MCC: To help get our discussion started, could one of you give a broad overview of Clifford Chance's work in the real estate sector?
Wisner: Our work in the real estate sector covers all classes of commercial real estate – office, retail, multifamily, mixed use, hotels, casino resorts, and major development projects, and our clients include non-U.S. investors, including sovereign investors in U.S. real estate transactions and U.S. investors in connection with outbound investment strategies. We also cover the full spectrum of real estate transactions – from all manner of public and private equity and debt financing to the actual purchase and sale of property. The work of Clifford Chance in the real estate sector is performed by a fully integrated cross-global team of real estate, corporate, private funds, finance (including experts on sharia-compliant financings), tax and capital markets lawyers who offer their skills in numerous jurisdictions and a multitude of languages.
As a result of our global footprint, we have particular expertise in cross-border issues and have the capability to work on large and complex real estate debt and equity transactions across the Americas, Europe, the Middle East and Asia and to represent new entrants to the markets where we practice. It's this worldwide platform and our ability to perform almost any type of work in the sector that sets us apart from other law firms.
MCC: Staying with the international theme for a moment, the U.S. REIT appears to be catching on globally. Jay, your firm advised on the first Mexican REIT, and also filed for an IPO of a U.S.-listed REIT composed solely of European real estate assets. What's behind the globalization of the product?
Bernstein: As an asset class, real estate requires a high level of local expertise, but attracts investors from all corners of the earth. The globalization of the real estate investor is a big driver behind this trend, as is the adoption of REITs or REIT-like structures by more than two dozen jurisdictions around the globe.
Collaboration certainly played a big role in our involvement in the launch of Mexican FIBRAs. The team that worked on FIBRA IPOs and follow-on offerings included members of our core REIT team, like Jake Farquharson, working side-by-side with our Latin American capital markets team. In addition to the necessary product and legal expertise, whenever you're working to help bring a new product to market, a certain degree of thought leadership is needed to develop and establish standards and approaches required for success. Many of the approaches we helped develop are now commonly used in the FIBRA space.
We're very proud of the contribution our firm has made to the Mexican REIT market. Beyond that, as you mentioned, we're now seeing increasing interest in forming U.S. REITs using European real estate assets – for example, a REIT comprising Scandinavian office and industrial properties. I think the global expansion of the product speaks to its attractiveness to investors. It's an exciting time to be a REIT lawyer.
MCC: Bob, you and your team do a lot of work in the RMBS and CMBS space in the U.S. and abroad. What have activity levels been like for cross-border securitizations and those in emerging markets like South America?
Gross: Most of the securitizations in Latin America have been related to infrastructure, like the Lima Metro and Red Dorsal transactions that our project finance colleagues in New York completed earlier this year. We are seeing some activity for receivables securitizations out of Brazil, like the Rioprevi deal (securitization of oil royalties for the State of Rio pension fund) and some attempts to securitize off-take obligations with respect to contracts in the oil and gas and mining space.
More broadly, we're seeing increased interest in European CMBS wanting to sell to 144A investors and access the U.S. markets. However, the regulatory changes – for example, Regulation AB II, diligence provider rules and risk retention – have deterred most deals from ultimately going 144A. I do have the impression though that dealers and originators are getting their arms around the implications, and so we should see volumes increase over the next year.
MCC: Domestically, there continues to be a great deal of discussion about the implications of Basel III. Do you feel the market has the clarity it needs to comply?
Wisner: The short version is that the requirements of Basel III, as they relate to loans for the acquisition, construction and development of commercial real estate, impose additional capital commitments on banks for "high-volatility commercial real estate loans" in their portfolios (150 percent instead of 100 percent). So, if a bank makes a $100 million HVCRE loan, for purposes of Basel III, it takes on the risk of having made a $150 million loan.
