Impact On Commercial Real Estate Lending Of Dodd-Frank And Basel
Earlier articles in this series have reported on precedential judicial decisions affecting those involved in commercial real estate: a court decision that a lender’s absolute assignment of leases and rents was not applicable to hotel revenues (https://cayuga.cogwheelmarketing.com /articlearchives/silverlining.htm); and the “springing” of a “bad-boy” guaranty arising out of the insolvency of a retail shopping center, notwithstanding the absence of the indicia of the commonly recognized bad-boy acts of fraud, misrepresentation, misappropriation and a bankruptcy filing of the borrower (https://cayuga.cogwheelmarketing.com/articlearchives/cmbs.htm). The judicial evolution of the case law in the real estate finance area has occurred in great part due to the unprecedented economic recession of 2007-2009 and the view of many of too much risk taking coupled with a lack of financial and regulatory accountability. This article will discuss, in the most general terms, the two main regulatory hurdles on the horizon affecting commercial real estate (“CRE”) and the credit markets: The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and the U.S. implementation of the Basel III global regulatory capital reforms from the Basel Committee on Banking Supervision (“Basel III”).
THE CAPITAL MARKETS AND CRE
In order to fully appreciate the impact of the proposed regulatory reforms on the CRE capital markets, it is helpful to also appreciate the CRE capital markets as they stand today, what some have referred to as the “wall of maturing debt.” Paul Vanderslice, President of the CRE Finance Council (“CREFC”) and Managing Director and Co-Head of the U.S. CMBS (Commercial Mortgage Backed Securities) Group of Citigroup Global Markets, summarized the current state of the CRE markets in testimony before the U.S. House of Representatives Committee on Financial Services, Subcommittee on Capital Markets and Government Sponsored Entities on July 10, 2012 as follows:
- The CRE market in the U.S. is funded by $3.1 trillion in commercial mortgages and approximately $1.5 trillion in equity;
- Approximately $2 trillion in commercial mortgage debt is scheduled to mature over the next 5 years, including $600 billion in CMBS loans;
- Traditional portfolio lenders – banks and insurance companies – are projected to be able to fund less than $200 billion of the annual replacement debt demand and potentially less than $35 billion of the annual demand will be able to be funded by CMBS debt;
- The funding gap is expected to be most pronounced in secondary markets and businesses in the small and midsized towns in America;
- In 2007, prior to the economic crisis, CMBS issuance approached $240 billion, but since the economic crisis, CMBS issuance has plummeted:
- 2009 $2 billion
- 2010 $12.3 billion
- 2011 $30 billion
- 2012 (thru 7/12) $18 billion
- 2012 (projected) $30-35 billion
- It is anticipated that the larger businesses and trophy properties in the country’s major urban centers will enjoy ready access to CRE portfolio financing, but smaller businesses, less high profile, non-trophy properties, and properties and businesses in secondary and tertiary markets will not have access to necessary financing when existing debt matures;
- CREFC, the collective voice of the $3.1 trillion commercial real estate finance market, believes that the combined effect of proposed regulations, when aggregated, will curtail credit further than intended by regulators.
Oliver Stone’s “Wall Street 2: Money Never Sleeps,” a semi-fictional account of the economic crisis, main-streamed the economic theory of “moral hazard;’’ where one takes risk at another’s expense. Dodd-Frank, and particularly for purposes of this article, section 941, attempts to mitigate such moral hazard in the CMBS market through its proposed risk retention rules. CREFC Chairman Vanderslice’s testimony before Congress on July 10, 2012 expresses concern that the proposed risk retention rules, while necessary, may go too far and, in light of the present size of the CMBS market, may result in the loss of the critical mass necessary to make it a viable source of debt for the capital markets. Chairman Vanderslice, in fact, states that the current size of the market, at a $30 billion per year issuance rate, will be insufficient to maintain the requisite infrastructure of the market.
