By Steve ‘Buch’ Buchwald – The Debt & Equity Finance Group
(Steve ‘Buch’ Buchwald, New York, 2/5/2019) — As it becomes more and more popular to gut renovate beautiful old buildings centrally located in various markets across the county, Historic Tax Credit transactions are becoming more common. Much to the chagrin of lenders, HTC deals have their own rules and, unfortunately, not all these transactions have identical structures. This further convolutes what is already a very complex and esoteric intricacy to commercial real estate transactions.
So, let’s back up. Historic Tax Credits can be either Federal Tax Credits, administered by the National Park Service (NPS), or State Tax Credits, administered by the state in question. These are based on qualified rehabilitation expenditures (QREs). While State Tax Credits can be relatively straight forward, the Federal Tax Credit rules often dictate complex org chart structures and create confusion among developers and lenders alike.
After a new set of IRS tax guidelines applicable to HTCs in 2014 were issued, the outright upfront sale of HTCs was prohibited and instead the tax credit investor had to become an investor in the transaction. The upfront payment was capped at 25% of the purchase price of the tax credits and the investor now had to have “skin in the game” throughout the construction period.
This resulted in two different structures:
The Single-Tier Structure – the structure whereby the tax investor is admitted as a partner of the property-owning entity and that entity is thus entitled to claim the HTCs.
The Master-Lease Structure – The property owner leases the property to an entity owned at least 99% by the tax investor. The master lessee in turn obtains a 10% stake in the property owner. While the property owner funds the QREs, it is permitted to pass the HTCs to the master lessee and thus to the tax investor through its interest in the master lessee.
If it sounds complicated, it is because it is. Even experienced lenders often balk at having to sign a subordination, non-disturbance and attornment agreement (SNDA) with the master-lease structure, claiming they will not subordinate to anyone. However, this is a must for HTC transactions since the SNDA prevents the collapse of the master lease structure upon foreclosure and, in turn, protects the tax credit investor’s rights to the HTCs. These tax credits can then be used by the investor over the five-year compliance period (20% per year) after obtaining Part 3 approval (the final NPS sign-off) post-construction. During this time, any take-out financing must also agree to sign a SNDA with the tax credit investor.
Another common point of confusion is how the HTCs can be used as a source of funding. There are generally three ways to capitalize a project with Federal HTCs:
A tax credit investor invests through the Single-Tier Structure and as a partner is entitled to the HTCs. This is straightforward as this investor would come in as a traditional LP partner. That said, this is incredibly rare and is not the standard for HTC commercial real estate transactions.
A tax credit investor purchases the HTC’s with the Master-Lease Structure and funds 25% of the HTC purchase at closing. Generally, these investors pay between 80 and 95 cents on the dollar and then 25% of this number (about 20-23% of the total HTC’s) can be used as a source of funds in the developer’s sources and uses. The remainder will typically come in over the course of the development, commonly at C of O, with some small amount held back until the developer obtains Part 3 approval from the NPS (typically 6 months or so after C of O).
With a tax credit investor structure similar to #2 above, the developer can then also obtain a tax credit bridge loan secured by the remaining payment stream from the tax credit investor that can be monetized up front. The amount of proceeds on the remaining 75% of the tax credit purchase net of the capitalized interest reserve and points on the tax credit bridge loan can then be added as an additional source of funds.
While these transactions are complicated, HTCs do significantly reduce the effective cost basis of renovation deals and thus are a necessary evil. Taking the time to properly understand the HTC structures can give developers a leg up on their competitors and lenders more deal flow and higher yields. Additionally, adding qualified professionals that understand HTCs to the development team including mortgage brokers, real estate attorneys, and tax credit consultants is a must for any developer that wants to tackle the complexities involved with Historic Tax Credit transactions.
In this Q&A, Michael Britvan, Managing Director Loan Sale and Asset Sale group at Mission Capital and Allison Israel, Product Manager of Mission Capital give insights into how machine learning and artificial intelligence will have a broad impact on lending operations.
How do you see artificial intelligence and machine learning impacting the mortgage space?
Israel: There are various applications for artificial intelligence across the mortgage industry, but one area where we’re already seeing machine learning make an impact is the analysis of loan portfolios.
When banks explore the sale of loan portfolios in the secondary market, they produce data tapes containing relevant loan, collateral, and borrower information from their servicing systems. Field names in these tapes frequently vary by servicing platform as there is currently limited industry standardization. For example, a data field in one loan tape might refer to “Origination Date,” while another shows “OrigDate” and a third is “Loan Origination Date.” Although each of these fields refers to the same thing, the fact that they are labeled differently means that an analyst looking to load a model might spend considerable time deciphering column headers and normalizing data.
Machine learning has the power to take this manual process and perform it automatically. For example, it is able to recognize that “OrigDate” means “Origination Date.” Additionally, when the system is processing a new tape and finds a term it doesn’t recognize, it uses natural language processing to parse the word and find the closest match. The more tapes we put through the system, the smarter it gets. A few months ago–when we first deployed the system internally–it generally recognized around 40 percent of the fields. But, as it learns more, and processes a greater number of tapes, we expect that number to climb closer to 90 percent.
