CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

The Cherryland case (discussed here and here) concerns one lender’s enforcement of a non-recourse guaranty pursuant to which the guarantor agreed to be personally liable in the event the borrower failed to maintain its status as a single purpose entity (which included an agreement by the borrower to remain solvent). As you might have guessed by now, the borrower failed to make payments due under the loan and the lender foreclosed, leaving a $2.1 million deficiency. The lender sued the guarantor for the deficiency, arguing that the borrower’s insolvency breached its single purpose entity requirements. A Michigan lower court agreed with the lender, finding the guarantor liable for the full amount of the loan under the guaranty as a result of the borrower’s inability to remain solvent. The Michigan Court of Appeals initially agreed with the lower court, noting that the failure of the borrower to remain solvent, regardless of the reason, was a violation of the single purpose entity requirements of the loan documents.

The guarantor appealed this ruling, and while on appeal, the Michigan legislature passed the Nonrecourse Mortgage Loan Act (the “Act”), a quirky bit of legislation which sought to protect guarantors from their own bad bargains. The Act provides, in relevant part, that a post-closing solvency covenant should not be used, directly or indirectly, as a nonrecourse carveout or as the basis for any claim or action against a borrower or any guarantor or other surety on a nonrecourse loan (with any such provision being deemed invalid and unenforceable).

With the Act then on the books, the Michigan Supreme Court remanded the Cherryland case back to the Michigan Court of Appeals, which overruled its prior ruling and found that, as a matter of public policy, a guarantor could not be liable to a lender as a result of a borrower’s insolvency. While any first year law student can tell you that invalidating a contract entered into by two sophisticated parties with a statute passed years after said contract is entered into raises numerous constitutional concerns, the Michigan Court of Appeals determined that the public purpose of averting “a broader economic problem of immense proportion in the interest of the public good” outweighed any such constitutional concerns. A more cynical blogger might interpret the legislation as protecting the very private interests of local landowners and developers at the expense of banks and investors (not always local) – but we won’t draw those same conclusions.

Where does this leave us? Prior to the Cherryland decision, there had been a string of recent cases in which courts either found or upheld recourse liability on the part of guarantors (discussed here) giving lenders confidence that their guaranty would be similarly upheld in court if the need for litigation ever arose. This decision has brought unwanted uncertainty to non-recourse lending as this case lays out a map to effectively undermine guaranties contracted between sophisticated parties. The Michigan Court of Appeal’s decision to affirm the 2012 legislation, which invalidates a guaranty made years prior to its enactment, may embolden other states to pass similar laws (protecting local guarantors and sponsors from the bad bargains they made in the boom years, and preventing lenders from exercising their contracted rights), which is something we should all pay attention to.

By: Matt Ginsburg and David Pildis
 

Now I can’t quibble with the data or much of the analytics. This report looked at the performance of the 7,000 plus insured depository institutions, and focused on those who had high CRE concentrations. By high, we’re talking institutions where construction, land and land development loans (CLD, to the trade) represented 100% or more of a bank’s risk-based capital and institutions where total investment (as opposed to owner-occupied) CRE (including the CLD portfolio) represented 300% or more of an institution’s risk-based capital. That, by the way, describes almost all regional and community banks. So which way is the causation arrow pointed? That seems to be a question the authors found curiously uninteresting.

While many conclusions are drawn from this data, the headline, above the fold, marquee conclusion is:

During the three year economic downtown, banks with high CRE concentration levels, proved to be far more susceptible to failure.

I’m breathless. Really?

I suspect equally rigorous academic studies could have come up any of the following headline conclusions:

• Small, Poorly Capitalized Banks Fail a Lot
• Banks in Geographic Areas Where the Economy Sucks Didn’t Do Really Well During a Really Bad Recession
• Banks With Nothing Else to Do Except Make CRE Loans Probably Didn’t Do Very Well, or
• Banks Run By Dopes Fail a Lot

The 2006 Guidance, which was certainly not a hot read, actually doesn’t impose a cap on CRE lending, but simply suggested that banks with high concentrations of CRE lending should have good practices, protocols and a knowledge base to justify being so concentrated in that space. Nothing to quibble about there. (Although one might observe that our policy of encouraging formation of lots of small banks with limited capital and a limited geographic footprint almost dooms those institutions to embrace over concentration in the CRE space as there is often precious little else to do.)

