The Voice of Commercial Real Estate Finance - CREFC

The Voice of Commercial Real Estate Finance

RLD

Summer 2017 Volume 19 No. 2

A publication of

CRE Finance Council

CRE FINANCE W

EVOLUTION

CHANGE

DISRUPTION

CREFC MIAMI 2O18 CRE FinanCE CounCil JanuaRy ConFEREnCE

JANUARY 8–10, 2018

loEWS MiaMi BEaCH HotEl, MiaMi, FloRiDa

SAVE THE DATE


CRE Finance World

Inside this issue... Retail Store Closing Fiction

Executive Director Letter Lisa Pendergast CRE Finance Council

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EVOLUTION

CHANGE

Abeer Ghazaleh PGIM Real Estate Finance

Krystyna Blakeslee Dechert

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Secular Trends Transforming the CRE Landscape Larry Kay Eric Thompson Kroll Bond Rating Agency

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Foggy Outlook for Legislative, Regulatory Relief

Non-Bank Lending in an Era of Bank Deregulation

Paul Fiorilla Yardi Matrix

Jan B. Brzeski Arixia Capital Advisors

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DISRUPTION Market Disruptors Are Here to Stay!

Editor’s Page

Joseph Ori Paramount Capital Corporation

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A Sherpa for CMBS Borrowers – The Value Proposition of Debt-Resolution Advisors Michael Gutierrez Morningstar

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A Rising Tide Lifts All LIBOR Loans, The Case for Investing in Floating-Rate CMBS Now Edward Shugrue Talmadge

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CMBS Conduit Q1 2017 Update: Retail Exposure Declined While Full Term IOs and Office Concentrations Rose Sharply James C. Digney James M. Manzi S&P Global

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Hurry Up and Wait! Banks Continue to Impliment Basel IV, Though Timing of Final Rules Still Unclear Christina Zausner CRE Finance Council

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Evaluating Alternative Lending Platforms and Their Prospects Going Forward Gary Bechtel Money360

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Cross Boarder Capital: A Rear View Mirror Only Lets You Drive Backward Jim Costello RC Analytics

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A Case for A.I. in CMBS Dr. Vince Gerbasi David Nabwangu AI-Spark

The Big Picture: CREFC Legislative & Regulatory Update David McCarthy CRE Finance Council

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The Clock is Ticking for Commercial Real Estate Ken Riggs Situs

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CRE Finance Council Officers Mark Zytko Chairman , Mesa West Capital Gregory Michaud Immediate Past Chairman, Voya Investment Management Richard Jones Vice Chairman, Dechart LLP Jack Cohen Secretary, Darkknight Ventures, LLC Daniel Bober Treasurer, Wells Fargo Nik Chillar Membership Committee Chair, Belgravia Capital Management Robert Brennan Long Range Planning & Investment Committee Chair Kim Diamond Program Committee Chair Brian Olasov Policy Committee Chair, Carlton Fields Timothy Gallagher Executive Committee Member, Prima Capital Advisors LLC Samir Lakhani Executive Committee Member, BlackRock Paul Vanderslice Executive Committee Member, Citi

CRE Finance Council Editorial Board and Roster Paul Fiorilla Editor-in-Chief, Yardi Matrix Joseph Philip Forte, Esq Publisher, Kelley Drye & Warren, LLP Krystyna Blakeslee Co-Managing Editor, Dechert LLP Dr. Victor Calanog Co-Managing Editor, Reis, Inc. Patricia Bach Genworth Financial Jeffrey Berenbaum Citi Stacey M. Berger PNC Real Estate/Midland Loan Services David Brickman Freddie Mac Sam Chandan, Ph.D. NYU SPS Schack Institute James Manzi S&P Global Ratings Jack Mullen Summer Street Advisors, LLC

CRE FINANCE W The Voice of Commercial Real Estate Finance

RLD

®

Publisher: Joseph Philip Forte, Esq. Editor-in-Chief: Paul Fiorilla Co-Managing Editors: Victor Calanog & Krystyna Blakeslee Publication Manager: David McCarthy, CRE Finance Council Design: D. Bruce Zahor Production: Kristin Searing CRE Finance Council Staff Lisa A. Pendergast Executive Director Michael Flood Deputy Executive Director Ed DeAngelo Senior Director, Chief Operating Officer Sara Elkas Senior Manager, Education Nina Fazenbaker Senior Manager, Programming Davine Henry Manager, Accountant Clerk Elizabeth Janicki Manager, Meetings & Events Isabelle Marques Analyst, Executive Assistant David McCarthy Director, Policy & Government Relations Kimberly Pang Analyst, Programming Meghan Roberts Manager, Sponsorship & Marketing Martin Schuh Senior Director, Head of Government Relations Christina Zausner Senior Director, Head of Industry & Policy Analysis CRE Finance Council Europe Peter Cosmetatos CEO, Europe Carol Wilkie Managing Director, Europe

David Nabwangu AI - Spark Brian Olasov Carlton Fields

CRE Finance World is published by

Lisa Pendergast CRE Finance Council Stephanie Petosa Fitch Ratings Caroline Platt Steven Romasko Nomura Securities International, Inc. Stewart Rubin New York Life Real Estate Investors Peter Rubinstein Daniel B. Rubock Moody’s Investors Service, Inc. Clay Sublett Eric B. Thompson Kroll Bond Rating Agency, Inc. Harris Trifon Western Asset Management Darrell Wheeler S&P Global Ratings David McCarthy CRE Finance Council CRE Finance World Summer 2017

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Volume 19, Number 2, Summer 2017 CRE Finance World® is published by the Commercial Real Estate Finance Council (CREFC ®), 28 West 44th Street, Suite 815, New York, NY 10036 email: [email protected], website: www.crefc.org. © 2017 CREFC - Commercial Real Estate Finance Council, all rights reserved. This publication is provided by CREFC for general information purposes only. CREFC does not intend for this publication to be a solicitation related to any particular company, nor does it intend to provide investment advice to investors. Nothing herein should be construed to be an endorsement by CREFC of any specific company or its products. We advise you to confer with your securities counsel to determine whether your distribution of this publication will subject your company to any securities laws. CRE Finance World assumes no responsibility for the loss or damage of unsolicited manuscripts or graphics. We welcome articles of interest to readers of this magazine. Opinions expressed are those of the author(s) and not necessarily those of CREFC.


CRE Finance World

Executive Director Letter

Welcome to the June Edition of CRE Finance World The Editorial Team of CRE Finance World (CREFW ), led by Publisher Joseph Forte and Editor-in-Chief Paul Fiorilla, never fail to disappoint. They have a knack for gathering timely and on-point articles that speak to the current state of CRE finance and property fundamentals. We are extremely grateful to the CREFW Editorial Board and all of those authors who give of their time, knowledge, and experience to make the CREFC magazine one of the best around. Each one of us face the ‘beat-the-clock’ work day — day in and day out. In focusing on the demands of today, it’s easy to lose the forest for the trees and miss tomorrow’s opportunity CRE Finance World allows our members the ability to ‘look-up’ and take measure of evolution and change and what they mean for our businesses going forward. The latest edition of CREFW is aptly titled Evolution • Change • Disruption, and it couldn’t be timelier. Evolution and change are everywhere in our industry — urban migration and an aging population, autonomous cars, artificial intelligence, drones, e-commerce — and have very meaningful implications for commercial and multifamily real estate. And just as ‘disruptors’ such as Airbnb, Amazon, and WeWork are shifting demand and supply dynamics in the property markets, new start-ups focused on CRE finance are doing the same. The CRE finance disruptors are increasingly present and are changing the way in which borrowers and lenders view the financing landscape, albeit slowly. An explosion of well-capitalized, non-bank lenders and a growing number of crowdfunding start-ups are exploiting the post-crisis lending environment in which regulation rather than relative value amongst lenders informs many a borrower decision.

Lisa Pendergast

Expectations are high that these lenders will mature over time, and provide more competitively priced debt capital and a more institutional and seamless delivery. CREFC stands ready to work with both traditional and non-traditional lenders to expand the availability of appropriately sized and structured capital and ultimately drive measured and sound growth in the sector. Perhaps one of the more interesting and potent ‘disruptors’ emerged in November 2016, with the election of a Washington, D.C. outsider as President of the United States. President Trump’s stated agenda of querying the way things have always been makes him perhaps THE Disruptor of 2017 and beyond. To wit, in early February, the President directed Treasury Secretary Steve Mnuchin to conduct a review of financial regulations and to report back within 120 days on possible regulatory or legislative changes. The CRE finance markets are undoubtedly one part of this effort. Again the CRE Finance Council will advocate for those legislative and regulatory changes for which we have consensus amongst our members. Where we do not, we will seek to educate the appropriate regulators and legislators on the varied views and opinions of our members. So, enjoy this issue of CRE Finance World, exploring not only evolution, change and disruption with CRE Finance, but also providing updates on regulation, property markets, the current strong demand for floating-rate debt and CMBS loan performance. Finally, your feedback and suggestions are vital in ensuring the continued high quality of the magazine and setting the direction and tone for future editions. With Kind Regards, Lisa Pendergast CRE Finance Executive Director

CRE Finance World Summer 2017

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Editor’s Page

Disruption Disruption — that seems to be the theme of the last six months. From the election of Donald Trump, to the Russia scandal, to the proliferation of fake news (well…seeming proliferation, maybe it’s that we all talk about it A LOT but there really isn’t that much of it), to the increased frequency with which cyber-attacks are levied around the world, there is much uncertainty, nay unpredictability, ahead. Incidents, events and people seem to be either irrelevant specks on the time continuum or disruptive forces that are shaping our societies and economies. “Disruption” — whether it be of an industry or an economy or through innovation — is a process. It takes time. And because it takes time, we often overlook the disruption until it is too late. This highlights the importance of thinking critically, engaging thoughtfully with other people, and getting out and really seeing the world. Now, I don’t have a crystal ball and I cannot tell you what the next really big disruption in our industry is going to be, but I can see that there are “disruptors” out there making small changes, steps forward, and leaps in innovation, every day. Over time, these disruptions will impact and fundamentally alter the way we do business.


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Krystyna Blakeslee Partner Dechert LLP

In this issue of CREFW, we are excited to bring a bit of “disruption” directly to you. We hope this issue will make you stop, think, and analyze all that is around and what it means (or doesn’t mean) for the future of the commercial real estate industry, especially. This issue boasts articles that (I hope) will (i) challenge your pre-existing notions about certain asset classes (like Retail Store Closing Fiction), (ii) reshape the way you think about CMBS and technology (like A Case for A.I. in CMBS), (iii) help you to “see” the word (like Market Disruptors Are Here to Stay!) and see connections within the broader economy and CMBS (like Secular Trends Transforming The CRE Landscape) and (iv) cause you to re-think regulation and its impact on the industry (like Non-Bank Lending in an Era of Bank Deregulation and Evaluating Alternative Lending Platforms and Their Prospects Going Forward). In addition to the articles referenced above, this issue, as usual, is full of great analysis and useful information that just might be the catalyst you need to be that market “disruption” we are waiting for. Krystyna Blakeslee Partner Dechert LLP


CRE Finance World

Foggy Outlook for Legislative, Regulatory Relief

Paul Fiorilla Associate Director of Research Yardi Matrix

Taxing the Real Estate Industry? At our publication deadline, a slew of issues important to the industry — including tax reform, flood insurance, capital and liquidity rules and bank regulations — were being debated. The 2016 election has great implications for regulatory policy governing the commercial mortgage market, which in recent years has been inundated with new rules in response to the last financial crisis. President Donald Trump and Republicans in both chambers of Congress promised during the campaign to reduce regulations on businesses and oppose tighter banking industry rules such as those embodied in Dodd-Frank. In early February, the President issued an Executive Order (EO) asking regulators to review financial regulations, with the expectation of delivering regulatory relief to banks sooner rather than later. However, implementing campaign promises is proving to be anything but simple as every President in their first term has learned. Nearly six months into the new administration, very little is clear as to when (or how) regulations affecting the commercial mortgage industry will change. Congress has been consumed by other issues such as health care and tax reform, and the administration has been slow to propose detailed policy recommendations or appoint officials to key regulatory and administrative posts that would work on the issues. With so many moving parts: A shifting political landscape, Congressional Republicans learning how to function in the majority, and an administration with The level of unknowns is high, no record to handicap, the level of unknowns even for Washington standards. is high, even for Washington standards. Amidst this backdrop, it is crucial that the commercial and multifamily real estate industry remains engaged and its collective voices heard.

In late April, the White House presented the outline of a tax plan that focused on lowering the corporate tax rate. Details about issues important to the commercial real estate industry — such as buzz that interest deductions, depreciation and 1031 Exchanges may be eliminated — remain unclear. Without a draft bill in either House of Congress or a detailed plan from the Administration, it is difficult to ascertain what really is on the table. The White House and Republicans in Congress want to cut absolute rates in a way that reduces revenue by $2 trillion over 10 years. However, Congressional Republicans, for the most part, want tax reform to be ‘revenue neutral.’ Therefore, they need to raise revenue to keep the tax reform bill from increasing the debt. That’s where the discussion over closing loopholes comes in. While the goal of a simpler tax code with lower rates and fewer loopholes is commendable, eliminating commonly used deductions would force significant and potentially damaging changes in the way the real estate industry operates. And, almost every industry has a differing tax treatment that they prefer. When one is taken off the table, another needs to be put back on the table Just like health care, passing tax reform is likely to prove difficult. Republicans are not united on policy, they have many issues to resolve this calendar year (including the fiscal year 2018 budget, raising the debt ceiling and reauthorizing the flood insurance program), and they face a Democratic filibuster in the Senate for any large tax cuts that do not help the middleclass. The GOP can get around that on budgetary issues by using a procedure called reconciliation, which allows the Senate to vote on a revenue-neutral bill by simple majority, but that would mean tax cuts would be temporary and might face legal challenges. Effort to Fix Bank Lending Rules In early May, the House Financial Services Committee passed the CHOICE Act, sponsored by Chairman Jeb Hensarling (R-Texas), along party lines. The bill, effectively allows banks that hold 10% capital to be exempt from many of the rules promulgated by Dodd-Frank. Although there is


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a chance the bill could get passed by the full House, likely along party lines, Senate Republicans are not likely to act on the bill. The Senate requires 60 votes on such bills to get through the chamber, and Republicans would need to convince eight democrats to join them in voting for the Choice Act, which appears extremely unlikely. If DoddFrank changes are to be made, they are likely to occur through the regulatory process, starting with Treasury Secretary Mnuchin’s expected June report on the effects of financial regulation on lending and liquidity. For construction lending, CREFC is one of more than a dozen real estate trade organizations supporting legislation that would clarify the rules on acquisition, development and construction (ADC) loans. The High Volatility Commercial Real Estate (HVCRE) regulations were implemented jointly by the Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC) and Federal Reserve. The regulations — part of rules enacted to implement Basel III in the wake of the last financial crisis that are intended to de-risk bank balance sheets — require banks to set aside 50% more capital on loans deemed to be high-risk (12% for HVCRE loans as opposed to 8% for non-HVCRE loans). Banks say that the added costs associated with HVCRE make them less competitive versus other lenders. Martin Schuh, head of government relations for the CRE Finance Council, said the HVCRE regulations “add as much as 50 basis points to the cost of a loan.” The diminished competitive position of banks has led to the rapid growth of non-regulated lenders such as private equity funds and foreign capital in this space. What’s more, from the time the rules were enacted, banks have complained that the HVCRE rules as written were unclear and that guidance from the various agencies in charge of compliance was often contradictory, and created an un-level playing field for market participants. Confusion was evident in early 2015 when banks re-classified loans already on their books to comply with HVCRE. “The lack of clarity … has negatively impacted ADC loan decisions for some banks, leaving borrowers with fewer and potentially more costly sources of ADC loan capital. A slowdown in ADC lending has the potential for broader economic impact,” says a letter drafted by more than a dozen trade groups, including MBA, CREFC, RER, the National Apartment Association, the National Multifamily Housing Council, and NAIOP Commercial Real Estate Development Association. In an effort to convince regulators to clarify the rules, the CREFC, MBA and RER each formed HVCRE working groups. The regulators did issue FAQ responses, which many believe generally failed to appropriately address the


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groups’ concerns. There is also a legislative fix underway. Reps. Robert Pittenger (R-NC) and David Scott (D-GA) introduced a bill, H.R. 2148, in the House in late April to provide the necessary clarity on HVCRE loans for banks Key Points of the HVCRE Bill The proposed legislation would maintain HVCRE’s higher capital charges, but clarify which loans are subject to the rules. Key points of the legislation include: •G randfather loans that were originated before 2015. •E xempt acquisition/refinancing loans for performing income-producing properties. The rules were meant to require banks to set aside more capital for loans considered to be riskier. But the requirement to include acquisition loans means banks may have to set aside higher capital charges for low-leverage loans on properties with stable cash flows, although that is an area where interpretations differ. •A llow sponsors to take internally generated capital out of properties, provided the required 15% equity contribution remains in place. To be qualified as a non-HVCRE loan, the rule requires that all cash flow from a property stay within the project until the loan is repaid. Such strict terms are unappealing to borrowers. •A llow banks to withdraw the HVCRE designation after the project meets the bank’s loan underwriting criteria for permanent financing. As it stands, HVCRE status extends for the life of a loan, even if the property becomes stable and meets prescribed standards for non-HVCRE status. •A llow appreciated value of land to count versus the cash equity contribution. Currently, to avoid HVCRE status, the developer equity contribution on construction loans must be a minimum of 15% of the “as completed” value. However, the value of the land as determined by the regulators for the developer equity contribution is the original purchase price, not the current value. That becomes problematic for certain construction loans in which the land was purchased in years past and has appreciated in value. In addition, the trade groups are looking for clarity and tighter definitions of what constitutes a “redevelopment” loan or how to treat preferred equity and mezzanine debt in the capital structure. The differences in interpretation have serious consequences for banks. At a meeting sponsored by the associations recently and held in the New York office of law firm Kelley Drye, a representative of large regional bank said it reclassified $1 billion of previously originated loans as HVCRE, which required it to set aside roughly $50 million of new capital and endangered the institution’s commitment to the commercial mortgage market.


