Which Changes in Financial Regulation Could Impact Real Estate Investment Returns

Critically Assess the Extent to Which Changes in Financial Regulation Could Impact Real Estate Investment Returns

Introduction

According to Gabriel, Stuart, and Chandler Lutz, it is now a decade since the global financial crisis and the regulators have just finished the bank proposals and agenda and they have rolled out the agenda of nonbank regulations. The Commercial Real Estate Council has assessed the holistic effect of regulations in the commercial real estate industry via qualitative and quantitative methods with the study of impacts associated with fund flows, market structure and behavior. With the regulator theories, various analyze have been constructed to estimate the costs associated with the new regulations. With the adoption of the final rule, it is estimated by regulators that a normal market condition will prevail but a median ten-year impact upon the real economy will be $209 billion. Also, there are suggestions that the smaller borrowers, markets, and lenders will experience an unequal percentage of expenses. Focusing on the impact from the bottom up, the incorporation of the single data point in the reporting framework for the SMEs firms will exceed the 1 million. As a significant and crucial tool, regulation in the sector will be perceived as a relatively more successful but with forceful wider change while still being considered as fairly blunt too that is hard to manage and control. Since the regulatory agenda and proposal will extend further to the next decade, it is somehow earlier for the regulators to analysis the impact. Despite this, there is emerging evidence that the agenda may change to risk rather than reducing the risk as planned.

Impact of New Financial Regulation on Real Estate Sector Returns

The aspect of financing the real estate investment as well as development remains the cornerstone of many country property sectors. Construction activity largely depends upon the finance availability mainly from the banks and other regulated sectors, for instance, accounts for 1.4  jobs and $1 trillion per annum in domestic investment in the US. However, it is evident that the commercial real estate investment structure has fully improved since the financial crisis lows, the aspect of long-term post-crisis regulatory involvement is still being analyzed. Basically, these rules are in their early stages of implementations and the cost burden is well understood. In other cases, the regulatory interventions are yet to be proposed. With such prolonged period of complicated regulation uncertainties, there is a significant challenge for setting clear business strategy and representing the risks to the entire system. Policymakers and market participants have remained optimistic that many economies will have the capacity of absorbing the relaxing unusual but accommodating monetary policy. In addition, there are concerns that the policy incorporates regulatory, fiscal, monetary, trade and tax which are insufficient for the new world orders. The question of the regulatory policy efficiency, effectiveness and correctness must be provided with a background of GDP and job growth.

According to the argument by Pavlov, Andrey, and Susan, the regulatory environment has remained influx and regulators have drawn a conclusion that the regulation will remain effective when utilized to attain broader objectives. According to the Federal Reserve data, the bank sector has been able to provide almost half of $3 trillion part of the outstanding real estate debt. Despite this, the new Basel III regulation requires the US banks, bank holding corporations, saving associations, and saving and loans holding firms with more than $500 million in assets to have a higher capital level. Such requirement may cause the allocation of the bank capital to get far away from the real estate as well as higher finance costs. As a consequence, developers may consider future projects as less viable. As cited by Renaud, Bertrand the new case of Basel III rule has resulted to more mortgages that are assigned the risk of weighting of 100 percent and banks are required to maintain a capital that is equal to 8 percent of the indebtedness balance. However, the rule allows the multifamily loans to be eligible with a lowered risk weighting of 50 percent in case after a year there is a proof of a timely principal as well as interest payments and that the loan is aligned with certain credit requirements. Such a huge change will be the risk weighting for the novel category of loans-high-volatility commercial real estate exposures. It will be defined in other words as a credit facility that finances or has financed the acquisition, development, or construction (ADC) of real property.” Such loans will receive a risk weighting of almost 150 percent where banks will be required to hold 12 percent capital rather than 8 percent.