Would you say that the greatest benefit of machine learning is time savings?
Israel: While time savings is an important factor, having standardized field names from the machine learning model also allows us to apply a standard set of “rules” within the same software. For example, with all tapes using the term “Origination Date,” we can tell the system that “Origination Date” must come before “Maturity Date,” and it will flag any loans that don’t comply with the rule. We currently have about 250 rules, and they are instrumental in enabling us to improve data integrity by catching data issues programmatically.
Conventionally, analysts have spent up to 80 percent of their time in Excel normalizing data, validating information in the tapes, and resolving errors. This results in very little time to analyze the value and potential of the portfolios at hand. With newly developed software, we’re leveraging machine learning to flip the scale and enable analysts to spend less time manually manipulating data tapes and more time on the actual analysis.
Across the industry, loan analysis and trading are made infinitely more efficient by introducing machine learning models and enhancing those models with historical big data. The key to leveraging big data is the ability to normalize it first.
What are the other benefits mortgage professionals realize from this technology?
Britvan: The technology empowers all mortgage professionals to validate, analyze, and visualize data more efficiently. Depending on the user and firm, this can translate into a range of different benefits.
Banks leveraging this technology might be able to gain better insight into their portfolios. By cleaning up data and eliminating errors, they are also better able to manage their service providers. For example, with a better handle on their portfolio, it will become easier for banks to spot-check loan servicers to ensure accurate reporting and potentially even audit remittances.
Investors acquiring whole loans are able to spend more time on analysis and less time cracking tapes and stratifying portfolios.
Do you think these innovations will have a broader impact on the whole loan sale market?
Britvan: Over the past decade or so, there’s been a significant shift in the perception of trading whole loans on the secondary market.
Ten or twelve years ago, selling loans on the secondary market was often an indicator that the seller had a problem on their hands, and the decision to sell stemmed from a desire to remove the problem from their books. That perception has changed. Today, the speed of transactions has increased, while the number of participants in the secondary market for whole loans has climbed significantly. Whole loans are a relatively liquid asset, and many banks routinely tap the secondary market to manage their loan portfolio.
We expect technology to increase efficiency in analyzing loan portfolios which should, in turn, expand the universe of buyers in the secondary market. Right now, most buyers considering entering the market rely on an analyst to clean and validate data prior to loading a model. With the strides we’re making in producing tools that clean up the data automatically, it allows investors to focus on finding value rather than allocating resources to data manipulation.
Do you think there are other notable tech trends that will have a significant effect on the secondary loan sale market?
Britvan: One area that has a lot of untapped potential is the incorporation of big data into mortgage analysis. When analyzing a loan portfolio, the quality of the valuation we can produce is often limited by the quality of data we receive. Key data points that are stale or absent require that assumptions be made.
By taking a big data approach to updating stale data or making assumptions, we can improve our estimates. For example, if we’re analyzing a multifamily property, we could leverage things like demographic trends, market occupancy, existing and future inventory, and housing data to make assumptions regarding a property’s current and projected future occupancy. This means that we are no longer just filling in missing or stale data but are also using historical trends to predict the market. This introduces brand-new inputs into our models that would have previously been unavailable without the breadth of data at our fingertips today.
Big data analysis of external factors, combined with proprietary market knowledge gleaned from our whole loan trading activity, will provide a better basis for secondary market participants to analyze loan tapes. We expect the industry to make significant strides in incorporating third-party data into their analysis in the years ahead.
Current market conditions have created a favorable environment to monetize whole loans.
Strong fundamentals in the labor markets led to vastly improved credit performance and fuller valuations in the loan space.
Investors continue to recognize the higher returns and wider moat that whole loans offer compared to traditional bond investments.
As a macro-economic backdrop, the unemployment rate is now at its lowest level in almost 40 years and wages grew at a healthy pace of 2.9% over the last 12 months.
Alongside the positive economic developments, loan sale volumes shifted substantially from Non-Performing to Re-Performing loans as loan servicers developed practices to collect more meaningfully on charged off loans and modify impaired loans more effectually.
Meanwhile, the positive credit performance was offset by softness in rates, which sold off in early October in response to Fed hikes and balance sheet run off. Likewise, the Fed’s Dot Plot shows a forthcoming inversion of the discount window, signaling a looming recession.
Given the full valuations and improved performance, it’s an opportune time for banks to sell their assets at attractive levels so they can focus on their core business of originating new loans. Further, this source of loan product provides investment managers an opportunity to diversify their exposure away from traditional bonds and into whole loans or privately structured products that generate more attractive returns. On the buy-side, the strong credit fundamentals provide an opportunity for funds to harvest their lower yielding assets at favorable levels so they can focus on working out more impaired assets.
Mission Capital represents preeminent financial institutions, investors and government agencies on the sale of performing, sub-performing and non-performing debt secured by all types of commercial and consumer collateral, commercial real estate investment property and tax liens. For more information, visit www.www.missioncap.com/loan-sales-real-estate-sales
[Published November 6, 2018 in the Commercial Observer]
When tech firms come to the neighborhood, they can have transformative effects far beyond the office space they lease. That, at least, is the perspective of Ari Hirt, a managing director who works on both debt and equity deals at Mission Capital.
