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North America Equity Research20 May 2019 U.S.Mid-and Small-Cap Banks NY Rent Regulation Deep DiveDramatic Changes Are Coming But from a Bank Risk View,Loan Growth the Concern Over Credit QualityU.S.Mid and Small Cap BanksSteven Alexopoulos,CFA AC(1-212)622-Bloomberg JPMA ALEXOPOULOS Alex Lau(1-212)622-Janet Lee(1-212)622-Anthony Elian,CFA(1-212)622-J.P.Morgan Securities LLCSee page 18 for analyst certification and important disclosures.J.P.Morgan does and seeks to do business with companies covered in its research reports.As a result,investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report.Investors should consider this report as only a single factor in making their investment With the most dramatic potential changes to rent regulations in decades now less than a month away,shares of SBNY and NYCB have each come under selling pressure.To this end,we are providing a deep dive into the proposed new regulations as well as the potential financial impacts to each bank.At the core of the potential change to existing regulations,there are currently 9 proposed pro-tenant bills,collectively referred to as“Universal Rent Control”,which will be voted on in mid-June.While replacing rent laws approximately every four years is the norm for NYC,this years update may lead to more impactful changes as this year marked only the third time in half a century that the Democrats have controlled the New York State Senate,leading to Democrats holding a trifecta in the state government.While the final bill will likely not be as restrictive as current proposals portend given the potential impact to the local NYC economy,the passage of more tenant friendly laws will negatively impact multifamily building valuations.While this is a clear negative for building owners,we see impact to banks as being more in the form of a significant reduction in loan volumes than a material adverse impact on credit quality.In fact,with vacancy rates likely to remain very low and banks typically lending on current cash flows(rather than prospective cash flows),we see defaults in the NYC multifamily segment as remaining low.In terms of reduced volumes,while this is likely to have a modest impact on SBNY(given a transition into C&I underway),the impact is more pronounced on NYCB,with a reduction in prepayment penalty income raising the risk of a dividend cut.Universal Rent Control package includes 9 bills.Changes to New York rent regulation are approaching as existing rent laws passed in 2015 that cover about 1 million rent stabilized apartments are set to expire on June 15.Of the proposed bills,the two that we view as the most impactful include(1)one that looks to repeal vacancy decontrol and remove landlords ability to remove an apartment from rent stabilization if rents reach$2,733/month and the tenants move out and(2)another that looks to end landlords ability to raise rent for major capital improvements.For the banks:more of an impact to volumes than credit quality.While an overhaul of rent regulation will have many ripple effects,we see the impact to banks being more on the volume front than on credit quality.When banks lend on a multifamily loan,while owners look at the potential increase in cash flow from vacant units,banks typically lend on the current cash flows of the building.While more tenant friendly regulations will likely impact the ability of building owners to increase cash flows over time(which negatively impacts valuation),over the near-term these measures are unlikely to have a materially negative impact on current cash flows which is the first line of defense that keeps a loan from moving into default!Not to mention that should a loan default,LTVs for multifamily are typically sub-60%.Stock positioning:we favor SBNY(OW)and would avoid NYCB(UW).With multifamily volumes likely to remain anemic,the impact is modest to Signature given(1)the company is now transitioning into a C&I bank and(2)prepayment penalty income already declined 80%q/q in 1Q19.We see the sell-off in SBNY as overdone.Turning to NYCB,however,with the company being far more dependent on the NYC multifamily market,with slowing volumes to weigh on loan growth as well as NIM(via reduced prepayment penalty income),a reduction of prepayment income could also put the risk ofa dividend cut back in the spotlight.2North America Equity Research20 May 2019Steven Alexopoulos,CFA(1-212)622- New York Rent Regulation UpdateThe Rent Act of 2015,which covers New York rent regulation,is set to expire on June 15 and New York politicians are debating new laws to replace the expiring rules.While New York rent laws coming up for renewal is a process that occurs every four years,the political landscape is different today as a result of the 2018 midterm elections,where Democrats took control of the New York State Senate for the first time in a decade and only the third time in half a century.This resulted in Democrats holding a state