The US commercial real estate market is in relatively good shape. Investor demand remains strong, as evidenced by continually increasing prices, and property owners still have relatively easy access to mortgage financing. However, there’s a real concern about the recent regulations, which will be enacted on December 24th of this year that could severely impact the market’s health. In fact, there’s concern that CMBS (commercial mortgage-backed securities), a type of mortgage-backed security that is secured by mortgages on commercial properties that provide liquidity to real estate investors and to commercial lenders, could either evaporate or change dramatically because of those rules.
Brokers are scared of the pending risk retention rules that go into effect in December. The rules are incorporated as part of the Dodd-Frank Wall Street Reform & Consumer Protection Act. Risk retention requires that the issuer of a CMBS deal has to either keep a slice equal to 5 percent of that deal’s market value for at least five years without refinancing or reselling, or find another investor to take on that risk. That means that whoever takes on the 5% will be buying bonds up to those rated BBB, or even higher. B-piece buyers currently buy bonds up to those rated BBB. The expectation is that the yields from those bonds would have to, at the very least, increase to compensate investors for their inability to trade out their B-pieces. Or, simply, loan prices will increase.
While many questions from lenders and sponsors have yet to be answered about the biggest regulatory hurdle the CMBS industry has faced, three main structures for new CMBS deals to comply with the risk retention rules appear to be taking shape:
- A bank retains a vertical slice of the capital stack.
- A bank retains a horizontal slice of the debt.
- A B-piece investor retains a horizontal slice of the debt.
We’re already seeing some results of these new regulations before they’ve even been enacted. The CMBS market was supposed to be on fire this year, and instead it has been ice cold for much of the year to date. Only time will tell what will happen in the unknowable fourth quarter. At present, CMBS loans account for 7% of all commercial real estate lending, down from 17% last year, which is quite a shift from the 2006 market when CMBS loans accounted for roughly 50%.
A Possible Solution
Concerns over the potential impact of risk retention on credit markets has prompted the real estate industry to lobby Congress on legislation to clarify the risk retention rules and to minimize negative impacts on commercial property markets. The Preserving Access to CRE Capital Act (H.R. 4620) bill proposed by the Arkansas Republican Rep. French Hill would soften the 5% risk retention requirement. The bill provides an exemption for single-asset, single-borrower transactions and would allow investors to split the retained risk horizontally and in line with the structure of the bonds. Passing the Capital Act could greatly enhance market liquidity and provide more financing options for investors interested in utilizing CMBS as a source of funding. This bill is supported by the MBA and the Commercial Real Estate Finance Council. It has been approved by the House Financial Services Committee, but unfortunately, it has gained little traction in the Senate.
There are going to be winners and losers and the market will determine which approach is preferred going forward, but it might take a while, and market disruption is likely. Although there is no clear fix for these issues, the Capital Act definitely presents more selection and eases the transition to the new regulations.
Although analysts are still in the dark about how exactly the new regulations will all play out in the market, it’s not looking good for commercial real estate brokers. The biggest savior for those in the industry could hope for is the Capital Act being bill being voted into law. Clearly there needs to be some compromise between the strict regulations and trying to prevent another market disaster. If not, the CMBS could cease to exist, opening the flood gates for more strict regulation for commercial real estate.