The Real Estate Philosopher


The Wall of Money Pouring Into U.S. Real Estate – Is it Slowing or Growing?

Nov 20, 2017

Almost every day – or at least every month or so – another country’s leadership announces restrictions on money getting out of that country.  There can be various reasons for this.  Sometimes it is just that they don’t want capital flight – and other times it can be that the leadership needs the money of wealthy people in order to fund other initiatives, i.e. Venezuela, Russia, and, most recently, Saudi Arabia.
 
Certainly, if you are in a country that has announced initiatives to control outflows of capital or is under autocratic rule, it is likely that you would be trying to figure out how to get your money out of the country to a safe location. 
 
What about other countries with autocratic leadership that have not – yet – announced capital controls or wealth confiscation?  Wealthy people are more likely to be attuned to world events and world risks.  So one would think that people in those countries would be starting to think that it might not be the worst idea to move money out, ‘just in case…..’
 
And what about countries that don’t currently have autocratic leadership but might have such leadership in the future if political events turn out a certain way.  Maybe citizens with wealth in those countries might be wondering too.
 
And oh yes – let’s not forget wealthy people in countries with leadership that is just fine, but with stagnant economies.  There are fewer places they can send their money as, by definition, they will be excluding all of the autocratic countries I just mentioned.  If they send their money into these places, they might not be able to get it out.  Once again, I see the money flowing right here. 
 
And finally, what about great countries where wealthy people just want to diversify.  The result is the same as the preceding paragraph.  There aren’t a lot of choices.  And, yes, again, more money flowing to the U.S.
 
In some of these situations, money will flow here quite legally and properly.  However, in other situations – the first few mentioned above -- the odds are that those with wealth to protect would be thinking about how to move their wealth legally, but if not legally, then likely illegally if they have no really good alternative.
 
Money leaving autocratic – and non-autocratic -- nations and flowing towards the U.S. is obviously nothing new, i.e. it has been going on for years; however, my belief is that rather than a wave cresting, it is, if anything, gaining in strength.  Yes – my view is that the wave of money coming towards the U.S. is growing and not slowing!
 
What does this mean for U.S. real estate?
 
I see two things:

First – it would point to continuously rising prices, especially in gateway U.S. cities. 
Second – it would point to a lot of shady transactions and attempted shady transactions.

What should real estate players do?  Two things:
 
First – don’t let this wall of money pushing up prices push you away from your good underwriting.  The fact that other players are making a rational choice to overpay – based on their political circumstances, should not push U.S. real estate players to overpay when we don’t necessarily have those political circumstances.  Said another way, don’t fall prey to the greater fool theory that because prices are rising for the foregoing reasons it means that the underlying value of the item in question justifies its price.  And said still another way, the wall of money flowing into the U.S. pushing up prices will come to an end at some point, at which time the pricing could fall precipitously. 
 
Second – in view of my prediction of increased efforts of frantic wealthy persons in other nations trying to get their money out, and the obvious benefits to third parties in assisting them in doing so, I suggest increased scrutiny of who you are dealing with.  In this regard, I suggest that U.S. real estate players be “over-careful.”  So called “know-your-client” and other protections should be increased.  It is never worth it to take a risk of breaking U.S. laws to capitalize on this otherwise potentially beneficial situation.  And, to belabor the point, turning a blind eye by pretending not to see something that has a funny smell to it, and hoping it will be ‘okay’ to claim ignorance if the matter is later challenged, doesn’t work either, as when it all comes to light everyone’s reputation is burned and sometimes irreparably. 
 
Third – ‘if you can’t beat ‘em, join ‘em.”  What I mean by this is that in a gold rush the people selling picks and shovels always do well.  This means that U.S. real estate players with the reputation and ability should consider working with the foreign money in an advisory, co-investment or other similar capacity.  To be clear, I am not advocating taking advantage – I am advocating the opposite; namely, being an honest U.S. teammate to help the foreign money be invested safely in U.S. real estate in a win/win manner.
 
That is my philosophizing for today.
 
A last thought – if you feel the need/desire to speculate, maybe buy Bitcoin.  Jamie Dimon is no fool and he said the following about Bitcoin:
 
“If you were in Venezuela or Ecuador or North Korea or a bunch of parts like that, or if you were a drug dealer, a murderer, stuff like that, you are better off doing it in bitcoin than U.S. dollars,” he said. “So there may be a market for that, but it’d be a limited market.” 
 
So if my theory that there is a wall of illegal money exiting autocratic regimes, it may result in pushing up the price of Bitcoin. 
 
To be clear I am NOT advocating buying Bitcoin – and I don’t intend to buy it myself – but it might be a fun ride for the pure thrill of gambling and not having to fly out to Las Vegas. 


BYE-BYE LIBOR

In years past, counsel for borrowers and lenders generally opted not to expend time, energy or legal fees negotiating LIBOR reset provisions in loan documents by rationalizing:  “If LIBOR goes away, we will have bigger problems than worrying about the replacement rate”, and “What’s ever going to happen to LIBOR?”  Re-set provisions became more of a concern after the rate setting scandal several years ago. However, many still did not think through how the re-set provisions would actually work if LIBOR really did go away.  Well, as we all know, LIBOR really is going away by the end of 2021 and a replacement index has at least been identified. Parties to loans utilizing LIBOR which extend past that year are now understandably concerned about how those re-set provisions will work or how they may need to be amended so that they will work in the post-LIBOR world.

