CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

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.