The problem, of course, is how something like this gets woven into a narrative that commercial real estate is a dodgy business full of executives whose compensation has not been “fairly” restrained by the populism-fed political fury unleashed on the banks and the real estate “moguls” somehow have suborned the world of Jimmy Stewart-led banks to do dumb things that probably should be illegal. It gets wound into the narrative not as a dry, unexciting and perfectly commonsensical notion that small banks with limited management systems should probably avoid excess concentrations of lending activities in asset classes in which they have no strong knowledge base but as part of the broad miasmic hostility to CRE capital formation. We have over 7,000 banks scattered across the country, many of which are in communities where everything is essentially a real estate loan, and those loans are probably as good as or better than the commercial loans which do not have the benefit of a mortgage on some dirt. When the whole world flirts with a depression, these loans will not work really well. I need a long, laboriously compilied academic report full of rigorous mathematics to figure that out?

This is not news and my anxiety here is mostly a concern that some will misuse this report as part of a narrative that commercial real estate is a source of all evil and needs to be more highly regulated (read, constrained) just at the time where we need the banking market, as well as other lending sources in this country, to meet the needs of the commercial real estate industry. Without that support, economic activity in general will be depressed.

We in the commercial real estate industry need to be vigilant that the narrative, like a metastasizing virus, doesn’t get used to further both political and regulatory hostility to CRE capital formation and commercial real estate.

OK, maybe I’m over-reacting, but I was thinking about taxpayers’ dollars at work and wondering why we really needed an interagency report to tell us that a lot of commercial real estate loans went bad when the commercial real estate market collapsed, and a lot of small banks got left holding the bag? A man bites dog moment it ain’t.

By: Rick Jones

First, a quick primer on how this all works. TRIA requires property insurers to offer terrorism insurance coverage in a manner similar to the way other more traditional coverages are provided. In exchange, the government provides a re-insurance backstop in case of catastrophic loss. The mechanics are complicated but, essentially re-insurance kicks in for individual loss events greater than $100 million to the aggregate insurance industry after the insurance company kicks in a deductible based upon a percentage of its terrorism insurance direct premium income. It all caps out at a loss of $100 billion. 

Ever since TRIA, our loan documents have generally required terrorism insurance. For those of you who don’t get that certain frisson of excitement for reading mortgage loan documents, you may not have actually memorized what our documents say about terrorism issues. A typical formulation looks something like this:

"insurance with respect to the Improvements and the Personal Property insuring against any peril now or hereafter included within the classification “All Risk” or “Special Perils” (including, without limitation, fire, lightning, windstorm, hail, terrorism and similar acts of sabotage, explosion, riot, riot attending a strike, civil commotion, vandalism, aircraft, vehicles and smoke), in each case (A) in an amount equal to 100% of the “Full Replacement Cost,”…"

In some, but not all cases, the following language may be found:

"Notwithstanding the foregoing sentence, Borrower shall not be obligated to expend more than [$___________] in any fiscal year on Insurance Premiums for Terrorism Insurance (the “Terrorism Insurance Cap”) and if the cost of the Terrorism Insurance Required Amount exceeds the Terrorism Insurance Cap, Borrower shall purchase the maximum amount of Terrorism Insurance available with funds equal to the Terrorism Insurance Cap; provided, however, in the event such Terrorism Insurance is customarily maintained by owners of [_______________] properties in the United States as part of the all risk coverage required pursuant to Section______ hereof, Borrower shall maintain such Terrorism Insurance as a part thereof, regardless of the cost of the related Insurance Premiums."

A bill was recently introduced by Congressman Grimm and others to reauthorize TRIA. The bill essentially extends the current program for five years without any material change. (Sidebar: How delightful to read Congressional work product that is only two pages long! There may be hope.) The politics of TRIA are complex and the dividing lines in the Congress and Senate do not run along traditional party lines. There is an element of the Republican party that says private enterprise should provide the solution, fullstop. The constituencies who understand the importance of TRIA to capital formation, as well as those who represent major urban centers which have been traditionally thought to be at particular risk of terrorism attack, support it voraciously. It’s very hard to tell at this stage whether reauthorization occurs, although policy wonks already seem to think that, at the end of the day, it will be.

As reauthorization began to creep into the collective conscience, more borrowers have begun to negotiate caps on the aggregate cost of terrorism insurance. Given uncertainty, it’s time to start thinking about risk with and without TRIA, or materially revised but with a totally different TRIA. Here is what we’re thinking:

• The coverage may get more expensive in the run-up to expiration; therefore, as a lender, consider pushing back on caps, and if you agree to cap coverage, make sure the cap makes sense both in the current environment and the run-up to reauthorization. As a borrower, run this paragraph backwards.

