2015 Real Estate Forecast

Improving commercial property fundamentals, a steady stream of offshore capital and an accommodating Federal Reserve interest rate policy will sustain robust property investment in 2015 as buyers keep seeking yield and safe havens in the U.S.

But rising interest rates, the cooling of energy markets amid oil's price plummet, and other variables threaten to thwart those expectations. What's more, 2015 could be the year that reveals whether escalating property prices are sustainable, especially as underwriting becomes more aggressive.

Among other trends, buyers are building more ambitious rent-growth assumptions into their underwriting to make increasingly expensive deals pencil out, says Kenneth Riggs Jr., CEO of Houston-based Real Estate Research, a national commercial property valuation and consulting firm. That's a departure from the more recent conservative practice of pegging rent growth to inflation, he adds.

Up to this point, I think value and price have been in alignment," said Riggs, whose firm was acquired in February by global commercial real estate and loan advisory Situs. "But I think we're at an inflection point and may be getting ahead of our skis. Next year we may see price outpace value."

Momentum Continues
Through November, commercial property buyers and sellers had completed nearly $366 billion in U.S. deals in 2014, topping dollar volume for the full year of 2013 by almost $5 billion, according to Real Capital Analytics, which tracks sales of more than $2.5 million.

Capitalization rates have been trending down for most major property types over the last several quarters, indicating more aggressive pricing in anticipation of continued strong investment demand and low cost of capital. The rates measure a property's initial yield for the owners, and they fall as prices rise.

The average cap rate for office and industrial buildings in November marked a year-over-year decline of 50 basis points for each property type, to 6.6% and 7.1%, respectively, Real Capital says. Apartment properties fell 50 basis points to 5.8%.

Hessam Nadji, chief strategy officer for property brokerage Marcus & Millichap (NYSE:MMI), anticipates that vacancies in 2015 will keep tightening for most property types.

Retail properties could see the most pronounced improvement, Nadji says, with average vacancy rates dropping by 60 points next year to 6% nationally in light of growing small-business confidence. In November, the National Federation of Independent Business' small-business optimism index surged 2 points over October to 98.1, a slightly higher reading than the 40-year average. Apartments, however, may see vacancies rise nationally from a current average of around 4.5% amid increased supply, Nadji adds.

From an individual-markets viewpoint, the plunging price of sweet crude oil to less than $60 a barrel from around $100 six months ago could dent investment in cities tied to the energy sector, which along with technology markets have led the nation's commercial property recovery.

Much of the focus will be on Houston, where some 17.3 million square feet of office space was under construction in the third quarter, according to brokerage CBRE Group (NYSE:CBG). In a Houston report this month, CBRE noted that a "steep fall in oil prices" would have to last a couple quarters before energy companies would alter drilling and production projects, which are planned on a long-term horizon. But it said eliminated or scaled-back projects would ultimately reduce office demand in the market.

While Houston's average office rental rate climbed 4.4% to $26.81 per square foot in the third quarter from a year earlier, the average vacancy rate ticked up 20 basis points to 14.4% over the same period, Reis says. The fall in oil prices has caught the attention of Riggs, whose firm ranks the city as one of the top-performing property markets in the country.

"Houston's economy is more diversified than it used to be," he adds, "but falling oil prices will definitely slow the momentum."

Interest Rate Question

Rising interest rates could derail property investments on a broader scale. Yet observers who expected rate increases over the past few years now say that they wouldn't be surprised if interest rates begin and end 2015 without much change.

Still, investors are aware of higher-interest-rate risks, says Gerry Trainor, executive managing director of capital markets for Houston-based property brokerage Transwestern.

"But all in all, they're moving forward because it's anybody's guess as to what happens," said Trainor, who is based in the company's Washington, D.C., office. "I don't think anybody anticipates a big, sudden rise."

The yield on the 10-year Treasury note, a benchmark for conventional commercial real estate loans, would likely have to jump more than 80 basis points to around 3% or higher before investment activity would slow materially, adds Riggs. But the yield will stay lower longer than what most people expect, he argues.

"There's a tremendous weight on keeping Treasury yields down because of global uncertainty," he said.

Nadji notes that oil's recent price decline, combined with slowing economies in Asia and Europe, prompted overseas investors to buy U.S. Treasury notes in a flight to safety that pushed the 10-year yield down some 50 basis points over the last three months.

"In addition, any substantive rise in interest rates would be accompanied by strong economic and employment growth," he added, "both of which will boost demand of commercial real estate."

Similarly, a greater cost of capital won't deter foreign real estate investors who pay with cash, notes Avi Benamu, managing partner of New York-based real estate investment manager Winchester Equities. Like offshore Treasury buyers, individuals and families in the Middle East, Russia and other areas seeing strife are buying properties in the U.S. to protect their wealth, he says.

"Even if property prices seem a little bit unreasonable they'll just park their cash in the U.S. because they know it will be safe here," Benamu said. "The money is just flowing in."

Amid the trends, CBRE and Jones Lang LaSalle (NYSE:JLL) — the two largest companies by market cap in IBD's Real Estate-Development/Operations industry group — have risen by 33% and 48% in the stock market this year, respectively.

North American Hotel Investment Conference

The 2014 North America Hotel Investment Conference (NATHIC), held November 19 through 21 in Chicago, brought together a strong showing of hotel owners, investors, brokers, consultants, franchisors, brand representatives, and students from Michigan State University, New York University, and DePaul University. Top U.S. hospitality executives served on panel discussions that addressed an array of topics related to hotel ownership, development, and management, as well as the recent proliferation of new hotel brands and the catalyzing impact of Millennials or “Generation C” on the industry. A sense of optimism echoed throughout the conference, supported by reports of continued hotel performance improvements in markets nationwide. Read on for some of highlights from NATHIC 2014.


New Brands
Established brands are plentiful in the current pipeline of new hotel supply, while new brands and brand concepts continue to emerge and gain traction. Many industry insiders—including keynote speaker Jack DeBoer, who originally conceived the Residence Inn, Summerfield Suites, Candlewood Suites, and Value Place lines of hotels and, most recently, the WaterWalk Apartments—believe that the limited availability of established brands brings about the creation of new ones. Some speakers, however, emphasized the connection between new brands and the focus on Millennials (the generation of people born in the 1980s or 1990s), particularly as these travelers tend to be aligned with brand concepts such as health and wellness and lifestyle hotels.

The “soft brand” concept, currently represented by Marriott’s Autograph Collection and the Curio – A Collection by Hilton, among others, will soon include a new competitor. Michael Palmeri, Senior Vice President of Acquisition and Development for Loews Hotels & Resorts, announced the company will be rolling out a new soft brand in the first quarter of 2015. These “soft brands” or collections of hotels offer travelers looking for cultural experiences in unique destinations the security of basic brand standards; they also offer owners the benefits of brand affiliation, especially distribution and reservation channels. Other supply trends noted at NATHIC included the growth of ground-up developments versus conversions and the increasing development of urban extended-stay properties.

Although new brands, independent hotels, lifestyle concepts, and softbranded hotels tend to target customers from specific segments, the number of emerging brands and concepts was on the minds of many attendees. During the panel on extended-stay hotels, Diane Mayer, Vice President & Global Brand Manager with Marriott International, stated that “as [the number of] brands proliferate, they get harder and harder to differentiate.” Hence, while many new brands are emerging in the market, the lack of brand recognition can hinder their acceptance by customers, especially as, from the perspective of guests, discernible differences or advantages among the newer concepts are less evident when compared with those among existing brands.

Millennials and the Content Generation
The shear size, youth, and technological savvy of the Millennial generation makes it a key target demographic in today’s hospitality market. Many NATHIC attendees and speakers recognized that no one brand is likely to corner the market on Millennials, which are composed of a great many physiographic segments. Still, even if brands targeting Millennials capture only a small, like-minded portion of the approximately 80 million members of the generation, this still presents a very substantial potential customer base.

Millennials represent a sort of paradox when it comes to what they want in a hotel. They have high expectations when it comes to lodging, but look for sleekness and simplicity in the experience as well. Millennials also favor innovative design at every price point, and they’re tech-savvy yet value driven. The term Generation C (or the “Content Generation”) was also used to capture the physiographic of customers at all ages who create and share content through YouTube, blogs, and other online avenues; the members of Generation C, which may extend even more widely than the Millennial generation, hone in intensely on hotel options that allow them to access and share content during their stay. No matter the term, the importance of offering exactly what the customer wants, without all the extras they don’t want to pay for, is key.


Higher Spends, Longer Stays, and Limited New Supply Boost Optimism

Hotel performance so far into 2014 has exceeded expectations and will likely end on a high note, with all segments anticipated to exceed RevPAR levels in 2007 (the pre-recession peak) and 2013. Overall, occupancy for 2014 is projected to reach 64.6% and to surpass 65% in 2015; STR Analytics noted occupancy hasn’t been so high since the 1990s. Average rates in 2015 are expected to experience all-time highs as well.

