Former Federal Housing Commissioner (1989-90) C. Austin Fitts. now president of Hamilton Securities in Washington, sketched a picture of the commercial real estate finance industry of the future in an interview with The Mortgage Marketplace. Fitts is president of the Hamilton Securities Group Inc. a real estate in Washington. DC. Following are excerpts from the interview. Additional excerpts will be published in future issues. MMP: What's your prescription for the commercial real estate market?
Fitts: In order to work, the first thing that needs to happen in the market is for the current outstanding debt to be restructured. and by that. I mean to be rewritten into an A and B and a C piece. Second debt needs to be put in a form where it is either securitized or it is held by an entity that can access the capital markets. It's critical that the debt be held by an institution that can freely access the capital markets without the burdens of regulation and capital requirements. The debt must be made more liquid. whether it's through securitization or it's a variation. liMP:. What is your goal at Hamilton Securities? Fitts: After that process of debt restructuring occurs in the mortgage community. Hamilton Securities is aiming to do the equivalent for real estate equity. We are returning to a world where real estate profit is determined by cash flow. not primarily by inflation and rising asset values. And several things are going to happen. First. the company or the organization that can maximize its cash flow is the one that can provide the best services (i.e., get the highest price and the lowest cost). On the service side. what that means is that instead of buying and selling assets for profit. companies are going to he in the business of delivering housing services or office space services that are attractive to the market. And that will require a real change in attitude.
I'll give you a very particular example. If you walk into any multifamfiy company today. or go to any multifamily industry association. you'll never hear the word 'client.' Rarely do you hear the word 'tenant.' What you hear is a great deal of discussion about property and the values going up and down. The industry is going to have to realize that it is in a business of providing services to people. and that the company that is going to make the most cash is the one that does the best Job of that. Now, I said also that the second haft of that equation is the lowest price. The organization that can deliver those housing services or office services at the very lowest price is the one with immediate access to all parts of the capital market. Let me explain what I mean. Let's say such a company sees an investment. perhaps a building. it wants. Bam! It can go into the commercial market. It can roll it over and go fixed-rate. long-term. to raise money. It has the choice of setting up individual properties with individual mortgages. Or it can go with general corporate financing. It can also sell stock. These investors have access to derivative products. that in combination with debt at the property level and at the corporate level allow them to carry substantially more debt with less risk than someone who doesn't have that kind of financial operation. What this leads us to is the fact that a large capitalization real estate operation can finance at substantially lower cost than its competitors. Because of that. and because the dollars will he in the capital market. the pressure on the real estate industry to reorganize into stock corporations or some other entity that can access those dollars. will be tremendous and continuing throughout the decade. Right now. most of our work at Hamilton is on the debt restructuring because that has to happen first.
But in the long run. our focus is in helping the small real estate organizations make the transformation from being stuck in a Neanderthal world where they have to go through very complicated and expensive processes to get financing, to one where they have free access to the capital markets.
And that means transforming a company into an organization like a stock corporation where it can acquire and grow using either cash or securities. But it needs to grow from a certain size to something big enough to move into the capital market.
MMP:. Do you have a feel for what that is? What size is big enough to play the game?
Fitts: Draw a picture of two large pillars almost next to each other. The capital markets pillar on the left side and the current pool of realestate finance is on the right. Draw an arrow that goes from the right hand side to the left, and up the left hand side. the capital market.
i think the winners in this game are not going to be the firms doing the huge RTC securitization deal. That's not the making of a company. that's the making of the liquidation process. I think the winners are always going to be the smart entrepreneurs who start on the right hand side and they build. They're not big enough to go into the stock market with an initial public offering, so they go through a venture capital route, or to the private placement market.
And they start teaming up with other entrepreneur. They build and they continue to lower their overall cost of capital against their competitors as they go up the capital market scale.
Ten to 15 years from now you're going to be looking at a huge number of real estate organizations that you and I wouldn't describe as real estate organizations. We'll think of them more as service providers, but with outstanding stock market capitalizations of over a billion dollars. because that's what institutional investors want.
They want a large capitalization stock. And they're going to be very attracted to a whole new industry class. Now, who will the winners going to be? As I said, l think they're going to be the entrepreneurs.
The key is obviously not that they'll get the capital. The key is that they're going to use technology to provide superior sen, ices to the client. And because they're good at that, they'll get the capital.
