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In a nonrecourse real estate loan to a partnership, the loan documents will often provide that if specific trigger events occur (a “nonrecourse carve-out”), personal liability will be imposed on the general partner or managing member and on a guarantor under a separate nonrecourse carve-out guarantee (a ‘“bad boy’ guarantee”).  A highly controversial IRS ruling on this common real estate financing feature recently caused concern in the real estate finance industry because the ruling called into question well-recognized tax rules relating to the use of nonrecourse debt in most real estate financing transactions.  Following strong opposition from the industry, the IRS withdrew its ruling.   This article summarizes the background and significance of the ruling and why the IRS decided to reconsider.

Section 1.752-2(b)(4) of the Treasury Regulations states: “If a payment obligation would arise at a future time after the occurrence of an event that is not determinable with reasonable certainty, the obligation is ignored until the event occurs.” Tax practitioners have viewed nonrecourse carve-out provisions that are triggered by the voluntary “bad acts” of a borrower, which include fraudulent actions or voluntary actions that adversely affect the value of collateral, impair or reduce its cash flow, or impede or delay a lender’s foreclosure of a mortgage, as within the scope of this provision, and therefore ignored until the triggering event occurs.

The IRS Office of Chief Counsel released legal memorandum 201606027 (the “IRS Memorandum” or “Memorandum”) that called into question two fundamental and well-established aspects concerning the tax treatment of investors in real estate limited partnerships and limited liability companies that utilize non-recourse financing. The Memorandum concluded that a customary “bad boy” guarantee given by an LLC member in connection with the LLC’s real estate non-recourse financing was sufficient to cause the financing (a) to constitute a “recourse” liability for purposes of determining the members’ tax basis in the LLC and (b) to fail to be a “qualified non-recourse financing” under the at-risk investment rules.  As a consequence, the non-guaranteeing members of the LLC were deprived of the necessary tax basis and at-risk investment to claim losses from the LLC in excess of their capital contributions.  If this position had become established law, real estate investors would have had to recapture billions of dollars in losses from previous years and would not have been able to share in losses in excess of their equity capital going forward.


To claim tax losses from a partnership (including an LLC taxed as a partnership), a partner must have sufficient tax basis and “at-risk” investment in his partnership interest. In a typical real estate partnership, a partner’s tax basis and at-risk investment is derived from his equity contribution plus his share of partnership “recourse” liabilities and his share of “non-recourse” liabilities (in the case of computing tax basis) and his share of “qualified non-recourse financing” (in the case of computing at-risk investment).  Recourse liabilities are those for which a partner bears the economic risk of loss, whereas non-recourse liabilities are those for which no partner bears the economic risk of loss.  Likewise, a qualified non-recourse financing is a financing meeting certain conditions, including that no partner has personal liability for its repayment.  Recourse liabilities are allocated only to the partner who bears the risk of loss with respect to the liability, while non-recourse liabilities and qualified non-recourse financings are generally allocated among the partners in accordance with the manner in which they share partnership profits.

For purposes of determining whether a partner bears the economic risk of loss with respect to a partnership liability under the tax basis rules of Section 752 of the Internal Revenue Code of 1986, as amended (the “Code”), and the Treasury Regulations thereunder, all statutory and contractual obligations relating to the liability are taken into account, including, for example, a partner guarantee of partnership debt. However, a guarantee obligation will be disregarded “if, taking into account all the facts and circumstances, the obligation is subject to contingencies that make it unlikely that the obligation will ever be discharged.”  Treas. Reg. § 1.752-2(b)(4) (emphasis added).  Further, if an “obligation would arise at a future time after the occurrence of an event that is not determinable with reasonable certainty, the obligation is ignored until the event occurs.”  Treas. Reg. § 1.752-2(b)(4).  Before the release of the IRS Memorandum, it was well-settled that a “bad boy” guarantee was a “contingent liability” and should be disregarded for purposes of determining whether the guarantor bore the economic risk of loss for the underlying debt because in practice it is unlikely that the guarantee would ever be triggered.



Most real estate partnerships use a combination of equity and non-recourse financing to fund their real estate acquisition and/or development activities. In this context, non-recourse financing means the lender will look only to the assets of the partnership and not to the partners to repay the loan, except that the lender often requires the sponsoring or managing partner to give a so-called “bad boy” guarantee.  A “bad boy” guarantee is triggered only upon the occurrence of certain events that would jeopardize the lender’s ability to be repaid from the partnership’s assets and that are within the control of the sponsoring or managing partner.  “bad boy” events often include the partnership’s voluntary bankruptcy filing, the managing partner’s filing of an involuntary bankruptcy petition against the partnership, etc.  In practice, “bad boy” guarantees are rarely triggered because the trigger events are within the control of the party providing the guarantee, and it generally would make no sense for the guarantor to voluntarily expose himself to full liability on the loan.

IRS Memorandum 201606027


The IRS Memorandum dealt with the following facts. An LLC, treated as a partnership for tax purposes, and its subsidiaries borrowed funds from a lender on a non-recourse basis to support their real estate activities.  One of the LLC’s members (the “NRG Member”) provided a customary “bad boy” guarantee, obligating him to repay the loan in full if the LLC failed to obtain the lender’s consent before obtaining subordinate financing or transferring the secured property, if the LLC filed a voluntary bankruptcy petition, or if the NRG Member colluded or cooperated in an involuntary bankruptcy petition of the LLC.

Analysis of IRS Memorandum 201606027

The Memorandum is dated October 23, 2015 and was released by the IRS on February 5, 2016. It was authored by the IRS Office of Chief Counsel.  The Memorandum ignored customary real estate industry practice and concluded that for purposes of allocating partnership tax basis among the LLC’s members, the NRG Member’s guarantee caused the LLC’s financing to constitute a recourse liability under Section 752 of the Code, thereby requiring the liability to be allocated entirely to the NRG Member and therefore depriving the LLC’s other members of any share of the liability in computing their tax basis in the LLC.  The IRS Memorandum also concluded that the NRG Member’s guarantee caused the LLC’s financing not to constitute a “qualified non-recourse financing.”

In reaching its conclusion that the LLC’s financing constituted a recourse liability under Section 752, the Chief Counsel reasoned that the mere enforceability of a guarantee under local law is generally sufficient to cause the guarantor to be treated as bearing the risk of loss for the guaranteed liability and that because the NRG Member could potentially be called upon to discharge his guarantee obligations before an actual payment default by the LLC, the trigger events contained in the guarantee were not “conditions precedent” that had to occur before the lender was entitled to seek repayment from the NRG Member.[2]  While it may be true that a trigger event under the guarantee could occur, and thus the NRG Member’s payment obligation likewise triggered, before an actual payment default by the LLC, it is difficult to see how the trigger events should not be viewed as conditions precedent to the NRG Member’s payment obligations because in the absence of the occurrence of any trigger event, the NRG Member would not be obligated to make a payment, and the NRG Member had every incentive not to cause a trigger event since by doing so he would voluntarily expose himself to full personal liability on a troubled loan.  The Chief Counsel attempted to bolster its position by arguing that even under Section 1.752-2(b)(4) of the Treasury Regulations (dealing with contingent obligations), the trigger events do not constitute “contingencies” that would make the NRG Member’s payment obligation unlikely to occur.[3]  It failed, however, to address the second part of that regulation, which requires a contingent payment obligation to be disregarded if it would only arise at a future time after the occurrence of an event that is not determinable with “reasonable certainty.”[4]  Given that “bad boy” guarantees, including the one at issue in the IRS Memorandum are triggered, if at all, only upon the occurrence of specified future events, which industry experience reveals rarely occur, it is unclear why further analysis was not given to this provision.  For example, voluntary bankruptcies and collusive involuntary bankruptcies almost never occur now because of a guarantor’s full recourse liability under standard “bad boy” guarantees.

In reaching its conclusion that the LLC’s financing did not constitute a “qualified non-recourse financing” under the at-risk rules of Section 465 of the Code, the Chief Counsel stated:

“When a member of an LLC treated as a partnership for federal tax purposes guarantees LLC qualified nonrecourse financing, the member becomes personally liable for that debt because the lender may seek to recover the amount of the debt from the personal assets of the guarantor . . . [and] the debt is no longer qualified nonrecourse financing . . . It should be noted that this conclusion generally will not be affected by a determination that the guarantee is a ‘contingent’ liability within the meaning of section 1.752-2(b)(4). Instead, the question is simply whether the guarantee is sufficient to cause the guarantor to be considered personally liable for repayment of the debt, based on all the facts and circumstances . . .”

Reaction to IRS Memorandum

Although the IRS Memorandum was not precedential authority and could not be relied upon by the IRS in other cases, it was released by the National Office of the Chief Counsel, so it signaled that the IRS may have intended to take a more aggressive approach in its treatment of “bad boy” guarantees.[5]  And if the IRS did not withdraw the Memorandum, real estate investors would face uncertainty that goes to the heart of the economics of many investments.  Investors could have ignored the Memorandum on the theory that it was illogical, contrary to standard practice in the real estate financing market and unlikely to be sustained by the courts.  They could also could have pressured lenders to forego “bad boy” guarantees, but that might have been difficult since lenders also consider such guarantees to be standard industry practice.  They could have considered structuring guarantees that are arguably distinguishable from the IRS Memorandum, such as obtaining a guarantee from a non-member manager that has no interest in partnership or LLC profit and loss, although since such a manager is likely to be an affiliate of a transaction party, this approach might be vulnerable.  Or they could have attempted to structure “bad boy” guarantees as being limited to the actual loss incurred by the lender resulting from the trigger event, rather than full recourse on the loan, which might have resulted in only a portion of the loan being treated as a recourse liability.  Negotiating such a position, however, was unlikely to be successful, as lenders would have insisted on full recourse liability with respect to Special Purpose Entity violations, voluntary and collusive involuntary bankruptcy filings, and impermissible transfers and encumbrances of the secured property.

This position would have prevented the non-guaranteeing members from being able to deduct partnership/LLC losses in excess of their equity contributions. Such a result would obviously have had a huge negative tax impact on thousands of past, present and future real estate partnerships and LLCs.

In response to the Memorandum, a small task force from the Real Estate Roundtable, including Joe Forte of Kelley Drye & Warren LLP, drafted an industry position paper and met with IRS Chief Counsel William Wilkins to share the real estate community’s concerns. The meeting was held on March 8th at the IRS in Washington, and was attended by Mr. Wilkins and eight other attorneys from the IRS.  At the meeting, Joe Forte described the legal and practical evolution of the particular “bad boy” guarantee at issue in the Memorandum. The participants explained to the IRS, among other matters, that the “bad boy” guarantee is a device to prevent the borrower from taking certain voluntary actions, such as a bankruptcy filing, and the guarantor is very unlikely to ever take any of the prohibited actions or have liability on the guarantee.

We believe the IRS was concerned that this admission of insolvency provision, which is included as a matter of course in the boilerplate language contained in most commercial loans, could be construed as giving a lender a “back door” means of enforcing recourse liability on the borrower or guarantor, without a voluntary “bad boy” action on the part of the borrower. The Real Estate Roundtable consulted with market participants and practitioners involved in negotiating and drafting nonrecourse carve-out provisions, including the admission of insolvency provision, to understand why it is in loan agreements, how the provision is understood by the parties and how it is enforced.

Since before the Great Depression, the admission of insolvency provision has been routinely included as a specific event of default in mortgage loan documents as the state insolvency law analogue to the provision that makes filing a voluntary federal bankruptcy petition an event of default.[6]  Since the mid-1980s when the life insurance industry first introduced nonrecourse carve-out provisions for voluntary borrower bankruptcy filings into their loan documents, an admission of insolvency, as well as bankruptcy filing, have been among the voluntary bad acts of borrowers enumerated in nonrecourse carve-out clauses that trigger recourse to borrower and “bad boy” guarantors.

The essential bargain between borrower and lender that permits nonrecourse financing is that the lender agrees not to pursue recourse liability directly or indirectly against the borrower or its principals provided that the lender can comfortably rely on the assurance that the value of the financed property will not be diminished or impaired, or the cash flow from the property disrupted, or the lender’s realization on the property delayed or prevented by “bad acts” of the borrower.

As the admission of insolvency provision is the state insolvency law equivalent of the ““bad boy”” clause which acts as a disincentive to borrower’s voluntary bankruptcy filing, its principal purpose is to disincentivize the borrower from initiating a state-level insolvency proceeding under state statutes. An admission of insolvency by the borrower generally is a prerequisite to initiating a state law receivership, and the language in the admission of insolvency clause is similar or identical to the language found in state insolvency laws. As the term insolvency is not considered to be susceptible to exact definition and has been recognized as having several distinct meanings, it is often defined within a specific statutory scheme.[7]  Moreover, in the absence of an ability to obtain a discharge of its obligations under an insolvency statute, it is unlikely that any borrower would seek protection under state law instead of filing for bankruptcy. In the absence of an express, voluntary action on the part of the borrower, we do not believe that this provision is designed or intended to create a mechanism to force recourse liability on the borrower or any nonrecourse guarantor. We are aware of no case law in which a borrower or a “bad boy” guarantor was held liable for a debt under this provision.[8]

The mere fact that a borrower may be insolvent or unable to pay it debts does not trigger recourse liability under the admission of insolvency provision — it requires a voluntary written express statement of the borrower to the effect that it is insolvent or unable to pay its debts as they become due.[9]  In Zwirn, delivery of a financial statement showing liabilities exceeding assets was not considered such an admission. Thus, an admission of insolvency by the borrowers must be a voluntary affirmative act, similar to filing for bankruptcy protection.

On April 15, 2016 the IRS Office of Chief Counsel released a new memorandum (“New Memorandum”) reversing the position taken in the original Memorandum. The New Memorandum acknowledged that a “carve-out” or “bad boy” guarantee is a device to prevent the borrower from taking actions which violate the terms of the loan in a manner which might harm the value of the property or interfere with the lender’s exercise of remedies. The IRS concluded that the adverse financial impact to the guarantor resulting from the prohibited acts would be contrary to the guarantor’s self-interest, making the acts and resulting personal liability very unlikely to occur. The IRS acknowledged that the “bad boy” acts were all voluntary acts of the guarantor, not matters which a lender could use to enforce personal liability in the absence of specific voluntary actions. Therefore, the New Memorandum concludes that a “bad boy” guarantee does not cause a non-recourse loan to become recourse unless one of the enumerated “bad boy” acts actually occurs.

Although withdrawal of the original Memorandum had been anticipated by the real estate industry as a result of the meeting with the IRS, issuance of the New Memorandum removes a cloud over the tax treatment of “bad boy” guarantees. Nonetheless, lenders counsel creating new “bad boy” full recourse guarantee events, and borrower and guarantor’s counsel reviewing “bad boy” full recourse carve-out events in proposed loan documents should consider the possible ramifications of the new guarantee provision on the qualified nonrecourse financing tax status of the transaction and possible heightened risk of borrower bankruptcy.