• As a lender, think about tying some aspects of loan document architecture to the presence or absence of coverage. Does the disappearance of the coverage trigger some sort of hyper-amortization or more rapid amortization to reduce LTVs? Might extension options be curtailed if coverage went away? I have some personal experience attempting to enforce terrorism insurance in a high premium environment, and I’m here to tell you the judiciary, broadly, is not going to be terribly sympathetic to an asserted event of default tied to the lack of terrorism insurance which is not commercially available at economically reasonable rates. As a lender, one would have to think twice about utilizing a breach of terrorism insurance coverage as a basis of an event of default. Better, perhaps, to think about other adjustments to the credit profile of the transaction in light of the deteriorated coverage.

• Consider tying some element of the coverage into recourse covenant.

• For issuers and underwriters, revisit risk factor disclosures, particularly for vulnerable properties such as large, standalone assets in major metropolitan area environments. Be crystal clear that terrorism insurance coverage at any level or at levels which are economically feasible might not be available 20 months from today.

If TRIA goes away, the private market will either be diminished or disappear entirely. That’s altogether possible. Several commentators have suggested that if TRIA goes away, there will be no terrorism insurance available from the private markets at all and, of course, at some level of pricing it becomes economically unfeasible in any event.

We’ve got some time here. This needs to get fixed. Other outcomes do not bear thinking about. We have a shot at bettering the odds by trying to effect policy. I would urge everyone to work with their trade organizations, CREFC, MBA, SIFMA, ASF, etc., (and, yes, contribute to their PACs) to ensure that the views of the industry are heard. Last time I was deeply involved in the TRIA Advocacy initiative, it was frustrating to see that many in Congress viewed this as an insurance company issue with the greedy insurance companies attempting to shift risk to the federal government. We in the commercial real estate industry shouted (but were not heard) “It’s not about them, it’s all about us!” This insurance is necessary for successful capital formation in commercial real estate. It’s not about the insurers. They will happily stop offering coverage without TRIA. It is commercial real estate that will take it on the chin.

We never really succeeded in changing the shape of the debate. We need to frame the debate early and forcefully. We need to make sure our Congressmen and Senators understand that the TRIA backstop is all about protecting the viability of the commercial real estate finance marketplace. As the Grimm Bill progresses this year (that just doesn’t sound right, does it?), or as other legislative efforts are undertaken between now and its expiration, our duly elected leaders need to understand that this is a reasonable governmental function to meet a need which cannot otherwise be met in the private marketplace, and which is critically important to capital formation. 
 

By: Rick Jones 

Later in the day George Will delivered an entertaining key note address before a capacity crowd. Taxation, social security and health care reform were among the topics discussed, along with a concise overview of the upcoming general election. The keynote address was humorous but insightful, and underscored the multitude of issues facing our nation.

It's been a great and engaging conference, and we look forward to taking on these issues and finding new opportunities.

By: Stewart McQueen and Matthew Ginsburg

The one-day program was eye-opening and fascinating. The speakers, present company excepted, were extraordinary. The keynote was delivered by Chris Flowers, one of the savviest investors on the planet. Speakers included Jim Lockhart, who’s Vice Chairman of WL Roth & Co. and currently running what’s left of the UK bank previously known as Northern Rock, our partner Tom Vartanian who is a genius on structuring private equity to save open but damaged banks, John Moran, the Secretary General of the Department of Finance of Ireland, Nils Melngailis and Steve Franck, Co-Head and Senior Director respectively of the Financial Industry Advisors team at Alvarez, Mike Krimminger, the General Counsel for the FDIC (who has certainly seen this movie before), Sophie Bertin-Hadjiveltcheva, the Head of State Aid for Financial Services of the European Union, Andrew Gracie, the Head of the Special Resolutions Unit at the Bank of England, Piers Haben the Director of Oversight for the European Banking Authority, and a host of others.  A financial glitterati prepared to slog into the detritus of a bruised, if not broken, bank system.

