Though signed into law nearly two years ago, the Dodd-Frank Act — the federal statute drafted in the wake of the financial crisis to increase regulations over financial institutions — is still being debated by the many government agencies responsible for its implementation.
Indeed, a slew of new Dodd-Frank rules have not gone into effect yet, and some are still being codified. But the 2,300-page document, a political hot potato, has already begun to impact the actions and mind-sets of many New York City real estate players.
In general, many in the industry are worried that the more restrictive lending rules it calls for, which will force banks to put more skin in the game, will increase borrowing costs.
Still, there is a recognition, even among those who have concerns, that some of these measures could help prevent the next economic bubble. “It’s a good idea to make someone other than a credit ratings agency underwrite the risk of the loan,” said Robert Ivanhoe, a partner at law firm Greenberg Traurig, referring to banks.
But restricted lending, real estate players including Ivanhoe argue, could be particularly problematic when it comes to the many commercial owners whose five- and seven-year mortgages were originated near the market’s crest and are now coming due. That’s because those borrowers are not likely to lock in the same favorable loan terms — and may even need to put more equity into their deals — when they attempt to refinance.
“The real question is, is the cost of improving disclosure and capital standards worth the reduction in lending when we have $1.2 trillion to refinance before 2017?” said Mike Flood, vice president of policy and research at the Commercial Real Estate Finance Council, an industry group based in Washington, D.C.
Proponents of the law say that these are the kinds of regulations needed to ensure that big banks don’t run afoul of the system again. And many say the rules don’t go far enough.
Below is a breakdown of some of the Dodd-Frank measures that real estate players are paying attention to.
Changes to Investment Advisers Act
One piece of Dodd-Frank legislation that has already been enacted is a revision to the Investment Advisers Act of 1940.
The amendment has been interpreted by some to mean that private funds with real estate assets must register as “investment managers” and be regulated accordingly. Once funds are labeled with this new classification, they have to follow Securities and Exchange Commission laws. They would have to create a “code of ethics,” hire a compliance officer and “review their trades” said Stephen Cohen, a partner with law firm Loeb & Loeb.
Making these changes will be “a major cost burden,” said Ivanhoe, who noted that the change could raise the cost of operations for a given fund by about 1 percent a year.
Another effect for companies required to register under the law will be a dramatic change in how those at the helm can be compensated.
Real estate funds frequently give “carried interest” — often called a “promote”— to a general partner in a development or a building purchase. The promote is a financial interest in the long-term capital gain of a development. Much like hedge-fund managers, developers are compensated this way because then they cannot realize the gain until after the project is complete.
If a project doesn’t do well, the developer may never realize that profit, but if it does, the money is taxed as a capital gain, not income.
“The carried interest is the bedrock of most real estate deals that I have seen,” explained Peter Hauspurg, CEO of Eastern Consolidated.
But if real estate funds comply with this revision, this sort of performance-based compensation will be limited for “managers” of funds whose clients have invested less than $1 million or have a net worth less than $2 million.
In addition, sources say, the change will result in a reduced incentive for some developers to take risks on new buildings. Nabbing a share of the upside is “the only way to get compensated,” according to Hauspurg.
Adding to the uncertainty around these changes is that, like other parts of Dodd-Frank, it’s not yet clear exactly which companies will be deemed “funds” and thus impacted.
The Volcker rule was originally proposed by Paul Volcker, a former Federal Reserve chairman who President Barack Obama also appointed to a panel of economic advisors.
The rule — which is designed to prevent banks from making speculative bets — is scheduled to go into effect this month and bans “proprietary trading,” meaning that banks can no longer invest their own capital in funds they operate.
Proponents say the Volcker rule will prevent banks from becoming “too big to fail,” by eliminating some of the riskiest trades, which only became legal after the repeal of the Glass-Steagall Act in 1999. They note that Volcker is meant to prevent banks from needing additional bailouts on the taxpayer’s dime.
Still, that could mean the closure or selling off of many private equity and hedge funds that invest in real estate funds operated by banks, sources explained.
As a result, funds like Goldman Sachs’ Whitehall and Morgan Stanley’s MSREF would need to be sold, dissolved or spun off into separate companies with no formal relationship to the bank.
Nonbank fund sponsors — such as the Blackstone Group, Apollo, the Carlyle Group and Colony Capital — could end up buying that business.
“It could create a consolidation in the market,” explained Evan Levy, a partner at Skadden, Arps, Slate, Meagher & Flom. Or another new ownership structure could be invented to fill the vacuum, Levy said.
He noted that there are exemptions for real estate in the Volcker rule, and banks are in the process of investigating whether their funds can qualify for them.
A major element of concern for real estate pros is Dodd-Frank’s impact on construction lending.
The law puts new restrictions on “high volatility commercial real estate loans,” which may be interpreted to include certain construction loans, experts explained.
The rules are intended to force banks to assess risk more carefully. While not all construction loans will be deemed high volatility — and the definitions are still in flux — a speculative office building will almost certainly be put in the category, while a preleased warehouse, for instance, will not, experts said.
Instead of the 8 percent reserve banks now must hold on their books for each loan they issue, when these rules go into effect next year banks will be required to hold 12 percent. The idea is that they’ll avoid loans that are too risky in favor of more conservative loans because they’ll have more money on the line.
But Richard Podos, president of New York–based Lance Capital, a real estate finance company, argued that the requirement could cause capital to dry up for developers.
The lack of capital would not only hurt real estate developers, but community banks for whom small-to-midsize construction loans are the bulk of business as well, Podos said, adding that nationwide, community banks do 40 percent of construction lending.
The change could also mean less development in New York’s outer boroughs, where smaller developers, who are more reliant on construction lending, tend to do business, he said.
Large REITs, like Brookfield, for instance, will do “whatever they need to do to make sure their construction loan is not deemed high volatility,” Podos said.
Perhaps most significant in its ramifications for real estate are the new constraints that Dodd-Frank will create for the commercial mortgage-backed securities market.
CMBS currently help facilitate the cost of commercial lending, traditionally for projects and building purchases outside of the “trophy range.” But new restrictions on CMBS could cause tighter lending for deals where loans are repackaged and resold, experts said.
Dodd-Frank requires mortgage originators to retain 5 percent of any loans they repackage and sell off. That means investment banks will “likely be knocked out of the CMBS game,” said Stuart Eisenberg, a partner at BDO, an accounting firm with a substantial corporate real estate practice.
Investment banks “don’t want to accept the low yield for the high risk” that CMBS will present once risk retention goes into effect, he explained.
Martin Schuh, assistant vice president for government affairs of the CRE Finance Council, said risk retention rules will likely be finalized in the third or fourth quarter of 2012, and won’t be implemented until 2013.
Greenberg Traurig’s Ivanhoe said legislators’ hearts are in the right place with new requirements, but implementation could mean more pain for the industry.
While he believes the new rules help eliminate moral hazard, they could also inhibit real estate lending.
“It could be devastating for the economy and growth,” he said. “Most people would say they have gone too far.”