As regulations and volatile market conditions hamper the traditional mainstays of the lending world, fast-moving unregulated lenders are in a position to cherry pick the best deals. Al Barbarino meets with Stuart Boesky and his team at Pembrook Capital Management to discuss the new environment
Mired by regulations, commercial banks have retreated from swaths of the real estate lending markets and the CMBS industry is suffering. The US stock market is shaky and the capital markets are in disarray.
The list goes on, and it’s all good for business if you ask Stuart Boesky, the founder and chief executive officer (CEO) of Pembrook Capital Management, and a group of his top executives.
Seated in brown leather executive chairs in a corner office at the firm’s Madison Avenue offices in Midtown Manhattan, Boesky and his New York team rattle off a long list of seemingly bad news that they say is actually creating great opportunity for Pembrook.
The private, mid-market bridge lending business Boesky started back in 2006 escapes much of the regulations (see panel p.25) that have impacted the banks and CMBS, including new risk retention and disclosure rules.
The regulations have caused a retreat of the banks, particularly on small- to mid-sized deals as well as more volatile ones, allowing Pembrook to do more transactions and become a lot more picky about those it chooses. Meanwhile, corporate debt defaults and stock market volatility has led to a general widening of spreads, particularly in the stumbling CMBS markets, Boesky says.
“When the banks go away, the mortgage REITs can’t raise money, and CMBS is slowing down, the private equity people have pricing power,” he says.
“Everything on balance sheet is much more expensive now, which requires them to raise more equity. [The banks] laid off thousands of people and are stretched thinner, so they no longer can focus on the mid-market business.”
The executives joining him at the table argue that Pembrook has more flexibility to serve borrowers’ needs on higher volatility deals because the firm can much more quickly and efficiently understand, price, and manage execution risk that banks and CMBS might not be able to take on going forward.
Terry Baydala, managing director and head of East Coast originations, describes Pembrook as “very nimble,” able to adjust quickly to market fluctuations and the volatility that is sweeping across the capital markets and commercial real estate debt.
“We are in a very good space for whatever is going to come down the pipe as an unregulated lender, and we are in the best place to pick off interesting opportunities,” he says.
New rules for the banks regarding “High-Volatility Commercial Real Estate” (HVCRE) have been particularly burdensome for the banks, leading to a gap in funding for the construction, development and transitional loans that Pembrook specialises in as a bridge lender.
“The poor guy who thought he could go to the community bank for a loan like he did 10 years ago can no longer do that,” says Robert Hellman, managing director and head of asset management at the firm. “All these sources of capital, if not disappearing, have contracted considerably.”
The firm’s previous investments have focused on short-term financing throughout the capital structure, including first mortgages and mezzanine loans in the $10 to $50 million range. Typical financings are three-year floating-rate loans with loan-to-values no higher than 85 percent.
“We find that the middle-market opportunities we seek are big enough to be attractive but small enough to be overlooked by really big lenders,” Hellman says. “The big banks are not financing the types of projects we are doing.”
This is particularly the case in instances where developers have owned land for many years and are seeking construction loans, Boesky says.
In his distinctively calm and methodical pace, Boesky tells the story of a developer who came to him recently seeking a construction loan. The developer had purchased a property in the burgeoning Williamsburg neighborhood of Brooklyn, New York roughly 20 years ago for just $2 million.
Figuring that the property, which boasts waterfront views, was worth at least $25 million today, the developer went to his local bank for a construction loan for the same amount to build out a residential property.
But that wasn’t happening; not after the new HVCRE rules, which came out last year under Basel III, which were meant to curb the sort of excessive construction lending that created major losses during the recession. Loans that fall into the category received heightened risk weighting for regulatory capital purposes, and thus banks have been forced to increase upfront equity requirements from borrowers.
“It took all of last year for banks to figure out the HVCRE rules and now they have, and they are erring on the side of being conservative, and it’s creating a big gap in the capital stack that wasn’t there before,” says Paul Mullaney, the firm’s managing director and head of underwriting.
In the case of the developer seeking a loan, the bank required $15 million up front, so he turned to Pembrook. But the irony of the story becomes apparent when Boesky says Pembrook ended up turning the developer down because he didn’t have the level of experience the firm is requiring of sponsors.
“With tighter available credit, the less risk we actually need to take to get the types of returns we want,” he says, and that includes the risks of taking on a deal with an inexperienced sponsor. “When credit is constricted in such a way you see greater deal volume, we can be pickier and have more negotiating power.”
As a result of the various factors creating voids in the lending markets, the composition of Pembrook’s loan portfolio has shifted considerably, with exposure to first mortgage loans increasing to more than 75 percent from less than 50 percent at inception.
“We worry about values being frothy, so we are aiming to be more senior on the capital stack, and we think we can be there and still earn equity value add-like returns,” Boesky says, noting that the firm continues to target – and hit – returns in the low- to mid-teens, as it has in the past.
The firm’s overall multifamily exposure has also increased from less than 15 percent of its loan portfolio at inception to approximately 50 percent today as volatility increases. As a short-term bridge lender, “when Pembrook goes into a deal we’re always thinking how we will get out of it,” Boesky explains; and multifamily carries a safety net provided by the agency lenders, mainly Fannie Mae and Freddie Mac, “unlike office or retail or hotels, which rely on the banks or insurance companies for take-outs.”