CRE Finance World

“The purpose of the legislation is not to eliminate the regulatory agencies’ requirements to hold more capital, but rather to clarify by definition the loans that should not be classified as HVCRE,” said Joe Forte, a partner at Kelley Drye who moderated the recent banker’s panel. “And also to conform provisions of the rule to existing applicable Federal banking regulations such as FIRREA (the Financial Institution Reform, Recovery and Enforcement Act of 1989).” Prospects for the success of the legislation is unclear. The aims of the bill align with the public comments to reduce regulatory burden on banks by Congressional Republicans and President Donald Trump, so the path to passage theoretically is favorable. However, the legislative environment is clouded by disputes among Republican factions and non-cooperation among Democrats who are in no mood to compromise. What should the commercial real estate market make of the uncertainty associated with HVCRE?

Given that, the Administration’s more immediate solution could be to install leaders in the regulatory agencies who will be less zealous about enforcement, says Mark Calabria, chief economist for Vice President Mike Pence. ‘Personnel is policy,’ Calabria said, noting that enforcement is one ‘part of the Obama era that can easily be replaced.’

First, legislative change will be difficult to accomplish and take longer than expected in the current environment. To gain passage with only Republican votes in the House, a bill must appeal to some combination of moderates and hard-liners. If that happens, it must survive the threat of filibuster in the Senate. That doesn’t mean a legislative approach is impossible, but efforts must be carefully calibrated. The bipartisan HVCRE legislation is an example of a reform directed at a narrow issue sponsored by a Democrat and Republican.

How to Reduce the Regulatory Burden One of the chief objections to banking regulations implemented in the wake of the last financial crisis is that the rules as written leave a lot of room for interpretation, and whatever banks do is subject to second-guessing from regulators. Calabria, who joined the administration from the Cato Institute, contends that “our financial and regulatory system is deeply flawed … in many cases, straightforward deregulation is the answer, but I recognize that the financial system is complicated.”

Second, relaxed enforcement The Administration’s more immediate and reduced compliance solution could be to install leaders in hurdles for banks are going the regulatory agencies who will be to be hallmarks of the Trump less zealous about enforcement. administration regulatory culture. One of President Trump’s first acts included signing an executive order directing Federal agencies to reduce the number of regulations. Slashing regulations already on the books, however, is complicated because it requires Congressional action and/or a lengthy rule-rewriting process by regulatory agencies that can take years.

Brian Gardner, a senior vice president of bank research at investment bank Keefe, Bruyette & Woods, also contends that prospects for legislative change are not good given the ideological differences between the House and Senate. The best hope to reduce the regulatory burden is likely to come from instruction that the new agency leadership provides to staff. “The first thing (the Administration) can do is to instruct supervisors and examiners to change their behavior,” Gardner said. It will take time to replace the heads of the agencies, though. For example, Federal Reserve chair Janet Yellen’s term expires at the end of January 2018, and Richard Cordray’s term as Director of the CFPB ends in July 2018. Some House Republicans have urged President Trump to fire Cordray, whose agency has drawn the ire of Republicans. However, under Dodd-Frank, the CFPB Director is only removable “for cause”. The removability of the Director by the President is one issue in a case currently before the D.C. Circuit.


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Hurry Up and Wait! Banks Continue to Implement Basel IV though Timing of Final Rules Still Unclear The package of risk-based capital requirements informally called “Basel IV” is still awaiting adoption by the Basel Committee on Banking Supervision (BCBS) nearly seven months after the first vote was planned. The vote on B-IV has been postponed several times since last November, first because of infighting about potential increases in capital requirements and then presumably also for political reasons. What does B-IV do? BCBS members decided several years ago that the differential between effective capital requirements from region to region and from bank to bank was too high. They decided that the trouble was the flexibility allowed into the riskbased capital (RBC) framework starting with Basel II when internal models were invited into the mix. Internal models were seen as the answer to better estimations of potential losses because they could be highly tailored. So now in this turn around the bend, the BCBS is attempting to swing the pendulum somewhere in between the risk-tailoring of internal models and the certainty of outcomes in the original Basel I regime. At the most basic level, Basel IV seeks to achieve conformity of outcomes through greater specificity around risk factor inputs, imposing capital floors and swapping some internal models for standardized approaches. The transition from Basel III to IV may impact CRE portfolios more so than others, especially CMBS and so-called repo financings drawn to financial institutions. The charges related to CMBS are expected to be at least two times those of comparable loan portfolios and CRE loan portfolios are also expected to require more in capital. What Happened to the Vote on Basel IV? In 4Q 2016, Germany said they would not adopt the Basel IV rules last year. Behind the scenes they let it be known that capital requirements for their banks would increase well past their pain point. Then in January 2017, Germany took over the presidency of the G20 and took on a more conciliatory tone, partly due to compromises promised by other BCBS members. At the same time, President Trump took office and started to search for nominees for key regulatory posts in the U.S., including the Federal Reserve’s Vice Chair of Regulation and Supervision and a new Comptroller of the OCC. CRE Finance World Summer 2017

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Christina Zausner Senior Director, Head of Industry and Policy Analysis CRE Finance Council

More recently, German officials publicly assured the U.S. that the incoming leadership should be allowed time to take their posts and to acclimate to the issues. When Might Basel IV Move Forward? In many ways, the bow to turnover in committee members may benefit all sides. If the Germans, new U.S. leadership or anyone else continues to express concerns about the level of new requirements, then this pause is a convenience and could go on indefinitely. Consider that the BCBS operates on unanimity. Every member must vote and vote in unison to adopt any measure. If a single member votes against some requirement, the very foundation of the BCBS is threatened. No one, not even the new U.S. Administration, has indicated that they would prefer to pull out of Basel, not when the consequences are so high. If a member violates requirements or pulls out of the group, then other member countries are free to limit that country’s banking activities abroad. Historically, capital rules are difficult to agree upon, and this may only be the beginning of the debate. Basel I was adopted in 1988 and the group immediately began to fashion Basel II, which was not fully implemented until roughly twenty years later. When will Banks in the US have to Conform to Basel IV? As the BCBS continues to delay its vote, U.S. and other banks are preparing for parts of B-IV. The segment of Basel IV known as the Fundamental Review of the Trading Book (FRTB), which covers CMBS, has technically already been finalized by the BCBS, though the industry believes that the regulators are revisiting the FRTB, along with all other parts of B-IV. As per the final BCBS standards, the FRTB is on track for conformity in the U.S. and elsewhere on January 1, 2020. The European Union was the first to propose its version of the FRTB several months ago and in that document, the authors pushed back conformance to 2021 in tacit acknowledgment of the burden and complexity of these requirements. Though the industry expects the BCBS to revisit calibrations of the FRTB methodologies, even though the banks have begun to build the relevant infrastructure While this dialogue proceeds between the industry and regulators, banks hope that U.S. regulators will fall in line with the Europeans and push back effective dates for the FRTB and B-IV in general. In the meantime, the banks must guess at their requirements while hoping for delays and mitigations.

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Michael Becktel 212.521.6437 [email protected]

CRE Finance World

The Big Picture: CREFC Legislative & Regulatory Update (As of May 19, 2017) While drama may continue to unfold at the White House, we do expect Congress to continue to press ahead on key initiatives such as financial regulatory reform, flood insurance and possibly tax reform. Financial sector regulators are somewhat insulated from day-to-day politics, but key changes in leadership, and possibly changes in the law, will impact their agendas. Below we present a spot check on both the legislative and the regulatory leadership slates and agendas.

Issue

David McCarthy CRE Finance Council

Legislative Spot Check As shown below, Congressional Republicans have outlined an ambitious package reforms and rollbacks. None have made it to the President’s desk as of yet. Tax Reform and Healthcare can be accomplished without Democrats’ support (if changed through the reconciliation process), but the rest will need at least some bipartisan votes to break a Senate filibuster. We do not expect to see wholesale reform of Dodd-Frank (such as passage of the entire CHOICE Act), but smaller bipartisan bills might gain traction as the year progresses.

Proposed Changes

Roadblocks

Healthcare

Repeal and replace of the Affordable Care Act (Obamacare)

Passage in the House was tough, passage in the more moderate Senate will be tougher. GOP can only lose 2 senators and still be able to pass a bill.

Passed House; Under Senate consideration

Summer 2017

Tax Reform

Multiple plans, but most seek to lower the corporate rate and reduce loopholes. Most call for up front expensing and elimination of the interest deduction.

Some GOP leaders want tax cuts to be revenue neutral by raising revenue through deduction eliminations or a border adjustment tax.

No legislative action as no bill has been introduced.

Post Healthcare, Q3 or Q4 2017

Financial CHOICE Act

Broad reforms to DoddFrank and financial regulations. Exempts banks from stress test and capital requirements if they hold 10% capital. Repeals Volcker and risk retention.

Democrats have opposed certain regulatory rollbacks. There is little appetite in the Senate for the bill where it needs bipartisan support.

Passed out of House Financial Services Committee; awaiting vote by entire House

House vote in late May or early June. Senate timing unclear, but consideration highly unlikely

GSE Reform

No unified plan; a number of proposals are floating around

Bipartisan support necessary to move any reform in the Senate

No legislative action

2nd Half 2017 and beyond.


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Status

Timeline


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Regulatory Leadership Beyond the big-ticket reforms, CREFC expects leadership turnover at the regulatory agencies to have an important impact on policy and enforcement going forward. In many cases, regulators have discretion to shape regulatory policy in the scope of a broad statute. Leadership will be key. Beyond Treasury Secretary Steven Mnuchin, the Trump Administration has confirmed only one additional leader of a financial sector regulatory agency, Jay Clayton as SEC Chair. As you can see in the tracker, there are plenty of important vacancies.

In particular, the Federal Reserve’s Vice Chair of Banking and Supervision, which has been filled only on an acting basis by other Governors, plays an important role in crafting bank regulatory policy, both at the domestic and the international levels. The position also takes the lead for the Fed at the international Basel Committee on Banking Supervision. Although there is an Acting Comptroller leading the OCC, Secretary Mnuchin informed the Senate Banking Committee on May 18 that President Trump had approved a nominee and that was proceeding through the vetting process. The nominee has not yet been announced.

Agency

Leadership Transition

Treasury

Secretary of Treasury: Steve Mnuchin

FDIC (1 Vacancy)

Chair Martin Gruenberg: Term ends Nov 2017 Vice Chair Thomas Hoenig: Term ends 2018 Vacancy

Board of Governors, Federal Reserve (3 Vacancies)

Chair Janet Yellen: Term as Chair ends Feb 2018 (Board term ends Jan 2024) Vice Chair Stanley Fischer: Term as VC ends Jun 2018 (Board term ends Jan 2020) Gov. Jerome Powell: Term ends Jan 2028 (named acting VC of Regulation and Supervision) Gov. Lael Brainard: Term ends Jan 2026 Vacancy; Vice Chair of Supervision and Regulation (Randy Quarles possible Nominee) Vacancy Vacancy

OCC

Acting Comptroller Keith Norieka (Joseph Otting possible Nominee)

SEC (3 Vacancies)

Chair: Jay Clayton: Term ends 2021 Comm. Michael Piwowar: Term ends 2018 Comm. Kara Stein: Term ends 2017 Vacancy Vacancy

CFTC (3 Vacancies)

Chair: J Christopher Giancarlo (named Acting Chair and Nominee) Comm. Sharon Bowen: Term ends Jun 2019 Vacancy Vacancy Vacancy

Regulatory Agendas Once more agency vacancies are filled, the agendas will begin to take shape. We’re also awaiting two key documents that may shed more light on priorities and timing: the Unified Regulatory & Deregulatory Agenda and Secretary Mnuchin’s Report on Core Principles for Regulating the U.S. Financial System. The twice-yearly Unified Agenda compiles agency rulemaking schedules over the coming year and indicates timing, what rules the regulators will take up, as well as providing status updates on stages of rulemaking. From the Spring 2017 agenda, we will be able to see the regulators’ priorities. The agenda usually is released in late May. Secretary Mnuchin’s report is in response to President Trump’s Executive Order signed on February 3, 2017, which laid out seven core principles and directed the Treasury Secretary to examine the “extent to which existing laws, treaties, regulations,

guidance, reporting and recordkeeping requirements, and Government polices promote the Core Principles.” The report, expected in early June, will cover banking. We expect this report and any subsequent reports will represent the Administration’s roadmap for regulatory reform. Implementing these findings could involve both legislative and regulatory action, but, as most of the financial regulators are independent agencies, the Trump Administration has limited ability to implement the findings directly. That independent structure underscores the importance of the appointees in regulatory or deregulatory actions. Stay Tuned Healthcare, tax reform, and Russia may dominate the headlines over the next few months, but opportunities remain for action on financial industry regulation. Please reach out to CREFC’s government relations team and keep up to date on our advocacy efforts on behalf of our members.


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EVOLUTION

CHANGE

DISRUPTION

Market Disruptors Are Here To Stay! When we hear the words “Market Disruptors” we generally think Google, Amazon, Airbnb, Uber, Netflix, and YouTube. We all know the effect Netflix had on Blockbuster, YouTube had on the record industry, and Uber had on the traditional Yellow Cab. Just like the Industrial Revolution changed the landscape from a rural economy to an urban-based economy, technology is changing the business landscape at an exponential rate. The shift has resulted (and will continue to result) in a multitude of disruptions to various market sectors. Seemingly, every time we go online, read a magazine, listen to the radio or watch TV, we hear of a new “Market Disruptor” or an existing player expanding its scope. CNBC’s Top 50 Disruptor list is projected to impact 15 industries, including financial services, medical services, aerospace, cybersecurity, retail and media. The sharing economy, automation, and technology have been the driving forces behind these market disruptors. This begs the question, how will the commercial real estate finance industry occupied by these industries be affected? To understand the broad reach and impact of these disruptive factors, it is important to consider growth and footprint of major disrupters, Amazon and Airbnb; the impact technology and changing trends have of commercial real estate spaces; and, finally, how commercial spaces are adapting to disruption. Disruptors: Investment and Growth Bloom Energy envisions “living off the grid and keeping the lights on”, and SpaceX is taking us to Mars. Pinterest, Spotify, and Snapchat have become household names. Corporate America seemingly overnight began utilizing DocuSign, SurveyMonkey and Dropbox. CNBC’s 2016 list of the Top 50 Disruptors reports $41 billion in venture capital was raised in 2016, and the Top 50 Disruptors have a combined market value of $242 billion. A dozen of these companies raised $1 billion or more with the median raised amount being $276 million. Fidelity alone has invested in 13 of the Top 50 Disruptors including Snapchat, Uber, Airbnb, Twilio, Oscar and SpaceX. Google Ventures was a dominant player that invested in a dozen tech companies. Foreign investment has joined the game and is fueling growth. Uber received $3.5 billion from Saudi Arabia’s Public Investment Fund, and Snapchat raised $200 million from the Chinese e-commerce giant Alibaba. Snapchat became a publicly traded company in March 2017 with the latest valuation at approximately $17.8 billion.


