Download Continuing the Effort to Restore Liquidity in Commercial Real Estate

Continuing the Effort to Restore Liquidity in Commercial Real Estate Markets
Situation Overview: Market Failure
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The current credit system in America simply does not have the capacity to meet the
ongoing demand for commercial real estate debt. With an average of $300 billion in
commercial real estate loans maturing each year for the next decade — and still
virtually no way to refinance these loans — stress to the financial services system,
individual financial institutions, and those who have invested in real estate directly or
indirectly will increase.
•
With very limited capacity to meet this ongoing demand for credit, a potential wave of
defaults from maturing loans could jeopardize economic recovery and, potentially,
undo much of the progress made to date in healing the banking system and credit
markets.
•
Policymakers have taken some bold steps to try to thaw frozen credit markets,
encourage a resumption of sound lending and prevent unnecessary defaults and
foreclosures. However, the magnitude and complexity of the problem demand that
policymakers consider additional action.
What does the CRE Refinancing Crisis Mean for Main Street USA?
•
Commercial real estate represents $6.7 trillion of value supported by $3.5 trillion in
debt. The health of this vast sector is vital to the economy (estimates show commercial
real estate constitutes 13% of GDP by revenue) and to our nation’s financial system.
•
An estimated 9 million jobs are generated or supported by real estate — jobs in
construction, planning, architecture, environmental consultation and remediation,
engineering, building maintenance and security, management, leasing, brokerage,
investment and mortgage lending, accounting and legal services, interior design,
landscaping, cleaning services and more.
•
Rising defaults (resulting from a lack of refinancing options) and plunging commercial
property values threaten to create a cascade of negative economic consequences.
Ø For millions of Americans whose pension funds invest directly or indirectly in
approximately $160 billion of commercial real estate equity, increased loan
defaults and lower property values will cause further erosion of their retirement
savings.
Ø For millions of construction, hotel and retail workers, the commercial real
estate liquidity vacuum will continue to translate into cancelled or delayed projects,
layoffs and pinched family budgets — exacerbating rising unemployment and
declining consumer spending. This, in turn, will further hurt U.S. businesses and
exacerbate falling demand for commercial real estate space.
Ø For state and local governments — already constrained by tight budgets because of
deteriorating home values — the freefall in commercial property values will mean even
less revenue from property assessments, recording fees and transaction taxes.
Ø For the communities they serve, it will mean deeper cutbacks in essential public
services such as education, road construction, law enforcement, and emergency planning.
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During the past few years, banks and the commercial mortgage backed securities (CMBS)
market provided about 83% of the growth in commercial real estate debt. Today, both of these
(traditionally) large sources of commercial real estate credit remain virtually shut down.
The CMBS market is illustrative of the problem. CMBS issuance peaked in 2007 with $230
billion of bonds issued. This plunged to $12 billion in 2008, a decline of nearly 95%. Thus far
in 2009, there has been no new CMBS issuance.
A Multi-Pronged Approach to Easing the Crisis
Since September 2008, The Roundtable has been working on multiple fronts to restore liquidity
to commercial real estate markets and assist in overall deleveraging. Thus far, three major policy
initiatives outlined in our Five-Point Liquidity Plan have been enacted or implemented:
•
The Federal Reserve’s Term Asset-Backed Securities Loan Facility (TALF), designed to
restart the asset-backed securities market, was expanded to include newly issued AAArated CMBS as well as “legacy CMBS.” As we urged in congressional testimony in July,
the CMBS program has also been extended (through June 2010).
•
A key provision of the economic stimulus package enacted in February (the “American
Recovery and Reinvestment Act of 2009”, H.R. 1) provided important tax relief for
businesses that reacquire, satisfy or otherwise discharge debt obligations at a discount in
2009 and 2010. This provision defers any tax on 2009 and 2010 cancellation of
indebtedness income (COD) until 2014, and then taxes the COD income ratably over the
following 5 years (2014-2018).
•
New Treasury guidance issued in September clarifies that discussions involving
modifications to the terms of a securitized commercial real estate loan “may occur at any
time” without triggering tax consequences applicable to Real Estate Mortgage Investment
Conduits (REMICs) if there is contemporaneous evidence of a “significant risk of
default”. By allowing servicers to modify such CMBS loans many problems can now be
addressed at an early stage before loans actually default.
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Although these policy steps have been most welcome, we believe additional action is needed:
Ø Extend TALF through the end of 2010, to provide sufficient time to assemble and
package new CMBS loans; and make the program accessible to a broader range of
investment-grade securities (not just AAA), so that it can be marketed more robustly.