Increased consumer confidence, longer stays with higher spending per stay, and limited new supply have all contributed to increasing occupancy and strong average rate. As the Great Recession becomes a thing of the past, consumers are willing to pay a premium for additional amenities and convenience. There was also discussion of the linkage between these trends and the aforementioned tendencies among Millennials and Generation C. Many spoke to how today’s consumers are extending their travel periods, most notably through an added Thursday or Sunday night to create an extended weekend. These longer traveling periods are becoming more prevalent in today’s hotel industry, and it was also recognized that many customers are willing to spend more on each day of their trip.

Lodging Econometrics reported that the U.S. hotel industry entered the expansion phase of the lodging real estate cycle in 2014. However, supply growth is expected to be approximately 1.3% and 1.6% in 2014 and 2015, respectively, which is notably below the 20-year average of roughly 2.0%. Conversely, the exit of hotel rooms is also below the industry average, according to Lodging Econometrics. Year-to-date through October of 2014, approximately 19,500 rooms have left the supply report, with approximately 4,000 of those located in Atlantic City. The industry average of hotel rooms leaving the system is approximately 35,000 per year.


Outlook
NATHIC 2014 made it clear that the optimistic outlook for the next several years, especially 2015, is well deserved. The potential impact of new legislature, such as the Living Wage Law, along with the influx of new brands, is important to consider going forward. Overall, however, the fulcrum of the hospitality industry is on the upswing.

Historic tax credit sunset spurs jump in NC renovation proposals

A building that once hummed with the whir of more than 100 people operating 10,000 spindles now lies dormant, a relic of a time when cotton was king and trains were the lifeblood of Southern commerce.

More than a century old, the 55,000-square-foot Clayton Spinning Mill closed in 1976. Its faded brick facade shows its age, but its owners believe it has some life in it yet.

They hope to turn the building and the surrounding land into a sports and retail complex with the help of the state mill rehabilitation tax credit they were awarded earlier this year, which will offset the cost of renovating the historic structure.

“You can’t do a project like this without the tax credits unless you’re walking around with $10 million in your pocket,” said Michael Hubbard, who owns the mill with fellow Clayton resident Steve Yauch.

The mill credit will expire at the end of the year for properties that haven’t been approved to receive it. With a month and a half left to apply for eligibility, dozens of developers are scrambling to get approval for rehabilitation projects like the Clayton mill, massive undertakings that often can’t be completed without the state incentive.

Tim Simmons, federal rehabilitation tax credit coordinator and senior preservation architect at the State Historic Preservation Office, said the number of applications submitted this year began to rise during the summer.

“I know that this year, mill projects are up,” he said.

The mill credit is one of three historic preservation tax credits that the state legislature chose not to renew this year. The 20 to 30% credits for residential and commercial properties will expire Jan. 1, while the 30 to 40% credit for mills will expire only for projects that haven’t received state approval before the year’s end.

Enacted in 2006, the mill credit can be used in addition to the 20 percent federal historic preservation tax credit for the rehabilitation of properties on the National Register of Historic Places. To date, the incentive has aided in the completion of 28 mill projects — more than half of them in Durham and Winston-Salem — and 43 more have been proposed in counties across the state.

But not all potential projects will be deemed eligible before the deadline. Myrick Howard, president of Preservation North Carolina, said any mills not yet listed on the National Register may not receive the credit because the listing process usually takes about a year to complete.

“These projects are going to be really hard to do without any tax credits, and there is a good chance we’re going to see mills like that being deconstructed for materials,” he said. “That’s taking an economic development opportunity and taking it apart and throwing it away.”

On Friday, the N.C. Department of Cultural Resources announced that 17 properties in the state had been added to the National Register, including the Merrimon-Wynne House in Raleigh.

The decision not to renew the historic preservation program aligns with the goals of the 2013 Republican overhaul of the state tax code, which reduced income tax rates for individuals and businesses and eliminated other tax credits. Between 2006 and 2012, mill rehabilitation projects qualified for about $128 million in credits, according to State Historic Preservation Office data. The tax credits for commercial and residential properties, available since 1998, have cost the state more than $230 million since their inception.

Economic benefits

In his 2015 budget proposal, Gov. Pat McCrory included a less expensive version of the historic preservation program that reduced tax credit percentages and capped eligible rehabilitation expenditures at $20 million. The modified program would reduce its cost to the state by $10 million to $15 million annually, according to State Historic Preservation Office data.

The House supported the less expensive program, but the Senate did not. Sen. Bob Rucho, co-chair of the Senate Finance Committee, did not respond to several requests for comment.

“Tax credits are not an acceptable part of tax reform, so it hit a wall in the Senate,” Howard said.

He said he expects the legislature will consider implementing a version of the tax credit or an alternative incentive next year.

Proponents of the preservation program argue the economic benefit of rehabilitating historic mill structures far exceeds the initial cost to the state. The 28 mills rehabilitated with the help of the tax credit cost a total of $563 million to complete, and each supplies more jobs and tax revenue than it did before its renovation.

The American Tobacco Campus in Durham, a $167 million investment, stands as the largest project completed with the use of the mill credit. Capitol Broadcasting, which owns the campus, hired Durham-based Belk Architecture to transform the million-square-foot former cigarette production complex into mixed-use space home to shops, restaurants and office space.

The mill credit also allowed Belk Architecture to repurpose Durham’s Golden Belt complex, a seven-acre campus with an $8,000 tax value before its renovation. After it opened as a commercial and residential space in 2011, its tax value rose to $16 million.

The Chesterfield Building in Durham was also approved to receive the mill credit. The $100 million project, which will turn the former Liggett & Myers Co. cigarette production facility into commercial and office space, began earlier this year.

Retaining history

Eddie Belk, owner of Belk Architecture, said most mill rehabilitations aren’t possible without the help of the credit because the cost of preserving and repurposing a heritage building generally exceeds the amount of revenue the structure will generate while new tenants take root and build a customer base.

“The only way you can make a profit on these very large structures on many occasions is to invent a new enterprise and give it a new start,” he said. “The credits develop equity up front to help get the project done, and then it becomes a viable asset to the community.”

Though less extensive than many projects completed with the use of the tax credit, rehabilitation of the Clayton mill will cost $3 million to $5 million. The building’s 150 arched windows are bricked over, and restoring their original design could cost as much as $7,500 per window, Hubbard said.

Hubbard is looking to use both a 30 percent state mill credit and a 20 percent federal credit. If the project ends up costing $3 million, Hubbard estimates it could qualify for about $1 million in tax credits. While North Carolina buildings that are later added to the National Register will be able to apply for federal credits in the future, those often aren’t enough to make a project economically viable.

Renovating the Clayton mill without retaining as much of the original architecture would cost less and might not require the mill credit to complete. But Hubbard said he and and his team opted to preserve the integrity of a small-town fixture, a goal that resonates with some Clayton residents.

“When you find a new purpose for older buildings, you’re saving the history,” said Pam Baumgartner, historian at the Clayton Library and longtime resident. “Cotton was one of the first big industries here, and (the mill) really did have a big impact.”

Construction is expected to begin next year. Hubbard said he hopes the development will fill a need in Clayton, a town of nearly 18,000 whose population has increased by a third during the last decade.

“Clayton has boomed in its own right, and for the most part it’s starting to burst at the seams,” he said. “That’s why we’re looking at this project. It can be a destination for the town.”

Senate Fails to Renew Terrorism Insurance

A U.S. program that backstops insurance companies’ losses from acts of terrorism is set to end after the Senate didn’t extend it.

Efforts to reauthorize the Terrorism Risk Insurance Act for six years fell apart after Senator Tom Coburn, an Oklahoma Republican who is retiring, held up the legislation. Without a renewal, the program will expire Dec. 31.

“It’s unfortunate, but his objection is going to kill TRIA,” Majority Leader Harry Reid, a Nevada Democrat, said last night on the Senate floor. “I’m very sorry about that, but it’s a fact.”

The House passed an extension on Dec. 10 that would reimburse insurers after industrywide losses reach $200 million. The House measure would increase companies’ co-payments to 20 percent from 15 percent and gradually raise the threshold for government involvement.

Congress first passed the backstop after the terrorist attacks of Sept. 11, 2001, when insurers said they were hesitant to sell coverage on New York City office buildings. Coburn’s objection stemmed from concerns over the underlying policy and a plan to set up a regulatory body to supervise insurance agents and brokers (the National Association of Registered Agents and Brokers Reform Act or NARAB).

Taxpayers assume most of the risk while “the insurance industry makes all the money,” Coburn said last night.

