Roundtable Remains Focused on Maintaining Reliable Credit Capacity, Capital Formations; Minimizing Regulatory Overreach; and Effective Risk Management Tools Vital to Liquidity
Policy Issues Snapshot: Q1 2017
More detailed information on various Capital and Credit policy issues can be found in recent issues of Roundtable Weekly — our weekly policy eNewsletter that can searched by key word or phrase. The Roundtable's 2017 National Policy Agenda, Real Estate: A Foundation for Growth, includes a section on Capital & Credit Policy.
News on various credit and capital issues can be found in recent issues of Roundtable Weekly — our weekly policy eNewsletter that can searched by key word or phrase.
• Federal Reserve Rate Rise Dilemma
• Cumulative Impact of Regulation
• Chairman Hensarling Marks Up Financial CHOICE Act
• Dodd Frank Credit Risk Retention Rules Raise Concerns About CMBS Issuance and Credit Capacity
• “Preserving Access to Commercial Real Estate Capital Act” (H.R. 4620) Advances
• Basel III Could Have “Deleterious” Effect on CRE Lending, CMBS Issuance
• Fundamental Review of the Trading Book
• Dodd Frank: Volcker Rule Raises Concerns About Capital Formation for Real Estate
• Reforming the Government Sponsored Enterprises (GSEs)
• Department of Labor's Fiduciary Standard Rule
• Long Awaited Lease Accounting Measure Released
• Custody Rule and Real Estate Capital Formation
• Terrorism Risk Program Extended
✓ Federal Reserve Rate Rise Dilemma
With the next Federal Open Market Committee (FOMC) meeting scheduled for March 14-15, 2017, members will be looking at positive economic readings. While there is widespread speculation over when a second interest rate increase may occur, prevailing sentiment now suggests that the FOMC will wait raise the benchmark interest rate in March.
The unemployment rate, at 4.8 percent in January, is in a range Fed officials regard as healthy, and inflation is rising back toward the 2 percent level that the Fed considers optimal. Rates remain at a low level by historical standards, supporting economic growth by encouraging borrowing and risk-taking. But Fed officials have increasingly concluded that the economy is nearing the end of its recovery from the 2008 financial crisis, and that maintaining low rates could increase growth to an unsustainable pace.
Property markets are generally strong; cap rates are little changed over much of the past year; delinquency and default rates of commercial real estate (CRE) loans and building vacancy rates are the lowest since the financial crisis. Latest commercial mortgage backed securities (CMBS) new issuance numbers suggest that the impending Risk Retention regulations may already be chilling new issuance activity. Over the next three years, approximately $1 billion a day in commercial real estate debt is maturing – including some $411 billion in commercial bank debt and $265 billion of CMBS loans. So, maintaining adequate credit capacity is vital for CRE.
✓ Cumulative Impact of Regulation
Various legislation and regulations – including Dodd Frank and Basel III – passed and implemented following the financial crisis are fundamentally altering the financial services industry. The cumulative effects of these measures are now starting to be fully realized – particularly for commercial real estate credit markets and overall credit capacity. Also of concern is an apparent contraction in bank lending to commercial real estate — documented in the Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices — which is expected to push borrowing costs higher for the industry. The tightening in bank lending for CRE appears to be a reaction to a Dec. 18, 2015 Interagency Statement on Prudent Risk Management for Commercial Real Estate Lending, warning lenders to reinforce prudent CRE lending risk-management practices amid an increase in many banks’ CRE concentration levels.
Overlapping regulatory changes under Dodd-Frank as well as Basel III also appear to be contributing to the apparent slowdown in banks’ CRE lending — as well as illiquidity and volatility in the CMBS market. The potential credit contraction could not only be a negative for CRE prices going forward, but could also lead to further problems as the 2006 and 2007 vintage loans reach maturity. The Roundtable continues to focus on addressing the cumulative impact these measures could have on credit capacity and capital formation.