An acquisition, construction or development commercial real estate loan can avoid being classified as an HVCRE loan by meeting each of three conditions:
- The loan-to-value ratio must be less than or equal to the applicable maximum loan-to-value ratio mandated by the bank regulators for particular types of loans, which are: raw land (65 percent); land development (75 percent); commercial, multifamily and other nonresidential construction (80 percent); one- to four-family residential construction (85 percent); and improved property construction (85 percent).
- The borrower has contributed capital to the project in the form of cash or unencumbered, readily marketable assets (or has paid development expenses out-of-pocket) of at least 15 percent of the real estate's appraised "as completed" value; and
- The borrower contributes the required amount of capital before the bank advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the term of the loan in a manner sufficient to continue to satisfy the 15 percent requirement.
The problem is that there are questions regarding what qualifies toward the 15 percent equity requirement, which is based upon the final value of the project and not the construction cost, as was traditionally the case. Since banks have to avoid having their acquisition, construction and development commercial real estate loans being designated as HVCRE loans, many banks have become quite conservative. Moreover, the 15 percent equity requirement not only requires an additional equity commitment, but such equity must remain in the property during the entire term of the loan, which limits the ability of a developer or investor to put the capital to other uses.
MCC: Another piece of regulation getting a lot of attention is the Alternative Investment Fund Managers Directive (AIFMD.) Roger, how has AIFMD impacted capital raising for real estate private equity funds? In your experience, are fund managers less interested in raising capital in Europe because of it?
Singer: I wouldn't say there's less interest. But AIFMD has resulted in a complex and evolving set of regulations covering the marketing of private funds across the member countries of the European Union. While starting from the same point, the rules are adopted by each country and vary substantially from the most lenient countries to the most restrictive. Managers are no less interested in raising European capital, but the costs and the complexity mean that some managers are now choosing to forego European marketing or limiting it to select countries. Conversely, the ones who do decide to proceed are making more vigorous efforts to increase the return on their regulatory investment and to capitalize on the decrease in competition from other U.S. managers.
MCC: And are those managers focusing on any particular asset classes at the moment?
Singer: Industrial investment has been particularly robust recently with a number of large, highly publicized transactions, in addition to a continuing robust market in more ordinary deals. If I were to identify one trend it would be core and core-plus investing, utilizing traditional closed-end structures as well as a marked increase in open-end vehicles. We have seen growth in both multi-class open-end funds and funds focusing on a specific property type, in part motivated by the evident demand from investors for both.
MCC: Bob, what about the RMBS market? With the U.S. housing market rebounding, what, if any, changes have been made to the way these assets are securitized?
Gross: We haven't seen the private label RMBS rebound. Newly originated residential mortgage loans that meet conforming limits continue to be securitized through Fannie and Freddie. There have been securitizations of so-called jumbo prime mortgage loans, typically by REITs and occasionally by funds. For the most part, the jumbo prime securitizations have involved a great deal of diligence and disclosure regarding the credit of the underlying loans. Aside from the new originations market, we continue to see securitizations of non-performing and re-performing residential mortgage loans. We expect that market will continue to be active for some time.
MCC: Coming back to REITs for a moment . . . Jay, in light of the product's recent growth and diversification, are there any major challenges for REITs on the horizon?
Bernstein: We are fortunate to have a stellar team of capital markets and tax partners who focus a great deal of their time on REITs. Collectively, we're in the market every day meeting with clients and listening to their ideas and concerns. Many of our nation's best real estate companies are asking whether accessing public capital markets is the right choice for them. In a world that seems once again awash in private capital, is going public the right answer, especially with the core institutional public REIT investors demanding so much to gain their participation in an IPO?
I also think we are going to find other challenges as the non-traded REIT market evolves into its next phase. We believe there is still room for the REIT to continue its evolution both structurally and geographically; it will be important for those of us who advise this market to stay at the forefront of the changes that are occurring as well as those that still lie ahead of us.
MCC: It seems real estate finance has undergone a bit of an evolution itself given the emergence of shadow banks under Basel III. What role do these non-bank investors play in the market today?
