The Fed Seeks to Stimulate Tepid Economic Growth ... U.S. and Euro-zone Deficits Thwart Economic Expansion ... Corporte Earnings Weaken ... Mounting Maturities Cloud Commercial Real Estate Outlook (October 2012)
- Some five years after the credit market collapse, the search for an enduring recovery continues. Investors remain cautious in the face of potential external shocks and a string of baffling domestic policy variables.
» Dodd-Frank Financial Services Reform: Implications for Real Estate
- Risk Retention — “Skin in the Game”
- Volcker Rule
» Reforming the GSEs - Government Sponsored Enterprises
» Covered Bonds
» Proposed Accounting Policy Measures Could Impede Reovery
» Basel III
» Renewing the Terrorism Risk Insurance Program
» Summary (October 2012)
In September, the Federal Reserve introduced the third round of quantitative easing, also known as QE3, since the onset of the global financial crisis in 2008. This rolling program of buying $40 billion a month in mortgage-backed securities was aimed at reviving the jobs market by stimulating the still troubled housing market. On top of the new plan, the Fed plans to continue its action to bring down long-term interest rates, dubbed "Operation Twist", through the end of 2012. Together the schemes will pump $85 billion a month into the U.S. economy.
The unemployment rate ticked down from 8.3% to 8.1%, driven down not by hiring ... but by 368,000 Americans leaving the labor force. The Fed chairman warned that the U.S. still faced "headwinds," most notably the so-called Fiscal Cliff, a year-end deadline for the expiration of Bush-era tax cuts and the imposition of massive spending cuts. According to the Congressional Budget Office, unless a political solution is found to the fiscal cliff, the U.S. could be plunged back into recession.
Some five years after the credit market collapse, the search for an enduring recovery continues. Hopes for the U.S. and global financial markets to return to normal operation in the near future return remain clouded by uncertainty – and further exacerbated by a lack of confidence in the regulatory climate. Despite some positive economic signs, credit markets are not yet operating smoothly. Investors remain cautious in the face of potential external shocks and a string of baffling domestic policy variables.
Uncertainty lingers despite positive economic signs on a number of fronts. With nearly 23 million men and women unemployed, not since the Great Depression have so many Americans been unable to find work for so long. Such malignant unemployment and persistent weakness in the housing market continue to impede economic recovery. And, despite historically low interest rates, the lending market has still not recovered on all levels. Most lenders remain focused on core properties in the stronger markets at relatively modest leverage levels. While credit capacity has strengthened in core markets, lending activity remains far less aggressive in secondary and tertiary markets.
An improving economy solves many problems in commercial real estate — so lifting the cloud of regulatory uncertainty and creating a positive climate for job growth and investment are essential. Most important now are policies that will facilitate capital formation, equity investment in real estate, restore vitality to the asset backed securities markets, help banks continue to clear their balance sheets of toxic assets and encourage prudent lending.
New issuance of commercial mortgage-backes securities (CMBS) has seen signs of improvement, with total new U.S. CMBS issuance finishing 2011 at $32.7 billion and approximately $25 billion issued year to date. While it is an improvement from 2010 – $12 billion – it is well below what is needed to refinance hundreds of billions of dollars in maturing commercial real estate debt. As CMBS delinquency levels reach 10 percent, it is clear that many of these loans are either underwater or unable to be refinanced at maturity. Such a development only adds to the challenges of “re-equitizing” the mountain of commercial real estate loans made during the boom.
One approach to filling this gap is to encourage capital from foreign investors, including sovereign wealth funds. Unfortunately, outdated, discriminatory tax laws such as the 1980 Foreign Investment in Real Property Tax Act (FIRPTA) are discouraging non-U.S. investors from investing in U.S. commercial real estate. FIRPTA reform is a top priority. To address FIRPTA reform, The Real Estate Jobs and Investment Act of 2011 (H.R. 2989) was introduced in the House in 2011, and a broader bill (S.1616) is being considered in the Senate (see Tax Policy section). FIRPTA reform is a top priority for The Real Estate Roundtable.