[1]               See, e.g., McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners, 4th Edition, Volume 1, p. 8-12 (“For example, an otherwise nonrecourse real estate loan is not transmuted into a recourse debt with respect to which the partners bear the economic risk of loss simply because they agree to pay the loan if the partnership . . . makes a voluntary bankruptcy filing.”).


[2]               This reasoning appears to run counter to the conclusion reached in Example 8 of Section 1.752-2(f) of the Treasury Regulations, where a general partnership (and its general partners) agreed with the lender that an otherwise non-recourse loan to the partnership would become recourse (and thus an obligation of the general partners) if the partnership failed “properly to maintain” the property financed with the loan. The Example concludes that because there was no “reasonable certainty” that the partnership and its partners would have any liability resulting from the partnership’s failure to maintain the property, no partner bore the economic risk of loss with respect to the loan and the loan was therefore a non-recourse liability.


[3]               The Chief Counsel points to Section 1.752-2(b)(1) of the Treasury Regulations, which sets forth the framework for determining generally whether a partner bears the economic risk of loss for a liability by asking whether if, following a hypothetical liquidation of the partnership, the partner would be obligated to make a payment to any person because that payment becomes due and payable and the partner would not be entitled to reimbursement from another partner. The Chief Counsel reasoned that under a hypothetical liquidation of the LLC, it would be more likely than not that one or more of the trigger events would occur. According to the Chief Counsel, therefore, the trigger events do not constitute contingencies under Section 1.752-2(b)(4) of the Treasury Regulations.


[4]               The IRS also suggests that the language of the guarantee would require the guarantor to satisfy its payment obligation merely upon a payment default by the partnership, without regard to whether any of the trigger events in the guarantee had occurred, perhaps puzzled over language in the agreement that described the guarantor as a “primary obligor.” See Footnote 2 of the IRS Memorandum.


[5]               Speaking at a conference on February 23, 2016, an attorney-advisor for the Treasury Office of the Tax Legislative Counsel stressed that the Memorandum was limited to the particular taxpayer to whom it was issued and said that it was her understanding that the IRS focus in the Memorandum may have been on the specific carve-out exception relating to assignments made for the benefit of creditors or admitting to insolvency or inability to pay debts as they become due, although the Memorandum did not focus its analysis on this carve-out.


[6]               Barth v. Backus, 140 N.Y. 230, 35 N.E. 425 (1893).


[7]               See 30 N.Y. Juris. 2d § 193, p. 229 (2006).


[8]               See D.B. Zwirn Special Opportunities Fund, L.P. v. SCC Acquisitions, Inc., 902 N.Y.S.2d 93 (App. Div. 2010).


[9]               See Magten Asset Mgt. Corp. v. Bank of N.Y., 15 Misc. 3d 1132(A) (Sup. Ct. 2007).


Estimated Losses Spill Over To Oil Exposed Loans


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After a year and a half of falling oil prices, the downturn’s rippling effects have spilled over into energy related CMBS loans. Based on our analysis, we have identified $684 million of CMBS 2.0 oil exposed loans and REO in Kroll Bond Rating Agency (KBRA) rated (21     ) and non-rated transactions (7) that have been designated KBRA Loans of Concern (K-LOCs). K-LOCs include specially serviced and REO assets as well as non-specially serviced loans that are at a heightened risk of default in the near term.

In its ongoing monitoring process, KBRA has placed increased scrutiny on identifying and monitoring loans in energy driven markets. The time lag between declining oil prices and commercial real estate fundamentals appears to have run its course, particularly in the Bakken Shale Region of North Dakota. As a result, KBRA has been refining its property valuations and loss estimates considering current and expected market conditions in the region. The estimates also factor in costs and expenses associated with liquidating the collateral.

KBRA identified 37 CMBS 2.0 loans and one REO across 28 CMBS transactions with collateral located in oil and gas related markets. The details of these individual assets, as well as our loss estimates, are listed in the Appendix. Properties secured by 24 of the loans and one REO are located in North Dakota, and 11 are in Texas. In addition, two loans are collateralized by properties in Colorado and Oklahoma. By state, the largest loss exposure is in North Dakota where the majority of the assets are found in the Williston and Dickinson markets.

Of the 38 K-LOCs, 30 were assigned estimated losses totaling $162 million. In the aggregate, for the K-LOCs with losses, the weighted average loss severity is 54.3%. Loss estimates were as high as 87.9%, with North Dakota ranging from 23.8% to 87.9% (weighted average of 63.7%) and Texas from 7.4% to 29.3% (weighted average of 17.9%). The largest loss severity was associated with the North Dakota Strata Estates Suites REO asset, which represents 1.9% of the COMM 2013-CR10 transaction. The trust collateral includes two corporate housing projects that at issuance had 77% of the units leased to energy related companies.

The other eight K-LOCs included six from Texas and one each from Colorado and Oklahoma. K-LOC status was assigned to six office properties with oil related tenants, as well as two hotels which generate business from the energy industry. Although, losses were not assigned at this time, the loans are at increased risk of default, as energy related companies reduce their workforce, which in turn impacts their space requirements as well as room night demand for hotels.

Additional information on the K-LOCs and assigned losses are available on our KBRA Credit Profile (KCP) Portal (kcp.kbra.com), a proprietary service that performs monthly transaction monitoring for much of the CMBS universe.

Multifamily and Lodging Most Affected

Oil related economies and companies have been contracting, thereby reducing demand for workers and investments in oil exploration and production. Most affected have been those areas with a high concentration of workers in energy-related jobs. According to the US Department of Labor, North Dakota’s oil and gas employment accounted for 4.8% of its workforce (see Chart 1). As a result, with oil’s plunge, North Dakota’s mining and logging employment growth, most of it related to oil drilling, has turned sharply negative (see Chart 2) on a year-over-year basis. Most impacted has been the Bakken Shale Region as production has slowed and oil rigs idled. Although, this region makes up only a small percentage of the CMBS population, KBRA’s loss estimates for K-LOC’s in this area are fairly high. Furthermore, they have the potential to increase if the global oil glut continues for an extended period.

Article 14 Chart 1

Article 14 Chart 2

By property type, most affected have been the multifamily and lodging sectors. Due to their short term leases they adjust to downturns much more quickly than the other major property types. Multifamily properties typically have fairly short term leases (one year or less) when rents can be adjusted, while lodging room rates can change daily. Individual K-LOC losses run as high as 87.9% and 63.4%, respectively for these two property types. In total, the loss severity is 71.1% for multifamily and 38.6% for lodging. Employment losses have led to less demand for apartments in the energy dominated markets, while new projects continue to come on line and add to existing supply. Energy related companies in these markets have reduced or eliminated corporate leases while laid off workers migrate to other states for employment opportunities. In one of the most affected markets, Williston, multifamily asking rents have declined from approximately $2,100 to $1,500 year-over-year through December 2015 according to our review of CoStar Group data. Other third party sources including Apartment Guide indicated that this figure could be lower.

With the demand for lodging, new hotels opened to help handle the flood of oil workers. Not only are the more oil dependent economies experiencing declining hotel occupancies and rates, but due to its exposure to the oil and gas business, Houston lodging has experienced weaker demand. According to Smith Travel Research (STR), on a full year-over-year 2015 comparison, Houston’s RevPAR fell by 3.3% primarily the result of lower occupancies. For all US markets, RevPAR increased by 6.3% during the same period. Vacant office space is also increasing in Houston, as companies reduce their space requirements through lease terminations, nonrenewal of expiring leases, and sublease of their excess space. We have identified $217 million of Houston office loan collateral that were assigned K-LOC status.

For the other major property types, retail is expected to be impacted especially in markets where there have been major employment losses, with fewer shoppers to support existing centers. Warehouse space may also come under pressure especially for facilities used for storing oil drilling supplies and equipment.

KBRA believes that the fallout from the oil decline will mostly be confined to those properties in energy related markets. However, in these and other markets, CMBS collateral with tenants that are primary and ancillary suppliers to the energy sector may ultimately succumb to the downturn’s persistence.





Specialty CRE Lenders bask in the Sunlight

The late Rock and Roll Hall of Famer Davie Bowie admonished us in his 1970s classic to be aware of ch-ch-ch-ch-changes. Developers and borrowers in 2016 would do well to heed this advice.   The commercial real estate (CRE) lending environment is going through a historic metamorphosis that is changing the players providing CRE debt. CRE lending has historically been led by commercial banks which, according to the Federal Reserve, control about half the $3 trillion CRE debt market. This market dominance is now being challenged by non-regulated Specialty CRE Finance Companies (CRE FinCo), lenders unfazed by the recent wave of US and international rules that pressure banks to limit their CRE exposure.

Banks traditionally were the “go to” source for debt capital on transitional assets: bridge loans, construction loans and mini permanent loans. This is now changing. With the publication of Basil III in 2009 and the passage of Dodd Frank in 2010, new bank lending and reserve rules were required (it is noteworthy that some of the most important rule changes did not become effective until last year, while others have still yet to be implemented). These rules are meant to keep banks from incurring excessive risk in real estate.

In 2015, the FDIC, the OCC and the Federal Reserve began requiring banks to treat certain CRE loans differently. These loans are classified as Highly Volatile Commercial Real Estate or HVCRE loans. HVCRE loans include credit facilities used to finance the acquisition, development or construction of real property (ADC loans), and enhanced reserve requirements apply throughout the life of the loan. There are also a number of important exemptions to this rule including loans that finance:

  • 1-4 family residential properties;
  • Community development loans;
  • The purchase or development of certain agricultural land; and
  • Other commercial real estate projects in which the loan-to-value (LTV) ratio is less than a supervisory ratio established by bank regulators (see box), and the borrower has contributed equity of at least 15 percent of the appraised “as completed” value.

Note that the equity requirement is fulfilled when the borrower has contributed cash equity of at least 15% of the appraised “as completed” value before the advancement of any bank funds, and that equity cannot be reduced during the term of the loan. This equity must come from the “borrower”. Borrowers cannot meet this requirement with additional real estate collateral. Costs paid for land and certain development expenses can count toward the equity requirement, but the current value of land is not considered in this calculation. As a result, the equity value associated with land acquired 10 years ago will be limited to the purchase price of the land, versus the current market value! Similarly, 3rd party grants, because they do not come from the borrower, cannot count toward the 15% Article 13 Chart 1requirement. Mezz debt from a 3rd party lender can fulfill this requirement, as well as fill the gap between the 15% borrower equity and the 80% maximum first mortgage. To be clear, banks are not prohibited from making a HVCRE loan. However, if they do make one, the reserve requirement for that loan jumps 50%.

A survey of representative banks reveals that response to the new rules has been mixed.  Some highly capitalized banks do not see a burden from the additional reserve requirements and have continued business as usual. Other banks have dramatically scaled back balance sheet direct ADC lending. Loans that these banks do make here are done in tiny credit boxes at sub 50% LTVs with platinum borrowers. Other banks have exited ADC lending altogether in favor of 5-10 year term loans on stabilized properties. The latter strategy appears attractive on the surface due to long term recurring income and low reserves. However, the mismatch between bank short term funding and LT lending could result in problems. Still other banks are adapting to the new regulatory environment by collaborating with CRE FinCo Lenders.

There are many types of companies that fall into the CRE FinCo category. The common characteristic is that they are all capitalized without insured depositor funds and are unregulated by the FDIC, OCC or the Fed. These lenders come in various shapes and sizes: finance companies, mortgage REITS, hedge funds, investment advisors, asset managers, fund advisors, private lenders etc. are all examples of CRE Finance Company Lenders. These firms can be private or public companies. Theoretically, if a CRE FinCo were to become very big, it could be deemed a Systemically Important Financial Institution (SIFI) by the US’s Financial Stability Oversight Council (FSOC). FSOC was created by Dodd Frank and can deem any institution “too big to fail” and thus subject it to new regulations. To date FSOC has largely focused on banks and insurance companies with over $50 billion in assets. This is murky regulatory territory as companies push back on being labeled systemically important. MetLife recently received judicial relief from earlier FSOC imposed oversight. In addition, last summer after much lobbying by Blackstone et, al, the FSOC decided that very large asset management firms did not represent a systemic risk because of the way they are funded and the low probability of rapid failure or bankruptcy.

Banks are interacting with CRE FinCo Lenders on a number of levels. First, banks are embracing mezzanine lenders and preferred equity investors who can augment borrower equity and get ADC loan capital stacks in compliance with HVCRE rules. Banks will also buy an “A” or senior position in CRE FinCo whole loans thereby “manufacturing” a mezz return for the CRE FinCo subordinate piece. This is an amazing turn of events for an industry where many players, just 10 years ago, turned their noses up at the non-banking, knuckle dragging world of CRE FinCo lending. Clearly, such lenders have become more sophisticated and their importance in CRE debt markets has become critical.

Banks are also active in financing CRE FinCos. Larger banks are providing warehouse and repo lines of credit that factor CRE FinCo loans. To be efficient, such lines of credit typically start at $100 million or more. Here the banks tend to advance less than 60% LTV and these structures successfully avoid HVCRE classification. With very large private and mortgage REIT borrowers, banks will consider unsecured facilities that effectively finance ADC loans. Many of these large banking institutions also have substantial investment banking operations. Extensions of corporate or secured credit by such institutions are often with the hope that the bank will get a first look at any I-banking fee business such as CLOs or public offerings.

ADC loans are a staple of liquidity throughout the CRE cycle. In this new regulatory environment, Specialty CRE Lenders have come out from the shade to now play a central role. Most CRE FinCos are not household names and it is a highly fragmented market. It would appear that CRE FinCos are another example of the global growth of non-bank financial intermediation (also known as shadow banking). The trend shows no sign of abetting.  Some industry observers have noted that given that fact that it took bank regulators 8 years post-recession to define new rules, we should not expect CRE FinCos to face central interference any time soon.  As the current regs play out, there will no doubt be a wave of new entrants, failures and mergers in the non-bank space. CRE borrowers and sponsors should pay keen attention since you may likely need to turn to a CRE FinCo for your next bridge or development capital need.






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They say life is tough at the top, but in truth, the largest public and private property companies with a strong balance sheet have relatively easy access to development finance and can often use corporate banking facilities or capital market funding (corporate bond issues, private placements etc.) to fund their development activities cost effectively.

In addition, many banks are willing to lend anywhere in the UK on development projects, provided it is for the right sponsor with the right project in the best location, and at least partially pre-let. International banks are typically more ‘London-centric’ and prefer larger transactions in prime city centre locations.