“What Google did to Chelsea [in Manhattan] made that neighborhood much hotter than it was. The same phenomenon has occurred in the West Loop of Chicago,” Hirt said. Given that companies like Google and Pinterest have hung out their shingles there, “now, everyone wants to be in the West Loop,” he said.
Peter Thiel, the Silicon Valley mainstay who founded PayPal, Clarium Capital and big-data contractor Palantir Technologies, has never shied away from iconoclastic gestures.
In 2016, Thiel bucked his fellow new-economy titans and offered an unqualified endorsement to Donald Trump; he promoted efforts to forge floating societies in international waters; he’s even advocated space colonization.
But one of the entrepreneur’s boldest heresies came earlier this year, when he launched a broadside at Silicon Valley itself. In February, Thiel announced that he would uproot his technology ventures from their Silicon Valley haunts for Los Angeles, arguing that the birthplace of the software industry had become too insular. …
We consider Howard Marks (with his team of course) one of the smartest guys in the room. He is the “five tool” customer: a lender to, borrower from, JV investor in, asset buyer from and seller of assets to, many of our clients.
Amid so much purportedly expert investment advice, it is worth asking who the experts themselves listen to. One answer, undoubtedly, is Howard Marks, among the world’s most successful investment managers as well as an intellectual leader of the profession. His client memos are widely distributed among investment professionals. “When I see memos from Howard Marks in my mail,” Warren Buffett has said, “they’re the first thing I open and read. I always learn something.”
[From the Wall Street Journal – October 4, 2018] You Should Worry More About Italy’s Bond Market By James Mackintosh
Oct. 4, 2018 1:04 p.m. ET
There are lots of reasons why contagion has been contained, but none are entirely satisfactory
The Italian bond market has a whiff of panic about it, while the rest of Europe has remained remarkably calm. This makes little sense, and is unlikely to last.
The basic logic runs like this. The rise in Italian yields relative to those of safe Germany is a sign that investors think Italy is more likely to default on its bonds, more likely to leave the euro and repay in devalued lira, or both. Fair enough: The populists now governing in Rome are unpredictable, and Italy’s government-debt pile is large.
Yet, it is obvious to everyone that if the third-biggest economy in the eurozone were to default on €2.3 trillion ($2.64 trillion) of debt or leave the currency area, it would at the very least blow up the rest of the Southern European countries. The bond yields of Spain, Portugal and Greece would soar, even if somehow they were able to remain within the euro.
“Italy is not Greece” is usually invoked as reassurance. In fact, the situation in Italy is a whole lot worse than Greece, because the solution applied to Athens—a default within the eurozone and capital controls—couldn’t plausibly be applied to Italy’s much more important economy and much larger debts.
This should mean that higher risk to Italy is also a higher risk to other countries that would face trouble, not to mention the many large European banks with significant Italian exposure.
So why has contagion been contained? There are lots of answers, none entirely satisfactory.
First is the idea that everything is fine because Italy isn’t in a full-blown crisis. While Italian government-bond yields have jumped, pushing up the spread over German yields that is the standard risk gauge, they aren’t high enough to make Italy’s debt unsustainable by themselves. Put another way, investors think everything will be fixed after a bit of pressure on the government in the form of higher yields.
“It’s fairly consensual that it will be resolved with another round of market pressure,” says Gilles Moëc, chief developed Europe economist at Bank of America Merrill Lynch.
But this is a dangerous game. If the market pushes up borrowing costs too much, Italy would be unable to service its debt with politically plausible tax levels. At that point, the spiral would become self-fulfilling, as investors fled and credit ratings were downgraded, and yields rose even more. Serious contagion would be all but assured. Don’t forget how suddenly Italian bond yields spiked in 2011 and again in 2012.
Harvinder Sian, a bond strategist at Citigroup, thinks a 10-year yield of 3.5%-4% is now the tipping point, after which yields jump toward the 7% reached at the height of the last euro crisis. Italy isn’t quite there, but on Tuesday its 10-year yield briefly reached 3.46%, the highest in four years.
A second explanation is that the lack of contagion is due to the quirks of supply and demand in Europe. Investors in European bonds are desperate for yield, and while they now worry about Italy, they have simply switched to other countries offering a decent pickup over German yields, such as Spain. At the same time, the threat of billions of euros of extra Italian bond issuance to finance its planned larger budget deficit next year means a higher yield is needed to attract buyers.
If eurozone governments were regarded as equally risky, any significant gap in yields would be pounced on by speculators. But arbitrage is difficult when there is such an obvious danger of a sudden jump in Italian yields, and outright buyers are deterred both by the risks and by worries that clients may be upset to find themselves heavily exposed to Italy.
One exception is UBS Wealth Management, which has piled into short-dated Italian bonds recently for the extra yield, arguing that Italy won’t default in the next two years.