“When markets get difficult for the banks and the mortgage REITs and CMBS, the agencies become even more aggressive,” he notes.
The banks have continued to finance large deals, however, including the high-end residential buildings that have risen in recent years along with exorbitant condo and rental prices in New York, where Pembrook holds about 44 percent of its loan portfolio. But that’s beginning to look like a risky business too, as developers struggle to meet their original condo sales goals, and the city experiencing its first dip in rental rates in years, Boesky notes.
“Multifamily is the strongest sector of the market in terms of fundamentals,” he says, noting that it has historically suffered from fewer defaults compared to the other main asset types. “But we worry about the high-end, luxury part of the market.”
The median rental price in New York City’s most expensive borough, Manhattan, dropped 2.8 percent to $3,300 in March from the same time a year ago, representing the first annual decline in two years, according to a report from Douglas Elliman Real Estate.
And during the last four months of 2015, 20 percent of the roughly 5,120 luxury properties on the market in New York experienced price cuts, up from nearly 10 percent during the same period of the previous year, a Compass analyst told the New York Times.
If poor condo sales continue, it’s terrible news for developers who initiated projects with lofty sales goals, not to mention it may be one of many signals that a more pronounced turn in the real estate cycle may lie ahead.
But the firm cites this as yet another area of distress that’s creating opportunities – in the way of inventory financing, which provide developers with additional funds to pay interest on their other loans due to lower-than-expected sales.
“As the condo sales pace slows, the expectation is that we’ll see more condo inventory loans in the coming 12 to 18 months,” Baydala says.
The timing couldn’t be better for the opportunities that the Pembrook executives speak of, as the firm continues to fundraise for its third debt fund. Though the firm and its executives declined to comment on the fund, Real Estate Capital revealed last month that Pembrook had raised $100 million of its $300 million target.
Pembrook has originated or participated in 85 investments totalling over $950 million. In November the firm closed a $30.4 million first mortgage bridge loan and preferred equity position for the acquisition and renovation of the Madison Oaks Apartments complex in Palm Harbor, Florida.
And in October the firm provided a $32 million first mortgage loan for the acquisition and renovation of a student housing complex in Los Angeles, near the University of Southern California (USC) campus.
Rules and regulations, and why the likes of Pembrook can prosper
A litany of regulations are weighing on the commercial banks and the CMBS markets. Here is a rundown of some of the rules and the impacts they are having:
Large banks are actively writing large senior loans, but under the ‘super-capital’ charge, so- called High-Volatility Commercial Real Estate (HVCRE) receive a heightened 150 percent risk weighting for regulatory capital purposes on a bank’s balance sheet, versus the 100 percent requirement for other CRE loans.
Higher capital charges for construction and redevelopment loans are causing a retreat of many small- and mid-sized banks and pushing their riskier loans to specialty lenders.
The change under Basel III is meant to curb the sort of excessive construction lending that created major losses during the recession. As a result, banks with heavy exposure to these loans are either pulling back or taking measures to mitigate the increased capital requirements, leading to a range of requirements they pass on to borrowers: lower LTVs, increased upfront cash equity requirements, heightened scrutiny of construction deadlines and shorter loan durations.
As a result, non-bank lenders like Pembrook can swoop in to make senior loans and have more leverage to charge more.
Regulation AB II
Going into effect in late 2015, these regulations state that the CMBS issuer is required to sign a certification for each offering, making them personally liable for any false information. Each issuer must designate one official — an “AB II certified person” — who reviews and certifies that all the information on loan documents is true.
Originators and issuers may need to make significant investments to meet new standards and, clearly, face greater liability. As banks become more conservative, they may be less willing to extend credit to smaller CMBS lenders which are funded with lines of credit, which may continue to force smaller issuers out of the market.
In one recent example, Redwood Trust called it quits in February. At the time the company’s CEO Marty Hughes said that the “challenging market conditions” were worsening and “not likely to improve in the foreseeable future”.
“The escalation in the risks to both source and distribute loans through CMBS, as well as the diminished economic opportunity for this activity, no longer make our commercial conduit activities an accretive use of capital.”
New risk retention rules are intended to promote more permanent, longer-term capital, but it has led to uncertainty in CMBS as lenders face uncertainty in structuring and pricing capital.
Starting in late 2016, CMBS issuers will have to retain a 5 percent slice of every new deal they issue — or designate a B-piece buyer to take on that risk. The 5 percent is much higher than what B-piece buyers typically purchase from a deal, which is around 2.5 percent, Trepp senior managing director Manus Clancy recently wrote.
“This new threshold is based on deal proceeds instead of notional balances, essentially market value instead of par value,” he writes. “B-piece buyers would be required to buy as high up in the credit stack as single A, rather than just bonds below BBB-.”
When B-piece buyers hold lower yield tranches higher up the capital stack, yield targets may no longer be attainable, forcing them to seek different ways to fund their investments, Clancy notes. B-piece firms are already raising funds with this lower yield target in mind and holding a larger share of the pool for a required five-year period, leading to wider spreads on those additional bonds and forcing lenders to increase coupons on the loans they issue.
Boesky estimates that the new rules will add 30 to 50 basis points to the costs of CMBS execution which, again, will be good for non-regulated lenders.