Energy Companies

The bill passed by the House includes a change to the 2010 Dodd-Frank banking regulation law to exempt agricultural and energy companies from having to post collateral for swaps that are traded directly with banks and not guaranteed at a third- party clearinghouse.

The measure also would require that the Federal Reserve include a governor with community banking experience.

Fifty-seven business organizations, including the National Association of Realtors and Hilton Worldwide Holdings Inc., sent a letter to senators on Dec. 14 urging passage of the terrorism insurance law without other amendments. The groups said the program ensures “economic resiliency in the event of a terror attack.”

Without a reauthorization of TRIA, insurers will have the right to cancel terrorism policies after Jan. 1, Howard Kunreuther and Erwann Michel-Kerjan wrote for Bloomberg Businessweek in the Dec. 9 issue. They are likely to do so for fear of insolvency should a massive terrorist attack take place with no government backup, according to the two academics, who wrote a paper on the law’s impact for the Wharton Risk Center.

Kunreuther and Michel-Kerjan asserted that a lapse could lead to cancellation of events such as the Super Bowl, a contention disputed by the National Football League.

“The Super Bowl will be played,” Greg Aiello, the NFL’s senior vice president of communications, said in a statement reported by news organizations including ABC and CNN.

The legislation is S. 2244.

The Property Casualty Insurers Association of America (PCI) today issued the following statement expressing its disappointment in the failure to renew the prorgam:

“It is unconscionable that the U.S. Senate would adjourn without finishing their job and reauthorizing a long-term Terrorism Risk Insurance Act (TRIA) when the threat of a terrorist attack against the United States is at the highest level it has been in a decade,” said David A. Sampson, PCI’s president and CEO. “TRIA plays a vital role in our national economic security. If a massive attack occurs before TRIA is reauthorized, there could be no terrorism insurance coverage or taxpayer protection. PCI is profoundly disappointed by the dysfunction in Washington and we urge the next Congress to address a long-term reauthorization of TRIA immediately when they convene in January.”

EB-5 Foreign Investors are Favoring Senior Housing

Despite recent criticism for perceived lack of supervision, the U.S. Immigrant Investor Program, or EB-5, is a popular way to boost investment in seniors housing development.

EB-5 was created by Congress in 1990 to stimulate the economy through job creation and capital investment by foreign investors. The program grants permanent resident visas (green cards) to foreigners who invest at least $1 million ($500,000 in low-employment areas) into a new or failing company and create at least 10 new full-time jobs -- and is facing some negative press. Fortune magazine recently ran a cover story on an Indian investor who tried to make millions of fake projects through EB-5. Other EB-5 projects have yet to repay investors, like Jay Peak, a Vermont resort.

Recently, PDC Capital Group, in Costa Mesa, Calif., announced that it will invest $750 million in new senior properties through 2017. PDC's investment in 25 new SummerPlace Assisted Living & Memory Care residences includes over $250 million from EB-5 visa seekers. Groundbreaking took place at $26 million SummerPlace Lincoln, a 228-bed facility in Sacramento, Calif., that PDC says will create 135 new jobs.

PDC CEO Emilio Francisco says seniors housing creates the least risk for green card seekers because it strongly impacts jobs and communities. The average senior housing development costs $30 million, he says. EB-5 investment represents 20% to 30% of the capital stack, or $10 million per facility.

EB-5 calls for "regional centers" that coordinate foreign investment. The centers must focus on a contiguous geographic area and promote economic growth through jobs creation, improvised productivity, and increased export sales and domestic capital investment. The number of EB-5 applicants has skyrocketed. There were less than 100 approved centers in 2010; as of June, the USCIS had approved 579 new centers in total.

Omega Communities LLC, in Birmingham, Ala., has centers in Florida and Puerto Rico. COO James Taylor Jr. says the Florida center creates almost 30 new jobs per investor. Omega focuses on senior housing development and acquisition, putting together the capital stack, then bringing EB-5 investors. "It allows us to move much more quickly because the USCIS can be unpredictable in its approval times, and it's beneficial to go to a foreign country and show them a capital stack already in place to operate it for two years without additional funds," he says. "They get significantly more comfort that the project is viable and will be successful, they'll be more likely to get their investment back -- and also their green card."

Taylor says most EB-5 investors are Chinese, and are knowledgeable about the world supply-demand curve for seniors’ properties. Plus, China has its own senior housing crisis, due to its single-child mandate.

San Jose, Calif.-based NES Financial has 250 EB-5 projects with $10 billion in capital, and administers EB-5's Global Premier America Regional Center in California and projects by RockBridge Senior Living Group. Executive Vice President Reid Thomas says about 85% of NEB's EB-5 money comes from China. "There's a lot of positives about this investment vehicle -- and it doesn't cost the U.S. taxpayer a dime."

An S&P Ban Seen Having Big CMBS Impact

Word that the SEC may suspend S&P from rating commercial MBS transactions sent a shudder through the sector this week.

CMBS lenders said a ban would have a major negative impact on the single-borrower market, where S&P is the dominant rating agency. CMBS shops would likely have to turn to Moody’s or Fitch, which generally take a harder credit-quality stance on single-borrower deals. That would result in smaller loan sizes or higher interest rates, which could depress CMBS issuance by driving borrowers to other types of lenders or by rendering some acquisitions and refinancings uneconomical.

The secondary-market impact could also be significant if an SEC action voided S&P’s outstanding ratings during a suspension. That could force investors whose guidelines require a rating from a major agency to dump bonds, depressing prices.

Bloomberg reported on Monday that the SEC "is seeking to suspend" S&P from rating CMBS transactions. The news agency added that S&P was holding settlement talks in an effort to avoid the sanction.

Nomura researchers speculated that a ban could last one year. The SEC and S&P declined to comment.

The exact nature of the SEC’s investigation is unclear. In July, S&P disclosed that it was being investigated for possible violations of federal securities laws connected to its ratings and disclosures for six CMBS transactions in 2011. Bloomberg said the SEC was investigating whether S&P "bent rating criteria to win business."

Given the uncertainty about the likelihood, scope, timing and length of any SEC sanction, CMBS lenders said they were taking a wait-and-see attitude for now, continuing to quote loan terms on the expectation that S&P will rate transactions. But they acknowledged that they risk taking losses on loans being warehoused when an SEC action is announced.

Likewise, traders said the Bloomberg report had no immediate impact on prices in secondary-market trading.

S&P has almost disappeared from the conduit market because of a series of missteps since the crash and issuer complaints that its methodology doesn’t produce consistent rating patterns. But that same methodology produces relatively favorable credit-enhancement levels on single-borrower transactions, enabling lenders to write larger loans at lower rates. That has made S&P the dominant agency in that sector, with an 81% market share this year, versus 19% apiece for Moody’s and Fitch. Single-borrower transactions account for one-quarter of overall U.S. issuance.

But if S&P isn’t used, a lower percentage of a loan would qualify for an investment-grade rating. That would force a property owner to either borrow less or use mezzanine financing to make up the difference, increasing the blended coupon.

Lenders said the impact would vary widely from loan to loan, but as examples, they said that leverage ratios might decrease to 65% from 70%, and coupons might rise by 25-75 bp. Borrowers would then have to decide whether to pay the higher cost, borrow less, turn to another lender or not proceed at all.

Senior CMBS executives were glum about the prospect of a suspension. One said it would have "a major impact." Another said it would make "a material difference." A third said it would "cast a dark cloud over the CMBS market."

One veteran in the large-loan market said that profits have already been squeezed by increased lending competition this year. "We’ve been skating on thin ice as it is," he said. "If S&P goes away, it’s going to make this business extremely tough."

"Stand-alone deals will still get done," said another lender, "but it means the whole pipeline will have to get re-priced. If it

happens suddenly, there will be some people who’ll get stuck. They’ll have priced a deal a certain way, then find they have to change directions mid-stream. That’s where the pain will occur."

For the secondary market, the worst-case scenario is that S&P would be forced to withdraw its rating on outstanding bonds. Some buy-side shops have investment guidelines requiring that bonds carry a rating from S&P, Moody’s or Fitch. So if S&P’s ratings are dropped and neither of the other agencies rates the bonds, those investors could be forced to sell.

"If [S&P has] to take all their prior ratings off, that would be a problem," said one CMBS trader. But another trader noted that since the market crash, some institutional investors have dropped the requirement of having a rating from the traditional "big three." And the impact would largely be limited to post-crash single-borrower transactions.

So far, secondary-market prices haven’t been affected. This week, unrelated to the Bloomberg report, an unidentified holder sold about $55 million of single-borrower CMBS rated in most cases by S&P but not the two other major agencies. All of the bonds traded at levels that met or exceeded price talk circulated by dealers.

