Real Estate Sea Changes
A specialist’s view of ongoing and looming tides in commercial real estate financing and taxation
John Pickering heads the commercial real estate practice at Balch & Bingham, representing banks and developers and advising on financing and acquisition transactions.
We spoke with him in January, first about the prospects facing commercial real estate following the November elections.
Then we got his take on the impact of major changes already in the works, with January 2015 implementation of the Basel III Capital Accords, which tightened the standards on bank lending, including stringencies on commercial real estate deals.
There is now a lot of energy for tax reform, and one party now controls the House and Senate at a time when there are no large-scale distractions to prevent them from doing something. What is happening in Washington D.C. is big, and the stuff that is on the table with tax reform could have big implications for commercial real estate. It could be really good or really bad or in between.
A lot of commercial real estate transactions happen under Section 1031 of the Internal Revenue Code, which deals with like-kind exchanges. There have been proposals to eliminate that. And if you ask somebody in commercial real estate, they say it would mean that they would never sell anything again. Certainly, in the short run it would be a big damper.
Big tax cuts could help commercial real estate. On the other hand, a proposed change in the treatment of carried interest, from capital gains to professional income, could have a big negative impact on the industry.
One of the major Republican proposals consists of two things. One proposal is to eliminate deductible interest on commercial real estate loans. And to the side of that is a proposal to change the 39-year depreciation for new buildings to having all of that expensed in the year you build or acquire the property.
There is political pressure at this time for tax reform. A lot of other countries in the world have lowered their corporate tax rates, and ours are still high. The other big issue is our tax code. The last big reform was in 1986, and it has gotten more and more complicated every year. But, then, if you cut the corporate tax rate and simplify everything, how can you still make the (government) books balance? They say “simplify,” and it sounds good, but one way they could simplify is to get rid of 1031 exchanges, and that is a terrible idea. Or you get rid of energy efficiency incentives, which someone else thinks is terrible idea.
Basel III proposed international banking risk standards that U.S. bank regulators applied to U.S. banks. This has been in place since January 1, 2015. Even the smallest community bank faces this. It involves all manner of things dealing with risk, but as it affects real estate folks, it defines what it calls high volatility commercial real estate (HVCRE) loans. If a bank has one of those loans on its books, it has to set aside 50 percent more capital for that loan than it would if it were not an HVCRE loan. It literally costs more in opportunity cost than it would if the bank made another kind of loan — a lot more, 50 percent more. The only way for the bank to make those numbers work is to charge a higher interest rate or make fewer of those loans.
If you miss any of three tests, you have an HVCRE loan and the bank is much less interested. First, there is the loan-to-value ratio of 80 percent or less, which is not a big hurdle. Real estate developers are used to dealing with that. It’s part of general banking real estate standards anyway. The second test is that the borrower has to put at least 15 percent equity into the deal, and that is 15 percent of the as-completed value of the project, once all the work is done and it is open and leased. And if you are going to use land for that — as many developers would like to do — you only get credit for what you paid for the land and not what it’s worth today. In the wrong set of circumstances, it can create a big cash gap from the bank finance perspective. The third point is that the equity has to go in first and stay in the project until the construction debt is paid off or converted to term financing.
What Basel has done, particularly in the most active markets, is that it has caused non-bank lenders — equity funds and REITs — to get more involved in acquisition and construction financing. Lending by private equity and REITs was up 68 percent in 2015 over the previous year. Bank lending went up also, but only by 35 percent. When regulated entities tighten up, the markets still want this type of lending, so they turn to non-regulated entities to get it.
In the larger cities, the equity funds and REITs also provide mezzanine financing, and some of the more aggressive banks have found ways to count that mezzanine funding toward equity financing. They are finding ways to count dollars as equity that don’t immediately and obviously look like equity. Those banks are taking a portion of the risk and reassigning it to unregulated lenders in the marketplace. I’ll leave it for others to judge whether that’s good for the overall economy.
The downside of unregulated lenders, from a policy standpoint, is that they have more incentive to make risky loans that arguably shouldn’t be made in the first place, and that could contribute to a bubble and cause chaos out there should a lending firm collapse. On the other hand, you could say this is exactly what the desired impact should be, because it matters less to the economy when a non-bank lender collapses.
Another pressure point on banks that is having an impact on commercial real estate is Dodd-Frank, the post-recession effort by Congress to put tighter regulatory controls on banks in the hope of preventing another recession. A piece of Dodd-Frank that just went into effect is the 5 percent risk retention rule for securitizations, including commercial mortgage-backed securitizations. This rule requires that lenders who want to securitize and sell off mortgage or other assets will have to retain at least 5 percent of the risk on those assets. There is concern that this rule will stifle the commercial mortgage-backed securities market, which is an important source of financing for commercial real estate, as it often offers fixed interest rate, non-recourse financing that is less commonly offered by banks.
Development has been on the upswing for several years, but we’re getting to the point where you start to see the end in the major markets. You have to broaden your horizons to secondary and tertiary markets. Everything in Alabama is tertiary. We trail behind the business cycle, and it gives us an opportunity to see what’s coming.
Chris McFadyen is the editorial director of Business Alabama.