Commercial Real Estate Property Brokers Experience Profit Drop as Market Slows Down

Commercial Property companies are starting to experience decrease in their profits as the commercial real estate market start to lose its heat.

According to Bloomberg.com, CBRE Group Inc. and Jones Lang LaSalle Inc. experienced their biggest loss since 2011 due to difficulties in equities. The loss brought a 14% drop for CBRE Group and 16% for Jones Lang LaSalle. HFF Inc. dropped with 20% in August while Marcus & Millichap Inc. dropped with 17%.

The possible further decrease in real estate transactions is raising concern among big brokerage firms that their profit will also decline together with the transactions. The possible drop in profit might cause for the firms to lease their properties instead of selling them.

Brad Burke, analyst at Goldman Sachs Group Inc., said that the profit growth at the companies "is in the rear- view mirror at this point. This is a natural maturing of the real estate cycle."

According to Real Capital Analytic Inc., commercial real estate transactions in the U.S. increase with 23% during last year's second quarter. Major several sales made early last year had "front- loaded" the first half volume of $255.1 billion. Two industrial portfolio were included in the transaction, namely Manhattan's Waldorf Astoria Hotels and Willis Tower in Chicago.

Sam Chandan, founder and chief economist of Chandan Economics, said that "We have had a very rich transaction market for some time, so the rate of growth in activity has necessarily begun to taper off. It's not the kind of growth we saw when we were coming off the bottom."

According to ChicagoBusiness.com, a quarterly report from Federal Reserve Data revealed that "the expansion in real estate lending is slowing." A 2.7% increase in outstanding commercial- mortgage debt in 2013 was observed and it raised again by 4.2% last year.

Various factors affect the slowdown in commercial property market business. Some of those factors were a strong dollar's effect non- U.S. profit, drop in oil prices that causes decrease in real estate demand "energy hubs" such as Calgary and Houston.

High Leverage for Apartment Loans Troubles Moody’s

With prices so high for apartment properties, any loan based on today’s appraised values is going to look very large compared to historic prices. But multifamily CMBS loans are especially troublesome, according to Moody's Investors Service.

“The credit quality of U.S. conduit/fusion commercial mortgage-backed securities (CMBS) continues to deteriorate, with conduit loan leverage in the second quarter pushing past its 2007 peak,” reads a July report from Moody’s.

These loans may look relatively modest compared to the appraised value of the apartments properties now. But if prices were to fall, a number of these loans might be in serious trouble. Lending experts argue that problems may be mitigated by stronger loan underwriting standards overall. Also, property prices may have even more room to rise relative to the income from apartment properties, and don’t have to fall anytime soon, as interest rates creep upwards, according to some apartment experts.

“Lenders are holding to pretty good underwriting standards,” says Bill Hughes, senior vice president for Marcus & Millichap Capital Markets. For example, lenders still resist to the urge to offers loans with interest-only periods longer then a few years, unless the loan is relatively low leverage, covering less than 60 percent of the property’s appraised value.

Moody’s: Underwriting way past the peak

The average CMBS loan was equal to 117.8 percent the value of the property in the second quarter, as measured by the Moody’s loan-to-value (LTV) metric. That’s very high–largely because Moody’s LTV compares loans to historic property values, instead of the high values that properties are appraised for in today’s market. The average CMBS loan was equal to 66.4 percent on average of the underwritten value of its property over the same period, according to Moody’s.

“The appraisals on Q2 collateral fully reflect the run-up in commercial property prices to levels that top the pre-crisis peak, while our values use a through-the-cycle approach,” according to Moody’s.

Just to compare, in the third quarter of 2007 the average CMBS loan has an average Moody’s LTV of 117.5 percent on average of the underwritten value of its property over the same period. In response to rising leverage, Moody’s is getting tougher in its CMBS ratings, giving fewer bonds in every CMBS issue the coveted AAA rating because the rating agency expects losses.

