

The unexpected deposit runs and rapid interest rate increases that felled these banks can have significant impacts on any lender’s balance sheet. In addition to liquidity issues, these can also affect capital requirements, concentration levels and loan-to-value regulatory parameters, which can put an institution at risk by severely hindering its operations and profitability.

Just as regulators are exploring new methods of stress testing, many commercial real estate lenders are seeking new approaches to optimize their balance sheets. Commercial property loan insurance has emerged an alternative. Other available options (including credit-linked notes, credit-risk transfers and credit derivatives) tend to offer mixed success at best, since they can be costly or unreliable.

There are two main strategies for lenders to employ in regard to CPLI. It can be used alone or in conjunction with a fixed-income collateral agreement. Either of these strategies can be highly scalable. Commercial mortgage lenders can quickly compare these paths by identifying the risk weighting for a specific loan amount, then reviewing the costs of each option using market percentages of first-loss protection.

For example, on a loan pool of $1.13 billion with a conservative overnight rate and spread of 12.5%, the cost to leverage loan insurance (with or without a collateral agreement) can be roughly 40% to 60% lower than using credit-linked notes or credit-risk transfers. This also provides more capital, operational efficiency and scalability for the lender.

Using CPLI on its own is an effective option, but commercial real estate lenders can also leverage it in conjunction with additional cash, or cash-equivalent collateral, for added risk-weighted benefits. Regulators are likely to view this collateral as having a zero risk weighting, which means a much lower impact on a lender’s overall capital requirements — and likely its concentration requirements.

Creating an agreement for pledged collateral that serves as a credit enhancement for a commercial mortgage is a fairly straightforward process, with the collateral remaining liquid and held in an escrow or equivalent custodial account. An investment grade-rated CPLI policy would then be purchased, either by the lender or the borrower, to remove the need for a personal guarantee. This places the insurer in the first-loss position ahead of other parties while protecting the collateral at hand.

Urgent action

This year’s bank collapses gave all lenders a sobering reminder of the consequences of a risk management failure. These events not only highlighted how difficult it can be to predict and plan for unexpected events — the purpose of any insurance product — but more importantly, why adhering to the status quo related to due-diligence strategies could be a costly or fatal move.

Banks are likely to be further scrutinized in the months ahead. As regulators broaden their methods of assessment, the commercial mortgage lenders that have traditionally taken a wait-and-see approach may quickly find themselves in a difficult position.

Additionally, as underwriting continues to be impacted by current pre-recessionary market conditions, and as nonbank lenders rush to fill the gaps left by many banks moving away from commercial real estate, the cost of borrowing is likely to continue to rise. Lenders that start to explore their options now rather than waiting until they are forced to react are likely to increase their risk mitigation capabilities. They could capture a significant competitive advantage in the marketplace or possibly even regain lost market share.

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With commercial mortgages representing the largest portion of assets in the portfolios of many community and regional lenders, the impact of failing to act could be devastating. As other areas of the capital markets explore alternatives to optimize balance sheets and lessen risk, the implementation of commercial property loan insurance can offer lenders an immediate and cost-effective solution. This can provide the regulatory relief and better risk management they need to thrive, regardless of anticipated market cycles or unexpected events. ●

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As a mortgage borrower, it’s essential to have a clear understanding of the risks associated with acquiring property in disaster-prone areas. Natural disasters caused $165 billion in damage in the U.S. in 2022, the third most-costly year since 1980, according to the National Oceanic and Atmospheric Administration (NOAA).

Mortgage professionals should take the time to educate their clients about the potential risks and liabilities associated with purchasing real estate in areas prone to natural disasters. This includes providing information on the specific risks associated with the property, such as flood zone designations or soil liquefaction zones, and helping clients understand the insurance requirements and expenses associated with these risks.

“Owning a home in a high-risk area comes with its own set of challenges — for example, how the potential impact of a natural disaster might affect property values or resale prospects.”