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» Dodd-Frank Financial Services Reform: Implications for Real Estate
The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in 2010, unleashed the biggest wave of new federal financial rule-making in generations. Over a year after its enactment, Dodd-Frank continues to reverberate across the financial services industry, as 11 federal agencies endeavor to implement some 243 new formal rule-makings. As the economy struggles to grow, this new law adds a myriad of new regulations – feeding the climate of uncertainty facing businesses across the country.
As regulations are being developed and reviewed, the Roundtable remains concerned about the overall negative impact the vast financial regulatory reform package will have on capital formation and credit capacity.
The Roundtable is focused on various aspects of the Dodd Frank reform:
» Risk Retention — “Skin in the Game”
One of the rules imposed by Dodd-Frank affects asset-backed securitization and, specifically, commercial mortgage-backed securities (CMBS). This so-called “skin in the game” rule requires banks who package loans to retain 5 percent of the credit risk on their balance sheets. This rule is intended to better align the interests of the sponsor with those of investors by providing sponsors with an incentive to control the quality of securitized assets. Last March, five federal banking and housing agencies, as well as the Securities & Exchange Commission (SEC), released a 367-page set of proposed rules to implement the Dodd-Frank mandated credit risk retention requirement for certain securitization transactions.
As stated in our August 1, 2011 comment letter, The Roundtable believes that the proposed risk retention rules were intended to ensure that the commercial real estate lending market function with an appropriate level of integrity and discipline. However, we are extremely concerned about the serious and presumably unintended economic consequences that the proposed rules could have on the effective re-emergence of a reliable new issuance market.
Although risk retention may be intended to safeguard bondholders, it also introduces the potential to raise costs for borrowers or to limit the amount of credit and liquidity that are available, particularly to borrowers in secondary and tertiary markets. Specifically, we oppose the imposition of the Premium Capture Cash Reserve Account (PCCRA) and are concerned this construct would significantly impede the new-issuance of CMBS.
The Real Estate Roundtable supports efforts to promote economically responsible commercial real estate lending that reflects sound underwriting and risk management practices, and rational pricing of economic risk. We continue to urge policymakers to take action that encourages stable valuations, enhanced transparency and sensible underwriting, and support efforts to establish appropriate systemic safeguards—all key factors for the return of a reliable credit system.
» Volcker Rule
Another component of Dodd Frank reforms that regulators must translate into regulation involves the so-called Volcker Rule – which is intended to reduce the risk exposure of financial firms by removing elements of proprietary trading and sponsorship of private equity and hedge funds. A number of financial companies currently have ownership in or sponsor private equity funds and other “third party” investment funds that invest in commercial real estate. In the process of “de-risking” financial firms, it is important that regulators not impose rules that will restrict appropriate capital formation or securitization activity– particularly for real estate.
Last November, the proposed rule was published in the Federal Register and comments were requested by January 13, 2012. Given the sheer complexity of the draft rulemaking — which seeks answers to over 1,400 questions — and concerns expressed on both sides of the aisle, the four federal agencies recently extended the comment period from January 13, 2012 until February 13, 2012. Clearly, more time is needed for affected stakeholders to truly understand the proposal’s economic impact and ensure that the regulations do not discourage capital formation or credit availability.
Unfortunately, the vast implementation proposal released last Fall does nothing to ease Roundtable concerns about the rule’s potential impact on commercial real estate capital formation or efforts to revitalize stalled securitization markets. In essence, the proposed regulations could push banks and bank holding companies out of the asset management and real estate fund business — further constraining capital and credit flows at the worst possible time.
