South Beach played host to the 2018 CREFC January Conference last week, as roughly 1,800 of our best friends in the CRE lending and securitization industry assembled in Miami to reflect on another year gone by and to muse about what’s in store (or out of store, in the case of retail) for 2018. In keeping with tradition, Dechert’s reception at the SLS Hotel was a hotbed of schmoozing, deal talk and employment fair, as over 400 guests took a break from discussing the SEC to… watch the SEC. The excitement of the Alabama-Georgia national championship game was a welcomed excuse to extend the party well beyond the official ending time (a move that is quickly becoming an expected budget buster for this annual event).
As usual, Dechert was well represented at the conference. Dechert’s Laura Swihart served as conference co-chair, and Rick Jones moderated a riveting (ok, not so riveting) panel on “Floating Rate Loans: Circa 2018”.
Conference panelists and attendees were generally bullish, and why wouldn’t they be after a 2017 that saw $95.3 billion in U.S. CMBS issuance (not including the GSEs). For color, that number is up more than 25% from 2016. Not a bad way to usher in the risk retention era.While risk retention pervaded the convention last year, it garnered barely a yawn in most sessions this year. The sentiment from panelists was consistent: risk retention is a pain in the ass…but just a pain in the ass. It increases costs and administrative hassle while having little or no impact on credit quality or loan volume (but investors still say they like it). One thing that 2017 did show us is that all three methods of retaining risk (i.e. horizontal strip, vertical strip and L-shaped strip) are viable, each being utilized in at least 25% of the year’s 52 conduit deals. Save for the mid-year Fun With GAAP true sale blip, risk retention has been relatively boring.
But “boring” did not describe 2017 as a whole. Trump was inaugurated, Brexit was in full swing, the proverbial “wall of maturities” came and went, CRE CLOs aggressively gained market share, a refinance-a-paloozas hummed along in the floating rate, Single Asset Single Borrower (SASB) space and, most recently, the U.S. tax code was reformed. And CRE got the good stuff; interest deductions and 1031 like-kind exchanges were preserved. Nice to have a developer in the White House.
Where does all of this place us in the “cycle”? The bulk of conference panelists and the punditry believe the aforementioned tax reform and the anticipated influx of off-shore capital wound us back a few innings. Others observed that the stable economic climate (complete with newly-settled tax laws) will drive M&A and encourage borrowers to deploy capital. Still others took comfort from the fact that LTVs remain significantly below 2007 levels (though an uptick in interest-only loans is tempering some of the optimism). Even with the death of LIBOR looming (but not looming too soon), pundits predict another booming year on the floating rate side, forecasting further that market participants will begin discussing a permanent replacement for LIBOR this year (and such pundits are optimistic that industry consensus is obtainable). All in all, the prevailing sentiment from conference-goers is that we’ll keep that party going in 2018.
One fact that garnered attention: the conduit market may be shrinking. Conduits have traditionally comprised about 70% of the conventional CMBS market (with SASBs and CRE CLOs rounding out the remaining 30%), but the SASB market alone had a 42% market share this year.
Where is the SASB market heading? 88% of 2017 SASBs were refinancings; however it seems that this refinancing cycle may be getting near its natural end. Good news for SASB fans: there’s more to do out there to do than just do refinancing. Tax reform is likely to drive M&A, leading to an increase in large loan lending. At one time these big loans were routinely wacked up into multiple conduit offerings, but they are increasingly likely to be done as standalones in 2018 as was the case in 2017.
And a big winner in 2018 will be the CRE CLO. Last year saw rapid growth in the space, and CRE CLO issuance is expected to nearly double in 2018 (from $8 billion in 2017 to $14-18 billion). The CRE CLO market is now competitive with the warehouse market (even without monetizing the benefits of matched duration and no mark to market). On the buy side, CRE CLOs are becoming more and more acceptable to the investors even as bespoke deals provide for increased flexibility to issuers.
In the conduit space, there are concerns, but certainly any reports of the impending death of the conduit business are exaggerated.
