Cornerstone speaks with Scott Muldavin
Q: For those unfamiliar with the term, please generally explain the concept of mortgage-backed securities.
A: These securities are backed by cash flows from pools of commercial or residential mortgages. Sponsors of mortgaged-backed securities, typically investment banks, package up the cash flows and create “traunches” of securities (AAA, AA, A, BBB, etc.), which they sell to investors.
Commercial Mortgage-Backed Securities (CMBS) have grown dramatically during the last decade from around $10 billion to over $100 billion per year in new originations. CMBS are important because they have brought in substantial new capital from bond investors who typically would not invest in mortgages, which subsequently reduces interest rates for borrowers and provides liquidity when borrowers would otherwise face a tight credit market.
Q: What differentiates Green CMBS from typical ones? Are they superior and, if so, in what way(s)?
To date, “Green” CMBS are just a concept, but have not yet been created. Green CMBS would be securities backed by cash flows from mortgages on green buildings. Alternatively, an important green goal in the CMBS industry is to enable lenders and rating agencies to appropriately value and rank the green attributes of any mortgage, whether included in a Green CMBS or just in a traditional one.
Securities backed by mortgages on green buildings could be advantageous to investors due to improved operating efficiencies, tenant retentions, higher value, and lower risk due to reduced cash flow volatility. (As energy price volatility increases, a building using less energy will experience less variability on its utility expense line.) Another benefit could be a reduction in potential lawsuits from indoor air pollutants and mold.
Sponsors of Green CMBS would make greater profits if rating agencies valued their mortgages higher (based on underwriting models that incorporate cash flow, value and risk issues) or if investors interested in socially-responsible investing increased market demand for Green CMBS securities, thereby improving overall pricing and originator profits. Borrowers would ultimately benefit through increased capital availability and lower capital costs.
Q: What “players” are or need to be involved in the adoption of these types of securities?
A: Key players include tenants, borrowers, lenders, CMBS sponsors, rating agencies, “B” piece investors, and investment grade investors. Tenant demand for green buildings is the driving force behind enhanced value. Concurrent to this demand, borrowers must seize the opportunity to make green-oriented decisions and investments upfront; lenders and rating agencies must know how to evaluate and appropriately recognize the value and risk attributes of green buildings; sponsors must take the initiative to push the concept and development of Green CMBS; and investors must recognize the benefits and rely upon proper lender and rating agency due diligence when making decisions.
Q: What are the main hindrances and solutions to the adoption of Green CMBS?
The most significant challenge is the relatively low volume of green buildings and related mortgages currently in capital markets. Not only is green building penetration in the private sector in its infancy, but the focus of these techniques has historically been on new construction. To date, the CMBS loan origination has only applied to existing properties where actual cash flows and value can be measured.
Other challenges include the development of underwriting practices and valuation tools to enable lenders and rating agencies to appropriately evaluate the cash flows, value and risk-reduction potential of green buildings. While a number of reports and case studies have demonstrated the worth of such investments, practices and models that would enable the evaluation of individual buildings given their attributes and specific geography are not well developed.
Q: What is your prediction of their future success?
The development of the practices and tools mentioned above is a key goal of the Green Building Finance Consortium that I am leading, and I am optimistic that lenders and rating agencies will make progress in this area. Given the rise in socially responsible investment funds, it is also likely that a Green CMBS fund based solely on green buildings will be undertaken in the near term, most likely relying on a few very large mortgages as underlying collateral.
Progress with Green CMBS will not be as quick as many would like because, fundamentally, bond investors are very conservative and place an emphasis on cash flow. That being the case, many harder-to-quantify benefits (those that might be more valuable to governments, corporations or owners) will only slowly make their way into the CMBS industry in conjunction with the improvement of analytic and valuation measurement tools.
Scott Muldavin, president of The Muldavin Company, Inc., has been a consultant for 25 years to many of the nation’s leading real estate companies, including Bank of America, Standard & Poor’s, and Freddie-Mac. He is a founding principal of Guggenheim Real Estate, a $2 billion private real estate investment company and an Advisory Board Member of Global Real Analytics, a company advising on over $1 billion of private REIT and CMBS funds. In 2006, Mr. Muldavin became executive director of the Green Building Finance Consortium, a group dedicated to addressing the private sector’s need for better valuation and underwriting tools to enable an assessment of green building investment from a fiduciary perspective. A frequent speaker, he has authored over 200 articles on real estate finance and investment. More information on Commercial Mortgage-Backed Securities can be found at www.cmbs.org.