It is essential for policymakers to focus on policies that will facilitate equity investment in commercial real estate. The Volcker Rule, if applied to commercial real estate, does just the opposite. It would limit the amount of private equity capital available while not advancing the stated purpose of the Act to reduce systemic risk. Commercial real estate private equity funds account for only a small portion of the real estate market. The fund documents themselves limit the amount of leverage in their subsidiaries at the property level and include restrictions that prevent the use of complex financial instruments. Accordingly, commercial real estate private equity funds do not present systemic risk.
As the rulemaking process unfolds, we continue to emphasize the importance of sound financial services regulatory policy that encourages essential liquidity and capital formation for commercial and multifamily real estate.
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» Reforming the Government Sponsored Enterprises (GSEs)
Repairing the nation’s housing finance system and the government sponsored enterprises (GSEs) which support it is essential for a robust economic recovery. Given the dramatic expansion of federal backing for such loans, there is widespread agreement that GSE reform efforts must foster the return of private capital to the secondary mortgage market.
In an “open letter” to Congress and the Administration last year, The Roundtable and 16 real estate trade groups agreed that private capital must bear the primary risk in any future housing finance system, but that some continuing and predictable government role remains necessary to promote investor confidence and to ensure liquidity and stability for homeownership and rental housing.
The coalition also urged that GSE reform be undertaken with care — and over a reasonable transition period — to ensure that a reliable mortgage finance system is in place to function effectively in the years ahead.
Any forthcoming GSE reforms should have a mechanism for supporting the conventional multifamily loan market during periods when the private financing market is distressed. Such reforms should also foster market stabilization, while permitting prompt re-engagement of private lenders in the market. On the multifamily side, the plan advocates additional support for rental housing through measures that could include expanding the FHA’s capacity to support lending to the multifamily market, with reforms like risk sharing with private lenders and dedicated programs for hard to reach property segments like smaller properties.
Congress and the Administration have not reached consensus on how to resolve the GSE conservatorships and define a path for housing finance. Legislative proposals have begun to emerge in the form of two comprehensive House bills, two comprehensive Senate bills and some eight piecemeal House bills. However, enactment of any of these bills appears unlikely in the near future.
On February 21, 2012 the Federal Housing Finance Agency released a blueprint for reforms of Fannie Mae and Freddie Mac. FHFA intends to use its authority under conservatorship to begin a new stage in the overhaul of the two agencies while attempting to preserve their core value and minimize cost to the taxpayers.
A key element is a plan to consolidate and modernize their securitization platform to serve the future securitization market whether the GSEs remain as constituted or are substantially transformed by Congress at some future date. FHFA also pledged to continue to work in many ways to help existing homeowners stay in their homes or avoid foreclosure and increase transparency for both consumers and lenders.
FHFA seems to be pleased with the multifamily operations of the GSEs and does not appear to be planning dramatic changes to these operations. FHFA has directed each Enterprise to undertake a market analysis of the viability of their multifamily operations without government guarantees. This will require market reviews of their respective business models and the likely viability of those models operating on a stand-alone basis after attracting private capital and adjusting pricing, if needed, to attract and retain that capital. It is significant to note that FHFA intends to pursue separate timetables for addressing the GSEs’ single-family and multifamily programs.
Although the GSEs are in conservatorship, without statutory changes their mission of supporting a stable and liquid mortgage market remains the same as before the conservatorships. FHFA has a statutory responsibility to ensure each Enterprise “operates in a safe and sound manner” and that “the operations and activities of each regulated entity foster liquid, efficient, competitive, and resilient national housing finance markets.
Under the new strategy, FHFA would pave the way to a single securitization platform, forcing the GSEs to abandon their systems and build a single infrastructure to support the mortgage credit business – including mortgage servicing agreements and requirements placed on companies that service mortgages. This would create a single GSE mortgage-backed security vehicle.
The second goal under the revised strategy is to reduce the GSEs’ presence in the market, replacing it with private-sector participation. Under the plan, this would be partially accomplished by shifting mortgage credit risk to the private sector through increased guarantee fees, loss-sharing arrangements that require private investors to bear most or even all of the risk, and expanded reliance on mortgage insurance.