Chief Investment Officer Mark Haefele says rather than infect other eurozone government bonds, Italian contagion shows up in the fall in the euro—perhaps linked to the idea that the European Central Bank will step in to buy more bonds of countries such as Spain that have restructured their economies and followed European debt rules.
This leads to a third possible explanation, involving even more intervention. A catastrophic Italian default or euro exit might finally push the rest of the eurozone to integrate properly, something that has proved politically toxic in Germany. “Italy could be the final straw that forces Europe closer together,” Mr. Haefele says.
True risk-sharing across the eurozone—in effect a united states of Europe—would make Spanish bonds only as risky as German bonds, justifying the absence of contagion. But it is hard to believe that divided European leaders worried about a populist backlash could take such a step, let alone bring German voters with them.
The market can stay irrational for a long time, and Italian politics is even more unpredictable than usual. My best guess is that a compromise will calm everything down for a while. But the danger of an Italian falling-out with Brussels prompting a self-fulfilling market crisis is real. At that point, contagion would be inevitable.
Commercial real estate professionals were largely unsurprised by the Federal Reserve’s interest rate hike Wednesday, and many do not expect the move to have an immediate impact on the market. Should the Fed continue to bump short-term rates at a fast clip, however, it could adversely impact the industry and the overall economy.
June 13, 2018
“In general, these moves are a function of an improving economic environment whereby inflation is expected to rise. Higher rates will increase the cost of capital, but there is a record amount of fundraising seeking a home in CRE and so we do not anticipate higher short-term interest rates to diminish access to capital,” Cushman & Wakefield Economist and Americas Head of Forecasting Rebecca Rocket said in an email.
Following the monthly two-day Federal Open Market Committee meeting, Fed officials increased the benchmark federal-funds rate by a quarter-percentage point to a range of 1.75% to 2%. This marked the second move of the year, after the Fed bumped rates to a range of 1.5% to 1.75% in March.
Recently appointed Fed Chair Jerome Powell suggested two more rate hikes could be on the horizon as the Fed looks to temper a growing economy and keep the inflation rate at 2%. The labor market continues to boom with employers adding 223,000 jobs in May and unemployment reaching historic lows of 3.8% — a level the U.S. has only experienced twice in the past half-century.
“The decision you see today is another sign that the U.S. economy is in great shape,” Powell said during the press conference following the meeting, the Wall Street Journal reports. “Growth is strong. Labor markets are strong. Inflati on is close to target.”
Should the Fed maintain its pace of rate hikes, commercial real estate developers and borrowers could be adversely affected by higher lending costs and tighter access to construction financing, which could, in turn, stifle deal volume and further compress margins for investors. As it stands, another two bumps in short-term rates this year are not expected to stifle investor access to capital, but it will lead to higher borrowing costs.
The market foresees a 75% probability of a third move in September and a 50% chance of a fourth and final move in December, according to a Cushman & Wakefield survey. Bisnow asked six economists and real estate professionals in the debt and finance space about the impact of this move on the industry. Read their responses below.
Mission Capital Advisors Director of Debt and Equity Finance Group Jillian Mariutti
What was your reaction to this boost in rates?
FOMC said in March that it was likely to raise rates two more times this year, so — especially with the economy humming along so strongly — today’s announcement was not surprising, and didn’t seem to give the markets any shock. It is also now expected that there will be two more rate hikes this year, for a total of four (not three, as was expected in March).
Some economists predict the Fed will boost rates four times this year. How will these moves impact CRE lending activity and access to capital, if at all?
Thus far, the rate hikes have not made any major waves. However, we may see some borrowers in need of refinancing their properties try to lock in loans before further increases. It’s noteworthy that the FMOC median projections show the Fed funds rate climbing from 2.375% in 2018 to 3.375% in 2020. LIBOR generally lives at about 20 basis points above the Fed target rate, so we could see LIBOR north of 2.5% by the end of the year and more than 3.5% by 2020. This will obviously have a significant impact for CRE borrowers with floating-rate debt.
What does this move signal about the state of the U.S. economy and its continued recovery?
The rate hike is definitely an expression of the strength of the overall economy, which will hopefully have positive ripple effects across the industry. The factors that the Fed will look at in determining whether to make future rate hikes include sustained expansion of economic activity, the strength of the labor market and inflation near their 2% objective. With unemployment just below 4% — its lowest rate since 2000 — and other factors on track, everything points to the Fed hitting its expectation of four increases in 2018.
Where does the 10-year Treasury stand now in relation to the long-term average, and what does this rate hike signal for the industry moving forward?
The 10-year now stands at 2.98%, well below its long-term average.
Any parting thoughts?
Since LIBOR moves in lockstep with the Fed rate, more or less, if we do indeed have two additional rate hikes this year, that would continue to push LIBOR up and increase the cost of capital. As a result of that, we’re likely to see an increasing number of borrowers execute hedges to mitigate their interest-rate risk.
Ten-X Chief Economist Peter Muoio
What was your reaction to this boost in rates?
We were unsurprised. The Fed had signaled this increase and the strength of the economy suggested that there would be no hesitation to the increase.
Some economists predict the Fed will boost rates four times this year. How will these moves impact CRE lending activity and access to capital, if at all?
