Nascent signs of economic recovery bode well for the commercial real estate sector, which lags the economy, but the ongoing correction in the sector is not yet done.
Not only that, any commercial real estate recovery in the next year or two may be tempered by an accounting regulation that will take effect in January and impact all sorts of securitization avenues.
In mid-June, the Financial Accounting Standards Board (FASB) came out with its final ruling on FAS 140, on which it has been working for a few years now in a bid to reign in abuse in the use of special purpose entities (SPEs).
In a statement, Robert Herz, chairman of FASB, noted, "These changes were proposed and considered to improve existing standards and to address concerns about companies who were stretching the use of off-balance-sheet entities to the detriment of investors."
The new standards are expected to help provide better disclosure to investors about a company's use of SPEs, and the associated risks, by doing away with some existing exceptions and making for enhanced disclosure requirements.
However, from the point of view of the industry, these additional disclosures could create further headaches and limit the benefits of securitization activities if a financial institution has to consolidate assets on its books that it might have had more leeway to take off its balance sheet previously.
Richard Jones, an attorney with the law firm of Dechert, who is liaising with the FASB on behalf of the Commercial Mortgage Securities Association (CMSA), noted, "At some level, the focus on QSPVs was born of the abuses of qualified special purpose vehicles in the Enron case. It's regrettable that people who committed fraud gave rise to such cynicism about SPEs, which were merely the chosen tools for those schemes."
He expects the changes to have "a very significant negative impact on securitization."
For one, the accounting body has done away with the concept of Qualifying Special Purpose Entities (QSPEs), vehicles that could be used to transfer assets off a financial institution's balance.
Instead, if an institution is deemed to be the primary beneficiary of a Variable Interest Entity, a format that includes many SPEs, it will have to consolidate the VIE's assets and liabilities on its balance sheet based on certain criteria.
In a related move, changes have been made to enhance the scope of requirements for consolidating the assets and liabilities of VIEs.
A company is required to consolidate assets in which it has a controlling interest, under accounting standards. In addition to the quantitative standards that are currently used to determine this, some qualitative standards will be used in the future to determine controlling interest.
Companies will also be required to provide more input about their involvement with VIEs and any significant changes in risk exposure due to that involvement.
The new standards call for an ongoing reassessment to determine if a VIE needs to be consolidated by a company. Under current standards, even as credit market conditions impacted the expectation of loss on securities, no ongoing reassessments had to be made about consolidation.
Jones believes that these changes will simply make deals more difficult to do. "It is extra transactional friction," he said. "There's extra cost, and it will eliminate structures and participants from transactions because of worry about accounting treatment. This is not positive change."
On a more positive note, speakers at the CMSA's recent annual convention in New York expressed optimism that the economy is getting better and that commercial real estate will follow.
Even then, there is scope for further deterioration considering that net operating income in the sector could decline 20%, according to a speaker who advised prospective buyers to anticipate erosion up to 2010.
Anticipate a peak-to-trough decline of 30% to 50% in property values, noted another speaker. Some property sectors are expected to be worse hit than others. For instance, while multifamily properties, which are supported by the activity of the government agencies, may see their values go down 20% to 30%, others such as hotel properties and office properties could see a steeper drop of 40% or more.
Retail properties are also likely to see more of a negative impact, considering that consumers have been less free-spending than usual of late.
And while excess construction has not been a negative for the market in this cycle, an imbalance has come about due to the destruction of demand. Some projections see commercial real estate vacancies topping those of the early '90s in this cycle. One speaker expects that they could get to 20%.
Even high-quality buildings in good markets such as New York are seeing pain in the current environment, one speaker said, pointing out that while markets like New York are immune to overbuilding, they are not immune to overleverage.
Another sign of trouble is in the form of "zombie loans" that are not good enough to be refinanced but are not bad enough to default either, one speaker noted. If the economy recovers by 2011, these zombie loans will not face any problem with refinancing, another speaker expects.
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