We continue to stress the importance of Fannie Mae and Freddie Mac to multifamily mortgage finance. As such, Policymakers should focus their efforts on creating a system that fosters market stabilization, while permitting the prompt re-engagement by private lenders to the market.
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» Covered Bonds
The Roundtable supports bipartisan legislation (H.R. 940, S. 1835) to facilitate the creation of a U.S. covered bond market, which would complement the resurgent CMBS market by providing an additional new source of CRE lending and investment. Covered bonds could also help reduce the need for U.S. government support of the $10.6 trillion U.S. residential mortgage market.
The 112th Congress continues to work toward developing the legal framework necessary to establish a covered bond market in the U.S. with introduction of legislation in both chambers known as the United States Covered Bond Act (H.R.940 and S. 1835). Importantly, Treasury Secretary Geithner and Senator Chuck Schumer (D-NY) support efforts to create a market for covered bonds, which are securities issued by banks and backed by pools of loans.
House Capital Market Subcommittee Chairman Scott Garrett (R-NJ), a strong proponent of covered bonds, continues to focus attention on this initiative and thinks a covered bond market could lessen the role of the GSEs. Such a configuration would recognize covered bonds as a distinct asset class and financial instrument, and would comprehensively address all relevant regulatory, insolvency, securities, tax, and other laws. This proposal would include highly-rated commercial mortgages and CMBS as “eligible collateral.”
As in much of Europe, where covered bonds have been used successfully for centuries, the pending House and Senate bills would include high quality commercial mortgages and CMBS as eligible collateral in a newly created covered bond framework. While covered bonds would not replace asset-backed securities, they could offer an effective long-term vehicle for enhancing credit availability and expanding lending activities — essential to economic recovery.
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» Proposed Accounting Policy Measures Could Impede Recovery
The Roundtable continues to raise concerns about the negative economic impact that accounting rule changes issued by the Financial Accounting Standards Board (FASB) could have on the resurgent economy.
U.S. policymakers should also promptly review a number of other policy issues with potentially negative implications for commercial real estate and economic recovery efforts. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are engaged in two projects that raise broad economic concerns for our industry. The Roundtable urges policymakers to defer implementation of these proposals until a thorough economic impact study can be conducted to determine if the potential benefits of such reform outweigh the costs.
» Lease Accounting
As the Lease Accounting Coalition (comprised of over 30 trade association members, including The Roundtable) prepared to meet with Financial Accounting Standards Board (FASB) Chairman Leslie Seidman recently, a coalition of House lawmakers — led by Reps. John Campbell (R-CA) and Brad Sherman (D-CA) — sent a letter to FASB just before Memorial Day urging them to carefully rethink proposed changes to lease accounting standards that could have “disastrous consequences” for the real estate industry, if enacted. The letter — signed by 61 House lawmakers — also recommended a comprehensive cost-benefit analysis of the proposed changes.
Leases are the fundamental building block for income-producing commercial real estate. Altering the accounting treatment for this essential economic element has broad implications for owners, investors and lenders and could have broad systemic impact on the banking system and credit and capital markets.
Proposed new lease accounting standards would dramatically change the way U.S. businesses account for their leasing activities — imposing costly new burdens on would-be employers and impede economic recovery. The new rules, as currently drafted, will result in tenants seeking shorter lease terms without renewal options or contingent rents to minimize the non-cash lease costs. This could promote market instability both for lessors and lessees – jeopardizing loan structures, valuations, financing covenants, and the fundamental nature of commercial real estate at the worst possible time.
The Roundtable has submitted comments individually and collectively as part of a broad, 35-member multi-industry coalition. We have requested, “that the Lease Accounting implementation project be delayed until an accurate economic assessment of the impact that this standard could have on the U.S. commercial real estate market, the real estate credit and capital markets, pension funds and the entire financial services sector.”