Key Issues
*Housing Appropriatlons/Reauthorization. HouseSenate conferees Sept. 22 agreed to a House provision of an appropriations bill (H.R. 5679) that would eliminate HUD's authority to set limits for the amount of closing costs that could be financed. Both versions of the bill to appropriate money for the departments of Housing and Urban Development and of Veterans Affairs contained a provision to increase the single-family loan limit for Federal Housing Administration-insured loans to 95% of an area's median-home price.
Similar provisions are contained in the Housing and Community Development Act (H.R. 5334). passed Aug. 5 by the House on a 369-54 roll*callvote. The bill would reauthorize several housing laws. The Senate Sept. 10 approved its reauthorization bill. the National Affordable Housing Act Amendments (S. 3031). which does not contain loan size and dosing cost provisions (see The Mortgage Marketplace. Aug. 24. page 3). *Tax Bill. The Senate last week again took up the tax bill it was debating when it went out Aug. 13 for the Republican convention recess. The House July 2 passed by a 356-55 roll-call vote the Revenue Act of 1992 (H.R. 11).
The key provisions include:
Passive Losses--Both versions allow deduction of losses from real estate activities or a taxpayer materially takes part in the business. Real property trade or business includes development. redevelopment. construction. reconstruction. acquisition. conversion. rental. operation. management. leasing or brokerage trade or business. The House version allows deductions of real estate income from any income. not Just that from real estate.
Mark-to-Market--Both versions would require dealers in securities to list any securities not held for investment at market value. Those not held for sale or for investment must be treated as sold at fair market value on the last business day of the tax year. and any gain or loss would be taken into account in determining gross income. The definition of securities dealers applies to banks. thrifts and mortgage bankers and the definition of securities covers whole mortgages.
Intangibles--The House version would establish a 14-year amortization peried for specified intangible costs. including the cost ofacquiring goodwill and purchased mortgage servicing rights. The Senate version would establish a 16-year amortization period and does not include the cost of acquiring PMSRs.
Pension Funds-Both versions ease rules for pension fund investment in real estate that has been seized by banks or regulatory agencies.
Depreciation Recovery--Both versions would increase to 40 years from 30.5 years the depreciation period for certain real estate.
First-Time Home Buyers-The Senate version provides for a tax credit for first-time home buyers equal to 1096 of the purchase price up to a maximum of $2.500. The full Senate approved the credit before it left GSE Regulation. The Senate July 1 passed the Federal Housing Enterprises Regulatory Reform Act (S. 27 33) by a 77-19 roll~call vote. The bill establishes a new regulatory system for the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. The House passed a different version (H.R. 2900) Sept. 25. 1991. and a compromise version must be worked out in a conference committee. The Senate added several controversial banking amendments that have delayed action on a compromise.
The GSE legislation contains these major provisions: Regulator--An independent regulator will be established in HUD. The House bill has a similar provision. though the Senate version makes the regulator even more independent.
Capital Standards--The bill sets both minimum and risk-based capital standards. The House version is virtually identical except that it does not take into account. as does the Senate bill. the fact that defaults would be lower in a rising interest rate climate than when interest rstes were falling.
Affordable Housing--The bill sets targets for purchases of mortgages on homes of moderate- and lowincome borrowers. The numerical targets are identical in both bills, but the Senate version adds a requirement that 300/6 of all purchased mortgages must be on dwelling units in central cities. The Senate bill also lists purchases that can'tbe counted toward the goals, including refinancings of existing portfolios.
New Programs-GSEs that meet the capital standards can go directly to the HUD secretary for approval of new programs. The House bill gives the independent regulator a role in the approval process (see The Mortgage Marketplace. April 13. page 1). Bankruptcy Reform. The Senate on June 17 passed the Omnibus Bankruptcy Reform Act (S. 1985) by a 97-0 roll-call vote. Most important to mortgage lenders. the measure prohibits 'cram-downs' of the value of mortgages in Chapter 13 cases. The bill also allows a lender an interest in rents from a property of the lender meets the filing terms of the Bankruptcy Code. Another provision would require a bankruptcy Judge to decide within 60 days of a debtor's filing for bankruptcy whether to lift a stay on foredosure. Mortgage lenders are concerned about Title 2. which establishes a new Title 10 of the code to deal with small businesses. It eliminates the absolute priority rule for debtors eligible for treatment under the new chapter.
