The 2017 CREFC January Conference, which took place last week at the Loews Miami Beach Hotel, provided an opportunity for those in the commercial real estate finance industry to reflect on an eventful 2016, and look ahead to 2017. Although attendance was down by almost 11% this year (we’ll blame Zika), around 1,600 people attended this year’s conference. The mood of the conference was generally upbeat, with most attendees expressing cautious optimism for 2017. As usual, the parties were lively, and 435 people attended Dechert’s reception at the SLS Hotel on Monday night to indulge in sushi surfboards and the national championship game.
While the panels, meetings and forums provided an opportunity to take the pulse of the industry, and we will get to 2017 and beyond shortly, we need to pause for a moment and look back at a year which may be an inflection point in our industry, our country, and possibly the world.
When we met in Miami last year, we did not hear anyone who predicted Brexit or the election of Donald Trump. Very few saw clearly the anemic growth of the first half of the year, nor the uptick in volume during the second half, despite some unprecedented headwinds.
Yet, here we are, days from Donald Trump being sworn in as the 45th President of the United States, and potentially only 2 months before the United Kingdom invokes Article 50 of the Treaty of Lisbon to formally begin the process of leaving the European Union, and the economy and our industry continue to chug along as if nothing happened – in fact, we are currently moving forward as if this was good news! Surprisingly little time at the conference was spent on macro-economic or political issues or, as Rick Jones noted in his panel, “orange swan” events, given the historic changes of 2016. What could have been full-on-panic, was generally a footnote of the conference. The world moves on…
For the CRE finance industry, much like the national championship game which had us glued to the TVs at Dechert’s party, the year brought three quarters of little scoring, followed by a final quarter of action and a thrilling finish. CMBS issuance dropped from around $95 billion in 2015 to around $63 billion in 2016, and much of that in the second half. CMBS accounted for only around 8% of all commercial real estate loans originated in 2016! At its height, CMBS accounted for almost 50% of all commercial real estate loans, a startling decline.
Projections for 2017 were generally bullish or bullish-ish. Many people at the conference expressed optimism with the pro-business cabinet picks in the Trump administration and general optimism that, despite the belief that we may be in the late innings of the current real estate cycle, we will see continued growth in the short and medium term, and even possibly a few “extra innings” over the next few years.
The general consensus is that 2017 will be at least level with 2016 – with issuance in the $50 billion to $100 billion range, and likely closer to the $95 billion in issuance from 2015 than the $63 billion in issuance from 2016. Almost no one openly prognosticated that issuance would exceed $100 billion in 2017. The so-called “wall of maturities” among CMBS loans will hit during the first-half of 2017 ($70 billion of CMBS will mature during the first half of 2017), and then CMBS refinancing will fall in the second half of 2017, as pending maturities drop significantly, and stay there for several years. We note, however, that several analysts have pointed out that most CMBS loans are not refinancings of other CMBS loans, and the total number of loans to be refinanced will remain strong throughout the next several years, so it is unlikely that CMBS will fall to great recession levels.
While CREFC’s keynote speaker, Salim Ismail, may have been a bit hyperbolic in suggesting that democracy is in the process of failing in the Unites States, 2017 starts with a significant amount of uncertainty about our government, economy and industry. 2017 will not be without its challenges.
The implementation of risk retention has come and gone, and the industry awaits the first risk retention compliant deals of 2017. Will risk retention be a significant turning point in the CRE finance industry, or simply another “Y2K”? What form of risk retention will win the day – vertical, horizontal, or “L” shaped? We will find out soon. The banks in attendance generally expressed a preference for vertical risk retention, but many investors, B-piece buyers and others in attendance believe that the horizontal, or more likely “L” shaped structure, will ultimately be the big winner (if issuers can agree to indemnities with the B-Piece buyers). We are likely to see each structure utilized during the first quarter of 2017.
How risk retention will impact pricing is yet to be determined. Bonds with “risk retention” structures executed in 2016 all priced well compared to the market. Many at the conference expressed a view that the coupon to the borrower must increase, but with indices creeping up, spreads compressing and other market forces at work, it will be difficult to discern how much was paid by borrowers for risk retention. All we know is that someone will pay.
In the early stages of the risk retention era, it appears that banks with the ability to hold risk retention verticals will likely be the big winners (moving risk away from the banks, eh?). 2016 saw a number of non-bank lenders drop out of the conduit market, and it’s likely that 2017 will see a further decline in non-bank conduit lenders. One generally positive early result of risk retention is that loan quality has held steady, despite rising real estate prices. LTVs in 2016 dropped to around 60%-65%, and most lenders do not anticipate a material increase in LTVs or drop in loan quality in 2017. 2017 will not be a repeat of loan quality from 2007.
Risk retention may help keep underwriting and loan quality in check, but even before risk retention hit, there was a sense that discipline remained in the market. Maintaining loan quality while refinancing 2007 vintage loans, on the other hand, may be an issue. Most 2007 loans were high LTV, and something will need to give on either loan quality or proceeds to the borrower. Time will tell.
On the regulatory front, it is possible that Dodd-Frank reform will be a lower priority in the Trump administration, and no material changes to the law are likely to occur in the near-term, if at all. We’re living in a risk retention world, and that is unlikely to change. What may have a greater impact on multi-family lending is GSE reform. While at this time it does not appear that GSE reform is at the top of the Trump administration agenda, any reform might suppress the volume of multi-family loans that the GSEs can acquire and may push multi-family loans towards CMBS.
Another significant unknown for 2017 will be the rise in interest rates – can the market absorb an increase in rates, or will increased rates negatively impact loan quality and volume? According to one bank’s research group, CMBS can absorb an increase of over 140 basis points before coverage rations will decrease below 1.50x, giving CMBS significant room to increase rates before loan quality drops below acceptable levels. Where rates may have a greater impact is refinance risk and the greater possibility of defaults at maturity.
On the positive side, we could see growth in 2017 in single-borrower CMBS deals. While banks continue to struggle with the risk retention model for conduit deals, the risk retention structures for single-borrower deals seem more straightforward. Many banks expect to see several single-borrower risk retention deals executed in the first half of 2017. We could also see a wave of new investment in U.S. properties during 2017 if proposed tax reforms drive the repatriation of foreign money back to the U.S..
Non-bank, alternative lenders also expressed optimism for 2017. We are likely to see several non-bank issuers endeavor to enter the market and take the poison chalice of risk retention away from the regulated banks. Too early to say how that might play out. 2017 should be an improved year for value-add and construction lending, providing higher yields for lenders and investors. Due to HVCRE (High Volatility Commercial Real Estate) regulations, many commercial banks have reduced construction lending, leaving a gap in the market which non-bank lenders hope to fill.
It’s unlikely, we hope, that 2017 will bring as many twists, turns or surprises as 2016. Instead, all signs point towards 2017 being a good year for the economy and real estate, and CMBS may be primed for a comeback. So, let’s all take a deep breath – then let’s all get back to work and make 2017 a great year.