New Regulatory Burdens for CRE Lenders

The financial markets are once again the target of recently passed legislation intended to make regulated CRE lending safer and less prone to public assistance and/or failure. Two examples of recent legislation are the risk retention rules applying to new CMBS issuance, and Basel III rules with regards to banks.

CMBS

“Skin in the Game”

New risk retention rules for sponsors and originators of CMBS debt securities require those sponsors/originators to retain a 5% stake in the assets they securitize for 5 years, a provision being referred to as “skin in the game.” Mandatory compliance of this rule begins December, 2016.

Sponsor Solutions

The sponsor of securities offerings maintain ultimate responsibility for compliance of risk retention rules, and therefore, must monitor compliance on a continuous basis. There are a variety of options open to the sponsor.

In what has been termed an Eligible Vertical Interest, the sponsor retains 5% of each class of security offered to the investing public. This position must be held for 5 years and is significantly restricted with regards to hedging and hypothecating the position. Furthermore, third party credit enhancement may not be used to replace the risk retention rules.

Another option for the sponsor to meet compliance regulations is to exercise what is known as an Eligible Horizontal Interest compliance where the sponsor, or an independent b-piece buyer acquires the most subordinated classes equal to 5% of the fair market value of the entire offering. Extra care must be taken by the sponsor in this case if it elects to use a b-piece buyer since risk retention compliance is ultimately the sponsor’s responsibility. First, the sponsor must assess the financial strength and experience of the b-piece buyer before including it in the bidding process. Second, after the acquisition of the b-piece has been completed, the sponsor must maintain ongoing monitoring of the b-piece buyer’s credit worthiness. If the b-piece buyer happens to file for bankruptcy protection, it’s the sponsor that must step up and either cure the deficiencies or repurchase the position. If the sponsor chooses the b-piece solution an Operating Advisor must be appointed to monitor the position. The OA’s responsibilities include acting in the best interests of the collective whole, consult with the special servicer if the principal value of the b-piece declines 25% or more, and to recommend replacing the special servicer if it has adequate justification.

Exempt Loans

A point of relief is the exemption for Qualifying Commercial Real Estate (QCRE) loans. QCRE loans themselves have zero risk retention. However, if part of a larger pool each QCRE loan reduces the pool risk retention rules proportionately, but by no more than 50% for the entire pool. In order to qualify for QCRE loan status a loan must exhibit the following characteristics:

1. A 1st lien where at least 50% of the funds for repayment of the loan is either sale or refinance proceeds, or rental income.

2. Ground leases with third parties

3. Ten (10) year term

4. Having no interest rate risk

5. Having an amortization schedule of no more than 25 years for commercial properties and 30 years for multi-family assets

6. A loan to value ratio of no greater than 65%

7. A 1.5x debt service coverage ratio for properties with no more than 20% of its gross revenues coming from a non-qualified tenant – which is a tenant with less than 6 months remaining on its lease term

8. A 1.25x debt service coverage ratio for multi-family loans with at least 75% of the NOI coming from rents and tenant amenities, in other words, non-commercial uses

9. A 1.7x debt service coverage for all other types of CRE loans

Likely Results of Rules Implementation

Some of the larger b-piece buyers are already taking action to raise capital to deal with the issues surrounding the risk retention rules. It’s likely that the larger, more well established groups, will have more success raising capital while the smaller groups will not and ultimately leave the space. Resulting in a smaller number of b-piece buyers, which could cause market efficiencies to drop and prices to rise.

In the past, b-piece buyers purchased the tranches rated BBB- and below, which typically represented 2-3% of the total offering. The new risk retention rules will force the b-piece buyers to buy tranches more highly rated in order to hit the 5% requirement, and thereby reducing their overall investment yields.

Since the costs of issuance will rise for sponsors, originators will likely be forced to pass much of this expense on to the borrowers. Industry experts are typically in the range of 35 to 50 basis points will be added to spreads at the point of origination.

To compensate for the lack of liquidity in the b-piece positions, loan spreads will widen for borrowers. If rates widen enough, CMBS loans will lose some/all of their current advantage over alternative lending sources, paving the way for non-regulated lenders to capture much of the business CMBS has been good at securing in the past. To counteract this force, b-piece buyers could become issuers themselves and reduce the market share of some of the existing larger originators. Also, originators could move toward lower leverage executions which would allow for more QCRE and lower risk retention requirements. And finally, originators might bifurcate loans into senior and mezzanine pieces, which would lower the leverage for the CMBS pieces but still provide the proceeds the borrower is looking for. However, this isn’t a perfect solution since the originator is still confronted with the obligation of selling the mezzanine loan.

Currently, b-piece buyers, with these new rules looming on the horizon, seem to be responding to offerings with the attitude of “why should I buy at a 15-18% yield today when I can buy at a 20-23% yield in 10 months from now.”

Banks

Basel III Regulations

According to KPMG, “Basel III contains various measures aimed at improving the quality of capital, with the ultimate aim to improve loss-absorption capacity in both going concern and liquidation scenarios.”

Phased in over a number of years (to be completed in 2019), the Basel III rules have two main objectives:

• To strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector;

• To improve the banking sector’s ability to absorb shocks arising from financial and economic stress, which, in turn, would reduce the risk of a spillover from the financial sector to the real economy.”

The term “Risk-Based Capital Ratio is defined by the equation:

• Regulatory Capital / Risk-Weighted Assets

Under Basel III Tier 1 capital ratios to increase from 2% to 4.5%, common equity to increase to 7%, and total capital to increase from 8% to 10.5%, but the ratios are to be calculated under Basel III less favorably to banks than Basel II. Specifically, the denominator of the ratio is the Risk Weighted Assets, or RWA. Under Basel III certain asset classes require differing capital reserve than under Basel II:

• Residential mortgages 50%

• Most commercial loans 100%

• High Volatility CRE 150%

Furthermore, Basel III requires that a bank’s total assets (including off balance sheet) should not be more than 33 times bank capital. One element of relief is this last measure is to be calculated on a gross basis with no risk weighting. Nevertheless, even well-capitalized banks, by past standards, are likely to be affected by Basel III. This will reduce credit and increase its cost.

High Volatility Commercial Real Estate loans, or HVCRE – requires 150% reserve requirement. The thresholds for loans falling into this category are not overly restrictive. Most notably, construction loans are all likely to be included in this bucket, causing banks to significantly pull back in their issuance. A reduction in construction lending is potentially damaging to bank profitability, especially in an era where net interest margins (the spread between rates paid to depositors and rates earned on loans) are being squeezed to death by a flat yield curve.

On top of the new legislation, bank regulators issued a warning in December 2015 to all banks regarding CRE concentrations and mandated to banks to either reduce CRE concentrations or raise additional equity. Of all the new regulatory challenges, we are hearing the most difficult to deal with is the regulators and their constantly changing interpretations.

Potential Results

• Although enhanced capital and liquidity buffers and enhanced risk management should lead to reduced risk of individual bank failures, there are some negatives:

• The weaker banks will be crowded out, since they will find it difficult to raise capital which will reduce their lines of business and strip them of their competitive abilities.

• New regulations will put pressure on margins and operating capacity, driving down investor returns and dividends at a time the industry is attempting to attract more capital.

• Increased liquidity will likely reduce bank lending and lead to a higher cost of borrowing to the borrower.

• And finally…. the opening up of the market to un-regulated lenders. Private equity and real estate funds are not considered Systemically Important Financial Institutions, or SIFI’s, and therefore don’t get noticed. Opportunities are especially strong for creative lending such as repositioning and new construction.