By helping their clients understand the risks involved in acquiring properties in disaster-prone areas, originators can help them make more informed decisions about their investments and avoid any financial pitfalls that may arise. Ultimately, a mortgage originator who truly cares about their clients’ well-being will prioritize education and transparency, providing guidance and support to help them make sound financial decisions that align with their goals and interests.

As trusted financial professionals, loan originators can offer valuable guidance to their clients in these high-risk locations. By understanding the threats, implementing preventive measures, executing emergency preparedness, and being aware of the rebuilding and recovery process, mortgage originators can empower their clients to mitigate risks and minimize potential damages.

Perilous areas

To effectively serve their clients in these risk-prone regions, originators must first have a thorough understanding of the location-specific hazards. Local climate patterns, historic data on past events and the specific dangers posed by disasters prevalent in the region will help originators educate their clients.

They can apprise them of the potential hazards to their home and offer appropriate recommendations. For example, homes in South Florida are part of a weather pattern known as Hurricane Alley. Florida has been hit by twice as many hurricanes as the next closest hurricane-prone state, which is Texas. Of the 308 hurricanes that have hit the U.S. since 1851, 125 have made landfall in Florida, according to NOAA.

“Mortgage professionals should take the time to educate their clients about the potential risks and liabilities associated with purchasing real estate in areas prone to natural disasters.”

Consequently, it behooves originators who work in Florida to be knowledgeable about the frequency and severity of hurricanes in the state, the typical paths these storms follow, and the potential damage caused by gale-force winds, potent storm surges and massive flooding. Originators should also be familiar with local building codes and zoning regulations that are intended to moderate hurricane risks, such as requirements for impact-resistant windows or hurricane straps for roof reinforcement.

Similarly, in tornado-prone areas, originators should be aware of the frequency and intensity of storms in the region, the typical paths they follow, and the possible damage caused by strong winds, flying debris and structural collapse. They should also be familiar with any local tornado warning systems, evacuation plans and emergency shelters to inform their clients accordingly. About 1,150 tornados were recorded in the U.S. in 2022, NOAA reported. Over the past three decades, Texas has seen the most tornados with an average of 150 each year, followed by Kansas at 91 and Oklahoma at 68.

Wildfire-prone areas possess their own disastrous risks. Besides being aware of the frequency and severity of wildfires in their region, originators should understand the typical causes of wildfires, as well as the potential harm caused by raging fires, flying embers and deadly smoke. And they should be familiar with any regulations or guidelines for creating defensible spaces (fire breaks) around homes, along with the use of fire-resistant building materials.

California led the nation with 9,280 wildfires in 2021 and more than 2.2 million acres burned, according to the Insurance Information Institute. Texas recorded the next highest number at 5,576, although only 168,000 acres burned. Oregon and Montana had fewer wildfires (2,202 and 2,573, respectively), but these disasters burned more land — about 828,000 acres in Oregon and 747,000 acres in Montana.

By having a solid understanding of the specific risks posed by extreme weather events where their clients’ homes are located, originators provide crucial services. They can make clients aware of potential hazards, provide reliable resources for weather alerts and updates, help to assess the vulnerability of homes and recommend the necessary preventive measures to reduce risks.

Advanced preparations

For homeowners in disaster-prone areas, having proper insurance coverage is vital. Naturally, homeowners will consult with their own insurance professionals to make sure they have sufficient coverage. But as trusted advisers, mortgage originators can also inform their clients on the necessity of insurance coverage that specifically addresses the risks in the areas where they are buying or refinancing a home.

Originators can also educate their clients about the different types of insurance coverage (including homeowners insurance, flood insurance and windstorm insurance), and help them understand the limitations, deductibles and exclusions that may apply to these policies. They can advise homeowners on the importance of regularly reviewing and updating their insurance coverage to ensure it is adequate for protecting their homes and belongings against potential risks.

Given their broad real estate expertise, mortgage originators can also advise their clients on the wisdom of preventive measures. They can stress the importance of reinforcing roofs, installing impact-resistant windows and doors, and securing loose objects in the yard.

