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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2016

Compliance Is a Juggling Act

Stay abreast of regulations that influence commercial mortgage lending

Compliance Is a Juggling Act

Because of the past years’ congressional gridlock, few new laws have come to pass. New rules and regulations have continued to flow, however. Players in the commercial mortgage arena should familiarize themselves with recent and new regulations that could impact the industry. These regulations include upcoming risk-retention rules, policies and laws surrounding marijuana dispensaries, and the changes made to the Foreign Investment in Real Property Tax Act (FIRPTA) this past year. Being skillful at understanding — and complying with — existing regulations while watching for the impact of new ones is what will set apart the best performers in the commercial mortgage market.

Commercial mortgage brokers don’t work in a vacuum. Regulations that impact lenders, investors and the overall commercial real estate market are relevant to their day-to-day business. In addition, commercial mortgage brokers are likely to be more equipped to help and advise borrowers if they understand the ins and outs of the rules and regulations with which lenders have to comply. To understand what might be influencing investment and lending decisions, the following regulations should be considered.

Risk retention

New updates to the Dodd-Frank Wall Street Reform and Consumer Protection Act will take effect at the end of this year. These updates include new rules regarding risk retention for conduit loans, also called commercial mortgage-backed securities (CMBS) loans, which are typically nonrecourse loans secured by income-producing properties. They have been attractive to many borrowers because of their nonrecourse status, as well as their competitive rates and loan-to-value limits. CMBS loans contain strong prepayment-type penalties and are difficult to modify, however.

CMBS loans have been around since the early 1980s, but they peaked in the period from 2005 to 2007, with more than $600 billion worth of loans issued in this period before falling off to virtually none in the crash. Volume has recovered in the past couple of years, with an estimate of $95 billion issued in 2015.

For commercial real estate, a decrease in CMBS issuance
could mean the potential for a liquidity problem in the market.

With CMBS, lenders make loans to borrowers, pool them, and sell them off in tranches as securities on Wall Street. Lenders typically sell 100 percent of the pool, recovering their capital to move on to the next deal. Like many other areas of real estate, the underwriting on the loans made in the 2005-2007 period have fallen under scrutiny, and many of those loans are creating losses to bondholders as they come due. There has been increasing criticism that lenders do not have “skin in the game.” A part of Dodd-Frank was thus directed to answer the question of how to incentivize originators to make quality loans.

The new risk-retention rules are set to take effect this December. These rules require lenders to retain 5 percent of their CMBS pool issuance for their own account. What effects will this have on commercial real estate? The risk-retention rules are being cited currently as a prime reason that many lenders are exiting the CMBS market entirely, because the business requires significantly more capital. In first-half 2016, CMBS issuance dropped 43 percent, from $54.5 billion to $30.7 billion.

For commercial real estate, a decrease in CMBS issuance could mean the potential for a liquidity problem in the market. Non-CMBS lenders have attempted to step up and fill this liquidity hole with new products, but it remains to be seen if enough financing will be available. Remember all those CMBS loans that were made 10 years ago? Those have all been coming due, and refinancing those deals could be an issue, especially with values being tight. Less available loans logically would mean an increase in rates on commercial loans — which could then have an effect on property values.

Everyone involved in the commercial mortgage lending arena, including buyers, sellers, refinancers and mortgage brokers, should be wary that financing may become more difficult and plan financing and refinancing well in advance.

Medical marijuana

It has been nearly 20 years since California legalized medical marijuana. Since 1996, 24 other states and Washington, District of Columbia, have followed suit, and in four Western states (Colorado, Washington, Oregon and Alaska) recreational marijuana is legal. More states, including California, are looking at passing similar legalization laws in this November’s election.

This legalization of medical and recreational marijuana has created a boom of sorts for retail and other properties to be repurposed as dispensaries. It is critical to understand that marijuana is still illegal under federal law, and under the Supremacy Clause of the Constitution, federal laws take precedence over any state laws. Federal officials have taken the stance that they currently are not enforcing marijuana laws against legal dispensaries in some states, but that could change at any time. In addition, because marijuana is illegal under federal law, dispensaries are ineligible to bank within the U.S. banking system.

Many property owners still avoid leasing to dispensaries so they are not associated with a drug industry. In addition, knowingly allowing illegal activity on one’s commercial property is typically a technical violation of a property owner’s loan. Renting a space to a dispensary may unwittingly cause a landlord default with other tenants, depending on what those other leases say. Owners and commercial mortgage brokers also should take into account that without typical bank accounts, these businesses may hold a lot of cash on site, making them potentially higher targets for robberies.

There are still significant barriers for those looking to get involved in the real estate aspects of dispensaries. For those who are comfortable with the risks, there have been — and will continue to be — opportunities, however. Commercial mortgage brokers should advise their clients who are looking to lease to marijuana dispensaries to consult with an attorney who specializes in this legal area.

Commercial mortgage brokers should advise their clients who are
looking to lease to marijuana dispensaries to consult with an attorney.

Commercial leases on dispensaries have seen many additional provisions, such as expanded rights of entry, representations as to permitted use, and greater indemnity provided to the landlord. Strengthening the terms of the lease with the dispensary tenant helps protect the landlord from exposure to legal action.

FIRPTA changes

The FIRPTA reform provisions went into effect this past December. The reforms include the following:

  • Higher threshold. In the past, foreign investors owning 5 percent or less of publicly traded real estate investment trusts (REITs) were not subject to FIRPTA taxation upon the sale of a REIT’s stock or the receipt of a capital gain dividend from a REIT. The reforms increase this threshold to 10 percent.
  • Foreign pension-fund exemption. The reforms exempt qualified foreign pension funds and entities wholly owned by such funds from FIRPTA taxation, which equalizes the tax treatment of domestic and foreign pension funds on the disposition of U.S. real property interests.

These changes have made it much easier for foreign capital to flow into the real estate market. The additional foreign capital may have helped to fuel real estate price increases so far this year.

•  •  •

These three legal issues are just a sample of regulations that have influenced commercial lending and the overall commercial real estate market. More changes are expected in the coming few months along with the presidential election and the makeup of a new Congress. Commercial mortgage professionals should continue to watch not only for what new laws are being passed, but also for how existing laws are being regulated and enforced. 


 


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