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Abeer Ghazaleh PGIM Real Estate Finance

Amazon is the behemoth of market disruptors. Amazon has had a marked impact on the retail sector and is the leading retailer of e-commerce. Amazon sales account for 8% of all retail sales and 43% of online sales in the United States. Net sales in 2016 were reported at $2.87 billion driven by more than 304 million consumers. The “Amazon Effect” has dealt a heavy blow to previous giants such as Borders, Sears, JCPenney, Best Buy, Office Depot, American Eagle Outfitters, and the list goes on and on. Announcements of new closures are revealed on a weekly basis. Amazon turned 21 in the summer of 2016. The National Retail Federation ranked Amazon 26 on the Top 100 Retailers as of 12/31/2010. In contrast Amazon was ranked eight as of 12/31/2016. Amazon’s ranking has steadily improved year over year as illustrated in the below chart. Chart 1 Amazon Ranking Top 100 2016

Former giants Sears and Best Buy have dropped off the Top 10 list as Amazon gained market share. It has been said time and time again, America’s malls are moving online. The Financial Times reports as of April 4, 2017, the consensus forecast amongst 49 polled investment analysts covering Amazon.com, Inc. is that the company will continue to outperform the market. This has been the sentiment of forecasters since 2009. Amazon reported net income of $2.87 billion in 2016. A new company challenging a traditional industry is not limited to the retail sector. Airbnb, a provider of travel accommodation has served over 30 million guests since its founding in 2008 and is valued at $10 billion. Without owning a single room, Airbnb’s valuation rivals those of major hotel chains, like Hyatt. Airbnb exemplifies the sharing economy concept. It derives revenue through service fees from both the guest (9-12%) and the host (3%). Airbnb built its online reputation by encouraging guests to rate their experiences through a star point system. Airbnb quickly became a threat to the hotel industry as travelers chose to stay in Airbnb rooms instead of the traditional hotels. It is estimated that hotels lose approximately $450 million in room revenue and an additional $108 million in food and beverage revenue annually due to Airbnb’s penetration of the hotel sector.

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Industrial properties have undergone conversions to residential units, film studios, hotels, and mixed use office/retail.

According to an article published by Phocuswright (D. Quinby 2016), Airbnb is now the third-largest online seller of accommodation worldwide, and it is probably the fourthlargest online travel intermediary by gross bookings. Airbnb’s site is currently used by 50,000 renters daily. Airbnb had one million available rooms in 2015, compared to Hilton, Marriott and Intercontinental which each had approximately 700,000 rooms. It is extremely cost effective for Airbnb to expand its platform by adding additional rooms through subscribing new hosts. Unfortunately, adding rooms for hotel chains is a costly proposition as the new product must be constructed. In a Fortune article title “Airbnb’s Profits to Top $3 Billion by 2020 (L Gallagher 2017). Airbnb projects it will earn $3.5 billion a year by 2020 which translates to more than the bottom lines of 85% of the companies in the Fortune 500. Each 10% increase in Airbnb revenue is estimated to result in 37 million room night bookings per year. By comparison, each 10% revenue increase for Airbnb translates to a 2-3% decrease in traditional hotel revenue. In addition to loss of room and food & beverage revenue for hotels, there is also an adverse impact to the collection of local and state taxes which may not be applicable at the same rate for Airbnb as they are for hotels. Attempts to combat Airbnb’s appeal to consumers have largely been unsuccessful. As traditional hotels move to

reduce room rates, (benefiting consumers) it results in further revenue declines. Unsurprisingly the hotel/Airbnb fight has shifted to the courtrooms and legislative bodies across America. Given consumer appetite for this and similar products, it will likely be a long, hard fought, and expensive battle. Will hotels adapt and reinvent themselves or will there be an oversupply in the marketplace? Only time will tell the outcome. Other travel sites such HomeAway, VRBO, and Expedia are also in the online booking market sector. They provide competition to both Airbnb and traditional hotels. Starwood and Wyndham have implemented loyalty programs to boost their bookings. Disruptions to Commercial Real Estate At CREFC’s Annual Conference in January 2017, keynote speaker Salim Ishmael went so far as to say the commercial landscape as we know it today will be unrecognizable in the next five years. “Wow,” I thought, “that’s a daunting prospect!” Because of that speech I have become sensitive to any mention of “Market Disruptors” and how this phenomenon is affecting uses of traditional commercial real estate. Which property types are most impacted and potentially becoming obsolete? How are these properties adapting in the new world?


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Nanotechnology could extend life span and eliminate disease. How will that impact the medical, insurance, and pharmaceutical industries, and, by extension, the physical spaces in which they currently exist? Drones will deliver goods to our doors. Our food will truly come from the farm to table. What will the impact be to the distributor, retailer, and space they occupy? Will the neighborhood grocery anchor and retailers driven by foot traffic disappear to be replaced by an Amazon distribution center? In a recent conversation with my seven-year old granddaughter, she was perplexed as to why I needed to go to the grocery store. She informed me that “Instacart” can bring me whatever I need and that no one goes to the grocery store anymore. It was a bit disheartening to learn from a seven year old how uncool and behind the times I was! Self-navigating automobiles could prevent transportation headaches and provide an accident free solution to commuters within the next few years. The Business Insider published an article titled “Here’s how Tesla’s self-driving cars see the world” (D Muoio 2016) which reported that Tesla will drive a car in a fully autonomous mode from LA to New York City by the end of 2017. Toyota also is also taking aim at producing autonomous cars to counter efforts by Google. This new mode of travel is anticipated to ease congestion along with wear and tear to vehicles, roads and highways. How will parking lots be impacted? Will there be a need for insurance providers? What happens to the millions of jobs currently supported by infrastructure maintenance, development, and product manufacturing? Adapting to Disruption Commercial Property Executive published an article titled “The Trend of Adaptive Reuse” (F. Romeo 2015). Mr. Romeo states, “On the most basic level, adaptive reuse can save on overall building design, material and construction costs. In general, these buildings have great foundations, facades and structurally strong frameworks, which can remain intact, while containing an abundance of existing core and shell space that can be quickly and cost effectively renovated to serve the needs of non-traditional tenants.” Evidence of adaptive reuse can be seen in multiple commercial real estate sectors today, and below are just a few examples of how malls, retail, office buildings, and even industrial spaces are being reinvented. The United States currently hosts approximately 1,200 indoor malls, of which only a third are performing well. Many have adapted to challenges brought about by the internetera by adding attractions like aquariums, escape rooms, fitness centers, day cares, and blow-dry bars to increase foot traffic and maintain their relevance. Restaurants and medical clinics are beginning to make up a larger portion of


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the tenant mix at many shopping centers. Stores such as Macy’s and JCPenney, in conjunction with implementing store closures, are experimenting with “store within store” concepts. They are partnering with the likes of Apple, Sephora and DKNY to reduce their footprint and lease expenses and to increase foot traffic. Additionally, advocates of New Urbanism contend that Which property types are dead malls are ideal sites for sustainable community most impacted and potentially centers, as large tracts and becoming obsolete? empty concrete shells are ideal for conversion into multi-function suburban town centers. Town centers combine residential, retail and office properties into a concentrated area (a concept that has proved enormously appealing to Millennials). Approximately 40 dead malls in the United States have undergone transformation into suburban downtown areas. Vacant Big Box space has been converted to a variety of recreational and institutional uses including churches, health clubs, and museums. Healthcare organizations have found it cost effective to convert Big Box stores into clinics as they are readily accessible to the community, expand patient base, and offer ample parking. Dated low-rise office properties are being converted into schools and distribution centers (to accommodate the online shopping appetite). On the other end, high-rise office properties offer opportunities to expand the limited housing supply in many metropolitan areas. Industrial properties have undergone conversions to residential units, film studios, hotels, and mixed use office/ retail. Even auto dealership sites have recently proved to be highly desirable sites and structures for manufacturing, such as a bottling plant in Michigan. Conclusion The sharing economy, automation, and technology are here to stay! They will continue to develop at an exponential rate changing lives, business practices, space occupied, and world views. Many industries, including commercial real estate must remain vigilant of the seemingly subtle shifts within portfolios. These unprecedented advances will also bring about moral and ethical questions regarding their implications which will need to be addressed through legislative bodies. Despite the challenges, change inevitably brings with it tremendous opportunity. Society must be prepared to facilitate rather than hinder the transformation process. The alternative is to be left behind.

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Secular Trends Transforming the CRE Landscape Social and demographic trends will continue to shape the commercial real estate landscape. The trends encompass a number of factors such as the size of each generational cohort, lifestyle choices about marriage, child rearing and retirement, shopping behavior, work and leisure, and even recreational drug legalization. Millennials (19 to 35 years old), which have surpassed the baby boomers (52 to 70 years old) to become the largest generation, are transforming the commercial real estate industry. The lifestyle choices and work preferences of this cohort will increasingly influence the use and configuration of real estate space. For those properties that adapt to the new world order of space usage, intrinsic value should be enhanced, for those that don’t, higher vacancies, or even obsolescence could result. In the report that follows, we will explore some of the secular trends that are driving the demand for, and shaping the future performance of CMBS property collateral.

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Larry Kay Senior Director Kroll Bond Rating Agency

Eric Thompson Senior Managing Director Kroll Bond Rating Agency

Warehouse tenant demand is not only coming from e-commerce activity, but from a new tenant that has entered this space, the cannabis operator. After Colorado voters approved the use and sale of recreational marijuana in November 2012, warehouse rental increases in Denver reached double digit growth in 2013, which continued in 2014 and 2015. This compares with the national annual rent growth during this same period of between 3 and 5%. In 2016, Denver appeared to be coming down from its marijuana high, with annual rent growth slowing to 4%. The slowing most likely reflects the increase in building deliveries which jumped in 2014 and then again in 2016 lifting the vacancy rate to 3.9% in Q4 2016 compared to 3.2% in Q4 2015. Exhibit 1 Warehouse Rent Growth

E-Commerce and Marijuana Light Up Warehouse Space E-commerce continues to command an increasing percentage of total retail sales. Based on U.S. Census data, Q4 2016 e-commerce accounted for 8.3% of total retail sales compared to 7.6% Q4 2015. Jones Lang LaSalle estimates that 30–40% of demand for industrial real estate has some type of connection to e-commerce. Retailers in the past typically processed their e-commerce sales at their brick-and-mortar locations. With the emphasis on logistics and proximity to customers, retailers are now more often utilizing fulfillment centers or revamping existing distribution centers to accommodate e-commerce growth. This supply chain reconfiguration plays into the instant gratification that e-commerce shoppers want—shortening the time between the click on their computer and the knock on their door for the delivered goods. Fulfillment centers are being developed near major population areas to help assure same-day delivery. Amazon clearly dominates this industrial space and its website notes that it has more than 70 fulfillment centers in the U.S., including 26 that were added in 2016.

Source: CoStar Group

Exhibit 2 Denver Warehouse Deliveries and Vacancy Rate

Source: CoStar Group, Kroll Bond Rating Agency, Inc.


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In November 2016, California legalized the use of recreational marijuana. If the rent growth that Denver experienced is any indication of what could happen in California, the country’s most populous state, the impact to warehouse space fundamentals could be even greater. However, the cannabis warehouse business is not without its challenges. Building owners that add marijuana tenants new to the business, or lease to inexperienced operators, will likely face a higher risk of tenant defaults. In addition, tenant improvements will need to be made to maintain this type of operation including specific lighting systems and expensive security systems. In addition to the risk and cost of running a cannabis warehouse business, another challenge for landlords is that although marijuana may be legal in some states, under federal law, it remains a Schedule I controlled substance, illegal for any use. As a result, KBRA does not expect to see CMBS loans collateralized by properties with tenants engaged in marijuana-related activities for as long as marijuana remains a Schedule I illegal narcotic under federal law. However, with 28 states and the District of Columbia legalizing marijuana for medicinal purposes and with more than 20% of the U.S. population living in states where recreational marijuana is legal, as well as the expected continued growth in e-commerce, warehouse demand should remain intact. Online Retailers Check Out Neighborhood Shopping Centers While the rise of e-commerce has benefitted the industrial sector, its increasing share of total retail sales has had a crippling effect on bricks-and-mortar retail. A recent UPS survey of online shoppers found that for the first time in the study’s five- year history, on average more than half of the shoppers’ purchases were made online. Among online retailers, Amazon stood out: the 800 pound e-commerce gorilla accounted for 43% of 2016 online sales in the U.S.

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vacancies from in-line tenants. As this has occurred, bricks-and-mortar retail has been searching for a way to provide shoppers with an experience that cannot be replicated online. The future of the retail industry will not only be on the Web, but also in creating omni-channel offerings that integrate the online and bricks-and-mortar experiences. While this has been going on for years as traditional retailers have expanded their online presence, the tables have turned as e-commerce outlets are now opening physical storefronts. Amazon has been at the forefront of e-retailers that are utilizing bricks-and-mortar integration. It recently opened a physical grocery store (1,800 sf) in Seattle. Based on recent articles, Amazon may be exploring other test grocery store locations. If these test stores are successful, we would expect others to follow. That may not be the only threat to the supermarket or grocery store. Millennials are visiting supermarkets less frequently than previous generations did. They are increasingly purchasing their groceries through online outlets such as Fresh Direct and Peapod. According to a report by the Food Marketing Institute and Nielsen Co., 70% of all shoppers say they expect to buy groceries online during the next ten years. In 2016, 28% of millennials bought groceries online. However, anchored neighborhood shopping centers that provide needs-based goods and services are expected to continue being a viable retail format. Despite this, centers that are in trade areas which have experienced in-migration from millennials may be adversely impacted by that group’s greater tendency to shop online. In addition, neighborhood centers with grocery anchors could also be negatively impacted in such markets, particularly if Amazon expands its grocery business. Exhibit 4 Percentage of Households Buying Groceries Online

Exhibit 3 Amazon’s Share of Online Sales

Source: Internet Retailer

The secular shift to e-commerce sales has contributed to recurring announcements of store closures and retailer bankruptcies, including those of JCPenney, Macy’s, and Sears, and the liquidation of Sports Authority, among others. Regional mall operators have struggled from reduced foot traffic due to the loss of anchors, as well as increased

Source: Food Marketing Institute, The Nielsen Co., Internet Retailer

Generational Gap Does Not Divide Living Preferences Demographics and living preferences are also shaping the multifamily sector. According to the U.S. Census Bureau, the number of millennials (75.4 million) surpassed baby boomers (74.9 million) in 2015. As the largest generation, millennials will be a major force in future housing demand.


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Lifestyle choices among both groups, however, will ultimately determine living accommodations, with multifamily most likely to be the prime beneficiary.

be reluctant to put down roots in a particular community. According to the U.S. Bureau of Labor Statistics, millennials only stay with the same employer, on average, for three years.

Exhibit 5 Population Estimates by Generation

Based on these factors, it is no surprise home ownership is being delayed. In a 2015 analysis, Zillow, a real estate database company, found that Americans now rent for an average of six years before buying their first home — more than twice the comparable figure in the 1970s of 2.6 years. Accompanying this statistic, the home ownership rate has been on a steady decline. Despite an increase to 63.7% in Q4 2016, the home ownership rate fell to its lowest level since the Census Bureau began tracking the figure in 1965 during Q2 2016, of 62.9%.

Source: Kroll Bond Rating Agency, Inc.; U.S. Census Bureau

Millennials are delaying marriage and childbirth until later in life, events that have tended to increase demand for single-family housing. According to a Gallup poll, 27% of millennials are currently married, compared to 48% of baby boomers that were married at the same age based on U.S. Census Bureau data. With home purchases by millennials being postponed, many are able to save money for down payments. However, those seeking to purchase a home may face obstacles, as lending requirements have generally been more stringent following the housing crisis. Furthermore, many millennials have outstanding student loan debt, and according to Experian, have the lowest average credit score of all the generational cohorts. In addition to credit, affordability is emerging as the number one concern among homebuyers. For millennials, affordability fears are even more severe, with 32.5% naming it their top concern. Exhibit 6 Millenials: Top Home Ownership Concerns

Source: Kroll Bond Rating Agency, Inc.; Redfin

While financial and credit issues may lead millennials to multifamily, other reasons that may make renting preferable for this cohort are more lifestyle related, as they seem to


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The home ownership rate is expected to continue to decline not only because millennials are putting off their home purchases, but also because baby boomers do not want to be tied down to larger, underutilized suburban homes as they age. As a result, they are downsizing to smaller rental quarters. On top of smaller accommodations, boomers also want the flexibility that a multifamily rental can provide so they can pick up and move to be near their children and grandchildren. City living could possibly be a viable alternative to those baby boomers that may want to increase their cultural experiences, and also have easier access to restaurants and shops. Urban living may also allow boomers to live in closer proximity to better healthcare choices. Although age may be the great divide between millennials and baby boomers, housing preferences at present are not. The ‘My’ To ‘Our’ Office Space Transformation With baby boomers retiring from the workplace and millennials moving in, the shift in workforce demographics has forced corporations to rethink their space needs. As a result, corporations have been reconfiguring their office space as they look to attract millennial employees. Individual work areas are becoming less about corporate rank and more about functional use. In addition, with more office staff working remotely and corporations employing outside contract workers for flexibility, companies have reduced their space needs. According to a 2017 Gallup survey, from 2012 to 2016 the number of employees working remotely rose by four percentage points from 39% to 43%. As more people work away from the office, corporations have moved to open space arrangements with hybrid floor plans. According to a survey by the International Facility Management Association, about 70% of U.S. companies have some type of open floor plan. Workspaces have become smaller, as technological advances and mobile devices reduced the number of workers that require a desk. According to CoreNet Global, an association of corporate real estate and workplace professionals, office space per worker is expected to continue to decline. From 600 square feet per worker in the 1970s, office space fell to 225 sf in 2010, and could decline to 150 sf this year, based on the most recent statistics available from the company.