The general consensus with respect to loans which utilize LIBOR and mature before 2022 is that no action needs to be taken.  While this is generally true, consideration might be given to loans which mature in 2021 in the event they are not paid off at maturity.  Is it clear as to how interest (including default rate interest) will be calculated in 2022 after LIBOR is no longer available?   In any foreclosure proceeding the lender must make a claim for the outstanding indebtedness.  If there is ambiguity about the calculation of interest, such ambiguity could be used to delay enforcement proceedings. Therefore, it may be prudent for lenders to check the LIBOR re-set provisions for existing loans which mature before but close to the date LIBOR will no longer be available.

With respect to existing loans which mature after 2021,  lenders and borrowers need to understand how their re-set provisions will work.   Typically, an alternate index is designated to replace LIBOR in the event LIBOR can no longer be ascertained.  This alternate index is often the prime rate which has historically been significantly higher than one month LIBOR (the index often used in floating rate loans).  Because the alternate rate (such as the prime rate), is not equivalent to the LIBOR index being replaced, loan documents should provide a  mechanism to adjust the applicable spread so that the interest rate going forward replicates as close as possible the interest rate that would have been in effect if LIBOR had continued.  Because this adjustment to the spread is often imperfect justice, parties to existing loans may want to revisit how this adjustment to the spread is calculated as it will no longer be theoretical after 2021.   

It was announced in June that in the United States the index that is being recommended to ultimately replace LIBOR is the Broad Treasury Financing Rate (the “BTFR”).  The BTFR, however, will be rolled out gradually and does not settle the question of how the replacement of LIBOR will be implemented.  Therefore, the following concerns still need to be addressed for new floating rate interest loans (particularly loans which will mature after 2021): First, how long should LIBOR continue to be used as the determinative index for new loans, and so long as LIBOR is used, what should be the appropriate mechanism for replacing it? Secondly and perhaps more problematic, how should hedging instruments be structured so that they mesh with the replacement index used in the related loan documents and provide covering payments at the appropriate threshold underwritten by the lender?  

As of now, lenders are for the most part punting on the foregoing issues and will continue to do so until there is market acceptance of the BTFR (or other replacement index).  Accordingly, it is expected that LIBOR will continue to be used in floating rate loans and the parties will “agree to agree” in the loan documents as to what comes next.   For example, replacement index language in loan documents is changing from simply designating the prime rate as the replacement index to designating the prime rate or an index that is “generally adopted by the commercial real estate financing market”.  Lenders of course, can be expected to reserve the right determine what that generally adopted index is.  Borrowers would be well served to persuade their lenders to agree that such determination should be “reasonable and in good faith”.  

The requirement of borrowers to provide interest rate protection once LIBOR is no longer available is also only broadly addressed.  Until derivative product providers determine how hedging will be priced and settled in the post LIBOR world,  it will not be clear exactly what terms borrowers must comply with in hedging instruments.   Therefore loan documents can be expected to require that borrowers obtain replacements of existing LIBOR based cap agreements with instruments which “provide the reasonably equivalent protection to the lender as currently afforded to the lender” in the then effective cap arrangement.   

In summary, the challenge presented to the financing industry by the transition from LIBOR to a new market tested and accepted index is likely to require that borrowers and lenders agree that the replacement index and terms of hedging instruments will essentially remain, at least for the present time, a “to be determined” standard.   The new mouse trap has not yet been designed. 


Real Estate Private Equity: Technology’s Next Victims? (Part 1)

by Dror Poleg


Traditional funds are at a disadvantage in the face of new competitors, new business models, and an abundance of capital. Read more.


Tax Reform Roller Coaster—Ups And Downs For The Real Estate Industry In The New House Tax Bill

There is a tax reform roller coaster going on in Washington right now and all of us in the real estate world are watching, waiting, wondering, worrying what will transpire.  Our tax group – led by Stephen Land, the former Chair of the Tax Section of the New York State Bar Association – and Jessica Millett, who spearheads our cross-border practice – has been putting out weekly articles charting what is going on with tax reform and how it will affect the real estate industry.  As Stephen and Jessica will be the first to tell you, these articles have a short shelf-life, as things change almost every day. To view the first outline, please click here. To view the second outline, please click here.

 

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As the Managing Partner of Duval & Stachenfeld – a law firm in mid-town NYC known as The Pure Play in Real Estate Law – I am inviting you to join The Real Estate Philosopher™. This will consist of my thoughts and also thoughts of friends and colleagues.

It will not be published in any traditional media – it will go only to friends of our firm. The purpose here is very simple – to put forth thoughts in the real estate world that are different, provocative, and challenging of accepted wisdom. Hopefully, nothing said here will be mainstream thinking.

You may be wondering how I am qualified to write on these topics since I am “just” a lawyer. However, I have an unusual place in the real estate world. As the managing partner of The Pure Play in Real Estate Law (one of the largest real estate law practices in NYC), I interact with an incredible number of real estate players. This ranges from small real estate shops with nothing but a gleam in their eyes, to some of the largest real estate institutions in the world, and everything in between. This gives me a unique and global perspective and allows me to act as an amateur philosopher in the real estate world. This has always been my hobby and it is what I love doing.

Regards,

Bruce Stachenfeld
a.k.a The Real Estate Philosopher™

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