However, following the introduction of Slotting, UK bank regulation has become more restrictive, and increased regulatory capital requirements have imposed additional costs on development lending, particularly for speculative development. Therefore traditional bank development finance, particularly for speculative development has fallen sharply (see chart below); it is now restricted by leverage (c. 60% maximum Loan To Cost), contingent on pre-lets and usually relationship led.

Article 12 Chart 1

So while banks still dominate the market for senior lending on pre-let and pre-sold developments to large scale REITs and developers, alternative lending platforms are now providing an increasing proportion of development finance for speculative schemes and developers who are outside the group of the largest public and private property companies.

Non-bank alternative lenders are not subject to the regulatory costs imposed on banks, therefore they have stepped in to fill the gap in the market for speculative development finance that banks largely avoid due to regulatory capital charges.



Non-bank alternative lenders are a broad group, operating diverse business models that target specific lending sectors to meet investors’ IRR expectations.

Until c. 18 months ago, many alternative lenders focused mainly on residential or residential-led schemes in London and the South East but most now lend across the UK. Increasingly alternative lenders are targeting purely commercial schemes in major cities and regions across the UK. At Aeriance our debt funds were originally targeted at residential development in the ‘golden postcodes’ in the West End of London, but since 2013 we have been lending against residential and commercial development opportunities across the UK, with an increasing focus outside London

The shift in focus for alternative lenders away from residential development is outlined in the charts provided by De Montfort University in their UK Commercial Property Lending Market Report (see below). The figures for 2015 are expected to confirm that the trend towards diversification across asset classes has continued.

Article 12 Chart 2

Alternative lenders now cover the full spectrum of development finance projects, from senior debt for a refurbishment project, to mezzanine finance for a speculative commercial development.

Due to the diversity of business models, alternative lenders’ IRR targets range from 7% to 20%+ dependent upon the lender’s risk appetite and sector focus; like traditional lenders returns are met through a combination of margin/coupon and fees, though profit shares and other types of return participation can also be considered.

Typically, alternative lenders offer stretched senior loans or whole loans, but some will also consider providing mezzanine debt behind a traditional senior lender. The ability to offer a whole loan solution for developers is a key competitive advantage for debt funds as it provides borrowers with certainty of funding, while reducing the execution risk, timescales, cost and complexity of a more ‘structured’ solution with multiple lenders.

Whole loans are typically available at up to 85% Loan to Cost, though some lenders may stretch to 90% in certain circumstances. This can boost IRR returns for developers to make projects economically viable, reduce the need for joint venture partners, and allow developers to proceed with multiple transactions.

Developers are attracted to the more bespoke and tailored financings offered by smaller debt funds who are more flexible than traditional banks with set credit criteria. Debt funds have the ability to deliver funding solutions quickly, with loans provided in a matter of weeks, often considerably faster than institutional lenders.

Debt funds are also an increasingly popular investment for institutions eager to increase their real estate exposure and benefit from strong fixed income returns, at a relatively low risk.


‘Traditional’ funding options for small developers are very limited compared with those available to their larger counterparts, as only a handful of banks will lend conservatively in the sub-£5 million space.

There are however, several alternative lenders that specialise in funding smaller developments. In addition, the past few years has seen the emergence of a new type of lending platform, the Peer-to-Peer lender. Peer-to-Peer lenders match retail investors’ (ordinary savers) risk appetite with borrowers, making it well suited to financing smaller developments.

Peer-to-Peer lenders offer retail investors fixed income returns that are higher than those available in UK savings accounts, though clearly there is greater risk for the investor as their investment is secured against a property or development project.

Peer-to-Peer lenders operate a range of business models, though many initially fund loans using an existing pool of money, pre-sourced from high net worth individuals or institutional investors before then selling down all or part of the loan to retail investors.

To date, the main sector focus has been residential, though an increasing number are now lending against student accommodation, commercial and mixed-use developments.

Peer-to-Peer lenders have focused on smaller deals with loan sizes range from sub-£1 million up to c. £10 million. Like other alternative lenders, loan pricing varies widely, depending on the usual factors such as location, sector, developer and LTC/LTV. Given the fixed costs of the origination and syndication platform, coupled with the coupon requirements of investors, pricing for smaller developments ranges from 8% – 15%+ coupon, with arrangement and exit fees in addition.

Peer-to-Peer lending is a fast growing and evolving sector of the development finance market. Some platforms are intending to include Peer-to-Peer exposures in tax-free ISAs, and there are vehicles to enable the inclusion of Peer-to-Peer loan exposures in Self Invested Personal Pensions (SIPPs). In future, alternative lenders and banks could move into the Peer-to-Peer space by acting as a conduit for retail investors; therefore this sector of the market is likely to see continued innovation and rapid growth.

One area of concern in relation to Peer-to-Peer lenders is that due to their ‘start-up’ nature and the timing of their entry to the market, their credit and risk management capabilities remain untested.


For many investors, 2015 has been a cyclical ‘sweet spot’, with property companies finding little difficulty in obtaining debt finance if they are a large, established developer with a good track record; and increasing exit prices for completed schemes.

We consider the breadth of funding options for developers to be beneficial for the broader real estate market; diversity of lenders can contribute to financial stability by spreading risk and exposures across a greater range of investors, and increased competition has reduced pricing.

However, looking ahead there are increasing concerns regarding rising site costs, construction costs and potential overheating, particularly in the central London market. The uncertainty over Brexit will also linger until June, though we have seen no evidence of a slowdown in loan enquiries as most developers do not have the luxury of being able to sit on sites which are ready to develop.

On the funding side, many new entrants to the market have yet to experience a downward cycle in the real estate market, others are staffed with experienced former bankers who have worked through a number of recessions and crises.

We anticipate a steady increase in development activity once the Brexit referendum is behind us, as sustained occupier demand is likely to lead to more development; with increased competition among lenders to finance the best schemes.

We expect increased liquidity in the development finance market driven by alternative lenders, as new entrants come to the market and established alternative lenders deploy newly raised debt funds. Bank development lending appetites are likely to continue to be severely constrained by regulatory capital issues.

Increased liquidity is likely to accelerate the trend of lenders looking to the regions to source deals and should increase the availability of speculative development finance. The prevalence of mezzanine development finance is also likely to increase as investors move further up the risk curve to meet their return requirements.

Additional liquidity is likely to lead to lower pricing, though regulatory capital constraints for Banks and investor return requirements for alternative lenders should ultimately put a floor under pricing for development finance.

Wine or Vinegar: How Have 2016 and 2017 Maturing Loans Aged?


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Morningstar Perspective

Morningstar Credit Ratings, LLC projects that paying off commercial mortgage-backed securities loans on time will become progressively more difficult through 2017, as many of the maturing loans aggressively underwritten near the peak of the market remain overleveraged. The balance of CMBS loans scheduled to mature throughout 2017 continues to shrink, with $56.98 billion scheduled to mature in 2016 followed by $99.88 billion in 2017, for a two-year total of $156.85 billion, down 29.5% from $222.48 billion at the beginning of 2015. Using loan-to-value ratios (Chart 1), debt yields (Chart 2), and loan proceeds (Chart 3) benchmarks, Morningstar is predicting a decline in the 2016 maturity payoff rate to about 65%-70%, while the 2017 payoff rate may slide below 60%, depending on the market’s appetite for loans with borderline metrics.


The first year of the so-called three-year maturity wave went well, with the 2015 payoff rate for $60.39 billion of maturing CMBS loans ending at 84.9%, in line with what Morningstar forecast at the end of the first quarter of 2015. The benign interest-rate environment contributed to the high rate of loans paying off at maturity in 2015. In the wake of the decision by Federal Reserve policymakers in December 2015 to raise the benchmark federal-funds rate for the first time in nearly a decade, we factored into our estimates for 2016 and 2017 how an environment of rising interest rates will affect borrowers’ ability to refinance. However, the prospects of a rate increase in the first half of 2016 are fading given market volatility.


Nevertheless, Morningstar expects the payoff rate to dip, as many of the loans scheduled to mature in the latter half 2016 remain overleveraged. In this report, Morningstar excluded certain floating-rate loans because they have not reached their fully extended maturity date, even though that may not be reflected in the servicer data, as reported floating-rate loan maturity dates can be subject to extension options.

Chart 1 – Morningstar Loan-to-Value Ratios: 2016 and 2017 CMBS Maturities

Article 11 Chart 1

Figures may not add to 100% because of rounding  Source: Morningstar Credit Ratings, LLC

2016 CMBS Maturities

The first two months of the two-year peak of the maturity wave have gone well, with the 2016 payoff rate at 85.3% through February. As noted, Morningstar expects $56.98 billion of CMBS loans to mature throughout the final 10 months of 2016, which is based on the balance of performing loans that six months earlier faced impending maturity, as CMBS loans typically can pay off without any fees within three to six months of maturity.

Morningstar has valued $56.79 billion, or 99.7%, of the loans maturing in 2016. After including the loans that already paid off through February and defeased loans, we expect the payoff rate to be about 65%-70%, as 43.0% of the loans maturing this year, with a total unpaid principal balance of $24.52 billion, have loan-to-value ratios greater than 80.0% and may have difficulty refinancing. Morningstar’s historical analysis indicates that an 80% LTV threshold is a reliable barometer of a loan’s likelihood to successfully pay off on time. However, given the market’s appetite for loans with higher leverage, the projected payoff rate would rise to 75% with an increase in the LTV threshold to 85%. By year of issuance, 2006 has the greatest portion of maturing loans, with 76.9%, and 44.0% of the loans originated in 2006 have LTVs greater than 80.0%.

Weaker LTVs among retail and office property loans are a major concern, as the two property types face the greatest exposure with about 30% apiece, by unpaid principal balance, of the 2016 maturities. We project both property types to vie for the lowest payoff

rate, as by combined unpaid principal balance, about half of the loans in each property type have LTVs greater than 80%. The $101.5 million Southern Hills Mall, the second-largest loan in Banc of America Commercial Mortgage Trust 2006-3, and the $140 million Plaza America Towers I and II loan (in Greenwich Capital Commercial Funding Corp. Commercial Mortgage Trust 2007-GG9) are examples of maturing retail and office loans whose refinance prospects may be limited by LTVs of more than 100.0% and debt yields less than 8.0%.

Conversely, Morningstar expects loans with healthcare collateral to have a much better payoff rate, as none of the 2016-maturing loans backed by healthcare facilities have LTVs greater than 80.0%. To keep that in perspective, the $51.2 million in loans backed by healthcare collateral comprise 0.1% of the balance of maturing loans.

Debt yields (based on the most recent 12-month net cash flow) among 2016 maturities tell a similar story. Based on a debt yield of 9.0%, the expected on-time payoff rate is 65.6%, which is in line with Morningstar’s projection based on LTV. However, lowering the debt yield to a less conservative 8.0% increases the successful on-time payoff rate to 77.9%. (We note that the most recently available net cash flow figures, which vary among servicers, may date back as far as 2013.)

Refinance proceeds paint a similar picture, as Morningstar estimates that only 62.1% of 2016 maturities generate enough cash flow needed to successfully refinance the existing debt. This assumes a conservative 5.0% interest rate and a 1.35x debt service coverage ratio. If we lower the interest rate to 4.5%, which is average in today’s market, we estimate that 67.7% of loans maturing in 2016 could be refinanced.

Chart 2 – Current Debt Yield: 2016 and 2017 CMBS Maturities

Article 11 Chart 2

Figures may not add to 100% because of rounding. Source: Morningstar Credit Ratings, LLC

2017 CMBS Maturities

As industry participants know, CMBS new issuance peaked at $228.56 billion in 2007, and Morningstar estimates $99.88 billion in performing CMBS will mature in 2017, 88.1% of which, or $88.0 billion by UPB, was issued in 2007. Not surprisingly, given the underwriting standards and real estate values during that time, half of the 2007-vintage loans by UPB have LTVs greater than 80%. For 2017, Morningstar has valued approximately 87.6%, or $87.47 billion by UPB, and projects the on-time payoff rate to drop to less than 60% based on more than 47.8% with LTVs greater than 80.0%. About $7.3 billion of the 2017 maturities, or 7.3%, that were underwritten at the height of the market under the most lax underwriting standards are specially serviced and are unlikely to successfully pay off without a loss.

Looking at 2017 maturities by collateral type, office collateral represents the bulk of 2017-maturing CMBS at just over one third, or $34.03 billion by UPB, while retail, with 29.7% of the 2017 maturities, has the highest exposure to LTVs greater than 80.0%, at 52.0%. The $305 million Riverchase Galleria loan, the largest loan in Banc of America Commercial Mortgage Trust 2006-6, is an example of a full-term interest-only loan maturing in February 2017. The loan is backed by a regional mall near Birmingham, Alabama, whose current LTV and debt yield will make it unlikely that the loan will get refinanced. We added the loan to the Morningstar Watchlist more than six years ago because of deteriorating net cash flow. The loan’s February 2012 modification carved out a $90 million B note, which we are modeling as a complete loss.

Looking at the 2017 maturities by debt yield, about 52.9% by balance will successfully pay off based on a debt yield of 9.0%, and using a less conservative 8% debt yield, the on-time payoff rate increases to 65.5%, by balance.

Based on calculated refinance proceeds, our payoff projections are similar, as Morningstar estimates that only 56.6% of 2017 maturities generate enough cash flow needed to successfully refinance the existing debt without additional borrower equity. As with the 2016 maturities, this assumes a conservative 5.0% interest rate and a 1.35x debt service coverage ratio. If we lower the interest rate to 4.5%, we estimate that 62.6% of loans maturing in 2017 could be refinanced without the borrower injecting additional capital.

Chart 3 – Effect of Change in Debt Constant on Maximum Loan Proceeds at 1.35x Debt Service Coverage Ratio

Article 11 Chart 3

Source: Morningstar Credit Ratings, LLC

Morningstar’s Bottom Line

While the payoff rate for 2015 showed impressive refinance demand for maturing loans, it will not be possible to refinance many aggressively leveraged loans made between 2005 and 2007 that haven’t achieved the net cash flow assumptions made at origination. LTV and debt yield are reasonable barometers in maturity analysis, but the ability of loans with higher LTVs to refinance is also subject to debt service coverage ratio, amortization, and lease expiration risk. Beyond individual property performance, factors such as capitalization rates and specific real estate market trends also will influence a loan’s refinance prospects.



The content and analysis contained herein are solely statements of opinion and not statements of fact, legal advice or recommendations to purchase, hold, or sell any securities or make any other investment decisions. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MORNINGSTAR IN ANY FORM OR MANNER WHATSOEVER.

Debunking the Receivership Myths


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Debunking the Receivership Myths

As the talk of another commercial real estate down-cycle begins to circulate, now is a good time for lenders to remember some common misconceptions about receivership that all too often interfere with maximum recovery on non-performing loans.

