“Working Around the Edges” For Strong Risk-Adjusted Returns
By Robert J. Dougherty
With U.S. commercial property prices having broadly surpassed previous peak the discerning investor is asking how long this pricing rebound can continue. Given corresponding declines in commercial real estate yields, where can interesting returns be earned in the current climate? How is capital protected and how are profits best insulated against a possible market correction?
This paper will examine how a secondary market strategy, which avoids investing in overpriced gateway cities, could offer strong returns as well as a high degree of safety. It will illustrate how trends in capital flows and supply/demand dynamics are continuing to provide strong support to property pricing and may counter any upward movement in cap rates in the near term. Lastly, it will present a case for strong risk-adjusted returns existing in the “middle market” segment, defined as properties valued at $25 million to $75 million.
Play to the Edges for Better Returns
Appreciation has been uneven
Looking a little deeper into commercial real estate’s post-recession price boom reveals that not all markets are created equally. In fact, any perception that real estate may be over-valued appears to be driven substantially by the dramatic appreciation of trophy assets in gateway cities such as New York, Boston, and San Francisco.
These are frequently the markets where institutional investors first venture forth from the real estate cycle bottom, so they usually lead commercial real estate out of its recessionary trough. This cycle appears to have been no exception.
The first chart illustrates how much greater price appreciation has been in the major markets of Boston, New York, Washington, DC, Chicago, San Francisco, and Los Angeles as compared with “non-major” cities.
Similarly, dissecting the broader price indices reveals that the highest-value properties, which tend to be office and multifamily projects located in gateway cities (particularly in their urban cores), have appreciated significantly more coming out of the global recession than have the lower-value properties.
As illustrated in the chart below, the gap between the value-weighted and equal-weighted indices is at an all-time high. Since the value-weighted index is concentrated toward the highest-value properties and markets while the equal-weighted index neutralizes property values, the gap implies real estate price growth since the recession has been concentrated in the high-value properties, leaving the lower-value properties (i.e., those in the middle market) under-valued. This trend points to value in the comparatively under-appreciated secondary markets – cities such as Denver, Phoenix, Dallas, and Southern California’s Inland Empire.
Among the major property types, this spread is the widest for office properties, reflecting the dramatic and disproportionate appreciation of core buildings in the gateway markets. This suggests that office buildings in secondary markets may represent the most under-appreciated asset class.
Enhanced yield in secondary markets – the first leg up
An arbitrage opportunity seems to be presenting itself, offering the savvy investor the chance to buy in non-major markets and in non-core properties. This trend often plays out in the real estate cycle, as safety-minded investors flock together and drive up prices for trophy real estate. Then, as the economy improves – as it has been – their emphasis on seeking shelter should diminish and they will grow dissatisfied with the low yields available in the primary cities. As they branch out to secondary markets in search of more interesting returns, the gap may narrow and investors in secondary cities could reap the benefit.
Value-add investments – the second leg up
The positive influence of these capital flows can be augmented if properties that are not presently considered core investments can be repositioned into the core investment channel. Value-add activities that can serve to reposition properties in this fashion include lease-up, renovation, portfolio aggregation, retenanting, rebranding, and other actions that serve to increase cash flows and
diminish risk. Such repositioning activities offer the chance for today’s investor to realize a “double lift” from value-add properties in these secondary markets.
Follow the jobs
Apart from the latter being more fully priced, the primary story in favor of the secondary markets is employment. Of the nation’s Top 20 cities in terms of office-using job growth (those that added 10,000 or more jobs for the 12-month period ended 12/31/15), non-gateway cities outpaced the gateway markets markedly in terms of percentage job growth (the San Francisco Bay Area was the primary exception, but prices there are approaching all-time highs). Notably, many of these second-tier cities are also boasting strong job growth in absolute numbers (e.g., Dallas, Atlanta, Phoenix, and San Diego). It should also be noted that the Western U.S. accounts for a disproportionate share of these high employment-growth markets.
Middle Market Properties Priced Less Efficiently
We believe strong risk-adjusted returns can be earned by segmenting the market based upon asset size in addition to geography. Recent capital raising can be broken down in a similar fashion to the price appreciation segmentation, and doing so reveals a corollary trend. A disproportionate share of capital has been raised in the post-recession cycle by $1+ billion “mega-funds.” The trend towards mega-funds symbolizes institutional investors’ desires to invest with the largest managers. It also reflects a move towards efficiency on the part of many investors as they are consolidating more capital with fewer managers. This concentration of capital has already manifested itself in the rapid appreciation of the highest-value core U.S. properties. With so much capital to deploy, these $1+ billion mega-funds must remain focused on the larger transactions, and this skews the balance of capital flows towards $100MM+ properties. A similar bias towards larger transactions is also starting to play out with foreign investors who are re-entering the U.S. market. The outgrowth of this larger-is-better trend is that comparatively less capital is seeking assets valued at less than $75MM. With less competition, pricing is less efficient for lower-value properties.
Suburban Properties Are Safer Investments Right Now
With higher-value urban properties “priced to perfection,” there is a much greater margin for error in lower-valued properties that tend to be located in “edge cities” and other suburban environments. According to a recent survey by Dr. Peter Linneman utilizing national data from Cushman & Wakefield, central business district (CBD) office rents are 10% below average 2007 peak rents nationwide, while suburban office rents are still approximately 25% below their prior zenith. Notably, suburban rents are still below their 20-year historical real average (while downtown rents remain above this average), and suburban rents achieved their prior 20-year high not in 2007 but during the early 2000s technology boom. The latter is noteworthy because recent space demand studies have revealed that a very high degree of the current office reabsorption in this cycle has been fueled by technology companies, with financial services companies, attorneys, and accounting firms still in their shells.
This time around, however, this growth has been more balanced between downtown and suburban office buildings, reflecting the preference by millennial workers for 24/7
environments. However, the urban/suburban tilt is actually a pendulum. As the millennial worker ages, has children, and seeks to buy an affordable home, this pendulum should swing
back in favor of suburban locations. While the pendulum may not tip back to the suburbs to the same degree as in prior cycles (reflecting a true demographic value shift) affordability
metrics for companies and their employees alike may cause it to swing back to some extent.
Employers may soon favor more affordable suburban locations
The widening rental gap between downtown and suburban properties has, in turn, spawned two additional trends that should also favor non-CBD investments over the next several years. First, tenants are finding their options increasingly limited and expensive in the nation’s downtowns and, thus, are beginning to absorb more space in the suburbs. This has led to rapidly declining suburban vacancy rates as evidenced in the chart below. This trend is likely to accelerate if economic growth slows because companies will face less competition for workers and, therefore, may be less pressured to offer higher cost urban work settings. At the same time, a stagnating economy will cause employers to become increasingly cost conscious, again favoring suburban environments.
