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When LCOR, a Berwyn, PA-based developer, acquired an empty office building in the Washington DC area submarket of Crystal City, VA, in 2012 it already knew it was going to replace it with a luxury apartment-condo twin-tower property. The demographics were right and Crystal City is a short drive to the nation's capital. And so it went through the permitting and approval process, which duly approved the plans and prepared to break ground. The final step was to secure the construction financing for the project, which would clock in at around $100 million.

That amount, as most know, is a sizeable loan for construction financing—especially after the Basel III requirements that created a new category of acquisition, development and construction loans called High Volatility Commercial Real Estate. It was assumed that the 150% capital requirement for HVCR loans would make them more expensive for both lender and presumably borrower and drive the latter to non-bank sources.

Or maybe not. LCOR got the construction financing from Wells Fargo, securing close to $101 million. The new regulations were not a factor in LCOR's negotiations for the Wells Fargo loan though, says Harmar Thompson, SVP of LCOR.

Why not? Thompson shrugs. It could have been because LCOR has a strong relationship with Wells Fargo. It could be because this is a strong project. Or maybe it's because Wells Fargo was underexposed to this submarket and this asset category in its portfolio.

Whatever the reason, Thompson remains unconcerned, although definitely not unaware of the pressure regulations facing banks, especially from the Basel Committee on Banking Supervision, which is proving to have a disconcertingly long reach into US commercial real estate finance.

“Wells Fargo is one of the few groups that can do a loan of this size on its balance sheet without syndicating it to other banks,” so capacity is limited in that respect, he says.

Right On Schedule

And so it goes for the commercial real estate market and its buyers and lenders and sellers. Every year it seems, at least since the end of the Great Recession, new regulations are proposed and passed that threaten to tighten liquidity. In the early years after the recession, the Dodd-Frank Act was the industry's favorite villain. Lately it has been Basel III, which has been issuing the oddest of proclamations when it hasn't been actively frightening the industry with such proposals as a rule change for banks' fixed income trading books that could impose a huge capital requirement on secondary market makers.

That rule change was supposed to be finalized in December, but has since been postponed until January. As of this writing, it hasn't been announced. Meanwhile the industry will just have to wait and probably wait some more to find out what Basel has in mind.

The proposals are preliminary, it said in its December announcement “and the Committee has yet to decide how they should be incorporated into the regulatory framework…”

“The Committee will assess the potential impacts of the proposals, particularly as to whether they adequately capture entities posing potential step-in risk.”

One gets the sense that something is coming, though. Basel said it is planning to conduct a Quantitative Impact Study in the first half of 2016 “to collect evidence on the nature and extent of step-in risk, so as to inform its deliberations on the final framework.”

A Regulator Bias Against CMBS, Shadow Banks

The bureaucrats and regulators working on Basel III would never admit it, says a lobbyist who used to work for a former US financial regulator as an analyst, but they have a clear bias against securitization and structured finance.

“They think it is confusing to investors and a way for the lenders to arbitrage risk and create bad products and then disown them.”

They also are determined to clamp down on risk in the so-called shadow finance ecosystem, this person also says.

Regulators have just about cleaned up the problems they saw with banks and now they are shifting their focus to non-banks and shadow banks. This category includes CMBS, broker dealers, asset managers, insurance companies, repos and securities lending and money market mutual funds.

Perhaps in another era Basel's rules would not have so great an impact on the regulations in the US, but the heads of the financial regulators now, the Federal Reserve Bank, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency, are very supportive of Basel III's work, says the lobbyist.

In December of 2015, the Fed, the OCC and the FDIC issued a statement “to remind financial institutions of existing regulatory guidance on prudent risk management practices for commercial real estate lending activity through economic cycles.”

They said that they have observed many CRE asset and lending markets that are experiencing growth, and subsequently bowing before increased competitive pressures to weaken underwriting.

Fortunately, other indicators of CRE market conditions, like vacancy and absorption rates, and portfolio asset quality indicators, such as non-performing loans, “do not currently indicate weaknesses in the quality of CRE portfolios,” the regulators concluded.

Translation: they will not be issuing any new regulations now but they will be stepping up scrutiny of lenders' books in 2016.

Also at the end of this year the risk retention rule for CMBS, a rule required under Dodd-Frank, goes into effect but for all practical intents originators will begin complying with it by mid-June.