Remember that receivership is an “ancillary remedy” usually tacked on to an existing legal action like a foreclosure proceeding. The court appoints its own agent to serve as an impartial “disinterested third party” to take possession and control of assets that are the subject of the legal action until that action is resolved. Those assets are any and all things pledged as security for the loan.

The court will empower the receiver with whatever authority is necessary to accomplish the goal. This frequently includes taking over all real and personal property, as well as proceeds from operation of the property and – increasingly – the power for the receiver to sell the property.

The receiver for a distressed asset typically will find many inherent problems in addition to the monetary default, among them deferred maintenance, limited marketing activity and unhappy employees. If existing funds are limited, the lender may want to provide funds to the receivership estate to make repairs, management changes, environmental mitigation, etc., – ultimately maximizing value for a possible sale.

In the following article, we analyze and debunk common myths about receivership.

Myth Number 1: Receivers are Very Expensive

Compared to what? Loss of asset value, neglect in management, potential liability costs? Unlike bankruptcy, which is historically a relatively new concept, receivership law provides a wide berth for the court to do whatever it deems appropriate to protect the assets and the parties’ interests. Bankruptcy at its foundation was designed to protect borrowers and close debtor’s prisons. Receivership in its current form is primarily used to protect people with a legal interest in property (like lenders) during a dispute.

Bankruptcy has volumes of rules and strict forms, procedures and timelines.

Receivership law in many states is limited to a few pages and gives the court broad discretion “in equity” to do what is fair and right.

Receiver fees are typically billed hourly, but the hourly rate alone does not predict actual cost. Will the receiver have to hire his own lawyer to explain his job? Will accountants, management companies, consultants and various other vendors be hired? Will the receiver be billing hours to review the work of all those other professionals? There are multiple ways a receiver can save significant total costs for the lender. When a property owner is headed toward foreclosure, the receiver can step in to control operations, protect the value of all assets, monitor and approve expenses and determine the best course of action for the property. This may include ceasing or continuing operations, preserving or liquidating collateral and/or preparing the property for a quick sale. If construction has not yet been completed, the receiver will advise the lender of the cost and benefit. The lender will decide whether to loan money to the receivership estate if the property has insufficient cash of its own. The receiver will have already seized cash from any accounts connected with the property or comingled in other accounts. Often referred to as “rents and profits,” this includes future income as well as any past income that can be found. This can range from pennies to many thousands of dollars and more.

The receiver will guard against further losses to the property, striving for optimal returns while preventing physical and financial damage. He/she will maintain oversight of all aspects of accounting, including receipts and disbursements, and other financial records.

Time is not the lender’s friend in default cases. The key is to get the receiver in as quickly as possible to prevent diverting or misuse of funds for other than the direct benefit of the secured asset. An experienced receiver knows how to find and control funds quickly.

Existing and future income can be used to address deferred maintenance and other operating expenses – or even to cover expenses associated with the receivership itself. Since the receiver is not responsible for past debt and the funds go to maintaining/operating the property, a more favorable recovery is achieved for the lender.

Myth Number 2: Appointing a Receiver Raises a Red Flag that a Property is in Distress

The mere filing of a foreclosure action brings negative attention to the property. The move to appoint a receiver can – and should – signal the lender’s attention to remedy all of the other on-site problems that are often apparent even before the monetary default. In reality, a receiver can help improve the public perception of the property. In the face of chaos, receivers can bring an objective management perspective to the business, instilling a higher level of professionalism to project management, operations, accounting and reporting which probably deteriorated during the period preceding the loan default.

An effective receiver will move swiftly to cure poor management, and correct on-site conditions that have an immediate impact on outside perceptions, while protecting the property that represents the security for the loan.

A receiver can help shield a lender or servicer from any potential bad press. In some cases, certain tenants have generated negative publicity, putting the servicer or lender’s name in a bad light in print or social media. But once the receiver is named, the press will tend to use that company’s name instead of the servicer/lender when writing about the project.

Also important to note: by the time the property goes into receivership, the people who affect its value – tenants, prospective tenants, the market, brokers – already know the property is in trouble. This is apparent because of vacancy issues, deferred maintenance, minimal money for tenant improvement – and the good old-fashioned rumor mill. The appointment of the receiver marks the “turn-around” point and can help signal the “upswing” of a property.

Myth Number 3: A Receiver Can’t Help a Property that is Already in Trouble

A receiver’s primary role in protecting a lender’s security interest is only part of what is accomplished. The receiver will get a quick start on assessing the project’s current status, determining operating expenses, planning options for optimal recovery and preparing the property for sale through appropriate strategies.

Strategies include applying for and maintaining all necessary permits and licenses; verifying that documents are being properly recorded; securing approvals; selecting and monitoring vendors and contractors; and, most importantly, assuring the project moves along carefully and swiftly.

Take the case of a property that has been damaged and insurance proceeds are due. A receiver will collect all proceeds from multiple insurers and dispute those that they don’t feel are appropriate. In a recent example, a monsoon created a flashflood which took out a bridge and caused debris and mud to run down two 18-hole golf courses and fill a tunnel – with mud overflowing into homes surrounding the courses. There were eight insurance carriers for a claim value of over $2.3 million. In this case, claims from the homeowners were successfully disputed and the receiver’s ability to prove business interruption losses was a key part of the claim.

In addition, a receiver can perform tenant improvements to drive value for future sale of a property. In another recent case, a major tenant wanted to lease 240,000 square feet in a “Tenants in Common” owned office building. With tenant improvements exceeding $10 million dollars, the receiver was able to execute the lease, manage the construction with funds provided by the master servicer. The receiver then sold the property at a price that exceeded the loan balance.

Receivers also have the ability to help drive value on maturing loans to assist in refinancing. In another recent case the borrower’s property had 100,000 square feet of vacancy, which prevented them from refinancing. A Letter of Intent had been negotiated for a tenant to take the entire space, but the borrower did not have the funds for the tenant improvements. The receiver was able to execute the lease, manage the construction with funds provided by the existing lender, and keep the borrower in place as manager under the receiver’s control. When the tenant improvements were completed, the borrower was able to refinance, pay off the first lender, and the receiver returned possession to the borrower.

In the event a borrower files bankruptcy to regain custody of a property after a receiver has been appointed, the receiver may be excused from returning possession if that would endanger the value of the property. Judges have allowed us to remain in possession of the collateral, making our receiver an agent of the bankruptcy court under a variety of titles. In some of those cases a receiver can be named the Liquidating Trustee.

Additionally, a receiver can:

    • Protect entitlements: liquor, water rights, licenses, permits and land uses
    • Save grandfathered height permits, signage, zoning (avoid vacancy to maintain current zoning, maintain building permit)
    • Clean up documentation and liabilities prior to foreclosure
    • Obtain copies of all leases, contracts, licenses, permits, reservations and deposits
    • Locate and seize property, related funds, securities, deposits
    • Correct code violations and life safety
    • Assess environmental risk
  • Determine true value. Is the rent roll accurate? Are the tenants paying? Is borrower’s reported NOI accurate?

Myth Number 4: Some People Will do the Work for Free

In the good old days, the local saloon offered “free lunch.” This is another myth that was quickly followed by grandpa’s sage advice, “There is no free lunch!” The free lunch came after you bought a drink. Free receivership work is done in exchange for some other payment or financial benefit. The most common example is when a broker offers to waive all receiver fees in exchange for the listing when the property goes to sale. While there are very few limitations on anyone calling himself or herself a receiver, the strict limitation is that the receiver must be a “disinterested third party” with no other business relationship with either party in the case, and cannot have any other business interest in the case. Working for “free” without disclosing that you are being given a future benefit is lying to the court about your legal qualifications.

Will anyone find out? Judging from our last serious downturn, probably not, unless someone tells the judge. But who would do that? Not the plaintiff/lender. Maybe an unhappy borrower whose counsel discovers it? The penalty for the receiver could be discharge, problems with ever getting appointed again, disgorgement of fees (but wait, there weren’t any, right?). And anyway, that’s the receiver’s problem, not the lender’s. Lenders probably only have to worry about Lender Liability, and how bad could that be?

In actuality, the consequences of hiring someone on the cheap can be disastrous. An inexperienced or unqualified receiver can generate a slew of costly mistakes, from unnecessary payment of pre-receivership debt to loss of franchise, liquor or gaming licenses.

Since receivership has very few hard-core rules and regulations and written guides, the court has very wide discretionary powers, allowing the receiver great latitude. This makes it even more important for lenders to enlist a competent, qualified professional.

The Bottom Line

Receiverships are an increasingly viable option during the period between default and foreclosure for a variety of reasons. Receivers can often clear up issues of potential liabilities tied to health, safety and environmental concerns; homeowner association regulations; existing liens; franchise agreements; and possible future warranty issues in residential tract developments or condominium conversions.

As an agent of the court, a receiver’s liability is limited to the assets of the receivership estate itself, as long as the receivership is properly conducted, and cannot be held personally liable.

In addition to limiting liabilities, receiverships steer the eyes of vendors, franchisors, supplies and others away from the lender’s pocketbook. Unlike the business owner, the receiver is not required to pay pre-receiver debts, and as such, can provide a clean break between borrower and prospective buyers. While the borrower remains as legal owner during the receivership, the receiver has sole legal possession.

Examining the myths surrounding receiverships actually sheds light on the truth of the matter. Turning to a receiver can help bring value to assets, making them more attractive to prospective buyers and investors. A well-managed receivership can restore and create an atmosphere of order and professionalism. Ultimately – and contrary to those myths – these improvements benefit the business on a long-term basis, well beyond the term of the receivership.



Commercial Real Estate in a Low-Growth World: Interview with Tom Flexner


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Paul Fiorilla: Welcome Tom, we at CRE Finance World are thrilled to hear your thoughts about the global economy and commercial real estate. You travel internationally and experience the economies and central banking policies in countries around the world – what is your view of major global economies and the generally accommodative monetary policies central bankers are employing?

Tom Flexner: We’re in a world of 2 to 3 percent GDP growth globally – with many factors ranging from demographics to commodity prices to excessive leverage levels to regulatory drags to geopolitics to a pervading sense of uncertainty and ambiguity – all conspiring to tamp down economic activity. The demand side of the world is just not responding, at necessary levels, to the concerted efforts of many Central Banks to stimulate job growth and capital investment.

Policy tools like quantitative easing and low interest rates are just not translating into stimulating the real economy. Even the China engine of the past 20 years is trending at its lowest GDP growth rate since its economy modernized.

These accommodative monetary policies have served to elevate financial asset values – balance sheet inflation, if you will, but have largely failed to create fundamental demand in the world’s real economies where new jobs are produced and wages are determined.

And I’m not sure the central banks have much left in their tool kits at this point. Who knows the effect of sustained negative interest rates? Fortunately the U.S. was the first to address these issues during the financial crisis and is, on a relative basis, ahead of its counterparts in Europe and elsewhere. But even here we continue to experience subpar growth. 2% annual long term is not enough to lift all boats.

Paul Fiorilla: So what is the way out of this weak economic growth cycle that we’ve been in for some time?

Tom Flexner: Paul, that is the big question confronting most world leaders. And there are no obvious answers which are pain-free or even politically feasible. It just feels to me that we’re in the midst of adjusting to some sort of overarching longer-term secular change marked by continued tepid growth, low interest rates, low oil prices, forced deleveraging by foreign sovereigns and so on. If so the adjustment may be to bring down return expectations to reflect the lower productivity of capital in this new world. Right?

So we have a whole bunch of things working against us, and frankly it’s hard to identify a single reason to be terribly optimistic about the world’s growth trajectory. Other than somehow it always seems to work out at the end. But, you know, up until the financial crisis we had a global economy supported by huge credit expansion – consumers, governments, companies. It lifted growth beyond what would have happened had credit not expanded at such a vigorous pace. Today, we still have a significant amount of leverage, particularly at the sovereign level, but also in the banking systems in China, Japan and Europe; plus regulatory initiatives which will serve to constrain credit creation going forward. And this kind of countervailing pressure – deleveraging – will possibly hinder growth, as credit creation will not be the tailwind it once was.

And demographically, here and through most of the developed world, we have headwinds in terms of aging populations, the percentage of people that are going to be productively engaged in the workplace versus the growing number that have to be supported by those in the workplace.

And so I think the twin impacts of globalization and technology are showing they also have downsides. Technological advances used to amplify human muscle or human capital if you will. That was a fundamental precept during the first two industrial revolutions – you created machines that increased human productivity in a way that allowed everyone to participate in the benefits of enormously increased output. People were able to become much more productive and people harvested a portion of those gains for themselves.

But today, it seems that technology is as often substituting for or replacing human capital as it is amplifying human capital. Think robotics and automation. And that puts a lot of downward pressure on job growth and wage growth in the traditional sectors. And with globalization we have an entire world competing against each other for a finite number of jobs. That’s why we there’s so much noise about unfair trade, currency manipulation and so on. The leaders of every country, if they want to stay in power, have to win on the jobs front, and globalization puts everyone in competition with everyone else.

What else? We have a lot of uncertainty and ambiguity, whether it’s the fractious noise around the presidential election, whether its migrant pressure in Europe, a nuclearized North Korea, terrorist attacks, climate change, a non-isolated Iran, or low commodity prices which create difficulties for the emerging market countries having to deal with dollar-denominated external debt.

I’m beginning to get depressed listening to myself. So all of these things combine, you know, to suggest it will be a long hard climb out of the low-growth world we’re in right now. And, of course, on top of all that and near and dear to CREFC and others is the impact of regulatory changes affecting bank capital, bank liquidity, trading rules, risk appetite, all of which are interrelated and which potentially serve to restrain credit and liquidity and which, in my opinion, could make it harder for the financial system to help avert or soften the impact of a future recession or liquidity disruption.

And of course all this affects decision-making in the C-Suite. How do you know where you want to invest and build and develop and produce when you don’t know what the tax code is going to look like, you don’t fully understand the evolving regulatory environment, you don’t know whether free trade agreements are going to be torn up, you don’t know which currencies will be manipulated – all of this works, again, to create more caution and hesitation on the part of business.

Paul Fiorilla:  We’ll get into some of those things a little bit later, but first I wanted to follow up because you said something about being in the ninth inning and you seem to feel that the global economy is exhausted and things are going to get worse. Do you think that the Fed has been pursuing the wrong strategy – what should they have been doing? And what could they do?

