European securitised loans that contain more aggressive provisions over property release pricing can pose risks for CMBS investors and could constrain CMBS liquidity, says Fitch in a new report.
With CMBS lenders unable to compete with the wider loan market on pricing, they are competing instead by writing more borrower-friendly loans.
The report scrutinises what Fitch’s Euan Gatfield calls “one of the levers at lenders’ disposal after headline pricing and leverage”, namely release pricing, which governs how much debt borrowers must repay if they sell individual properties out of securitised portfolios over the life of a loan.
The research looks at two recent deals: Bank of America Merrill Lynch’s German retail Taurus 2016-1 DEU DAC and Goldman Sach’s Logistics UK 2015, where in both cases Blackstone is the sponsor and the collateral is a large portfolio of properties.
Fitch says that, typically, some deleveraging is required if properties are sold before the end of a loan in order to offset rising concentration or the prospect of strong properties being sold first leaving weaker residual ones.
Traditional loan structures require repayment of a pre-determined amount, with a property’s release price being composed of a fixed allocated loan amount (ALA) and a release premium (usually a percentage of the ALA). Sales of stronger properties would be conditional on a sufficiently large debt repayment, mitigating future risk. Conversely sales first of weaker assets would mean relatively little deleveraging but this would be mitigated by the strength of the remaining collateral.
But, Fitch observes, recent new issuance “has gone into more complex terrain.” In these more borrower-friendly structures the provisions are relaxed so that the release prices of remaining properties are lowered after each sale.
This means a borrower could use the structure to release equity or prolong equity returns rather than pay down the loan.
The two deals analysed deal with release pricing in different ways. While the rating agency says both solutions contain protection for senior noteholders, they introduce a level of complexity (see below).
“Highly negotiated structures designed to differentiate among vastly increased numbers of permutations of property disposals and debt repayment necessarily embed greater complexity in CRE loan and bond documentation”, the report says.
Assessing the scenarios (which also depend on the different characteristics of each property) and the risks, and how they change over time “will be time consuming and costly and constrain CMBS liquidity” it continues.
In terms of constraining liquidity, Gatfield, Fitch’s head of EMEA CMBS, said the risks were more in the secondary market. “I’d be more concerned about the ability of investors to offload bonds over time than at the initial point of issuance when the deals are a focal point of attention for investors and there is lead time, roadshows and so on.”
He added: “But CMBS is quite complex at the best of times and simplicity is a virtue in structured finance transactions. Two years down the track you need to look at what properties are still in there and there’s a level of work you have to do to assess what’s going on. This makes it harder to do that work and that’s a transaction cost. There could be insufficient disclosure for meticulous investors to fine-tune the analysis.
“The simpler they can be designed, the more liquid they can be in different parts of the cycle.”
Commenting on the two deals analysed he said: ‘The saving grace is they are one loan in each. If there were several loans with these structures…it begins to stretch what is reasonable. These are bespoke deals and the real danger would be if a bespoke structure becomes commoditised.
How Taurus 2016-1 DEU and Logistics UK 2015 work
The report takes two hypothetical loans, both secured on portfolios of assets of equal value with the assets sold one after another at regular intervals. One, represented by the red line, is a ‘traditional’ loan with a traditional release pricing structure and the other a ‘dynamic’ loan where the release price of loans sold is used to reduce release prices of yet-to-be disposed assets. (The bars are the number of remaining assets).
Initially deleveraging is largely identical but it is very different later. The traditional loan is redeemed well before the last few properties are discharged but the dynamic loan is exposed to the performance of the residual assets and has more debt outstanding for longer.
The Taurus deal allows recycling release prices from a property sale to be used to cut the release prices for unsold properties, slowing deleveraging. But the allocated loan amounts are not reduced, locking in prior deleveraging. Also, the reductions are applied pro rata across the unsold properties, preventing Blackstone from cherry-picking and stripping out equity from stronger properties.
In the Logistics deal, Blackstone can use the release prices to reduce allocated loan amounts and the release prices start at a low level (5 percent of ALA) meaning initial sales generate virtually no deleveraging.
Once £240 million of the £680 million loan has been repaid the release prices rise to 15 percent.
When a property is sold, if Blackstone chooses to decrease the release price of the next property selected for sale, that subsequent property’s release price will still include a positive release price when it is sold. This is then applied to cut the allotted loan amount of another asset, and so on.
The creditor protection in this deal lies in two stages and favours the AAAs. First, after the £250 million threshold is reached and release prices are fixed at 15 percent, downward release price recalculation is no longer permitted. And second, release prices are applied sequentially, protecting senior noteholders. Also, the loan’s outstanding balance cannot fall below £275 million or it becomes due.
Innovations in CRE debt structures may undermine portfolio diversity, Fitch Ratings