An ongoing real concern is with the depth of the AAA market. Who are the AAA investors anyway these days? A grumpy, disconsolate lot at the best of times, but the real problem is there are just too few of them. There are now as many mezzanine buyers in the market as there are AAA investors, which concerns CMBS issuers. One MD called the lack of AAA investors “the single biggest hurdle facing our industry”. Maybe we ought to have fewer, larger deals (think $1.5 billion conduits). Clearly, the issuers are attracted to the decreased costs associated with larger deals, but they also aver that larger, more diverse pools would benefit IG investors. But others say it is the same IG investors who are holding back deal size. Hmmm? One panelist took the “if you build it, they will come” approach. Another disagreed, noting that until more AAA investors demand increases, it’s difficult for loan sellers to originate more loans. Chicken or egg?
Pricing is one way to grow the conduit market, so expect increased competition among the major players in 2018. Leverage can also increase volumes. 60% to 65% LTVs are expected this year and, per most panelists, “that’s ok”. B-buyers and bankers alike can price this risk, and those ratios sit comfortably below the 2007 marks (Did I really say that?). Improving the borrower experience is another focus in 2018 that the irrationally exuberant among us apparently think, could, over time, further “conduit growth”.
Another hot topic this year: what kind of collateral are we going to see for 2018 CMBS loans? Industrial properties have been down (think 5% of modern conduit pools versus 20% of pre-crisis pools), but demand for industrial locations surrounding population centers could increase as thriving e-commerce companies try to cut delivery costs. Hospitality property contributions are generally capped, but suburban office, single-tenant office and skilled nursing properties seem promising. But the elephant in the room, and the topic discussed by conference keynote speaker Walter Robb: what about retail?
The former Whole Foods co-CEO acknowledged that the U.S. has too much retail space and that online marketplaces will continue to thrive. So how do retail stores avoid extinction? By creating, Robb says, an ecosystem of experiences and entertainment. One example: Whole Foods has added bars and restaurants in its stores. Experience, rather than price, should be the new focus of brick-and-mortar retailers. Note to my colleagues: Can we make paying legal fees an experience rather than a just a grubby transaction? Would show tunes and dancing partners make paying these fees more pleasant? I love the experience notion.
Notwithstanding this roadmap for retail success, most agree that some retail spaces (e.g. Class B and C shopping malls) will continue to face challenges, particularly if inline tenants have co-tenancy provisions with struggling department stores.
But as one sector falls, another rises. While multifamily (or at least the really good stuff) has traditionally been monopolized by GSEs, potential FHFA caps could lead to increased contributions of multifamily loans in conduits. Average renters are older and have higher incomes than ever before, and investors appear confident in rent growth in 2018. What’s more, tax reform (namely re: property tax deductions) and potential demographic shifts could lead to multifamily growth in certain geographic markets.
Reform was a common theme throughout the conference. Revisions to the U.S. tax code are generally viewed as net-positive for CRE, as 1031 exchanges and interest deductions were ultimately preserved. As important, REITs are among those that will benefit from the 20% deduction on income from pass-through entities.
Both sides of Congress appear to be pushing (or perhaps pretending to be pushing) for GSE reform. While we are almost certain to see lots of bloviation and posturing and delivery of serious position papers full of thoughtful, pontifical observations (We need to strive for a synergistic, impactful, performance-based, stable and robust housing finance infrastructure…blah, blah, blah) and opaque math, most folks don’t actually expect material GSE reform this year. (If it ain’t broke, don’t fix it?)
Regulatory reform, however, is possible. While elections and global distractions may take priority over CRE issues, new agency/committee leadership makes Volcker and/or HVCRE reform possible this year.
One item that will no doubt be addressed sooner rather than later is the U.S. debt ceiling. While there’s wood to chop before deadlines can be extended (think DACA and National Flood Insurance Program debates), most believe the metaphorical can will be kicked down the road. A two-year deal would give industry participants a bit of comfort and certainty.
So where are we in the cycle? Extra innings? Did tax reform send us back to the seventh inning stretch? Are we even playing baseball anymore? Whatever it is we’re playing, let’s keep going while the stadium lights are still on. Oh and if you see construction lending on the rise, run!