We believe that CRE investors have already factored this into their thinking. Capital remains available and we don’t foresee this diminishing. Higher financing costs and upward pressure on cap rates will likely exert downward pressure on pricing and perhaps make negotiations more prolonged.
What does this move signal about the state of the U.S. economy and its continued recovery?
The U.S. economy is strong, and the job market is healthy. Consumers are confident and spending, so the Fed continues to tighten as expected.
Where does the 10-year Treasury stand now in relation to the long-term average, and what does this rate hike signal for the industry moving forward?
The 10-year is still low by historical standards, it’s just up from the extreme lows of recent years. Clearly, increases in rates can have an impact on pricing and deal flow, but we are not at some choke point for the CRE capital markets.
Any parting thoughts?
Absent some external disruption to the economy, the Fed will continue to tighten.
Cushman & Wakefield Economist and Americas Head of Forecasting Rebecca Rocket
What was your reaction to this boost in rates?
This was a widely expected move, so the only cause for concern would been if the FOMC did not vote to raise the federal funds rate.
Some economists predict the Fed will boost rates four times this year. How will these moves impact CRE lending activity and access to capital, if at all?
We agree that the FOMC is likely to vote to raise rates at four meetings this year, but decisions will continue to be data-driven. We are halfway there. In general, these moves are a function of an improving economic environment whereby inflation is expected to rise. Higher rates will increase the cost of capital, but there is a record amount of fundraising seeking a home in CRE and so we do not anticipate higher short-term interest rates to diminish access to capital.
What does this move signal about the state of the U.S. economy and its continued recovery?
It signals that the economy is performing well and we are well beyond the point where the expansion is considered a “recovery.” Inflation is rising because the labor market is tight, and the U.S. and global economies are strong. It also signals that the FOMC anticipates continued growth and inflation, since it has been clear that it is willing to allow inflation to overshoot its target for short periods.
Where does the 10-year Treasury stand now in relation to the long-term average, and what does this rate hike signal for the industry moving forward?
The 10-year Treasury rate ended the day around 3%, which is 285 basis points below the historical average. A hike, while signaling that the economy is improving and inflation brewing, does not reflect the fact that capital is still relatively cheap compared to the past. Longer-term interest rates will continue to rise and commercial real estate will continue to benefit from continued economic and job growth. Jobs have been created at a 2 million year-over-year pace for a record 62 consecutive months now, which puts into perspective some of the tailwinds buttressing demand for commercial space.
JLL Ports, Airports and Global Infrastructure Managing Director, Economist and Chief Strategist Walter Kemmsies
What was your reaction to this boost in rates?
I was not surprised. [Every] cost-push factor is going up: commodity prices, labor, transportation rent/lease rates. The Fed is exactly on target.
Some economists predict the Fed will boost rates four times this year. How will these moves impact CRE lending activity and access to capital, if at all?
The impacts are already being felt in lending activity, not just in real estate but also infrastructure — the surge in municipal Bain’s issuance is substantial in the last few months.
What does this move signal about the state of the U.S. economy and its continued recovery?
[It] says demand growth remains in excess of supply growth [and signals the] need to moderate demand growth via rate increases.
Any parting thoughts?
Consumer balance sheets are still fragile. I am struggling a bit to see four holes this year. But [I] am in consensus on four hikes this year.
Colliers International USA Chief Economist Andrew Nelson
What was your reaction to this boost in rates?
With inflation running at multi-year highs simultaneous with unemployment at multi-decade lows, there should be little surprise that the Fed is moving more consistently now to cool the economy. Since starting to raise rates in December 2015, the Fed has hiked the Federal Funds Target Rate a total of seven times in 2.5 years, with a cumulative increase of 175 basis points.
With another two hikes likely this year and more to follow next year, we can expect these hikes to start taking their toll — eventually.
But context is important, as these hikes are rather measured compared with prior economic cycles. In the last expansion, for example, the Fed raised rates 17 times in the two years from mid-2004 through mid-2006, with a cumulative increase of 425 basis points. But even then, the economy still ran hot for another two years into 2008 as the impacts of rate hikes take time to work through the system.
So the recent rate hikes will have limited immediate impact on the economy and property markets. But expect the economy to start cooling next year as higher interest rates begin to slow corporate borrowing and consumer spending — just as the fiscal stimulus from the federal tax cuts and spending hikes begin to fade.
JLL Chief Economist Ryan Severino
What was your reaction to this boost in rates?
Completely as I expected. Not remotely a surprise.
Some economists predict the Fed will boost rates four times this year. How will these moves impact CRE lending activity and access to capital, if at all?
If we get two more hikes of 25 basis points this year, we will get closer to the point where interest rate increases have a more prominent impact on CRE and the economy. Individual rate hikes do not mean much, but the cumulative impact over time will.
What does this move signal about the state of the U.S. economy and its continued recovery?
The economy is performing well, especially relative to potential. Fiscal stimulus should have a robust positive impact over the next couple of quarters.
Where does the 10-year Treasury stand now in relation to the long-term average, and what does this rate hike signal for the industry moving forward?