The SEC’s investigation is believed to stem at least partly from a controversial incident in July 2011, when S&P abruptly withdrew its ratings on a $1.5 billion CMBS transaction that had already priced and was about to settle. The unprecedented action derailed the multi-borrower transaction and caused issuers

Goldman Sachs and Citigroup to lose millions, touching off a firestorm of criticism in the industry and prompting angry issuers to boycott the agency on conduit transactions.

S&P attributed the unprecedented action to the discovery of a possible inconsistency in how its analysts had been calculating the debt-service-coverage ratios for new and legacy transactions.

Commercial mortgage delinquencies returning to prerecession levels

The delinquency rates of most types of commercial and multifamily mortgages fell in the third quarter, with multifamily loan delinquency rates back at prerecession levels, according to Mortgage Bankers Association (MBA) research.

The 30-day delinquency rate for commercial mortgage-backed securities (CMBS) loans was down 0.37 percentage points to 5.47%. The 60-day delinquency rate of commercial and multifamily loans held by life insurance companies fell 0.03 percentage points to 0.05%.

The 60-day delinquency rate for multifamily loans backed by Fannie Mae decreased to 0.09%, while the 60-day rate for Freddie Mac multifamily loans increased 0.01 percentage points to 0.03%.

The post-recession highs for Fannie Mae and Freddie Mac multifamily delinquency rates occurred around 2010. In the fourth quarter of 2010, the 60-plus day delinquency rate for Fannie Mae was 0.71%, and was 0.33% in the third quarter of 2011 for Freddie Mac.

In the fourth quarter of 2006, the Fannie Mae 60-day delinquency rate was 0.08%, and the Freddie Mac rate was 0.05%.

Some delinquency rates were still above recession-era peaks. Approximately 1.28% of loans held by the Federal Deposit Insurance Corp. and banks were delinquent 90 or more days in the third quarter. That delinquency rate peaked between 2010 and 2011 at above 4%, with the low at 0.8% around mid-2006.

CMBS 30-plus and real estate owned (REO) delinquency rates stood at just above 5% in the third quarter. The peak was in 2011 at close to 9%. Between 1997 and 2009, CMBS delinquencies were below 2%.

“Improving property fundamentals and values, as well as a strong finance market, are helping drive delinquency rates down across all investor groups,” said MBA Vice President of Commercial Real Estate Research Jamie Woodwell in a press release.

Mortgage REIT to Launch CRE Platform

Jack Taylor, the head of Prudential Real Estate Investors’ global debt unit, has joined Pine River Capital Management to oversee a commercial real estate investment program that will be seeded with $500 million of equity.

He’s been named global head of commercial real estate at Pine River, a Minnetonka, Minn., investment manager, and has been joined by his Pru team members, Stephen Alpart and Steven Plust, who were named managing directors.

Their responsibilities will include oversight of the commercial real estate investment program being planned by Pine River’s affiliate, Two Harbors Investment Corp., a mortgage REIT. It said that it plans to launch a “commercial real estate initiative” that would have an initial equity commitment of $500 million. Additional details could not be learned immediately.

Taylor is well known in the global high-yield debt world. He and Plust joined Pru in 2009 from Five Mile Capital Partners, a Stamford, Conn., investment manager, while Alpart previously was managing director and co-head of opportunistic lending at Capmark Investments of Horsham, Pa.

The three all had worked at Paine Webber and Co. prior to and after the investment bank’s merger with UBS in 2000.

Taylor co-headed UBS’ Americas and European real estate investment-banking operation and had led PaineWebber’s real estate group. At Five Mile, he was portfolio manager for the firm’s Structured Income Fund.

Their addition to the “Pine River team will enable Two Harbors to diversify our portfolio into commercial real estate assets,” explained Thomas Siering, chief executive of the REIT. “The opportunity in the commercial real estate market is attractive.”

The REIT’s assets as of Sept. 30 included a portfolio of residential mortgages with a balance of $4 billion; $12.7 billion of residential mortgage-backed securities, and a residential mortgage servicer affiliate. It also owns shares in Silver Bay Realty Trust Corp., a REIT that invests in single-family homes, which began business as a venture between Two Rivers and Provident Real Estate Advisors.

Risk Rule Seen Favoring Larger B-Piece Buyers

As the commercial MBS industry prepares for the risk-retention rules due to take effect in about two years, B-piece buyers face the prospect of raising more capital, from a broader range of sources, in order to stay in the game. The result, industry experts say, could be a different roster of players — likely fewer, larger firms, including new entities formed by combinations of high-yield and investment-grade bond buyers. “I think you’re going to see a lot of innovative structures,” said George Green, associate vice president of the Mortgage Bankers Association.

The reason is CMBS issuers are expected to rely on B-piece buyers to assume the risk-retention responsibility, and that will mean buying more bonds, farther up the capital stack, than those investors are accustomed to taking.

“[The rule] is going to benefit larger, more diversified investment managers,” said Stephen Renna, chief executive of the CRE Finance Council. “If you’re smaller, and your source of capital is more specific, it could be more difficult to participate in deals.”

At the heart of the voluminous final rules, adopted last month by six federal regulators to implement provisions of the Dodd-Frank Act, is the requirement that securitization issuers retain 5% of each deal. An exception for CMBS allows the issuer to instead sell bonds equivalent to 5% of the deal proceeds, from the bottom of the capital stack, to one or two “third-party purchasers.”

Whereas B-piece buyers now take the below-investment-grade portion of CMBS deals, that won’t be enough to satisfy the 5% rule. Industry pros say issuers will have to carve off a chunk of triple-B-minus bonds — maybe even some single-As — and wrap them into an expanded B-piece. The regulators rejected proposals to allow two investors to split that bottom piece into senior and junior portions. If there are two buyers, they must take pari-passu portions.

The resulting B-pieces won’t match the yield hurdle or the buying power of many current buyers. One source gave a back-of-the-envelope calculation that, where it might take $40 million to acquire a typical B-piece today, it could cost $60 million to buy enough bonds to satisfy the 5% risk-retention requirement.

“You have to get better-capitalized B-piece buyers,” said an executive at a major asset manager. “They need to be bigger so they can buy more.” And they’ll have to be willing to add investment-grade bonds to their usual diet of high-yield paper. That necessity is likely to lead to the invention of vehicles that bring together investors with varying risk appetites.

One of the main ideas being floated by industry experts would involve a B-piece buyer raising capital from a wide range of investors for a fund that would be structured with varying levels of risk for specific limited partners. As one current buyer described that scenario: “I can bring in another investor within the fund framework and create a return structure that works for him and also works for me. Maybe the fund would have a Class A for the senior risk and a Class B for the junior risk. I don’t think that would run afoul of the regulations.”

A slightly different approach would be for two or more parties to form a joint venture to buy B-pieces and split up the risks and rewards — including control of the special servicer — tied to specific senior and junior bonds. Securitization lawyers said such a joint venture could qualify so long as it was a single legal entity.

“I think [the regulators] are giving us flexibility to figure out how to make it work,” said Dechert partner Rick Jones.

Renna at the CRE Finance Council said that if the regulators were concerned about different sources of capital teaming up to purchase B-pieces, “they would have written something into the rule to prevent it, and they didn’t do that.”

Still, some investors said they’d be wary of using structures that would appear to directly flout the regulators’ prohibition of senior/junior B-pieces and might prompt the agencies to issue clarifications that would block such maneuvers. In adopting the rule, the regulators stated that “allowing the third-party purchasers to satisfy the risk retention requirement through a senior-subordinated structure would significantly dilute the effectiveness of the risk-retention requirements.”

A number of bond pros noted that the rule doesn’t prescribe penalties for failure to follow the risk-retention mandate. But presumably the individual agencies that collaborated on the rule will devise enforcement measures. There’s speculation the lead role would go to the SEC, which oversees disclosure and other rules for securities issuance. Jones pointed out that the ultimate responsibility for compliance lies with the issuer — raising questions about what would happen if a B-piece buyer doesn’t live up to its risk-retention obligations.

Many are forecasting that the number of firms competing for B-pieces — which in recent months has grown to as many as 17 — will shrink as the need for more capital gives large companies an advantage.

“I’m hearing people call this a ‘big institution rule,’ ” said one investor. “That means it’s good for the big guys, like BlackRock or Rialto Capital, and bad for the little guys. Their cost of capital is going to keep them out of the game.”

When it comes to forming new funds or partnerships, “the money will coalesce around the best-in-class guys,” one investor said. “The institutional guys — the pension funds, the endowments — will decide that a handful of [B-piece buyers] are good at this, and those will be the guys who survive.” That investor expects fewer than 10 competitors to remain.

Fewer bidders, larger buyers and the mandate that third-party purchasers hold the bonds for at least five years will add up to wider spreads on the new B-pieces, experts predict. That would reverse the recent trend that has seen yields shrink as more shops have competed to win deals.