Suburban locations face less supply-side risk
CBD office rents have been escalating more rapidly than in the suburbs, and, partially in response to this demand, new construction has also ramped up in many of these downtown markets. Development has resumed in this cycle and, while office construction remains below its historical average nationwide, much of the current supply pipeline is concentrated in very few cities. According to Colliers, nationwide office space under construction reached 106 million square feet in 3Q15, the largest total since 116 million square feet were under way in 3Q08. Of this space under construction, seven cities – all of which had over 5 million square feet under development – accounted for nearly half of this nationwide construction. This construction is concentrated in tech-heavy gateway markets and mostly in their respective downtowns. This increased supply threatens to dampen future rent growth prospects for the urban markets. Conversely, U.S. suburban markets are adding relatively little new supply because rents have not reached “replacement rents” – the level required to make new development economically viable. This should lead to accelerating rental growth in the suburban markets provided that the recent suburban demand trends continue.
Suburban risk premium (without the higher risk)
A look at relative cap rates indicates that the rapid compression of CBD office cap rates has caused the spread between urban and suburban cap rates to expand well beyond its historical average. Even if the next generation office worker favors an urban environment, it is reasonable to believe that lifestyle considerations of the employee and cost considerations by the employer will cause space utilization to swing back in favor of the suburbs, narrowing investors’ perceptions of the risk differential between these environs. This cap rate spread should narrow over the next several years as suburban cap rates move towards CBD cap rates, reflecting a reversion to the more normalized historical gap.
Expect Commercial Real Estate to Continue Generating Solid Risk-Adjusted Returns
When benchmarked against Treasury yields, the spread between average cap rates and the 10-year Treasury bond remains relatively attractive, certainly when compared against the minuscule risk premium during the 2006-2007 bubble. The status quo will most likely continue with prices remaining strong and yields remaining relatively low for commercial real estate generally, absent some forces that jolt the market out of its current track. Cycles tend not to expire. Instead, some disrupting force usually causes them to shift. However, there are many factors at work that we believe should cause property prices to remain strong and, even if yields moderate, property returns will continue to look attractive versus other investment alternatives.
FACTOR ONE: Supply/Demand Fundamentals Contributing to Improving Property Income
Strong post-recessionary demand
Strong market fundamentals are expected to continue to buoy investments over the near term. Most U.S. markets and property types are exhibiting favorable trends with positive net absorption, declining vacancy rates, solid rent growth, and limited new supply.
For example, in the U.S. office sector, strong employment gains coming off the recession have led to very healthy net absorption.
This, in turn, is causing vacancy rates to decline nationwide and rents to rise. Naturally, certain markets are exhibiting more robust job gains and corresponding income growth than others. These cities present the most compelling investment opportunities given the strong correlation between employment gains and property net operating income (NOI) growth.
Limited development pipeline, especially for office space
At the same time, the supply of new office properties remains relatively muted compared to historical levels, suggesting that existing inventory will need to absorb most of the market’s growing space needs and helping to ensure that the favorable supply/demand balance continues to generate rental and income growth.
Notably, relative to demand, the office sector exhibits the least active construction pipeline compared with other major property types. Retailers are absorbing relatively little new shopping center space, so comparatively little is being built, and while demand is strong in the apartment and industrial sectors, developers have geared up to meet surging demand. In 2015, the multifamily sector added new supply equal to approximately 1.95 percent of its nationwide inventory while industrial deliveries amounted to a 1.27 percent addition to existing stock compared to the <1 percent office supply additions.
FACTOR TWO: Solid Capital Flows
Investor demand provides price support and liquidity According to the most recently available surveys of institutional investor sentiment (Preqin’s H2 2015 survey), 78 percent of surveyed investors plan to maintain or increase their allocation to commercial real estate over the next 12-months, as compared with the preceding 12-months. Over the longer term, only 11 percent of respondents indicated that they planned to decrease their allocation to private real estate, while 34 percent projected a long-term increased allocation.
This sentiment is evidenced in the nearly $300 billion that has been committed to private real estate funds since the beginning of 2013. Similarly, “dry powder” available for investment in commercial real estate reached an all-time high of $244 billion in 3Q15, according to Preqin.
Furthermore, the influence of offshore capital on U.S. real estate appears to be in its early innings. Foreign investment in U.S. real estate is soaring, totaling $70B for the 12-months ended 6/30/15 while it had not exceeded $30B per annum for any 12-month period from 2008-2012. Specifically, Asian investment in the U.S. topped European and Canadian investment in 2015 for the first time since the global financial crisis, and there are signs that Asian investors, particularly Chinese investors seeking a safe haven for their capital, are far from done. These increasing inflows of foreign capital should continue to stabilize U.S. commercial property prices and keep cap rates from rising significantly over the next 12-24 months.
More liberal lending environment, except for construction
Debt capital is now flowing more freely to commercial real estate investments. Mortgage origination volumes for life insurance companies and Commercial Mortgage Backed Securities (“CMBS”) lenders have trended up significantly, and overall outstanding U.S. commercial and multifamily debt reached an all-time high of $2.7 trillion as of 2Q15. However, in the current credit cycle, lenders are lending more freely for existing cash-flowing properties, while they remain far less willing to finance speculative construction due to significant regulatory restrictions. This credit environment is favoring existing properties and constraining new construction nationwide. At the same time, despite increased lending volumes, underwriting standards are also more stringent for income properties in the current cycle than before the global financial crisis. More conservative loan-to-value and coverage ratios should help prevent any credit-fueled market decline.
FACTOR THREE: Wide Spread for CRE Investments Can Absorb Interest Rate Increases
We expect U.S. interest rates to remain comparatively low, driven down by global demand for dollar-denominated investments. Even with a modest increase in interest rates, it is reasonable to believe that such an increase will not necessarily translate into rising cap rates. This is because the spread between the risk-free rate and property yields is on par with 2003 levels and roughly in line with its historical average. This suggests that, as long as economic fundamentals continue on the road to improvement, as they did in 2004-2005, investors may allow for spread compression before adjusting property pricing.
Statistical analysis tends to confirm that interest rates and commercial property capitalization rates are not closely correlated. In fact, as the chart below illustrates, several meaningful interest rate increases over the past 20 years have not necessarily translated to rising cap rates. Capital flows to various investments seem to have their own independent drivers.