Most of the upward movement in the 10-year had probably happened already unless the Fed raises their long-run target rate. I’d expect more movement upward at the short-end than the long-end, causing the yield curve to flatten further. That typically happens during tightening cycles.
Any parting thoughts?
For now, the interest rate environment remains positive for the economy and CRE, but as rate increases continue, they will eventually slow the economy and have an impact on the market.
The financing is flowing — but only from a few well-funded lenders (yes, Bank of the Ozarks is one)
April 20, 2018
In Los Angeles as of late, it seems the cash spigots have been turned on for several large-scale developments.
Huge construction loans have flowed in recent months to high-profile apartment, hotel and retail deals — some planned for years — from North Hollywood to downtown to Marina del Rey.
But scratch the surface, and a more nuanced picture of the lending market emerges. The Real Deal’s ranking of the county’s top construction loans found that it’s just a handful of lenders that account for most of the activity. As market conditions have become less favorable and some fairly recent financial regulations limit risk, the pool of loan sources has shrunk, those in the industry say.
“In today’s market, construction lending is difficult, and every year it gets more and more difficult,” said Bryan Shaffer, a principal of George Smith Partners, an L.A.-based capital advisory firm. “For most banks, it doesn’t make sense anymore.” Lenders are likely stingier now, knowing the recent boom is winding down, said Paul Habibi, a teacher at the UCLA Anderson School of Management and a principal at Habibi Properties, a large residential landlord.
“As construction lenders perceive it, when you get in bed with a developer, you are looking at a two-year commitment. So you will have two years to get out from under that commitment,” he said.
“And we are relatively late in the real estate cycle. It’s why some economists think 2019 will be a cloudy year,” he added.
Zeroing in on transactions from 2017, TRD also ranked the largest construction lenders in L.A. County across commercial development categories, though most of the transactions involved new apartment buildings.
The biggest lender — which won’t come as a surprise to anybody who has followed its aggressive moves in recent years — is Bank of the Ozarks, from Little Rock, Arkansas. It issued about $721 million in construction financing in L.A. County in 2017, at an average of $80 million a pop.
And five of the 10 largest construction loans in L.A. originated with the bank, which in the last four decades — through a chain of acquisitions — has swelled from a community bank to a national player with $21 billion in assets in 2017.
The largest single loan in the Ozarks portfolio last year was a $205 million issue to Sunset Time, a hotel-condo project on Sunset Boulevard in West Hollywood that broke ground last year and is scheduled to open in 2019.
Developed by Combined Properties, a Washington, D.C., firm, and AECOM Capital, the project will offer 149 hotel rooms and 40 condos in a row of buildings with staggered heights that together resemble steps.
Spokespeople for both Combined and AECOM said it was premature to discuss the project, which plans to begin marketing later this spring. Bank of the Ozarks did not respond to requests for comment.
If the construction loan market has tightened, the Sunset Time project embodies the kind of deal that still does get done, some brokers say.
Because of its deep pockets, Ozarks can satisfy tough Dodd-Frank financial rules that require lenders to have capital reserves covering the entirety of their loans to protect against financial collapses, like in the last recession. That might mean having, say, $100 million on hand to cover a $100 million loan, even if the loan is released in stages, as construction loans usually are, Shaffer said.
In the pre-Dodd-Frank days, lenders usually only held reserves for the amount of the specific stage, Shaffer said.
Those regulations, some of which went into full effect as recently as 2015, have had a chilling effect on smaller banks, which has strained the construction lending business overall, brokers say.
When loans are available, they are often nonrecourse loans — those that allow the lender to go after just the property in the case of a default but not after other assets. These loans usually carry higher interest rates and require low loan-to-value ratios. Ozarks, for one, specializes in loans of this type.
If construction loans generally offer interest rates of 7 percent, Ozarks might charge 10 percent, brokers said.
Naturally, well-capitalized developers are able to play in a market where money costs more. Combined Properties, which has developed $1 billion in properties since the mid-1980s and has another $1 billion in its pipeline, according to the company, is the type that can weather the current climate, brokers said.
That climate also seems to favor hotel and apartment projects over office development, in a city where the office vacancy rate was 15.4 percent in the fourth quarter of last year versus 14.4 percent in the year-ago quarter, according to Cushman & Wakefield figures. But even Ozarks, which is known for having a stomach for risk, seems to be making relatively conservative moves, like with Park Fifth, a mixed-use development in Downtown L.A. Developed by MacFarlane Partners, the project — on Pershing Square Park — scored a $103 million construction loan from the bank in May 2017. It was seventh largest loan last year.
MacFarlane, a 30-year-old investment manager with a development arm, was also issued another $80 million from the bank for the same project in 2016, which wasn’t included in TRD’s survey.
For that loan, Ozarks said it would cover only about half the development total for the $335 million project, said Dirk Hallemeier, a managing director of MacFarlane. The project also benefited from a $60 million mezzanine loan through the EB-5 program, which grants green cards to foreign investors in exchange for their financial support for job-creating projects.