✓ Chairman Hensarling Marks Up Financial CHOICE Act
On Sept. 13, the House Financial Services Committee conducted a markup of the Financial CHOICE (Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs) Act of 2016 (H.R. 5983). The measure passed by a narrow margin of 30-26, with no minority support. Committee Chairman Jeb Hensarling (R-TX) formally introduced legislation that would scale back the replace the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). He says the bill “will end taxpayer-funded bailouts of large financial institutions; relieve banks that elect to be strongly capitalized from growth-strangling regulation that slows the economy and harms consumers; impose tougher penalties on those who commit financial fraud; and demand greater accountability from Washington regulators.”
The bill is intended to provide much-needed regulatory relief to commercial banks, rolling back portions of Dodd-Frank that affect the leveraged finance markets, including the Volcker Rule and risk retention, in exchange for higher capital reserves through an optional capital election. House Republicans are expected to use the bill as a focus of their 2017 financial services agenda. Senate Banking Committee Chairman Richard Shelby (R-AL) continues work on his own financial services reform package, but there is little interest in the Senate in moving his bill forward, or for any other significant legislation.
✓ Dodd Frank Credit Risk Retention Rules Raise Concerns About CMBS Issuance and Credit Capacity
The final rules for implementing Section 941 of the Dodd-Frank Act as it relates to credit risk retention will becaome effective Dec. 24 last year. The commercial mortgage backed securities (CMBS) market is impacted by the rules. As the second largest source of credit for the commercial real estate sector, the new rules are raising many concerns, and markets are already reacting negatively.
New CMBS risk retention require the originator or control investor must hold ~ 13% of the capital structure for minimum of 5 years. Unlike the rules for residential mortgage backed securities (RMBS) – which were the principal cause of the 2008 financial crisis – regulators set the bar for QCRE loans well above what the majority of the CMBS marketplace could provide.
Section 941 requires that a securitizer retain an economic interest in a material portion of the credit risk for any asset that it transfers, sells, or conveys to a third party. The final rule provides for broad exemptions for certain "qualified" residential mortgages put into residential mortgage backed securities (RMBS), while subjecting commercial mortgage loans to only a very narrow band of qualifying exemptions. Estimates suggest that some 90% of residential loans would be deemed “qualified” under the risk retention rules whereas only 3-8% of commercial loans would qualify for QCRE status. Under the final rule, CMBS are treated in a punitive and unjustified manner despite the fact that empirical data demonstrates a very positive track record and unparalleled transparency. A comparison of the final rule's treatment of "qualified" RMBS loans versus "qualified" CMBS loans suggests that regulators made a number of assumptions that were factually incorrect.
As a result, the new measure is expected to raise borrowing costs and reduce real estate credit capacity – particularly in Main Street markets. In addition to impairing Main Street’s access to institutional capital, a number of CMBS market participants are already leaving the market. Market making is key to bond market liquidity, and the number of dealers with capacity to hold CMBS inventories has declined by approximately 80 percent – from ten to two or three. As a result, investors who relied on liquidity have largely exited the market, leaving a gap at the lower end of the bond stack.
Despite The Roundtable’s efforts to exempt "single-borrower" transactions from the risk retention rules, the regulators did not provide for an exemption for these types of transactions. Currently, these transactions are generally not structured with a B-piece. So, under the new rules, single-borrower transactions will be subject to the same risk retention requirements as conduit CMBS. CMBS.
✓ “Preserving Access to Commercial Real Estate Capital Act” (H.R. 4620) Advances
Congress has stepped in with a bipartisan bill to clarify the risk retention rules and propose some modifications that would ease the new requirements on the CMBS market. On March 2, 2016, the House Financial Services Committee passed the bi-partisan “Preserving Access to CRE Capital Act” (H.R. 4620) by a vote of 39-18.
Introduced by Rep. French Hill (R-AR), the measure would exempt certain single asset/single borrower (SASB) securitizations from the risk retention requirements, allow the B-piece buyer to acquire the risk retention piece in a senior/subordinate capital structure and relax the criteria for a qualified commercial real estate loan – better accommodating how investors raise capital and divide risk in the capital stack. Working with a coalition of real estate groups, the Roundtable continues to advance this important “fix” to the Dodd-Frank Credit Risk Retention rules.
✓ Basel III Could Have “Deleterious” Effect on CRE Lending, CMBS Issuance
The Roundtable continues to raise concerns with U.S. and international bank regulators regarding the impact burdensome financial regulations could have on bank lending, CMBS issuance and overall real estate liquidity.