In summary, we believe commercial property fundamentals are solid and are projected to remain so for some time. Barring some unforeseen exigent event that shakes up the
U.S. economy, supply and demand should remain well balanced leading to steady occupancy and rental gains over the next several years. Employment factors, domestic capital flows (both debt and equity), and the inflow of foreign capital are projected to buoy asset values and keep a lid on cap rates. Within this environment, we believe premium risk-adjusted returns can be realized over the next several years by playing to the edges. Appreciation of larger properties in gateway cities has been so dramatic that they may carry more risk of price declines than under-appreciated assets that tend to be smaller properties in secondary markets and submarkets. These smaller assets – mostly suburban office buildings – generally offer strong yields to investors, are comparatively insulated from supply risk, and present compelling rental economics to tenants. Investors in these middle market properties may find less competition on the buy side today and are likely to benefit from capital flows trending towards these secondary cities down the road. Those who reposition non-core assets in secondary markets into core-quality investments may also realize a “double lift” by combining income gains with increasing buyer demand.
NEWPORT BEACH, CA—The CRE finance market is watching to see whether the Trump administration will advocate changes to Dodd-Frank and how those changes could impact the securitization and banking side of the market, Buchanan Street’s Matt Doerr tells GlobeSt.com.
The commercial real estate finance market is watching to see whether the Trump administration will advocate changes to Dodd-Frank and how those changes could impact the securitization and banking side of the market, Buchanan Street Partners VP Matt Doerr tells GlobeSt.com. The firm recently provided a $16-million loan to refinance 21845 Magnolia St., a 29‑acre industrial facility in Huntington Beach, CA, recently purchased by subsidiaries of Shopoff Realty Investments. The loan represents the company’s ongoing strategy to provide reliable bridge financing for value-add real estate.
Buchanan Street also recently provided an $18-million loan to a major Los Angeles-based development firm for the acquisition of an existing shopping center in Granada Hills, CA. The loan was funded through Buchanan Street’s proprietary bridge lending platform and provides additional funds for interest, pre-development expenses as well as “good news” funds if entitlements are secured. The borrower recognized the attractive in-place zoning, which may permit high-density commercial and multifamily use. The “by‑right” zoning designation greatly enhances the site’s redevelopment appeal.
Lastly, Buchanan Street continues to expand by recently adding Chris Cervisi as assistant VP to its debt-investments team to meet its growing business and market demand. Cervisi joined the team last month with more than eight years of experience structuring equity and debt and is responsible for sourcing, structuring and underwriting real estate debt investments. In his previous role, he was focused on office and retail acquisitions and asset management, including underwriting, market research, business-plan formulation, reporting of fund investments and dispositions.
We spoke with Doerr about these two transactions and the hiring of Cervisi, how they all relate to the company’s strategy going into 2017 and where he sees the private-lending market heading.
GlobeSt.com: How are the refinancing of the Huntington Beach industrial/land property, the acquisition loan for a San Fernando Valley shopping center to be redeveloped and the addition of Chris Cervisi related to your company strategy?
Doerr: These most-recently funded loans and the hiring of Chris are tangible indications of not only our platform and personnel growth, but the positive reception of the Buchanan Street brand within the bridge-lending business. These loans specifically affirm our Western US regional focus and adaptive structuring capabilities in customizing varied loan solutions. Chris’s diverse background on both the equity and debt side of the ledger allow us to further build out our talent base to serve our broker and direct borrower relationships.
GlobeSt.com: What type of growth do you envision for your company in the next year?
Doerr: Since our company’s inception of the mortgage-lending business, we have continued to grow our active pipeline and loan closings, which point to an increased production year for us in 2017. Anecdotally, we have seen a significant increase to our pipeline within the past 60 days aligned with the recent uptick in interest rates. In addition to our bridge lending, we also provide institutional mezzanine capital for larger projects. Both products are becoming more active within the construction lending area where banks have been negatively impacted by the increased regulatory environment.
GlobeSt.com: How do you see the future of the private-lending space?
Doerr: We believe that the private-debt-capital space will continue to capture more market share in the wake of HVCRE rules and other regulations. The CRE finance market is watching to see whether the Trump administration will advocate changes to Dodd‑Frank and how those changes could impact the securitization and banking side of the market; however, it’s unlikely that any changes will occur in 2017, and regardless, there will always be a need for predictable private capital to meet varied and customized borrower demand. There continues to be a need for capital that can provide structuring flexibility, responsiveness and certainty of execution. We pride ourselves on our discretionary, efficient and expeditious closing process.
GlobeSt.com: What else should our readers know about your company?
Doerr: As we enter into our 18th year, Buchanan Street continues to innovate and develop new investment products for our diverse investor client base. It is evident that real estate is becoming a significant part of an investor’s asset allocation, with its ability to offer fixed-income characteristics while providing tax advantages and an inflationary hedge. Accordingly, we are continuing to explore new property segments for portfolio diversification to satisfy our increased client demand.
By Carrie Rossenfeld
IRVINE, CA—The Center for Real Estate at UCI’s Paul Merage School of Business paid tribute to four of the top leaders in the real estate industry at a recent awards luncheon and presentation of the lifetime achievement award at the Hotel Irvine here. The luncheon was sponsored by FivePoint, a California-based community real estate development company, and Kennedy Wilson, a global real estate investment company; more than 500 guests attended the celebration.
Among the honorees were Douglas C. Neff, partner/president at IHP Capital Partners, who was presented with the 2016 Lifetime Achievement Award. According to long-time friend John Duncan, “Doug is one of the brightest people any of us know. He’s also one of the most competent and one of the most effective.” Larry Webb, CEO of the New Home Co., commented, “Doug is a powerhouse in the real estate industry. He’s easily the smartest guy in every room.” Gordon McNeill, president of Sage Hill School, added, “In an organization, there’s always a few people who really transcend the entire institution. Doug is one of those people.”
Marco Vartanian, SVP of Colony, Starwood Homes, received the 2016 Rising Star Award. John Cushman, chairman of Cushman & Wakefield, Inc. remembers giving Vartanian advice. “I told him to always remember one thing: the early bird gets the worm, and the harder you work, the luckier you get. And, that’s Marco.”
According to Vartanian, “What motivates me is to encourage the people I work with to see a vision of the future that is greater than what they can see for themselves. I think of myself as a service provider for all of the people I work with every day.”
Other award recipients included Timothy L. Strader, Sr., founder/chairman of Starpointe Ventures, who received the 2016 Distinguished Service Award, and Robert S. Brunswick, co-founder and CEO of Buchanan Street Partners, who received the Orange County Community Foundation Power Packed Philanthropist Award.
By Tina Borgatta and Kristen Schott
There is a need in every community; but generosity runs deep in Orange County. From the agencies that feed and heal out children to the individuals whose dedication and altruism are changing the lives of many; here are the organizations and leaders driving our philanthropic scene right now.