While there are early indications that our efforts are beginning to resonate with standard-setters, we continue to work with a broad, multi-industry working group to educate Washington policymakers on this issue and the negative economic impact this standard could have.
The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) in 2010 proposed new lease accounting rules that would dramatically change in the way U.S. businesses account for their leasing activities, force income-producing real estate to be re-characterized as a financing business on financial statements, and which could potentially hurt the U.S. banking system and credit and capital markets.
Responding to an outpouring of stakeholder concerns (from The Real Estate Roundtable, U.S. Chamber of Commerce, and others), FASB and the IASB this past fall agreed to exempt at least some commercial property owners from the new requirements, stating that lessors would be allowed to measure their investment properties at fair value by electing the fair value model under IAS 40, Investment Property.
Unfortunately, commercial property tenants (i.e. lessees) would still be required to capitalize real estate leases on their balance sheets — discouraging businesses from leasing commercial space, or to seek shorter lease terms without renewal options or contingent rents to minimize the non-cash lease costs — i.e. having to record rents due as liabilities, and recording their right to use property allowed by the lease as assets.
These changes could discourage businesses from leasing commercial space, or prompt them to seek shorter lease terms without renewal options or contingent rents to minimize non-cash lease costs. This Such changes could promote market instability for lessors and lessees — income property fundamentals, jeopardizing loan structures, property valuations, financing covenants, and the fundamental nature underlying economics of commercial real estate at the worst possible time.
A recently released, coalition sponsored study indicates that IASB and FASB’s proposed accounting standard would destroy up to 3.3 million U.S. jobs, minimize household earnings by as much as $7.8 billion annually, and shrink the GDP by up to $478.6 billion. Additionally, corporate real estate owners would lose as much as $14.8 billion in the value of their real estate. The measure would also balloon the apparent liabilities of U.S. publicly traded companies by $1.5 trillion, with approximately $1.1 trillion of this attributable to balance sheet recognition of real estate operating leases.
Given the potentially huge economic impact of the proposed lease accounting changes, The Roundtable urges policymakers to reissue the standard and to defer their implementation until a thorough economic impact study can be conducted to determine if the economic costs posed by such reforms outweigh the costs.
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» Basel III
Basel III is an international agreement that updates capital and liquidity requirements for banks and other financial institutions. This proposed 750-page regulation will impact the ability of non-financial businesses to raise capital and increase their costs of borrowing.
In a series of three separate but related proposals, the regulators proposed substantial revisions to the U.S. regulatory capital regimen for banking organizations that, if adopted, will have a significant impact on the entire U.S. banking industry. The U.S. rules are based on the core requirements of the 2011 international Basel III Accord and in significant part on the “standardized approach” for the weighting and calculation of risk-based capital requirements under the 2004-2006 Basel II Accord. Importantly, the proposals will extend large parts of a regulatory capital regime that was originally intended only for large, internationally active banks to all U.S. banks and their holding companies, other than the smallest bank holding companies (generally, those with under $500 million in consolidated assets).
While the goal of the new regime is commendable, requiring banks to hold far more capital to prevent financial disaster could further exacerbate credit challenges for real estate and broader credit capacity. “Basel III” will require banks to hold far more capital to prevent financial disaster but is not expected to be fully in place until 2019. The new accord requires banks to hold equity — Tier 1 capital — in the amount of 6 percent of total assets, up from the current requirement of 2 percent. In addition, banks must reserve an additional capital conservation buffer of 2.5 percent of total assets to withstand future periods of stress in the global economy, bringing the total amount of capital needed to 8.5 percent.
While the top U.S. banks are already working to implement the new standards, there is much concern about the impact the rules could have on overall credit capacity. Tom Hoenig, a director at the Federal Deposit Insurance Corporation, recently called for financial supervisors to reject the Basel III accords and instead institute simpler rules for capital and liquidity. “I suggest that we not only can go back, we must,” he said. The Americans are not the only ones to raise concerns about Basel III: Andy Haldane, executive director for financial stability at the Bank of England, who last month told the Jackson Hole conference of central bankers that Basel rules had “spawned startling degrees of complexity and an over-reliance on probably unreliable models ... It may be time to rethink its architecture.”