Last year, harsher capital requirements were placed on certain High Volatility Commercial Real Estate (HVCRE) loans in accordance with the Basel III international banking standards. As we have communicated to regulators, we have concerns with the newly imposed loan rules and how they disproportionally affect commercial real estate acquisition, development and construction (ADC) lending. The rules artificially bundle CRE loans into an overly broad category – HVCRE.
The Roundtable submitted a comment letter in last July regarding the April 6, 2015, Frequently Asked Questions (FAQs) on the Basel III Regulatory Capital Rule, High Volatility Commercial Real Estate (HVCRE). The letter – addressed to the Federal Reserve, the OCC and the FDIC – raises concerns regarding key aspects of the Basel III Regulatory Capital Rule as it impacts commercial real estate lending and focuses on:
- Prohibition of Withdrawal of Internally Generated Capital
- Bank Confusion on Interpretation of the Rules
- Using “as completed” Appraisal Values for Initial Equity Determination Focuses Solely on Completion, not Lease-up Risk of ADC Loans
- Recognition of Appreciated Land Value
Although the Roundtable supports the Basel III Rules, we believe the Agencies should take appropriate steps to quickly modify or further clarify certain aspects of the rules related to HVCRE exposures that are addressed by the FAQs.
Without modifications, the consequences of the 150% risk weight under the Basel III Rules for HVCRE exposures will have a deleterious economic impact on commercial real estate acquisition, development and construction (“ADC”) lending conducted by U.S. banking organizations.
Specifically, we raised concerns that the guidance provided by the FAQs in conjunction with the Basel III Rules’ requirements on HVCRE exposures may:
- disrupt availability of development credit from banks to the commercial real estate sector;
- reduce overall credit capacity for commercial real estate development lending in the U.S.;
- increase loan pricing to all borrowers, with a likely greater impact to smaller borrowers with less valuable relationships; and
- add to project development costs even after ADC risk has passed.
The Roundtable, along with eight real estate organizations, in March jointly submitted comments to the Basel Committee on Banking Supervision (BCBS) on a proposed framework for determining risk weights for bank loans to commercial real estate.
The real estate industry groups (which include eight U.S. organizations and one based in Singapore) concluded that certain capital increases proposed by the BCBS — coupled with rules that are not appropriately linked to economic risks — “could have negative consequences for lending to real estate and affected economies.”
The coalition urged further careful study of how the proposed regime would affect commercial real estate (CRE) credit capacity, market liquidity and national economies.
Noting that in this “environment of rapid change,” when financial institutions are “absorbing a great number of [overlapping] regulations” — including Dodd-Frank “risk-retention” rules affecting commercial mortgage-backed securities (CMBS) and the Basel III “Liquidity Coverage Ratio” rule (“Reg AB”) — the March 27 letter said “covered institutions have been approaching regulatory implementation in a spirit of conservatism.”
As the letter explained, “Given the layered interaction of these rules, the impacts on pricing, credit availability, liquidity, and other critical features of the financial system will not be known for years. There is ample evidence to suggest that financial institutions decrease lending in the face of uncertainty about returns, which will have potentially harmful effects on the economy. The merits of additional regulatory regime changes contemplated by the Consultative Document should be carefully weighed against the existing regulatory implementation challenges that U.S. banks are currently facing.”
In a March 17, 2016 comment letter to the Basel Committee on Banking Supervision (BCBS) regarding their Dec. 2015 “Step-In Risk” proposal, the Roundtable raises concerns about how the measure could hurt commercial mortgage securitization and raise borrowing costs — particularly on top of other Basel, Dodd-Frank policy changes with implications for real estate capital and credit.
✓ Fundamental Review of the Trading Book
The BCBS is also proposing the Fundamental Review of the Trading Book (FRTB) measure that will exponentially increase the risk-based capital requirements for bank trading books, undermine securitization markets and diminish credit capacity. As currently envisioned, the rules could make it unfeasible for any bank to trade in CMBS and other asset-backed instruments. If it becomes unprofitable to trade existing bonds, new issuance could dissipate.