You can hear the smile in Shana Baker’s voice when she talks about her 1 ½-year-old adopted son, Jaxson: “He likes to go, go, go!” The same happy note reverberates when she talks about her philanthropic “itch.” It grew out of her grandmother’s charitable passion, took root in her teens when she served Thanksgiving meals with the Salvation Army and has led her to numerous efforts, like the Pediatric-Adolescent Diabetes Research and Education Foundation. She’s championed the cause since 2012, when her then-3-year-old nephew was diagnosed with Type 1. “I asked myself: Were there a lot [of kids] like him?” recalls Baker, the VP and controller for Newport Beach’s Buchanan Street Partners (she’s also on its charitable board and was an ambassador for Talk About Curing Autism). It fueled her to join PADRE; she held various board positions before being named president last spring. And it’s been a banner year for the Orange-based nonprofit, which provides educational and psychosocial programs to 2,500-plus children affected by the life-threatening disease of the pancreas. It’s boosting its research focus through partnerships with local projects for a cure; it recently donated $25,000 to UCI’s Clinical Islet program. And the annual fashion show—Baker’s co-chaired it for the last two years—landed a record $300,000. She’ll take on that role next year too (the bash is set for May 13). Then there’s her hope that PADRE will soon expand with satellite offices: “I see how happy these kids are,” she says. “When they are with others [with Type 1], they don’t feel alone.” PADRE Foundation, padrefoundation.org
By: Robert J. Dougherty
Expect millennial workers to return (if they ever really left) to where they were raised
- Housing affordability and quality public schools are driving factors
- Millennials will favor submarkets that offer elements of the CBD’s they are leaving
- Transit-oriented communities allow workers to keep a foot in both worlds
- Workspaces that replicate contemporary urban style will be preferred
Much has been written about the so-called “Millennial” or “Generation Y” worker. Demographers have failed to pin precise dates on when this generation of people begins and ends, but generally the millennials are considered to be those born between the early-1980’s and the late-1990’s. The term “millennial” is believed to have been coined to refer initially to those graduating from high school around the turn of the millennium. Today, the millennial office worker ranges from those preparing to graduate college and take their place in the workforce to vice presidents in their mid-30’s.
Millennial workers are undoubtedly a powerful cohort in the U.S. labor market, representing the largest single generation employed today, so it is important for real estate investors to understand how their traits and desires will influence space utilization trends. Naturally, the millennial generation is heavily tech oriented and thoroughly plugged in online. They have also become tagged with a reputation for being entitled, needy, and self-centered. Whether or not these labels are appropriate is an assessment better left to the sociologists. However, the savvy real estate investor will seek to determine what this generation will demand from commercial and residential properties because, according to the Bureau of Labor Statistics, millennials will comprise nearly 75% of the U.S. workforce by 2030.
Flocking to the cities?
A widely held view in the real estate community is that millennials have migrated to U.S. central business districts (CBD’s) in droves, a trend which is believed to have accelerated as the economy emerged from recession in 2010-2011. Proverbially, the millennial worker emerged from his/her parents’ basement in Reston or Irvine (if Irvine had basements) and found a job again - some for the first time. Attracted by the vibrant arts and social scenes that downtowns offer, America’s professional youth took up residence in flats from New York to San Francisco and showed up to their desks in DC and Los Angeles. These children of the suburbs were becoming urbanites.
Of course, the last two sentences above could have been written as accurately in 1972, 1987, and 2002. Twenty-something’s have gravitated towards cities for generations, maybe even centuries. Data does, in fact, illustrate that younger Americans are more urban-oriented [chart] than their elders, but does this come as any surprise? Are they more city-loving at their current ages than their parents were 30 years ago?
Some say yes. They believe that millennials are, in fact, signaling an important demographic shift towards urbanity. Being connected to a large online social network, they value integrated community living, as well. They are concerned about their carbon footprint so they shun the automobile in favor of mass transit and laying down actual footprints on city sidewalks. They crave the pedestrian lifestyle of the corner coffee shops that they knew in college and look forward to posting on Instagram or Snapchat about dining at the hot new restaurant in town and hitting the coolest clubs afterward.
The real estate corollary is that absorption of office space since the Great Recession has favored CBD’s over the suburbs. [chart/table]. Conventional wisdom holds that employers were forced to compete for talent as the economic recovery took root, compelling them to rent downtown offices in order to attract millennial workers living nearby. Ping pong tables, bike lockers, wired internet lounges, and stocked cantinas . . . even climbing walls and massage rooms became necessary accoutrements for drawing in the desired millennial worker pool.
So goes the accepted narrative. But is it accurate and does it tell the whole story? Consider that companies may have chosen to rent space in the CBD’s as their employment needs expanded because it was comparatively cheap coming out of the recession. [time series chart of office rents in major CBD’s] The dramatic rise in office rents that has been witnessed recently really began in 2014. From 2009 – when landlords would have given away space if they had any takers – through 2013, downtown office space was comparatively inexpensive on a constant-dollar basis versus historical rents. Of course, suburban space was even cheaper but, if one can get a Lexus for the price of a Toyota, the “luxury” choice is often made. Maybe accommodating workers’ desires was secondary to cost considerations in companies’ expanding downtown?
But will they stay?
Some sociologists are debunking the notion that millennials are more city-loving than generations which have preceded them. For instance, demographer William Frey argues that many millennial workers have mentally “aged out” of the cities in which they dwell. However, they’ve been “trapped” downtown as victims of economic circumstance since the Great Recession. Declining real wages, poor job prospects in a tepid recovery, and a larger load of student debt than any prior generation have left millennials unable to afford to buy homes in suburbia. Even those whose fortunes have improved in the latter stages of the current job expansion may have missed their window to buy an affordable home in the suburbs given the sharp rebound in housing prices in major U.S. metropolitan areas. [Insert Economist chart]
But are millennials really pining for the “home with a white picket fence?” Perhaps the younger generation does not covet home ownership to the same degree their parents did. This thinking argues that millennials would rather rent in the cities versus buying in the suburbs. (Buying in the cities has basically become a “one percent” proposition.) Proponents of this view point to a rate of U.S. home ownership that reached a 50-year low of 63.1% in the second quarter of 2016 and, more particularly, the low rate of home ownership amongst persons aged less than 35 years – 34.1% as of 2Q16 according Census Bureau data. The latter rate has also declined markedly in recent years. At the end of 2010, the ownership rate amongst sub-35 year-olds was 39.2%, so it has fallen off over 500 bps while home ownership for all Americans declined only half as much, by 260 bps, from 80.5% to 77.9% over the same period.