The B piece buyers, on whom this requirement mainly falls, are positioning themselves for this date but they are not revealing exactly how they plan to address this requirement, says Stephen Renna, CEO of the CRE Finance Council. The best guess is that B piece buyers will want better credit and will be willing to pay for it in terms of better spreads, he says. “But that will make CMBS more expensive and harder for certain borrowers and deals to get.”

A World of Robust Liquidity

But back to LCOR's Thompson, who fully expects to continue to do business with Wells Fargo. He sees an entirely different CRE capital markets environment than the one just described.

This capital market ecosystem is robust and capital is plentiful—and smart too, with a long memory. Lenders are not underwriting to pro forma and they are not inclined to go out of bounds on underwriting standards, he says.

CREFC's annual report in which it surveyed its membership sees similar largeness in the market. CMBS is estimated to be in the range of $100 billion to $125 billion.

Respondents believe other capital sources are stepping up their CRE allocations. For instance, 66% of survey respondents expect a higher level of loan originations from balance sheet lenders this year and 76% predict that nonbank or private capital sources will originate more loans this year, compared to last. The majority of survey respondents expect foreign investment in both CRE debt and equity to increase.

The London-based Preqin reported that closed-end private real estate funds raised a combined $107 billion globally in 2015, just below the $111 billion raised the previous year. And because Preqin expects these figures to rise 10% to 20% as new data become available, 2015 looks set to be the biggest fundraising year since the financial crisis.

Last year also saw dry powder hit record levels to stand at $252 billion at year end, Preqin also noted—a reflection of both the strong fundraising market of recent years “and the challenges fund managers face putting capital to work.”

The reason for all this dry powder is, of course, the long era of low interest rates and the relatively higher returns that commercial real estate has offered investors compared to other fixed income investments.

Signs of Tightening

This is not to say that these two capital market worlds—increasing regulation versus still-strong liquidity—exist in parallel dimensions. There are signs of tightening even as deals continue to get done.

Michael H. Sonnabend, managing member of PMZ Realty Capital LLC, a boutique real estate investment banking firm in New York City that focuses on the hotel industry, has noticed it even as he continues to arrange financing.

Construction finance for hotels is definitely tighter than it was a year ago, he says. As the year goes on it will become even more difficult to source capital for hotel deals, he said.

Here's the rub, though: Sonnabend doesn't believe this is due to regulatory constraints but because of where the hotel cycle is right now and lenders' reluctance to be caught at the top.

Like Thompson, he's not worried. Maybe first mortgage lenders will become too conservative for hotel transactions but there is “plenty of equity money out there that is under exposed to hotels and would like some coverage.”

Other asset classes, meanwhile, are heating up and investors are finding little trouble funding acquisitions. Washington, DC-based ASB Real Estate Investments made its first office acquisition in Portland, OR—a 55,500-square-foot warehouse property in the city's upscale Pearl District. ASB and its joint venture partner Specht Development plan to redevelop it into creative office space.

It's a beautiful historic asset with exposed timber and brick, says CEO Robert Bellinger. It will be the perfect workspace for Millennials, as will similar assets that the company has under contract in Boston and San Diego as well as a second building in Portland.

The company made the investment on behalf of its Allegiance Fund, a $5-billion core investment vehicle. These office types—urban located, suitable for creative work forces and Millennial employees—can now be considered core.

The Wave Meets The Wall

Could this be the root of regulators' fears? Eager investors snapping up, let's be frank here, an old warehouse—in a second-tier city, coming up on its 100th-year delivery anniversary—for $14 million? There is plenty of historic evidence of other investor bets on categories and markets that bombed spectacularly. Just ask any suburban office owner.

There are also any number of savvy investor bets that have paid off and in the case of ABS, Bellinger has done his homework on workforce trends, demographics and eventual ROI. Rents are rising in Portland but even if they remain where they are, the purchase should still do well for the fund, he says. And investors like the concept of targeting Millennials, he adds.

So maybe it is possible that regulators look at smart money chasing after dusty, aging warehouses and see the beginnings of an excess that could lead to another financial meltdown. And maybe they do put the brakes on so hard that capital becomes harder and harder to secure.

But here's another image that also applies to the current environment. In previous years a wave was the go-to metaphor used when discussing CRE trends—as in, a wave of maturities coming due that would crush the then-struggling industry.

So let's continue to use that wave to represent the capital market—only now it is the still-pent up liquidity in the system and it is crashing around the wall the regulators are trying to build around the economy.

Which force is stronger? That is to be determined.

Wells Fargo

Instant Insights /

A Capital Market Explosion (Or Is That Implosion?)

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