Tom Flexner: I don’t think the Fed has been pursuing the wrong strategy, I think what I’m saying is the Fed pursued the only strategy it could. And it’s easy for people to second guess the Fed on the heels of their multiple rounds of QE and so forth, but the fact of the matter is the Fed was staring at a true black swan financial crisis almost 8 years ago. Think back to the fall of ’08 and what was happening. So today, I think even though we’re not feeling all that great about our economy and our country – and the election primaries are raising all the fundamental issues we should be concerned about – we’re in better shape than most. My personal opinion is the Fed did what it should have done and could have done, but by itself it was not enough.

I think gridlock in Washington, in terms of budget reforms and stimulus spending etc., meant there was no real fiscal policy corollary that would have reinforced the Fed’s actions. Instead, there was just partisan divisiveness over spending bills, tax reform, entitlement reform and so forth over the past 6 years. So you can’t put the entire weight of an economic recovery on a Central Bank because they only have one tool and that’s monetary policy. And it takes more than one tool.

Paul Fiorilla: Do you get the sense that they’re going to continue to be dovish about raising rates going forward, which seems to be the consensus right now?

Tom Flexner: You know Paul, I hope they continue to be dovish because I don’t think we’ve seen enough domestic progress on growth, wages or inflation, and the world economy is pretty fragile and we are not decoupled from that. What is the primary fear of ballooning up the money supply? The primary fear is that inflation expectations and then inflation itself will get out of control, right? And the dollar will crash, correct? Well we haven’t seen either meaningful inflation or a weakened dollar. We’re finally seeing a little wage growth which is very good, but the fearfulness, you know, around a Fed balance sheet which has grown by $3 trillion over the past several years is completely misplaced. In fact, the flip side of the Fed’s balance sheet expansion has been a dramatic increase in excess reserves deposited at the Fed by member banks. And you better get used to it. A $4 trillion Fed balance sheet is the new normal in my opinion. Why? Because the new bank regulatory liquidity requirements are most efficiently met through holding excess reserves, which I believe will stay at quasi-permanently elevated levels which by definition requires a much larger Fed balance sheet. And by the way, will also mean that the targeting of the Fed funds rate will be much less relevant in the future.

Now you can argue that what it has done has created balance sheet inflation in the sense that financial asset classes of all types – both risk off and risk on – have risen in value and probably become a bit disconnected with underlying fundamentals. So maybe you have a correction. But I think that a small price to pay for pursuing a policy that is trying to avoid the U.S. slipping back into a recession and/or seeing a possible re-spiking of unemployment.

So, in my mind it’s almost an asymmetric options value approach the Fed is taking. They’re basically saying, “We’re willing to run the risk of overshooting our inflation target and then correcting, in order to avoid the risk of suddenly pushing our country back into recession, and then having to correct for that.”

And it’s complicated because everything is interconnected across the globe. The Fed, you know, is not just dealing with a closed economy. It is dealing with trade partners, cross-border financial flows and relative currency movements. And if the Fed starts tightening while everyone else is in easing mode, as we’ve seen already, even the expectation of tightening caused the dollar to materially strengthen over the past 18 months. Now, it has given some of it back as the Fed is viewed as being more dovish again. But all of these things are interconnected and have to be considered.

Paul Fiorilla:  I agree. One of the interesting things about real estate is that the technical or capital market side led it out of the recession ahead of the fundamentals, but now we seem to be seeing that the capital markets are slowing down while fundamentals are still not bad.

Tom Fiorilla: Yes, I personally think, looking at the fundamentals, we’ve got more runway in front of us. Sixth inning maybe? Extra innings? It doesn’t feel so bad looking at the space markets, rents, vacancies etc. That’s been because with few exceptions – like New York hotels and ultra-luxury condos – we haven’t had significant new development. And over the course of my career, the majority of real estate cycles ended when there was a supply shock, not a demand shock.

2008, on the other hand, was a demand shock that affected everything everywhere, not just real estate. Although real estate’s beta was front and center for a while then. But historically, most of the imbalances in real estate were driven by supply shocks – ample easy capital, or tax shelter demand, or improvident demand forecasting – leading to excess development.

I think today, due in large part to regulatory constraints and an embedded lower risk tolerance, we are not going to see the profligate sort of lending we saw leading up to the crisis. And while underwriting standards did loosen a bit over the past several years, lenders are pretty disciplined compared to pre-’07. And the B-piece buyers are lot smarter these days, so the market will to some degree regulate itself. And that will help put a cap on the supply side.

Paul Fiorilla:  There’s a lot of discussion at real estate events about whether we’ve gotten overheated. Property sales have gotten almost back to 2007 levels, cap rates are at the all-time lows and prices are at all-time highs. Total debt outstanding is once again setting records every quarter, and a lot of people say, well, ‘it’s been seven years since the last recession, so we’re about due for another one.’ But on the other hand, cap rate premiums are still above historical averages and well below where they were in 2007 and leverage as you just said is not nearly as aggressive across the board. Plus, the economy is continuing to chug along and create jobs, workforce participation and wages are going up, stuff like that. So where do you think that will lead?

Tom Flexner: It’s a worthy debate, Paul. The backdrop on fundamentals is OK, but nothing to write home about. Values have not been supported by rosy forecasts this time around, but rather by historically low interest rates and reasonably tight risk premia. But I think, you know, there is a general sense that for the first time in seven years we’re beginning to see a plateauing of commercial real estate prices.

We’ve seen certain credible major investors say that they think the market has leveled off, and we’ve seen some Wall Street research saying that we’ve actually suffered a slight decline since the beginning of 2016.

And it does feel that way. If you’re an intermediary brokering real estate deals, a year ago you might have gotten 20 bids, five final round bidders and a fierce bidding war by the final two. Today you might get six bids, two make it to the final round, and the winner then tries to re-trade. Different dynamic and one that points to a less exuberant market.

And I would add that all of the regulations that you’re familiar with – Dodd Frank in terms of risk retention and market-making liquidity; Basel III rules around total loss absorbing capital; Tier 1 common equity, risk weightings, liquidity requirements; the Formal Review of the Trading Book risk capital treatments which are punitive for securitization – these will serve to further constrain the extension of capital to not just real estate but other asset classes. They’re certainly not going to act to increase credit overall.

My view is the regulatory envelope will impose a level of discipline on the market that many players will not like. And many of the fine details of the regulations I don’t necessarily agree with, and they may in fact increase certain types of risk in an unintended way. But overall, the financial system is far stronger with greater regulatory oversight than it’s ever been historically, and I think this is a good thing long term.

But, having said all that, on a global basis including the US, I think real estate will outperform other asset classes over time. In this world we’ve been talking about – low rates, low growth, high volatility – real estate offers yield, stability and predictability, all characteristics which are attractive in such an environment. The world is starving for yield. So call real estate the least worst investment alternative, if you will.

Paul Fiorilla: What’s your outlook on CMBS volume? A lot of the analysts have downgraded the volume expectations since the beginning of the year from $100 billion or more to $60 billion to $70 billion.

I guess don’t have a good view on that. Volume forecasts have certainly degraded as you point out, although the pace of issuance has begun to pick up. And we have a wall of maturities this year and next, approaching $200 billion, of which maybe only 15% have been addressed so far. So you have at least a picture of the demand side. But forecasting is tough because world volatility levels remain very elevated – back and forth risk on, lurching from new datapoint to new datapoint – which is why I think it’s hard to have a prediction forecast, especially in an election year like this one.

Also, remember CMBS issuance faded toward the end of 2015, we thought the year would end at $110-115 billion but it ended just shy of $100 billion. And then we had material spread widening through January in and February, hedging strategies failed, and it was clear that CMBS was not insulated from the broader credit markets. You had record corporate bond issuance and near record high yield issuance 2015. And then we saw, starting in mid-summer last year the massive knock-on effects of China’s currency devaluation and stock market collapse, and continued pressure on oil prices – we saw credit spreads gap out across both the high yield and investment corporate bond markets. And it wasn’t just limited to energy companies, whose P&L’s were getting crushed because of oil prices.

No. It was a broad sell-off. Liquidity was drying up. The High-Yield index gapped out 200 to 300 basis points. And CMBS was not immune because your typical portfolio manager is going to say: “Where am I going to get value on a risk-adjusted basis?” And he’s looking at CMBS, he’s looking at high yield, and he’s looking at investment grade corporate. And the latter two just got a lot cheaper, making CMBS less interesting unless the price drops. That’s why I think it’s hard to predict. And it’s the supply side that’s less predictable.

I’d love to see a $100 billion CMBS market this year, to address the upcoming maturities and new financings. At this point I don’t think we’ll get much help from the life companies because they started the year with $60 billion allocated and I think they’ve been using it up pretty fast.

And banks aren’t certainly being prodded by the Fed and their other regulators to go all in on commercial real estate. And we have risk retention to look forward to also.

Paul Fiorilla:  Right, I think that probably the big effect in terms of the lending markets right now is the cost is going to go up a little bit for borrowers. I guess you could debate whether that’s such a terrible thing, given how low rates have been, but it seems to me that’s probably going to be the biggest impact in the second half.

Tom Flexner: I agree with that.

Paul Fiorilla: Let’s talk about liquidity. One of the causes of the recent spread widening is a reduction in liquidity as market makers leave the secondary markets due to regulatory restrictions and Volcker rules. Is there any way you think liquidity can be brought back into the market?

Tom Flexner: You know, “liquidity” is an interesting word because on the one hand you can count up all the hedge funds and credit funds that have dry powder, all the private equity firms that have dry powder, all the pension funds and endowments that have increased their real estate allocations but not yet fulfilled them, the sovereign wealth funds. There is, I think, on one level, a lot of liquidity, right?

And real estate to some degree is competing for that liquidity along with other asset classes. That is one form of liquidity. Let’s call it investor liquidity. Then there is, say, the dealer or intermediary liquidity which embraces the market making activities you just referred to – the lubricant which historically functioned to narrow bid/ask spreads, to allow buyers and sellers to execute trades quickly and efficiently, and to reduce overall market volatility.

This market-making liquidity has in many cases been materially reduced because of the Volcker Rules, because the definition of what is treated as a customer-driven trade versus a proprietary trade is not clearly and crisply distinguished. And Basel III makes it more expensive to maintain market-making functions because you’ve got to allocate more regulatory capital to supporting those functions than you did before Basel III.

And you have the FRTB right? The formal review of the trading book which intends to impose extra capital costs on assets that are in securitizable form or will be securitized.

And then you have the liquidity requirements that compel banks to hold a significantly higher percentage of their total footings in the form of liquid instruments like Treasury bills and other cash equivalents or readily marketable securities.

Paul, these all serve to constrain not just overall bank lending but also market-making liquidity. Now maybe, I think, we will see more shadow banks step up, and maybe the whole way origination and securitization occurs will change. Risk retention especially may change the types of players and their roles in this business.

Paul Fiorilla: If the industry is not successful in changing regulations that you just described, does that mean that there will be sort of a wholesale change going forward in terms of how banks approach the market-making functions and everyone is just going to have to adjust? Or do you think that eventually people will get comfortable with the regulations and basically get back to doing what they were doing before?

Tom Flexner: Well I don’t think you can just go back to the good old days because these rules will literally change the cost of lending when fully implemented. It’s both a pricing and availability of credit issue. And while borrowers will inevitably bear most, if not all, of the surcharges, that only works up to a point – proceeds are affected, positive leverage at some point possibly disappears. Lots of unknown unknowns.

Paul Fiorilla:  Is that going to change the way CMBS is originated or securitized?

Tom Flexner: Well, when you look at the FRTB rules, they apply to all securitizations, not just CMBS, but RMBS, student loans, car loans, etc. And I think that the regulators, in their sincere efforts to de-risk the system – and they’ve done a lot to accomplish that goal already – could find that in some unintentional ways the result is to elevate certain systemic risks. Not at the individual bank level but at the broad market-functioning level.

I think historically, when there was an event that caused people to run for the exit, the intermediaries have always been the ones to step in and try to restore some order out of the chaos. Primarily through their market making. But these regulations make that less likely to happen in the future. So in some ways I think the de-risking of the financial markets could actually increase the risk to the underlying economy, by causing deeper adjustments that would have historically been somewhat muted by the market-making.

Paul Fiorilla:  I guess it’s a tradeoff – I know there are a lot of negative impacts in our industry, but regulation has reduced leverage in the banking system, which is one of the things that was intended.

Tom Flexner: Yes. And I think the number one benefit of this regulatory scrutiny and regulatory change over the last seven years is to de-lever the banks and encourage them to have more liquidity. And it’s not just a function of deleveraging but it’s also changing the composition of their leverage, terming it out, less reliance on repo, better match funding, so that we don’t have the same short-fund contagion risk that dramatically broadened and magnified the impact of the financial crisis.

Now do I think in some cases they may have gone too far? Personally, yes. But I think on balance what they’ve done directionally has strengthened the financial system and I applaud them for that. Again, the devil is in the details, and we may even find over time that as certain unintended consequences become apparent, the regulators will proactively respond to fix them.

These regulations are not cast in stone for the rest of eternity. I think if it is determined that they are doing more harm than good at the margin, they’ll be tweaked. But we may have to go through some pain to get to the tweak.

Paul Fiorilla: Right now I think the biggest regulatory initiative in the CMBS industry is risk retention and there’s a lot to talk about how the required capital will be raised from whom at what price. How do you think the industry is going to handle risk retention? Has your firm developed a strategy?

Tom Flexner: Clearly everyone is looking at a number of strategies. And I do think we’ll see a number of the sub-scale originators exit the business for multiple reasons. But the committed players are thinking about how best to execute in this new environment. For instance maybe someone who originates today will rent somebody else’s balance sheet, use someone else’s shelf, act solely as a distribution agent for the securities, or create a minority-controlled subsidiary to meet the risk retention requirement. Who knows?

But at some point, at the margin, the pricing will adjust. If the B-piece buyer retains the risk, the pricing will adjust to reflect the fact that the 5% market value requirement will include BBB’s which don’t currently meet the return requirements of the B-piece buyer. If the bank retains the risk, as a vertical strip for example, the price will adjust to reflect the bank’s cost of regulatory capital supporting that risk retention. And by price, I mean interest coupon to the end borrower.

And of course there are other CMBS issues to be considered. B-piece transferability, AB II, qualified mortgage definitions etc.

Paul Fiorilla:  So do you think this will impact issuance volume going forward or the willingness to lend?

Tom Flexner: I think at some point it has to. I mean, these regulations are not neutral. And they’re not supportive of increased issuance.

Paul Fiorilla:  Do you think there is going to be a problem finding B-piece buyers? That’s one of the major concerns, to have a normal B-piece market the way it functioned in the past.

Tom Flexner: No I don’t. We have I think eight active B-piece buyers out there today – with most of the volume being done by the top three or four. But the reality is I do think pricing will ultimately self-adjust as I mentioned before.