government trifecta in controlling the Governors office along with both state legislative chambers(the Assembly and Senate).As a result of this,Democratic politicians have proposed rent regulation bills that are very pro-tenant.Below,we lay out the 9 proposed bills,collectively referred to as the“Universal Rent Control”package,which is in large focus in the upcoming vote(estimated for mid-June).Nine separate Democratic New York State Senators sponsor each of the nine bills in the package and all were introduced in the first few months of 2019.Currently the nine bills are in their respective Senate committees,which include 8 bills in the Housing,Construction and Community Development Committee and 1 bill in the Judiciary Committee(S2892A).The next step for the package of the bills after going through the committees is to get on the calendar for consideration by the full Senate and could be amended by any Senator.After consideration and debate of the bill by the Senate,a vote is taken and a majority is required to move on to the next stage which is the state Assembly(the other legislative branch of New York State).In the Assembly,the process is similar to the steps in the Senate and the bill is considered and may include amendments by Assembly members.After,the bill will be voted on by the entire Assembly and if there are no amendments made to the bill,the bill will be sent to the Governor to be signed into law,or be vetoed by the Governor.If the Assembly votes to approve the bill with amendments,the revised bill will be sent back to the Senate to be voted on and only when both the Senate and Assembly both approve identical bills,the bill will be sent to the Governors office to be approved or vetoed.In situations in which the Senate and Assembly pass similar bills but cannot easily reconcile between the two,they can form a conference committee to which each legislative branch appoints 5 committee members from their respective houses to serve on the committee and reach an agreement on a final bill.Once both the Assembly and Senate approve the same bill,Governor Andrew Cuomo is next in line in the process to either sign or veto the bill.If Governor Cuomo signs the bill,it becomes law and if he vetoes the bill,it would be sent back to the house that passed the bill first with a statement of reason for disapproval.In a scenario which Governor Cuomo vetoes a bill,it would require two-thirds of the members of each house(Senate and Assembly)votes to override the Governors veto.3North America Equity Research20 May 2019Steven Alexopoulos,CFA(1-212)622- Figure 1:Process for Passing“Universal Rent Control”into Law in New YorkSource:www.nysenate.gov.Below we provide a list and description of the nine bills termed the“Universal Rent Control”package which is up for debate:1.Repeal vacancy decontrol(S2591A):The bill would repeal the provision that allows landlords to remove apartments from rent stabilization or rent control when these apartments could be rented at$2,733/month or more after a tenant moves out.Supporters of the bills raise concerns over the loss of rent stabilized apartments as a result of loopholes in the current rent laws which allow landlords to take rent stabilized apartments off the market.It was estimated that more than 300K rent stabilized apartments that have been removed from rent regulation in New York City and Nassau,Westchester,and Rockland counties under vacancy decontrol.A bill to end vacancy decontrol was introduced in 2009 and waspassed in the state Assembly but voted down in the state Senate.a.Introduced January 28,2019 and sponsored by Andrea Stewart-Cousins(D),35th Senate District2.End rent increases for major capital improvements(S3693):This bill would restrict owners of rent stabilized apartments to increase rent solely to help pay for building improvements.The bill also notes that rent increases have been used to pay for inflated project costs and that tax benefits and higher property values should be enough to pay for capital improvements.Opponents to the bill cite that the bill would disincentivize landlords from making the needed renovations to properties due to cost.a.Introduced February 12,2019 and sponsored by Michael Gianaris(D),12th Senate District3.End rent increases for single apartment improvements(S3770):Similar to the bill outlined above,this bill would remove the ability for owners of rent stabilized apartments to increase rent solely due to apartment renovations.Some lawmakers have noted that owners have used this provision to accelerate rent increases of rent stabilized apartments above the existing decontrol threshold(of$2,700).a.Introduced February 14,2019 and sponsored by Brian Kavanagh(D),26th Senate DistrictIntroducedIn CommitteeOn Floor CalendarPassed SenatePassed AssemblyGovernor Signed/VetoedBill Becomes Law if SignedNext Step4North America Equity Research20 May 2019Steven Alexopoulos,CFA(1-212)622- 4.Repeal provisions permitting 20%rent increases after