The new measures are intended to serve as a regulatory guide for national regulators in monitoring the health of banks. Policy makers should ensure that the new risk calculations not exert a drag on real estate lending or the reemerging securitization market. It is also important that the measure be appropriately calibrated to avoid disproportionately higher borrowing costs for commercial real estate borrowers. It is important to recall that the U.S. backed away from applying the previous Basel II rules based on similar concerns.
As requested in a joint industry comment letter, regulators extended the comment period from 90 to 150 days until October 22, 2012, on three notices of proposed rulemaking (NPRs) that would revise and replace the agencies' current capital rules. The Roundtable has established an internal working group and is also working with other industry partners on drafting comments for the regulators.
» Renewing the Terrorism Risk Insurance Program
Terrorism continues to pose a threat to our nation and to real estate. It remains a unique risk with potentially catastrophic implications for our economy and our way of life. When, where and how it might happen is anyone’s guess. Insurers tell us that they cannot adequately quantify the risks associated with this peril and are not able to offer the coverage without a federal mechanism.
Unfortunately, the nation’s federal terrorism risk insurance program established by the Terrorism Risk Insurance Act of 2002 (TRIA) and its subsequent extensions is scheduled to sunset at the end of 2014. Because a viable private sector marketplace for this coverage does not yet exist, the program’s expiration would leave policyholders and taxpayers exposed and unprotected – just as they were after 9/11.
The bottom line – terrorism risk is a national problem that requires a federal solution. Our nation must have a long-term economic strategy in place – an effective, long-term, terrorism insurance program - that provides adequate market capacity for U.S. economy and the safety and certainty markets require.
To aid in our efforts to maintain a federal role in the terrorism risk insurance market, we have reactivated our Coalition to Insure Against Terrorism (CIAT). This broad coalition of commercial insurance consumers was formed after 9/11 by the Roundtable and others to ensure that American businesses could obtain comprehensive and affordable terrorism insurance. CIAT’s membership includes some 79 major trade and membership associations, representing virtually every sector of the U.S. economy.
The House Financial Services Subcommittee on Insurance, Housing, and Community Opportunity held a hearing on the 11th anniversary of the September 11th attacks to examine the terrorism risk capacity of the insurance industry and to discuss the future of the nation’s federal terrorism risk insurance program. Testifying on behalf of CIAT was Rolf Lundberg (Senior Vice President for Congressional and Public Affairs at the U.S. Chamber of Commerce). This hearing was just the first step in a much longer journey to extend the federal government’s role in the terrorism risk insurance market.
Despite our successful legislative efforts in 2002, 2005 and 2007, and the fact that terrorism remains a clear and present danger, most anticipate this next effort to extend a federal program will be the most challenging. While the program does not sunset until 2014, efforts to reauthorize the federal program will begin in earnest in 2013. To that end, we plan to organize a working group to help the Roundtable’s efforts on this important issue.
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The Roundtable’s Real Estate Capital Policy Advisory Committee (RECPAC) is working to address these issues, while encouraging national policies that restore stable asset values, appropriate flows of capital and credit to the real estate sector. RECPAC’s purpose is to identify, analyze and advocate policy positions on capital, credit and investment-related initiatives affecting real estate.
Co-chaired by Jeffrey Horowitz (Bank of America Merrill Lynch) and Mark Begor (GE Capital) and vice-chaired by D. Michael Van Konynenburg (Eastdil Secured), RECPAC consists of principal members from a broad spectrum of real estate investment, ownership and financial services companies.
For additional information on RECPAC issues, please contact Clifton (Chip) E. Rodgers, Jr., Senior Vice President at The Real Estate Roundtable at (202) 639-8400