 They can also educate their clients on the importance of having a disaster preparedness plan in place. This might include emergency supplies such as food, water, flashlights, batteries, candles, a portable generator and a first-aid kit. It is also important to have detailed evacuation and family reunification plans in place, and to know the exact location of the nearest emergency shelter.

Finally, originators can suggest that homeowners set aside a financial emergency fund to help with unexpected expenses in the event of a disaster. This can include expenses such as deductibles, repairs, temporary housing and other unforeseen costs that may not be fully covered by insurance.

Informed decisions

If a homeowner’s property is damaged or destroyed by a natural disaster, originators can offer their clients assistance in the rebuilding and recovery process. This might include working with insurance companies to file claims, or negotiating any challenges or disputes that may arise during the claims process.

Originators can be a good source of information on available assistance, such as government relief programs, disaster recovery loans and other forms of financial aid. Additionally, originators can help homeowners understand the implications of rebuilding or repairing a home in a high-risk area. For example, homeowners may be required to comply with updated building codes or regulations intended to reduce the risks of future natural disasters. Originators can help homeowners analyze the potential costs and benefits of complying with such regulations.

 After a disaster, it is also important for homeowners to conduct thorough inspections and assessments of their homes to identify any potential structural or environmental hazards. Originators can counsel clients about this process to ensure that a home is safe before moving back in or initiating repairs.

Owning a home in a high-risk area comes with its own set of challenges — for example, how the potential impact of a natural disaster might affect property values or resale prospects. In these zones, it might be more difficult to sell a home due to lower demand, or there might be increased insurance costs. There could also be a stigma associated with the region due to its history of disasters. By providing insights into these factors, originators can assist homeowners in making informed decisions about their long-term plans and exit strategies.

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In addition, originators can be an invaluable conduit to other experts in their respective fields. These might include insurance agents, contractors, inspectors and disaster preparedness specialists. These kinds of referrals can help homeowners connect with professionals who can provide specific advice and assistance tailored to their unique needs and circumstances. ●

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Independent agencies

Tech solutions

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The true cost of Hurricane Ian may be much more significant not only in total dollars but in its true impact to the mortgage origination market in Florida.

Coastal allure

Costly insurance

Unaffordable rebuild

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Adding an investment-grade insurance policy is superior to even the highest-rated personal credit alone.

Delinquency rates

Policy advantages

Natural hesitancy

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Genuine need

Permanent benefit

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Finding the right title company for a specific transaction can be the difference between a process free of pitfalls and one where you watch the closing date get pushed back — or worse yet, see a deal fall through. In commercial-property deals, title companies carry out several key functions behind the scenes. The firm researches the title to prove evidence of ownership, and to look for any outstanding debts or judgments that might encumber the property. The firm also provides title insurance that protects the owner from any defects that might later be discovered and could prevent the investor from selling the property.

The title company maintains the escrow account. In complex commercial real estate deals, this account can hold money from several different capital sources. And a title company usually prepares all the closing documents. In ground-up construction projects, the firm is often tasked with monitoring progress for the lender and distributing money to pay contractors.

As you can see, the title company carries out numerous critical duties. Commercial real estate deals are usually complicated and have issues that are unique to the specific project. Thus, it is important for mortgage brokers and lenders to partner with a title company that best fits your client’s project.

White-glove service

Due to the sophistication of commercial mortgage transactions, there are obvious advantages to knowing the individuals on your title team. The title company will frequently interact with each of the key parties involved in the sale.

You will want to be partnered with a personalized closing team consisting of a few key people, which often includes high-level executives. This core group also should be available whenever the client requires guidance or assistance. At some commercial title companies, however, this team can number close to 100 people. That’s a lot of different hands touching a deal and it allows more room for error. It also can be overwhelming for your client and leave them feeling like a number.

Also, many investors will go back to the same title company over and over again. Your client will typically want to work with the same people. The process tends to move more smoothly if the title team knows the investor’s history and has experience working with them. In some cases, however, your client will bring a repeat deal to the title company and, given its large size, will have to work with an entirely new group of people.

