Uncertainty Prevails As Final Rules Have Yet to Be Drafted. However, Banks, Hedge Funds and Private Equity Appear to Have More At Stake Than REITs
The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama last week, is a cornerstone of Congress and the Administration’s financial regulatory reform agenda, creating the most sweeping changes in U.S. financial regulations since those put in place following the Great Depression.
The regulatory overhaul of the U.S. financial markets comes as commercial real estate has begun a nascent recovery following the Great Recession and the financial crisis of 2008. And while the new regulatory framework will undoubtedly impact the capital-intensive commercial real estate market, it may be years before the full extent of the impact will be known after the specific rules and regulations are developed to implement the law's provisions.
The new law includes provisions affecting lending practices that will have a direct impact on individuals and investors, and others that will affect the fundamental ways in which Wall Street functions. The act will require that systemic risks that could imperil the entire financial system be monitored by a new Financial Stability Oversight Council. The Federal Insurance Deposit Corp. (FDIC) will manage the liquidation of "too big to fail" banks and institutions whose demise the Treasury Secretary determines could disrupt the nation's financial stability.
To address risky lending practices, banks will be required to set aside additional capital to cover potential losses, and certain securities will no longer be acceptable as vehicles for capital reserves held by large banks. Banks also will be required to retain at least 5% of a loan on their books as "skin in the game" if the loan is sold and/or repackaged with other loans and securitized. Some relatively low-risk mortgages -- for example, fully documented loans with fixed interest rates -- are exempted under the law.
Banks also will be more limited in their ability to make proprietary trades on their own accounts, deals which could represent a conflict of interest in their relationships with clients. They also will have to set up separate operations to handle their most risky derivative trades, including swaps. A bank will not be permitted to invest more than 3% of its core capital in hedge funds and private equity, but it may still organize such offerings as long as certain conditions are met. The Federal Reserve will oversee a new Consumer Financial Protection Bureau to regulate consumer financial products and services.
National firms and groups such as the Commercial Real Estate Finance Council and Deloitte have recently held workshops and strategy sessions to address the wide range of potential impacts in a law that affects everyone from credit card holders to the nation’s largest banks, hedge funds, bond rating agencies and institutional investors.
spoke with two experts in national commercial real estate and financial markets for more insight on the expected impacts of the 2,319-page legislation on real estate mortgage lenders and borrowers, during a critical time when the economy and commercial property markets are making a slow transition into recovery.
"Obviously, the legislation has a huge impact on banks, private equity and hedge funds. The impact on real estate is less direct than it is on some other financial services industries," said Robert T. O’Brien, leader and vice chairman of the U.S. real estate practice of consultancy firm Deloitte. "The legislation itself calls for a lot of regulation rule-making over the next few years, so it’s not entirely clear what the full impact is going to be. It’s going to come down to the actual regulations that are put in place."
The new legislation will directly impact commercial real estate mortgage lenders and borrowers in three areas, added Norm Miller, vice president of analytics for CoStar Group, Inc. First, the requirement for banks to have 5% ‘skin in the game’ will mean that lenders will need to scrutinize and document real estate loans more carefully, Miller said.
"The quality of appraisals will need to be higher and the assumptions backed up with more documentation, thus market reports in appraisals cannot simply be boilerplates," Miller said. "Overall, I expect this is going to mean tighter lending standards, with the risky speculative financing impacted the most, which of course was its intent. Gone are the days of 100% financing for spec development and high loan-to-values (LTVs) -- at least until we forget about all this a decade or so from now."
Second, Miller said, banks will be required to carry more capital reserves -- not only for the current U.S. financial reform, but also for the new global banking agreement being negotiated as an extension of the international Basel Accords, bank supervision guidelines adopted over the last two decades by a committee based in Basel, Switzerland.
"Overall, lenders will need to prove they have the correct reserves and, based on the recent default rates and delinquencies, they are probably looking at significant increases," Miller said. "This will likely decrease the overall amount of lending [capacity] that is possible relative to the equity capital of any institution. It is hard to know how much this will matter in the long run, but in the short run we are talking maybe 20% to 30% less lending per dollar of what we once called capital reserves."
Third, Miller said rating agencies will bear more risk and liability under the new legislation.