A lot of great take-aways: 

• Every bank on the continent is engaged in the naval gazing exercise of dividing risk assets into core and non-core. In some significant measure, and because of politics, “non-core” is code word for the financial NIMBY: “Loans not made to my citizens.”
• When folks like Chris Flowers and Jim Lockhart of WL Ross & Co. think it’s worth hanging around the European bank rim, it’s worth hanging around the European bank rim.
• The European Commission has provided in excess of €5 trillion in aid to the European financial service sector. €5 trillion. There’s an attention grabber!
• The recent massive infusion of liquidity into the sector by the ECB will, on balance, make it slightly easier and more likely the European banks will dispose of non-core assets. The notion that this liquidity means assets will not be sold is wrong-headed.
• There’s something like $2 trillion in commercial real estate assets on the balance sheets of the European banking community as a whole. Largely, it’s marked at par. Largely, it’s worth 80 cents on the dollar. That’s a $400 billion hole in the collective balance sheets of the banks. Because of Basel III, the ECB is requiring that the banking community provide something in the range of $300 billion of additional capital before summer. Is that really $700 billion?   
• The ECB defines capital needs as a ratio of capital to risk assets. Adding liquidity doesn’t fix that ratio. Raising equity or selling assets does. The bet is assets will get sold before capital will get raised. John Moran, the Irish finance minister, pointed out the Irish government is way out ahead of largely everyone else with a creative and aggressive assault on bank solvency with a comprehensive bad bank, good bank, government assisted scheme. The herd is not following the Irish bell cow here. 
• Major EU banks are enormous. Many of these institutions have assets exceeding the gross domestic product of their host countries. Note that Lehman at its height had assets amounting to about 4% of US GDP. How does the mouse hoist the elephant?
• The European banks are also woefully at risk because of their reliance on wholesale funding. US deposits as a percent of bank liabilities are almost 60%. In the Euro area, just over 30%. Yikes. 
• To maximize the opportunities for buying European bank assets, we need a Goldilocks moment. If the banks’ capital is too low, kicking the can becomes the only strategy and they simply cannot sell assets to improve capital ratios. This compels a strategy of comprehensively fibbing about capital and hoping cheap liquidity will somehow fix the problem. If they are lavishly recapitalized by their respective host governments (see above; not likely in most cases), then they can afford to kick the disposition can down the road. Bet is we’re getting Goldilocks. The EC and host countries are doing everything they can to prop up these banks. It’s likely to be just enough to allow the banks to sell non-core assets but not so much that they can ride out the storm and just hope for a tsunami of appreciation.
• Assisted deal to fix open and at least notionally solvent banks is the best way to fix the European bank problem. There are, regrettably, massive headwinds in the way of this getting done. The bank regulatory structure of Europe is vast, diffuse, overlapping, confusing and highly politicized. One thing the regulatory community agrees on though, is that Anglo-Saxon private equity is pretty much evil. If you cannot invite in private capital, assisted with a modicum of state aid, and you cannot face the dilutive consequences of selling vast quantities of common stock, you better sell assets. 

From where I sat on the podium, all of this seemed to be a validation of our view here at Dechert that the disintermediation of the European banks is a trend that will continue to provide real opportunities to entertain the US players for the next couple of years. I love validation. Next time, practical pointers on how to buy and sell pools of bank assets.

By: Rick Jones

First, our Strengths and Opportunities:

• We’re coming out of the deepest and most torturous recession in 70 years. The financial markets came close to collapsing, credit evaporated, the U.S. housing market went into a tailspin and commercial real estate values dropped between 30% and 40%. But things are demonstrably getting better. All downturns end and are followed by sustained periods of recovery, right?
• Interest rates are at insanely low levels. I’m still trying to wrap my brain around a one-month LIBOR of 20 bps and ten-year Treasury below three percent.
• Bank balance sheets have repaired (some), the financial market has crept back from the edge of oblivion. There’s money to be lent.
• Cap rates have dropped like a rock from ’08 and ’09 and higher valuations resulted. In some CBDs, prices are within single digits of pre-fall highs.
• The GSEs might be in conservatorship, but for dead people, the Twins are pretty damn active market participants. They should have a recurring role on True Blood.
• The housing market must be near its bottom. It just must! The experts have been predicting the bottom for 24 months and eventually they have to be right. When the bottom’s reached, the consumers will find their courage and the consumer sector of the economy, some 70% of GDP, should start to perform more like normal.
• The stock market’s going great guns, there’s trillions of dollars on the balance sheets of corporate America.
• With a little luck, we won’t spend more lives and treasure on more wars and wacky governmental recovery initiatives.

So, that’s all good and, voila, a functioning commercial real estate mortgage market and a growing economy result. I’m feeling good, so far.

