A CMBS recovery is widely expected this year; the question is, in what form? Lauren Parr reports
To the surprise of many, the signal has turned green for CMBS issuance to make a comeback, albeit at a very gradual pace. The US market re-opened last year and is even flourishing, while in the UK, several European banks, including UBS, BNP Paribas, Deutsche Bank and Credit Suisse, are re-exploring the concept. There is also speculation that senior debt used to refinance the Citigroup tower at Canary Wharf could be securitised.
Deutsche Bank has progressed further than most in the CMBS revival: last year it is thought to have taken soundings about whether there was an appetite for a European conduit CMBS, based on the restructured US securitisation model. This year it is testing the market for a UK CMBS deal with borrower Blackstone Group, which is contracted to buy Chiswick Park (see below).
If the prime west London business park is securitised, it would be the first true deal for more than three and a half years. The market perceived Tesco’s fourth CMBS issue, rated this month, and its others as essentially lease deals to a very credit-worthy tenant, because all four are backed by Tesco’s own property and the retailer’s credit rating.
A market ‘down but not out’
The Emerging Trends in Real Estate Europe 2011 report, published this month by the Urban Land Institute and Pricewaterhouse- Coopers, says that according to respondents: “CMBS is down but not out. It will come back at the highest quality in 2011, but it’s a slow process.”
The financial markets also reflect these optimistic sentiments. CMBS spreads have been steadily declining, implying that restored confidence is driving down the price of risk. At the same time, US CMBS bond prices are soaring, luring investors to trade about $4bn so far this year. Total US issuance last year was $11bn; it could reach $50bn this year and the ULI predicts that the figure could hit $100bn by 2013.
Speaking at a CRE Finance Council meeting on 9 February, Chris Dunn, a Deutsche Bank managing director, said: “Almost everyone is surprised that CMBS has really come back with a lot of velocity. We priced a [US] deal yesterday that is the largest in two years and there was huge demand.” Conor Downey, a partner at law firm Paul Hastings, says CMBS may be coming back sooner than had been expected because the banking market’s prospects this year are even worse than they were in 2010.
“Last year in the UK, German banks were the only game in town for property lending at around 60% loan-to-value ratios, for loans between €50m and €80m,” Downey says. But of the 12 German banks he considers to have been active in 2010, DG Hyp has since quit the UK. “Any loan over €80m has to be syndicated; it’s impossible to find bank funding for big ticket property now,” he adds. If borrowers cannot obtain large bank loans, CMBS may become a reasonably attractive second choice.
Demand from property investors
If some borrowers need CMBS, do investors? Research by Mark Nichol, an analyst at Bank of America Merrill Lynch, suggests demand is likely to come from traditional asset-backed security investors, as well as from property-focused investors. “Yields above 7.5% on subordinate CMBS tranches, secured against a single property, could be attractive to mezzanine debt or other property investors that may not be able to put cash to work otherwise,” he says.
US buyers are also expected to increase their exposure to the European market this year, although their current interest is in the secondary market, thanks to the relative gap between primary spreads in the US and higher secondary spreads in Europe. “The US market’s definitely back; you look to Europe and think ‘it’s got to follow’,” says Caroline Philips, managing director and head of securitisation at Eurohypo. “Loan margins are going only one way – up. We need a bit of tightening on secondary CMBS spreads, but secondary CMBS, based on old loans, old structures and old valuations, is not relevant to primary CMBS.
“If the market could come up with a new, clean, simple issue, priced at par rather than at a discount, the actual spread should be significantly tighter than where secondary spreads are pricing.” But not everyone sees a clear constituency of investors, particularly for triple A and other senior bonds. Speaking at the CREFC event, Ravi Stickney, partner and portfolio manager at Cheyne Capital Management, said his feedback is that pension funds and insurance groups prefer to buy whole loans rather than bonds.
Another caveat involves the form in which CMBS will return. Single-borrower deals with single assets and predictable cash flows are likely to lead the way – a far cry from former CMBS structures. For this reason, and because a string of non-performing deals have tarnished the structure, it has even been suggested that from a marketing point of view, CMBS in its reborn form needs a new name.
Dominic Reilly, joint managing partner at King Sturge Finance, says: “CMBS will eventually return to what it was originally designed to do – spread the income risk from a group of defined assets or loans.” However, he acknowledges that the first few deals are likely to be attractively priced and very transparent. In rebuilding the US market, CMBS issuers have revised the structures to remove perceived conflicts of interests. They call this initiative CMBS 2.0 (see panel below), to signify a new precedent for CMBS.
The European market shares the same aims as the US one: to improve disclosure of information and develop structures that will better align the interests of the various parties in a deal with those of bond holders. However, Deutsche Bank’s Dunn said at the CREFC event: “I would be cautious about comparing them too much, as they are different markets. The US market for triple-A class bonds is much deeper. It has taken buyers of that paper time to come back into the market; in Europe we have to recreate many of the buyers, since the structured investment vehicles are permanently gone. It’s not insurmountable, but it’s a challenge.”
To enhance the appeal of CMBS to property investors, Bank of America Merrill Lynch proposes that junior-tranche bond holders be given a call option to buy the underlying property. As well as paying the sponsor a nominal amount, junior note holders would have to buy all senior ranking debt at par. This would avoid the cost and delay of a formal enforcement and give note holders a clear route to taking over the property.
By making junior CMBS tranches more attractive to investors, this call option could help bring in spreads for new deals. The potential for a full prepayment would create extra value and may also justify tighter spreads on senior tranches. In the event of a default, the borrower arguably could expect to lose its property, so would be indifferent to granting the option. A breach of loan-to-value covenant may not be severe enough to justify triggering the option, but a payment default would be fair game.
Transparency must improve
Dunn felt the main change needed was an increase in market transparency. Christophe de Noaillat, senior vice-president at Moody’s Investors Service, supports regulation requiring lease information, for example, to be distributed beyond just rating agencies.
Cheyne Capital’s Stickney said there needs to be more clarity about the payment structure for investors. Dunn called for clearer documentation, while Paul Hastings’ Downey believes future documentation will contain disclosure about who holds bonds, under new rules requiring the issuer to retain 5% of any CMBS. Class X bonds, a tranche giving issuing banks a slice of loan interest with rights ahead of the note holders, should be removed, said Stickney.
“At this moment, when you are trying to bring CMBS back, the last thing you want to do is handicap it against competition from debt placed in a simple whole-loan format. I think the Class X note has no place in European CMBS 2.0.” Downey concludes that whatever happens next, “European CMBS is certain to change.”