Figure 1 showing commercial real estate risk weightings

Source: Basel III

However, certain loan types may be exempted from the high-volatility commercial real estate (HVCRE) classification and other ADC loans may only be exempted in case they meet specific criteria. First, the ADC loan should have a loan-to-value ratio (LTV) of 80 percent or less. Also, the borrower is expected to contribute capital toward the project in form of cash in form of unencumbered marketable assets of approximately 15 percent of the total appraised complete value. In addition, the borrower capital needs to be contributed before the bank funding and must be part of the project all through the life of the project. The project life is concluded after the crediting facility is changed to a permanent financing source, sold or loan is repaid in full. Such exception standards are directed toward improvement of bank lending standards but many ADC loans have the possibility of not falling under the HVCRE definition due to the exemptions. According to Antoniades, the majority of bank institutions consider providing ADC loans at leverage levels that are quite lower than the 80 percent set verge while the borrowers are expected to make a contribution of equity toward the project before the bank accept funding the debt. Despite this, the third exemption is directed toward borrower equity which makes it hard to attain as the test diverges from the customary bank credit practice in two significant ways. Basically, the expected equity tends to be based on the project expenses instead of the ‘as a completed value of the project.’ Conversely, banks mainly offer credit to the current value of the developable land in the form of borrower’s ‘skin in the game.’ The third exemption, in this case, remains a problem for the developers who wish to build on the land formerly capitalized and considered as a viable market situation. Such borrowers may find it challenging to source capital from the banks as well as timing and the amount of the additional equity will cause a direct impact upon the project feasibility. Capacity to find construction capital from a non-customary lender may consider the elimination of equity issue. However, the cost of capital sourced from the private equity as well as other nonbank lenders will remain higher. In such circumstances, the equity requirements may negatively impact development. With limited constructions especially in countries such as the United States in the last five years, demographic shifts and population growth in the next one decade will necessitate the need for crucial commercial development.

Impact on Cost and Liquidity 

Probable results of the new rules will entail that banks will no longer require being a core source of ADC capital for the real estate sector. Securitization, as well as other related traditional lenders like life companies, have lower chances of filling the gap. This would cause the borrowers to seek for funds from the non-customary lenders like the private equity funds, a source that is quite expensive. In such instances, the bank would wish to remain in the ADC business where they hold required expertise and infrastructure but would be forced to set extra charges for the HVCRE loans to ensure profit is retained. Despite the route undertaken, the cost of the ADC capital is highly likely to increase which would cause an upward pressure upon the capitalization rates which would result to a stabilized properties and discounted rates driving the value of the new and temporary properties high. The resultant low collateral values may raise the LTV ratios and eventually lower the loan progresses to the real estate borrowers.

As well, the rate may increase for all the commercial mortgages especially changes on the capital requirements related to the mortgage servicing rights (MSRs), which is separate assets developed after the bank’s sources a mortgage loan. These new rules are complex and the bottom-line considers that the banks hold relevant MSRs, a risk weighting against the increase as a higher as 250 percent. Such would result in increased servicing fees and the fees may be entrenched in the mortgage interest rate. In case there is more servicing toward the nonbank servicers, the advantage would be taken for the situation via raising the fees. Also, despite servicing being undertaken inside or outside the banking system, the borrowers would have to experience a permanent change in the commercial mortgage pricing. On a positive side of the case, Basel III would tempt the bank to offer more capital especially to the multifamily sector with a low-risk weighting of about 50 percent. Such would be beneficial to the apartment owners since it would increase aspect of liquidity when widely required. The change from the homeownership aspect to the rental housing will continue. However, it is worth to note that the multifamily ADC loans are similarly treated with any other type of property. While developers are capable of meeting the continuous demand for the rental units, the lenders will have not to benefit from the low-risk weighting up to the time the project will stabilize.

However, the full impact of the new regulation is yet to reach the marketplace. Currently, there has been an increased regulatory demand with a focus on the newly implemented Basel II and the Dodd-Frank provisions in relation to securitization and trading derivatives. These regulations have largely impacted the large institutions mainly the banks. Mera, Koichi, and Bertrand Renaud quote that compliance expenses more so the costs associated with meeting the marginal regulatory capital and the liquidity requirements, fines and additional risks activities will be increased by $2 billion per year. Small lenders will have a relatively heavier burden of the new regulatory provisions. The burden will increase due to fragmentation of the regulatory authorities especially in the domestic and international limelight which allow parallel and overlapping initiatives. Commercial Real Estate debt is considered as a diverse asset class for much lending of 50%+ and for the nonbanks such as REITs, life companies, asset managers, and the commercial mortgage accounting for the rest. Conversely, the standards set for the risk-based capital ratios have remained increasingly conservative. In this case, the numerator comprises of the large tangible common equity while the denominator is approaching the Basel III standards which are considered as more rigorous when compared with Basel II. This means that 12.75 percent tier 1 capital currently is higher than the rate it was in 2007.

