Industry Pins Hope on Legislation That Could Save CRE Capital Markets

The Capitol

WASHINGTON, DC—If you think the commercial real estate capital markets have been volatile this year just wait until several pieces of pending US and global regulations come into effect. The sum total of these measures could easily throw the CMBS market into a prolonged period of confusion and upheaval. The most immediate rule worrying the industry is Dodd-Frank’s credit risk retention requirement, which will become effective on Dec. 24, 2016. Briefly, the risk retention rule was adopted by several federal agencies in 2014 after the commercial real estate industry beat back the most onerous provisions that had been originally proposed in 2011. The rule requires asset-backed loan originators to retain at least 5% of the credit risk relating to the assets that underlie the securities using one of two structures: an  eligible vertical interest, in which the sponsor retains 5% of the face value of each class of securities issued in the CMBS transaction or an eligible horizontal interest in which the sponsor retains 5% of the most subordinate class of the fair value of all of the CMBS issued. The industry has been expecting the B piece buyer community to figure out a way to navigate these rules to keep the market afloat. Using the horizontal interest approach, CMBS sponsors can satisfy the requirement with investments from one or two B-piece buyers. Whether these investors are willing and perhaps more importantly, able to do this, has been an open question as we will see in a minute. The House Passes Preserving Access to CRE Capital Act Now a more tangible solution is on the horizon: a measure sponsored by Congressman French Hill, (R-AR)  that passed in the US House of Representatives in March called “Preserving Access to CRE Capital Act.” The bill could have major implications for low-risk CMBS lending as it would give sponsors the choice of using either a pari passu structure or a senior/subordinate structure for the third-party purchaser option, wrote Trepp research analyst Catherine Liu earlier this month in Trepp Talk. See, one major challenge for B piece buyers under the credit risk retention rule is that it requires the horizontal interest is be split equally between both parties on a pari passu basis when two B-piece buyers are involved, Liu explained.  Nor can the securities be hedged or transferred to an outside party for at least 5 years. They must also be purchased in cash. Liu wrote:

B-piece buyers are sold non-rated and below-investment grade securities that generally only constitute 2-3% of their fair value for EHRI under the present rules. As a result, additional lower-yielding investment grade assets must be sold to meet the 5% risk retention minimum, an offering that has less appeal to B-piece buyers. Under the new amendment, the option to use a senior/subordinate structure enables sponsors to attract a larger pool of investors with varying levels of risk tolerance and yield requirements.

The proposed language of the bill would allow certain low-risk commercial real estate mortgages to qualify as qualified commercial real estate (QCRE) loans, a category of loans which are exempt from the risk retention requirements given their superior historical performance, Real Estate Roundtable CEO Jeff DeBoer explained. In particular, the language would allow for Single Asset/Singe Borrower (SASB) transactions to be considered QCRE loans, he said, noting that SASB deals represented approximately 40% of CMBS issued in 2015, and roughly 10% historically. The bill “would also provide more flexibility in how CMBS transactions are structured, in order to better accommodate how investors raise capital and divide risk in the capital stack, reducing the rule’s unintended negative impact on CRE liquidity,” DeBoer said. The situation is getting dire as a number of CMBS market participants have already left the market, DeBoer told GlobeSt.com.  He said that the number of dealers with capacity to hold CMBS inventories has dropped 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,” he said. The “Preserving Access to CRE Capital Act” would help the situation, DeBoer said — provided, of course, the Senate passes a version of the bill in the  limited number of legislative days left on this year’s calendar. The Senate Holds a Hearing Last week Mike Crapo (R-ID), Chairman of the Senate Banking Committee, held a hearing entitled “Improving Communities’ and Businesses’ Access to Capital and Economic Development” before the Securities, Insurance and Investment subcommittee to discuss the state of the CMBS market, the industry’s concerns with continuing lack of liquidity — and the House bill. Drew Fung, managing director and head of Clarion Partners’ Debt Investment Group, testified on behalf of the Commercial Real Estate Finance Council. He warned there was little time to waste. “Certain aspects of the marketplace are so fragile today —even before half of the planned regulations come into place that CMBS is experiencing severe pricing volatility, a marked contraction in issuance and reduction in capacity.”