Extending VA Entitlements to Reservists. The Senate Veterans Affairs Committee has reported out a bill (S. 3108) that would grant reservists who complete their sixyear obligation eligibility for VA housing programs. The bill also would establish pilot ARMS programs. The house passed a similar bill (H.R. 939} March 3. The administration opposes the legislation.
Secondary Market Agencies
*Securities Market Participation. Fannie Mac has announced a program to increase participation by minority- and women-owned firms in the markets for its securities. *MultiLender Swap. Freddie Mac has added several enhancements to its MultiLender Swap program. The coupon range was expanded to 100 basis paints from 50. The highest acceptable note rate is 125 bp above the PC coupon and the lowest acceptable note rate is 25 bp above the PC coupon.
Ginnie Mac Remics. Freddie Mac will begin issuing Ginnie Mac-backed Remies and strips. Ginnie Mac is not permitted to issue its own Remics but Fannie Mac and brokerage houses have been using Ginnie Maes to back Remics for some time (see The Mortgage Marketplace, Aug. 24, page 1}.
Record RTC Sale. In the largest single transaction ever awarded by the Resolution Trust Corporation to a secondary market agency, Freddie Mac purchased approximately $1.5 billion in mortgages from HomeFed Bank of San Diego, now in receivership by the RTC. The mortgages represent both fixed- and adjustable-rate mortgages on about 16,800 homes.
Negotiated ARM Plans. Fannie Mac, effective Sept. 8, began making ARM plans that previously were negotiated available through the standard commitment window. This will make the plans available without a required minimum commitment amount. Fannie Mac also is now issuing commitments for standard certificate of deposit-based ARM Plans 1030 and 1031 through the standard commitment window and offering 1O-day commitments for all ARM plans through both the standard commitment window and the regional office negotiated transactions desks.
Forbearance for Borrowers in Disaster Arm. Fannie Mac and Freddie Mac have notified their seller / servicers to use their standard procedures for assisting borrowers affected by natural disasters, including Hurricane Andrew. The procedures include temporary indulgence, special forbearance and assistance with obtaining federal disaster relief and insurance payments.
Affordable Housing Information. Fannie Mac and Freddie Mac announced that they will require from seller/servicers additional information relating to the race, sex and income of borrowers. The new requirements, which will go into effect Jan. 1, antidpate passage of the GSE legislation that will set specffic affordable housing goals.
Affordable Gold. Freddie Mac announced its new program to increase homeownership for low- and moderateincome families. The minimum down payment Is 5%, with 3% to come from the borrower's funds and 2% to come from grants, gins or unsecured funds. Self-Employed Borrowera. Fannie Mac has revised its guidelines for underwriting self-employed borrowers. Among other changes, for loan applications taken after Sept. 1, self-employed borrowers will have to give the lender written permission to request copies of the borrower's tax returns from the Internal Revenue ServIce. Also, if a borrower's application is dated within 120 days of the end of his or her tax year, the borrower will not have to give a year-to-date profit-and-loss report for the current year.
Payoff Fees. Fannie Mac said servicers may charge a borrower a fee for releasing, conveying or discharging the company's lien against the property only if the fee Is paid to a third party for Its services. In cases where state, county or local law requires payment of recordation fees by the mortgagee rather than the borrower, the servicer must pay the fee, but will be reimbursed by Fannie Mac.
Housing and Urban Development
Minority Banking. Under its new Minority Banking Initiative, HUD will deposit approximately $41 million in funds held by FHA-insured multifamily properties Into five minority-owned banks. The banks are Boston Bank of Commerce; Hamilton Bank, Miami; Highland Community Bank of Chicago; Women's Bank of Denver; and FIrst Central Bank of Cerritos, Calif.
Veterans Affairs
Vinnie Macs. The Department of Veterans Affairs on Aug. 27 issued the second Remic security backed bythe full faith and credit of the U.S. government. Legislation authorizing DVA to guarantee payment of principal and interest was signed May 20 and the agency issued its first Remic June 15. It plans to issue a third in December. Ginnie Mac cannot currently issue securities through a Remic (see The Mortgage Marketplace, Aug. 24, page 1).
