L&C 2015 Report: The Rules Are Changing

Posted on January 4, 2016 in Viewpoints by Admin

“You have to learn the rules of the game. And then you have to play better than anyone else.” -Albert Einstein

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For the last decade or so the SEC has been in full crack down mode on the financial industry.  Since July 30th 2007 FINRA has had big banks and other investment entities squarely in its sights. So far, however, the real estate sector has not received much attention. But that has changed.  In recent audits of NAREIM member firms it has become very clear that real estate is now a priority for scrutiny.  The SEC expects that real estate firms can prove that every action they make is in the best interest of the investor, and are challenging many aspects of how we have done business in the past.

At the same time, a robust economic recovery and rapacious investor appetite for real estate is driving investment managers to work harder, smarter, and faster than ever before.  It is time to examine the rules of the game, and make sure we are all ready to play them well.

The Langham Hotel in Boston was a fitting location to hold this year’s Legal & Compliance meeting.  Formerly the Federal Reserve Bank in Boston, many of the rooms still retain some of the original architectural details of it’s magnificent past.  In the Wyeth Room, under the watchful eye of President Lincoln (painted larger than life by the famed N.C. Wyeth), NAREIM members discussed how to move forward under ever changing economic conditions and increased regulatory pressure.

What Drives Real Estate Markets Now?

“The talent war among the technology and innovation driven companies which are driving the American economy,” says economist Doug Poutasse of Bentall Kennedy.  This demand for talent is at the root of real estate growth in both the residential and the commercial sectors for favored markets.  At the same time, the Fed’s largesse and low interest rates have helped insure a steadily growing flow of capital into our sector, especially from outside the US. For the last few years, the US economy has been strong and economically stable compared to most other markets, and overseas investors have responded.  Could this change? “The central banks have been working in very close collaboration since the financial crisis and it was no mystery that quantitative easing ended in the US about seven minutes before it was launched in Europe and Japan…if the US raises rates and no one else can the dollar goes through the roof.”  This would ebb the flow of offshore money, and as a result level off the skyrocketing prices, but only slightly.

But far more important than interest rates, jobs and the talent pool that take those jobs are major drivers to watch. “The US cannot compete on cost, we have to compete on talent.” Almost every major market has produced more jobs since the downturn than the seven or eight years before; the strongest growth markets being Austin, San Francisco, and San Jose.

However, there is more striation in the landscape than ever before. “Millenials grew up knowing there is no such thing as lifetime employment.” As a result they want to live in areas that have as many options as possible for when their current “gig” ends.  That translates into huge growth in certain areas, and no growth in others. For every market that has bounced back twofold, another has not bounced back at all. The job creation is going to occur in the markets where the talent is and wants to be. More talent means more jobs means more demand for housing and office space. Good news, for certain markets.   For the markets that remain, job creation, and therefore real estate value, has little hope for significant growth in the near future.

NAREIM L&C (40 of 55)

But What Drives the Flow of Talent?

Education and immigration. One of this country’s greatest exports is education.  Young people come from all over the world come to U.S. based universities.  Saudi Arabia doesn’t even have a formalized higher education system because it’s more cost effective to send students abroad. For years we sent these highly skilled, highly intelligent individuals back home.  The current student visa system allows a legal stay for education and for one year of practical training afterwards. However if an employer helps you apply for a green card, you are able to stay until your case is adjudicated. It is not unusual for this process to take many years. This loophole has driven growth markets in the last decade. The population of San Francisco and San Jose are now almost 35% foreign born. The fact that we have not run out of skilled talent, as Europe has, is largely due to immigration. Our rate of immigration is second only to Canada whose economy is also booming. Europe has been economically stagnant or worse, and according to Mr. Poutasse that is mainly due to an, “immigration system based on asylum.” Refugees desperately need a safe harbor, but do not tend to be at the top of the IQ charts.

But what happens if we slow down immigration?  If, as many politicians suggest, we increase limitations, or even more strictly enforce the laws already on the books, our talent advantage could quickly go away.   According to the CDC, the total fertility rate in the United States estimated for 2014 is 1.86 children per woman, which is below the replacement fertility rate of approximately 2.1. Without immigration, the US population, and therefore the economy and real estate demand falls.  With immigration, our population of talent rises.

The immigration discussion is one that real estate investors need to closely watch, as it has a direct impact on the value of our portfolios.

 NAREIM L&C (35 of 55)

What Are the Regulatory Challenges?