Shiller posits that the additional new requirements related to liquidity and capital at the SIFIs and banks will as well raise the headline requirements which would cause the executives to widely reallocate the capital. Taylor Rule is related to the 2 percent inflation process of setting the US monetary policy. In the same vein, the rule has set a relation between the official and the inflation rates with a connection of economic growth and the bank capital requirements. Such recent implemented regulatory initiatives have raised the bank as well as other lending costs when making construction and Commercial Real Estate loans. As well, lenders incentives have been reduced toward the real estate sector. In fact, there is an agreement that such higher costs have been impacting the allocations made to the Commercial Real Estate across various balance sheet lenders such as banks and life insurance companies. However, the lending parties have the capacity of passing such costs to the borrowers. As a consequence, there is a net impact upon additional regulatory burden incorporating high lending expenses for the lenders, high borrowing costs for the borrowers and reduced volume for the lenders and the borrowers. Within the upper limits, there are estimates that such costs would be higher to a given exposure. Additional regulatory requirements within the banks, as well as other highly regulated institutions, will have to go further across liquidity, capital, risk management, disclosure and compliance requirements. Price will be a concern for the properties and volume will remain constrained due to the extra apportioning of the balance sheet to capital and to the liquid assets. In addition, the institution that used to lend excessively to the Commercial Real Estate sector will ensure that there are few loans in case each loan provided necessitate large capital allocation. Indeed, capital allocation to the real estate sector will have an increased demand for endless capital reserves whereas lending in other sectors will as well be negatively impacted. As argued by Reinhart, Carmen and Kenneth Rogoff increase in a particular segment of a given particular market would have to influence the costs of other sector segments. Within the novel risk-based capital requirements, the construction loans (even to the well-rated borrowers) have the same risk weight as loans with the 60-days negligent. Due to this, construction lending will have to take a great increase in the regulation of capital costs for various lending classes. Even when the new regulations would not directly extend to the non-banks, they remain too subject to increased costs of regulations via various sources. One of the direct ways is when the banks consider passing the costs via the lending agreements to the non-banks utilized for purchasing and repositioning the properties. However, there is an issue when sturdy bank partner considers cutting the lending agreements as a result of strict concentration limits. Focusing on such situation, a strong lender may decline the relationship with a strong borrower to ensure that there is avoidance of high capital charges which suggest a negative bias in the selection of client composition.

On the other hand, the Commercial Real Estate sector has been argued to have improved since the sector financial crisis afoot. Some of the largest changes of the game entail lower rates, limits in the new constructions, resolving problematic loans, disciplined underwriting, and excellent disclosures. Capital has accumulated in the real estate sector which has been spread across all types of the non-banks with a consideration of counterbalancing of the pullback in the bank lending. Industrial players have suggested tens of billions in terms of capital have been raised by the opportunistic funds. Such availability of capital in the sector is a suggestion that there will be continued valuation. Conversely, higher property values and recovered operational income is a reflection of a positive connection between the real estate sector investment and capital markets together with property fundamentals and macroeconomic conditions. For example, in the first quarter of the year 2015, there was an increase in annual commercial property sales to $111.4 billion. The regulation of the Commercial Real Estate sector has assisted in accelerating the balance of risks among the lower and higher-regulated institutions. With evolving capital and liquidity charges, new behaviors that are diverse from proved practice have remained standard. Within higher levels, balance sheet expenses that are considered as relatively stable have the capacity of changing widely on the quarterly basis. Such is an indicator of benchmarking for an excellent deal of profitability.

Conclusion

Banks have historically been proved as the largest source of debt capital for the commercial real estate industry, especially for the ADC loans. The consequences of higher capital requirements for the MSR and HVCRE loans under Basel III remain higher for mortgage rates and probably less capital will be allocated to the commercial real estate sector. Such implementation of such changes, there will be a collision with the environment for increased interest rates as well as increased developmental demands. The loss of liquidity, as well as higher pricing, will make the business of owning and developing business less profitable while curtailing the construction, development and real estate transactions.

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