In comment letters to the BCBS and key regulatory agencies, The Roundtable and its coalition have raised concerns about the reduction in global market making capacity and resultant diminution in credit capacity that will result from the proposed FRTB rule. One of the letters raised specific concerns about the impact on CMBS issuance: “...the magnitude of the charges will be greatest for securitized products, particularly private label CMBS, for which the proposed treatment is especially punitive... We believe their viability will be threatened if the rules are finalized without significant changes to the proposed requirements.”
The Roundtable and others continue to press regulatory agencies and are raising concerns with members of the House Financial Services and Senate Banking Committees. Congress should encourage policies that provide relief from overly restrictive capital requirements and support measures that would encourage capital formation, balanced lending and investments in the U.S. economy — supporting job creation and economic growth.
✓ Dodd Frank: Volcker Rule Raises Concerns About Capital Formation for Real Estate
Intended to reduce the risk exposure of financial firms by removing elements of proprietary trading and sponsorship of private equity, the final rules prohibit insured depository institutions and companies affiliated with insured depository institutions ("banking entities") from engaging in short-term proprietary trading of certain securities, derivatives, commodity futures and options on these instruments, for their own account.
The final rules also impose limits on banking entities' investments in, and other relationships with, hedge funds or private equity funds. A number of financial companies sponsor real estate private equity funds. The Roundtable has raised concerns that rules will restrict appropriate capital formation/ securitization activity– particularly for real estate. The final implementing regulations for the Volcker Rule were released by the five regulatory agencies last December.
In 2014, the Federal Reserve granted banks two additional years to unwind private-equity, venture-capital and hedge funds covered by the Volcker Rule, extending the deadline to 2017, from 2015, for banks to draw down investments in such funds.
✓ Reforming the Government Sponsored Enterprises (GSEs)
Eight years after Fannie Mae and Freddie Mac were put into conservatorship, the housing finance system has still not been reformed. Despite substantial bipartisan progress made in the 113th Congress, efforts to advance meaningful reforms have stalled.
Last year, Senate Banking Committee chairman, Richard Shelby (R-AL) and the Committee’s Ranking Member Sherrod Brown (D-OH) remained at odds on a clear path forward, It is unsure whether Congress will be able to reach consensus on meaningful mortgage market reforms in 2017.
Successful reform should meet the housing finance needs of the American economy while protecting the taxpayer. The Roundtable encourages lawmakers to build upon successful risk sharing mechanisms and products by employing the existing multifamily finance structures being utilized by Fannie Mae and Freddie Mac.
✓ Department of Labor Fiduciary Rule: Final Rule Issued in April
The Department of Labor (DOL) final 1,000-plus-page fiduciary rule requires retirement advisers to abide by a “fiduciary standard", intended to avoid conflicts of interest by "putting their clients’ best interest first". The central tenets of the fiduciary rule remain largely consistent with the 2015 proposal. As a result, concerns remain that it could trigger significant operational shifts for certain aspects of the retirement management industry. However, it appears that certain aspects of the final fiduciary standard rule – including some related to real estate – were softened:
- The removal of the Best Interest Contract (BIC) exemption asset list is a positive for non-traded REITs.
- The rule also exempts appraisals from being "considered fiduciary investment advice for purposes of the final rule." Instead, the DOL has reserved all appraisal issues, not just those involving ESOPs, for a separate future rulemaking. So, stay tuned for this ruling.
- With the help of our The Fiduciary Rule Working Group, The Roundtable raised concerns about these measures.
The rule updates ERISA’s definition of retirement products and expands the definition of a fiduciary to anyone receiving compensation for providing financial advice. The rule also includes an exemption that allows the preservation of "common" commission structures but comes with new legal liabilities.
While the Roundtable supports the DOL’s primary objective of making sure that consumers receive investment advice that is in their best interest, the rule could have the unintended consequence of limiting client access to financial advice and retirement solutions. Of course, financial advisers have been held to a fiduciary standard that requires them to put their client’s interest above their own since the Investment Advisers Act of 1940. Since U.S. pension funds are a key source of capital for real estate, there is broad concern about how this rule could affect pension related real estate investment and other real estate finance activities.
