Disciplined drivers keep US market on rising road

Growing economy and sound attitude to debt underpin strong market, CREFC conference hears

This US commercial real estate cycle will last another three to five years and “knowledge is the most important thing we have” when comparing this cycle to the last. So predicted most of 30 industry experts at the Commercial Real Estate Finance Council’s conference Industry Roundtable last month.

The annual conference, held at the Marriott Marquis in New York City, drew more than 1,200 industry participants, who largely agreed that as the economy grows, capital continues to flow into real estate.

There is plenty of mileage left in the US CRE cycle, delegates said
There is plenty of mileage left in the US CRE cycle, delegates said

“Fundamentals are also better now,” one panellist said. “A lot of people think prices are back to where they were, but if you look back historically, prices are not wildly high.”

A strong market generally favours borrowers, which could cause underwriting and credit metrics to deteriorate as competition heats up (see Special report, p30). But conference delegates argued that discipline remains in the system.

“We are taking on significant risk, but there is still not a tremendous amount of debt loaded on the commercial real estate system right now,” one delegate said.

“There’s a lot of equity going into deals,” said another. “I think that’s a strong sign for the continuation of the market.”

A borrower-driven market also brings more lending options, which can convolute the borrowing process, as highlighted by the panel of heavyweight US real estate developers who took centre stage for the conference’s opening session.

Although there has been a massive influx of capital into US markets, a litany of post-
recession regulations have also been imposed on banks. This has given rise to a range of alternative lenders, particularly on big developments.

New finance for development

Top developers shaping US cities are turning to hedge funds, listed mortgage REITs, private equity firms, foreign capital, as well as EB-5 financing, which encourages foreigners (mainly Asian in this real estate cycle) to invest in the US and create American jobs, in exchange for US green cards giving them permanent residency.

But many of those options come at a premium and can complicate things when trying to finance big developments. They could also lead to overbuilding, as inexperienced developers also call upon less traditional lenders, the developers said.

Related Companies, which is spearheading the vast Hudson Yards project on Manhattan’s west side, has a massive $7bn in construction financing in the pipeline in 2015 alone, said Stephen Ross, the firm’s founder, chairman and CEO.

But it is “very, very hard today to syndicate construction loans” with the banks, he noted. While there are plenty of alternatives, “with  the non-traditional lenders getting involved… demand is great and the fees are great” too.

A company involved in a large-scale development – the type that could reshape major swathes of cities – will bring in a range of “banks, foreign funds and domestic, non-traditional resources” to achieve the right mix of reliable financing at a favourable cost, Ross said.

There’s an “awful lot of money available”, he added, but one-stop-shop type financing is “not available for mega products like Hudson Yards… and trying to get construction financing in those large dollar amounts is almost impossible”.

The retreat of large banks “is a real cause for concern”, another developer said, as less experienced players can now obtain financing from non-bank entities that are not traditional real estate lenders.

“The quality of projects and developers is much lower than, say, six months ago,” he said. “We have to look at that to see if there will be overbuilding. You wonder: will there be overbuilding again because of the [declining] discipline in lending? There is so much money available today.”

Stephen Ross (L) and Robert Taubman
Stephen Ross (L) and Robert Taubman

Some major New York City developers have turned to EB-5 financing. Through EB-5, immigrant investors and their families get green cards for creating at least 10 full-time jobs. However, the majority of the visas go to immigrants investing $500,000 or more.

One delegate turned heads when he asked if that might be the “most undisciplined source of capital”.

One developer retorted: “Not really. It is a source of cheap capital and ends up costing around 4% and the sponsor has the ability to use the money as it sees fit. There have been a small amount of abuses, but it has been a very good programme to get people with the skills we need into this country. It’s not just for wealthy foreigners. It’s been good for the real estate industry.”

CMBS issuance to top $100bn

CMBS is a major focus for the CRE Finance Council and its annual conference. Almost all panellists at the Industry Roundtable predicted issuance this year of more than $100bn, up on last year’s $94bn.

But some delegates noted that while robust, investor appetite for CMBS is not near the level seen during the pre-financial  crisis period. Tepid investor demand – particularly for triple-A tranches – will keep issuance from reaching the peaks of the boom years, a group of bond investors said during one panel discussion.

Buyers have slimmed down their CMBS books considerably since the recession (one speaker mentioned a decrease of nearly 70%) and alternative investment vehicles have pulled out of the market. “It’s a product of being more selective and more guarded about liquidity if everyone were to run for the exits at the same time,” one panellist said.

There was about $192bn in conduit CMBS issuance in 2007, compared to just $56bn in 2014, according to data provided by Trepp. But the reason for the discrepancy was not so much the number of deals as their size. There were 61 deals with an average deal balance of $3.145bn in 2007, while 2014 saw 50 deals with an average balance of just $1.143bn.

Weaker demand hits deal sizes

There has been about $26bn in CMBS conduit issuance so far this year, with average deal sizes continuing to reach that $1.1bn-1.2bn range. So, when will deal sizes creep up to $1.5bn-1.6bn, $2bn, or even $3bn? Not anytime soon, panellists said, as weaker demand is keeping deal sizes smaller because of perceived unfavourable spreads and total returns.

“Dealers will not go there right now,” one speaker said. “They’ve found a sweet spot in the $900m-1bn size deal. They don’t want to take on too much warehousing risk and quite frankly there’s a struggle to sell all the $300m in triple-A that they have to sell.