Ø Establish a federally-backed credit facility, possibly created by expanding the existing
public-private investment fund program (P-PIP) or through a privately funded guarantee
program, for originating new commercial real estate loans.
Ø Encourage non-U.S. debt and equity investment in U.S. real estate by (1) amending or
repealing the outdated Foreign Investment in Real Property Tax Act (FIRPTA), which
applies to equity investments and (2) by clarifying the effectively connected income tax
application to new origination and workout debt investment.
Ø Encourage banks and loan servicers to extend performing loans, based on cash flow
analysis.
Ø Reject new anti-real-estate-investment taxes, such as the carried interest proposal; and
provide a five-year carry back for the net operating losses (NOL) of all businesses.
Background
The current commercial real estate (“CRE”) crash — with values potentially declining by 50% or
more from their peak — stems in large part from the financing side, where a massive
deterioration in lender underwriting standards and excessive leverage have lead to problems of
similar (or greater) magnitude than the 1990s, even without supply problems.
Lack of new CRE loans: Banks are not lending on new transactions but, rather, temporarily
extending existing loans at maturity (rather than foreclosing) and categorizing them as “new
loans.” Scarcity of credit is making it very difficult to find new loans at institutionally sized
proceeds and terms, even those that should normally qualify under new, tighter underwriting
standards.
Mountain of debt maturities: There is a total of $3.5 trillion of CRE debt outstanding
(excluding government-sponsored and agency loans).
Ø CMBS represents $700 billion (or 25%) of total CRE debt outstanding. At its peak in
2005-2007, CMBS saw $600 billion in total issuance (three-quarters was interest-only
and on average 87% was rated AAA at securitization) and now constitutes nearly 70% of
total delinquent CMBS. $236 billion of total CMBS matures between now and 2013.
Ø Banks and life insurance companies, which make up 50% and 10% of total CRE debt
outstanding, respectively, are potentially an even bigger problem. Banks have $1.5
trillion in CRE loans on their books that look even more vulnerable than CMBS,
especially smaller regional and community banks that have very high exposures to
troubled construction and land development loans. According to the FDIC, this includes
$1 trillion of core CRE loans and $532 billion of highly volatile construction and land
development loans.
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Ø Life insurance companies have approximately $222 billion of direct loans maturing
through 2018 according to the Mortgage Bankers Association.
Ø The total rolling maturities from these three sources (CMBS, insurance companies
and Banks/Thrifts) is $1.3 trillion maturing through 2013 and $2.4 trillion maturing
through 2018.
Source: Deutsche Bank, Intex, TREPP, Mortgage Bankers Association, Federal Reserve
Need for a Catalyst
Property fundamentals continue to deteriorate: Adding to the pressure from the frozen credit
markets, macroeconomic problems are causing vacancies to increase, reducing cash flows and
further reducing valuations.
Ø Office rents are down; concessions are up dramatically (e.g., in New York and San
Francisco, Class A effective rents are down 30-40%); and vacancies are increasing, as
financial services and related tenants downsize and attempt to sublease excess space.
Ø Hotel occupancies and average daily rates are down 25-30%, while NOI is down, in
some cases not even breaking even at the property level (before debt service).
Ø Retail vacancies are increasing, as consumers pull back and tenants are forced to
declare bankruptcy and/or close stores (Mervyns, Gottschalks, KB Toys, Sharper
Image, Circuit City, Eddie Bauer, Linens ‘n Things, Steve & Barry, etc.). Mall cotenancy clauses creating downward spiral effect.
Ø CMBS delinquency rates have already increased from 0.5% in July 2008 to 3.5% as of
June 2009 (as a % of total CMBS outstanding balance).
Ø Likewise, CMBS transferred to special servicing has spiked from 0.5% in July 2008 to
5.0% as of June 2009 (as a % of total CMBS outstanding balance).
Negative Feedback Loop: With CRE debt markets still mostly frozen and macroeconomic
conditions still weak, property values continue their precipitous decline.
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Ø Transaction volume down 90% from 2007 peak.
Ø Cap rates up at least 300 basis points on declining property income as investors
contend with lower leverage, higher costs of debt and deteriorating fundamentals.
Ø Thus, values have already declined as much as 40% as investors require a much
lower price to generate an acceptable return.
Ø Lower CRE values only exacerbate bank/financial institution balance sheet
problems and inhibit issuance of new loans; this results in no new development
where warranted, further impacting job creation, tax revenues for local, state and
federal governments and overall economic recovery.
