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Hugh Frater ’85 is chief executive officer of Berkadia, which specializes in commercial real estate financial services. Previously, he worked at Good Energies and PNC Financial Services among other firms. Frater serves on Columbia's MBA Real Estate Program Advisory Board and is a member of the Columbia Business School Real Estate Forum. In a recent interview with Evan Abrams ’13, he discusses business strategy and opportunities, commercial mortgage-backed securities (CMBS), and career development.
Please tell me about Berkadia’s business model.
Berkadia is an integrated commercial mortgage banker and servicer. As a loan servicer, we service over 25,000 loans with over $200 billion in principal balance located in almost all corners of the United States. As a mortgage banker, we differentiate ourselves by providing a diverse mix of lending products and investor options for the borrower. What that means is we originate loans for our borrowers/clients on behalf of our relationships with life insurance companies, CMBS conduits, and other institutional lenders. We are also a leading lender for government agencies such as Fannie Mae, Freddie Mac, and HUD/FHA. Another aspect of the Berkadia model that differentiates us as a mortgage banker is our capital base and our sponsorship. We are owned by well-capitalized corporate entities (50 owned by Berkshire Hathaway and 50 by Leucadia) and so by virtue of our capitalization we are able to use our balance sheet in ways that smaller mortgage bankers are not. We have a proprietary lending group with an active pipeline of loans that we have originated and kept on our books because they are loans to assets that are in transition and thus not ready for more traditional permanent financing sources. When the property reaches stabilization, it is our objective to find permanent financing through our long-term lender investor relationships.
That said, most of the loans originated by Berkadia are not held on balance sheet and are thus sold to end investors. For sold loans, we typically retain servicing responsibility, which means collecting loan payments and maintaining cash escrow balances on behalf of the investors. Berkadia is the third largest primary national servicer and, on a cash basis, we earn most of our money through our servicing business. Origination is where we earn some cash, but what we are really doing is originating and building up and maintaining our servicing business.
Being an integrated mortgage banker and servicer allows us to provide a single experience to the customer: We originate loans to the borrower/customer and we continue monitoring those loans on behalf of the investor while maintaining a relationship and dialogue with the borrower throughout the process, so it’s a full-service relationship. Our business is ultimately all about cultivating strong relationships with our borrowers and investors through our integrated business lines. Maintaining a two-way dialogue with both groups allows us to know and understand investors’ appetites and successfully match those with our borrowers’ needs.
Are you focused on any particular investment style, property type, or geography with regard to the groups to which you lend?
Multifamily has historically been our core specialty, but we have the expertise to lend on all property types in all markets across the country, provided we feel we can get the right execution for the borrower and again, that’s all about having the right investor relationships to serve your borrowers’ needs.
Multi-family is particularly an interesting area right now for a couple of reasons: one, there is fundamental demand for rental housing that is not going to subside in the near-term and two, there are more attractively priced financing options available for multifamily with the existence of the federal housing agencies. If you add up all of the permanent financing in the multifamily market, Berkadia is in the top three.
What do you see as the biggest challenges facing today’s real estate industry from a capital markets/lending perspective?
In a broad sense, the biggest challenge ahead of us is in the form of loan maturities between 2014 and 2017. More than half of all permanent mortgages outstanding were originated between 2004 and 2007 and most were 10-year loans, so they will be maturing between 2014 and 2017 in what might well be a higher rate environment. Historically, with low risk free rates and thus, low mortgage rates, a lot of deals will work that would not otherwise. However, if you remember that the historical long-term average of the 10-year Treasury is 6.5 over the past 50 years, we may have a much higher 10-year rate and thus a much higher mortgage rate when these loans mature. In our servicing portfolio, for instance, the typical note rate on those maturing loans is around 5.5 and if you have not had substantial rental growth at these properties, which might be 20 to 30 years old at maturity, it’s going to be a big mess. From my perspective, that’s the elephant in the room, and this situation is particularly exacerbated by the fact that we have not had a robust recovery in the CMBS market. Without the CMBS market, in my opinion, there is not enough capital to finance commercial real estate in the U.S. This is because you need long-duration investors to finance permanent loans, and who are the long-duration investors? Pension funds, insurance companies, and the CMBS market, which is nothing more than the mechanism by which pension funds and other institutional investors invest in the long-term commercial debt market.
So, unless you get long-duration investors involved via the CMBS market, you have to dramatically shorten the duration of the loan market and hope that the commercial banks step up to take on additional real estate exposure, which could be a long shot. So again, no matter what direction I look at it from, the issue is the wave of maturities and where are the long-duration investors that are going to invest in and refinance the maturing loans.
Where do you see the greatest opportunities for your business model going forward?
What we believe is that there are a variety of regulatory factors that are creating opportunities for us. In a world of Basel III and Dodd-Frank, of slow growth and low nominal returns, we believe that all these things taken together mean the future favors less regulated entities that are also well capitalized and highly efficient. If you have an environment of lower nominal returns and less spread on the investments that you’re making, then you really have to be more productive. More regulation certainly means less regulated entities should be able to thrive, but it doesn’t mean that they don’t have to be well capitalized. The market is going to be looking for the ability to retain risk, refinance counterparties and so on. As mentioned previously, Berkadia is well sponsored and well capitalized and we are the most efficient mortgage servicer. We plan to be the servicer’s servicer, offering other servicers a compelling combination of service and value. For instance, we have the lowest cost of service in our industry, so if other servicers have built up big servicing operations but don’t have enough revenue to spread over that cost basis, we can act as a sub-servicer and help them save money by transitioning some of their fixed costs into variable costs. What enables us to be efficient is the fact that we have operations at scale.