Paul Fiorilla:  OK, to switch topics again, foreign investment in the U.S. grew from $47 billion in 2014 to $90 billion in 2015. Much of the increase is attributable to the commodities-based economies in the Middle East and Asia. Can we expect this trend to continue with commodity prices weakening? Will FIRPTA reform be a difference maker?

Tom Flexner: That is a question on everyone’s minds. A healthy portion of the $90 billion was sovereign, but certainly not the majority. And while the oil-dependent sovereigns are under pressure right now, we haven’t seen any pullback, at least not yet. In fact, Norges, the largest one – although not technically a sovereign wealth fund – just increased its allocation to real estate. The question is if we continue to have sustainable lower oil and commodity prices, consistent with the longer-term lower GDP growth possibly we discussed earlier, will that ultimately put pressure on the sovereigns to reduce their real estate appetite? And my definitive and highly confident answer is: maybe.

And that’s the best answer I can give you because, you have to ask yourself, what would the sovereigns actually sell first if their sponsoring countries needed to monetize assets to fund deficits in their own national budgets?

And if it gets to that, everything is up for grabs – stocks, bonds, real estate, private equity, etc. My suspicion is the first things to go are liquid securities and hedge fund redemptions for example. But honestly, I just don’t think it will get down to that in a meaningful way.

With respect to your FIRPTA question, the recent changes were helpful but I don’t think they are a huge needle mover. First, on the private investment side they only benefit foreign pension funds, not necessarily you average SWF. And the definition of who is and who isn’t a foreign pension plan is still up for debate. On the public side FIRPTA increases foreign limits on REIT ownership from 5% to 10%. Again, helpful at the margin – maybe $20 billion in potential flows over time – but I don’t think a true needle mover will happen until there’s comprehensive tax reform which would include a much broader revamping of FIRPTA or even its complete elimination. But I’m not holding my breath.

Paul Fiorilla:  Alternative investors expect to raise $67 billion this year compared to $52 billion last year.  The regulation of the banks we talked about is providing debt funds with the opportunity and means to come into the market. Do you see a big increase in specialty lenders and debt funds increasing their market share?

Tom Flexner: I’d like to see more alternative non-bank debt funds raise capital and make it available to our industry. As long as they’re prudently structured and competently managed. Which CREFC will guarantee right?

I think there are components of the credit markets today where banks don’t really want to play or are have an inefficient cost of capital. Mezz debt for example. We can’t, it’s too expensive to hold. Or preferred equity, with a dollar for dollar risk capital allocation.

So I think these alternative credit funds are actually going to complement the large bank lending programs because the banks would rather focus on the senior tranches of debt, those that are mortgage secured and investment grade, whether for securitization or balance sheet hold.

But in many cases a typical borrower’s need for leverage goes through the investment grade inflection point – in either acquisition financing or refinancing. So to the extent these credit funds are out there and can take down the piece the banks can’t afford to hold, it provides the banks with greater assurance of circling the whole facility, knowing that the bank’s got a home upfront for the lower-rated tranches that the bank doesn’t want to keep. So yes, I like the idea they’re there.

Paul Fiorilla: We are out of time, but on behalf of CREFC I’d like to thank you, Tom, for sitting down with us and sharing your thoughts on the industry. I learned a lot, and I’m sure our readers will as well.


Foreign Investment Capital – U.S. Outlook for 2016


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As we finish the first quarter of 2016, it’s a good time to evaluate what’s ahead for U.S.-bound real estate investment capital. To understand the broad trends, and the outlook for 2016 and beyond, we can use cross-border commercial property transactions data, recent surveys from important industry organizations, and opinions expressed by industry experts.

According to Cushman & Wakefield’s Atlas Outlook 2016, global property trading activity fell in 2015 (for the first time in six years) by 2.4% to $1.29 trillion, although, excluding land, global volume rose 8.2%. “Insurance and pension funds increased their activity by 23% with a focus on North America and Europe, but the strongest growth was among private equity and sovereign growth funds.” The report also concluded that the fastest growing source of global capital was the Middle East with an 81% increase in cross-border investments.



Article 8 Chart 1a

Source: Atlas Outlook 2016. Cushman & Wakefield Capital Markets Research Publication

In a similar vein, CBRE’s 2016 Global Real Estate Market Outlook indicates that “global commercial real estate activity will remain robust (in 2016), but the pace of growth will slow after [past] six years of recovery and expansion…” as indicated by the global investment turnover in H1 2015 which was nearly five times above the H1 2009. The report attributes this growth to excess global savings, low bond yields and under allocation of real estate in Asia. Furthermore, JLL’s Global Market Perspective, Q1 2016 indicates that the market has recovered as U.S. 2015 transaction volume at $765 billion surpassed the pre-recession peak of $758 billion in 2007.

U.S. Capital Inflows

If we focus on the U.S. property market, historically, 80% of the cross-border capital inflow emanates from Europe, Canada and Japan. However, in recent years, and particularly after the growth of investment from oil-exporting countries, the makeup of cross-border investor groups has changed, with increasing participation by sovereign wealth funds and countries with surplus savings, such as China, Singapore and UAE.

The largest source of global capital inflows during the past five years, in decreasing order of importance, comes from Canada, China, Singapore and Norway, while the largest drop in investment is from Australia, Germany and UAE.


Article 8 Chart 2a

Source: Atlas Outlook 2016. Cushman & Wakefield Capital Markets Research Publication

According to Real Capital Analytics (RCA), a commercial property data and analytics firm, the cross-border investment in the U.S. real estate market totaled $78.4 billion in 2015, or a little over 16% of the total $483 billion invested. Canada remained the number one buyer, followed by Norway. Nearly 20% of volume was in six major U.S. gateway cities, 13% in secondary markets (Dallas, Atlanta and Seattle) and 10% in tertiary markets.

 Investment Rationale and Top Global Investors      

According to Atlas Outlook 2016, investment flow into the U.S. may be better in 2016 due to low global interest rates and the relative strength of the U.S. economy, currency and property markets. Canadian and global funds doubled cross-border spending in the U.S. and took a 28% market share of transactions in 2015 (Atlas Outlook 2016), a 70% increase in cross-border investment from 2014. This increase was largely due to investments from China, Singapore, Norway, Canada, Switzerland and Germany. As a result, the market share of the overseas investors increased from 10% to 18.1% by 2015 (the highest on record).

The Counselors of Real Estate’s online magazine in a recent article titled “The CRE 2015-16 Top Ten Issues Affecting Real Estate” states, “Funds continue to flow from outside the U.S. to purchase U.S. real estate. The supply is driven by economies that have high savings rates, a shortage of mature financial markets and few safe assets.” Also, according to Urban Land, the magazine of the Urban Land Institute, “Global economic and political uncertainty continues to drive capital to a “safe haven” in the United States. The U.S. property market is the most stable and transparent in the world, making it an easy investment choice.”

This sentiment is further supported by the Association of Foreign Investors in Real Estate (AFIRE), whose survey shows that multifamily and industrial are the preferred property types. Investment in retail, office and hotel properties are other sectors of interest, in order of preference.

Based on data provided by RCA, the following Tables summarize total investments in millions of dollars in the U.S. commercial property market in the past 5-year and 10-year periods, respectively, beginning in Q1-2006 and ending in Q4 2015, for transactions of $5.0 million and above, by individuals, portfolio investors and pension fund entities.

Article 8 Chart 3


Source: RCA

In the most recent 5-year period (Table above), China, Singapore and Norway have increased their U.S. real estate holdings tremendously (from an aggregate of $2.1 billion in the 2006-2010 period to $57.3 billion), followed by Canada, Switzerland and Germany (from an aggregate of $41.9 billion in the 2006-2010 period to $102.5 billion). Also, Japan and South Korea have replaced Australia and UAE as two of the prominent global investors in the U.S. from the previous five years (Table below).

Article 8 Chart 4

Source: RCA

It is noted that the average value per transaction has remained similar over both 5-year spans ($32.66 million) and ($31.37 million).

Favorite Sectors for U.S. Real Estate Investment

From 2005 to 2014, industrial and multifamily were the favorite sectors among global investors, followed by hospitality, retail and office (RCA).

Yet from Q1-2011 to Q4-2015, the new favorites are office, $88.24 billion; multifamily, $41.55 billion; industrial, $36.59 billion; hospitality, $31.13 billion; and retail, $27.82 billion. During the past five years, the favorite destination for these investments were Manhattan, Los Angeles, Boston, Chicago, Dallas, D.C., San Francisco, Houston and Seattle. This is largely true for the previous five year period beginning Q1-2006 and ending in Q4-2 011, though Seattle has replaced Atlanta.

Total investment in the industrial sector in the past ten years was $42.11 billion, of which $36.59 billion is attributable to the most recent five years. This indicates that the growth in this sector was one of the fastest and perhaps more strategic with high demand for logistics space, as retailers and distributors adjust to the continued customer demand for more rapid delivery. The compound annual growth rate (CAGR) in this sector was 45.98%.

The multifamily sector is one of the most popular among foreign investors. The investment in this sector was $41.55 billion from 2006 to 2011, and $53.89 billion in the past ten years which translates into a CAGR of 27.46% in the past five years.

The hotel sector also has been quite popular among foreign investors. The total investment in this sector from 2006 to 2015 is $42.38 billion. The investment just in the last five years alone has been $31.13 billion indicating that the investment in this sector grew from a mere $11.25 billion at the end of 2010, at a CAGR of 22.58%. This is particularly noted in the context of more or less stagnant Chinese investment in the sector in the past five years at around $10.5 billion, which is likely to change in 2016 due to increased and seemingly large scale inflows into this sector from Chinese investors.

Online shopping has been gaining ground and retail store sizes are shrinking. Since January 2011, foreigners have invested $27.82 billion in this sector. The total investment over the past ten years is $53.19 billion, representing a CAGR of 13.84% during the recent 5-year period.

A total of $143.25 billion has been invested by global investors in office properties since 2006 of which $88.24 billion took place just in the last five years, at a CAGR of 9.91%.

Search for Better Returns

The Fed pushed up the federal funds rate by a quarter point in December 2015 while acknowledging the fact that U.S. economic growth was stable and in the right direction towards lower unemployment rate (below 5.0% as of Feb. 2016) and inflation was much under the target level of 2.00 percent. U.S. capital markets seem to have absorbed the interest rate hike of .25% during the anticipatory period and should do the same with additional slow increases in the coming years. In contrast, with the negative interest rate scenarios in Japan and the Eurozone, one can expect foreign investors to do their math and consider increased cross-border investing in the U.S. market.

Challenging Influences

There are many factors that continue to influence and affect cross-border investing and the flow of capital into the U.S. market in 2016 and beyond. A select few are stated below:

Low commodity prices are expected to continue creating a drag on surplus investable capital from many countries dependent on such exports. However, according to CBRE Research, “the world economy will still have a very substantial “glut” of savings, and the oil producers only account for around 40% of this.”

  • Monetary policies, reform agendas, political developments and election outcomes in a number of countries will affect the investment atmosphere in the coming months.
  •  Bold economic measures in some countries, including QE as market support in Eurozone, may actually free up capital for cross-border investment in the U.S.
  •  Lending in the U.S. is contracting as banks are getting more cautious by applying tighter underwriting standards. Market and price contraction is already being noticed at the high end of the residential market which also seems to have an excess supply.

 Mixed Environment

Overall, global investment flow into the U.S. market is expected to remain fairly stable, mainly attracted by the U.S. real estate market fundamentals, which are expected to stay solid.

There are mixed opinions about the yields due to uncertainty about the Fed’s decision on short-term interest rates. Increase in interest rates will put upward pressure on 10-year US Treasuries and required yields in commercial real estate; however, competition from investors for quality assets is expected to keep the yields mostly in the range they have been in the past few quarters.

Atlas Outlook 2016 argues that persisting lower oil prices will bring changes in the investment policies of some of the Middle Eastern buyers, which may include lesser demand and divestment of existing asset. This is borne out by other industry leaders: CBRE points out that the depressed commodity prices has created a low cash flow into these countries and consequently there will be a low level of recycled capital outflows in 2016.

China’s economic slowdown is considered positive for global investing as smart capital moves out of the country looking for long-term stability, better returns and just parking for the short-term. Chinese buyers spent $8.6 billion in U.S. commercial real estate in 2015, more than four times the amount spent in 2014. China is expected to further liberalize its capital account, thus giving additional impetus to outflow of capital from China. Additionally, with their negative interest rate environments, Japanese and European investors are likely to increase their overseas investments to diversify and boost investment yields. A substantial chunk of all this money is likely to go into real estate acquisitions in the U.S.

The growth of global investments in the U.S. in 2016 is also expected to be boosted by the reforms to FIRPTA (Foreign Investment in Real Estate Property Act of 1980), which allows foreign pension funds to invest through any structure and exempts them from the 35% withholding tax on proceeds of real estate dispositions, thus providing incentives to buy as much as 10 percent of a U.S. publicly-traded real estate investment trust, up from the previously set position of 5 percent.

2016 and Beyond

2016 and beyond cannot be looked at in isolation from the past or the recent capital market trends. “The Big Picture, Overview Across All Property Types”, published in March 2016 by RCA, states that as real estate financing terms have been changing in the past few months due to various factors, the year-over-year deal volume in the U.S. fell 46% in February, 2016 on sales of $25.5 billion; further, year-over-year single asset sales were down 26% on sales of $18.8 billion with strongest year-over-year decline seen in the industrial (78%) and hotel (73%) sectors.

Going by these indicators, it is debatable whether the U.S. real estate market is on the verge of a severe downturn or ripe for a correction. However, it is likely that the market is absorbing various global market pressures of the past few months, including commodity prices and monetary and regulatory policy measures, leading to a periodic review of investment portfolios by market players.

We have to keep in mind the positives of the U.S. economy: 2.7 million non-farm jobs were created in the U.S. last year; the cumulative increase in employment since the trough of early 2010 is more than 13 million jobs; and the unemployment rate has dropped to 4.9% in February 2016.

CBRE Research indicates that we should expect the real estate environment to remain positive in 2016, with a moderate yield compression as investors do have a large amount of capital to deploy. Atlas Outlook 2016 concludes that there would be a 4.2% rise in real estate trading volumes in the U.S. as global uncertainty will boost demand from some quarters coupled with strong supply of debt in the U.S. capital market.

It’s also helpful to keep in mind that while all investments involve a risk-return trade-off, cross-border investments have additional risk-return dimensions such as fluctuations in currency exchange rates, significant and often uncertain socio-economic and political situations, and unattractive tax environments. Real estate investments are less liquid than traditional investments and investors would be wise to consider longer investment horizons beyond 2016.