“The lenders are being very cautious, let me put it that way,” Hallemeier said. With Ozarks, “the pricing is a little higher, and you have to meet their expectations in terms of liquidity and coverage and those kinds of things, but they set their loans up to be relatively secure,” Hallemeier said. Ozarks also typically asks for large down payments, according to news reports.
Park Fifth, which will open in 2019, consists of a high-rise with 347 one- and two-bedroom rental units and a mid-rise building with 313 units in a complex that will also offer shops.
The project, which is rising from a site cleared in the ’80s by developer David Houk for a hotel-and-office complex that never came to pass, is the latest example of a long-planned project that lenders seem to be giving another look.
Downtown, which has enjoyed a population spike in the last decade, is the kind of walkable, densely settled area that some L.A. lenders believe is good bet, even if some projects there, like the Bloc, are struggling.
Another neighborhood that seems to fit that bill is North Hollywood, or NoHo, an area well served by subways and buses. Rising there is NoHo L&O, a mixed-use property with 297 studio to two-bedrooms, plus a 26,000-square foot Whole Foods grocery store. “There’s nothing really like it over there,” said Jeff Cairney, a director of New York-based Camden Securities Company, the project’s lead developer. Joining it are Hayes Capital Management and Canyon Partners Real Estate, both of California.
The project, which broke ground last year and is set to open in 2019, scored a loan of $70.5 million from Ozarks, good for a 10th-place finish on TRD’s list.
Though Ozarks has aggressively pushed into L.A., it remains to be seen if the effort will continue, brokers said. Last summer, Dan Thomas, the head of the bank’s real estate group, abruptly left the publicly traded company, causing its stock price to plunge.
It seems to have recovered somewhat. On April 9, the bank’s stock was $46.35, up from a recent low of $40.35 on Sept. 7, 2017, though that was still off from a peak of $56.24 on Feb. 26 of last year.
Meanwhile, traditional banks are also still kicking in the market. Bank of America was responsible for two deals in the top 10 and was the third-largest construction lender in L.A. last year, with $416 million across six loans, according to TRD’s ranking.
Private equity groups deploying debt funds are also doling out hefty sums.
The Blackstone Group, for one, was the second-biggest lender in L.A. County last year, with $475 million in issuances, though in just a single deal.
The loan was for Row DTLA, the massive redevelopment of the former Los Angeles Terminal Market, a 1923 produce complex near downtown. With seven buildings and 1.3 million square feet, Row DTLA is being built by a partnership of Atlas Capital Group and Square Mile Capital with funding from HOOPP, a Canadian pension fund.
An earlier plan from Evoq Properties to redevelop the concrete buildings that line the site, called Alameda Square, did not come to fruition despite a $78 million loan in 2013. The loan, from a firm called Olen Properties, was for renovations, Evoq principals said. Those principals suggested in interviews at the time that the unconventional mix of tenants at the site — startups and garment manufacturers — meant loans from traditional banks would have been difficult.
Atlas and Square Mile picked up the sprawling 32-acre property for $357 million from Evoq in 2014. Representatives for the project, and Blackstone, were unavailable or declined to comment.
Financial firms like Blackstone used to be interested in buying completed projects, said Ari Hirt, a managing director with Mission Capital Advisors.
But as prices rose, “they got into the lending business instead, which allows them to manage returns better,” Hirt said. Private equity firms will also generally offer nonrecourse loans, for high fees.
While multifamily properties are attractive to banks, industrial projects are perhaps a hotter subsector, Hirt added. Indeed, sixth on TRD’s list of top construction loans was Victory Unlimited Construction’s closing of a nearly $105 million loan for a new warehouse project on Union Pacific Avenue in East Los Angeles.
“It’s a very sought-after and easy-to-finance asset class,” said Hirt, who added that borrowers with those kinds of projects often don’t even have to lock in an anchor
tenant first.
Going forward, Hirt is keeping an eye on macroeconomic events. The federal tax law passed in 2017 is one to watch, though most attorneys and analysts have so far issued no serious guidance about how it will impact construction lending.
New tariffs, though, could hike steel prices, though Canada, a source of a lot of U.S. steel, has been exempted. “But we just don’t know yet,” Hirt said.
In the meantime, many developers seem bullish on the chances of locking in loans for developments in L.A. — even as other markets soften — as the city embraces the types of urban-core projects other metro areas jumped on long ago.
“L.A. has always been a world-class city, but the sidewalks rolled up after 5 p.m.” Hallemeier said. “Now it has crossed the tipping point.”
In the aftermath of the financial crisis, banks were saddled with scores of soured loans. But even if institutions were looking to sell these assets, and investors were interested in purchasing them, banks were often constrained by capital level requirements from taking the necessary write-offs associated with fire sales.
Now capital levels are higher, so banks would be better able to absorb losses, and investors are still hungry to buy distressed assets for good prices. But banks have mostly been reluctant to complete loans sales.
That could be a mistake if credit quality were to take a turn for the worse, and there are a few indicators that new problems could be on the horizon.
“If you are selling assets today, you are probably being more tactical,” said Jeff Davis, a managing director in Mercer Capital’s financial institutions group. “You are thinking strategically as the economic cycle ages, and you are trying to take some chips off the table.”