A complementary effort to introduce a similar fiduciary standard across non-retirement savings products was introduced in Dodd-Frank, but is stalled at the Securities and Exchange Commission (SEC).
✓ Long-Awaited Lease Accounting Measure Released
The Financial Accounting Standards Board (FASB) last February released its long-awaited final standard on lease accounting. For public companies, the new standard takes effect for annual and interim periods beginning after Dec. 15, 2018; for private firms, the standard will go into effect for annual periods beginning after Dec. 15, 2019, and interim periods the following year.
Over the years, the Roundtable raised a number of concerns about the impact the proposal could have on real estate. As originally proposed, there was concern that lessees may seek to reduce their leasing exposure, pushing for shorter term leases without renewal options or contingent rents to minimize the non-cash lease costs.
Through the Roundtable’s work with FASB and IASB, constructive progress was made on the treatment for real estate lessors. For most real estate leases, lessors and lessees will both report rental income on a straight-line basis. The new standard represents a clear improvement over the original proposal for real estate, but concerns remain about the administrative costs and the impact on lessee leasing strategy."
✓ Custody Rule and Real Estate Capital Formation
Following the adoption of the Dodd-Frank Act and amendments to the rules under the Investment Advisers Act of 1940 (1940 Act) adopted by the Securities & Exchange Commission (SEC), many previously unregistered managers to private funds, including real estate private equity funds, were required to register with the SEC under the 1940 Act.
The SEC has raised questions during the examination of certain registered investment advisors about their compliance with the Custody Rules of the 1940 Act when Real Estate Investment Trusts (REITs) are included in investment structures and the advisors have not obtained and distributed the REIT’s audited financial statements to the REIT’s shareholders (or obtained surprise security counts for the REIT’s investments).
Certain investment advisors include REIT subsidiaries in their pooled investment funds for tax and other purposes. REIT status requires at least 100 shareholders. So, a fund manager typically uses accommodation shareholders to fill in the other 99 slots; they get a preferred return and collect their annual payment but have no concerns about the REIT’s investment performance.
With thousands of these REITs in existence, it is creating a significant administrative burden on existing fund sponsors. The SEC position will also have a chilling effect on the use of the private REIT structure for future investments which will also impact foreign investment in U.S. real estate. The Roundtable is working to address this regulatory overreach.
✓ Terrorism Risk Insurance Program Extended
In the first order of business for the 114th Congress, the U.S. Senate passed H.R. 26 - the Terrorism Risk Insurance Program Reauthorization Act of 2015 - by a vote of 93-4, following a nearly unanimous vote of 416-5 in the U.S. House of Representatives. The President signed the measure into law on January 12, 2015.
The law extends the federal terrorism insurance program through Dec. 31, 2020, increases the insurer co-pay from 15 percent to 20 percent, gradually increases the program’s trigger from $100 million to $200 million and increases the recoupment amount by $10 billion, to $37.5 billion. The Terrorism Risk Insurance Act (TRIA) was originally enacted in 2002 and previously extended in 2005 and 2007.
Through its Coalition to Insure Against Terrorism (CIAT), the Roundtable recently provided comments to the Treasury’s Federal Insurance Office (FIO) in response to two requests: first, a request for comments on the overall effectiveness of the TRIA Program and, two, in response to a notice of proposed rulemaking (NPRM) that would replace the current TRIA regulations in their entirety.
Terrorism risk is a national problem that requires a federal solution. Developing a long-term solution to the terrorism insurance problem is a top priority for the Roundtable – to ensure adequate capacity, avoid periodic market interruptions and provide the safety markets require.
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 a reliable credit system.stable valuations, enhanced transparency and sensible underwriting, and support efforts to establish appropriate systemic safeguards—all key factors for a reliable credit system.
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 a reliable credit system.
(For more information, please email email@example.com or call 202-639-8400. For weekly updates on key policy issues affecting commercial real estate, see our eNewsletter Roundtable Weekly
The Real Estate Capital Policy Advisory Committee (RECPAC) is co-chaired by Dennis Lopez (AXA Real Estate) and Mark Myers (Wells Fargo) and vice-chaired by Diana Reid (PNC). 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, The Real Estate Roundtable, at (202) 639-8400 or via e-mail at firstname.lastname@example.org.
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