“Loans sized to 70 percent of peak values likely will under-perform those sized to 70 percent of trough values, as can be seen by comparing loans from the 2007 peak with those from mid-cycle 2003,” says Tad Phillipp, Moody's director of commercial real estate research.

Sky-high prices

The issue of leverage affects the whole business of lending to apartment properties, not just the CMBS business, because it is driven by high prices for apartments.

Lenders are still avoiding some of the worst practices of the real estate boom, however. For example, lenders still require borrowers to show the expenses from a property on a trailing, 12-month basis, says Hughes. Also, borrowers typically can’t get away with forecasting rents that would justify a larger loan, even though the property has now history of earning those high rents.

“I’m not really seeing any of that,” says Hughes. That restraint makes measurements like a loan’s debt service coverage ratios much more meaningful today than it was during the last boom, when giant loans were made based on rosy projections of high rents and low expenses.

Even though apartment properties are selling at historically high prices, by at least one measure prices have room to rise even further. Apartment properties now sell at average cap rates of 5.5 percent. That’s 320 basis points higher than the yield on 10-year Treasury bonds. Just to compare, in 2006 at the height of the boom, cap rates were just 100 basis points higher, according to Institutional Property Advisors.

Cap rates are likely to get a little closer to the yield on 10-year Treasuries. “As investors seek opportunities in secondary and tertiary markets throughout 2015 and compress cap rates there, the spread nationwide to the 10-year will continue to narrow,” according to Institutional Property Advisors.

Interest rate outlook: Federal Reserve

The benchmark yield on 10-year Treasury bonds is also likely to stay relatively low for a long time. “Even the anticipated increase in the Federal Reserve’s benchmark later this year will likely have minimal short-term effect on long-term rates,” according to Institutional Property Advisors. That’s because the bond markets have expected the Fed to inch rates upwards for a very long time, and there is not much in the latest economic reports to pressure the Fed to act quickly. A strong dollar and low energy prices are helping keep inflation below the Fed’s target of 2 percent. “The Fed has the maneuvering room to adjust rates very slowly,” according to Institutional Property Advisors.

Understanding the Swiss Franc Currency Shock

I dedicate this blog primarily to real estate headlines and news. But on occasion there are non-real estate issues in the global financial system that deserve exposure, and the Swiss Franc Currency Shock is one of them. If you don't fully understand the issue, you're reading the right blog.

The currency shock happened when the Swiss National Bank (or SNB, similar to our Federal Reserve) announced that they would lift the "cap" on the Swiss franc's value.

Why did the SNB create a "cap"?

When countries in the Eurozone (countries that use the Euro) began to have problems (think Greece, Spain, Portugal and Ireland), firms began trading their Euros for Swiss francs (the Swiss have a long-held reputation for having a strong financial system). However, Switzerland is an exporter. They sell goods and services primarily to other European countries. When the Swiss franc increased in demand and the Euro fell in demand, the Swiss franc became more expensive, and it became harder for Swiss firms to sell their goods and services to other European countries. The SNB created a cap in 2011 to protect their exporting firms.

How did the SNB create a "cap"?

A country can peg its currency to another currency by buying and holding large sums of a particular currency. SNB did just that: bought and held various, depreciating European currencies like the Euro. Makes sense, right? If you bought and held a large stake in a foreign currency, your net worth would be tied to that currency. This is not entirely uncommon, and is the same mechanism Tim Geithner accused China of using when he said China is "manipulating its currency". If you don't remember, click here.

Ultimately, this cap means that as the value of the Euro decreased, so did the value of the Swiss franc.

Why did the SNB lift the "cap"?