Credit quality has improved significantly since the depths of the recession. Problem assets for all banks totaled $193 billion at Dec. 31, according to data from the Federal Deposit Insurance Corp. That figure included other real estate owned, assets that were 30 to 89 days past due and at least 90 days late, and those in nonaccrual status.
That is down from a peak of $581 billion at year-end in 2009, according to FDIC data.
Still the recent number is roughly 42% higher than the $136 billion recorded in 2006, according to data from the FDIC.
“Banks still have a pretty elevated level of classified assets because many of them didn’t fully pull off the Band-Aid half a decade ago,” said Jon Winick, CEO Clark Street Capital. “You are starting with a decent sized workout universe to begin with. Now there are new credits coming in.”
There are signs that credit quality could weaken, though certainly no one is predicting an imminent financial collapse. For instance, the Federal Reserve Bank of New York said in a report on household debt earlier this year that credit card delinquencies increased “notably.” The percent of credit card balances that were at least 90 days late rose to 7.55% in the fourth quarter from 7.14% a year earlier, according to the report.
Winick said an uptick in credit card delinquencies can be an early indicator of wider problems to come. Generally, business customers have more resources to keep their loans current when trouble starts to brew.
Interest rate hikes may also put pressure on certain commercial customers, especially in the commercial real estate portfolio. For instance, multifamily housing has been overbuilt in some cities, meaning that supply has out stripped demand. Owners of these buildings could have problems increasing rents as a result. That may become a problem as their loans come due and they get new financing at higher interest rates, Winick said.
Owners of retail properties in some areas may also struggle to raise rents on tenants either because of long-term leases or because the market won’t support such hikes, Winick said. Retail is also facing pressure from broader changes in consumer behavior as more people shop online.
“The 900-pound gorilla is Amazon,” said Lynn David, CEO of Community Bank Consulting Services. “What it is doing to retail is phenomenal. It has to be a concern to everyone. I don’t care if it is paper towels. You can now order it online from Amazon and get them shipped for free.”
To be sure, there have been banks in recent months that have looked to sell loans, both performing ones and problem credits. Substandard loans that banks consider selling may still be performing, but there could be other concerns, such as a covenant being breached.
A bank may decide to unload good loans if they are concerned about concentration levels, are looking to exit a certain business line or decide they could redeploy the funds into a higher-yielding asset.
PacWest Bancorp in Beverly Hills, Calif., announced in December that it would sell cash flow loans worth roughly $1.5 billion as it looked to wind down its commercial lending origination operations related to healthcare, technology and general purposes. PacWest President and CEO Matt Wagner said in the release that the $25 billion-asset company made the decision “for both cyclical and competitive reasons.”
Other banks looked to pare back their exposure in energy after oil prices tumbled.
Still, many banks are deciding to hold onto credits, even ones that are in danger of becoming distressed. This lack of supply could be helping to drive up pricing for the loans that do become available, said Kip Weissman, a partner at Luse Gorman.
“We are at the top of a credit cycle and that means there’s less of a supply,” Weissman said. “More loans are performing, and it is a countercyclical industry.”
Michael Britvan, a managing director in loan sale and asset sale group at Mission Capital Advisors, has observed banks are currently less willing to sell loans at a loss, likely due to the potential impact on earnings. This decision seems counterintuitive as the market is awash in liquidity, resulting in the narrowest bid-ask spread in recent history, he said.
”Performing, subperforming or nonperforming debt is in vogue,” he said. “We have been in an extended bull market run, therefore investors are targeting fixed-income investment, targeting assets they view to be slightly less risky and less correlated with the broader market.”
Matthew Howe, vice president of special assets at Lakeside Bank in Chicago, said he has seen better pricing on stressed commercial loans than in recent years. He said the bank is seeing bids between 85% to 90% of a loan’s outstanding balance, compared with offers in the low 80s just a few years ago.
Even though the $1.6 billion-asset Lakeside is not suffering from the credit problems that plagued the industry after the recession, management still tries to be proactive in managing its loan portfolio. That means even in a strong economy sometimes the bank offloads distressed credits.
Howe says one reason driving buyers’ interest in distressed assets is that foreclosures are moving faster through the court system. That can eliminate some of the uncertainty for potential buyers of troubled commercial real estate loans.
“It has been aggressive,” Howe said. “There is an appetite in the marketplace for distressed and for performing loans.”
(Steve ‘Buch’ Buchwald, New York, 2/5/2019) — As it becomes more and more popular to gut renovate beautiful old buildings centrally located in various markets across the county, Historic Tax Credit transactions are becoming more common. Much to the chagrin of lenders, HTC deals have their own rules and, unfortunately, not all these transactions have identical structures. This further convolutes what is already a very complex and esoteric intricacy to commercial real estate transactions.
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Recently appointed Fed Chair Jerome Powell suggested two more rate hikes could be on the horizon as the Fed looks to temper a growing economy and keep the inflation rate at 2%. The labor market continues to boom with employers adding 223,000 jobs in May and unemployment reaching historic lows of 3.8% — a level the U.S. has only experienced twice in the past half-century. 