But hold on, let’s look at the Weaknesses and Threats:

• While some parts of the banking sector and the financial services sector are well on their way to health, not all is well. There still are a lot of outstanding questions about what lurks on the balance sheets of institutions large and small, and whether the full story of repair has been played out.
• We can’t seem to get to a budget. Yet it seems that, at some point, this Ponzi scheme of continuing to borrow and spend must stop. Could you imagine what would happen if the Treasury’s borrowing costs went up 500 bps really quickly? Portugal, anyone?
• Commercial real estate is increasing in value not because more butts are in seats and more sales are happening (although there’s some of that), but because of the changes in cap rates. When one lives by cap rate moves, one can die by cap rate moves. What happens if we stop believing an optimistic narrative that things will continue to get better? If that narrative is disrupted, it could turn ugly in a hurry.
• Interest rates are extremely low. Where are they going to go? How long can they actually stay at these historically anomalous levels? At some point, they have to go up. We’ve certainly seen commercial real estate markets operating robustly with an eight handle on the ten year, but how do you go from three to eight? Maybe if that happens over a decade, all’s good. If it happens over a quarter, it’s bad.
• Europe is a disaster. We shot right by Spain on the road to Italy. Europeans are playing world class kick the can and as long as a common currency is off the table, there’s no way out. Europe’s Hotel California contagion moves from sovereign to sovereign and then from major international bank to major international bank. It will be hard to keep all this away from the shores of this economy.
• The government seems to be, or at least is perceived by market players as being, hostile to capital formation. That, by itself, creates a miasma of doubt and uncertainty which chokes off momentum. Add to that our new and as yet untested regulatory burden and one wonders if growth can win out. Oh sure, there are some good reasons behind the current regulatory transformation, but for every safeguard there is a cost. For every provision designed to prevent something bad in the future, there is a drag on capital formation now. Dodd-Frank and its progeny will have an enormous and yet not fully appreciated impact on the ability of all markets to grow and innovate in a way critical to the successful re-acceleration of our economy. Risk retention is, perhaps, the most visible current face of Dodd-Frank. No matter how the final regulations turn out, they will, with a moral certainty, decrease the availability of affordable credit to the commercial real estate market and to the broader economy.

So throw all of that onto the scales and try to get comfortable about the sustainability of this recovery. As long as they play music, I’m going to dance. Just don’t make me tell you when the band’s going to take a break.

By Rick Jones.
 

Still, the bad boy guaranty (together with amendments to the Bankruptcy Code rendering single-asset bankruptcies less attractive to borrowers) did, in fact, work to reduce the number of bankruptcy filings during this most recent downturn and provided lenders with a measure of dry powder when seated at the negotiating table. A warm-body guarantor is often thought of as the gold-standard of behavior modification – no one wants to explain to their children how their college fund was paid over to a CMBS trust. Of course, a high-net worth entity can be equally as effective – so long as its assets extend beyond the subject real estate. Lenders’ confidence should be bolstered by the recent Empire State decision, which is in line with the majority of legal precedent on this issue:

● Blue Hills Office Park LLC v. J.P. Morgan Chase Bank  - Massachusetts court applies plain language of guaranty to uphold claim arising from misapplication of settlement proceeds;

● CSFB 2001-C-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC – New Jersey court rejects argument that recourse guaranty constituted an unenforceable liquidated damages provision;

● GCCFC 2006-GG7 Westheimer Mall, LLC v. Edward H. Okun - New York court finds guarantor liable for full amount of the loan after voluntary bankruptcy petition; and

● Diamond Point Plaza L.P. v. Wells Fargo Bank, N.A. – Maryland court holds guarantor responsible for full amount of loan after misapplication of rents and failure to maintain SPE status.

Recent vintage loans are, generally, including expanded carve-outs that are supported by stronger credit (indeed, the CREFC model representations and warranties include a specific representation on the presence of a recourse guaranty). Moreover, there has been a significant push by 2.0 issuers and rating agencies to require foreclosing mezzanine lenders to provide a substitute guaranty from credit-worthy entities - in some cases, that meet objective asset and shareholder equity thresholds - as a condition precedent to foreclosure (whether or not the existing guarantor is released).

Alternatively, sophisticated borrowers – themselves weary from the battles of the past half-decade – are now insisting that mortgage loan guaranties burn-off after they’ve been removed from control as a result of mezz foreclosure. Telling the kiddies that the tuition is gone because your mezz lender filed the property into bankruptcy is a different conversation altogether.

