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.