Section 941 of the proposed Dodd-Frank regulations proposes that the CMBS sponsor retain 5% of the credit risk of the assets collateralizing the issuance. CREFC’s overriding concern appears to be not so much with the 5% risk retention requirement, but an additional requirement that the CMBS sponsor also fund a Premium Capture Cash Reserve Account (“PCCRA”). The PCCRA proposal would require that the revenue from the “excess spread” on the issuance be monetized and be retained by the sponsor for the life of the transaction. Dodd-Frank defines “excess spread” to be the difference between the gross yield on the pool of securitized assets, less the cost of financing those assets, charge offs, servicing costs, and any other trust expenses (such as insurance premiums). CREFC interprets this additional premium requirement of PCCRA as a capture of not only profits, but also what would be the recoupment of costs associated with the infrastructure of the CMBS origination platform. Chairman Vanderslice’s testimony is arguably a clarion call that this requirement removes the profit motive and ability to recoup origination costs that provide the economic incentive to insure the vitality of the CMBS market. Christian deRitis, Director and Mark Zandi, Chief Economist of Moody’s Analytics in their “Special Report: A Clarification of Risk Retention” (Sept. 20, 2011) reported that this requirement will increase the cost for borrowers from 1-4 percentage points.
CREFC’s Chairman Vanderslice also testified to other provisions of the proposed Dodd-Frank regulations which he felt would potentially further jeopardize the vitality of the CMBS market. Chairman Vanderslice’s full testimony may be found at: http://financialservices.house.gov/uploadedfiles/hhrg-112-ba16-wstate-pvanderslice-20120710.pdf
As discussed above, the “wall of maturing debt” will need two primary “re financing” sources, the CMBS market and portfolio lenders. The vitality of the future of the CMBS market will depend in great part on the final regulations adopted under Dodd-Frank. Arguably, the most important regulatory factor affecting credit availability and portfolio lenders will be found in the proposed Basel III accords.
CREFC Chairman Vanderslice, has publicly stated that until banks and lenders are Basel III compliant, they will be reluctant to put “more money to work” in the real estate market. Basel III is a global regulatory standard on bank capital adequacy, stress testing and market risk agreed upon by the 27 member countries of the Basel Committee on Banking Supervision. In December of 2011, the U.S. Federal Reserve announced it would implement the Basel III capital requirements. On August 8, 2012, the Federal Reserve announced that it had extended the comment period from September 8, 2012 to October 22, 2012. This announcement came a day after a group of state banking organizations requested an extension of the comment period. Most generally, Basel III regulations, to be phased in from 2013 to 2019, will require banks to maintain top quality capital (Tier 1 capital) equivalent to 7% of their risk bearing assets, roughly 3Xs what they are required to hold under existing rules. Additionally, the number of banks that will be required to comply with Basel III will grow from roughly 20 of the large financially complex institutions (“LFCI”) that were required to abide by Basel II to roughly 6,000 banking and lending institutions.
Risk bearing assets are weighted differently, depending on the particular asset, under Basel III. For example, cash, gold, government debt are allowed a 0% “risk weighting.” Of most concern to the CREFC is the proposal in Basel III of assigning a 150% risk weight to “high-volatility commercial real estate” (“HVCRE”) from the current risk weight of 100%. HVCREs are loans that finance or financed the acquisition, development or construction of real property. This in essence would require a bank to set aside capital based upon 150% of the value of the HVCRE loan in case the loan goes into default. Paul Vanderslice’s testimony before Congress on July 10, 2012 stated that the proposed Basel III capital credit rules “will function to decrease credit availability, especially from smaller banks, and increase the cost of that credit to borrowers.” Chairman Vanderslice’s testimony echoed the comments of Chip Chippeaux, Chairman of Century Bank in Santa Fe, New Mexico, with $550 million in assets. As reported in the July 6, 2012 edition of the New Mexico Business Weekly (D. Domrzalski, reporter), and commenting on the increased risk weighting for HVCRE, Chippeaux states, “It will require more capital to make those types of loans, and somewhere along the way, somebody is going to have to pay for it . . . banks that have to make those loans will have to charge higher interest rates to borrowers . . . t’s not one of those deals that will facilitate lending, especially commercial real estate lending.”
Hospitality industry professionals are inextricably intertwined with the economy and the financial markets. For those professionals more directly involved in acquisition, development and ownership particular attention should be paid to the proposed Dodd-Frank and Basel III regulations. To the extent there is maturing debt on the horizon in your portfolios, the public comment to date on these proposed regulations would suggest that it may be prudent to tend to these matters in the short term.
About the Author
Francis L. Gorman is a former member of Cayuga Hospitality Consultants.
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