By Matthew Clark
 

But then Frankenstein’s monster smashed the bars of its cage and began to kill villagers. Turbo-charged by an environment where pushing the envelope was the mother’s milk of financial engineering, the CRE CDO became unhinged from its intellectual moorings and turned into the instrument of mass financial destruction.

Two decisions turned this perfectly good financial vehicle into the stuff of bad memories. First, we decided this would be a terrific vehicle to hold B notes, participations, mezz loans and other high-yield debt. Second, structural criteria were developed which enabled this business to flourish. Where high-yield debt was concerned, the criteria baked ill conceived structural arbs into the plumbing, which permitted sponsors to stuff these vehicles with dodgy but high yielding assets which were often treated the same in the eligibility and over-collateralization mechanics as less risky, lower yielding assets. Guess which type of asset filled those vehicles?

Enough painful memories. While the NRA’s famous slogan that guns don’t kill people, criminals do, causes eyes to roll amongst the chattering classes, there is some truth to the aphorism. The misuse of this technology should not blind us to the value of the device as part of a well-managed securitization or portfolio business. To be clear, I’m talking here about financing performing newly originated whole loans.

The whole loan CRE CDO is fundamentally a fairly simple structure. The rating agency driven criteria for whole loans, informed by years of experience in rating and surveilling CMBS, actually works pretty well. Whole loan deals with good diversity and CMBS consistent criteria will perform as well as the underlying asset category and frankly, that’s really all we can ask. Whole loan CRE CDO will work. With good managers, there is nothing intolerably scary about active management of a dynamic CDO with straightforward and transparent eligibility criteria and plumbing. These deals should not be conflated with the opaque, mind-numbingly complex, almost unmanageable (perhaps, in fact, unmanageable) multi-category CDOs that characterized 2006 and 2007 (everyone remember the synthetic bucket and future funding insanity?) and gave these devices the odor for which they are justly famous.

We know the criteria for whole loans, we know how it works. A dynamic reinvestment mechanic that allows for reinvestment, prudently constrained, in the hands of a high quality manager with an established track record and substantial skin in the game, is a perfectly reasonable device to help lever an origination business and we ought to find a way to bring it back.

But, we need a new name. The optics of CRE CDO are horrific. Perhaps we should have a contest to name the new vehicle. How about Dynamic Interim Mortgage Entity, or DIME? Brother, can you spare a dime?
 

Also not news: there remains substantial anxiety. Is there sufficient loan demand? The girls have decided to have a dance, have hired the hall, put up the bunting and blown up the balloons, the band is tuning up. No guys. Or not enough. What happens, that little voice natters on, if we re-built this sell-side edifice, put expensive rumps in seats, and the buy-side don’t come to the dance? That’s simply not acceptable. To a man with a hammer, everything looks like a nail. A rebuilt, robust sell side will lend or die trying. And what might that do to heretofore heartfelt pledges of discipline?

On fundamentals, the consensus was pretty positive.

Jamie Woodwells, MBA’s brilliant commercial real estate economist, said at the conference in his state of the union:

• We should see good GDP growth for the next several quarters, in the 3% range.
• Interest rates are still benign and, even if the long end of the curve creeps up 100-200 bps, risk spreads will come in, keeping coupons at acceptable levels. LIBOR will also be benign.
• Employment will remain anemic but grow.
• Housing will continue to “grow more affordable” (nice way of saying prices continue to decline) at a slower rate and slowly but surely the shadow inventory will be absorbed.
• There’s been precious little new stock built in any of the major real estate food groups in years.
• There is a modest but a growing sustainable demand for mortgage credit. Plenty of refis to do.

That’s all basically good.

On the other hand, there does seem to be too much retail, too much multifamily, and Corporate America really doesn’t even need the space it has. And, on employment, there’s precious little evidence of real growth yet. (Is the new normal 8% structural unemployment? If so, what’s that going to do to us?) QE3 is on the runway, deficits continue to balloon, the consumer is still overburdened with debt, housing is doing a double dip, 30% of homeowners are under water on their biggest investment. Oops, there I go, going negative again. Don’t worry, it will somehow all work out.

And maybe that’s the headline both for CREFC and CREF. Somehow, it will all work out. After three wrenching years of retrenchment and loss, growth simply must be back. Somehow it will all work out! I kinda think so too.

By: Rick Jones.
 