Wisner: Well, it's not just Basel III. It's true that under the current regulatory framework, banks are facing challenges that may limit or prevent them from underwriting loans as they have done in the past. But there are also significant levels of capital and liquidity in the real estate sector right now, and the result is an environment that affords investors the opportunity to provide bank-style lending, capital markets financings, securitization vehicles, and permanent capital to borrowers who have to go outside the traditional sources of debt for their real estate investments. These non-bank providers are largely unregulated and include real estate investment funds, CMBS, mezzanine financing, crowdfunding and EB-5 facilities. Alternative lenders have the ability to dictate the terms of the loans, which many times are much more restrictive than traditional loans, and certain loans, such as mezzanine loans, are viewed as being riskier, which increases the cost of capital to the borrower.
During the financial crises, many of the alternative lenders were viewed as having caused or contributed to the problem. Moreover, some began buying distressed debt as "loan-to-own" investments, limiting the ability of the borrower to restructure their defaulted loans. Alternative lenders are now an important part of real estate finance structures, and we are regularly involved in transactions that include institutional and non-bank debt at various levels. These transactions might otherwise not be feasible if the sponsor had to look only to traditional funding sources. Non-bank providers of real estate loans are here to stay, and I expect that new sources of alternative lending will be developed in the years to come.
MCC: Roger, are there unique issues that affect the creation of real estate funds, as opposed to other kinds of private funds?
Singer: The United States, similar to many countries, taxes the ownership of real estate differently than the ownership of stocks or other securities. This harsher treatment is an issue particularly for non-domestic investors. As a result, real estate funds that have non-domestic investors often require fund and/or investment structures that are more complicated than those found in similar funds whose assets are not real property. Also, some investors are not familiar with these issues and need more education about them and the possible solutions, especially when those solutions involve a number of entities and the use of leveraged structures.
The other big difference in real estate private equity is that many managers provide services to the real estate assets, such as property management, that would otherwise be provided by third parties. This can mean profits to the manager that are not tied to the performance of the investments.
MCC: So what are fund managers doing to get deals done in the current market environment?
Singer: While many clients tell me that the market is frothy, real estate is an inefficient market, so they must focus on identifying and unlocking value. This allows them to find opportunities that are not priced into transactions. Another strategy fits with the growth in core funds I described earlier: buy core properties that are less susceptible to changes in value because of their nature and because of the long-term hold periods for those assets that lasts well beyond the next market cycle. In the open-end structures, it may be possible to hold assets for many multiples of the typical 4-6-year hold period for closed-end funds.
MCC: Jay, your firm has advised on some very innovative real estate transactions. How did these deals come about, and should we expect to see more of them going forward?
Bernstein: We strive to be innovators in the real estate space. We believe that a lot of innovation can be found at the connection points of distinct practice areas. As a firm, we take a think tank approach to problem solving and come together both within and across practice areas.
In my practice, we ask questions like, where can the REIT vehicle be taken next? or, where can we bring REITs or REIT-like structures to other industries? Partners in our capital markets, corporate, finance, tax and real estate practices meet on a regular basis to talk about challenges and opportunities. From that, we work to develop structural ideas that we think would be valuable to clients by finding those connection points in other practice areas where we believe we excel. An example of this would be the extension of the REIT vehicle to the clean energy and sustainable infrastructure industries. Our Energy team had worked on a series of clean energy project financings and gained valuable expertise along the way. We put our heads together with this team to better imagine how the REIT structure could work for ownership of clean energy assets. We also worked with our best minds in the securitization space to come up with a number of structures that are valuable to mortgage REITs.
The key for us is bringing people together from different disciplines and perspectives to work on a common challenge or problem to help our clients achieve their objectives. It's always gratifying when you can do that and to continue to be asked to take on clients' most difficult structural challenges – the ones that require real collaboration and creativity. Those are the deals we always enjoy taking on.
Published September 3, 2015.