vacancy(S185):The bill would repeal the“vacancy bonus”or the ability of a landlord to increase rent by 20%(which is known as“statutory vacancy bonus”)after vacancy of a rentregulated apartment.Under the current law,a landlord is eligible for a statutory vacancy bonus once per year after vacancy of a housing accommodation.a.Introduced January 9,2019 and sponsored by Jos M.Serrano(D),29th Senate District5.Ensure preferential rent until an apartment is vacated(S2845A):This bill would restrict owners of rent stabilized apartments to revoke their tenants preferential rent at lease renewals.Preferential rent is defined as a rent price that tenants pay that is less than the legal maximum amount.Since 2003,owners of rent stabilized apartments have been able to terminate preferential rents during lease renewal,forcing tenants to pay higher rents.For context,more than a quarter of rent regulated tenants in New York City currently pay preferential rent.If this bill passes,owners may only be allowed to alter preferential rent once an apartment is vacated.a.Introduced January 29,2019 and sponsored by Liz Krueger(D),28th Senate District 6.Prohibit eviction without good cause(S2892A):The bill would prohibit a landlord from evicting a tenant or non-renewal of leases without good cause.Some of the examples of“good cause”include:(1)a tenant has failed to pay rent(unless its due to an“unconscionable”rent increase,which is defined as more than 1.5x the local inflation rate);(2)a tenant is violating a substantial obligation of his or her tenancy;and(3)a tenant is committing or by reason of negligence damaging the housing accommodation.a.Introduced January 30,2019 and sponsored by Julia Salazar(D),18th Senate District7.Establish the statewide tenant protection act of 2019(S5040):The bill would remove any geographic restrictions on applicability of the states rent and eviction regulation system,allowing any municipality across New York state to regulate rents and evictions when there is a housing emergency based on a vacancy rate of 5%or less.The current law has arbitrary geographic restrictions that only allow New York City,Nassau,Westchester and Rockland counties to regulate rents in a housing emergency.a.Introduced April 4,2019 and sponsored by Neil D.Breslin(D),44th Senate District8.Rent control/rent stabilization parity(S299A):This bill would introduce uniformity between the maximum rent increases allowed for rent controlled and rent stabilized apartments.Currently,tenants of rent controlled apartments can see annual rents increase by as much as 7.5%per year.The Department of Housing and Community Renewal would be required to cap the increase in the annual rent percentage for rent controlled apartments(1 year leases)at a similar level with the Rent Guidelines Boards annual adjustments for rent stabilized apartments.5North America Equity Research20 May 2019Steven Alexopoulos,CFA(1-212)622- a.Introduced January 9,2019 and sponsored by Brian A.Benjamin(D),30th Senate District9.Eliminate state of limitations for tenants to file overcharge complaints(S4169A):This bill would allow tenants of rent stabilized apartments to file overcharge complaints beyond the current state of limitations(currently four years).Current tenants are the ones that must file a complaint if they suspect their rent is too high,but they may not realize that they are being overcharged until several years after moving in to an apartment,which penalizes the tenants.a.Introduced March 4,2019 and sponsored by Zellnor Myrie(D),20th Senate DistrictAmong the 9 proposed bills,we would highlight two of the most significant ones to be the proposal to(1)repeal vacancy decontrol and(2)end rent increases for major capital improvements.We would note that Governor Cuomo has voiced support earlier in the year in his ninth State of the State address in Albany for reform of rent regulation,which included“eliminating vacancy decontrol,ending preferential rent limits,limiting building apartment improvement charges,and strengthening the tenant protection unit.”However if the bills were to be passed into law as they currently stand,this would have significant impacts to the New York economy,which Governor Cuomo would not likely support.Laying the Groundwork:Rent Control vs.Rent StabilizedWhile the terms“rent control”and“rent stabilized”both fall under the umbrella of rent regulation,these terms are not interchangeable as they are different concepts that are impacted differently by existing laws,with the pending bills potentially impacting each term in unique ways as well.The overarching term of rent regulation in New York City dates back to laws that have been in place since the 1920s,which were enacted to limit sharp increases in annual rents,due to a decrease in new construction,in the years following World War I.In the decades since then,additional laws and amendments have been enacted to keep pace with changes in the citys very expensive housing market.One example of this includes e