The main event - former Secretary of HUD Henry Cisneros' comments on the state of the CRE market. Whatever your politics, Cisneros is a vastly powerful intellect and commanding speaker. In 35 minutes (speaking without notes that I could see) he forecast the next 30 years of commercial real estate. To survey my scribbles - he is bullish on multifamily, contrasting the plight of countries suffering population decline (Japan, Spain) with the explosive growth expected Stateside (376mm by 2030; 400mm by 2050). The first Baby Boomers will turn 65 this January, with many down sizing to rentals (apparently the new trend in getting gray is "Aging in Place" - bad news for Arizona). If Generation Y will just (at some point) move themselves (and their Xboxes) out of their parents' basements at rates that even approach historical norms another 1.4mm people could be looking for a place to rent. Combining these factors with increased immigration (something like 82% of new U.S. immigrants rents for their first 5 years in this country) and lower home ownership rates (Barney Frank's victory notwithstanding), Cisneros' math leads him to a need for the construction of over 2 billion square feet of new multifamily by 2030.

However, the former mayor of San Antonio (as an aside - see this story on that city's growth during these past few years) is significantly more bearish when it comes to other asset classes - specifically office and retail. As far as retail goes, he's had overseas investors tell him they think we're 30% overbuilt (I say we are not a foot more than 25% overbuilt, but that might be the Patriot in me). The flat, jobless recovery; sector consolidation; internet shopping - the cards are stacked against retail as we near Christmas.

 Some parting highlights - Cisneros doesn't see the home mortgage interest deduction going away (you could tell this just killed him to admit). He points to strength in specialty sectors like medical and assisted living. (Did I mention the first Baby Boomers turn 65 this January?) Infrastructure of all kinds is booming - Cisneros relayed an interesting trend - internet purveyors (think Zappos building distribution sites in (or adjacent to) airports (that's how you get your wingtips the next morning). Alternate energy was another sector where technology will drive the need for growth - Green building and retrofits are now the norm.

I have more notes, and will recap the balance of the conversation in a forthcoming post - including a great panel that included the Davis Companies' Jon Davis. Again, congrats to TREC BC for a great event.
 

By Matt Clark.

First, while it’s doubtful the current administration has exhausted its populist impulses to reengineer the economic and social life of America, I can't envision any more historic, paradigm shifting legislation coming out of Washington (at least until 2013).  With the Republicans in charge of the House and a cloture-proof Senate with a righter right and a leftier left staring at each other across an empty middle, dramatic legislation seems practically impossible.  That in itself is significant. Count that as a Treat.

Maybe we get the Bush tax cuts extended in the lame duck. Treat 2, Trick 0.  Healthcare is not going away, FinReg is not being repealed, the trillions of stimulus money (and the whopping new debt) can't be taken back.  Treat 2, Trick 1.  Let’s not forget populist fervor.  Regrettably, it’s not the exclusive province of the left or the right, Democrat, Republican or Tea Party or whatever.  Free Trade is under assault, easy money is a near religion and God knows what else will fire the heaving middle.  Treat 2, Trick 2.

The tiebreaker is regulatory oversight.  This may sound like Washington small ball, but it’s huge in the here and now.

Just like to the man with a hammer everything looks like a nail, to a regulator, everything looks like an opportunity to regulate.  Even absent the jet fuel of a left of center Congress, the regulatory instinct is to regulate.  And that constituency tends to have a tin ear for unintended consequences and is broadly unimpressed by macro arguments of the impact of regulation on capital formation and business in general.

In short, the new Republican majority is likely to have a fairly significant moderating impact on the regulatory implementation of FinReg and any further regulatory shenanigans.  This is a benefit not to be lightly dismissed.  FinReg left so much to the imagining of the regulating community - it invites the regulators to exercise unprecedented power to shape the new lending and capital formation environment.  If that brief opportunity had been empowered by the left-leaning (oops, “progressive”) Congressional leadership of the last Congress, we’d without a doubt have seen a Congress encouraging, if not demanding, the broadest possible interpretations of government power and authority to constrain business behavior.  A right-leaning House leadership will likely do the contrary.

I hope those who say gridlock is good for business and the country are right, cause that’s what we’ve got.  Gridlock is pretty thin gruel to set the table for a return to prosperity.  But, as 2011 dawns, the regulatory burden should be materially lighter than would have been the case if Messrs. Dodd and Frank, Kanjorski and the like still held the whip hand.  So, we’re Treat 3, Trick 2.

