Private and preferred equity seems to be a hot topic; why do you think it has become appealing to investors?
We are seeing an uptick in the construction lending space, which is resulting in more preferred equity structures than mezzanine loan structures in transactions that involve traditional bank financing. This is largely due to the new high volatility commercial real estate (HVCRE) regulations under the Basel III accord, which require, among other things, borrowers under acquisition, development and construction (ADC) loans to have contributed equity to a project equal to at least 15% of the projected “as completed” value of the project in order to avoid classification of the construction loan as an HVCRE loan for bank regulatory capital purposes. If a loan is classified as an HVCRE loan, the lending bank must maintain a capital reserve of 150% of the loan amount, rather than at 100% for non-HVCRE loans, making these loans more expensive for banks to hold on their balance sheets. Under the current guidelines, mezzanine loan indebtedness does not qualify as “equity” for purposes of the HVCRE exemption, so borrowers and sponsors are gravitating towards preferred equity structures; and we expect that this trend will continue for the foreseeable future.
Are there specific equity investment trends you are seeing? Is it in all sectors or is real estate a leading indicator?
We are seeing more non-bank lenders entering the mezzanine lending space for construction loans, particularly for projects above $300 million since the 15% equity requirement is more of a hurdle for large projects. These lenders are offering borrowers “stretch” loans that involve both senior and mezzanine debt. Once the loan has been made, the non-bank lender will either retain both pieces or, more typically, sell the senior piece to another lender. The new regulatory environment is definitely making it more difficult for banks to make loans at attractive prices and to continue to hold those loans on their balance sheets. We’re seeing the trend tilt away from bank financing to non-bank financing in virtually every sector of the market, so it is not just limited to real estate. This is clearly a result of legislation that was passed in response to the 2008 financial crisis, and we also expect this trend to continue for the foreseeable future.
The real estate market is steadily rising, generally speaking, but can the financial sector benefit from rising interest rates—what are the positive and negative impacts you are seeing?
Although the federal government hasn’t taken action to raise interest rates yet, we expect that they will do so soon, and we expect that there will be both positive and negative impacts resulting from the rate increase. The upside is that rates will likely rise due to an improving economic outlook, which should trigger more economic growth and higher consumer spending, resulting in higher capital rates, occupancy rates, rent rates and richer valuations for real estate in general. The downside is that the costs of financing investments will increase, spreads will tighten and investors may begin to look at other asset classes that may offer more attractive investment opportunities.
You recently participated in Alston & Bird’s West Coast Finance Forum. What are some of the key takeaways from the forum?
The general consensus of the forum was that the commercial real estate market is not currently an investor’s market, but rather a borrower’s market due to the artificially low cost of capital and increased competition by lenders. “Value-add” is currently driving the market as investors seek opportunities to renovate existing properties and increase rents. Market participants don’t believe the market is overheated, but rather in a state of equilibrium due to slow job and wage growth and deteriorating conditions in the global economy, particularly in China. Investors are also concerned about the loosening of underwriting criteria among lenders due to increased competition. In addition, there is a definite trend towards non-bank lending due to existing regulatory headwinds. As for the much discussed “wall of maturities” in the CRE market, some market participants view it as a myth since it seems to be a moving target.
What kind of investments can be funded with EB-5 funds—what factors should be considered when working with a foreign investment?
Typically, EB-5 investments include real estate development projects that revitalize communities and create and support jobs, infrastructure and services. These investments are usually made through a limited partnership or limited liability company structure. Foreign investors in these entities should consider the tax impact of FIRPTA (the Foreign Investment in Real Property Tax Act), which is designed to ensure that all gains by foreign investors in U.S. real estate are subject to U.S. tax prior to expatriation. In addition, foreign investors should consider the impact of U.S. withholding taxes on rental income and the effect of potential state and local taxes. Foreign investors may get better treatment on these issues if they are entitled to benefits under a tax treaty between the U.S. and the jurisdiction in which they reside. The EB-5 regional center program’s statutory authority is set to expire on December 11, 2015. It remains to be seen whether this will be a viable, or even available, program going forward.