However, the preponderance of research seems to run contrary to the reputation of the city-loving millennial. One researcher recently wrote, “Millennials presence in the city should not be confused with a preference for the city.” Nearly all consumer surveys indicate that Americans still greatly desire home ownership. For example, a recent survey conducted by the National Association of Realtors (NAR) indicated that 87% of Americans believe that home ownership is part of the American Dream, and a similar survey by Ipsos asked consumers if they agreed with the statement that home ownership is a dream come true … 86% agreed. Instead, it seems far more likely that the decline in home ownership across the board and amongst millennials has much more to do with the inability to afford a home versus lacking desire to own one.
In fact, according to the U.S. Census Bureau, 78% of households earning above the national median income owned their homes while only 48% earning below the median were home owners at the end of 2Q16. The Great Recession put a major dent in potential down payments of many would be home owners. Despite historically low interest rates, some have yet to see their incomes fully recover enough to afford the ongoing mortgage service. Reduced wealth – households headed by persons younger than 35 years saw a 30% decline in net worth between 2010 and 2015 – is causing many life decisions to be delayed out of necessity and adds to the notion that some millennials are stuck in the cities. Marriages are happening later in life amongst the younger set, and millennials are far less likely to possess a car or a driver’s license than prior generations. The latter presents a conundrum. Some don’t own cars by choice because it’s expensive and unnecessary in America’s largest cities, but those who can’t afford to own a car are truly beholden to urban dwelling.
Still other potential buyers are saddled with credit problems and debts racked up during the recession and face a more stringent lending environment in which banks and other mortgage lenders are far choosier in selecting borrowers and documenting qualifications. One-third of millennials fail to satisfy the minimum average credit score of 620 which Fannie Mae requires for mortgage purchases, making it difficult to obtain a conventional home loan.
Nonetheless, time heals all wounds, and America remains a society that values and promotes home ownership. It is engrained in our national ethic, embodied in our financial system, and codified through material benefits in federal tax laws. As the bank accounts of millennials eventually recover and as they age and expand families with more children of their own, it is reasonable to expect that they will seek to plant deeper roots just as their parents did. But where will they settle down?
If one accepts affordability as the principal impediment to home ownership, then it’s hard to believe that family roots will be established under city streets. According to a recent study by Zillow, homes located in urban U.S. ZIP codes appreciated by an average of 7.5% in 2015, while suburban homes appreciated 5.9%. Over a five-year period, between 2010 and 2015, city homes are up 28.4% compared with 21.1% growth in suburban home prices. Notably, the differential is much more pronounced in America’s largest cities, especially coastal markets. In Los Angeles, the value of urban homes rose a whopping 42.1% between 2010 and 2015, while homes in LA’s suburbs appreciated by 33.9% over the same time frame. A similar story has played out over the past 5 years in Boston (37.1% city home price growth vs. 20.5% in the suburbs), Washington, D.C. (23.8% vs. 14.4%) and San Francisco (65.3% vs. 58.7%).
How can the typical millennial, who has faced declining household wealth afford a home in the heart of San Francisco when it costs 65% more than it did in 2010? Furthermore, if a buyer still values space, it is also worth noting that city homes are getting smaller at the same time that they’re getting more expensive. In Washington, D.C., for example, urban homes in 1996 cost 6% more per square foot than suburban homes. In 2015, they cost 41% more per square foot.
A case can be made that this increase in urban home prices, particularly in America’s largest coastal cities, needs to be viewed through the lens of rising income, which is taking place in major U.S. cities even while income growth is tepid across the country as a whole. Housing affordability is more important to assess than absolute pricing. However, the nation’s largest coastal cities also remain challenged in terms of price-to-income ratios. As the chart below reflects, East Coast metroplexes Boston, New York, Washington, and Miami all have price-to-income ratios above the national mean. San Francisco, Los Angeles and Seattle all tell a similar story of challenging affordability on the West Coast, as well. Granted, these ratios are well-below the credit-fueled bubble of 2005-07; however, with fewer cheap mortgages available except to the most creditworthy clients, true “affordability” may be worse even while price-to-income ratios are lower.
Evidence is mounting and more articles are being written which suggest that the reputation of the city-loving, permanently renting millennial may be apocryphal. Given that millennials seems to harbor home ownership aspirations, and the cities in which they are living are unaffordable, is their return to the suburbs preordained?
Reverse migration has begun
Actually, it appears that millennials have already commenced a return to the land of their upbringing. Population statistics released by the Census Bureau at the end of 2015 show a continued outmigration to the suburbs. In fact, the ballyhooed urbanization of America may have been nothing more than a blip or, at the most, a short-lived trend. Census data indicate that growth in urban areas was greatly outpaced by suburban population increases during the mid-2000’s housing bubble, as rising suburban home construction attracted buyers from all walks of life.
Emerging from the financial crisis, both suburban and urban areas gained population. The supposed preference for urbanity seems to have been drawn from the slowing of a decades’ long trend of suburbanization. The differential in the rate of population growth between U.S. cities and their outskirts narrowed markedly after the housing bubble popped. However, only in one year – 2011 – did the population in cities actually grow faster than in the suburbs, and in 2015 urban growth actually slowed to its lowest level since 2007.
CBRE analyzed the Census data and concluded that approximately 30% of millennials reside in cities but noted that “the other 70% do not appear to be rushing to move downtown.” CBRE also pointed out that so-called “midrange” U.S. millennials - age 25 to 29 – migrated more frequently from the cities to the suburbs (529,000) in 2014 than into downtowns (426,000). This outmigration was even more pronounced for persons 30 to 44 years of age. In 2014, 1.2 million of them left cities for the suburbs while only 540,000 headed in the opposite direction.
This suburban trend is more likely to grow than abate because the population peak of the millennial generation has not yet reached prime home buying age. Sociologists peg 1990 as the peak birth year for the millennial generation. While this ignores the impacts of immigration, U.S. births did decline markedly after 1990 [chart]. Thus, the peak millennials are now 25 years of age and will be “maturing” economically into potential homebuyers over the next 10-15 years.
Many demographers believe that the credit and housing bubble substantially distorted U.S. migration trends. Massive homebuilding fueled growth in the suburbs during the mid-2000’s. After the crash, America experienced a migration into the cities in search of higher paying jobs and more plentiful rental housing during the depth of the recession. The developing school of thought is that, now that the effects of the housing bubble are becoming normalized, the U.S. is reverting to its inexorable 60-year-old suburbanization trend.
Will the jobs follow? As with the millennials, they already are . . .
