Brian Lancaster is an Adjunct Professor of Finance at Columbia Business School. He also teaches MBA courses at the NYU Stern School of Business. He is President of The Minot Group, a real estate finance, investing and consulting firm. Previously, Professor Lancaster was Managing Director and Co-Head of Structured Transactions Analytics, Risk, and Strategy at the Royal Bank of Scotland (RBS). Prior to joining RBS, Professor Lancaster was the Chief Investment Officer of the Real Estate Division of Wells Fargo/Wachovia and Head of Structured Products Research. He was also a Managing Director Principal at Bear Stearns. In a recent interview with Brian Hwang '17, he discusses the current real estate debt market, his own professional experience, and his recommendations for aspiring real estate professionals.
There has been prolonged widening of CMBS spreads since last summer, a corresponding decline in CMBS issuance, and volatility in the CMBS lending market. What are the underlying causes of the widening spreads?
CMBS issuance is almost 50% lower than last year and spreads are definitely wider and more volatile. Equity, high yield and commodity market volatility, the first Fed rate increase, China’s slowing economy, Brexit, Europe and Japan’s sluggish economies, combined with the Volcker rule, which has diminished sell side market making and liquidity, have all made CMBS spreads volatile, particularly lower-rated ones and pushed them wider to compensate for the increased market risk. Greater volatility makes CMBS less competitive as it is harder for originators to guarantee rate quotes which borrowers need.
New, end-of-year, Dodd-Frank risk retention requirements are also weighing on the market. CMBS originators or holders of the lowest rated bonds in these deals, called "B-pieces," must retain 5% of a deal’s market value (much more than what is currently held) for at least five years. This will increase costs by as much as 35 to 50 bps. CMBS "B-piece" buyers are also rejecting more CMBS loans because of loan quality concerns given the lateness in the real estate cycle and competition. For example, B-piece buyers, who get a first look at a CMBS loan pool before it is created and sold, recently "kicked out" 30% of all the loans of a recent CMBS deal. This was costly to the lenders as "kicked out" loans are "blackballed" and must be sold at a significant discount. To compensate, originators charge more to borrowers and their financing becomes less competitive, which reduces CMBS originations overall. Less CMBS issuance means less money for secondary and tertiary market real estate, which is already hurting transactions. $150 billion of mixed quality 10-year loans made during the 2006 and 2007 peaks are maturing this year and next, which is concerning given smaller issuance and market volatility.
What other capital sources can step in and fill the gap left by lower levels of CMBS debt issuance?
Insurance companies, banks, and Government Sponsored Enterprises (GSE) are lending more, but can only fill in part of the gap. Insurance companies prefer higher quality loans in larger markets and banks can only increase long-term 10-year lending capacity so much given they are short funders. Lending "long" has gotten banks into trouble when short-term rates have risen. That said, some banks, this time, are trying to mitigate that risk by originating "CMBS-ready" loans. There are less regulated players including private equity, which are lending more and providing transitional bridge lending, mezzanine lending for higher leveraged properties and buying B-pieces. While helpful, their capacity may be limited, as many are funded by banks competing for the same business. Fintech and crowdfunding—hot academic and media topics—and financing from smaller private equity sources, are also around, though certainty and reliability of execution, is a challenge. Borrowers want certainty around their closings.
What is the role of government regulation in real estate capital markets?
Government regulation is definitely needed in real estate capital markets. I sat on the Executive Boards of the Commercial Real Estate Finance Council and the Mortgage Bankers Association, the most important advocacy associations for CMBS and real estate finance respectively. Some lament the bureaucratic morass of Dodd-Frank and the Consumer Financial Protection Board (CFPB), and think we should "defang" or eliminate both through "reform." This is clearly wrong—both need refinement, but regulations are necessary. The residential and commercial real estate industries left to their own devices pre-crash, albeit with help from politicians, nearly blew up the US economy with excessive and misvalued credit. Regulations, tailored properly, dampen long-term system volatility, i.e. risk, but the cost is usually slower growth. For example, without speed limits, traffic zooms through, but periodically, horrendous accidents happen. In contrast, few accidents occur with 5 mph limits, but traffic crawls to a standstill. The key is calibrating the right balance. I am trying to help in that effort by leveraging my industry experience and academic objectivity by serving as a consultant with the government, teaching at CBS, and exchanging ideas at conferences. I have been working with the Federal Home Loan Banks on REIT regulations, US regulatory advisory teams, a European government bank on housing finance regulations, and with mainland Chinese institutions who believe that Chinese real estate and banks today are where the US was in late 2006 and are looking for guidance.
How are big data and analytics being used in the real estate industry, and will this change over time?
Data and analytics have always been used in commercial real estate through a variety of providers, such as CoStar, Green Street, ARGUS, and in my experience, huge real estate players, such as Wells Fargo. Wells Fargo, the largest real estate lender, probably has as much data on borrowers and properties as anyone. When I was at Wells Fargo, we literally had a file on every borrower and property that Wells ever made a loan to. If we were called upon to make a loan to that borrower or property, the file was pulled up. Big data and analytics can be more readily applied to the residential real estate markets where there are millions of small loans. Given the size and heterogeneity of commercial real estate loans, the commercial real estate business will be—in my view—a large, "block and tackle business" involving intense individual loan and property analysis rather than sweeping generalizations made through algorithmic analysis of huge amounts of data. That said, there is considerable room for improvement. For example, I am consulting with one of the largest owners and creators of commercial real estate data—who get their information through satellites, millions of government and credit documents, and hundreds of "boots on the ground"—to apply this rich trove of information to the CMBS market where data is notoriously "variable."