“I don’t see issuers willing to try and supersize deals they are already struggling with. I thought, with rates backing up [rising] the way they have in the past couple of weeks, there would be renewed demand for better-yielding triple-A, but they’re constantly stuck in the mud.”

The fact that some loans contributing to CMBS pools are of even worse quality than those from the legacy period is causing additional concern. As new originators enter the space (see June issue pp30-33), there might be up to six loan contributors on a deal, one speaker noted.

She pointed to a recent Fitch Ratings report that noted disparities in underwriting standards between large, small and non-bank US CMBS loan originators, which has led to a “decline in credit quality in recent months”.

Fitch’s analysis of 30 originators found that the largest banks have the strongest credit metrics, while smaller banks or non-banks have the weakest; and that CMBS investors are becoming increasingly concerned about credit quality as the number of originators continues to grow.

“The smaller originators out there have higher delinquency rates, a higher percentage are on the watch list – on legacy, and it’s even worse in terms of [CMBS] 3.0 performance – so I think that speaks volumes,” said one panellist.

“Not surprisingly they have higher costs of capital than a bank would, so by nature they will be making riskier loans,” he added. “They’re serving areas that are generally the underbelly of the market, or markets people don’t want to be in. They certainly serve a place for liquidity in the market; I just don’t know if these should be CMBS loans.”

Anthony Wood, sector head of CMBS at Hartford Investment Management, added: “The non-bank issuers are not good for diversification; it’s just a weaker set of loans with weaker structures.” n

CREFC has changes to report on CMBS

The Commercial Real Estate Finance Council (CREFC) has revised standardised reporting for CMBS by issuing US Investor Reporting Package: CREFC IRP v7.1, effective from the end of June.

The package provides bond, loan and property-level information across 850 fields of information for all CMBS in the US, fulfilling the US Securities and Exchange Commission’s reporting and disclosure requirements.

There is $600bn worth of CMBS outstanding in the US and more than $100bn in new issuance expected this year.

“Timely, reliable information and transparency about the performance of loan pools are the cornerstones of a healthy, functioning CMBS market,” said Stacy Stathopoulos, a CREFC executive vice- president.

“This update to the IRP is the result of the commercial real estate community working together to adjust to the changing demands of our industry and our desire to continually evolve our standards to provide the market with the most comprehensive information available,” added Leslie Hayton, a managing director at Wells Fargo and co-chair of the Investor Reporting Package initiative.

New CMBS buyers may upset plan B for established players

Buyers of the lowest rated, or unrated, CMBS tranches have rights allowing them to play an active role in making decisions that have an impact on the value of the loan or collateral. During a B-piece buyer panel discussion, participants suggested that their slice of the market is as competitive as they want it to be, and that the emergence of additional B-piece buyers could disturb their healthy relationship with originators of loans that go into conduits.

“In a highly concentrated market things can get really exciting really quickly, and get really bad really quickly,” one speaker said. “Adding a player or taking away a player can change things quickly. That’s what keeps me up at night: who is the new guy in the market and what will that do to pricing? One or two new guys can ruin the party.”

(L to R) Parkus, Cromer, Salem

A handful of B-piece buyers make up the majority of the market and many of them were on stage at the CREFC panel. Last year, the four top B-piece buyers accounted for about 70% of the $60bn or so total B-piece deals. They are intent on keeping it that way.

“It’s nice to have a deal with a limited bidding pool,” said Richard Parkus, managing director of Seer Capital Management. “Then you can definitely have more flexibility on credit. Things are manageable at this point and we expect to be very active as long as credit and yields remain in this spot.”

Some investors are pulling out of certain deals or demanding higher spreads to compensate for credit quality concerns, but the interactions with originators are generally allowing the main players to shape and bid on most — if not all — deals.

B-piece buyers now rely more on these relationships with originators, as opposed to having to more aggressively “kick back” (or kick out) problem loans to agree on deals, panellists said. That means working with originators on structure, understanding their perspectives and shaping the loan pool “from the get-go.”

“In today’s market we work hard to give constructive feedback up-front to originators,” said Rialto Capital Management managing director Joshua Cromer, one of four panellists  representing B-piece-buying firms. “Our relationship is healthier than ever… we’ll suggest ways to restructure the loan rather than saying we’re going to kick out loans.”

Another panellist added: “It’s more of a partnership than it has been in the past. It feels like originators are thinking more about their brand and execution in the market… there’s more agreement that we should show up with a good pool that will execute well.”

But after the session had ended, one panellist disputed that this was really the case.

“They are just sugar coating this,” he said. “Everybody tries to work things out and find constructive approaches, but if you’re going to filter out the worst loans, that means hard decisions and many loans simply cannot be restructured because of fundamental flaws. You have to be willing to stand your ground. We kick out a lot more loans now because credit has deteriorated.”

Today’s deals attract up to six bids, whereas the number might have been half that at the peak of the last cycle. But that also makes the bidding process more complex. “We’ve bid on every deal presented in the market this year,” said Adam Belham, Starwood Property Trust’s co-head of real estate investment and servicing. But he added: “Our credit meetings used to be half a day affairs. They are turning into several day affairs.”

Among other concerns cited in addition to loosening credit and creeping leverage levels, speakers mentioned the growing prevalence of interest-only loans — “it seems like interest-only loans are a throw-in to win a deal”, one executive said — and the high number of originators in the CMBS market.