Capital Versus Capitol

Around the end of February, Paul Vanderslice trekked to Capitol Hill to plead his case before the House Financial Services Committee. He spoke not as co-head of the US CMBS Group and the head of the Commercial Mortgage distribution efforts for Citigroup Global Markets, but rather on behalf of the Commercial Real Estate Finance Council, where he recently served as chair.

The message to Congress was a simple one: please add more flexibility to the proposed risk-retention rules for CMBS. If not, the consequences could be significant for this form of commercial real estate finance, which is only just now finding its sea legs after the financial crash of 2009.

Vanderslice's comments come at an interesting time for CMBS and provide a telling allegory for the rest of the commercial real estate capital markets. Last year was a banner one, relatively speaking, for CMBS and 2014 is expected to be just as good or better. Ditto for private equity, GSE financing, REIT capital raising and bank lending. The economy is improving and subsequently demand for multifamily, retail, office and industrial are all high. Construction pipelines have been relatively constrained, except perhaps for multifamily, setting the stage for a favorable supply-demand dynamic.

ULI senior resident fellow Steve Blank says, “CRE fundamentals have improved. Right now, real estate is just waiting for the rest of the economy to do its thing and increasingly there are signs that this is happening.”

Yet over all of this lies a question—and a giant shadow that it casts: what will Washington do? One or two wrong moves from the government could throw the industry's capital markets back into the dark and dour years after the financial crash, the CMBS market a case in point.

Last year for example, CMBS lending rose 85% to reach $82 billion, thanks to such new and returning players as New York City-based Credit Suisse Group AG, which came back to the market after a six-year absence with a $187-million hotel deal, and Ares Commercial Real Estate Corp. in Chicago, which posted its first CMBS transaction in the fourth quarter of 2013.

2014 promises to be even more robust, with the general consensus being that the market will hit $100 billion in issuance.

A Mortgage Bankers Association survey released at the start of the year reported that commercial and multifamily mortgage lending is expected to increase as lenders' appetites to place new loans grow. A full 91% of the top firms surveyed by MBA expect originations to increase in 2014, with 48% expecting an increase of 5% or more. Almost two-thirds (64%) expect their own firms' originations to increase by 5% or more.

To be sure, challenges exist, as they always do. While lenders are positively enthusiastic about placing money, borrowers are still slightly shell-shocked from the recession, Jamie Woodwell, MBA's vice president for commercial real estate research, acknowledges. “Borrowers' appetites to take out new loans are expected to remain strong, but perhaps drop a bit from 2013 levels,” he says. “The resulting competition to lend leads originators to expect loan risk to increase marginally in the face of moderating returns.”

If that sounds like there will be a further loosening of underwriting standards, that is probably because there will be. However, the industry appears to be determined not to repeat the lessons of 2007, and borrowers, too, for that matter, as Woodwell's comment indicates. Borrowers, in general, are financing a smaller portion of a property's overall worth and they are using a smaller portion of their cash flow to pay off debt. LTVs and debt service ratios, in other words, are still worlds away from where they were in 2007.

The same conservative approach underpins CMBS. Last year, the average US CMBS loan was 63.6% of the property's value, according to Trepp; in 2007 it was 69.3%.

The industry is also well-prepared to handle the expected spike in commercial and multifamily loan maturities in 2015 and 2016. At the same time, property values have risen and many assets that were underwater at the time are now solvent.

But these rosy scenarios and projections assume Congress will listen to the industry's plea for flexibility on the CMBS rules mandated by Dodd-Frank. “The proposed CMBS retention rules impose a cost on borrowers that is projected to be between 40 to 50 basis points,” Vanderslice warned in his testimony. “This translates into an increased cost burden on commercial property owners of 8% to 10% at current market borrowing rates of approximately 5%.”

REITs Are Still the Capital Markets' Darling

REITs are another example of a commercial real estate category that has high hopes for the capital markets this year-with the proviso that Washington doesn't muck it up.

Since the start of the year, at least until mid-March, REITs have been outperforming the larger S&P 500 stock market, after a disastrous year (at least from shareholders' perspective) in 2013.

For the first two months of the year, the FTSE NAREIT All REITs Index was up 8.22%, the FTSE NAREIT All Equity REITs Index was up 8.13%, and the FTSE NAREIT Mortgage REITs Index was up 10.52%, compared to the S&P 500's gain of 0.96%, according to NAREIT figures.

Investors have rethought their knee-jerk response last year to the Federal Reserve Bank's decision to begin tapering, explains Brad Case, NAREIT's vice president of research. Conversely they also reevaluated portfolios and decided, especially after last year's rocket ascent of the S&P 500, “that the non-REITs side is overvalued.”

The bigger story, he says, is that investors are starting to be more reactive to macroeconomic improvement and not solely to the direction of interest rates as they were last year starting in May. “It's not that the market ignores interest rate rises, but improvements in the economy are more important. For some reason last summer, investors ignored the macroeconomic improvements and focused only on interest rates.”

Capital raising for REITs is an equally happy story. US equity REITs raised a total of $8.87 billion in capital year-to-date as of March 7, according to SNL Financial, which is slightly less than the same period in 2013 but still a solid number.