What has been the most rewarding highlight for your professional life?
The market and investment calls I made in 2006 which led to my becoming Chief Investment Officer at Wells Fargo/Wachovia. At the time there were many signs of a market top. Cap rates compressed through Treasury risk-free rates, shrinking pot lists (the list of buyers for bond deals), rapidly increasing prices, soaring leverage and "overwriting." Complex "Rube Goldberg" type financing structures with financially engineered equity, e.g. risky mezz and B-notes which were securitized into CRE CDOs where "AAA" CDOs tranches were miraculously carved out and sold abroad to structured investment vehicles engaged in the carry trade. All the signs were there. Once the residential market—which was being financed with similar techniques—began to crack, it quickly spilled into commercial real estate as the market recognized the similarities. In early 2006 I called for cutting back CRE lending, increasing underwriting standards, and later rejecting a huge $26 billion Archstone Smith apartment deal that sank Lehman Brothers. I publicly supported Moody’s increasing its’ credit enhancement levels for CMBS, which garnered a lot of industry flack. All of these calls ultimately led to my promotion as Chief Investment Officer. Real Estate is often described as being demographically homogenous, especially at the executive level.
What has your experience been like as a successful LGBT professional in the industry?
My experience has run the gamut, which is symptomatic of the changes that have occurred in real estate over the last few decades. In the late 1980s, a partner at Salomon Brothers tried intensively to recruit me out of the Federal Reserve Bank of NY. After interviewing with 14 people, I was told the job was mine but I should do one more "courtesy interview." During that interview I was asked whether my father graduated college (he hadn’t finished high school), if I had a girlfriend, and if I was married—questions one wouldn’t and couldn’t ask today. Then silence. After several weeks, the partner who recruited me confided that the last partner thought that I might be gay and probably couldn’t handle the Solly trading floor! As it turns out, Solly was nothing compared with Bear Stearns where the head of trading, formerly an Israeli general, whacked me over the head at 7:00 one morning with the Wall Street Journal I had been reading, because "a Bear Stearns employee should know everything about the markets before it’s in the Journal." In contrast, 15 years later as Chief Investment Officer at Wells Fargo (formerly Wachovia), my assistant told me one day the CEO wanted me in the board room. Not knowing why, I went in. The investment banking head, CEO, head of trading, and my entire team shouted, "Surprise!" They had thrown a baby shower for me, my newborn daughter, and husband.
What advice would you give to current business school students and young professionals looking to pursue successful careers in the real estate industry?
Take my course, Real Estate Finance in the fall! Seriously, though, being successful today in real estate requires that you understand the "theory" and the "art" of real estate. My course and others give you the theory and some of the "art" through cases, but experience and relationship-building—given the decentralized, hands on nature of real estate—are essential. Theory will teach you how to do a proforma, price a loan, value a property, value distressed debt, understand how sub and mezz debt affects return and risk, and deconstruct a private equity deal to see who benefits when and how, etc. This is what I teach. I also show my students where reality contradicts theory: sometimes called a "paradox," by academics but what I call a profit. The "art" is the intangible assumptions and judgments one makes that are harder to teach and mostly can only be acquired in practice.
What cap rate should be used, and what idiosyncrasies in zoning that are not priced into the purchase price can we exploit?
I try to teach this "savvy" by using lots of cases which can contain misleading, ambiguous or subtle information, which is what happens in reality. But mostly, you need to gain relevant experience, which is why I do mini-career meetings with my students between classes. For example, we developed condos in Tribeca where the original building backed up to another, which meant fewer windows. We added value by pulling back the wall from the adjacent property, creating more windows while simultaneously adding a few extra floors with great views. Where to work and type of experience to pursue depends on what you want. If you want development, find a smaller firm that will work you hard doing a variety of things, so you can understand the whole messy process. If you want acquisitions, work at a firm like Blackstone. If you want real estate lending, get an internship helping a bank lending officer work on spreadsheets and loan committee presentations. In any career, you should look for business inefficiencies. These could be brought about by new technology, regulatory arbitrage, rating agency arbitrage, changing demographics, supply and demand lags, and ignorance.
In my own life, I, at one point, pursued a lucrative career in securitization for this very reason—to arb the real estate and debt markets. I always loved real estate and did my first internship at MIT as a sophomore, helping to repurpose the Boston Navy Yard into residences and stores. Simultaneously, I was taking graduate bond finance courses at Sloan, where I learned about the then nascent securitization markets, which more powerful computers were making possible. The idea stuck: if I could thoroughly understand both the real estate and capital markets and participate in connecting the two, I could do very well financially. This led to my taking a job in capital markets at the New York Fed, real estate at Chemical Bank, and in securitization at Bear Stearns, working for Howie Rubin of Liars Poker fame. A $50 billion market then grew to $10 trillion and I went along for the ride. My other advice is to take risks particularly when you are young, network, be aware of opportunity, and be able to negotiate. At Columbia, join the Real Estate Association and any other associations that fit you; there is an association for just about every interest.
Brian Hwang '17 is a 2011 graduate of the University of Pennsylvania where he completed his B.A. in Economics. Brian is the VP of Site Tours for the Real Estate Association at Columbia Business School. He previously worked for CBRE in the Valuation & Advisory Group and spent the summer at M&T Bank in the NYC Real Estate Debt Group.