"CMBS issues will need to be more conservative, with lower LTVs and higher debt service coverage ratios, and simpler to understand. We will see less of this kind of financing for quite a while. It is likely that the CMBS market will return very slowly, perhaps by bundling together the better assets that are no longer underwater, or where equity has been infused."
Within the real estate industry, there is general agreement that the new legislation will have a more significant impact on private equity real estate than on the public real estate investment trusts (REITs), Deloitte's O’Brien said.
During the lengthy conference meetings prior to passage of the legislation, REITs expressed concern that tightening regulations on banks and derivatives, including interest rate swaps and caps, would increase their cost of capital significantly. REITs often borrow under variable rate loans, using swaps and caps to hedge interest rate risks.
The National Association of Real Estate Investment Trust (NAREIT) and its members supported efforts to increase transparency into the derivatives market and to contain the systemic risk posed by market participants, dealers and speculators, the trade group said in a policy statement.
"However, NAREIT had significant concerns that some initial proposals to require clearing, exchange trading or margining for the derivatives used by real estate companies or other 'end-users' to hedge against fluctuations in interest or exchange rates would dramatically increase the cost, and limit credit and liquidity at a time when both are already in short supply," the group said.
The derivatives reform in the final legislation represents "a considerable improvement" over earlier proposals, and efforts were made to limit its direct impact on many end-users, NAREIT said. However, uncertainty regarding the implications of the law will likely remain as regulators undertake the rulemaking process.
“It is clear that the Dodd-Frank Act will significantly impact the derivatives market by providing transparency and containing risk, but it also could increase costs for end-users," NAREIT said.
O’Brien noted that although REITs are potentially impacted by increased costs of bank debt capital, they’re also blessed with access to many types of capital, with the ability to raise public debt or even tap the renewed CMBS markets as it comes back.
"REITs have a number of alternatives at their disposal to navigate some of the uncertainties created by financial regulatory reform," he said.
The CRE Finance Council’s main concern is that that regulatory reform does not, in effect, nip the fledgling recovery of the CMBS market in the bud. That securitization market was beginning to show signs of life in the form of a couple of successful offerings at end of 2009 with several more issues reportedly pending.
The private equity side is where regulatory reform has created a great deal of uncertainty, and some would suggest, opportunity, O’Brien said. Reform will have a big impact on banks’ involvement and co-investment in private equity fundraising for commercial real estate.
O’Brien noted that banks are in the process of determining the future of their real estate fundraising operations, and some are deciding to sell. Citigroup sold its real estate investment business to Apollo Global Management LP in March. ING Groep and reportedly, Morgan Stanley are evaluating the potential sale of their real estate fund businesses.
While the impact on private equity real estate and fund sponsors that are banks and regulated financial institutions is potentially very significant, "they’re going to have a long runway to deal with it," O’Brien said.
"The legislation takes into consideration the impact of trying to unwind or sell this component of banks’ business in this type of environment. Nonetheless, it does create a level of uncertainty around the future of these bank-sponsored real estate funds and how banks will be able to exit them."
"If a bank is sponsoring a private-equity fund, I think the bank is going to think through how they’re going to adjust their business to be in compliance with regulatory reform -- and whether that involves selling their real estate private equity arm or in effect reconstructing their investments so they have less capital at risk," O’Brien said.
That presents a tremendous opportunity for those with the means to build scale by acquiring existing fund platforms from banks, along with the related talent and access to investors.
The other big open question is how banks will handle future construction and development lending, which comprises a significant portion of the troubled loans the banks have in terms of exposure to commercial real estate, O’Brien said.
"Regulatory reform is going to create ongoing challenges to obtaining construction financing and it’s going to make that financing more expensive," he said. While there’s no new construction lending going on right now, "at some point, supply constraints will trigger more development, and that’s where we’ll really see the impacts."
What happens next?
"Accounting rules and the gray areas will be debated," Miller said. "Rating agencies will want clarification on liability and until these issues are resolved, we will see a tepid and measured response by lenders," Miller said. "Still we are seeing traditional, yet conservative underwriting come back at traditional LTVs, for example 75%. We will simply have to get used to using real equity to finance real estate."