We should, therefore, look to the fundamentals of the economy for our guidance as to what the next couple of years will look like with more confidence.  I said in this column a few weeks ago, why not be optimistic that, on the whole, the fundamentals for 2011 don't look bad.  So perhaps November 2nd this time around represents a little more treat and a little less trick and we can get on with the business of business.

By Rick Jones.

MERS is a creature of necessity, established in the wake of the explosive growth of residential securitization. When a mortgage loan (residential or commercial) is sold, the promissory note (evidencing the debt) is assigned to the purchaser via allonge – the mortgage (which is placed of record at origination) is assigned through a recorded assignment. Relatively simple, until one considers the number of mortgage loans being securitized, the fact that the securitization of a single mortgage loan may require multiple assignments (remember, the GSEs are accumulators, not direct lenders, and therefore needed to first acquire the underlying loans, to say nothing of assignments to depositors and repo lenders) and also, the fact that (with extremely few exception) the land recordation system in place in this country is almost impossibly outmoded in terms of technology. The overwhelming number of assignments - coupled with the inability of local recorders to keep pace - created a need for a more modern approach to tracking the ownership of mortgage loan, and MERS satisfied this need by offering a DTC-like registry for mortgages.

This is a developing story, and one sure to play out over the course of coming months. Last week we issued this Dechert OnPoint to clients that might be concerned with respect to potential issues in their foreclosure processes. Of course, we will continue to monitor these issues as they develop.

By Matt Clark.

This is a really encouraging story – a successful distressed-debt play on a big-time asset and one of the largest CRE trades in the country this year. The Hancock Tower was acquired by Normandy/Five Mile in 2009 for $660 million (give or take) – a number that put a point on exactly how far values had fallen (the defaulting borrower had taken the building down in 2007 for $1.2 billion). Normandy/Five Mile was smart and aggressive in acquiring debt at the right levels – and then – maybe more importantly – had adequate know-how and sufficient dry ammo to turn things around (re-purposing underground space for parking, building a new lobby restaurant, earning LEED certification, and inking a 15 year lease to Bain Capital for 200,000 sq. ft.).

I (Boston College A&S ’97, Law ’00) sit on the 27th floor of the Hancock and have watched this story play out – as tenant, participant, observer and blogger – for the better part of five years. Each night, beginning at dusk, you can watch as large bands of dark space begin to stripe the building’s tenanted floors – the outward scars of rolling leases that were never replaced as the credit markets ceased and the bottom fell out of everything. Is this story an aberration? Without doubt; the owners seemed fully ready to carry the building for another 4-5 years. Getting out in 18 months with a massive gain sui generis for certain. But it seems that, soon enough, when I leave at night, there won’t be as many dark windows.
 

By Matt Clark.

Which leads me to Jerry Brown filing a lawsuit against Fannie Mae and Freddie Mac last month for refusing to refi mortgages that carry liens relating to PACE bonds.  Mr. Brown, in the midst of a bid for the Governator’s seat, claims the GSEs’ actions are wrecking his State’s ability to grow a green economy and is pushing for the President to step in.  PACE bond programs give grants to homeowners for energy-efficient home improvements, for which the homeowner pays a tax-like assessment.  The economic benefits of the energy improvements – nebulous cost savings over the long term – are questionable at best. And as you’d expect, the liens associated with the assessments prime a lender’s mortgage.  This makes the bonds salable for the municipalities – but places the burden of paying for those improvements on the mortgage lender in a default scenario, causing Fannie and Freddie to balk.  So now, and without any visible sign of irony, Candidate Brown wants the Obama Administration to bully Fannie and Freddie into lowering their underwriting standards.

Now, I might suggest that there are better places to put your money than any debt issued by the State of California.  And I also might say that, at least here in the Commonwealth of Massachusetts, it’s considered rather rude to campaign against a Kennedy relative.  But let me instead end with this: the really interesting story that will develop around green improvements in coming years is the retro-fit of existing commercial real estate – most significantly, office buildings – and who will pay for it.  All industry constituents – banks, developers, government agencies and lawyers – are trying to figure out a viable way to finance energy-efficient improvements to existing buildings.  The biggest obstacle facing lenders is how to translate the cache of LEED certification, the promise of marketing “green” space to politically-conscious tenants and the possibility of reduced operating costs over the long term into cash flow that can service the lender’s debt.  Not so different than figuring out the right windows to buy, really.  One thing is for sure – the first to figure it out will make a good deal of money on the estimated $520 billion expected to be spent on green retro-fits over the next 8 years.