Pre-Credit Crisis Post-Credit Crisis
Lender Underwriting
NOI (1)
Property Cap Rate
Property Value
$6.5
6.5%
$100.0
$5.9
9.8%
$60.0
Senior Mortgage Debt
Interest Rate / Debt Constant (2)
Interest Coverage
Loan Proceeds
LTV
Debt Yield (3)
5.0%
1.9x
$68.4
68.4%
9.5%
9.4%
1.9x
$33.0
55.0%
17.7%
Subordinated Debt
LTV Target
Loan Proceeds
Interest Rate
Debt Yield (3)
Interest Coverage (Includ. Senior)
80.0%
$11.6
8.0%
8.1%
1.5x
N/A
N/A
N/A
N/A
N/A
Investor Equity
% of Property Value
Equity Investment
Free Cash Flow After Debt Service
20.0%
$20.0
$2.2
45.0%
$27.0
$2.8
Blended Cost of Debt
Investor Return on Equity (4)
5.4%
10.8%
9.4%
10.2%
(1)
(2)
(3)
(4)
Capital Structure Comparison
Equity
$20.0
Subordinated Debt
$11.6
Equity
$27.0
Senior Mortgage Debt
$68.4
Senior Mortgage Debt
$33.0
Pre-Credit Crisis
Assumes 10% decrease in property net operating income (NOI)
Assumes interest-only for pre-credit crisis debt; assumes 8.0% interest rate plus 25-year amortization for post-credit crisis debt
Debt yield calculated as NOI divided by last dollar risk; measures lender risk exposure to cap rate expansion and NOI decline
Investor Return on Equity calculated as free cash flow after debt service divided by equity investment.
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40% decrease in
value
Post-Credit Crisis
Similar to the residential housing bust, downward spiraling CRE values could further weaken a
fragile financial system; the period 2010-2013 will be one of very significant stress if the
current stalemate between borrowers, servicers, lenders and investors isn’t resolved quickly.
CMBS Modification Process: Until recently, REMIC tax rules prevented CMBS loan servicers
from modifying/extending in advance of an anticipated loan maturity default. Instead, they were
required to wait until the loan was either in “imminent” default (close to maturity) or in technical
default — leaving them inundated with delinquent loans. Borrowers were unable to even begin
discussions with their loan servicers until they had already defaulted or were within weeks or
months of defaulting.
In early September, the IRS issued new REMIC (real estate mortgage investment conduit) tax
guidance that provides significantly greater flexibility to rework the terms of commercial
mortgage loans that have been securitized into CMBS. Under the new rule, discussions
involving modifications to the terms of a securitized loan “may occur at any time” without
triggering tax consequences.
By allowing borrowers and servicers to begin loan work-out talks before the point of default, the
rule change should help reduce foreclosures and prevent further erosion of property values and
local tax revenues. With an estimated $236 billion in CMBS loans coming due between now and
2013, this IRS action is most welcome.
Potential Solutions
CRE has been among the hardest hit sectors in the current economic downturn and is in need of
three distinct but interrelated solutions:
1. A vehicle to purge toxic, legacy CRE loans
2. A mechanism to incentivize modification of performing loans (where appropriate)
3. A catalyst to generate new CRE loans
Toward that end, The Roundtable urges the following steps:
Extend TALF for legacy and newly issued CMBS beyond their respective March 31 and
June 30, 2010 sunset dates, through the end of 2010 and potentially expand the program to
include lower rated, investment grade CMBS tranches.
Without such an extension, only a limited number of new CMBS securitizations will take place
and the program will end before it has had the desired effect on price discovery and return of an
active securitization market.
TALF for new issuance currently addresses only senior AAA-rated bonds (35-45% loan to
value), which does not address the vast majority of maturing CMBS loans that need to be
refinanced; it is cost-prohibitive to add debt over the AAA-rated piece due to frozen credit
markets and banks unwillingness to warehouse higher-leverage loans on their balance sheet.
Policymakers should consider loosening TALF terms to include lower-rated, investment grade
bonds.
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TALF for legacy CMBS props up asset values for an already relatively insulated (lower loss
likelihood) tranche of legacy securities. It does not address/encourage buyers for truly toxic
loans and lower-rated, investment grade CMBS currently clogging financial institutions’ balance
sheets and preventing new originations.
Finalize details and implement the PPIP Legacy Loans Program previously announced by
the FDIC.
Ø The Legacy Securities Program, like TALF, only addresses a narrow segment of the toxic
asset problem (CMBS constitutes just 25% of total CRE debt outstanding).
