Dodd-Frank Changes Could Lead To Increased Investment Opportunity In Secondary Markets

In May, Congress approved rolling back regulations put in place for midsize and regional banks after the Great Recession. Under prior legislation, banks with at least $50B in assets had to undergo stress tests from the Federal Reserve and were prevented from making riskier investments. The new legislation loosens restrictions on banks with under $250B in assets, improving flexibility for smaller banks and credit unions.

For commercial real estate, the easing of lending regulations could open the door to increased investment, particularly in new construction in secondary markets that institutional lenders had considered too risky in previous years.

“Regional or even community banks, depending on what markets you are in, have traditionally been the funding sources for many boots-on-the-ground developers who would have otherwise been stuck with these tough regulations under Dodd-Frank,” CohnReznick partner Tim Trifilo said. “They will now have more freedom to make their own risk-adjustment decisions on lending. That will have the result of changing many dynamics, including freeing up and having new entrants in those markets.”

The original Dodd-Frank reform law went into effect in 2010, after the bankruptcy of several large banks during the financial crisis. The reform covers 16 major areas, with the primary objective to prevent banks from exhausting their reserves or lending to unqualified borrowers.

Under the Volcker Rule, banks are limited in the amount of capital they can invest in their own private equity and hedge funds. This includes speculative investment in real estate funds. Prior to the ruling, Morgan Stanley invested 9% of its Tier 1 capital into its hedge fund, private equity and real estate funds. Goldman Sachs invested approximately 22%.

Increased scrutiny over these investments, CRE experts argue, impacts the securities market by increasing costs for banks to lend, which in turn drives up the cost of loans for borrowers. Commercial mortgage-backed securities, in particular, have seen reduced liquidity, impacting the availability of mortgage financing for developers of grocery stores, apartments, office buildings and warehouses in secondary markets.

It is in these markets, where a small handful of real estate families and community banks drive development, that Dodd-Frank limited activity.

“Many of those banks have exited that business because of all the regulation and focused on other areas because it was too hard with the interest rate environment to make any meaningful spreads after the cost of compliance,” Trifilo said. “Not to mention the capital requirements they had to follow under Dodd-Frank.”

With the easing of regulations for midsize banks, there is an increased opportunity for investment in secondary and tertiary markets, Trifilo said. All other sectors of CRE would benefit from having this increased liquidity, and middle markets will now have better access to capital, including foreign investment.

Regardless of the impact that the changes to Dodd-Frank will have on CRE investment trends, there has been a recent resurgence in private real estate funds raising capital for value-add and opportunistic investments. Private real estate funds raised $33B between January and March, the highest level raised during Q1 since 2008. Institutions in 2017 increased real estate investment by 10.1%, up from 9.9% in 2016, NREI reported. Industrial, in particular, has become a popular asset class among banks and other institutional investors.

Despite strong activity, concern remains that the market will overheat, and investors should always be cautious to look at investment pro forma and economic outlooks.

“The issues get tricky when you have other markets for loans that may have been made with one institution and then that risk is sold to another institution,” Trifilo said. “That initial judgment of risk was made by an institution that could stand to make more in upfront fees rather than the risk of the loan, and that’s where it gets tricky. ”

Ultimately, allowing banks, investors and financial institutions to make their own judgments on risks will benefit the economy and commercial real estate, Trifilo said.

This feature was produced in collaboration between Bisnow Branded Content and CohnReznick. Bisnow news staff was not involved in the production of this content.