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Exhibit 7 Office Space (SF) Per Worker

Source: Kroll Bond Rating Agency, Inc.; CoreNet Global

Provided it is economically viable, landlords may seek to repurpose buildings that cannot accommodate the new workforce. Generally, the buildings that are repurposed are those Class C properties that are less competitive, and in some cases obsolete due to outdated infrastructure and technological deficiencies. Gensler Analytics, a global architecture, planning, and consulting firm, has determined that approximately 185 million sf office space may be considered obsolete and an additional 300 million sf may not be competitive due to lack of building upgrades. This amounts to about 6% of the total U.S. office stock. Corporations are not only reducing their own leased space, but are utilizing space more frequently through co-working centers. Shared space provides companies with the ability to scale up or down depending on the company’s needs without committing to a multiyear lease. This arrangement can also be attractive for tenants that may not want to obligate themselves to either the traditional or the hybrid office structure. Start-ups might find shared workspaces especially attractive, as may companies whose industries face large seasonal variations in business needs. According to Statista, an online statistics and research portal, worldwide there were 7,800 shared office spaces in 2015. This number is expected to reach 37,000 by 2018.

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But as with hybrid office space, shared office space comes with drawbacks. Workers may be interrupted by others from unaffiliated companies looking to network or socialize. They may also be noisier than individually leased or owned offices, and with less ability to keep work private. However, co-sharing work space is expected to continue to grow, as a new generation that prefers a flexible work environment enters the workforce. Hotels Are Not Taking Airbnb Lying Down Airbnb, an online community marketplace for room accommodations, continues its rapid growth and popularity with millennial travelers. These young travelers have gravitated towards Airbnb as it provides them with a nontraditional lodging experience at an affordable price. This sought-after cohort currently makes up over one-third of the world’s hotel guests. According to the Cornell Center of Hospitality Research, it could represent 50% of all travelers by 2025. Airbnb’s business model relies on hosts renting out their extra bedrooms or unused properties on a short-term basis. It has resulted in an online hospitality platform of roughly three million global rental unit listings. According to a recent Smith Travel Research (STR) study, this figure is more than the number of listings for the next three largest traditional hotel companies combined. The study indicated that Airbnb had a fairly small market share across 13 global markets, with less than 4% of total demand and 3% of revenues. STR also reports that one-half of the rooms listed on Airbnb are sold for seven days or more. This challenges the conventional wisdom that Airbnb typically competes for the short-term or daily traveler. Based on STR’s analysis, it may compete more directly with extended stay properties. Exhibit 9 Largest Lodging Companies by Rooms/Listings As of November 2016

Exhibit 8 Global Number of Coworking Spaces

Source: STR, Kroll Bond Rating Agency, Inc.

Source: Kroll Bond Rating Agency, Inc.; Statista

Airbnb’s Average Daily Rate (ADR) appears to be very competitive especially on weekends, when there is stronger competition for leisure travelers. According to the STR study, U.S. hotel ADR on weekends has a negligible 2%–8% price premium over Airbnb. On weekdays, however, the premium is 14%–23%, reflecting more demand, higher occupancies, and less price sensitivity from corporate travelers. As


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millennials move into the corporate world and are in positions that oversee travel accommodations, an increase in Airbnb’s corporate clients could narrow the weekday price spread. Some of this increased business activity is already occurring with last year’s announcement that American Express Global Business Travel will integrate Airbnb into their platforms. As a result, its employees and travel managers are able to book stays with Airbnb. Airbnb estimates that 10% of its bookings are for business travel. Exhibit 10 U.S. ADR by Day of Week July 2016, 12-month moving average

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Source: STR, Kroll Bond Rating Agency, Inc.

For years, travelers have been booking hotel rooms through online travel agent (OTA) sites including Expedia, Orbitz, Priceline, and Travelocity. Some of the larger hotel chains such as Hilton Worldwide have been responding by offering discounts to customers that book directly with the hotel chain. In 2016, both Hilton and Marriott aggressively implemented direct booking and loyalty marketing campaigns. With Expedia’s acquisition of HomeAway, Orbitz, and Travelocity, merger and acquisition activity in the sector has picked up. Hotel consolidations have been occurring as chains look to increase scale, improve operating efficiencies, and maintain a larger marketing budget for national campaigns. Hotel mergers and acquisitions activity typically follows economic cycles. However in our view, the secular online threat of peer-to-peer accommodations will persist.

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Non-Bank Lending in an Era of Bank Deregulation The decade since the financial crisis has been challenging for our nation overall, but it has been a fertile period for non-bank real estate lenders. The great majority of Americans were angered by what they saw as reckless and sometimes cynical behavior by both commercial and investment banks who profited immensely from lax lending practices, and then needed taxpayer bailouts to avoid bankruptcy. As a result, Congress passed new rules, mostly generated from the Dodd-Frank Act, that greatly restricted bank lending to real estate investors and developers of any kind. A new wave of non-bank lenders sprang up to fill the void. This includes start-up lending funds, some of which have grown to have billion-dollar balance sheets, as well as the most established real estate private equity firms, most of whom have launched non-bank lending programs of one kind or another. But with the changes in Congress and the Administration, it now seems likely that the pendulum will swing back toward less restrictive bank regulation. This article examines three topics: (1) What is the state of non-bank real estate lending today?; (2) W hat factors have allowed this industry to grow and thrive?; and (3) H ow are non-bank lenders likely to evolve in the years ahead? Non-Bank Real Estate Lending Today In the past, there was a clear distinction between institutional lenders on one hand — including banks and insurance companies — and private or hard money lenders on the other. The gap between the two worlds was wide, in terms of both pricing and standards of professionalism. Today, non-bank lending covers a wide range of loan types and sizes. Pricing in some cases is very competitive with bank pricing. The “hard money” niche still exists but the space in between hard money and institutional lending has filled in with hundreds of lenders offering every type of loan. These lenders tend to break down into a number of groupings based on factors which include the following:

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Jan B. Brzeski Arixia Capital Advisors

• L oan Size. Different lenders compete in different parts of the market, with pricing often lower for larger loans because of the economies of scale involved in underwriting and originating such loans. Also, larger loans are usually floating rate, while smaller loans are often offered at fixed rates. Multi-billion dollar lending vehicles tend to focus on loans of $20+ million and they often prefer $40+ million loans. Loans of $5–$20 million tend to attract their own lenders whose funds may be in the hundreds of millions. Within this grouping there are many lenders who prefer $10+ million loans and others who usually stay below $10 million. Loans under $5 million attract their own group of lenders — usually local and regional companies rather than national ones. Finally, the market for loans under $1 million tends to be occupied by mortgage brokers who work with affluent individual investors, matching each loan with one or more investors. • Loan Maturity. Bridge loans of 12–24 months attract a dedicated group of lenders who are set up to handle a large volume of transactions with relatively quick payoffs. These lenders tend to hold loans on balance sheet until maturity and often service the loans they originate, because securitization makes more sense for loans that will be outstanding for several years. Bridge lenders often market themselves as being able to close quickly, usually in under 30 days. Certain bridge lenders offer to close in 7–10 days, in order to justify higher rates or origination fees. Many bridge lenders focus on the as-is value of the collateral, and probably won’t require that the asset be able to cover debt service. Other lenders offer maturities of 2–5 years, featuring lower rates. Often these lenders require enough income in place at the time of closing to cover debt service. These loans on “transitional assets” are attractive when the business plan for the property will take time to implement, such as if some leases will not roll over until 2–3 years from the time of funding. • Specialty Lenders. Some lenders focus on a particular asset type, such as single family homes. Within this category there are sub-specialties including fix-and-flip lenders (which was the original focus of Arixa Capital, the author’s company), rental houses (for example, B2R which is owned by Blackstone Group) and construction lending on for-sale housing. Other specialties include hospitality, senior assisted living and even cannabis-related properties.


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What Factors Have Allowed Non-Bank Lenders to Thrive? The most successful non-bank lenders today often have an entrepreneurial culture and a “can-do” attitude. They embrace short deadlines and try to solve problems to get loans closed, rather than focusing on meeting strict and arbitrary lending criteria. This, in short, is why they are thriving and taking market share away from banks which rarely have an entrepreneurial approach to lending. To understand today’s lending landscape, it helps to start with a simple question: what advantage do banks have as real estate lenders in the first place? The answer is, they have a very low cost of capital because of deposits from individuals and businesses on which they pay under 1% interest per year. To avoid “runs on the banks,” such as those during the Great Depression, these deposits are insured against any losses by the FDIC. In other words, we the taxpayers are guaranteeing that even if a bank fails, depositors won’t lose money. In the financial crisis, the Troubled Asset Relief Program invested $700 billion to prop up bank balance sheets. Banks’ very low cost of capital comes with strings attached. You and I as taxpayers have an interest in not seeing banks pursue risky investments. Otherwise, bank executives could make huge profits most of the time, pursuing more aggressive investments, and then walk away from the rubble when their banks failed every time a crisis emerged, leaving taxpayers to foot the bill. This is exactly what most Americans believe banks did before and during the financial crisis. This perception — whether it is true or not — has weakened the fabric of our society in meaningful ways. Consider the anger on the part of most citizens against the “1%”, against commercial and investment banks, and against other elites. It is impossible to imagine the uprising by outsiders against insiders that brought Donald Trump to power without the backdrop of the financial crisis and the deep-seated resentment about perceived unfairness built into our economic system. It would be simple to say that non-bank lenders have thrived because of excessive bank regulation after the financial crisis. However, this view misses the larger point. The bank regulation after the financial crisis was a reaction to the fact that taxpayers really are footing the bill for any future bank bailouts. “Too big to fail” means that large banks are basically utilities, too important to our economy to be allowed to fail. Smaller banks may be allowed to fail, but the FDIC — and ultimately taxpayers like you and me — must still pay up if the FDIC ever became insolvent. Free markets function well most of the time, but our society already has major, unavoidable areas of government intervention. It wouldn’t be fair to give banks special protection without requiring something substantial in return. In the case of banks, that something is strict monitoring of banks’ balance sheets and lending activities, and penalties in the form of increased capital requirements for those banks who choose to make loans with higher risk. Non-bank lenders have thrived because they are free to provide exactly what their borrowers require, without regard


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to the special regulatory burden that rightly accompanies being a public utility guaranteed by taxpayers. Non-bank lenders usually charge higher interest rates than banks — sometimes significantly higher — however they also perform a valuable service for borrowers. They free the borrower from needing to deal with a highly regulated lender, which saves the borrower a great deal of work. Just as banks need a lot of extra compliance employees to make sure the bank will pass regulator’s inspections and audits successfully, real estate investors and borrowers who deal with banks essentially take on some of this burden in the form of extra employees whose main job is to provide banks with all the documentation and other requests they need every week. Non-bank lenders enjoy lighter regulation than banks because they have no deposits and no government insurance. If a non-bank lender loses 100% of its investment in a portfolio of loans, the investors in that lender will lose their principal. But such investors are typically sophisticated wealthy individuals and partnerships who have been made aware through SEC-mandated offering documents of the risks associated with investing in a non-bank lending vehicle. Future Trends Among Non-bank Lenders In the coming years, it is likely that the trends since the financial crisis will continue. Some of those trends include the following: The volume of non-bank lending will grow. In California the

Department of Business Oversight tracks mortgage lending by non-banks. They report that licensed lenders originated 537,757 mortgages in 2015, up 47.3 percent from 2014’s total of 365,045. The aggregate principal for mortgages originated in 2015 grew 56.7 percent from 2014, to $179.3 billion from $114.4 billion. Expect this trend to continue and to be mirrored across the U.S. Non-bank lenders will continue to become more professionalized . As many lenders approach or surpass the

billion dollar mark, they are adding all sorts of highly refined services. This may include technology designed to make borrowers’ lives easier, or simply better training for their employees. The coming years are likely to produce — for the first time in recent memory — nationwide brands offering bridge loans to real estate investors and developers. Traditional hard money lenders will fade as fund-based non-bank lenders grow. Hard money used to consist of

brokers who matched real estate owners and investors needing quick funding with investors wanting a good return on their money. Increasingly, the model of matching loans with investors is giving way to debt funds who charge less, offer more transparency on pricing, and who have a lot more capital available to put to work. Increasingly non-bank lenders will compete on pricing with banks. As leverage becomes more available to real

estate lending funds — often at attractive rates — these funds can price their loans closer and closer to bank rates. This is already true for larger sized bridge loans in the many tens of millions of dollars. As interest rates rise and bank lending rates increase, expect to see a convergence of rates between bank and non-bank lenders on smaller balance loans as well.

CRE Finance World

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Evaluating Alternative Lending Platforms and Their Prospects Going Forward Traditionally, commercial real estate borrowers’ only option was to approach banks or other traditional lenders when seeking out a loan, a process that can be inconvenient and time consuming. Today, a wide variety of commercial real estate alternative lending platforms exist that can provide convenience and time savings, as well as flexibility for borrowers who may not be able to get loans approved from traditional lenders for a host of reasons. These platforms

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Gary Bechtel President Money360

offer many benefits to lenders as well, such as direct access to loans, resulting in lower costs and higher returns. What’s the Market for CRE Alternative Lending Platforms? Commercial real estate presents a $3.3 trillion opportunity for online lenders — far greater than other peer-to-peer markets such as consumer ($2 trillion) and student loans ($1.3 trillion). With nearly $300 billion in loans coming due in the next 18 months, alternative lenders in commercial real estate will have opportunities to fill the void left by other lenders, curtailing their lending activities and giving borrowers quicker access to funds at better terms than what may be offered by many traditional lenders. According to American Banker, the industry has grown by nearly 700 percent over

Today, a wide variety of commercial real estate alternative lending platforms exist that can provide convenience and time savings as well as flexibility for borrowers.


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the past four years. These platforms are already shifting the world of commercial real estate finance, and will only continue to grow over the next several years. With increased regulatory oversight within the commercial mortgage-back securities (CMBS) and banking industry in recent years, the pressure on traditional lenders is increasing, limiting their ability to provide new construction loans and refinance existing loans. As a result, alternative lenders are moving in to fill the gap and will become more necessary than ever to keep up with the demand for capital. Crowdfunding vs. Marketplace Lending Crowdfunding is one alternative lending method that is gaining popularity in the commercial real estate space. While these platforms typically raise money from many different investors, if not enough people contribute to fund the full transaction, all of the investments may fall through. Crowdfunding platforms also typically have limited options when it comes to loan terms and don’t match borrowers and investors based on the best fit, making it a less effective platform than more tailored lending platforms. Marketplace or peer-to-peer lending is another popular option. These platforms match borrowers and lenders, giving borrowers timely access to funds from either individual or institutional investors, depending on the platform’s strategy. The marketplace lender sources, underwrites and services the loan, while marketing it to potential investors, typically after it has been funded. The lenders set the loan rates and terms of the loans they originate. What is the Role of Technology? In addition to expediting the process of finding an appropriate borrower or lender, marketplace platforms allow investors to review a variety of investment options in one place, do their research, and stay up-to-date on the latest investment opportunities. Investors and borrowers are updated in realtime during each step in the loan transaction, increasing transparency and reducing the back-and-forth lag in communication that occurs with traditional lenders. Technology allows these platforms to be more accessible and easier to navigate, but the key is to have a team of knowledgeable professionals in commercial real estate financing with years of underwriting experience behind the company. Alternative lending platforms should use technology when beneficial to streamline processes, but investors and borrowers should be wary of platforms that use technology at the expense of human judgement. What Are the Benefits of Commercial Real Estate Marketplace Lending? In addition to providing much-needed capital for borrowers, marketplace lending offers investors access to a wide range of commercial real estate debt at varying rates of return


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that are typically highly-competitive, and often better, than other fixed-income investments. Marketplace lending offers many options, from smaller interests in larger loans to whole loans, for investors seeking higher yields than those offered by traditional fixed-income investments, such as CDs and U.S. Treasury bonds. In addition to attractive yields, the fact that real estate debt is secured by collateral — unlike unsecured debt such as car or student loans and credit card debt — makes it a less risky investment prospect. Often times the investment property is income-producing, further reducing the risk in comparison to unsecured debt. How Should Investors Evaluate Potential Opportunities? Marketplace lending can be more effective and efficient than traditional loans, but only if done correctly. Every commercial real estate loan is different, and both investors and borrowers need to find the platform that is most appropriate for them based on the underwriting process and criteria. A casual investor looking to invest $1,000 has different requirements than an accredited investor with $250,000 in capital. Alternative lending platforms need to have experienced teams on staff to ensure lenders and borrowers are matched appropriately, that both parties are educated about the terms of the loan and that the loans are originated and unwritten correctly. Besides the loan platform itself, there are many types of commercial real estate loans investors can choose from when evaluating potential opportunities. Each opportunity should be evaluated based on the investor’s goals, risk tolerance, timeline, diversification preference and overall portfolio strategy, but there are some general rules to keep in mind. Permanent and bridge loans typically are less risky because they are in a first lien position, secured against a property, and the loan structure has a defined rate of return with regularly scheduled payments. Equity loans, on the other hand, do not have a defined rate of return but offer the ability to have a permanent stake in the real estate. For investors seeking more diversification and less risk, professionally managed, low-cost commercial real estate funds that pool these investments can be an attractive option that some marketplace lending platforms offer. Gary Bechtel serves as president of Money360, the leading commercial real estate marketplace lending platform that caters to institutional and accredited retail investors. Prior to joining the company, he was chief lending/originations officer of CU Business Partners, LLC, one of the nation’s largest credit union service organizations (CUSO). He can be reached at garybechtel@ money360.com or (949) 525-9311. Learn more at money360.com.