Ø Bulk of the Problem: Until toxic senior mortgages, construction/land loans and
mezzanine debt are cleansed from financial institutions’ balance sheets, the prospects for
new loan origination and CRE value discovery and recovery are dim.
Establish a federally-backed credit facility, possibly created as a third PPIP structure or a
privately funded guarantee program, to help stimulate the origination of new, solidly
underwritten commercial real estate loans.
Ø PPIP for New Origination: Adaptation of the PPIP structure to a third program
matching private investors and federal government equity plus fund-level government
leverage to fund a pipeline of new CMBS or whole loans origination.
One option would involve adapting PPIP’s public-private investment structure under the
stalled Legacy Loans Program (LLP). Under this structure, Public Private Investment
Funds (PPIFs) would be created, utilizing private capital with leverage from the federal
government.
But instead of using the program for so-called legacy (or troubled) loans, the PPIFs
would be used to fund a pipeline of solidly underwritten, newly originated commercial
real estate loans. Instead of acquiring legacy loans, the program would shift to new loans
and provide an important source of liquidity to the industry at the whole loan level. It
would also help solve the warehousing problems afflicting potential TALF-eligible
CMBS loan originators.
Ø Government Credit Enhancement: Alternatively, create a federally chartered, privately
funded loan guarantee facility (similar to FDIC) for newly issued CMBS or whole loans,
such that an insurance pool stands behind these securities/loans, thereby helping to create
a stable secondary market into which banks can sell newly originated product.
We have been studying the creation of a federally chartered, privately funded loan
guarantee program for commercial real estate securities. After an initial period of support
from TARP and the Federal Reserve (similar to the TALF program), such a program
would be self- funded by a fee charged to the issuers of securities — in much the same
way the FDIC insures bank deposits.
Such an entity would create an insurance pool to stand behind these securities and help
restore investor confidence and restart securitization markets. While our interest is in
focusing such an entity on the CMBS market, it could be used for a variety of asset
classes.
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By creating a loan guarantee facility for newly issued mortgage backed securities, banks
and loan originators will have a stable secondary market into which they can sell newly
originated, solidly underwritten loans.
Encourage foreign capital investment in U.S. real estate equity and debt by amending or
repealing the outdated Foreign Investment in Real Property Tax Act (FIRPTA) and
clarifying the securities trading safe harbor Tax Code section 864(b)(2).
Because of significant value declines in commercial real estate, there must be significant
additional equity investment into the market place for lending to resume and transactions to
go forward.
Preliminary conservative estimates reveal an “equity gap” exceeding $1 trillion over the
next several years. One potential source for this needed equity investment is foreign pension
and other non-U.S. fund pools — but policy must facilitate this investment.
Under current policy, gains realized from the sale of U.S. real estate by non-U.S. investors
are subjected to U.S. taxation at full U.S. rates under the 1980 FIRPTA law. Such taxation is
completely at odds with the U.S. tax treatment of many other types of foreign investment in
the United States. With a few technical exceptions, FIRPTA is literally the only major
provision of U.S. tax law that subjects non-U.S. investors to taxation on capital gains realized
from investment in U.S. assets. By modifying FIRPTA, non-U.S. investors will be
encouraged to inject much needed capital into the U.S. real estate markets.
Over the years, FIRPTA has had an adverse effect on foreign investment in U.S. real estate.
In fact, the obstacles that are imposed under FIRPTA have led many non-U.S. investors to
invest in real estate elsewhere — in countries such as Brazil, China and India — shifting
wealth and economic dynamism away from the U.S. market.
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The laws relating to foreign investment in U.S. real estate should be reviewed by Congress
and corrected in a responsible way to allow increased investment into U.S. real estate, while
still ensuring that the real estate is domestically controlled.
It is important to lower the threshold for new pools of capital to acquire U.S. CRE assets
while other equity sources continue to dry up or sit on the sidelines waiting for further
distress.
Treasury and IRS should issue guidance confirming that CRE loan originations/modifications
are encompassed by the proprietary securities trading safe harbor of section 864(b)(2) of the
Tax Code and that such actions do not constitute a U.S. trade or business.
Clarifying this would expand real estate lending capacity and enable non-U.S. investors to
originate new real estate debt and provide more capital to invest in existing debt.
Conclusion
The overriding concern lies in the credit markets. Here, it is important that the government
continue to take appropriate steps — along the lines of the TALF and PPIP — to restore
functionality to credit markets and create an environment conducive for business and investors to
invest and deploy capital.
At the same time, it is important that unnecessary barriers to equity investment and debt
acquisition, workouts and origination be lowered and that taxes on risk taking not be increased.
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