Of course, just because more heads are resting on suburban beds, doesn’t mean that jobs are also migrating to the suburbs. However, the post-recession trends in office absorption seem to mirror the population trends outlined above. Emerging from the global financial crisis, America’s downtowns enjoyed their day in the sun. From the beginning of 2010 through mid-2012, Class A CBD space led all categories of space in the rate of net absorption relative to inventory [JLL chart]. Notably, the flight to quality referenced above was also in evidence, as only Class A space – whether urban or suburban - enjoyed positive absorption in 2010 and 2011. However, since late-2012, suburban Class A space overtook all other office categories as the relative net absorption leader and has remained the leader since.
Of course, higher office space absorption in the suburbs has likely been a function of greater availability. In fact, suburban office buildings of all quality levels (Class A, B, and C) continue to remain less occupied than their downtown counterparts. [JLL chart]. However, expect this occupancy differential to narrow as CBD office space becomes increasingly expensive. As the chart below illustrates, cumulative rent growth since 1Q 2010 for downtown Class A office space (29.0%) has been more than double that of Class A suburban space (14.4%).
As Class A CBD office rents continue to reflect a rapid ascent, the overall gap between CBD and suburban rents has widened to a post-recession high. According to Jones Lang LaSalle, CBD office rents were 62% higher than overall suburban rents at 3/31/16. If the U.S. economy softens, will belt-tightening cause employers to look more closely at this rent differential? If their workers are increasingly moving to the suburbs, perhaps relocating more jobs nearby would carry a “double bottom line” of lower costs and improved employee morale. This seems, if not inevitable, more likely than not.
Winners and losers . . . implications for commercial real estate
What will be the effects of this emerging suburban “renaissance” and what strategies can smart real estate investors employ to take advantage of it? The following are a few possible takeaways:
- Emphasize housing affordability – In what seems an obvious implication, investments which pursue areas of housing affordability should fare well. These include residential projects which themselves offer affordable housing or commercial properties presenting proximate employment opportunities. In a similar vein, properties in cities with cheaper housing for millennials – whether urban or suburban – should benefit from millennial migration. Millennials have demonstrated that they are mobile and can move between metropolitan areas just as well as within them. The prevailing exodus to Western and Sunbelt cities is resuming. [See chart below.] Cities with a high quality of life, strong employment growth, yet more affordable housing should benefit from long-term migration trends. Austin, Denver, Dallas, Atlanta, Charlotte, and Phoenix have already experienced this type of growth, seemingly at the expense of places like Detroit, Cleveland, and Pittsburgh. However, don’t be surprised if growth slows in high-cost Tier I markets and the second-tier Western and Sunbelt cities begin to siphon people from Boston, New York, and Seattle, too.
- Replicate urban amenities in the suburbs - Even if millennials are pining for the suburbs for the primary reason of cheaper housing, it makes sense to think that they still love their coffee bars, clubs, and communal living. Successful real estate developments and renovations in the suburbs will recreate elements which attracted millennials to the city initially. This might include an on-site barista lounge, ping pong or fussball tables, wifi-enabled common areas, and more contemporary office layouts and finishes. Other amenities, such as sand volleyball or bocce ball courts – one building in San Diego’s Del Mar Heights even has a wetsuit locker - might be unique to the suburbs but reflect millennials’ desires to mix work and play.
- Seek urbanity in the suburbs – Places which are the “next best thing” to living in the city will be coveted by millennials. Provided that the public schools are good and soccer and baseball fields are plentiful, having some acclaimed restaurants, shopping boutiques, and semi-cool clubs nearby will make “going suburban” a less bitter pill to swallow for many. If these shops, gyms, and studios are pedestrian-friendly, that’s even better. Semi-urban suburbs like Alexandria, Bellevue, Walnut Creek, and Bethesda offer many of these attributes. Granted, real estate there is by no means inexpensive, but these edge cities should be the beneficiaries of millennials’ wishes to – incomes permitting - have their cake and eat it, too. If the reputation of the millennial generation holds true, they’ll figure out how to do just that in “hipsturbia.”
- Public transportation is valued on multiple levels – Building or acquiring projects close to public transportation in the suburbs should pay off by catering to the next generation worker. Even if this worker will increasingly be living and working in the suburbs several factors make convenient access to public transportation very valuable. Although the recent trend favors suburbanization of millennials, several factors may keep them tied to the cities and wishing to commute frequently between downtown and the suburbs. As indicated above, jobs may or may not out-migrate. Commuting on LA, DC, and Bay Area freeways is more grueling than ever, and millennials are more inclined than their parents to be concerned about their cars’ emissions contributing to climate change. They are likely to place a higher value on the option of public transit. Additionally, even if their job has followed them from downtown or they found a new position in the suburbs, many millennial suburbanites will have left friends, dentists, hairdressers, or their favorite bars and yoga instructors in the city. They will value a convenient commute. Lastly, a few die hard urbanites simply won’t be able to bring themselves to leave the city. In this case, placing employment centers near public transportation will allow the city dwellers to reverse commute to jobs in the suburbs. This is a phenomenon that is growing more abundant.
All in all, it appears that the conventional wisdom that millennials are initiating a permanent trend towards urbanization is too simplistic and overblown. While it is clear that metrocentric millennials have sparked a resurgence of the urban core, the idea that they’ve permanently forsaken the suburbs doesn’t jibe with the data or stand up to closer scrutiny. CBRE speculates that the notion that downtowns are surging while the suburbs are sinking derives from recent trends in several high-profile cities such as Washington, DC and San Francisco, along with the few anomalous post-recession years in which downtowns actually did outperform their outskirts. The pendulum swings between the suburbs and the city, often in keeping with the economic tides. It is now swinging back in favor of the ‘burbs’. Perhaps it will swing less far this time, but the savvy investor will recognize and benefit from these evolving demographics.
 It should be noted that the chart looks at entire metropolitan areas, both suburbs and downtowns. The available data does not allow one to determine whether downtown incomes have kept pace with the rapid rise in city prices.
By Lisa Brown
DALLAS—The law expiration is drawing more corporate users seeking proximity to the airport and executive housing communities such as Bluffview and Preston Hollow.
According to Buchanan Street Partners, Dallas Love Field experienced an 87% increase in passenger traffic year-over-year in September 2015. This increased activity followed the October 2014 expiration of the Wright Amendment, a 1979 federal law that limited long‑haul flights out of the airport.
Bluffview Towers, a 196,356-square-foot two-building office property adjacent to Love Field Airport has been acquired by Buchanan Street. The Love Field traffic bump-up prompted Buchanan to purchase the buildings for an undisclosed amount from Commercial Developments International (CDI).
