The slow start to 2016 did not dampen the enthusiasm at CREFC’s Annual Conference, held last week in New York City. The conference saw record attendance, with standing-room-only crowds at virtually every panel. As with the Industry Leaders Conference in January, the hot topics on people’s minds were risk retention (and the rest of the regulatory headwinds), liquidity and the competitiveness of the CMBS market.
The conference made very clear that we are at an inflection point in the current cycle. The general mood of the conference, in our view, was the confluence of nervousness and cautious optimism. The gloominess of the first quarter, and fears over the “sky is falling,” has yielded to mild bouts of enthusiasm (at least if the parties were any indication). The capital markets have settled down over the past few months, spreads have tightened, and borrowers have begun to trickle back into the CMBS market.
Clearly our industry faces headwinds, and nobody is betting on a record second half, but we also did not hear anyone ringing the death knell for our business. We left the conference with more questions than answers. Here are some:
- Fundamentals continue to be relatively strong in the real estate market. Although we may be in the late innings of the current cycle (seventh inning stretch?), fundamentals are much stronger than at the end of days of the last cycle. It may be 2007 but next year’s not going to be 2008.
- Some panelists expressed concerns over the biggest driver of GSE and balance sheet lending, multi-family. Although multi-family continues to be a hot market, there were whispers at the conference that the recent boom in multi-family construction could lead to oversupply. Some lenders stated that multi-family properties are falling short of their proforma numbers, which is causing some uneasiness in the sector.
- Foreign money has inflated property values in major markets, and prices are likely to dip on high-end real estate if foreign capital dries up; and there is some sense it is.
- CMBS issuance is down almost 50% year over year, and accounts for only 7% of the CRE lending market (down from 17% in 2015 and 50% in 2006!). Virtually all panelists believed that total issuance would be below $100 billion in 2016, with the general consensus falling somewhere between $50 billion and $75 billion. A startling decline from predictions early this year.
- The market has blessedly snapped back to close the first half of 2016. Spreads on recent conduit deals have tightened significantly and there appears to be some stability in the market. Liquidity is there, although at perhaps barely adequate levels, and deep concerns remain.
- Rates continue to be historically low, yet borrowers have sought any source of capital other than CMBS during the first half of 2016. With recent decreased volatility in the capital markets, lenders are quoting borrowers more competitive rates with better cost certainty (i.e., less flex). We ate some of our seed corn in the retrenchment caused by price volatility in late 2015, and we continue to pay the piper on that. We are now starting to see the borrowers migrate back into the CMBS market. We hope that’s not wishful thinking.
- HVCRE is a having a material impact on construction lending and it’s likely to get more meaningful as the year goes on. The capital charges attendant to making an HVCRE loan are a real drag, which at the least will decrease the quantity of acquisition, development and construction lending and make it more expensive. Moreover, uncertainty around how to comply with the Rule is a very real problem.
- Nobody has found a scalable panacea for the risk retention problem. It is becoming increasingly likely that we will not see one consensus solution, but rather will see multiple approaches with some issuers holding a vertical strip, and others utilizing the B-Piece exception. There are likely to be winners and losers, and the market will determine which approach is preferred going forward. But it might take a while and market disruption is likely until risk retention is resolved.
- Could risk retention be the next Y2K? Despite the general sense of doom around risk retention, there was a surprising whisper at the conference that risk retention may be much to do about nothing. The truth is likely somewhere in the middle – there will be pain, but risk retention will not be a fatal blow to CRE securitization.
- Decreased volume and increased competition in the market, together with the pressures of risk retention, HVCRE, Reg AB II and other regulatory requirements, may drive some conduit lenders out of the market. 2016 will likely be a year of consolidation.
- The maturity wall…There continues to be a significant amount of uncertainty over the size and impact of the looming maturity wall. It’s likely that many higher-quality properties financed in 2006 and 2007 have been refinanced over the past few years, with many non-CMBS lenders helping to ease the pressure of the maturity wall. While there may be less loans than initially feared (or gleefully anticipated) maturing in 2016 and 2017, the quality is likely lower (as a whole) than expected, which may make it more difficult for those loans to be refinanced. By some estimates, only 70% of CMBS loans maturing over the next year can be naturally refinanced (without mezz or infusion of the new equity).
- We expect the alternate banking marketplace (that which our regulators nastily refer to as the shadow banking market) to become an increasingly important component of the commercial real estate finance industry in the next year or two. As the regulatory pressure increases on the prudentially regulated banks, we expect the alternate lending marketplace to expand rapidly with lots of dynamic innovation around how the balance sheets of these institutions are managed. This means a rapid increase in repo and warehouse lending as well as CRE securitization-type transactions to feed the machine.
- Speaking of warehouse finance, many banks see repo financing to shadow banks as an attractive alternative to directly making commercial real estate loans. It’s possible that we see a strong flow of capital from the banks to the shadow banking market going forward.
- On the positive side, Dechert hosted a CMBX roundtable early Monday morning to discuss the future of CMBX, and the possibility of creating a clearing house platform for CMBX. An effective CMBX platform would allow issuers to hedge risk more effectively, possibly leading to increased liquidity in the CMBS market.
In addition to fundamentals, liquidity and regulatory concerns, 2016 has been and will continue to be volatile at the macro level. The chatter at the convention was who actually thought we would be stuck with a Trump/Hillary choice and what does the presidency of either of these two individuals portend for our market place? What about Brexit and Europe? What about geopolitical risk in the Mideast, Eastern Europe and the South China Sea? What about the fact that the global economy seems to be slowing, and what do we think about the zero bound interest rate environment that continues to spread around the world? Plenty of headwinds facilitate the global economy, to be sure, and the knock-on effect of those headwinds for the CRE market is uncertain to say the least.
But despite all those hurdles, the new regulations, the volatility and the geopolitical risks, the conference had an overall positive feel. Most in the industry appear to be taking a pragmatic approach to the remainder of 2016 – yes, there will be bumps, but the sky is not falling, and we are not hitting a wall. Halftime is over – time to get back to work and salvage what is left of 2016, and look forward to 2017.