As Europe’s commercial real estate debt market enters its sixth year of credit crunch disruption, it is increasingly clear that traditional bank lending cannot meet demand for new finance. However, three significant bond deals this year moved real estate financing into the high-yield spectrum that we believe is part of the outlook for 2013.
The first was UK holiday park operator Centre Parcs’ £1.01bn investment-grade issue, which sowed the seed for what now seems an obvious move to bridge Europe’s real estate funding gap in high-yield markets. The deal, while not high- yield in itself, was notable for issuing long-dated, fixed-rate bonds – rare in the traditionally five- year floating rate European real estate debt market.
The deal’s make-whole and early redemption premiums have not previously been widely accepted by European real estate borrowers and the deal was seen to show that European property owners were ready to change their traditional ways and accept new terms to secure finance in a changing market.
The next step, in June, was a £525m issue by Terra Firma vehicles to secure finance to buy Four Seasons’ UK nursing homes business. Like the Centre Parcs deal, this partly refinanced previous CMBS financing of the assets. But unlike Centre Parcs, which can be seen as an unusual CMBS deal with high-yield features, the Four Seasons deal was a classic New York law-governed, high- yield issuance on standard high-yield terms.
But the most important deal was Annington Homes Group’s November issue of £550m of PIK notes, backed by the equity interest in a housing portfolio leased to the Ministry of Defence. The deal partly financed Terra Firma’s acquisition of Nomura’s portion of the Annington business. This was also a CMBS-associated deal, the note issuer receiving cashflow mainly from two CMBS bond issuers with significant outstanding transactions.
The Annington indenture contains a number of innovative terms in an otherwise standard high-yield covenant package. They include:
- No ratio debt in the limitation on indebtedness covenant. In a typical high-yield bond, the amount of additional indebtedness allowed rises in line with the financial performance of the restricted group (so called ratio debt). In the Annington deal, the amount is confined to a few limited situations. It was introduced for the Annington Portfolio’s rentals and developments business, but based on loan-to-value and loan-to-cost ratios, rather than adjusted earnings before interest, tax, depreciation and amortisation to interest expenses, or of consolidated net debt to adjusted EBITDA, as would be typical for high-yield bonds.
- In a typical high-yield bond, the restricted group may make restricted payments – pay dividends or make investments – in an amount of 50% of the group’s consolidated net income. So the ability to make restricted payments is flexible, changing in line with the group’s financial performance. But the Annington deal has very limited exceptions to the otherwise static restricted payments covenant.
- Introduction of a cash sweep and trustee-controlled accounts at issuer-level for certain proceeds, available exclusively for note repayment. Neither are found in traditional high-yield bonds.
- Creation of an order of priority of payment for the use of certain funds by the issuer. Other than in inter-creditor agreements, such ‘waterfalls’ are foreign to high-yield bonds, where investors rely on the covenant package to protect their interests.
- Addition of real estate typical reporting to bond-holders. Typical high-yield reporting includes annual and quarterly financials and an updated management discussion and analysis. In the Annington deal, investors also get reports made available to the CMBS investors, including information on the properties and their valuation.
- As the first high-yield deal with distinctive real estate finance features, the extent to which the Annington issue will be a precedent for similar deals is not yet clear. However, high-yield bond issues are sure to be another source of funding for the debt-starved European real estate industry.
Karl Balz, Conor Downey and Charles Roberts are finance partners at Paul Hastings