Over the past two years, the traditional life insurance companies have reemerged as active lenders in the market as the CMBS shops have been sidelined. As CMBS slowly starts to come back, how do you see CMBS competing in terms of credit, asset and market quality, pricing, and so forth without exposing themselves to the risks so prevalent leading up to the financial crisis? Do you see CMBS returning to its pre-crisis prominence with regard to market share in the real estate lending space?
I have no doubt that the CMBS market will come back in part because it needs to. I don’t think there is enough capital available in the commercial real estate space without it. This is especially true for commercial property where we don’t have the level of government support in the form of agency financing like we do for multifamily. When and if this government support goes away, the need for the CMBS market will be even more acute. Life insurance companies, for example, allocate a certain amount of capital to commercial real estate and they may allocate a greater percentage to meet some of the pending financing demand. However, these companies are focused primarily on the higher end of the property market and their industry is not one of high growth, so they cannot become a financing force for the broader commercial real estate market in a dramatic way.
If you believe that a healthy CMBS market needs to be originating approximately $75 to $100 billion of capital per year, and you think about what we were talking about before with the big bubble of originations back in the mid-2000s, in 2007 alone CMBS originated $270 billion of capital and a big chunk of those originations will mature by 2017. So, if the CMBS market is currently originating approximately $30 to $40 billion annually, there is a long way between where we are today and where we need to be, even if you take loan amortization into account over the 10-year period. Because of this, and because of the relatively limited amount of capital coming from other long-term capital providers, the CMBS market will come back but it will be reasonably efficient, with less leverage available for lower quality properties and the need for more equity in deals.
Can you discuss how the role and influence of special servicers have evolved since the onset of the financial crisis given that the number of troubled prerecession loans reaching their maturity dates continues to grow?
I think that the special servicer market is evolving and there is a passing of the torch from a former group of special servicers to a new group. The biggest special servicers were originally built up as part of investment operations that were investing in high-yield bonds. There were also a few third-party servicers that provided asset management services for a fee. With a new generation of high-yield investors, there is a new generation of special servicers coming along. With regard to the controversy of how special servicers influence outcomes to benefit their own economics, bond investors that have assets being managed by the special servicers are watching their activities much more closely than before, and there has been the emergence of the operator-advisor role to check on the activities of the servicers.
I think that overall, special servicers are a very important part of the market because if they are honest actors, and certainly most of them are, they are simply trying to provide thoughtful advice to the people that bear the economic consequences of the assets in question which, at the end of the day, are the bond market investors. When there are unanticipated problems, the good news is that these investors have someone whose business it is to deal with troubled real estate, think about resolution strategies, and recommend actions that are in the best interest of the bondholders’ trustee. So, I think the role of special servicers is a critical one that has been getting more attention as there have been more problems in the market over the past few years.
Moving ahead, I believe you will see the level of loan delinquencies actually decline until that wave of maturities that we were talking about before comes along. So, the issue in the special servicing world is starting to become: How do you maintain your capabilities and expertise as activity levels decline? That’s the on-the-ground operating challenge that some special servicers will face as the number of troubled prerecession loans goes down for a while before it starts going back up.
Given the uncertain economic environment and the wave of maturities set to come due over the next five years, where do you think the best opportunities are for lenders today? How will the lower quality assets in tertiary markets get refinanced?
The best opportunities will rest in the ability to provide bridge or mezzanine-level financing. The lower quality assets in tertiary markets might get refinanced by smaller banks in those markets, but that’s a big if. In any case, more equity is going to be needed when these loans come due.
You have had an impressive entrepreneurial career. What suggestions do you have for current students interested in starting and building successful businesses? Two pieces of advice: number one, no matter what you do, be good at it; make people notice you for your competence. And number two, look for mentors; find the smartest people you can and learn from them. I got lucky but that’s what worked for me. When I worked at Lehman Brothers, my boss there was the smartest guy I ever met. When he eventually told me he was leaving the firm, I thought, “Great, now I’m the smartest person at Lehman Brothers.” Of course it wasn’t true but the point being that he was and still is a really smart guy and a great mentor.
A key element to success in the real estate industry is the management of industry relationships. Do you have any advice to current students on how to nurture and create a successful network?
It is important to develop and maintain your relationships from school, with your peers, adjunct professors and alumni. Be sure to also develop relationships in your industry: friends at other firms, contacts on a deal, your competitors. You never know how those relationships will pay off, but I assure you they will. At a minimum you will learn from them. What others in the industry are doing could be advantageous to you and what you’re trying to do; it may lead to business opportunities or ways to improve your own business. You never know.
You have been very involved as a Columbia Business School alumnus. What do you think are the best ways for alumni to get involved?
There are many ways to be involved but coming back to campus to share your accumulated expertise is one way to stay connected. Another is getting involved in recruitment. And of course, if you have the capacity, be generous and give money. All of these things can only enhance the value of your Columbia degree.