$ $

BILLION

BILLION ORIGINATED

$

BILLION SERVICED

FIXED | FLOATING | AGENCY

$54.6 billion originated since 2010. $56.1 billion loans serviced as of February 28, 2017. California loans will be made or arranged pursuant to a Finance Lenders Law License.

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CRE Finance World

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A Case for A.I. in CMBS The concept of Artificial Intelligence (AI) engenders both hope and fear — we have all seen fantasy movies in which servile robots support human masters or Matrix-like dystopian worlds in which robots run amok. More concretely we’ve seen how automation is the leading cause of labor force displacement (far and away more impactful than outsourcing or immigration, see “Quick Reading Suggestions” below). It is difficult to grasp just how disruptive AI will eventually be, but one thing for sure is that its influence is notable and growing: examples include the way Alexa or Siri listens to and interprets our words, innovations in automotive safety, the simple Google search, smart e-mail boxes that detect and filter our spam, and robots in logistical warehouses (which enable Amazon to mail packages within minutes of a mouse click).

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David Nabwangu Founder AI-Spark

Dr. Vince Gerbasi

massive amounts of data for problems that are this hard, which will not practically become available (even in the long term). That doesn’t mean AI won’t be a tool used in commercial real estate, in fact it can help people become more accurate and efficient. Let’s review a little about the origin of AI and its strengths and weaknesses as an analytical tool in today’s CRE industry. Background Behind all of these exciting, and at times frightening innovations lies the discipline of machine learning. Machine learning is the science of enabling computers to learn without explicit direction, to form their own logic, and learn from new experience. The field is an inter-disciplinary amalgamation of methods, both old and new.

Given the ubiquity of AI in our lives, surely it will play a big role in business. What is the relevance of AI for commercial real estate and CMBS? Will machines ultimately change the way we do our jobs? Our view is a demonstrable ‘yes,’ — but with qualifications. In a sector such as ours, machines will be hard-pressed to have the same impact as they will on other industries that will see wholesale dramatic change (think self-driving truck and taxi services).

Its roots are founded in common statistical techniques uncovered and developed in the 18th and 19th centuries, including the work of Thomas Bayes (1701–1761), and Andrey Markov (1856–1922).

Why is that? Forecasting real estate demand and trends involves variables (including human behavior and preferences), that are many, and often unpredictable. Machines require

In 1967 the algorithm of the Nearest Neighbor (see “Quick Reading Suggestions”) was created, which remains at the root of many clustering techniques today.

The 1950s saw the first machines that attempted to mimic human learning. IBM produced machines that could play checkers and learn from past experience.

Machines can be trained to recognize nuances and inform humans about on-going changes in correlations between and within clusters.


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By the 1990s machine learning began to leverage data and data science; IBM’s Deep Blue beat the world champion of chess in 1997.

This grouping could be done with any characteristic. Multiple ways of cutting the data expose a similar dynamic, where defaults rates are often elevated in a subset of clusters.

Today, two things are happening that contribute to a renaissance in the importance of machine learning: (i) affordable computing power dramatically increased in the past three decades (Moore’s Law suggests that this rapid rate of increase may continue), (ii) large data sets became openly available to academics and data scientists permitting them to develop, refine, and test mathematical and computational algorithms.

#2 Clusters correlate Clusters correlate in two different ways that play into the hands of machine learning algorithms. First, they sub-stratify and correlate with each other (for example oil towns across Oklahoma and North Dakota are highly correlated).

Machine Learning in the CRE Industry There are a number of aspects peculiar to CRE data that lend themselves to machine learning methods. #1 Risks Cluster CRE credit risk analysis involves the seemingly endless task of identification, and evaluation of the impact of performance clusters. Whether it is identifying all loans impacted by JCPenney, Macy’s and Sears store closings, or forest fires in Santa Rosa, California or Fort McMurray, Canada. Analysis of clusters function as critical harbingers of CRE trends. Many machine learning algorithms are dedicated to clustering analysis. For example a Machine Learning algorithm developed in the 90s by Michael Eissen and colleagues is used by scientists to analyze the expression of genes from yeast. In the case of yeast gene expression data, genes that consistently change their expression under specific conditions cluster together. In the case of CMBS data — clustering highlights properties, loans and bonds that follow similar performance trends.

Second, they correlate across time: A change in performance (we’ll call it a “spark”) in a given cluster can increase the likelihood of a spark in that cluster in the future. Additionally, correlations among properties in a cluster, or between different clusters, can be intricate and nonlinear — a reality which lends itself to machine learning solutions. Consider the performance of office properties in tertiary areas (where they struggle), vs. industrial properties in tertiary areas (where they thrive), or the performance of a multifamily properties with low DSCR’s (which is a norm) vs. hotels with low DSCR’s (many times indicative of distress). Machines can be trained to recognize nuances and inform humans about on-going changes in correlations between and within clusters. #3 Risk metrics change Risk metrics are never static in their impact on CRE collateral and CMBS bond performance. Over time, they change (sometimes dramatically). This is starkly illustrated by the migration of historical frequency of default curves depicted below. Exhibit 2

In fact, the CRE market as a whole can be represented as the sum total of its clusters: The chart below expresses newly special serviced loans in a 2-year window broken out into clusters (“Dimensions”). The dimensions are groups of loans that share a similar property type, zip code, largest tenant, city and/or state. Of note are the clusters with elevated default activity (properties where Staples is the largest tenant, and properties located in oil industry zip codes and cities). Of interest as well are some of the clusters that are not represented below: those with the lowest default rates in the time period such as clusters of loans in Toronto, San Francisco, and/or Mobile Housing properties. Exhibit 1 Spark Clustering


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The curves map reported trends in delinquency against DSCR’s from 1997 through to 2016. The curves react to the dotcom bubble, the Great Recession, and the struggles of highly levered loans in today’s refinancing environment, increasing and subsiding through time. Machines can be trained to acknowledge these patterns and actively track and recalibrate models to reflect both long-standing trends, and the memory of short-term events. Limitations If you look at each of the major advancements and applications of machine learning technology in our lives, there is often a common thread: Machines have done very well when there is a strict (or limited) set of rules to follow or interpret, AND where there are massive amounts of data to learn from. Credit risk in CRE is different. It is a harder problem in that it has a very large number of risk factors that can affect collateral or bond performance, and, perhaps just millions1 (as opposed to billions) of rows of accessible information for a machine to learn from. The often cited ‘curse of dimensionality’ first mentioned by Richard Bellman in the 1950s stipulates that for each additional characteristic, the machine needs an exponential amount more data to learn from. In Chess, there are an expressly limited number of moves that each player can make at any given time. And there are billions of rows of data available from which machines can learn. In logistics, robots have set paths they can follow, and a set number of shelves and packages of merchandise to search, along with billions of transactions taking place that they can learn from. Even self-driving cars are limited by the roads that they must travel, as well as the rules of the road, and they are helped by decades of car driving experience and data. Any application of machine learning algorithms for credit risk analysis requires domain knowledge to circumvent the difficulties posed by this problem. Machine Learning in credit risk analysis succeeds when it helps people become more accurate and efficient. Conclusion Evaluators of CMBS risk know these dynamics first hand. We are aware of risk clusters and their effect on portfolios, we are aware that these risks change through time, and keep our minds occupied with trying to quantify their effects. Many of the performance “sparks” in CRE data today will prove to be harbingers of bond losses in the future. Given the high dimensionality of credit risk (and the relative scarcity of data); machines need to be trained and supervised


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by humans with the proper domain knowledge. But the rewards of applying machine learning algorithms to CRE credit risk are many; humans can Given the high dimensionality of credit train machines to constantly and risk, machines need to be trained and consistently follow the data, and supervised by humans with the proper recalibrate their measurements of domain knowledge. risk — while they get more sleep. Quick Reading suggestions For more information on the exciting and fast growing field of Machine Learning here are some suggested readings: The Impact of Technology on Jobs in the US: The Myth and the Reality of Manufacturing in America, Michael J. Hucks, PhD, and Srikant Devarag Introduction to Nearest Neighbor Analysis: https://www. analyticsvidhya.com/blog/2014/10/introduction-k-neighbours-algorithm-clustering/ Automation in Logistics, Kiva Robot: https://www.youtube. com/watch?v=8gy5tYVR-28 Moore’s Law: http://www.mooreslaw.org/ Self-Driving Trucks: https://www.trucks.com/2017/02/16/ deep-learning-self-driving-truck/ https://www.wired.com/2016/10/ubers-self-driving-truckmakes-first-delivery-50000-beers/ The Authors David Nabwangu is an experienced researcher, quantitative risk modeler, and founder of AI-Spark. David was previously head of CMBS research at a leading rating agency where he developed methodologies, credit risk models, and risk analytic systems used across Europe, Canada and the United States. Dr. Vince Gerbasi is a cross-disciplinary researcher with experience in analyzing and comparing large datasets using clustering algorithms. Vince received his PhD from Vanderbilt University Medical School and performed his postdoctoral studies at Northwestern University. His past research used state of the art biochemical, genomic and computer science approaches to tackle some of the most difficult problems in biology and medicine including infectious disease outbreaks and vaccine development. Data Sources Data for this article was provided by CMBS.com and AI-Spark 1 The CREFC Investor Reporting Package provides approximately 20 million rows of loan level historical data as of Q2 2017

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CRE Finance World

Retail Store Closing Fiction

Joseph Ori Executive Managing Director Paramount Capital Corporation

Many Wall Street and CRE pundits have declared that malls and shopping centers are dead. The brick and mortar stores will be relics in 20 years. Amazon’s online business will disintermediate them out of business and consumer shopping habits have changed forever. There have also been weak first quarter earnings reports from many retailers including; JCPenney, Sears/Kmart, Kohls, Macy’s and others. These retailers and many others have been on a store closing binge that the experts claim is the final nail in the shopping center store coffin. Retailers that experience tough business conditions do not represent the entire retail industry. Walmart, the various dollar stores and home improvement retailers have been doing just fine. Most of the retail earnings softness is due to poor management decisions regarding inventories, store expansion, purchasing programs, sloppy general business operations and a stingy consumer. In addition, the rosy economy and 4.6% unemployment rate are a mirage. The economy is not doing well for the average American and the real unemployment rate is around 15%. The labor participation rate is at a 40 year low of 62% and there are more than 95 Companies that fail to provide an million people out of the labor force. Increased minimum wage rates in many enticing and seamless experience cities have also contributed to higher costs and lower profits in the retail and will struggle and potentially close restaurant industries. Most of the new jobs created during the last eight years their doors. have been low wage part-time service jobs. Obamacare has also been a big job killer, by converting many full-time jobs to part-time to escape the employer health cost mandate. The sky rocketing and unaffordable premiums for many under Obamacare have also lowered the average consumer’s disposable income, which cannot be spent on goods and services. Obamacare has been one CRE Finance World Summer 2017

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of the biggest killers of consumer retail demand since the introduction of the income tax.1 All of these factors are the real reasons the retail business is hurting and it’s not Amazon or the Internet. Online shopping sales are only about 8% of total retail sales and will never account for a large majority of sales. Most individuals still prefer the in-store shopping engagement and experience. To be a successful retailer today, a company must offer attractive goods or services at a competitive price and, most importantly, an enticing and seamless shopping experience over three platforms, brick and mortar, internet and mobile. Companies that offer this experience will continue to grow and generate increasing sales and profits. Just look at Apple Stores, Nordstrom, Total Wine and Best Buy as examples. Companies that fail to provide an enticing and seamless experience will struggle and potentially close their doors. One of the main statistics claimed by the pundits, when declaring that malls and the retail markets are dead, is the large number of store closings. Retail store closings are a natural occurrence in the retail industry. When economic times are good, retailers are optimistic and flush with cash and expand aggressively. However, when the economy softens or enters a recession retailers contract and close stores. Even if the economy is solid, some retailers — through poor merchandising, management and expansion policies — experience difficult financial results and therefore need to cut costs. The easiest place to reduce expenses is to close underperforming and marginally profitable stores. Retail store closings are a natural part of the ebb and flow of the retail industry. We here at View of the Market have looked back at store closings in 2008 and in 2016, to see if there are more store closings today than there were 10 years ago. The table below shows equivalent store closings in 2008, per Retail Info Systems News, and in 2016 per the retail industry. Retailer Circuit City 99 Cent Stores Disney

2008 Store Closings 150

Retailer Sports Authority

460

48

Walmart

269

98

Aeropostale

154

Kmart/Sears

78

B Moss Clothing

70

Ralph Lauren

Barbeques Galore

65

Chico’s

120

153

Hancock Fabrics

255

KB Toys

460

Macys

100

Linens n Things

120 Men’s Warehouse/Jos Bank

Friedman’s Jewelers Sharper Image Zale’s

92 Office Depot 120 Wolverine Worldwide 90

Walgreens

2016 Retailer Bankruptcies

Circuit City

Sports Authority

Linens n Things

Aeropostale

Friedman Jewelers

Sports Chalet

Whitehall Jewelers

Bob’s Stores

Fortunoff

Pacific Sunwear

Fred Leighton

Wet Seal

Goody Mervyns Sharper Image Wickes Furniture

We here at View of the Market believe that the Wall Street pundits are wrong about the decimation of brick and mortar stores and the retail industry. 1 http://www.zerohedge.com/news/2016-12-23/top-whitehouse-economist-admits-94-all-new-jobs-under-obama-werepart-time; https://www.advisorperspectives.com/commentaries/2016/10/17/taking-a-wrench-to-healthcare

50

Pacific Sunwear

Goodyear Tire

2008 Retailer Bankruptcies

2016 Store Closings

117

Ann Taylor

Another interesting analysis regarding the tumultuous retail industry, is the number of retail companies that have gone bankrupt. Listed in the table below, are some of the largest retail bankruptcies in 2008 and 2016. This is not an all-inclusive list, but still illustrates the large number of retail bankruptcies in any year and further evidence of the ‘creative destruction’ in our capitalistic economy. As stated above, retailer’s open new stores when the economy is good and close stores when the economy declines. This is the normal function of a competitive market and when companies do not perform to the expectation of customers and investors, they usually go out of business.

250 400 100 200

100

Talbot Kids

78

GAP

85


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CRE Finance World

A Sherpa for CMBS Borrowers — The Value Proposition of Debt-Resolution Advisors

Michael G. Gutierrez Managing Director, Operational Risk Assessments Morningstar Credit Ratings, LLC

Loan advisory services date back to the beginnings of the CMBS industry, but the sheer volume and complexity of restructuring troubled loans in the wake of the 2008 financial crisis have created significant demand for firms to fill that role.

not be used. In addition to observations about the impact of these companies’ actions on defaulted loans, we sought to determine what common characteristics, if any, clients of these advisory companies share, especially in terms of unpaid principal loan balances and property types.

Some borrowers with loans in CMBS need guidance to maneuver through the complex requirements embedded in securitization documentation. As such, Morningstar Credit Ratings, LLC believes that qualified and reputable companies can assist in educating borrowers less familiar with CMBS requirements.