It’s also a not-so-hidden secret that some title firms may balk at smaller piecemeal deals if there’s not a guaranteed steady stream of business right behind it. It is important to find a title company that will treat each client the same, regardless of the deal size or the prospects of future business. The firm should know the advantages of building relationships that will earn future business.

Title attorneys and underwriters, for example, should be willing to take time to identify the intricacies of a deal from its beginning to its closing — no matter how long it takes to determine all the implications of an investor selling and waiving any rights of ownership to adjacent property. There’s true value and realized cost savings in being treated as more than another number.

Commercial real estate is a people business at its core. In fact, the collaborative effort between borrowers, brokers, lenders, underwriters and title attorneys doesn’t have to end with the transaction.

Nimble and smooth

A title company should be, in a word, accessible. Knowing the right person to contact when you have a question is a timesaver, as is getting an on-the-spot response. Another important attribute is flexibility. A title team needs to be nimble when the situation requires. An effective title company can switch gears quickly to address obstacles and present multiple options to clients.

Some firms may look at a more challenging deal as a headache not worth the time or energy, especially if it’s a smaller transaction. Depending on a project’s size and scope, there could be endless unknowns and obstacles. But the company should see the challenge as an opportunity.

In a complex commercial real estate deal, your client is likely to have numerous questions. For example, what are the implications of selling and waiving any rights of ownership? Do they have rights to adjoining properties and land parcels? A boutique title firm has more time to explain these issues because there’s less pressure from corporate headquarters to rush through closings and move to the next client. An independent title company also will order decades of parcel records and scrutinize legal descriptions to ensure the deal can proceed. It’s about quality, not quantity.

Commercial real estate is a people business at its core. In fact, the collaborative effort between borrowers, brokers, lenders, underwriters and title attorneys doesn’t have to end with the transaction. A title firm can connect mortgage brokers to the stakeholders it works with regularly to help them grow their business over the long term.

This type of interaction — whether virtual or in person — is something that often gets lost in the shuffle at some title companies. Building a bridge for better interactions among local market leaders, developers, lenders, attorneys and other key stakeholders is important to many title companies. These firms understand that their future business blossoms from their ability to strengthen existing relationships. ●

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California also has an outsized economic presence. Prior to a significant contraction caused by the COVID-19 pandemic, its $3.1 trillion gross domestic product (GDP) outpaced nations such as France, India and the United Kingdom. California’s compound annual GDP growth of 3.3% from 2009 to 2019 was a full percentage point higher than the U.S. average while the state’s per capita income of $66,619 in 2019 was 18% higher than the nation as a whole.

According to a winter 2020 report from Allen Matkins law firm and the UCLA Anderson School of Management, commercial real estate developers were becoming more optimistic about California’s major asset classes. Six months earlier, developer sentiments for the state’s multifamily, office, retail and industrial sectors were almost entirely negative. The most recent survey, however, indicated a largely positive outlook over the next three years as many developers are likely to get an early start on the next expansion cycle.

Still, there are concerns for California’s long-term sustainability. A report this past October in The New York Times posited that companies may leave the state due to high taxes and high costs of living for employees. State government officials are grappling to reduce urban sprawl, which has undermined efforts to reduce auto emissions and has placed more homes in areas prone to wildfires, the report stated.

Like other areas of the nation, California’s retail businesses have struggled during the pandemic. The governor’s office reported this past August that 44% of the state’s small businesses were at risk of closure, with minority-owned businesses being disparately impacted. California’s legal-cannabis industry, however, has shown resilience as dispensaries remained open throughout the pandemic. Voters approved 32 local measures this past November to legalize and tax marijuana, which should add to California’s head count of 715 licensed storefronts and accelerate tax revenues that have topped $1.45 billion since 2018.