The capital raised via common equity totaled $1.57 billion, while senior debt offerings generated $7.31 billion.

The growing popularity of non-traded REITs is another indicator of these vehicles' popularity with investors—and their favorable positioning for 2014. “Non-traded REITs are claiming a very large piece of the capital markets and we think that trend will continue to grow,” says Jeff Edison, co-chairman and CEO of Phillips Edison & Co., in Cincinnati.

Phillips Edison, for instance, recently registered its second non-traded REIT through which it expects to raise $2 billion of equity. “On the debt side, we see a lot of interest as well,” he says. “We have closed on one major debt line and we have a second unsecured debt line we will close for another non-traded REIT.

Demand drivers include the appeal, in general, of a lower-leveraged grocery anchored portfolio, and specifically, the durable income stream delivered to the investor, he says.

Washington's potential threat in this scenario is not the Fed's tapering activities. Rather, it is House Rep. David Camp's proposed rewrite of the US tax code. Granted, no one believes this proposal is likely to make it into law in the near future. However, debate over the proposal has been heated because many believe it will be a talking point for tax reform for years.

One of the many items in the proposal had to do with REITs. Namely, provisions that would end or discourage many REIT transactions, including tax-free REIT spin-offs, REIT conversions, “dividend access” and “opco/propco” REIT structures and investments in “non-traditional” REIT asset classes, according to an analysis of the legislation by law firm Hunton & Williams.

Specifically, it said, the legislation based on this discussion draft would:

• Make REITs entirely ineligible to participate in tax-free spinoffs and prevent any corporation involved in such a transaction from making a REIT election until the 10th taxable year beginning after the taxable year in which the spinoff occurred.

• Require C corporations that converted to REIT status to pay corporate income tax on the built-in gain in its assets at the time of the REIT conversion. This provision would also apply if a C corporation transferred assets to a REIT in a carryover-basis transaction.

• Under current law, the tax on the built-in gain on assets a REIT acquires from a C-Corp upon a REIT conversion or in a carryover-basis transaction is generally paid only if the REIT disposes of the built-in gain property in a taxable transaction during the 10 years following the REIT conversion or carryover basis transaction, Hunton & Williams explains.

• Mandate that if rent based on a percentage of gross sales or receipts (“fixed percentage rent”) received by a REIT from a single C-Corp exceeded 25% of all fixed percentage rent received or accrued by the REIT for the taxable year, then none of the fixed percentage rent from that C-Corp would qualify as good income for the REIT gross income tests.

Remaking the GSE s

Another well-functioning portion of the commercial real estate capital markets are Fannie Mae and Freddie Mac. After a quiet period during which many investors in the multifamily sector were collectively holding their breath, Congress is taking the initiative to dismantle the GSEs and replace them with a private-sector led program.

Briefly, the proposal would provide an explicit government guarantee for mortgages, but only after private investors have taken the first losses. A new federal regulator would be established, the Federal Mortgage Insurance Corp., that would provide this guarantee and oversee the system. Fannie and Freddie would be wound down and eliminated and specific benchmarks and timelines would be put in place to guide Federal Mortgage Insurance Corp. and market participants in the transition.

One of the few nods the proposal makes to the GSEs' support of the multifamily industry is that this market “would be supported with the development of risk-sharing mechanisms and products.”

Long sensing which way the wind was blowing, the GSEs have moved into this sphere with the introduction of risk-sharing investment vehicles. Last year, Fannie Mae rolled out its C-Series product line. This year in February, Freddie Mac debuted a $1-billion offering of Structured Agency Credit Risk (STACR) debt notes after introducing the product in 2013. Essentially, the STACR bonds transfer risk to private investors with Freddie Mac retaining the first loss position and a vertical slice of the bond.

The GSE expects to issue them on a regular quarterly basis, Mike Reynolds, director of portfolio management at Freddie Mac, says.

Capital sources are reconfiguring their operations to accommodate this expected shift, but the transition is bound to result in some lost deals and dislocation.

Again, though, not all challenges in the CRE capital markets are Washington-made. There are signs that investors are getting tired, or at least leery of, multifamily product, says CohnReznick's David Kessler. “When I speak to equity sources they tell me they are looking for more office, retail, hotels and even the alternate classes of senior, military housing, homebuilding, self storage and data centers,” he says. “A lot of capital has flowed through multifamily through the Great Recession and now people are starting to fear an oversupply will lead to an inability to raise rents.”

Also, to be fair, the institutional existential threat to CRE is not limited to Washington. The US Financial Accounting Standards Board and the International Accounting Standards Board could force companies to revamp their real estate holdings and balance sheet accounting methodologies if a proposed rewrite of lease accounting standards goes through. Stay tuned for that story—the two standard-setters are expected to meet again in March to make further determinations of this long-standing issue.

Meanwhile, though, the industry can take hope in a sentiment shared by ULI's Blank. “I think one of the greatest takeaways companies in the industry learned from the recession was how to be flexible and to always be prepared for the worst the markets can throw at you.” Regulators too, he might have added, and one day soon, perhaps will. ?