From the Special Servicers’ Viewpoint The majority of special servicers reported a positive experience working with commercial debt-resolution mediators, although most had one caveat: namely, that the experience depended on the company involved. Certain intermediaries made a difference in the quality of the borrower experience, while others were less effective. Some servicers cited cases where they believed an advisor hindered the process by repeatedly objecting to reasonable resolution offers. In addition, special servicers reported certain companies, which they didn’t name, that did little or nothing on borrowers’ behalf and in their opinion were simply interested in collecting an upfront fee. This is, unfortunately, not uncommon in many consulting industries, especially in their infancy, and has been widely reported in the general press with regard to mortgage modification and foreclosure consultants in the residential market, for example. This also may indicate the lack of sophistication of some CMBS borrowers served by this industry. Some servicers on their own initiative have taken steps to address borrowers’ concerns. Midland, for instance, established an ombudsman who borrowers with unsolved issues or requests may contact directly.

There are two types of commercial debt-resolution advisors. Both handle sophisticated and institutional borrowers with complex and high-profile properties serving as collateral for large loans, which could involve hundreds of millions of dollars. One type of advisory company, which deals solely with these sophisticated borrowers, is typically run by former commercial lending and asset-management professionals with experience in both the debt and equity sectors. Another type also administers to borrowers with much smaller balance loans and plain-vanilla collateral. These investors are typically unaware of the requirements for administration of the pooling and servicing agreements (PSAs) governing these CMBS loan pools. Debt-resolution mediators can provide these borrowers guidance on consent requests, most notably assumptions, which was particularly valuable during the early stages of the financial crisis. These intermediaries are now assisting those borrowers in working out their troubled loans upon their transfer to a special servicer. This commentary will focus on those businesses that deal with both sophisticated and less-experienced borrowers with smaller balances. To gauge the effect commercial debt-resolution advisors have had, Morningstar Credit Ratings, LLC reached out to executives at six of the largest or most active special servicers in CMBS, including Midland Loan Services, a division of PNC Financial Services Group, Inc.; Torchlight Loan Services, LLC; and Situs Holdings, LLC for feedback on their experience with these companies. Others willingly spoke with Morningstar, but requested that their names


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According to most of the special-servicing companies we spoke with, the typical borrower engaging a commercial debt-resolution advisor has an unpaid principal loan balance of between $5 million and $25 million, with a few pegging the usual upper limit at $15 million. (As of late February, the average size of all loans in the Morningstar CMBS database was $11.5 million.) Property types are concentrated in the office and retail sectors. Borrower advisors likely will have a lot of work this year, given the maturity pipeline. In our February remittance Maturity Report, Morningstar reported that some $56.40 billion of CMBS loans will mature this year, and many, written at the market’s peak in 2007, will have difficulty refinancing because they are overleveraged. Of the maturing balance, $18.64 billion are backed by


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office properties; office has the greatest balance of loans at 33.1% of the maturing balance. Morningstar projects 58.4% of maturing loans backed by office collateral will have trouble paying off because of loan-to-value ratios above 80%, which we consider a reliable barometer of refinancing prospects. Meanwhile, we project 56.7% of maturing loans backed by retail properties will have refinancing woes. (Retail is second-highest with $17.91 billion of maturing retail loans, or 31.8% of the total maturing loan balance.) A common theme among these special-servicing executives is the important role played by these advisory companies in educating borrowers on the requirements and restrictions in CMBS transactions. A number of special A CMBS borrower advocate helps servicers expressed level that playing field by providing relief in having the advisor take on this the borrower with insight into the time-consuming task, because tutoring a inner workings of CMBS. borrower regarding what can and cannot be done under a particular PSA interferes with the special servicer’s goal of achieving an expeditious resolution of a defaulted loan at the best return possible to the trust and its investors. While a few executives believed that commercial debt-resolution advisors added little or no value to the default-resolution process, most opined that while education of the borrower was important, the end result for the borrower differed little because of the advisory company’s intervention. They based this opinion on their belief that it is primarily the underlying value of the property, its cash flow capabilities, and the access to equity capital by the borrower that determine the resolution outcome. Morningstar believes that commercial debt-resolution advisors play an important role in persuading the borrower that the realities of the property’s income-generation capability and the borrower’s ability to provide any equity infusion make a particular outcome accepted by the special servicer the borrower’s best, and perhaps only, choice. From the Borrower Advocate’s Viewpoint Morningstar spoke with executives of two commercial debtresolution advisory businesses: Grapevine, Texas-based 1st Service Solutions, Inc. and Hart Advisors Group, LLC of Dallas. Both consider the vetting process they undertake before engaging any borrower clients to be a key element of their strategy. First, the companies gauge the level of understanding borrowers have regarding requirements of CMBS transactions. Agreeing with the special servicers that emphasized the importance of borrower education, they pointed out the need to ascertain whether the borrower

would heed their counsel. Ann Hambly, founder and CEO of 1st Service Solutions, stated that the company rejects over 50% of potential clients because of this process. While this might seem counterproductive to business growth, it increases efficiency by letting asset managers focus on borrowers with a higher chance for successful resolutions. In the interest of full disclosure, Morningstar, which provides operational risk assessment rankings on commercial vendors, has assessed 1st Service Solutions at its secondhighest ranking, MOR-CV2, as a debt-resolution advisor. Morningstar identified another potential benefit these businesses offer: equity capital sourcing for borrowers in need of cash for their properties. Both companies we spoke with confirmed that they have relationships with brokers and other sources of capital that they could refer borrowers to when, as is often the case, the special servicer requires a capital infusion as part of any restructure negotiation. While the debt-resolution advisors themselves do not invest in the asset or engage in lending, this can provide an important service to borrowers who lack the contacts to procure funding. In an email, Tanya Little, CEO and founder of Hart Advisors, wrote the company formed a subsidiary to focus on sourcing debt and equity in 2014 after realizing that its clients “lacked sufficient levels of capital and liquidity to close on deals.” Little wrote that the service gives clients confidence that Hart Advisors will place them in a position to execute on a resolution strategy. Executives from the advisory companies added they play a helpful role in the loan-resolution process. In an email, 1st Service Solution’s Hambly noted that given the structure of CMBS, when a borrower may not be able to speak with decision makers, that “the playing field is heavily tilted” in favor of the lender. A CMBS borrower advocate helps level that playing field, she wrote, by providing the borrower with insight into the inner workings of CMBS. There are, however, some companies claiming to be debtresolution advisors that have little asset-management experience and serve only to close loans. According to the special servicers we spoke with, this type of business can be detrimental to a successful loan disposition. Assessing Commercial Debt-Resolution Advisors: Operational Best Practices Morningstar applies its traditional standards for assessing operational risk when examining commercial debt-resolution advisors. These include organizational structure, technology architecture, and a strong quality-control regimen. We look for well-documented policies and procedures with an authority matrix for revisions or additions. We scrutinize turnover rates for management and staff as well as employee training.


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We also consider industry experience, particularly in lender workouts and CMBS asset management, and company tenure for all employees, although tenure is less of a factor in such a nascent industry. Morningstar looks for commercial debt-advisory companies to follow an established protocol for reviewing each asset’s performance and critical issues to propose reasonable resolution terms that are acceptable to the special servicer and can deliver an optimal outcome for the trust. We believe companies should formalize such analysis in an asset action plan and approve it by a credit committee or delegated authority matrix, depending upon loan size and asset complexity. The Bottom Line: Guiding Borrowers Through the Next Mountain of Default It is difficult to gauge the impact of commercial debt-resolution advisory businesses. Special servicers’ asset-management systems typically are not programmed to create reports filtered by the variable of a borrower’s use of an intermediary, as such information would be in the commentary section of the loan record or asset action plan. There is little public information on this topic other than what would be noted in servicer comments on monthly trustee reports. However, based on Morningstar’s discussions with special-servicing and commercial debt-advisory professionals, we believe that value can be gleaned from the participation of qualified and reputable advisory companies in the resolution of certain types of loans involving borrowers less familiar with CMBS requirements. Accordingly, Morningstar believes there will be a role for advisory companies in the resolution of certain distressed CMBS loans, particularly this year when billions of dollars’ worth of loans written at the height of the market will mature.


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DISCLAIMER The content and analysis contained herein are solely statements of opinion and not statements of fact, legal advice or recommendations to purchase, hold, or sell any securities or make any other investment decisions. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MORNINGSTAR IN ANY FORM OR MANNER WHATSOEVER. To reprint, translate, or use the data or information other than as provided herein, contact Vanessa Sussman (+1 646 560-4541) or by email to: [email protected]. ©2017 Morningstar Credit Ratings, LLC. All Rights Reserved. Morningstar Credit Ratings, LLC is a wholly owned subsidiary of Morningstar, Inc. and is registered with the U.S. Securities and Exchange Commission as a nationally recognized statistical rating organization (NRSRO). Morningstar and the Morningstar logo are either trademarks or service marks of Morningstar, Inc. Michael G. Gutierrez is managing director of operational risk assessments for Morningstar Credit Ratings, LLC. He manages a team of experienced operational risk professionals and is responsible for the operational risk assessment reports and related rankings for each participant analyzed by Morningstar. Gutierrez holds a bachelor’s degree in political science from Williams College and a juris doctor degree from Columbia University School of Law.

What’s going on at CREFC Europe? 3-5 July Executive Education Programme Contact Rachel [email protected]

6 July Member Only Summer BBQ Contact Carol [email protected]

11 July After Work Seminar

13 July

Non-Performing Loan Refinancing – Lending Opportunities behind the NPL Wave

YPREF Networking Drinks

Host: Paul Hastings

Contact Rachel [email protected]

Contact Carol [email protected]

12 September Morning Seminar

Host: Allen & Overy LLP

Lending in Europe

Registration to open mid-July Contact Carol [email protected]

CREFC Europe Autumn Conference 14 & 15 November Secure your place as a sponsor and register in June Be an early bird Contact Carol [email protected]

CRE Finance World

A Rising Tide Lifts All LIBOR Loans The Case for Investing in Floating-Rate CMBS Now

U.S. interest rates are on the rise. In March 2017, the Federal Open Market Committee (“FOMC”) voted to raise interest rates for only the third time in a decade, increasing the federal funds target range by 25 basis points to 0.75%–1.00% based upon, “the economy’s continued progress toward the employment and price-stability objectives assigned to us [the FOMC] by law.” Having awoken from its slumber since 2009, interest rates across the board from Treasuries to LIBOR are increasing with estimates of twoto-three increases by year-end 2017. Increasing rates will impact CMBS investors in several regards, including loan coupons, fair-market-value (“FMV”), debt-service-coverage ratios (“DSCR”), loan-to-value (“LTV”) to the extent that rising interest rates impact property values, and total returns. In a rising interest rate environment, we believe that a tactical shift into floating-rate CMBS can enhance an investor’s returns both offensively, through increasing monthly coupons, and defensively, by reducing FMV loss exposure due to decreases in value solely related to increased Treasury yields. This paper will examine the floating-rate CMBS universe, how floating-rate CMBS work and the risks and benefits of a floating-rate CMBS focused strategy. Chart 1 The Federal Funds Rate — 2003 to 2017

Source: Federal Reserve


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Edward Shugrue Talmage

Chart 2 Three Year Forward LIBOR Curve (April 2017)

Source: Bloomberg

The Floating-Rate CMBS Universe The floating-rate CMBS universe consists of approximately $72 billion of outstanding transactions accounting for approximately 13% of the entire CMBS universe and includes: Single Asset/Single Borrower (“SASB”) transactions, pooled floating-rate loans, CRE CLOs (typically securitizations of first mortgages), and loans secured by multi-family properties issued by Freddie Mac. While not packaged as CMBS, floating-rate commercial real estate debt can also be found in the whole loan market, the mezzanine loan market (particularly in SASB transactions) and, to a lesser degree, in the bank loan market, which together add $30+ billion of additional floating-rate inventory. Floating-rate loans continue to be a popular source of funds for borrowers, particularly private equity sponsors, for large and more transitional assets due to a lower current coupon, typically interest-only, and the lack of (or substantially more modest) prepayment penalties. The “transition” element for the property, or the portfolio of properties, is often a “wholesale to retail” rationalization of a portfolio of recently acquired properties, as was the case with Blackstone’s $3.5 billion 2013 Hilton transaction HILT 2013-HLT (which included both floating and fixed-rate components) and which spawned subsequent fixed-rate transactions for the retained portfolio, such as the Hilton San Francisco HILT 2016-SFP. Transitions can also occur at the property level, as was the case for Blackstone’s Willis Tower financing in March 2017 where the borrower used the floating-rate financing to improve and stabilize the asset’s cash flow before seeking longer-term and potentially fixed-rate financing.


CRE Finance World

Chart 3 Willis Tower — Capital Structure ($000s except PSF data) Class

Rating

Loan Amount

Credit Support

A

AAA

$506,628

50%

Coupon

LTV

Loan PSF

NOI Yield

L+0.80%

33%

$131

18%

NCF DSCR 10x

B

AA-

112,584

39%

L+1.10%

41%

160

15%

4x

C

A-

84,438

31%

L+1.25%

46%

182

13%

4x

D

BBB-

103,577

21%

L+2.25%

53%

209

11%

4x

E

BB

140,730

7%

L+3.30%

62%

246

9%

3x

F

BB-

20,688

5%

L+4.10%

64%

251

9%

3x

HRR

B+

51,355

0%

L+5.50%

67%

264

9%

2x

Total

$1,020,000

Source: Commercial Mortgage Alert

Floating-rate loans typically have a five-year term but can be as long as seven years. The loans are typically open to prepayment (on the loan’s monthly remittance date) and often have limited call protection. How Floating-Rate Loans Work Floating-rate loans offer borrowers flexible financing that is typically of a shorter term and open to prepayment without penalty. For loans that are intended to be held for less than three years, they can also offer a lower “all-in” financing cost due to the favorable difference between one-month LIBOR and US Treasury rates, assuming equal credit spreads for comparable borrowing amounts. One-month LIBOR is the most frequently used index for floating-rate CMBS loans (as opposed to three-month LIBOR for many bank loans) and the borrower is responsible for paying on a monthly basis the index (one-month LIBOR) plus the loan’s credit spread. Each month the index is reset, higher or lower, depending upon prevailing LIBOR rates. As illustrated below, since the Financial Crisis, one-month LIBOR has been below 50 basis points and has only recently started to climb. Chart 4 Historical LIBOR 2003–2017

Unlike many bank loans that contain LIBOR floors (recently, typically 1%), most floating-rate CMBS have no floors. All floating-rate CMBS loans do require the borrowers to purchase interest rate caps that are assigned to the CMBS trust and which are written to a minimum debt service coverage ratio based upon in-place cash flow. While these caps limit the borrower’s debt service burden in a rising rate environment, the benefit (from the rate protection) is passed along to the CMBS bond buyers who have unlimited LIBOR upside. Importantly, and to reduce up-front expenses, a typical five-year floating-rate CMBS loan will be written with an initial term of two or three years with successive one-year extension options (to full term) conditioned only upon there being no event of default and the borrower purchasing additional interest rate protection for the next period. Additionally, floating-rate CMBS loans are typically open to prepayment without penalty, often resulting in a shorter actual duration than the contractual maturity. Benefits and Risks of a Floating-Rate Investment Strategy Floating-rate CMBS offer investors several benefits but also carry certain risks as compared to investing in longer-dated fixed-rate CMBS with call protection. We believe that the primary benefits of a floating-rate CMBS strategy are: •O ften acquisition financing with excellent alignment and identifiable sponsor equity; •T ypically larger, institutional-quality, SASB transactions; •E liminates the risk of FMV erosion should interest rates rise; •A llows the investor to capture upside (through the LIBOR index) should LIBOR increase; •T ypically shorter duration; and

Source: Bloomberg

•M ore conservative loan-to value attachment points (due to lack of diversity) as compared to a comparably rated (and diversified) conduit transaction.


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CRE Finance World

Chart 5 Floating-Rate vs. Fixed-Rate Capital Structure Analysis 1 Floating-Rate LTV

Fixed-Rate LTV

AAA

Rating

33%

41%

AA

41%

48%

A

46%

51%

BBB

53%

54%

1 Capital structures and metrics taken from representative 2017 CMBS SASB and conduit transactions.

We believe that the primary risks of a floating-rate CMBS strategy are:

Chart 6 CMBS Conduit Valuation Changes Due to Treasury Increases1 Treasury Increase (bps)

Value Change (%)

T+50

-4%

T+100

-8%

T+150

-11%

T+200

-15%

T+250

-18%

1 Utilizing Bloomberg pricing models and a $1 billion 2017 ten-year new issue conduit transaction at constant spread and 0% CPY.

We believe that floating-rate CMBS offer investors a more pure alpha credit strategy as opposed to a “rates driven” strategy that also allows investors to capture upside should LIBOR continue to increase, as appears to be likely for the foreseeable future, given the current environment. Floating-rate loans also offer a typically shorter duration and an emphasis on CMBS SASB transactions that are better suited to individual asset due diligence than a typical conduit transaction.

