CMBS pioneer Ethan Penner has alighted at CB Richard Ellis Investors, as reported recently, coming aboard as executive managing director. It was an odd move to some, given the entrepreneurial spirit of the man and the forms-and-policy structures that can be part of any corporate environment. But the man who founded Capital Co. of America/Nomura Capital–at the time, among the largest real estate lenders in the country–and who took a principal position in Lubert-Adler, has different thoughts on the subject. He also has some strong positions on the state of the market, the current near-death experience of the CMBS sector and the duration of the current down times, and he doesn’t hesitate to share them: I see a bifurcated market–those on the sidelines and those who see opportunity. I’m assuming you stand on the side of opportunity.

Penner: There’s a great classic-contrarian quote from Warren Buffet that says when greed is pervasive, that’s the time to be fearful and when fear is pervasive that’s the time to be greedy. There’s much more danger in a market that’s highly capitalized than there is in a market such as this. How has the market changed?

Penner: The business of real estate investing and real estate finance are synonymous, but people tend to bifurcate the capital structure. That’s a fundamental mistake because regardless of where you are in that structure, the essence is understanding the asset itself, its value and how that’s likely to fluctuate in response to market changes. Over the past four or five years, the market has become dominated by people for whom the fundamental value was not a prime consideration and we got more into a financial-arbitrage business. So I think there’s going to be a return to emphasizing fundamental value. So, during the go-go 2000s, were we doing the right things for the wrong reason?

Penner: I’ve always been the youngest guy in a business and now I’m one of the older guys, and sometimes it hits me that there’s no substitute for age and experience. We all look for comparisons, and the initial comparison many young people were making was to the 2001 period or 1998–both of which were short downturns. The cycle we began last spring was much more fundamental. It was derived from excesses in the financial markets related largely to securitization, and it touched everything–real estate and corporate finance and asset-backed securities and single-family mortgage finance. The gravity of this downturn is going to be much more severe than I think people believed. Did I see that deals didn’t make sense? Yeah, of course. You had people accepting extraordinarily low cap rates with the hope that rents would accelerate in a manner that didn’t make a whole lot of sense.

But, having said that, it’s not like I was smarter than everybody else. A lot of people saw it too, and frankly, those who were making the purchases–push comes to shove–might have admitted that they saw that possibility as well. But the system was providing a free option–tons and tons of leverage available and tons of other people’s money, which could be managed for exorbitant fees with significant sharing of the upside. When you have misaligned motivation you’re not going to end up in a good place. It was in CMBS where you carved your name in the rock. How do you look at the hit its taking?

Penner: It’s funny how people overlook some very basic things. There are a couple of data points I’d like to give you. There are, essentially, three ratings agencies, but Moody’s and Standard & Poor’s represent probably 80%-plus of the market. Now, the largest portfolio lenders would be Teacher’s, MetLife, Prudential or GE Capital. The largest amount of loans that they might have originated in a given year is somewhere south of $10 billion. Last year, there was $230 billion of CMBS originated. That means that S&P and Moody’s effectively underwrote $200 billion in loans. That’s 20 times the largest lender in the history of the US was able to underwrite. Does that make sense? Does any single company have the capacity to get their arms around the credit risk of $200 billion in loans in a single year? Where was the skepticism? Also, on average, a triple A in 1995 had 33% subordination, in 2000 it was about 20% or 22%. In 2007 it was 12%. How’s that even possible? Where’s the logic to support that slip? No one was asking, as far as I can tell.

In addition, triple A’s in ’95 were bulletproof compared to the triple As of ’07. A triple A should always have the same credit-worthiness in every market, but they were less credit-worthy and they were bid-up more feverishly by the market. Not only was the market not skeptical but it was welcoming these inferior triple As with open arms. All of this should have led to more skepticism, but the opposite occurred. The market was more embracing than ever. Just to be clear, you don’t blame the ratings agencies?

Penner: I really don’t. If the market’s sending you $200 billion to rate, you rate it. You say, “Thank you very much,” and do the best job you can. It’s not their fault, it’s just that there was no skepticism in the market. Is the market wising up?

Penner: The market is starting to wake up and see those statistics. And that’s a very healthy thing. And it’s why we have a stock market. People ask when this environment will correct, and that’s really a foolish question. People that ask that question perhaps are either engaged in wishful thinking or don’t understand the nature of what’s happened.

How do you put a price on something when you’re not sure what the real credit-worthiness is? The data clearly reflects that a triple A from 2006 or 2007 doesn’t have the same credit-worthiness as a triple A from 2000. It’s going to take a long time to sift through all those deals. The market’s stuck, and the Wall Street community, which is not in the business of holding assets, finds itself in this sad game of musical chairs and holding the largest possible inventory they could possibly imagine. And that’s a very bad thing for them and for the market at large. That’s why there’s no liquidity; you have no market-makers anymore. Market-makers can’t make markets when they’re sitting on inventory that’s not movable. Let’s focus on your role at CBREI. What assets, what geographies, what opportunities are you focusing on?

Penner: We have a number of different funds, and we’re going to raise a number of new funds through which we hope we build a platform that allows us to be smart and address the broad opportunities we see in the market today. There is no end to opportunity. People have commented about your entrepreneurial reputation and how that will fit into such a corporate environment. What’s your take?

Penner: I am an entrepreneurial guy, and I like to think creatively, but for my skills to be best harvested, I need to surround myself with people who are not exactly like me and, perhaps, opposite from me and, therefore, complementary to me. Neither CBRE nor CBREI are companies that are stuck in the mud. They’re extremely ambitious, with CEOs who are brilliant and aggressive and ambitious–which are great entrepreneurial attributes. This company has 28,000 or 29,000 people all engaged in the business of real estate. So the information that I have available via a phone call is monumental. I fit in great and, although I’ve been here for less than two months, I feel a remarkable sense of belonging. What’s your outlook, long term?

Penner: We’re in a multi-year adjustment process. It’s the sobering period when the party is finished, and now the excesses of that party are being wrung out of the system. Healthy business, profitable business can start getting done now, in the mainstream rather than on the fringes. More rational approaches to risk underwriting will prevail in every business. To me that’s invigorating. But I don’t think we’re out of the woods by the way, the full down-cycle hasn’t happened yet. We’re not at the bottom?

Penner: We’re not even close to the bottom. There hasn’t been the clearing of the assets from 2006 and 2007. Is 2009 too soon to be optimistic?

Penner: I think 2009 and even ’10 are going to be dominated by pain and suffering. And I think it won’t be until ’11, ’12 or even ’13 that you’ll see the next cycle of cautious underwriting beginning.

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