“We have noticed a significant change in the area surrounding Love Field. The surge in traffic and business at the airport was a major factor in the buildings’ purchase,” said Matt Haugen, vice president at Buchanan Street Partners. “We anticipate local expansion as corporations view this area as a more preferred location, both for daily commutes and accessibility to the airport for business travel.”
Bluffview Towers is located at 3860 and 3890 West Northwest Hwy., near the affluent Bluffview and Preston Hollow neighborhoods, within three miles of Preston Center, an 800,000-square-foot retail and dining center. Bluffview Towers is currently 82% occupied with several long-term tenants. The property features an Embassy Suites hotel on site, which was not included in the purchase. Buchanan Street has plans for lobby improvements and tenant common area upgrades to bring the project up to class-A standards.
Haugen tells GlobeSt.com: “Additionally, the rapidly growing rental rates in Uptown and Preston Center have caused the options around Love Field and specifically Bluffview Towers to become an attractive option for users that want to locate in the area for a more affordable price. We are going to reposition these buildings and bring them up to a first-class standard. It seems these two buildings have flown under the real estate community’s radar, and we plan to leverage the growth at Love Field to elevate the building and put it on the map as another Buchanan Street building in Dallas. We believe in the Dallas market.”
The Wright Amendment limited flights between Love Field to airports only within Texas and its four neighboring states: Arkansas, Louisiana, New Mexico and Oklahoma. Its expiration allows flights into Love Field from major cities such as New York, Denver, Los Angeles and Washington, DC. It is expected to draw more corporate users seeking proximity to the airport and executive housing communities such as Bluffview and Preston Hollow.
The Bluffview Towers purchase marks Buchanan’s fourth acquisition in the Greater Dallas area in the last 16 months. Buchanan Street also recently purchased several other buildings that are poised for growth as a result of positive absorption and infrastructure improvements. The properties include Tollway Plaza, a prominent two-building property in Addison, TX, Richardson Office Center I & II in Far North Dallas and Granite Tower in Northwest Dallas along LBJ Freeway.
Jack Crews, Evan Stone and Lauren Zimmer of JLL represented CDI in the transaction, while Buchanan Street represented itself.
By Robert Brunswick, CEO of Buchanan Street Partners
NEWPORT BEACH, CA—As the CMBS market continues to slow, how will the capital markets sector be affected? Buchanan Street Partners’ Robert Brunswick weighs in on the subject EXCLUSIVELY with GlobeSt.com.
Much has been reported about the CMBS market continuing to slow, plateau, freeze—fill in your own verb. GlobeSt.com spoke exclusively with Robert Brunswick, CEO of Buchanan Street Partners, to get his take on how this trend is affecting the capital-markets sector now and in the future.
GlobeSt.com: As wider spreads translate into higher costs for borrowers on CMBS loans, what alternative financing solutions are coming available?
Brunswick: When we talk about CMBS, we first need to frame what it has brought to the real estate markets and where it might be lacking. The advent of CMBS brought much-needed liquidity and additional participants to the debt markets—both improving liquidity to the market and further validating real estate as an asset class in terms of investor fluency and their ability to assess risk and return. In turn, real estate debt through CMBS now competes with capital flows to other asset classes and the greater volatility of the liquid markets. Geopolitical issues, market cycles, rating agency moods, increased regulatory requirements and past CMBS performance all affect the day-to-day pricing of new origination and resale and purchase of existing bonds. Therefore, we need to be careful to not overreact when CMBS goes down or up since it is not an indicator of the demise of CMBS but instead recognition of the variables that impact its daily pricing.
In the past few years, we have seen a reduced volume of new issuance of CMBS, due in part to what happened with prior performance of CMBS and in large part due to real estate’s devaluation in the last cycle. Rating agencies were questioned as to their objectivity and the bond’s ultimate performance. Where are we today? CMBS bonds now have to compete with all other asset classes and types of bonds, and with that there is a more disciplined assessment of its associated collateral and cash-flow predictability. It’s currently difficult to provide borrowers with a predictable rate within the CMBS market until the loan is ready to close, thus limiting current origination volume. Further, banks and life insurance companies are much more active in their availability today, offering borrowers more predictability of outcome. Additionally, there is a trend for many buyers of real estate to de-lever (or bring in more equity to) their acquisitions and real estate, which plays more into the hands of the life- insurance companies and banks.
A majority of CMBS originations have catered to those borrowers seeking higher leverage to satisfy a refinance, a secondary or tertiary market consideration, or reduced equity position on assets that might not fall into a bank or insurance company’s lending parameters. CMBS has historically financed riskier assets, and with rating agencies starting to now see slippage in underwriting quality, and with the pending new risk‑retention rules for CMBS taking effect in December under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the bond-buyer market has become skittish, limiting originator capabilities.
With this uncertainty, many private lenders (shadow banks) are being formed and/or becoming more active to provide capital for the potential shortfall. We ourselves have set up a private-lending vehicle to provide a predictable capital source for those transactions that have good sponsorship, are properly sized, might require some structure but couldn’t go through a conventional CMBS underwriting or do not have the necessary time to wait. The private-lending market can be an interim source of capitalization for many borrowers, but it’s not a long‑term solution. As people fix their assets’ problems or buy assets and stabilize them, interim financing can be a short-term solution, but not a long-term one because the property cannot withstand the higher yield associated with these types of loans. This ultimately creates a lower-priced source of capital available to those buyers. To fuel this type of lending, many investors are eyeing the debt space since it affords a more predictable yield with tangible subordinate equity.
There are roughly $250 billion of CMBS loans maturing between 2016 and 2018. If the property is not sold, the refinance lender is either the new CMBS market or a private lender who might accommodate the transitioning nature of the asset. Interestingly, though, a lot of prior CMBS borrowers have defeased their loans early given the attractive refinance markets, brought in more equity and are now refinancing through banks and insurance companies. We have to recognize that CMBS, for most borrowers, has never been the first choice.
GlobeSt.com: What does the uncertainty in the CMBS market mean for buyers and sellers of commercial assets? What does it mean for asset values?
Brunswick: For every transaction, only 10% of the market uses CMBS. I would draw the conclusion that CMBS by itself is not going to drive down valuations or cause them to pause. There are other factors, such as the greater economy, the lack of significant growth in rent rolls, the over-exuberance of pricing as investors are wanting to put their money to work and get some yield. But this is a levered asset class, and as leverage is reduced, that will mean less yield on your equity. You’re either going to be willing to accept lower leverage with less yield on equity, or sellers will have to be more realistic on pricing their assets given the reduced leverage that is available to buyers. A slowdown in sales is not solely attributed to the debt markets; it’s a variable. You can put your money to work in other asset classes that might be better priced to get the yield you thought you were getting in real estate. Real estate appreciated too quickly.
