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% requirement. 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.