Office of Thrift Supervision
Valuation of PMSR. OTS has proposed a Thrift Bulletin to give guidance for the valuation of purchased mortgage servicing rights. The agency said the market value of PMSR will continue to be determined through a present value, or discounted cash flow analysis. OTS seeks comment on several issues, including whether thrifts not deemed to be 'problem' institutions and with 25% or less of core capital invested in PMSR should be excused from the independent appraisal requirement and, if so, is the 25% level an appropriate cutoff point? Interest Rate Risk. The OTS published a revised proposed regulation that describes a system for measuring interest rate risk. The system would use present value modeling plus an extra step to measure prepayment risk. It is more complex than an interest rate risk model proposed by the Federal Reserve Board for itself and the two other bank regulatory agencies (see Federal Reserve Board item below and The Mortgage Marketplace, June 29, page 1). The comment period ends Nov. 2.
Thrift LenderTest. The OTS proposed rules to implement a less stringent qualified thrift lender test mandated by the FDIC Improvement Act of 1991. The regulation would require that 65% of a savings institution's assets be related to housing finance. Congress had raised it to 700/0 in 1989. The comment period will end Oct. 3. Equity Investment Capital. The OTS proposed a regulation that would permit thrifts to count certain equity investments as risk-based capital. Most affected by the proposed changes would be stock in Fannie Mae and Freddie Mac and loans with equity participations. The comment period ends Oct. 3.
Muitifamily Capital Rule. The OTS proposed a regulation that would implement a provision of the Resolution Trust Corporation Refinancing, Restructuring and Improvement Act of 1991, the act requiring the federal banking agencies to impose a lower capital charge on multifamily housing loans that meet certain criteria. Among the changes, there would no longer be any limit on the number of dwelling units involved. Currently, the loan can finance up to 36 units to qualify for the 50% risk-weight category. The comment period ends Oct. 3.
Accounting Reporting Requirements. The OTS adopted, effective Oct. 3, a regulation that will require thrifts to report to their customers how well they meet capital requirements.
Recourse. The OTS has defined recourse as 'the acceptance, assumption, or retention of some or all of the risk of loss generally associated with ownership of an asset. It is not necessarily a function of ownership or prior ownership of an asset, nor does it arise only as an incident of an asset sale. It may arise without a contractual obligation.'
Federal Reserve Board
Interest-Rate Risk. The Federal Reserve Board June 24 approved a notice of proposed rulemaking that describes a system for measuring interest rate risk it has developed in conjunction with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. It suggests that for every dollar of interest rate risk above a norm, an extra dollar of capital must be set aside. The comment period ends Oct. 9.
Comptroller of the Currency
Appraisals. The comptroller has issued two interpretive letters and two no-objection letters relating to real estate appraisals. In Interpretive Letter 587. the agency said the bank itself must determine whether an appraisal is still valid and present methods for such determination. Interpretive Letter 588 set out conditions under which national banks may renew loans originated before the effective date of the appraisal regulation without obtaining a new appraisal. In No Objection Letter 92-2, the agency said appraisals performed under the OCC's Appraisal Regulation were not required for loans made under the streamlined refinancing program of the FHA. No Objection Letter 92-3 cited factors that could materially change the value of an appraisal, including the passage of time and environmental contamination.
Federal Deposit Insurance Corporation
*Guidance on Mortgage Derivatives. The FDIC has published expanded guidance on the treatment of mortgage derivative products consistent with the interagency policy statement that went into effect Feb. 10. The memorandum includes specific guidelines for determining whether a mortgage derivative product is high-risk and how such investments must be treated.
Financial Accounting_ Standards Board
Market Value Accounting. The board has issued an exposure draft that would expand the use of market value accounting for investments in debt and equity securities. Trading securities and securities available for sale would be reported at market value. Those whose management has the intent and ability to hold to maturitywould be reported at amortized cost. The deadline for comments is Dec. 8. Public hearings are set for Dec. 18 and 3. 7-8 (see The Mortgage Marketplace, Sept. 14, Aug. 10 and July 20, page 1).
Investments With Prepayment Risks. The board authorized the staff to proceed with the drafting of a statement requiring the calculation of anticipated prepayments. This will affect holders of mortgages, mortgage-backed securities and MBS derivatives. FASB said it will not specify how changes in prepayment estimates should be recognized. Prepayment estimates would have to be made for investments that were acquired or originated at a premium and for which prepayments were possible. capable of estimation and which would have a significant effect on the investment's yield.