The bigger shops likely will be able to negotiate deeper discounts because they have the capacity to take down the thicker slices. In addition, buyers will demand a pricing premium for the loss of liquidity.

“B-piece buyers get a yield of around 14.5% now, and I wouldn’t be surprised to see that go up to as much as 17.5%,” said one sell-side executive. He added that loan kickouts will likely become more common under the new regimen.

“B-piece buyers can either ask for a price adjustment or they can kick out loans,” he said. “But if they price-adjust under the new rules, and the price drops, that will make it harder to [reach] the 5%-buy requirement. So instead of price adjustments they will probably be kicking out more loans.” That would promote one goal of the regulators: improving the credit quality of securitizations.

Several experts pointed out that the market has two years to figure out the details. And some expressed hope that the regulators would adjust or clarify their positions in response to questions and concerns raised by the industry.

“We’ve got two years . . . which is forever in Washington,” said Jones at Dechert. “Just because it’s final doesn’t mean we’ll stop talking.”

Tech Industry Driving Chicago Real Estate Market

After years of struggles that followed the financial crash of 2008, Chicago’s economy is finally starting to get into gear. According to a report issued by the Illinois Department of Employment Security in September, the Illinois unemployment rate fell from 9.2 to 6.7 percent in just one year, marking the largest year-over-year decline since 1984. Preliminary data released by the IDES and the Bureau of Labor Statistics show there are also 40,600 more jobs this year than in 2013, most of them in leisure and hospitality, trade, transportation and utilities, and professional and business services.

 

In the context of this economic resurgence, Chicago’s real estate industry is also experiencing a revival, as office vacancy has now dropped to pre-recession levels, according to most recent data collected by Marcus and Millichap. The demand for office space is primarily driven by tech companies seeking downtown locations, mostly in the River North and River West submarkets. California-based Google, Inc. is one of many tech companies set to move to downtown Chicago. The company will occupy about 360,000 square feet in a 10-story building at 1000 W. Fulton Market by early 2016.

 

Job growth in the tech sector helped boost the office market this year, while strong rental demand in suburban office space brought rents higher. Marcus and Millichap reports that a total job growth of 1.6 percent is expected in 2014, with 70,000 new jobs added to the market. More than 2 million square feet of office space is currently underway in Chicago, with another 8 million square feet still in the planning stages. The largest project currently under development is the 1 million-square-foot River Point tower in the West Loop, a 52-story building slated for completion in 2017. According to Marcus and Millichap, developers are expected to add roughly 400,000 square feet of office space in 2014, after no new office space was completed during the last four quarters.

 

Chicago is also performing well when it comes to the retail industry, as the jump in employment and rising incomes are driving consumers to spend more. The retail market encountered a significant halt with the closing of 72 Dominick’s grocery stores in December 2013, but as of now all but one of the former stores have been purchased and are in the process of re-opening. Marcus and Millichap reports that more than half of the space vacated during 2013’s final quarter has been absorbed, as the market is attracting buyers from Canada, Europe and South America, and demand for retail properties surpasses the supply. The boost in employment is another factor in the rise of retail sales, and builders have nearly 500,000 square feet of space under construction to be delivered throughout 2015.

 

The drop in unemployment and the rising number of tech jobs in the region are also contributing to a growing demand in apartments in the downtown area. Roughly 6,000 rental units are currently underway, most of them located in the West Loop, the city’s tech core. Developers are expected to bring 3,100 multifamily units online in 2014, including 130 units of student housing, 80 senior apartments and 96 affordable rentals. The largest project finalized in the first quarter of 2014 was the 450-unit Hubbard Place apartment community at 360 W. Hubbard in the Streeterville/River North submarket.

What Does the End of Quantitative Easing Mean for Real Estate Values?

This past week the U.S. Federal Reserve announced the end to its quantitative easing (QE) program of mortgage-backed securities and U.S. government bonds purchases, which it began in 2008 in an attempt to stimulate the economy by lowering long-term interest rates.

The announcement came as no surprise.

For over a year, the Fed has directly and indirectly signaled that this was coming, in effect pulling the Band-Aid off ever so gently. The immediate market reaction has been very measured, with the 10-year U.S. Treasury yield only up modestly in the last week--less than 10 basis points (bps) as of mid-day on October 30, 2014.

The end of QE is a big step in the recovery from the Great Recession. Although the medium-term effects are difficult to predict at this point, conventional wisdom points to rising interest rates in 2015. Our view is that there are several factors that mitigate the likelihood of a material rise in interest rates in the medium term.

The most notable factor is the recent weakening of the global economy, particularly in the European Union, where a form of QE was recently implemented and additional stimulus measures seem likely. The deterioration in growth in China, which is hurting emerging markets, and some developed economies like Germany is dampening global growth expectations as well. Other factors include the recent rise in the value of the U.S. dollar, which, along with falling oil prices, is helping to suppress domestic inflation.

Global real estate consultant CBRE feels that a material rise in rates remains some way off and the impact on commercial real estate of the recent announcement will be negligible.

To support this, CBRE looked back to the events of May-August 2013, when Chairman Bernanke made the first direct suggestion that the Fed would reduce its bond-buying program, which triggered the "taper tantrum" that caused 10-year U.S. Treasury yield to expand by over 100 bps in the course of four months.

CBRE studied the immediate effect on commercial real estate of the rise in the 10-year U.S. Treasury by looking at actual trades executed by CBRE Capital Markets professionals following the spike. The results showed very modest changes in values, with almost no effect in all asset types except multifamily, which, while small (generally less than 2%), was greater than all other asset types. Commercial real estate proved resilient to a rapid rise in long-term interest rates in mid-2013, and CBRE believes it will be the same over the next several years.

CBRE says there is certainly a strong long-term relationship between long-term interest rates and real estate cap rates. However, the lags are rather long and there are powerful medium-term offsets. For instance, high institutional demand for core commercial real estate against relatively limited supply and good U.S. GDP growth momentum have created positive market sentiment. Most of all, pent-up rent increases across the major asset classes--due to rolling leases entered into during the 2008-2010 time frame and new occupancy demand driven by a growing economy--should bolster cap rate stability, even in a rising interest rate environment.

Other mitigants include geopolitical turmoil, which makes U.S. Treasuries, the "risk free" security of choice, more attractive and keeps rates low, and the increased globalization of commercial real estate financing sources, where some foreign buyers are tapping into financing from their home countries, which have a much lower cost of debt than the U.S., to underwrite purchases.

Also, the good news of a tightening labor market cannot be ignored, particularly for many industries that directly or indirectly affect commercial real estate including trucking, oil and gas, and construction. However, inflation expectations remain low and stable, and short-term rates are likely to move up only very slowly.

Spencer Levy, head of CBRE Americas Research concluded with: "The end of QE speaks to the gathering strength of the U.S. economy and won't affect commercial real estate values."

Investing In New York City REITs

New York City’s real estate market includes some of the most high-profile properties in the world. It is also one of the most expensive in which to invest (and why so many residents are renters). If you can’t afford to invest directly in New York City’s real estate market there are several publicly traded real estate investment trusts (REITs) that can give you exposure.

REITs are essentially real estate companies that invest directly in real estate through properties or mortgages. The Internal Revenue Service requires REITs to pay the majority of taxable profits in dividends to shareholders. Companies with REIT status do not pay corporate income tax.

You can buy and sell shares of REITs. Like stocks they trade on an exchange. There are three publicly-traded REITs that focus mainly on New York City real estate.

SL Green

SL Green Realty Corp. (SLG) maintains that it's New York City’s largest office landlord. It primarily focuses on acquiring, developing and managing commercial properties in Manhattan. Its portfolio holds ownership interests in 96 buildings in Manhattan. SL Green also holds ownership interests in 35 buildings in Brooklyn, Long Island, Westchester County, Connecticut and New Jersey.

One of its trophy properties includes 220 East 42nd Street, which is known as The News Building. Its lobby houses the iconic rotating globe featured in the 1950s Superman television series.

Financial services firm Citigroup Inc. (C), meanwhile, is one of SL Green’s high profile tenants. Its Global Wealth Management and Global Trading divisions are headquartered in a two building campus located at 388-90 Greenwich Street in Tribeca.

Shares of SL Green trade on the NYSE. Its stock price has ranged between $89.05 - $113.08 in the last year.

Empire State Realty Trust

The aptly named Empire State Realty Trust Inc. (ESRT) boasts the Empire State Building among properties in its portfolio. Altogether its portfolio includes 14 office properties and six retail properties in Manhattan and the greater New York City metropolitan area.

Nine of the office properties, including the Empire State Building, are in Midtown Manhattan. The remainder are in Westchester County, New York and Fairfield County, Connecticut. The six retail properties are located in Manhattan and Westport, Conn.