Floating-rate CMBS are helpful from a risk management perspective due to their shorter duration (less tail risk) and typically greater subordination levels (debt and equity) as compared to typical conduit transactions. Additionally, since the majority of floating-rate loans are used to finance acquisitions and/or assets in some form of transition, sponsor equity is typically contributed at closing and the alignment of interests between lender and borrower is well established. While floating-rate CMBS may be more difficult to perfectly match an asset/liability balance, for total return investors willing to perform the extra due diligence, in today’s environment, they offer compelling upside in a comparatively conservative structure. Floating-rate CMBS also help better define a manager’s true alpha generation from credit selection as opposed to returns that can be whipsawed, positively or negatively, by changing interest rates. All-in, floating-rate CMBS offer compelling total returns for investors in today’s increasing interest rate environment.

Conclusion With interest rates finally moving upward, nearly ten years following the financial crisis in 2008, floating-rate CMBS offer a compelling way to capture upside (should LIBOR continue to increase) and to better manage risk. Floatingrate CMBS maintain value as opposed to losing value when Treasury rates rise, as shown in the chart below.

Edward L. Shugrue III is the CEO of Talmage, LLC. Talmage is a New York based investment manager and special servicer focused on the US commercial real estate debt and CMBS markets. Since 2003, Talmage has made in excess of $12 billion of real estate debt investments and has completed over $40 billion of special servicing assignments. More can be learned at talmagellc.com.

• Limited or no call protection; • Lack of certainty on duration (difficult to match up with liabilities); • Concentrated credit (often SASB); and • Declining debt-service coverage (up to the cap) in a rising interest rate environment.


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CRE Finance World

CMBS Conduit Q1 2017 Update: Retail Exposure Declined While Full Term IOs and Office Concentrations Rose Sharply

James C. Digney Senior Director S&P Global Ratings

James M. Manzi, CFA Senior Director S&P Global Ratings

closed significantly, but remains somewhat wide. In our view, less diverse pools accentuate credit risk, especially if the loans are higher leverage, as a few large loan defaults may create investment-grade principal losses or interest shortfalls. In the first quarter of 2017, S&P Global Ratings observed some quarter-over-quarter improvement in loan leverage, diversity metrics, and lodging exposure. However, those improvements were offset by a sharp rise in full-term IO concentrations. As such, our required CE levels on reviewed pools remained consistent, and on average, remain about 200 basis points (bps) higher compared to priced deals. In terms of property type trends, amid heightened investor/ media focus, retail exposures in collateral pools fell sharply in the first quarter, while office concentrations increased significantly — to nearly 50% on average. We believe that specific property concentration creates fundamental exposure risks as one property type comes into favor and another moves out of favor. Our rating methodology for conduit/ fusion transactions assumes that collateral pools are diversified not only by loan count, borrower, and geography, but also by property type. Some Loan Metrics Improved In The First Quarter, But Not Full-Term IOs Compared with fourth-quarter 2016, the nine new collateral pools S&P Global Ratings reviewed in first-quarter 2017 had lower leverage (90.6% in first-quarter 2017 versus 92.5% in fourth-quarter 2016). We attribute this mostly to the onset of U.S. risk retention regulations for property concentration CMBS in late 2016.

Specific creates fundamental exposure risks as one property type comes into favor and another moves out of favor.

First-quarter 2017 pools also maintained fairly consistent debt service coverage (DSC) ratios (1.72x versus 1.75x), lower exposures to lodging properties (14.3% versus 15.8%), and modestly higher final effective loan counts (Herfindahl scores). Focusing in on the effective loan counts, the gap between preliminary and final pools

One metric that deteriorated significantly during the most recent quarter was full-term IO exposure, with a concentration of 42% in pools we reviewed in the first quarter, up from 30% in fourth-quarter 2016. In fact, the final pool full-term IO concentrations for first-quarter 2017 and fourth-quarter 2016 were even higher at 46% and 36%, respectively, indicating that full-term IO concentrations are actually rising from preliminary to final pools. We penalize full-term IOs in our model with lower recovery assumptions, as the lower payments during the loan term somewhat reduce term default risk, but the lack of amortization raises maturity/ balloon refinancing risk considerably. Given the overall movement in credit metrics, our average required CE levels remained mostly unchanged. S&P Global Ratings’ average ‘AAA’ CE levels increased very slightly to 24.8% in first-quarter 2017 from 24.6% in the fourth quarter, and average ‘BBB-’ CE levels increased to 10.0% from 9.9%. Although similar to the fourth quarter, both CE levels remain higher than the prevailing average CE levels in the market (22.5% for ‘AAA’ and 7.5% for ‘BBB-’ in the first quarter), which resulted in S&P Global Ratings being requested to assign ratings to only two of the nine transactions reviewed during the first quarter. In our view, the two rated transactions had significantly lower leverage (86.6%) than the seven unrated transactions (91.4%). These metrics encompass both rated and unrated trans actions. For the unrated transactions, the metrics reflect the preliminary collateral pools presented to us by issuers. The actual or final pool metrics cover the pool compositions upon pricing.


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CRE Finance World

Table 1 Summary of S&P Global Ratings-Reviewed Conduits Weighted averages

2013

No. of transactions reviewed Average Deal Size ($mn)

2014

2016 (all)

2016 Q4

2017 Q1

46

39

40

8

9

1,181

1,170

856

860

962

68

72

51

48

47

Average Number of Loans S&P Global Ratings’ LTV (%)

85.5

90

91.3

92.5

90.6

S&P Global Ratings’ DSC (x)

1.65

1.52

1.71

1.75

1.72

S&P Global Ratings’ beginning DY (%) Final Pool Herf/S&P Global Ratings Herf

9.6

9

9

8.9

9.1

24.2/29.6

27.7/32.7

25.4/36.0

25.1/40.3

25.7/33.1

% of lodging properties

15.7

15

17.3

15.8

14.3

% of full-term IO

14.3

17.2

28

29.7

41.9

% of partial IO

30.5

40.9

32.6

31.2

28.3

-7.6

-8.4

-10.8

-10.6

-11.9

S&P Global Ratings NCF haircut (%) S&P Global Ratings value variance (%) ‘AAA’ actual/S&P Global Ratings CE (%) (i) ‘BBB-’ actual/S&P Global Ratings CE (%) (i)

-24.3

-25.2

-32.1

-31.9

-33.3

21.7/22.8

23.6/26.0

23.0/25.6

23.1/24.6

22.5/24.8

6.9/7.6

7.6/9.3

7.8/10.2

7.7/9.9

7.5/10.0

(i) S &P Global Ratings’ CE levels reflect results for pools that we reviewed. Actual CE levels represent every deal priced within a selected vintage, not just the ones we analyzed. LTV–Loan-to-value. DSC–Debt service coverage. HERF–Herfindahl score. DY–Debt yield CE–Credit enhancement. IO–Interest-only. NCF–Net cash flow.

Retail Exposure Fell While Offices Increased Heightened competition for retail sales from e-commerce and industry peers has been squeezing profit margins and lowering overall space demand for several years now; the overall trend is not new. However, this year’s post-holiday store closure figures (both the number of stores and number of retailers) appear to be accelerating, and that, combined with increased short interest in CMBS derivative indices (CMBX), has led to a laser focus on the sector from market participants. One consequence has been a sharp decline in the percentage of retail exposure in collateral pools. The first-quarter 2017 average was about 22% compared with 35% in fourth-quarter 2016, and a 30% average during full-year 2016. Chart 1 Changing Property Type Composition Apartment Industrial Lodging Office Retail Other 2016

10

6

16

29

30

9

Q4 2016

8

5

14

32

35

6

Q1 2017

5

6

13

46

22

8

In the early “2.0” vintages, retail was by far the highest percentage exposure by property type, at 55% (2010), 45% (2011), 36% (2012), and 32% (2013). While weakness within the retail sector seems broad, we continue to stress the importance of a loan-by-loan and deal-by-deal approach to predict future outcomes for malls — similar to what we utilize in our new issuance/surveillance analyses — as they are likely to vary widely based on location, tenant mix, sales per square foot, occupancy costs, co-tenancy clauses, and many other variables. CRE Finance World Summer 2017

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A result of retail exposure avoidance is that office exposures have climbed significantly, averaging nearly half of the collateral pools in the first quarter. In fact, the 46% figure is up sharply from 32% in fourth-quarter 2016, and the 29% full-year 2016 average. Additionally, recent conduit pools have included a significant number of single-tenant office assets, which present unique challenges in determining a long-term sustainable cash flow and value for those properties. Similar to our approach to retail assets, S&P Global Ratings reviews these single-tenant properties on a loan-by-loan basis, considering such things as location, tenant credit profiles, lease terms, rent levels, dark/subleased space, termination options, competing properties, and new supply dynamics. In some instances where we see heightened risk associated with a particular tenant, we may utilize a dark value approach to account for downtime and any costs associated with re-leasing the property. Lastly, multifamily exposures in recent deals have been lower, at just 5% in the first-quarter, while industrial — a property type buoyed by e-commerce — has remained at about 6%, equal to the 2016 average and up from 4% in 2015. In conclusion, we suggest that specific property concentration creates fundamental exposure risks as one property type comes into favor and another moves out of favor. Our rating methodology for conduit/fusion transactions assumes that collateral pools are diversified not only by loan count, borrower, and geography, but also by property type. To the extent we see an outsized portion of a pool concentrated in one particular property type, we may make additional qualitative adjustments to our credit enhancement levels to account for this concentration risk.


CRE Finance World

Cross Border Capital: A Rear-View Mirror Only Lets you Drive Backward As in other recent market expansions, deals completed by cross-border investors have been a signature feature of the US commercial property market in the cyclic expansion seen since the Global Financial Crisis (GFC). Is this growth of cross-border capital a sign of impending doom for commercial property prices? Regulators are concerned about this capital coming to the US in that cross-border investment was a signature feature of the market expansion in the late 1980s and in the US housing boom last decade. Much of the recent spotlight has focused on Chinese investors in particular, along with misguided comparisons to the experience of Japanese investors in the US in the late 1980s or the Australians in 2005–2008. In every expansion of the market cycle, there are features of the market that echo with those seen in previous expansions. However, it is a mistake to assume that history repeats itself entirely. Looking at the expanding Chinese investment in US commercial real estate only as a function of the behavior and motivations exhibited by investors previously will miss much of what motivates their activity today. With this thought in mind the activity of the Chinese investors is not a sign of doom to come for the US property market. If they make mistakes it will not be the mistakes of the Japanese, they will make their own, new mistakes. What Drives Capital Flows? There are any number of forces which might drive capital to seek opportunities in commercial real estate in other countries. Reform efforts for instance may tear down walls closing off an economy from outside capital or remove chaotic government policies which act as another sort of wall scaring away capital. For the two previous big waves of cross border capital that came to the US in recent memory though, it was not about us, it was about them. Forces external to the US economy drove cross border capital to seek out opportunities here during these previous big waves of investment. External forces that drive capital flows are particularly worrisome to banking and financial market regulators. Often, they will have no insight into the

Jim Costello RC Analytics

external forces motivating these capital flows and no levers with which they might control such flows. In developing countries, there are often barriers to internal and external capital flows to prevent wild price swings in the domestic economy. The US by contrast has very open and transparent investment markets and capital flows. One challenge that regulators and market participants face in understanding how these capital flows impact market performance is that these flows are often pro-cyclical. In other words, if there is bandwagon of capital moving into a CRE sector, cross border capital is often a part of that bandwagon. It is not clear however that this capital is ever leading the bandwagon. These two big previous cycles where cross-border money invested heavily in the US CRE markets happened in periods of strong economic and price growth. The experiences of these investors can provide some perspective on ongoing activity by Chinese and other global investors, but should not be used as a roadmap to understand all their behavior. External Forces in the Late 1980s Japanese investment in the US real estate surged in the period from 1985 to 1993 and the inflow and later outflow of this capital exacerbated structural problems underway in the US property market. The initial inflow however was about changes in Japan. Betrand Renaud of the World Bank argued that the Plaza Accords, which realigned the exchange rates between the G7 countries, generated an asset bubble in Japan which in turn led to excessive risk taking overseas.1 Japanese investors in the late 1980s were able to use over-valued Japanese land as collateral to obtain bank loans which they then used to buy assets overseas. For the Japanese investors, this trade provided marvelous yield opportunities while land markets were still bubbly in Japan. As land prices fell however and loans came due, Japanese investors scrambled to sell US assets at discounted prices to make good on promises back home. This inflow of cross border capital quickly became an outward flood which added fuel to the fire of a property market downcycle fueled by excessive over construction in the US.


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Figure 2 The Sedimentary Layers of Cross Border Capital Focused on US CRE Investments There were lessons in this Japanese behavior which Chinese and frankly all cross-border investors have looked at and used to their benefit in this most recent market cycle. By and large, these investors are not securing loans in one currency and purchasing investment vehicles denominated in another currency. As shown in Figure 1, the majority of loans originated for investments by cross-border investors have been handled by US based institutions. Figure 1 Origin of Debt Capital for US CRE Investments by Origin of Investors 2016 Year Totals

Source: Real Capital Analytics

The US / Australia exchange rate moved south, so to speak, with the US dollar losing 13% of its value relative to the Australian dollar from 2004 to 2008. The Australian dollar denominated performance of these funds faltered, even ahead of the GFC. The extreme negatives experienced by the retail sector as US consumers pulled back led to even more pain and individual investors lost faith in these funds and sold out of their positions. Source: Real Capital Analytics

It is the case the Chinese investors are more apt to use Asian financial institutions for their investments with 21% of their US acquisitions in 2016 financed by such institutions. The European investors are even more pre-disposed to use debt from organizations headquartered in their home regions with such debt behind 33% of their activity. As opposed to the Japanese in the 1980s, these Asian and European lenders have established operations in the US to originate mortgages in the US on collateral in place here. In the current market, Chinese investors are less likely to face the same currency mismatch, which in turn will prevent the sort of massive selling of the Japanese in the early 1990s. The Procyclical Nature of the Housing Boom In Australia, citizens have, over a number of years now, been required to put a fixed percentage of their earnings aside to fund their retirements. The capital built up in these funds had traditionally been directed by professional managers but in 2005 a change in the law allowed individuals more choice in fund allocation and flows to real estate related vehicles surged. With favorable exchange rates and a steady source of capital, Australian investors became one of the leading buyers of US commercial property in the economic expansion that accompanied the housing boom. As shown in Figure 2, their purchases totaled $13.8 b in 2007 alone. Australian investors were behind $10 b of retail purchases at the time.

The lessons from the experience of the Australians is mixed. Currency regimes do not stay fixed forever. Even if currencies seem to be trading in a fixed range over time, they can move suddenly based on changes in growth and productivity between nations. How investors manage these risks, which is really beyond their control, is an issue that can turn the capital spigot off or turn it on full-blast. The Implications for Chinese and Other Cross-Border Investors Today In making the decision to move capital to the US, this new generation of Chinese and other global investors are cognizant of the mistakes that others made in the past. Just because these investors are aware of these mistakes does not mean that they necessarily will not repeat them. Likewise, there are a number of lessons that one can take away External Forces Now and in the Future The rear-view mirror of the Japanese experience of the 1980s is not that of the Chinese investors active in the US today. Like the Japanese though, it was changes in market drivers in China which led capital to flow here. Both cases involved forces external to the US economy, but these external forces varied. As a developing economy, historically there were a number of barriers in place to prevent sudden capital outflows from China. As these barriers were eased over time more capital flowed out of China. First state-owned enterprises, then developers bringing some of their construction expertise abroad, then most recently insurance company investors. From the point of view of a regulator in the US, Chinese money showed up out of the blue and drove multi-billion dollar transactions like the purchase of the Waldorf Astoria hotel in New York. Such transactions where cross-border


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investors paid top dollar for an asset raises red flags on the part of regulators in the US as the Japanese did most of the same sort of thing in the 1980s. The red flag on this activity comes from the fear that just as the Japanese capital flowed in and then out so quickly that the Chinese capital may follow the same path. The Japanese chased deals in the US simply because it was a yield opportunity. This movement of capital was truly hot money in that these investments only made sense due to interest rate differentials. This Chinese insurance money came to the US though for a different reason. Despite the variety of sources of capital from China, what they had in common was the simple fact that barriers on capital outflow had left these groups allocated 100% to Chinese real estate and a need to diversify their holdings. Figure 3 Chinese Investors Have Bought Different Type of Assets than Other Cross Border Investors

What the Chinese investors have been buying also indicates at least an intention to hold assets here over the longer term. Looking at all cross-border investment activity in the US over time, only 5% of capital invested by non-Chinese investors was tied up in development sites. The Chinese though have put 12% of their capital in development sites as the intention is not simply to hold assets for yield but to build businesses. Moving forward, capital coming to the US from China may move in fits and starts. Chinese policy makers have recently acted to curtail capital outflows to manage the devaluation of the Yuan in a controlled manner. This pullback has led to the fear that Chinese investors will disappear from the North American markets moving forward. A limit on current outflows of capital from China is not the same thing as saying that capital will flow backward. Presumably these limits may be eased in the future as the Yuan/US$ exchange rate stabilizes at a level that puts no pressure on Chinese foreign currency reserves. Another issue to consider here is that as financial markets liberalize worldwide other countries may suddenly invest strongly in the US as walls to efficient capital movement fall. Mexico for instance has been moving to tear down internal barriers to the efficient operation of the real estate market with the FIBRA legislation. If external barriers to this investment were suddenly removed, one might see as many headlines about Mexican capital investing in the US with some of the same features of recent coverage of the Chinese investors. Do Cross-Border Investors Execute Efficiently? One significant fear of regulators is that cross-border money is not expert in local markets. If these investors come into a market, the fear is that they will naturally overpay, face performance challenges and flee quickly as expectations change. Coming in and out so quickly, the fear is that this cross-border money will destabilize markets. Capital can flee quickly as expectations change but there are signs to suggest that this investment quick flow is moderating and is not as destabilizing as feared. Looking at the behavior of the Australian money that came to the US during the housing boom, it was a clear case of a bandwagon effect. Strong growth in the retail and housing markets in the US combined with a need to place capital quickly arguably helped push pricing in the retail market to unsustainable highs. Had this money been better hedged against currency swings, the investment opportunity may not have looked as attractive and many not have grown as quickly.