The 2016 international investment outlook for the U.S. market is aptly summarized by James A. Fetgatter, CEO of AFIRE: “The investment opportunity is the United States itself. The real estate fundamentals are sound; the economy remains strong; there are opportunities across all sectors of the real estate spectrum and in both gateway and secondary cities. The recent legislation bringing welcome relief from certain FIRPTA taxes should provide additional incentives for foreign investment into the US. In an environment that is regarded both as the safest and most secure in the world, with a strong currency and the best opportunity for capital appreciation, the US is the safest harbor.”

In the increasingly unstable global eco-political atmosphere, foreign investors will seek more certainty on returns and reallocate saving surpluses to seek U.S. growth opportunities.


Historical Property Revenue Volatility Analysis Suggests Caution In Evaluating U.S. Hotels



As the U.S. economic expansion enters its seventh year, it is constructive to consider how commercial property revenues perform relative to U.S. unemployment rates and to evaluate property revenue volatility among the five major property types (hotels, multifamily, industrial, office, and retail). To that end, Standard & Poor’s Ratings Services performed an historical revenue volatility analysis for each of the five major property types.

Our findings indicate that hotel revenues are the most sensitive to changes in the unemployment rate, which makes them more susceptible to default. Like the overall U.S. economy, the U.S. lodging sector is now entering its seventh consecutive year of growth as measured by revenue per available room (RevPAR). However, the growth rate appears to be slowing, and in several larger markets, RevPAR has declined thus far in 2016. As hotel concentrations have increased in commercial mortgage-backed securities (CMBS) pools since the financial crisis, we believe our analysis indicates that a relatively more cautious approach to evaluating the lodging sector is warranted, and supports the use of lower loan recovery rates relative to the other major property types.

 To perform this analysis, we measured the correlation between national and regional rents/RevPAR for each of the major commercial property types with national unemployment rates over the past 18 years. Next, we calculated the annual percentage change in revenue for each property type using CMBS loan data over the same time horizon to analyze revenue volatility during various time periods. Finally, to evaluate the degree to which revenue volatility impacts loan performance, we examined debt service coverage (DSC) levels as well as default and recovery rates by property type for the underlying commercial loans.

 Of The Five Major Property Types, Hotels Have The Highest Correlation Between Rents/RevPAR And Unemployment Rates

Almost 1:1 (inverse) correlation between national RevPAR and unemployment rates

To test the sensitivity of commercial property rent/RevPAR data to the national unemployment rate, we ran a simple linear regression between these two variables, with the change in rent/RevPAR as the ‘y’, or dependent variable, and the change in the unemployment rate as the ‘x’, or independent variable. The results showed that hotels have almost a 1:1 correlation with unemployment (-0.94 correlation), followed by multifamily (-0.88), industrial (-0.67), office (-0.62), and then retail (-0.32). Chart 1 shows the clear inverse relationship between rent/RevPAR growth and national unemployment for the five property types.

Article 7 Chart 1

Hotels also have the strongest correlation between local regional rents/RevPAR and national unemployment rates

We also tested the correlation between local rents/RevPAR and national unemployment. Some markets display a very high (inverse) correlation, while other markets that may benefit from insulating factors provided by specific industries within a region (such as government, global tourism, or oil exploration) show lower correlation coefficients. The property types that typically have longer lease terms (industrial, office, and retail) than both hotel and multifamily properties also show a weaker relationship between rents and unemployment. Not surprisingly, the results again show that within local markets, the strongest correlation between rent/RevPAR (the dependent variable) and unemployment (the independent variable) was for hotel properties. The correlation between RevPAR and unemployment for the 25 local markets sampled averaged -0.80 for hotel properties; in 19 of the 22 markets where data were available for all five property types, hotels show the highest correlation to unemployment based on our annual percentage change metrics (see table 1). Among the remaining major property types, multifamily again demonstrates the highest correlation within the local markets and on a national level.

Table 1 – Correlations Between Annual Percentage Change In Rents/RevPAR And Annual Percentage Change In The National Unemployment Rate: 1997-2015(i)

Favorably, January payrolls increased in 325 of the 387 metros that are tracked by the U.S. Bureau of Labor Statistics, which paints a near-term positive story for commercial real estate markets. However, the correlation between commercial property rents/RevPAR and unemployment leaves us somewhat concerned, as the underwriting for hotels and multifamily properties, which show the strongest correlations to unemployment, must be based on a long-term sustainable level in order to mitigate any sudden economic setbacks.


With RevPAR Growth Showing Signs Of Slowing, And High Lodging Concentrations in Recent U.S. CMBS Deals, The Strong Hotel Correlations Are Concerning

Although national U.S. lodging sector RevPAR growth continues, the slowed pace of growth, together with hotels’ high concentrations in recent U.S. CMBS deals, have caused the strong hotel correlations to become a concern, in our view.

U.S. RevPAR showing signs of weakening

The RevPAR gain of 6.3% in 2015 was primarily a result of average daily rate (ADR) increases as hotel operators lifted rates in an environment of record high occupancy levels. The 2015 occupancy level of 65.6% was the highest in two decades. Memories of the unprecedented 17% decline in RevPAR during 2009 are fading, and many prognosticators, including Standard & Poor’s Corporate Ratings lodging analysts, forecast RevPAR gains to continue through 2017, albeit at a moderately lower growth rate than the 5%-8% annual increases gained since 2010.

Article 14 Chart 3

While our U.S. lodging sector outlook for 2016 and 2017 remains positive, pockets of weakness have begun to emerge, with RevPAR only increasing by 2.8% in February and 2.4% in January, and a larger share of the top 25 markets recording year-over-year declines than we have seen in many years. In both January and February, that figure grew to nine of the top 25 lodging markets, including New York, Houston, Miami, and Chicago. In addition, supply is set to grow in the next couple of years after hovering at less than 1.0% between 2011 and 2014, with major urban markets experiencing declines in international visitors as the dollar strengthens and room sharing services like Airbnb beginning to have an incremental negative effect in certain markets.

U.S. CMBS lodging exposure increased sharply in recent vintages

As RevPAR has increased, U.S. CMBS exposure to the lodging sector has also risen. The conduit sector’s share of hotel exposure increased to 17% in 2015 offerings from 3% in 2010 (see chart 3), with some deals as high as in the low-to-mid 20% range (some deals with exposure as low as the mid-single digits were exceptions). In addition, hotels were the most securitized property type in 2015 single-borrower deals, accounting for roughly 27% of issuance by balance. While investors and other market participants have sounded cautionary tones on the sector at conferences and in meetings, the trend of elevated exposures to the sector has shown no signs of reversing. Several recently announced large hotel company/portfolio purchases may also support single-borrower issuance.

Article 14 Chart 4

Lodging sector may experience less accommodative refinancing conditions

Beyond this recent issuance trend, it is noteworthy that 16% ($26 billion) of 2016 and 2017 maturing loans are backed by hotels. While admittedly incomplete, our data sample indicates that hotel debt yields have benefitted from several years of strong revenue gains, as the majority of maturing hotel loans have current debt yields over 10% (see table 2). We note that some other property types, which have been slower to rebound, have higher percentages of loans with debt yields under 8%.

Table 2 – Amount Maturing And Debt Yield Summary 2015-2017(i)

Notwithstanding the relatively low percentage of hotel loans with less than 8% debt yields maturing in the near term in our sample, we note that rising concentrations of hotels, combined with revenue volatility and a potential for rising interest rates, could lead to less accommodative refinancing conditions for the sector when newly originated loans approach their maturity dates.


Hotels Show The Most Revenue And Cash Flow Volatility To The Downside

Beyond the increase in CMBS exposure, the lack of long-term leases, high capital investment needs, operational risk, and exposure to event risk all contribute to a much higher level of net cash flow volatility for hotels relative to the other major property types. This volatility stems from the low operating margins for hotels, which typically range from 20% to 25% for full-service hotels and 30%-35% for limited-service hotels. Thus, changes in hotel revenue can, and often do, result in net cash flow changes twice that rate, eroding DSC at a faster pace than the other major property types. So while hotels were one of the first property types to rebound after the recent recession, they were also the first to exhibit weakness in 2008 as economic conditions began to deteriorate.

We illustrate this volatility in chart 4 by creating a performance tracker that shows the annual percentage change in the weighted average revenue per unit for loans from each of the five major property types. Our sample includes well over 60,000 loans that were securitized within Standard & Poor’s-rated deals or were pari-passu with loans in Standard & Poor’s rated deals between 1998 and 2014:

Article 14 Chart 5

We highlighted several points in chart 4:

  • Hotels clearly emerged as the most volatile property type in the data sample for the time period covered. Most prominently, hotel revenues within our securitized population dropped by over 15% between 2008 and 2009. This compares with some relatively smaller declines for the other property types during 2009-2011 in the period around the Great Recession; for example, roughly 5% and 4% declines for retail and industrial, respectively, in the 2009-2010 period, a 2.5% decline for office in 2011, and a 2% drop for multifamily in 2009.
  • Hotels also experienced an average revenue drop in 2001 and 2002 after 9/11, while none of the other major property types exhibited an average revenue decline in this period.
  • The longer-term leases of industrial, office, and retail tend to limit gains in the stronger performance periods and constrain declines during more distressed periods, resulting in more of a performance lag than hotels. While multifamily is sensitive to employment, stable vacancy levels may be providing more stable gross revenue performance.

Cash flow volatility can lead to volatile DSC and more defaults when DSC drops below 1.0x, especially for hotels

To account for their significant cash flow volatility, hotels are usually underwritten to a higher DSC level at origination relative to the other major property types. On a weighted average basis, the DSC at origination for hotel properties has remained above that of other property types in legacy deals (2008 and before), CMBS 2.0 (2010-2011), and CMBS 3.0 (2011-2016) (see table 3).


Table 3 – Securitized Debt Service Coverage By Property Type(i)


In our analysis, we calculated the number of loans within our sample, by property type, that dropped below a 1.0x DSC. Loans secured by hotels have a higher propensity (33%) to fall below a 1.0x DSC than the other property types (see table 4), despite typically being originated at a higher going-in DSC. More importantly, of the loans whose DSC fell below 1.0x at some time during their loan term, 47% ultimately defaulted, which we define as having gone 60 or more days delinquent. Office had the next highest propensity to default subsequent to DSC falling below 1.0x, but at a much lower 32%.


Table 4 – Default Rates By Property Type For Loans Below 1.0x DSC And Resulting Loss Severity


Table 4 also shows the loss severity rate for the loans that met our definition of a default. Retail and hotels had the highest severities, at just over 50%. For retail, aging properties in secondary and tertiary markets can lead to somewhat binary outcomes; thus, it is not surprising that underperforming loans would liquidate at the highest average severity. Multifamily was the top performer, at 37%.


Table 5 looks at the percentage of each property type by loan count that had a DSC less than 1.0x in any given year. Hotels had the highest percentage of loans with a DSC under 1.0x in nine of the 18 years examined. Notably, hotels demonstrated the highest percentage of loans below a 1.0x DSC between 2001 and 2003, largely because of the impact on the U.S. economy from the events of 9/11, in addition to the technology bust that occurred during this period. Similarly, the lodging sector again exhibited the largest increase in the percentage of loans with a DSC under 1.0x in 2008, as U.S. economic conditions started to weaken and then jumped by a staggering 8.8 percentage points in 2009 to 14.1% as the recession took hold.


Multifamily had the highest percentage of low DSC loans in the years leading up to and during the peak CMBS issuance years. This is likely due to the fact that homeownership levels peaked during this time, hovering around 68%-69% in 2004-2007, compared with a current level of approximately 64%. Also as previously noted, multifamily is the most aggressively underwritten property type, in terms of having a lower starting DSC, on average. So although the DSC for multifamily loans frequently fell below 1.0x, table 4 indicates that this didn’t lead to defaults nearly as frequently as it did for hotel loans. Additionally, multifamily properties show the lowest loss severity in the sample for loans that met our definition of default.


Table 5 – Percentage Of Loans Below 1.0x Debt Service Coverage By Property Type (1997-2014)


Hotels’ Downside Risk Necessitates A More Conservative Analysis Of Property Cash Flows And Credit Enhancement Levels

Despite currently healthy property fundamentals, we believe our findings clearly show that hotels are more volatile than the other major property types that collateralize CMBS transactions. While hotel demand is dependent on many factors, hotel sector revenues exhibit nearly a 1:1 inverse correlation with unemployment rates. If employment levels falter, hotel revenues will likely quickly follow. This volatility, coupled with the sector’s low cash flow margins, results in loan-level metrics that demonstrate more volatile DSCs, higher default rates when DSCs fall below 1.0x, and lower recovery rates relative to the other major CMBS property types.

 While the percentage of hotel loans contributed to CMBS transactions continues its upward trajectory, it is our view that caution is warranted when analyzing this property type. Our analysis of hotel properties aims to derive a sustainable net cash flow and value that can endure both upward and downward market fluctuations, typically reflecting more conservative RevPAR assumptions than what recent market conditions and property performance may indicate. Additionally, our stand-alone loan-to-value thresholds, which are used to determine expected principal recoveries in the event of default, are significantly more conservative for hotel properties (e.g., 35.0% at the ‘AAA’ rating level compared to 47.5%-50.0% for the other four property types). As a result, a collateral pool with a higher percentage of hotel loans will typically require higher credit enhancement levels up and down the capital structure based on our analysis.


Hotel Sector Trends in 2016 and Beyond: Value and Risk Drivers


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2015 was a record breaking year for the hotel sector: occupancy levels rose to 65.5%, and according to Moody’s, RevPar increased by 6.3% over 2014 levels.[i] Forecasts for 2016 are healthy, with a side of cautious optimism. According to Smith Travel Research (STR), demand will grow by 2.2%, exceeding a 1.4% increase in supply.[ii] Similarly, average daily rate (“ADR”) is expected to grow to 5.2%, likely leading to an increase in RevPar, which according to PwC’s 2016 lodging forecast will increase by 5.5% in 2016.[iii] However, recent research published by Moody’s suggests that while past growth is a “good indicator” of future performance, potential market saturation may lead to a “tipping of the scale” where supply outpaces demand.[iv]

Comparison of Occupancy, ADR Growth and RevPar Growth Since 2005

 Article 6 Chart 1

Looking ahead to 2016, what factors may contribute to industry growth and strong fundamentals? How can the hospitality sector bolster their current upward trend? Lower oil prices, a strong US dollar and maturing debt will impact the marketplace in the short term. Forecasting through 2016 and beyond, hotel insiders should focus on the rise of the millennial traveler, refurbishment and renewal with a technological and “green” focus and outpacing market disruptors such as Airbnb.

Low Oil Prices. Strong Dollar. Maturing Debt.

In addition to the strengthening US economy and Bureau of Labor Statistics-certified job growth of approximately 2.3 million in 2015, other forces are playing unique roles in the hotel industry’s current performance, including energy prices, a strong dollar and debt maturities.