The locations of Empire State Realty Trust’s Manhattan office and retail properties include Union Square, Grand Central, Columbus Circle and several properties along Broadway.

Empire State Realty Trust’s shares also trade on the NYSE. Its stock price has ranged between $13.20 - 17.34 in the last year.

New York REIT

American Realty Capital's New York REIT Inc. (NYRT) became the latest entrant in the New York City REIT universe when it debuted on the NYSE in April of this year. It acquires income-producing commercial real estate and owns stakes in 22 properties, which are predominantly office and retail.

Properties in its portfolio include Worldwide Plaza in Midtown and the Twitter Building, located in Manhattan’s Silicon Alley.

Stay tuned as the future of this REIT unfolds. In October 2014, American Realty Capital announced that it had hired Barclays Capital and RCS Capital as financial advisors to evaluate strategic options to boost shareholder value. Empire State Realty Trust has expressed an interest in acquiring New York REIT, according to reports.

"It should come as no surprise that management and the board of directors are disappointed and believe that the market is undervaluing our shares," Michael Happel, President of the New York REIT, said in the announcement. "In light of the inquiries we have received involving potential strategic opportunities, our board felt strongly that we should engage financial advisors to provide fully-informed, objective advice to assist management in assessing all of our options," he added.

Shares have ranged between $9.51 - $12.32 since the REIT started trading.

Risks and Rewards

Because the three REITs detailed above are publicly traded they are highly liquid investments. Remember, you can buy and sell their shares like stocks. They also provide diversification, potential capital appreciation and an affordable way to for investors to gain exposure to New York City’s commercial real estate market.

Another benefit to investing in REITs is that they generate dividend income for investors. They are required to distribute at least 90% of taxable income each year to shareholders through dividends.

Like any investment there are risks involved in investing in REITs. Returns are not guaranteed.

REITs are also unique as rising interest rates can affect their returns. To make acquisitions REITs rely on debt or borrowed money. When interest rates rise, the cost of borrowing does as well, cutting into profits.

The Bottom Line

New York City has three publicly traded REITs focusing on its commercial real estate market. They offer liquidity, diversification and an affordable way for investors to gain exposure to one of the most dynamic real estate markets in the world. They also pay shareholders dividends and offer potential capital appreciation for moderate to long-term investors.

Real-Estate Funds Needn't Be Riled by Rising Rates

Investors have pulled money out of real-estate funds for two straight months, even though they remain among the year's best performers and pay bigger dividends than many stock funds. The worry is that rising rates will hurt growth for the owners of apartment buildings, offices and other commercial real estate, as well as limit demand for their stocks.

Before joining the crowd, bear in mind that rising rates don't always mean losses for real-estate funds. Many have delivered solid returns even during periods of rising interest rates. The key is how quickly and how high rates rise. Real-estate fund managers say they can still make money for investors, though they acknowledge that the performance won't be as good as this year and the recent past.

"One of the things you have to ask is why are rates rising," says John Wenker, co-portfolio manager of Nuveen's Real Estate Securities fund since 1999. "If rates are moving up moderately because the economy is starting to strengthen, that's fine for commercial real estate."

For real-estate funds, dividends are king. Most invest in real-estate investment trusts, which can avoid income taxes if they pass on 90 percent of their profit to shareholders as dividends. REITs can own shopping centers, self-storage units or senior housing communities.

Because they pay out so much of their income as dividends, REITs attracted income investors who grew tired of the low yields offered by bonds. That demand helped the average real-estate fund return an annualized 17.4 percent over the last five years, according to Morningstar. That beats the 15.6 percent annualized return for the Standard & Poor's 500 index over the same time.

One concern for REITs is that a rise in interest rates, which economists say is inevitable, will push investors to dump them and go back to bonds. Higher interest rates also make it more expensive for REITs to raise money to buy and develop real estate.

Those fears hurt REITs last year, when the Federal Reserve hinted that it may curtail its bond-buying stimulus program. The yield on the 10-year Treasury note quickly jumped from 1.63 percent in early May to nearly 3 percent by the end of the year. That drove the average real-estate fund into the red in the last three quarters of 2013. For the year, the average real-estate fund returned just 1.5 percent, versus 32.4 percent for the S&P 500.

REITs can deliver gains if the increase in rates is more moderate and the result of an improving economy. In such a scenario, fund managers say property owners should be able to charge higher rents and have fewer vacancies for their apartments and office buildings. That would lead to higher dividends.

The economy hasn't been as strong as many had hoped, but it is improving. Many economists believe growth next year will be the strongest since 2005. The unemployment rate is also at its lowest level since 2008, and the job market is strong enough that the Federal Reserve earlier this week announced the end to its bond-buying program. The central bank could begin raising its target for short-term interest rates next year, and many economists expect a measured rise.

Investors have pulled money out of real-estate funds for two straight months, even though they remain among the year's best performers and pay bigger dividends than many stock funds. The worry is that rising rates will hurt growth for the owners of apartment buildings, offices and other commercial real estate, as well as limit demand for their stocks.

Before joining the crowd, bear in mind that rising rates don't always mean losses for real-estate funds. Many have delivered solid returns even during periods of rising interest rates. The key is how quickly and how high rates rise. Real-estate fund managers say they can still make money for investors, though they acknowledge that the performance won't be as good as this year and the recent past.

"One of the things you have to ask is why are rates rising," says John Wenker, co-portfolio manager of Nuveen's Real Estate Securities fund since 1999. "If rates are moving up moderately because the economy is starting to strengthen, that's fine for commercial real estate."

For real-estate funds, dividends are king. Most invest in real-estate investment trusts, which can avoid income taxes if they pass on 90 percent of their profit to shareholders as dividends. REITs can own shopping centers, self-storage units or senior housing communities.

Because they pay out so much of their income as dividends, REITs attracted income investors who grew tired of the low yields offered by bonds. That demand helped the average real-estate fund return an annualized 17.4 percent over the last five years, according to Morningstar. That beats the 15.6 percent annualized return for the Standard & Poor's 500 index over the same time.

One concern for REITs is that a rise in interest rates, which economists say is inevitable, will push investors to dump them and go back to bonds. Higher interest rates also make it more expensive for REITs to raise money to buy and develop real estate.

Those fears hurt REITs last year, when the Federal Reserve hinted that it may curtail its bond-buying stimulus program. The yield on the 10-year Treasury note quickly jumped from 1.63 percent in early May to nearly 3 percent by the end of the year. That drove the average real-estate fund into the red in the last three quarters of 2013. For the year, the average real-estate fund returned just 1.5 percent, versus 32.4 percent for the S&P 500.

REITs can deliver gains if the increase in rates is more moderate and the result of an improving economy. In such a scenario, fund managers say property owners should be able to charge higher rents and have fewer vacancies for their apartments and office buildings. That would lead to higher dividends.

The economy hasn't been as strong as many had hoped, but it is improving. Many economists believe growth next year will be the strongest since 2005. The unemployment rate is also at its lowest level since 2008, and the job market is strong enough that the Federal Reserve earlier this week announced the end to its bond-buying program. The central bank could begin raising its target for short-term interest rates next year, and many economists expect a measured rise.

REITs Surge Ahead in Volatile Oct. Market

October was a volatile month for stocks in general. But REITs fared well, and were driven in part by strong earnings announcements. This month, through Oct. 29, the FTSE NAREIT All REIT Index was up 6.94 percent. That compares with a 0.4 percent drop in the Dow Jones Industrial Average, 0.62 percent increase in the S&P 500 Index and 1.24 percent increase in the Nasdaq Composite Index.

Fueled by strong market fundamentals and a favorable interest rate environment that has facilitated growth, the largest REITs announced strong third-quarter earnings that have met or beat expectations. Boston Properties, for instance, reported $1.46/share of funds from operations, handily beating the $1.37/share it was expected to post. Others that beat expectations include Equity Residential and AvalonBay Communities in the apartment sector, industrial REIT Prologis, Kimco Realty Corp. in
the retail sector and healthcare REIT Ventas Inc.

Meanwhile, REITs in several sectors provided investors with healthy total returns, including dividends and stockprice appreciation, for the month. Those in the manufactured-housing sector, for instance, provided a 10.2 percent return.

Those in the industrial sector provided a 9.79 percent return and those in the healthcare sector provided a 9.77 percent return, while retail REITs provided a 9.43 percent total return. Behind those were hotel REITs, with an 8.93 percent total return; apartment REITs, with an 8.89 percent return; self storage, 8.85 percent, and office, 8.4 percent.

Mortgage REITs, meanwhile, which are highly sensitive to changes in interest rates, posted a 3.7 percent return during the month. For the year so far, REITs have provided investors with a total return of 21.55 percent.