Source: Real Capital Analytics

Into late 2016, the cost to hedge the US/Euro exchange rate was growing.2 Conservatively leveraged German investors pulled back on their investment activity by 17% in 2016 versus 2015 as a result. Generally speaking, these investors are not buying currency hedges for individual asset purchases, instead putting on hedges at the portfolio level across all asset classes. Still, even at the fund level, too


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much exposure to US $ denominated assets is acting to curtail German investment at a time when prices are at or near a cyclic high. With respect to the Chinese investors active in the US today, it is generally understood that the Chinese Yuan had been slightly overvalued until recently and that an ongoing devaluation was in place. In 2016 as hedging currency risk became too expensive for German investors they curtailed property purchases in the US. The Chinese though expanded their property purchases as these real assets here acted as a natural hedge on the devaluation risks faced at home. Investing for capital preservation is not behavior that suggests a discounted sale in the near term. More fundamentally however, do these cross-border investors overpay when they purchase assets in the US. Here the evidence is mixed. In an examination of cross-border capital coming to the office market of the US, one study found that yes, markets with the strongest price increases and highest absolute price levels had a higher concentration of cross-border capital.3 However, the authors noted that more research was needed as the capital may focus on these markets for other reasons. A more recent study focused just on the New York office market does suggest that the causality is all reversed. Cross-border capital may not be driving prices up in the largest markets of the US by paying the highest prices, but instead are paying the lowest cap rates because they are buying the highest quality assets.4 Conclusion While the Japanese investors came in so aggressively in the late 1980s there are indications that they will be coming back to the US in the near term. After suffering years of low level returns, Japan’s Government Pension Investment Fund (GPIF) announced recently that it is recruiting managers to deploy capital into real assets.5 Just as there have been headlines in the business press fretting over the Chinese investors coming to the US as a sign of a market peak, if and when the Japanese return in force with investments in US real estate, these headlines will be more extreme.


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Into this market cycle there have been fears expressed that the inflow of cross border money is a sign of a price bubble. The rationale after all is that Japanese money flowed into the US quickly and as it flowed out, this hot money distorted market activity and amplified price declines. The motivations of Chinese capital coming to the US in this cycle are externally driven just as the Japanese investors were motivated not by forces in the US but by forces in Japan. These motivations give regulators pause. These external forces by their very nature are not something that regulators will have an easy time measuring, managing or controlling. Still, it is a mistake to view this cross-border money as unprofessional and price insensitive. This is not to say that the Japanese, Chinese, Mexican, … whatever capital origins you might imagine … will not make mistakes in this cycle. Ultimately this capital is deployed by people and people often misjudge opportunities and make mistakes. However, if these investors make mistakes, they are going to make their own mistakes. 1 World Bank, Policy Research Working Paper, WPS 1452, “The 1985-1994 Global Real Estate Cycle: Its Causes and Consequences” May 1995, Bertrand Renaud 2 https://www.wsj.com/articles/dollar-hedging-costs-hit-treasurys-1473979806 3 “ Does Foreign Investment Affect US Office Real Estate Prices?” Pat McAllister, Anupam Nanda, The Journal of Portfolio Management, September 2015. 4 Steven Devany, David Scofield http://www.tandfonline.com/ eprint/Dz2v2ihnB958NygZNk8f/full 5 http://www.reuters.com/article/us-japan-gpif-alternativeassets-idUSKBN17D0DR


CRE Finance World

The Clock is Ticking for Commercial Real Estate Today, the commercial real estate (CRE) world is abuzz as investors try to understand where we are in the cycle. While the cyclical nature of CRE is no secret, some investors are too busy trying to push capital out the door when they should be understanding the position in the cycle. The clock is counting down toward the end of the CRE cycle, where values are not being supported by prices, and investors need to be particularly conscientious about how they invest in the capital stack of CRE, what property types are best suited to this phase and what locations are better positioned to come out ahead. We have been climbing a wall of worry for a few years now, anticipating rising cap rates and downgrades to values. Even so, deals are getting done but with caution and selectivity. Fewer buyers today are willing to pay steep prices in certain markets. But make no mistake — there is capital in the market for CRE. One reason this cycle has lasted so long compared to other cycles is that the lending process has been more selective, although this has resulted in a decreasing number of transactions. I, along with the many investors I talk with every quarter, believe we have entered the eleventh hour of the real estate cycle (see Exhibit 1 for a graphic representation). The alarm is set to go off at the peak of the cycle, values compared to prices are flat to declining, and investors need to be prepared. This article presents evidence that the economic and CRE recovery is “long in the tooth” and discusses the implications for the CRE industry as a whole. Exhibit 1 Commercial Real Estate Market Cycle

Ken Riggs, CFA, CRE, MAI, FRICS, CCIM President Situs RERC

Since the bottom of the Great Recession, which is at the 6:00 position of our clock, CRE has experienced a very nice run-up with few hiccups in the investment market. On a risk-adjusted basis, many would argue it is the asset class that has done the best. CRE was an attractive alternative during the early years of the recovery because it offered a real/tangible asset class with a strong income component. In an era when 10-year Treasury rates have been less than 3% over recent memory, a 5%-plus income return has been a major strength for the CRE market. When you include years of double-digit returns, it is easy to sort out the winners from the losers. The time from the bottom of the recession to roughly the end of 2015 could be considered the expansionary phase of the market cycle. 2015 saw record transaction volumes and, at the time, record prices. Since 2015, the market has begun to plateau and has entered into the peak of the cycle from a value versus price perspective. Many analysts have disagreed about how long this peak will last, but general sentiment points toward a downturn in 2018 or 2019. Since the recovery (and eventual expansion) began in 2009, real GDP grew by 17%, led by technology, electronics and health care. Personal income and disposition have grown almost 4% annually since 2014 (Bureau of Economic Analysis) and quarterly personal consumption expenditures (PCE) has been 1.6% or greater since Q1 2014, with consumer spending increasing every quarter. The consumer price index (CPI) from March 2016 to February 2017 rose a steady 2.7%. These macroeconomic indicators suggest stable growth, yet the market is nervous about the uncertainty in the world and pausing to ask, “How much longer can this recovery last?” Between 1945 and 2009, the average duration of an expansion cycle in the U.S. was 58.4 months, according to the National Bureau of Economic Research (NBER). As of April 2017, we are in the 94th month of expansion. Headwinds for the economy, such as a graying American population and slowing aggregate U.S. population growth, will be trends to watch as the expansion cycle continues (or ends).


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The Final Countdown: Nearing the End of the Cycle from a Value versus Price Perspective Volume and Prices CRE deal volume fell to $133 billion in fourth quarter 2016, down 20% from fourth quarter 2015. The drop in volume is attributed to a pullback in portfolio and entity-level transactions, however, not to a lack of demand. The Wall Street Journal reported that global CRE fund managers had a record $237 billion available to invest at the end of 2016 compared to $136 billion at the end of 2012. The unspent amount of the total committed capital, called dry powder, is at a record high, signifying that the drop in transaction volume is not explained by a drop in demand. Instead, it reflects investors’ caution related to geopolitical events such as the U.S. election results, Brexit and a series of European elections this year. This fall in volume, however, has not corresponded with falling prices. As of the beginning of 2017, CRE prices have grown to roughly 23% beyond their pre-recession peak, according to Moody’s/Real Capital Analytics Commercial Property Price Index. Interest rates are rising and buyers are concerned about future cap rate movements. On the other hand, sellers are not willing to match the buyers’ concerns because sellers believe the strong demand suggests their property value can rise even more if they wait. Total CRE Returns Probably the most striking evidence of the end of the cycle is the forecasted trends in CRE returns. CRE enjoyed double-digit returns from 2010 to 2015, according to the National Council of Real Estate Fiduciaries (NCREIF). Average total CRE returns dropped to about 8.00% in 2016; based on statistical modeling by Situs RERC, total returns are expected to further decrease to near 6.00% in 2017 and about 4.40% by 2018 (see Exhibit 2). These expected total returns are for the base-case scenario. It is important to note that, while much less likely, the upside scenario forecasts total returns to go up again. The primary driver of these decreased returns is the expected decrease in capital appreciation, which is expected to slow to about 1.00% by the end of 2017 and become negative in 2018 as the cycle matures and the chance of a CRE market correction increases. Exhibit 2 Situs RERC Total Return Forecast (2010–2018)

Cap Rates and Yield Rates According to survey-based research conducted by Situs RERC, expectations for real estate yields and cap rates continue to hover around their historic lows as the market appears to be approaching a turning point in the cycle. For many property sectors, expected rates have begun to level off. In some cases, they have started to creep up toward the levels seen at the peak of the last expansion. Record valuations have been the primary catalyst for rate compression. With investors potentially looking to begin taking profits at these high prices, there might be continued choppiness in rates over the short term. It is worth noting that within the property sectors, the apartment sector has begun to see noticeable increases in required pre-tax yield, going-in and terminal cap rates, according to Situs RERC’s respondents. Situs RERC survey results have generated mixed sentiment about the apartment market. Some survey respondents believe it is still a good investment, citing demographic and economic trends, while others feel the market is overbuilt and might soon see a correction. Over the longer term, Situs RERC expects overall CRE cap rates will begin to rise as valuations start to fall back to earth. Situs RERC’s cap rate forecast has required rates increasing to about 4.80% by the end of 2017 and 5.20% by the end of 2019 (see Exhibit 3). These forecasted cap rates are for the basecase scenario. Should the economy improve significantly over the next couple of years, that cap rate compression could continue. Exhibit 3 Situs RERC Capitalization Rate Forecast (2010–2019)

Note: The Capitalization Rate Forecast is Situs RERC’s proprietary model based on Situs RERC data and data from the NCREIF Property Index (NPI) and are for unleveraged, institutional-grade properties. Source: Situs RERC, 4Q 2016

Note: The Total Return Forecast is Situs RERC’s proprietary model based on Situs RERC data and data from the NCREIF Property Index (NPI) and are for unleveraged, institutional-grade properties. Total returns are derived from an income component and a capital appreciation/depreciation component. Source: Situs RERC, 4Q 2016


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Yield spreads are also signaling the end of the cycle. The Federal Reserve raised the Federal Funds rate from 0.75% to 1.00% in March 2017 and indicated that the Fed would start shrinking its balance sheet this year, which would lead toward normalizing monetary policy. The CRE industry has enjoyed historically low interest rates for a long time, which translated to wider yield spreads. The spread between the yield (discount rate) and 10-year Treasurys jumped from 390 basis points (bps) at the end of 2007 to 680 bps at the end of 2012, and the spread at the end of 2016 was 576 bps (see Exhibit 4). Rising interest rates will put pressure


CRE Finance World

on yield spreads and the shrinking spreads might lead to diminished risk-adjusted returns as the benefits associated with the relative safety of CRE begin to be overtaken by other investments. However, rising interest rates also signify a strong economy, which tends to be associated with a strong real estate market. The current strength in the economy is in part fueled by President Trump’s promise to reduce regulations and taxes. If he delivers, it could encourage more lending.

standards in fourth quarter 2016 were the most conservative they have been in three years, another indicator that we are long into the cycle. Exhibit 5 Situs RERC Historical Availability vs. Underwriting Standards of Capital

Exhibit 4 Yield Spreads — IRR vs. 10-Year Treasury

Source: Situs RERC, 4Q 2016

Sources: Situs RERC, 4Q 2016

How Is the CRE Cycle Affecting Lending? The CRE lending environment is facing challenges as prices peak and competition for deals continues to change the nature of the market. Strong regulations stemming from Dodd-Frank and other legislation have made it more difficult to borrow during this cycle than the previous cycle. However, the more disciplined approach to lending has created a less volatile market for CRE, reducing risks for lenders and potentially staving off a crash. With the tighter lending standards, some are searching outside of traditional lenders for access to capital. This has led to the emergence of dark pools of capital from non-traditional lenders, such as private equity firms, that have stepped in to provide capital for deals and taken advantage of the void. Availability of Capital and Underwriting Standards According to data collected by Situs RERC, the availability of capital for both equity and debt investments has generally trended downward over the past two years, though the amount of available capital remains above average. This is a good signal from the market that pricing and market We have entered the eleventh cycles are being watched and driving the capital flows hour of the real estate cycle. into the market. As shown in Exhibit 5, the availability of capital appears to have peaked in second quarter 2014. At the same time, underwriting standards remain relatively disciplined, but they are more lenient than those imposed in the aftermath of the Great Recession. Ratings for underwriting

Loan-to-value (LTV) Ratios and Commercial Mortgage-backed Securities (CMBS) In the debt sphere, LTV ratios have been decreasing since the immediate aftermath of the Great Recession. This is particularly true for traditional lenders such as banks, which are subject to stringent regulatory requirements. In response, alternative lenders such as shadow banks have stepped in to fill the capital void, because they are not subject to the same regulations and are able to take on more risk and provide loans at higher LTV ratios. Portfolio allocations have started to shift toward the debt side; investing in debt often results in better returns and still offers the stability of the CRE market’s cash flow. However, proper CRE debt valuation procedures are a top concern for investors, particularly open-ended funds, as the CRE cycle comes to an end from a value versus price perspective. As investors seek access to liquidity, mark-to-market valuations — which factor in interest rate changes and collateral-specific risks — become more useful and accurate. The CMBS market has seen big declines in issuances so far in 2017. According to Trepp, CMBS issuance fell by 34 percent year-over-year; no deals were issued in January, and only 15 deals were issued in February and March. Borrowers have struggled to refinance loans that were originally issued when the underwriting standards were not as strict. These pre-crisis loans, known as the wall of maturities, are still a primary concern for the market. The risk-retention rules that went into effect in December 2016 and non-competitive pricing have also created headwinds for the CMBS market. While the overall CMBS market has declined recently, investors who have stakes in less risky (i.e., investment-grade) bonds that are toward the top of the distribution waterfall will be least affected, while those invested in riskier, subordinated CMBS bonds will be hardest hit.


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While many may believe the CRE market is fast approaching a downturn, it is worth noting that the market may not experience a large downturn but rather a slight dip. The fundamentals underlying CRE, such as unemployment and job growth, are strong and demand remains high in many markets. In many ways, the signals may be pointing toward a soft landing rather than many quarters of decline. So, what does this all mean? It means the real estate cycle clock is at 11:45 and the alarm is about to sound for the end of the cycle (refer to Exhibit 1) as values are coming under pressure compared to prices. CRE lenders should keep in mind: • By keeping lending standards tight, lenders might have learned their lessons from previous cycles and not let cheap money make the eventual decline of the market even worse.


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•T he most important factor for lenders is whether a tenant can make loan payments. As long as the economy holds firm and supports CRE tenant revenues, debt payments can be made, even if property values decrease. •A lthough prices have peaked in the market, LTVs have remained in check and cushions are still favorable. CRE lending can and will continue to occur. •Y es, the CMBS market is slowing, but there is a silver lining for investment-grade debt. As values and prices flatten or decline, investors need to heed the warnings of the end of the cycle and adjust their investment strategies accordingly. The market has been bracing for an adjustment, but we’ll find out for sure how well investors have battened down the hatches to weather the correction when the clock strikes 12:00.

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