GlobeSt.com: What does this turmoil mean for borrowers as originators stop making CMBS loans because it’s now dramatically more difficult to price loans due to the inability to predict the future cost involved?
Brunswick: Most borrowers who use CMBS either have a relationship with a particular lender or they have a higher-leverage requirement, and CMBS is their only option vs. going to a bridge lender who might charge more. Spreads have actually reduced recently as the bond buyers have come back into the market a little bit. They were in the 350 range, and are now 310 to 320, depending on the asset. It’s becoming a known reality that if you do a CMBS loan, you have to live with the volatility of not knowing what your rate is going to be until you close. That’s a tough presentation for borrowers as they want certainty of pricing. It’s creating volatility on the buy/refinance side, and it means that these borrowers will have to put more equity to work and accept some volatility.
GlobeSt.com: What else should our readers know about alternative financing solutions and CMBS?
Brunswick: A lot of folks are now saying they’d rather be in the debt seat than in the equity seat. They will put more in debt until they get comfortable with the valuations of CRE or debt yields are driven down on the private side. There will be varied debt players who will start to backfill the capital markets as their investor base reconciles this mispricing and opportunities present themselves, and investors recognize that the risk-adjusted yield is more attractive on the debt side than the equity side at the moment. CMBS is not going away. It will come and go as capital does and as the market adjusts. The market is pretty smart and will price and adjust accordingly.
By Robert Brunswick, CEO of Buchanan Street Partners
Last year, the Federal Deposit Insurance Corp. (FDIC) implemented its Regulatory Capital Rules, a new set of directives intended to address regulatory deficiencies that contributed to the 2008 banking collapse. The regulations impose significant limits on bank acquisition, development and construction (ADC) loans, and create an opportunity for loan originators, specifically nonbank lenders, to expand their ADC offerings.
The most notable change requires banks to increase the amount of capital set aside for ADC loans that exceed loan-to-completed value standards or do not comply with minimum real-cash equity investments. The nonconforming loans affected by these regulations are characterized as High Volatility Commercial Real Estate (HVCRE) loans. The new laws were first released in October 2013 and implemented at the start of 2015.
The new reality
Banks that were major players before the recession have returned to the market, but on a limited and inconsistent basis. Lenders have been producing ADC loans at a significantly lower volume than the peak in 2007, causing a decline in the market share of ADC loans originated by regional and community banks.
Under the Regulatory Capital Rules, banks must categorize an ADC loan as HVCRE if it fails to meet several conditions. Chief among them are the following: The borrower has contributed at least 15 percent of the appraised-as-completed value of the asset before receiving bank financing; and the loan-to-value ratio of the financing does not exceed 80 percent. Also, loans for land development must not exceed 75 percent LTV.
This new ruling affects bank offerings on HVCRE loans nationwide, limiting borrowers’ access to capital — and leaves the door open for private lenders to swoop in, especially those able to serve unmet demand with flexible loan structures and efficiency.
Clarifying the rules
The FDIC has issued clarifications of the law over the past year. First, if a loan is initially classified as HVCRE financing, it remains so until the acquisition, development and construction loan is refinanced with a permanent loan. Nonetheless, a loan cannot be classified as permanent if it is based on the “as completed” value of the project. Furthermore, these clarifications included a distinction between the “as completed” and “as stabilized” values, so that the latter value cannot be used to determine whether a loan meets the definition of HVCRE financing.
Clarifications also established that borrowers may not withdraw capital generated internally by a property during the term of an HVCRE loan. Neither unrelated real estate assets nor grants from state, federal or municipal governments, or nonprofits can be included as part of the borrower’s 15 percent equity contribution; and preconstruction deposits on condominiums cannot be counted as a borrower-equity contribution.
Also, junior liens collateralized by the property, cannot be considered part of the 15 percent contribution. It is not clear yet whether mezzanine loans secured by partnership interests and originated by a lender unrelated to the bank will circumvent this rule. Borrowers are, however, permitted to include land contributed to a development project as a part of the required capital. The value of this contribution must correspond to the borrower’s real-cash equity in the land. For example, if a borrower purchased a site in 1980 and since entitled it, the cost basis is the original land purchase price plus the entitlement expenses. This is a major shift in bank regulations, creating a void that can only be filled by nonbank construction lenders.
A borrower’s contributed capital can include soft costs, such as brokerage fees, marketing expenses or costs of feasibility studies. Project costs paid to related parties for developer’s fees, leasing expenses and brokerage commissions, and management fees may be included in the soft costs — provided they are reasonable in comparison to fees paid to third parties for similar services.
The new regulations do not preclude banks from originating HVCRE loans. In the wake of their implementation, however, some banks may determine that HVCRE loans will not generate sufficient returns as compared to alternative investment options because of the additional costs associated with higher reserve requirements. This situation presents greater opportunities for flexible, nonbank lenders to move into the space.
Impact on Lending
The regulations have created a competitive advantage for private lenders in funding high-leverage construction loans, construction mezzanine loans, and highly structured bridge and land-acquisition financing.
A study by Joseph Rubin, Stephan Giczewski and Matt Olson of Ernst & Young LLP pointed to several significant effects of the new regulations:
- Higher capital requirements from the borrower could result in banks shifting assets away from the commercial real estate sector;
- Interest rates could increase to account for the increased costs; and
- Borrowers may be forced to shift to higher-cost private lending sources.
Although the new capital regulations impose limits on bank lending, banks are not out of the picture. According to the Ernst & Young study, a minority of commercial real estate loans are likely to fall into the definition of HVCRE because banks already avoid loans with LTVs of 80 percent or above, and most borrowers acquire development sites simultaneously with, or just prior to, the closing of the acquisition, development and construction loans.
Even among nonbank institutions, there are relatively few lenders that specialize in loans with LTVs above 80 percent. But there is demand for such loans, as well as opportunities for nonbank lenders. Their biggest advantage is the ability to structure flexible debt more quickly than banks, and commit to deals while banks are still evaluating them.
Some other situations where nonbank financing is a good fit include:
- A borrower has owned the land for a significant period of time, but has a very low real-cash basis;
- An asset has increased in value because of rezoning, or the entitlement process;
- A borrower seeks more than 80 percent of cost-construction financing for a preleased, investment-grade, credit-tenant building;
- A borrower requires cash out from unit sales to fund unrelated projects — for example, a situation in which a condominium developer previously arranged an 80-20 percent split of unit-sale proceeds to pay a principal or dividends; and
- A bank rejects a borrower’s assertion that developer’s fees included as part of the contributed equity are justified by the market (a standard that has yet to be defined by regulators).