In a way, the US and the Eurozone have been dealing with the same global recession, but in two different ways. In Europe, nations have imposed "austerity" measures. This is particularly evident in Greece, where the Eurozone has been requiring the country to impose higher taxes and cut spending. In the US, the Federal Reserve has taken to several rounds of "quantitative easing." The Federal Reserve has spent billions nearly every month on bonds in recent years to prop up the financial system. (The Fed spends money on financial firms' assets. Financial firms can sell their assets for more money. This means that financial companies have more cash. If competing financial firms have excess cash, they can't charge borrowers as much to lend that money, and interest rates go down. Ultimately, it's cheaper for borrowers to make investments.)

The American method appears to be attractive to the Eurozone. But another thing happens when you have excess cash in your financial system; the value of your cash depreciates. 

It looks like the Swiss National Bank is afraid of quantitative easing in the Eurozone. If quantitative easing proceeds, AND the SNB is committed to pegging the exchange rate, the easing would further depreciate the Swiss franc. While this may sound like good news because the Swiss watch you've been eyeing is getting cheaper and cheaper, this may not be so good for the Swiss. In real terms, letting the currency become worth less and less, means that the country is becoming increasingly disenfranchised. Get it? The value of the country's holdings (i.e. money, assets, everything denominated in Swiss francs) become worth less and less. This is why they removed the cap.

How did the SNB lift the "cap"?

They will stop their practice of buying and holding weaker currencies.

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.

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."

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.

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."

New Risk Rules Add Hurdle for Project Loans

Impending changes in the risk-based capital rules for banks are starting to affect the terms and pricing of some high-leverage construction loans.

The U.S. version of the "Basel 3" guidelines, which take effect Jan. 1, sharply increases the amount of capital banks must hold in reserve against "acquisition, development or construction" loans unless the leverage is 80% or less and the borrower’s up-front capital contribution is at least 15% of the project’s value.

While most bank loans would fall well under the 80% leverage limit, the equity requirement is proving to be an obstacle for some deals — largely because the 15% threshold is based on the estimated value of a project "as completed," rather than the cost of construction.

As they start negotiating loans that may close after the first of the year, banks are informing borrowers that they’ll need to put up enough cash to meet the new requirement, or pay a higher interest rate to compensate for the cost of holding additional risk-based capital, according to industry pros.

Complicating the calculations are some gray areas in the new regulations, adopted last year by the

Comptroller of the Currency, the Federal Reserve and the FDIC to conform with the Basel 3 standards set by the Bank for International Settlements. The regulators haven’t spelled out just what "as completed" means, said George Green, associate vice president of commercial/multi-family policy at the Mortgage Bankers Association.

"Is that stabilized, is it non-stabilized?" Green said. "The value of an income-producing property is based on its leased income. Significantly different values are generated if a building is substantially leased versus minimally leased."

The higher the projected value of the completed property, the more cash the borrower would have to provide upfront to reach the 15% threshold. The rules also mandate that those funds remain committed to the project until the loan is retired or converted into permanent financing meaning the developer can’t draw out leftover cash as a project nears completion.

Construction loans that don’t meet the leverage and borrower-equity requirements must be treated as "higher volatility commercial real estate" under the Basel 3 rules. Loans in that category will be subject to a risk weighting of 150%, while most other commercial mortgages will be weighted at 100% and certain multi-family loans will qualify for a 50% weighting. Banks are generally required to hold capital against 8% of the balance of their loans, but the higher risk weighting will bump that up to 12%.

While many banks have already set new lending standards in response to the rules, others are still working out the details. "It seems more banks are just waking up to this new regulatory environment," said one originator.

Some banks are starting to put language into preliminary loan agreements stating that the proposed pricing can change if the estimate of the project’s "as completed" value comes back higher than expected and the borrower’s equity doesn’t reach 15% of that figure.

One broker said he was already seeing signs that some banks are cutting back on construction lending to avoid the new capital charges.

Another industry pro said he knew of a few cases where banks walked away from potential deals when their calculations showed the loans would fall into the higher-volatility category.