In a statewide ballot measure last year, California voters rejected Proposition 15, which would have rolled back commercial real estate tax protections that have been in place since 1978. The measure would have raised an estimated $6.5 billion to $11.5 billion annually for local governments and schools, but opponents such as business groups and the real estate industry claimed the tax hikes would have been passed on to tenants and consumers. ●

In a third-quarter 2020 report, Cushman & Wakefield noted that San Francisco’s office-property asking rents remained the highest of any major U.S. market at $78.45 per square foot. This figure, however, was down 5.6% from the prior quarter and down 0.8% on a yearly basis. Although rents remained relatively stable, the marketwide vacancy rate soared to 14.1%, an increase of 860 basis points from a year earlier.

Pandemic-related shelter-in-place restrictions greatly impacted the ability to sign new tenants, the company reported. Across the San Francisco market, only 385,000 square feet of new leases were signed in Q3 2020, a 30-year low. By comparison, the dot-com bust of the early 2000s saw this quarterly figure bottom out at 933,000 square feet. But there is good news on the horizon: San Francisco has 1.4 million square feet of new office space set to be delivered by midyear 2021 and all of it has been preleased.

Focus: Healthcare

As of this past December, California surpassed 1.5 million confirmed cases of COVID-19 — the most in the nation, according to The New York Times — although it ranked near the bottom of all states for positive cases per 100,000 residents. Still, the virus was spreading there and California became the first state to record 30,000 cases in one day, including more than 12,000 in Los Angeles County alone.

A report this past June from the California Health Care Foundation noted that Gov. Gavin Newsom had requested an additional 50,000 hospital beds for inpatient needs. Increases in overtime pay and temporary staffing were contributing to a monthly revenue decline of $3.2 billion across the state’s hospitals, a 37% drop from pre-pandemic levels. Much of this deficit hadn’t been backfilled by federal aid. The pandemic figures to remain a burden on California’s health care system in 2021.

What the locals say

“In California — specifically Southern California — I would say retail and office (properties) are obviously hit the hardest. We’ve seen rent deferrals in terms of the tenants in our portfolio now. … With rents, people underwriting to a pro forma of their value-add strategy are now looking back and bringing the numbers down, maybe not doing as much value add as they were before, as the yields wouldn’t make sense in that regard. They are not performing their value add or pumping the brakes on their value-add strategy, and waiting to see what happens so that they can underwrite to the right rents.”

Marissa Wilbur

Vice president of originations, Archway Capital

3 Cities to Watch

Fresno

Fresno is California’s fifth most-populous city with about 538,000 residents and has grown by about 8% over the past decade, census figures show. It is located in the San Joaquin Valley near the state’s geographic center. Fresno County was the nation’s top agriculture-producing county in 2018 with a value of $7.9 billion. Almonds, pistachios, grapes, poultry and garlic are among the top local ag products. Manufacturing companies employ 105,000 and generate $15 billion annually across the regional economy.

Los Angeles

Unemployment in the L.A. metro area reached a high of 19.3% this past May and still stood at 11% in October — 410 basis points higher than the U.S. rate for the same month. The leisure and hospitality sector was recovering but employment was still down 24% year over year in November. According to CBRE, L.A.-area industrial properties remain in high demand. Prices fell and capitalization rates rose for these properties, but the $1.4 billion in transactions during Q3 2020 exceeded the average of the previous five quarters.

Sacramento

The state capital has about 2.4 million metro-area residents and appears to be benefiting from a migration out of the Bay Area. A recent report in The Mercury News showed Sacramento’s median home value was about one-third of San Francisco’s and San Jose’s, while Sacramento apartment rents experienced one of the largest annual hikes in the U.S. at 4.3%. The office market dipped, however, with leasing activity in Q2 2020 at about 50% of its five-year quarterly average, Colliers International reported.

Sources: American Enterprise Institute; California Health Care Foundation; CBRE; Colliers International; Cushman & Wakefield; Leafly; Office of the Governor of California; San Francisco Chronicle; San Joaquin Valley Manufacturing Alliance; The Fresno Bee; The Hollywood Reporter; The Mercury News; The New York Times; Tunedly; UCLA Anderson School of Management; U.S. Bureau of Economic Analysis; U.S. Bureau of Labor Statistics; U.S. Census Bureau; World Population Review

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