The Fed shrugged off this month’s stock market volatility and voted late in the month to end its bond buying program. The move was widely expected and led to a small drop in stock prices as investors believe that the end of economic stimulus will lead to higher interest rates. REITs were affected more than most other companies.

Although the Fed emphasized its plan to maintain its benchmark short-term interest rate near zero for “a considerable time,” investors are on alert for the first hints that rates will move higher. It is widely thought that the Fed will start allowing rates to increase by the middle of next year, but it has noted that its time-frame will depend on its employment and inflation objectives.

A NY REIT tumbles 30% on accounting ills

Shares of American Realty Capital Properties plunged on Wednesday after the Manhattan-based company, one of several real estate investment companies founded by Chairman Nick Schorsch, announced that it had misrepresented its earnings and had dismissed two top accounting executives.

By midday Wednesday, shares of the publicly traded real estate investment trust had plunged 30%. Among the disclosures the company made was that it had inflated a key earnings measure by about $23 million in the first half of 2014 and that its financial statements from 2013 "should no longer be relied upon."

"The accounting issues are unacceptable, and we are taking the personnel and other actions necessary to ensure that this does not happen again," CEO David Kay said in a statement released with ARCP's disclosure of its accounting trouble.

The firm said it had fired its CFO, Brian Block, and its chief accounting officer, Lisa McAlister, and replaced them.

ARCP is part of a group of real estate investment companies founded by Mr. Schorsch, who acquired a stake in West Side office tower Worldwide Plaza last year in a deal that valued that building at $1.45 billion. Mr. Schorsch made that purchase through another investment trust entity called New York REIT. He is the chairman of both that firm and ARCP.

As that acquisition was being made in 2013, RXR Realty, a major commercial landlord in the city, launched a lawsuit against New York REIT. The suit alleged that Mr. Schorsch’s firm had originally agreed to partner with RXR to buy Worldwide Plaza, but instead used the company’s in-depth financial analysis of the property to make its own bid without RXR. New York REIT won that suit and completed its purchase of the stake alone.

A lawyer who represents shareholders of ARCP said that owners of the company’s stock were considering a lawsuit.

"Reading between the lines, our suspicion is that the two top accounting officers saw the error in the earnings and let it go," said Jeff Block, a lawyer at Block & Levitan, based in Boston. "You have a very profound drop in value any time you have accounting issues like this because it calls into question the credibility and honesty of the company."

According to Forbes, ARCP was created by the merger of two nontraded REITs founded by Mr. Schorsch. This month, he stepped down as CEO of the company, handing over the reins to Mr. Kay in a move that had been done to increase financial transparency, reports suggested.

Is Houston the Next Gateway City?

Institutional investor demand for Houston commercial real estate, coupled with job growth, a less expensive cost of housing and movement of oil and energy industries into the city is leading local players to predict that the most populousmetropolis in Texas could become the next gateway market. "Houston has always been a strong market for institutional investment, but it is now viewed as a gateway city," Kevin Roberts, the southwest president at Transwestern, said. "Today, it is considered one of the top tier investment markets in the U.S."

Las yea, the city was ranked fourth in the U.S. for foreign investment and fifth globally, according to the Association of Foreign Investors in Real Estate. "This was a huge improvement since not all that long ago, Houston was not a primary investment market for foreign capital, because most foreign investors were going toward gateway markets such as Los Angeles, San Francisco, New York, Washington, D.C., and Boston," Tom Fish, executive managing director at JLL, said. "[The city has] recently been perceived as a gateway market in the eyes of foreign investors, and [it] now has a healthy amount of foreign bidders."

Consolidation of the oil and energy industries into Houston has created internationally competitive jobs that draw foreign capital to the region, Kevin Roberts, the southwest president at Transwestern, said. He explained that Houston is predicted to be the number one supplier of oil and gas in teh United States in 2015.

Because of this, there has been a rapid increase in foreign investment from Mexico as well as an in-migration trend, according to Jan Sparks, managing director of structured finance at Transwestern. "There is significant influx of wealthy Mexican nationals into Houston, predominantly in Mexico City and Monterrey. Houston offers a stabilized, safer environment for them to raise their families and conduct their business. Commuting to numerous cities in Mexico from Houston is easy and inexpensive. They can get in and out of Mexico in the same day if they desire," she said.

The city has seen in-migration from the Northeastern, Midwestern and Western parts of the U.S., Roberts said, as people seek to take advantage of low-tax business opportunities. "Our governor has been very aggressive in trying to attract people to those businesses," Fish said. "The one thing that is interesting about the oil business is that it's not just people in hard hats drilling. It also produces an enormous amount of technology jobs, and a lot of people are coming in from places like California to fill those positions."

 

Job growth in Houston, which is seeing 80,000-100,000 new jobs created each year, is close to double the national average, Fish said. This means the office sector has seen a lot of demand, Sparks said, as it has been an efficient way to place large amounts of equity for the past two years. Houston now has more office space under construction than any city in the country, according to Fish, a vast majority of which is already leased.

 

Multifamily is also one of the leading product types in Houston this year, Roberts said, with more than 17,000 multifamily units delivered in 2014 and nearly 15,000 of those units abosorbed. "Many members of Generation Y are coming in and renting these urban, multifamily units," Roberts said. "Sixty percent of Generation Y renters think that they'll move within the next five years, so they're willing to pay up for apartment units because they are renters by choice."

 

With all of the new construction, Fish said that he believes there is enough discipline in the market to limit it to the best products that are able to get capitalized. "We have had a terrific four years of double-digit rent growth, and as long as we continue to experience the job growth that we are now, I think we'll be able to absorb the units that we have coming in," he said. "Even though construction prices are going up because of the heightened labor market, I think the future of Houston looks pretty healthy. There's always a little bit of caution about what will happen in the oil industry, but I'm very optimistic."

 

Although the market in Houston has been favored among investors for a couple of years, according to Roberts, he doesn't believe Houston has seen its peak yet. "Many use baseball analogy that we're in teh middle innings of an extra innings baseball game," Roberts said. "Fundamentals in Houston and the economy's supply and demand equilibrium are very much in check, and I do believe that this current cycle will have a very nice run. I don't think we're close to the end. I think we have several years in the future to enjoy this momentum and continue to build on it."

Risk Retention Rules Approved; Higher Pricing, Less Capacity for CMBS

The credit risk retention rules mandated by the Dodd-Frank Act and then the subject of fierce debate over the last two years by regulators and the industry as they were being written are now finalized. These rules will shape a number of financial products and lending activities, from mortgages to highly-leveraged corporate bonds to commercial mortgage-backed securities going forward.

The changes will be significant for the CMBS market, starting with higher pricing that could range from an additional 25 basis points (according to estimates by regulators) to between 35 to 50 basis points (according to industry associations). The new rules are also expected to limit capacity, as well.

Still, these final rules--adopted by the Office of the Comptroller of the Currency, the Department of Treasury, the Federal Reserve Bank, the Federal Deposit Insurance Corp., the US Securities and Exchange Commission, the Federal Housing Finance Agency and the Department of Housing and Urban Development—are not as bad as the industry originally feared.

"The whole process has been an evolution," says CREFC president and CEO Steve Renna. Over time this 'evolution' moved considerably more in direction that CREFC and other industry associations had advocated, he says.

Briefly, for the CMBS industry, the final rules eliminated the Premium Capture Cash Reserve Account that had been proposed in the earlier risk retention proposal. This onerous requirement, which would have required all issuer profits to be placed in a first-loss position, had been tentatively dismissed about a year ago, but to have it jettisoned from the final rules is a relief. Also gone from the final rules are cumbersome cash flow requirements.

The heart of the rules — a doubling of the amount of risk that has to be retained to 5% stayed in place — but further negotiations with regulators made this rule far more flexible to implement, Renna says.

The bottom line is that B piece buyers have a lot of flexibility in figuring out the best way to raise capital they need for the additional retention. In addition, the retention can be divvied up between the issuer and B piece buyer. "We asked for flexibility and optionality in fulfilling the risk retention rule and the regulators provided that," Renna says. "They also originally said the B piece would have to retain the risk for ten years. We said five and they agreed."

Unfortunately, they wouldn’t budge on the single-asset loan criteria, he says.

CREFC had been lobbying to keep certain loans that were conservatively underwritten—namely securitizations based on a single asset such as one building or a single credit—exempt from the risk retention rules. "No lenders want to keep that big of a loan on its balance sheet and it wasn’t necessary, from an investor protection standpoint, to apply risk retention to these loans," Renna says.

The regulators didn’t agree and Renna believes the consequence will be that these loans will be pushed into the cheaper – and less transparent -- corporate bond market.

"The regulators didn’t make a strong case for why they decided this," he says. "These loans don’t belong under risk retention."

