By: Eric Nielsen
Heading into the second half of 2017, the murky waters surrounding the fiscal, regulatory and macroeconomic environment continue to infuse uncertainty into the commercial real estate lending market. Activity in the first half of the year did little to provide clarity to investors, as economic reporting highlighted mostly mixed signals for the economy and large scale financial reform failed to materialize. One critical component of the regulatory environment that did begin to materialize; however, is the risk retention rules for commercial mortgage backed securities (CMBS) that became effective late in 2016.
Since their introduction in the late 90’s, CMBS products have represented a small but significant portion of the lending environment for commercial real estate. At the height of the market in 2007, roughly 75% of 10 year-fixed rate loans went into the CMBS market. Although issuance levels have continued to increase since bottoming out during the financial crisis, overall volume is still well below its pre-crisis peak. Today, less than 20% of 10-year fixed rate loans go into the CMBS market and CMBS issuance represents less than 10% of CRE loan originations. As the CMBS market continues to navigate choppy terrain, the impact of regulations on the market will have important second and third order effects on both the overall commercial real estate debt universe and the broader CRE investment market.
The Commercial Real Estate Market
Before delving further into the effect of new market regulations, it is important to understand how the current market environment underscores a renewed appetite for commercial real estate lending. Within the industry, key fundamentals remain strong and the commercial real estate market remained on solid footing in the first half of 2017, as trends in cap rate compression, NOI growth and foreign investment continued to propel national property prices well above their pre-crisis peak in 2007. Commercial rents have continued an upward trajectory and demand is exceeding supply across most asset types. However, some indicators suggest that headwinds to attaining desired return targets are developing on the horizon. For one, the rate of equity appreciation has slowed. Per the NCREIF, equity appreciation has been positive but falling for 9 consecutive quarters, from a peak of 2.33% in the first quarter of 2015 to a low of .4% in the first quarter of 2017, demonstrating four consecutive quarters of sub-1% appreciation. Furthermore, with the Fed raising its benchmark interest rate for the third consecutive quarter in June, and with several more increases likely in the short-term, it may become more difficult to maintain the historically low acquisition yields the industry has been enjoying during the current cycle. As a result, the market’s appetite for lending is expected to accelerate as a higher level of leverage offers investors a greater opportunity of attaining their target returns.
Following the full implementation of risk retentions rules for CMBS, several compliant deals have successfully been brought to market in each of the structures allowable under the regulations. Solid pool level underwriting metrics have resulted in a flattening of the credit curve and tighter spreads across the capital stack. As expected, the market has begun to experience a constriction of CMBS loan contributors, as the regulations have created a competitive advantage for permanent capital providers who are able to eliminate transaction risk by acting as both the lender and primary B-piece buyer in a deal. With more stringent underwriting and a consolidating lending universe, the cost of borrowing in commercial real estate can be expected to increase in the short term. However, the longer-term effects of risk retention are yet to be seen. If a higher quality CMBS product is able to lower spread premiums demanded by investors, the cost of borrowing may decrease in the long-run. Furthermore, if the CMBS market is able to successfully implement risk retention rules while driving long-term cost savings, it is likely that the key elements of risk retention will reverberate to the wider universe of CRE lenders.
What it all means for the Commercial Real Estate Market
With an increasing need for leverage and growing demands for quality underlying assets, value creation is now as important as ever. Investors can no longer afford to abide by a strategy that relies on expertise in a particular asset type or geography, while ignoring others. Rather, keen insight must be developed to pick the winners in every asset type and geography, while avoiding the losers. JMA’s broad investment mandate and entrepreneurial process allow us to deploy our deep institutional knowledge to an evolving marketplace and successfully adapt to the financial and regulatory backdrop. Whether the risk retention rules have introduced a new paradigm to the CRE market or will simply become an afterthought, the importance of being able to identify value across the market spectrum will never lose its importance in driving return for commercial real estate investors.