Thursday, July 29, 2010

My random thoughts on regulatory reform and the market

The one thing we know is this: markets hate uncertainty.  And after reading this CoStar piece about Dodd-Frank I can see why there is a lot of angst and uneasiness among some investors in the commercial real estate market.  It is going to take time -- and a lot of manpower and legal analysis -- to sort through yet another behemoth set of laws, rules and regulations.  While I am not a deal guy, here's what I am thinking, and I encourage you to critique me or even tell me I am dead wrong.

Pricing and cap rates will have to be lower than they were to sustain any good returns on deals.  If the days of what I liked to call "cowboy lending" are over, that is fine.  I was never a big fan of it anyway as a lawyer.  But we need to adjust to the fact that with lower LTVs on loans and stricter underwriting (including the requirement that lenders keep at least 5% of all their loans on the books as so-called "skin in the game") and more documentation (yay, lawyers!), this will be a change from the go-go days.  Yes, we will all have to work a little harder and be a little more careful.  Once again, fine with me.  If you have real money at stake you are going to be more careful.  But at the same time that means the "home runs" of a few years ago are going to be harder and harder to find, unless we go the the old days of, "Buy at a 10 cap, sell at an 8."

What I think is a dual concern and an opportunity is that some people will just stay out of real estate or exit the investment market.  Why?  Better places to make returns right now, even with prices deflated by as much as 50%.  There is already evidence of banks dumping their RE investment arms and advisory groups to boot.  So why is this an opportunity? Plenty of good pros will be out there needing something to do, and there will be a lot of property on the market.  Hopefully one or two of them will be calling me.  And what does this do to the hopefully slightly reviving CMBS market?  Again, uncertainty.

Another concern is development.  It might be a lot harder to build new projects with reforms and tighter standards in place, like we have had the last few years.  Again, this is not necessarily bad, but without construction moving then how is the economy ever going to really recover?

This is not meant to be gloom and doom for real estate.   I see and hear and know about opportunities in the market all the time.  But I do think some certainty and then some major league creativity is going to be what it takes to really get the market moving again.  That's going to be a fun cycle once it comes, be it next month, next year or down the road.  We will all have to put on our thinking caps for each deal.

Lastly, I also wonder aloud to what extent this will make mezz financing even more popular as a means to improve return rates to the levels that some of the players really want.  But we'll save that discussion for another time.


David said...

One thing re: the rules is that I don't think the 5% "skin in the game" thing set in stone. The language of the bill itself seems to exempt commercial real estate from this rule and, like much else in the bill, is subject to "further study."

The bill sets up a framework that will rely on regulators to fill in the banks. So a big question, then, is who will the regulators be? That will be hugely important in determining how this shapes up.

And overall, yes, it does seem like we're talking about a process that takes several years before we have some clarity. That is worrying to me because as you pointed out existing uncertainty is clearly not helping with the economy already and we're heaping more uncertainty on top of that.

Dianne said...

Thx for a terrific blog. EDR just closed our quarterly survey of environmental due diligence professionals and although deal flow and lending are both obviously down dramatically, I took comfort in the finding that 55% said their clients are "demanding more thorough environmental due diligence on deals today," an increase of 9 percentage points since the first quarter. One noted that rather than a nuisance, more clients view due diligence as a comfort factor and good business sense. Let's hope it continues even as the market recovers (which I think is on a loooong timeframe).

David said...

David: good points on the regulators. Who makes the rules will be important. But I'd rather know what beast if any has to be faced than continue down a muddy path.

Dianne: the bad news is that, for now, you are doing fewer deals. The good news is that when deal flow finally does pick up you will be jumping like crazy. No more of this, "Oh, the oooold Phase I will do" stuff.

Dianne said...

David, A lot of those old Phase Is are being put through the lens of today's underwriting standards and they're failing miserably. In many respects, the market's learning some hard lessons right now, including an important one about the value of having good solid due diligence conducted by a qualified environmental professional.