There is a new paradigm floating around the commercial real estate investment community today — it is that mortgage debt is worth more than the real estate itself, so buy the debt and skip the angst of property ownership. As odd as this may sound, it is playing out precisely that way in both the financial and property transaction marketplace.

The latest quarterly figures from the Federal Reserve show outstanding mortgage debt in the commercial/multifamily sector in the first quarter rose by $60.8 billion to $2.3 trillion. Multifamily mortgage debt outstanding grew to $856 billion during the first quarter, an increase of $18.5 billion.

At the same time, the number of global property transactions fell by 46% in the first quarter of 2008 compared with the same period a year ago, with deals in the Americas down by two-thirds, according to PrivateEquityReal Estate.com, a fund investment research organization. Asia, the group reports, was the only part of the world to see an increase in sale transactions. And this all happened while mortgage investors were stepping up their investment search.

CMBS gives up its crown

Commenting on the Fed data, Jamie Woodwell, the senior director of commercial/multifamily research at the Mortgage Bankers Association said, “The global credit crunch meant a net decline in the balance of mortgages held in commercial mortgage-backed securities, collateralized debt obligations and other asset-backed securities, but banks, thrifts, life insurance companies, Fannie Mae, Freddie Mac and nearly every other investor group increased their holdings of commercial and multifamily mortgages during the quarter.”

But as encouraging and energizing to market cheerleaders as these numbers may appear, there is an underlying issue not reflected in these statistics — the fate of existing non-securitized loans on lenders' books. And based on the Fed's recent flow of funds analysis, there was a decline in loans that are securitized — a big decline.

Mortgage- and asset-backed securities issued in the first quarter are down significantly, with total CMBS issuance, for example, at $5.9 billion compared with $33.3 billion in the previous quarter, and $61.2 billion in the same quarter last year (see chart). Much of the originations' slack that would otherwise feed the CMBS machine is being picked up by banks, thrifts, government-sponsored enterprises, and insurance companies. Thus the place to go for a commercial/multifamily loan these days is to a portfolio lender such as the local bank or a life insurance company.

Cash rules for now

So what happens to all those non-securitized loans made over the past 12 to 18 months? The simple answer is they continue to sit as unwanted freight on the balance sheets of lenders — many of which made these loans with the expectations of having moved them off of their books by now and into a securitization pipeline. And in many cases, these lenders have been forced to bring their loan origination machines to a grinding halt. That said, the name of the commercial real estate investment game for the next 18 to 36 months boils down to one question: Who can quickly and successfully execute loan trades without having to give away the store?

The wild card in all of this is loan buyers in the form of pension funds, hedge funds and other private equity real estate investors. These players will drive the immediate future of real estate because they are holding the wads of cash raised in the private and international marketplace over the past six months. And there is ample evidence — found in just about every daily real estate news item around the industry — that institutional investors are chasing commercial mortgage debt that either has high yields or a distressed situation attached to it.

Loan buyers today are clamoring for high yield, and are attempting to pay fire-sale prices to acquire even well performing loans that were originated with sound credit and real estate fundamentals. Therein lies the challenge for the loan trading professionals in the coming months. They must execute good loan trades in order to preserve their lending institutions' eroding capital base. They must give their shops an opportunity to begin lending again — albeit much more cautiously.

To be sure, this will not be an easy feat to accomplish against the tide of real estate investment funds and loan buyers with minimum required investment returns, in some cases, well over 12%.

W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance consultant.