In 2015, oil prices traded below $50 per barrel, a sharp contrast to $110 per barrel in June 2014.[v] As observed by e-forecasting.com, low oil prices facilitate upticks in travel and vacation plans, with July 2015 delivering a growth rate of 6.9% followed by a 7.6% growth rate in August 2015.[vi] Moving into summer, continued low oil prices should result in increased vacation travel within the US, a boon to hotel occupancy rates.

While a strong US dollar may negatively impact foreign travel to the US in destinations beyond gateway cities, it is not impeding foreign investment. High profile recent acquisitions include the 2015 acquisition of New York City’s Baccarat Hotel by an affiliate of Sunshine Insurance Group, and Chinese insurance giant Anbang’s late 2014 acquisition of New York City’s Waldorf Astoria. Although abandoning its plan to acquire Starwood Hotels & Resorts for $14 billion in late March, Anbang nevertheless expanded its US hotel portfolio by acquiring Strategic Hotels & Resorts for approximately $6.5 billion. In a recent call with investors, Starwood CEO Tom Mangas characterized Anbang as having a “great interest in the US hotel market,” something which Mangas noted he could not “see any reason why that would change.”[vii] Similarly, at the Hospitality Law Conference in Houston, Kevin Mallory, senior managing director and global head for CBRE Hotels, advised that “the hotel industry is coming off a fantastic year for investment activity. . .  the current trend is there’s a great deal of foreign investment activity. . . .”[viii]

Another predicted factor behind increasing movement in the hotel sector for 2016 is a pipeline of legacy 10-year CMBS loans originated between 2005 and 2007. Trepp’s CRE Research estimates that approximately $19.6 billion in lodging-sector loans will mature in 2016, and $10.9 billion will mature in 2017.[ix] Reporting back the insights gleaned from the Americas Lodging Investment Summit of 2016, the hospitality consulting firm HVS noted that this “wall of maturities” has the potential to create in the next 18 months “the most dynamic financing period the industry has ever experienced.”[x] During the first five months of 2015, hotels led all major property types in loan origination, with Trepp’s research indicating “healthy market fundamentals, low interest rates and the impending wall of maturities have led to increased lending in the hotel sector.”[xi] According to the Mortgage Bankers Association CREF/Multifamily Housing Convention and Expo 2016, “moderate supply increases, strong demand levels, and expensed RevPar growth. . .  should continue to make hotels an attractive segment for investment in 2016.”[xii]

 What’s Next for 2016: How Can Hospitality Stay Ahead of the Curve?

 Hospitality is performing strongly, but looking through 2016 and beyond, industry insiders should consider the rise of the millennial traveler, refurbishment and renewal with a tech and “green” focus and outpacing market disruptors, such as homeshares, in order to keep strong fundamentals on track.

Generation Y (aka, millennials; those born from 1980–2000), outnumber the Baby Boom generation (1946–1964) by three million and are predicted to outnumber boomers by as much as 22 million by 2030.[xiii] Each year, more millennials become the client base of the hospitality industry. To date, millennials comprise 22% of all travelers and have spent approximately $200 billion a year on travel.[xiv] Sarah Kennedy Ellis, Sabre’s vice president of marketing for hospitality suggested that by 2017 or 2018, millennials will likely become the biggest spenders on travel.[xv] Understanding this demographic and responding to their needs is a key factor for the hospitality sector’s continued growth. Similarly, creative tech-based marketing is also important to attracting millennials. Bob Rauch, president of RAR Hospitality noted in his “Top 10 Hotel Trends for 2016” that “guests are using social media outlets, community apps, and online forums not only to research and book hotels but to gauge the hotel’s brand identity.”[xvi] The rise of websites such as Oyster.com and TripAdvisor create an online community of information gathering for guests and an opportunity for hotels to make or break their marketing strategies. Best Western president and CEO David Kong advised colleagues at the Hunter Hotel Investment Conference in Atlanta that hotel operators should “up [their] investment in sales and marketing and take as much market share as you can now . . . invest in products and services to build guest loyalty.”[xvii]

In the age of the millennial, social media presence can create an identity. For example, Starwood’s Parker in Palm Springs, California has gone beyond having its own Facebook or Instagram page; instead, its social media platform is authored by “Mrs. Parker,” a fictional character who refers to her followers as “Darlings” and affectionately refers to herself as “Mrs. P.” In this sense, the resort can literally speak to its customer base—appearing on a newsfeed, seeming much less like an advertisement and more like a note from an old friend.

Social media platforms are not only a way for players in the hospitality industry to get out their message, but also a way to track their customer base, respond to feedback and bring reservation services to their guests anywhere in the world. Focusing on technological improvements in an effort to create seamless mobile experiences has the potential to increase transactions and revenue, and generate positive shares on social media, while also providing hotels with guest data and personalizing guests’ experiences.

Millennials move in a fast-paced digital world, where a check-in kiosk may be preferred over a traditional front desk. The Carlson Rezidor hotel group unveiled in 2014 its “Radisson Red” concept, touted as being in touch with the “ageless millennial mindset” and focusing on technology-based guest interfaces such as app-based check-in, and online concierge services. One observable millennial trend is a reliance on techno-do-it-yourself-ism, while at the same time seeking communal shared experiences. Millennial business travelers are seen to prefer an “alone together” concept, utilizing communal lobby spaces, rather than sitting in their rooms. In line with “alone together,” is the rising trend of co-working spaces within hotels.

As more workers seek location-independent jobs, co-working spaces function as communal offices that allow unrelated workers and employees to work in a shared environment. Jessica Festa of Road Warrior Voices spells out several reasons why co-working hotels may be hospitality’s future.[xviii] For many hotels, the traditional business center became obsolete as travelers carried their own laptops and tablets. To adapt to this, some have forgone updating their business centers to instead create more inviting, work-friendly lobbies. Second, hotel-based co-working spaces are useful for both guests and non-guests, expanding usability beyond the sphere of guests and their clients to include local location-independent workers. Hotel Schani in Vienna provides desk rentals in its lobby managed by an online Co-working Market Place. The marketplace enables guests to book a room online, select their desired floor, proximity to the elevator, amenities and even furnishing arrangements from a menu on the hotel’s web app.[xix] In New York City, the Ace Hotel in Midtown has turned its lobby into a collective workspace for a variety of professionals—designers, academics, stylists, advertising executives, writers, entrepreneurs, etc.— whose fields of work often lack a formal office structure.[xx]

In addition to the expansion of shared spaces and technologically advanced guest interfaces, millennials are also seeking unique, bespoke travel experiences. Kimpton Hotels has responded to this desire by focusing on local design, community integration and locally-sourced food and beverage. According to Greg Oates of Skift.com, Kimpton strives to provide unique experiences to consumers that would otherwise not be readily accessible.[xxi] Kimpton launched a monthly initiative named “Like a Local” that provides guests with hotel staff’s personal recommendations for interesting local activities. The Radisson Red also features on their website a curated “Inspirations” page which includes photo tours of “city breaks, adventure and local culture” touting that “we’ve explored it so you can browse it.”

With rampant competition among hotel providers in the modern era, mastering the art of original branding can be a key tactic in distinguishing a hotel from its competitors.

Invest in the Environment.

Another trend attractive to millennials and useful for boosting property fundamentals is the green movement. A February 2012 report by HVS found that consumers are exceedingly environmentally conscious and support businesses that adopt green practices.[xxii] Implementing green initiatives, including renovating in order to qualify for LEED (Leader in Energy and Environmental Design) Certification, provides an opportunity for hotels to improve their fundamentals both by appealing to environmentally-focused guests, such as the millennial cohort, and by lessening the burden on hotel operators in consuming natural resources. There is great potential in adopting sustainability measures in the hospitality sector since hotels voraciously consume natural resources. US Green Building Council’s LEED in Motion: Hospitality report states that US hotels operate for 24 hours a day, seven days a week, while occupying more than five billion square feet of space. LEED is the most widely used green building rating program in the US and has been of increasing importance in the hospitality industry. Sustainable buildings include solar panels, natural ventilation, water storage and shading technologies that improve a building’s resilience. In new construction projects, green techniques also include the use of sustainable concrete or timber, materials that are efficient with resources and maximize natural light, and techniques that minimize energy and water use, all of which can help increase a property’s fundamentals by decreasing its environmental impact while appealing to guests.

Are Home Shares Cause for Concern?

The factors that help maintain strong fundamentals aren’t the only considerations for a bright 2016. The hospitality sector also needs to weigh the impact of market disruptors. How much of a risk does the rise of the sharing economy and websites like Airbnb present to the industry? As of September 30, 2015, hotel REITs produced a total return of -22.2% year-to-date compared to a -4.3% return during the same period for the MSCI US REIT Index.[xxiii] According to the Chilton REIT team, some of the decline can be traced to home-sharing websites like Airbnb.[xxiv]

CBRE Hotels’ Americas Research indicated that overall Airbnb supply represents approximately 3% of traditional hotel stock.[xxv] CBRE’s research further suggests that the higher the RevPar, the greater the number of Airbnb units; however, the higher the price of an Airbnb the less of a threat such Airbnb is to traditional hotels. A March 2016 report by Moody’s indicated that Airbnb tends to compete with leisure guests “mainly with lower-priced hotels that are unaffiliated with major brands.”[xxvi] The report further noted that the service is less competitive for business travelers and less competitive with hotels with conference and other amenities services. Moody’s overall prediction is that a “supply-demand imbalance from overbuilding in the hotel sector” poses a larger threat to hotel fundamentals than the impact of Airbnb.

A 2013 study conducted by Boston University found that “higher-end chain scales, as well as hotels that cater to transient business travel, should be the most insulated from Airbnb”.[xxvii] Further, despite popular belief, shared-space renters were not necessarily traveling alone: 31% of renters traveled as a couple or with another adult, and 22% were families with children. An additional 9% of travelers rented with adult friends or family.[xxviii] Airbnb travelers tend to travel in groups, stay for longer and be more price sensitive than the typical hotel guest. This observation suggests that Airbnb renters are likely seeking a different experience than those travelers seeking an urban, business-focused stay. Moody’s cited that “Airbnb is less competitive for business travelers than higher priced, traditional brand name hotels.”[xxix] 30-40% of Airbnb travelers have reported they would not have taken their trip were it not for Airbnb.[xxx] As such, the sharing economy and websites like Airbnb may be a growing of the pie, rather than a shrinking of the pieces affected by this disruptor.


 Overall, the outlook for the hotel sector appears optimistic, bolstered by strong fundamentals and positive indicators such as low oil prices, foreign interest in US investments due to a strong dollar and increased lending as a result of loan maturities. Despite the hopeful outlook, hotel operators should consider adopting measures to embrace the unfolding demands of the rising millennial customer base, including providing unique, tech-based interactions, integrating co-working spaces and taking sustainability measures. By implementing strategies to address these points, the hotel sector can better hedge for sustained strong market fundamentals in the coming years.


[i] “Moody’s: US Lodging Growth Slowdown Continues in Q4 2015; Cruise Companies Maintain Strength” Moody’s Investor Service, January 21, 2016.

[ii] Zacks Equity Research “Hotels Rebound: Sustainable Over the Long Term?” Zacks.com, March 30, 2016.

[iii] Scott D. Berman, “In 2016, Average Daily Rate Reluctantly Takes the Driver’s Seat, Says PwC US” PwC, January 25, 2016.

[iv] “Robust 2015 Hotel Performance Masks Softening” Lodging Magazine, March 16, 2016.

[v] “Brent crude oil price dips below $50 a barrel” BBC, January 7, 2015.

[vi] “Hotel Industry Benefits from Lower Oil Prices” E-Forecasting.com, September 22, 2015.

[vii] Hui-yong Yu, “Starwood CEO Sees Hotel M&A Accelerating After Marriott Deal” April 4, 2016.

[viii] Bryan Wroten “Hoteliers Talk 2016’s Legal, Investment Issues” Hotel News Now, February 23, 2016.

[ix] Susan Persin “wall of CMBS Loan Maturities Shrinks, Remains Daunting” Trepp CMBS Research, February 2016.

[x] “Seven Key Takeaways from the Americas Lodging Investment Summit 2016 (ALIS)” HVS, 2016.

[xi] “Can Lodging Real Estate Fundamentals Support Continued Growth” Trepp CRE Research, May 2015.

[xii] “Uncertain Outlook for Commercial Lending, Including Hospitality” Hotel Investment News, February 16, 2016.

[xiii] Aisha Carter “How Millennials are Changing Hotels” BisNow, July 8, 2015.

[xiv] “Millennial Expectations are Reshaping Travel Industry” GBrief, February 19, 2016.

[xv] “Sabre: Millenials May Be the Largest Hotel Spenders as soon as 2017” TNooz, March 11, 2016.

[xvi] Bob Rauch, “Top 10 Hotel Trends for 2016” Hospitalitynet, December 2, 2015.

[xvii] “Hunter: Now’s the Time to Reinvest in Your Hotels” Hotel News Now, March 18, 2016.

[xviii] Jessica Festa “6 Reasons Coworking Hotels are the Future of Hospitality” Road Warrior Voices, November 2, 2015.

[xix] Christine Lagorio-Chafkin “Co-Working, but for Hotels. (Seriously)” Inc., October 9, 2015.

[xx] Lizzy Goodman “Ace Hotel’s Communal Workspace Shows a Winning Hand” FastCompany, August 12, 2011.

[xxi] Greg Oates, “How Kimpton Hotels Built Its Brand on the Local Experience” Skift, October 28, 2013.

[xxii] “Current Trends and Opportunities in Hotel Sustainability” HVS, February 2012.

[xxiii] Chilton REIT Team “The Effect (If Any) of Airbnb on Hotel Companies” Nasdaq, October 1, 2015.

[xxiv] Ibid.                        

[xxv] Jamie Lane “The Sharing Economy Checks In: An Analysis of Airbnb in the United States” CBRE Hotels’ Americas Research.

[xxvi] “Moody’s: Continued Hotel Construction a Greater Threat to US Lodging Sector CMBS than Airbnb” Moody’s Investor Service, March 15, 2016.

[xxvii] Georgios Zervas et al “The Rise of the Sharing Economy: Estimating the Impact of Airbnb on the Hotel Industry” Boston University, December 14, 2013.

[xxviii] Amber Wojcek, “Shared Lodging Is Here to Stay—How You Can Compete” Travel Media Group, August 24, 2015.

[xxix] “Moody’s: Continued Hotel Construction a Greater Threat to US Lodging Sector CMBS than Airbnb” Moody’s Investor Service, March 15, 2016.

[xxx] Georgios Zervas et al “The Rise of the Sharing Economy: Estimating the Impact of Airbnb on the Hotel Industry” Boston University, December 14, 2013.