 

Philadelphia Area Fourth Quarter 2013 Apartment Market Report

Economy on Sound Footing, Driving Apartment Sales

Respectable job growth and the formation of new households reduced vacancy in the Philadelphia metro over the first nine months of 2013 and is supporting a strong multifamily sector. Nearly every private-employment sector added workers during the period, though many industries still have additional hiring to do to recapture all of the positions lost during the downturn. Job opportunities in degreed fields or those requiring specialized training, such as healthcare, are available, but lower-skilled workers continue to face challenges. Specifically, deficits to former peak staffing levels in retail and wholesale trade persist and may be suppressing the performance of apartment buildings on the lower rungs of the quality scale. Economic trends are pointing upward, however, which could hasten the pace of hiring in lagging employment sectors in the quarters ahead. A recent regional survey by the Federal Reserve showed a rise in the index of new orders for goods and services and also signaled improved prospects for hiring.

Although investor demand outweighs the number of properties listed for sale, deal volume continues to surge. Nonetheless, the recent rise in long-term interest rates is motivating additional owners to place properties on the market. Generally, for owners contemplating a sale in the next year or two, the current bidding climate and the relatively modest rise in interest rates improves the probability of executing a transaction. Lenders are competing to provide acquisition loans, with leverage reaching as high as 80 percent. In many instances, local and regional banks have emerged as more competitive sources than the agencies. Cap rates are virtually unchanged from six months ago, and healthy disparities persist between first-year returns on different classes of assets. Class A properties, for example, typically trade in the low- to mid-5 percent range, while Class B properties change hands in the mid-6 to low-7 percent band. Cap rates for Class C or lower-quality properties with working-class tenancies typically start in the mid-8 percent range, though many deals settle closer to 9 percent.

2013 Annual Apartment Forecast

• Employment: Payrolls will swell by 33,000 jobs in 2013 to expand employment in the metro 1.2 percent. Growth in education and health services employment underpinned the creation of 28,700 positions in 2012.
• Construction: Projects containing 3,400 units will come online in 2013, up from 1,278 rentals last year. New stock will be placed in service in 10 of the metro’s 16 submarkets. The greatest impact is in Center City, where 1,429 new rentals will expand stock 4.6 percent.
• Vacancy: Vacancy will decline 30 basis points this year to 4.9 percent, the lowest year-end level in six years. The vacancy rate was unchanged in 2012.
• Rents: Following a 1.1 percent bump in 2012, average rents in the metro will rise 2.6 percent this year to $1,128 per month. With the projected increase, rents will have climbed 10 percent since bottoming four years earlier.

https://www.marcusmillichap.com/services/research/webreports/Philadelphia/Apartment.aspx

 

Rep. Frank: Revamped Mortgage Rules a ‘Grave Error”

Summary:  The Federal Reserve and the Federal Deposit Insurance Corp. are against a new rule in the Dodd-Frank law requiring those underwriting mortgage securities to retain 5% of the credit risk on their books.  Barney Frank, an author of the bill, believes this to be an error.

Washington, D.C.  --(WSJ Developments)--
An architect of the 2010 Dodd-Frank law is accusing federal regulators of watering down new mortgage rules in the face of opposition from the housing industry.

Former Rep. Barney Frank (D., Mass.) slammed federal regulators for their decision to dial back a proposal to impose new rules on the mortgage-securities market–a key piece of the Dodd-Frank law that bears Mr. Frank’s name.

“This is a grave error, and contrary to the assertion that it would best carry out the statutory intent, significantly repudiates it,” Mr. Frank wrote in a comment letter being sent to regulators Tuesday.

At issue is a proposal from August by six regulators — including the Federal Reserve and Federal Deposit Insurance Corp. — to revamp proposed rules requiring issuers of mortgage securities to retain 5% of the credit risk on their books. Supporters of this requirement, including Mr. Frank, argue it will force Wall Street to be more cautious when packaging assets such as mortgages into securities.