Buffalo, NY commercial real-estate market is on track for a $600 million year

More than $71.7 million in commercial real estate value changed hands in September, led by a Williamsville apartment complex, a bakery warehouse in Lancaster and a senior affordable housing building in Lancaster, according to data from the Erie County Clerk’s Office.

 

Those three deals together amounted to $39.2 million, or more than half of the total deal value in 25 transactions during the month.

 

So far this year, deal activity has surpassed $452 million through the first nine months just in Erie County, putting the market on track for a $600 million year. Last month, the largest deal was the $15.2 million purchase of a pair of apartment complexes at 355 and 395 Evans St. in Williamsville by the Ashley Companies of Rochester, a privately owned real estate investment and management company from Harry and Esther Rosenfeld, through Georgetown Apartments LLC.

 

The first complex, at 355 Evans, consists of seven two-story buildings with 11,520 square feet, built in 1967 on 8.7 acres, and assessed at $5.6 million. The second one, at 395 Evans, has six two-story buildings on 3.4 acres, with 11,714 square feet, built in 1969, and assessed at $3.1 million. Both have pools and parking.

 

In Lancaster, CSM Bakery Products Inc. sold a warehouse facility at 3765 Walden Ave. to AGNL Pastry LLC, a unit of hedge fund sponsor Angelo Gordon & Co. of New York City, for $12.58 million. Located on 8.5 acres, the property is assessed at $3.5 million.

 

Founded in 1988, Angelo Gordon manages $26.5 billion in assets for clients, with almost $13 billion in commercial real estate properties. Its “net-lease” division – AGNL – provides sale-leaseback financing, offering companies that own their own real estate a way to cash out while still leasing their facilities back.

 

CSM Bakery provides bakery ingredients and products such as cakes, cookies, brownies, muffins, mixes, icings, toppings, fillings and pastries to bakeries, consumer food companies, grocers and other retailers. It’s a subsidiary of Amsterdam, Netherlands-based CSM, a global leader in bakery products and natural food preservation, with operations and 9,500 employees in 60 locations.

 

Nearby, Henry Meyer, through Lancaster Towers Associates LP of Pepper Pike, Ohio, sold the Lancaster Towers apartment building for seniors to SRK Caravel Arms Associates LP of Lauderdale Lakes, Fla., for $11.4 million. The 2.3-acre property at 1 Pleasant Ave. is assessed at $6.02 million.

 

SRK also owns the Caravel Arms affordable senior complex in Florida, but the business is managed by Amherst-based Benchmark Group.

 

And Dr. Fadi Dagher, a Buffalo General Medical Center surgeon who has been investing in Western New York real estate, bought a third Waterfront Village office building at 40 LaRiviere Drive. Dagher, through his D&S Capital Real Estate III LLC, paid $6.875 million for the property, adding to two others he bought early this year for $7.2 million.

 

He also bought the Buffalo Tourist Lodge on Main Street near the Buffalo Niagara Medical Campus, with plans to convert it to a new Sleep Inn or similar hotel, and was part of the investment group that purchased the former Holiday Inn Grand Island at a foreclosure auction. That is now the Byblos Niagara Resort & Spa.

 

In other deals:

 

• Independent Health Association paid $5.9 million to buy 300 Essjay Road from Ciminelli Real Estate Corp., which owns the Centerpointe Corporate Park in which the facility is located. The building purchase is part of an office space shuffle that enables the health insurer to consolidate its offices and employees onto one campus.

 

• Salit Specialty Rebar of Niagara Falls, N.Y., through SSR 1050 Military Road Inc., paid $2.7 million to buy 1050 Military Road in Buffalo from Rochester-based Klein Steel Service Inc. The property is an industrial warehouse and manufacturing facility. Salit, part of Myer Salit Ltd. of Niagara Falls, Ont., is a stainless steel rebar supplier and fabricator.

 

• National Gypsum Services Co. paid $2.64 million to buy 1650 Military Road in Tonawanda from 1650 Military Road Associates LLC, which is linked to Robert Nuchereno of Arista Real Estate. The 3.6-acre property has a 54,920-square-foot warehouse, built in 1964.

 

• Nuchereno’s 1650 Military Road Associates, meanwhile, paid $2.525 million on behalf of Len-Co Lumber to buy 8075 and 8095 Sheridan Drive in Clarence from Trinity Place Holdings Inc., the real estate successor to the bankrupt former clothing retailer Syms Corp. The property is a former Syms store, that is now occupied by Len-Co, with the rest available for lease.

 

• William and Carl Paladino’s Ellicott Development Co., through Pearl Group LLC, bought 500 and 512 Pearl St. in Buffalo from Buffalo Christian Center Inc. for $2.525 million. A mixed-use project is planned for the facility.

 

• Rite West Partners LLC, a Long Island investor, bought a property housing a Rite Aid Pharmacy at 350 Niagara St. in Buffalo from WEC 97A-7 Investment Trust of Houston, an investment security managed by Hines Investment, for $2.1 million.

Federal Housing Finance Agency Unveils Plan to Loosen Rules on Mortgages

For years, politicians, housing advocates and potential home buyers have complained that tight credit policies after the housing market crash have kept too many deserving people from qualifying for mortgages.

Now the government is taking steps that it says it hopes will allow more first-time buyers and lower- and middle-income Americans to get home loans at low rates.

On Monday, Melvin L. Watt, the nation’s chief housing regulator, announced a program offering more reassurances to mortgage banks that fear they could suffer unpredictable losses on the loans they sell to the government.

Separately, he disclosed that efforts are underway to allow borrowers to receive government-backed loans with much smaller down payments than are now required. But contrary to early expectations, he offered few details on such plans.

“We know that access to credit remains tight for many borrowers, and we are also working to address this issue in a responsible and thoughtful manner,” said Mr. Watt, director of the Federal Housing Finance Agency, which regulates the mortgage finance giants Fannie Mae and Freddie Mac.

The move in large part is intended to reassure banks that have had to pay tens of billions of dollars to settle legal cases arising from the housing boom and bust and buy back bad loans sold to Fannie and Freddie. To avoid having to make those payments again, many lenders now demand that borrowers meet stricter requirements for loans, known in the industry as overlays.

“We know that this issue has contributed to lenders’ imposing credit overlays that drive up the cost of lending and also restrict lending to borrowers with less-than-perfect credit scores or with less conventional financial situations,” Mr. Watt said in a speech on Monday to the Mortgage Bankers Association convention in Las Vegas.

Some economists, with mortgage bankers, welcomed the new plan, saying that it, with more gains in the job market and a recent dip in mortgage rates, could put the housing recovery back on track. Ben S. Bernanke, the former chairman of the Federal Reserve, recently told an audience that even he could not get a loan to refinance his mortgage.

“Creditworthy borrowers who have been locked out of the housing market will finally have an opportunity to become homeowners,” said Mark Zandi, chief economist at Moody’s Analytics.

But some housing finance analysts contend that tight credit does not sufficiently explain the weakness in the housing market. Instead, they say, an aging population, stagnant wages and a wariness of taking on new debt have all reduced demand for mortgages.

“The reality is that this is as much a demand-driven drought as it is a credit-driven drought,” said Joshua Rosner, of Graham Fisher & Company, a research firm.

With the new plan, the government is trying to strike a balance between the frenzied years of the housing bubble, when mortgages were approved with little regard for the ability of borrowers to repay them, and the tight grip on mortgages after it burst.

“It requires a lot of fine-tuning to get a national mortgage market that achieves all the objectives we want,” said Stan Humphries, chief economist for Zillow, a real estate website.

To reassure mortgage lenders, the housing finance agency intends to further relax the agreements that determine when Fannie and Freddie may require banks to buy back bad loans. The terms that are being loosened involve loans that show evidence of fraud or other flaws in the underwriting process.

Under the new agreements, for instance, Fannie and Freddie would demand buybacks only when there was a pattern of misrepresentations and inaccuracies in the loans. In addition, if problems are later discovered in loans, the deficiencies would have to be significant enough to have made the loans ineligible for purchase by Fannie and Freddie in the first place.

These changes follow other recent adjustments by the housing finance agency to calm mortgage lenders. But mortgage banks did not increase lending to less creditworthy borrowers.

Now, some housing specialists are more hopeful that the overhaul announced on Monday will prompt the banks to lend more. “It will be helpful in moving the needle,” Jim Parrott, a senior fellow at the Urban Institute, said.

Mr. Watt said he would give specifics in a few weeks about a plan for borrowers that could include down payments of as little as 3 percent.

Borrowers can already apply for low down-payment loans that are backed by the Federal Housing Administration. But housing specialists said that some borrowers who qualified for loans backed by Fannie and Freddie were being directed to the F.H.A., which backs loans that have much higher interest rates.

“You want people to get the loan they qualify for,” said Michael D. Calhoun, president of the Center for Responsible Lending.