“Conflicts of interest,” says Stephanie Monaco of Mayer Brown.  This age old behavioral pitfall is obviously identifiable at ten thousand feet and clearly visible with 20/20 hindsight vision.  However, when you’re trying to move forward in the trenches you can fall into it very easily.

The SEC is primarily focusing on expense allocations and disclosures. If your company uses affiliates, which so many do, how do you know that you are paying fair market rate for their services? And if you have used that affiliate over the course of many years, how can you be sure that the quality of the service they are providing is top notch? The SEC’s point of view is that if you are not seeking the most competitive rates for the highest quality products you are doing your customers a dis-service.

Suppose, for example, that you use an affiliate to get an appraisal on a property.  How can you be sure they are going to give you an unbiased assessment? And isn’t that a conflict of interest?

This challenges some fundamental practices in our industry.  For a long time vertical integration has been a beneficial practice.  It can save cost, time, and headaches. It means you can build trust and leverage personal relationships against prices and timetables.  But – “how do you know when you’ve hit the market?” Asks John DeMarco of Lowe, “Many of us might say that we  “just know” because we are in the market every day.” But the SEC wants proof. “You can’t just use an affiliate because you like them,” says Monaco, because, “the SEC will require you to prove that the cost of your affiliate is market comparable or better and you need to document how you’re going about getting that information.”

When asked if he thought the vertically integrated model itself is under pressure to change, DeMarco responded, ‘Absolutely. Unequivocally.”

Disclosure is another hot topic for the SEC and “disclosure is ugly,” according to Monaco.  If you use an affiliate you must disclose your affiliation to your customers.  If expenses are being borne by a fund, you must disclose that in painful detail. If you can’t show that you’ve disclosed every minute detail, the SEC will assume that you are trying to hide something from investors.

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So What Can We Do To Prepare?

“I want to make sure that my senior executives know that the regulators are coming – it’s only a question of when,” says Matt Campbell of Bentall Kennedy.  He makes sure that senior management is aware of current SEC areas of focus and assesses the firm’s practices around those areas.  “I want to make sure that people are aware of what’s going to be on the exam.” It’s important that companies can show an effective process of prevention.

Awareness and preparation are essential, and outside consultants, while expensive can help assess whether the firm is ready for an exam.  SEC inquiries can take anywhere from a couple of months to a couple of years and the costs can be enormous. Given that the threat is imminent, rigorous assessment is imperative.

“Relative to successful capital raising and profitable investing, compliance can be viewed as an expense.  Some think that there is no accretive, bottom line value in good compliance,” says Monaco. However, Campbell argues it should be treated as, and is now considered to be, a value added service. “We are dealing with institutional investors, the clients are more sophisticated. Their due diligence focuses on compliance and they value it.”  The better you are at compliance, the more they can trust you and your returns.

Should We Worry About Cyber Security?


According to FBI Director James Comey, “There are two kinds of companies: Those that have been hacked and those that don’t know they’ve been hacked.”  There is nothing we can do to be 100% secure but there are many steps we can take to manage the risk. Any SEC inquiry will be looking for proof of precautions. “It’s no longer an IT guy’s problem.  This is a board level issue,” says David Wheeler of Chapman Spingola.

“The NIST Framework is by far the best standard” according to Chuck Orrico of Dyonyx.  They have established good baseline guidance for proactive protection. The SEC and investors are going to be very concerned with what steps companies are taking to mitigate the onslaught. Adopting a coordinated defense program is important for both regulators and clients.

It’s not just cyber security that is important, but information security in general. “Use best practices and common sense. IT and software is one means of protection but physical threats exist as well,” says Patrick Shea of Cordium.  Who has access to information and at what level?  What happens to a USB drive if it’s left in an obvious place? Basic precautions can protect you against the very real threat of sensitive information walking out of your office.

Shea likened corporate security to home security, “If your neighbor leaves their screen door open all the time and your house has a steel door and a security system, it’s clear where the hackers are going to go.  They tend to go for the paths of least resistance.”

Be careful.


The rules are changing.  Our compliance will be tested, our firewalls will be bombarded, and our ability to adapt will be of paramount importance to the survival of our business. But with change always comes opportunity. Those who can look forward will take these new challenges and translate them in to great investments, better marketing campaigns, and stronger funds that will be more attractive to the investors. Big markets are going to get bigger.

Those who best understand and play the new rules will certainly be the investors to watch over the next few years.