The regulators’ original proposal from 2011 contained a narrow exemption focusing on only high-quality loans, where the borrower brings a 20% down payment and meets other stringent criteria. But a proposal released in August for the so-called “qualified residential mortgage” exemption is much broader and covers most loans being made today.

Mr. Frank castigated the regulators, saying they are heeding a fierce lobbying campaign from the real-estate industry. Mortgage lenders, real-estate agents, home builders, civil-rights groups and consumer advocates formed a group, called the Coalition for Sensible Housing Policy, that lobbied heavily against the original proposal for tighter rules.

“If all of these people were correct in their collective judgment, we would not have had the crisis that we had,” Mr. Frank wrote. “More importantly, what their arguments reflect, and what I believe unfortunately is carried over in proposal, is the view that things must always be exactly as they are today.”

Lawmakers have offered competing interpretations about what they intended in drafting this piece of Dodd-Frank. Several Senators, including Sen. Johnny Isakson (R., Ga.) and Kay Hagan (D., N.C.) have argued the law calls for a broad exemption and were key players in a push to eliminate a 20% down-payment requirement from the original proposal.

Speaking on the Senate floor this month, Mr. Isakson said banking regulators “did a great job” in revamping the rule.

The new proposal largely adopts a separate mortgage definition put forward earlier this year by the Consumer Financial Protection Bureau that outlines steps banks must take to demonstrate that a borrower has the ability to repay a mortgage. Regulators also asked for comment on an alternative definition that would add a 30% down payment to the exemption requirement.

Some regulators also have been critical of the new proposal. Daniel Gallagher, a Republican member of the Securities and Exchange Commission, issued a 3,000-word dissent to his agency’s August vote, saying the proposed exemption was “unrealistic and dangerously broad.”

Mr. Frank argues regulators are ignoring the essential purpose of Dodd-Frank — to force changes in the financial market.

“I understand that since risk retention is a new concept, people in various phases of the business of housing are unused to it, and do not like the changes it will force in their operation,” he wrote, “But the very purpose of the statute was in fact to bring about changes in a number of areas in our financial life, residential mortgages foremost among them.”

The Fed’s predicament in three paragraphs (Be the Fed)

Summary:  The Fed has few options in driving mortgage rates back down when not tapering hasn't done enough.  Lowering the Fed Funds Rate is pointless when you're virtually at 0%, forward guidance has little effect on long term rates, false, negative forecast may bring rates down, but will also stall economic activity, false positive forecast could bring rates up, which is self-defeating.  Basically, the Fed is out of options.

St. Croix --(CreditWritedowns.com and The Center of the Universe)--


So imagine you are a moderate FOMC number.

Mortgage apps are down, new home sales marginal, and private sector job creation sagging. And you keep revising your GDP forecast lower at each meeting. Likewise inflation remains low, and you believe the risks are asymmetrical. That is, you know you can stop inflation and growth with rate hikes, but you’re not so sure about fighting deflation.

And so, as an FOMC member, you’d like to see mortgage rates back down. So how do you get them there? You might not like QE, and at least highly suspect it doesn’t have any first order effects, and you fear there are unknown costs, but you know tapering, for whatever reason- almost to the point the reason doesn't matter- causes rates to go higher. And you know not tapering brought them down some, but not enough. Fed funds are already close to 0% so there’s no room there. Forward guidance, etc. has kept the short end low but not the long end. You are afraid to simply peg long rates with an unlimited bid for securities at your target rate. You know a weaker economic forecast will bring long rates down but that it would be intellectually dishonest to manipulate a forecast.

And maybe worst of all, if you do something that causes markets to believe the economy will do a lot better, mortgage rates go higher, presuming Fed rate hikes will accompany growth, and thereby make things worse instead of better.

http://www.creditwritedowns.com/2013/10/the-feds-predicament-in-three-paragraphs.html

http://moslereconomics.com/2013/10/25/be-the-fed/