The reappearance of European CMBS

The European CMBS market has worked on a slow burn this year even by its own standards, with the first public deal creeping in just weeks before the end of 2017.

Bank of America Merrill Lynch’s £347.9 million (€389.3 million) Taurus 2017-2 UK DAC was the only public conduit transaction in Europe in 2017. To make it happen, it seems the stars aligned for a publicly traded CMBS to become viable; spreads tightened across asset-backed securities markets, while a lack of supply of CMBS notes ensured that investor appetite was strong.

“Securitisation spreads have been tightening for a while since there is very little you can buy to generate a proper cash return,” says Matthias Baltes, head of EMEA commercial real estate structured finance at BAML.

Sterling-denominated AAA-rated CMBS spreads fell from nearly 200 basis points in July 2016 to less than 100 bps in July 2017, according to BAML’s Structured Finance Outlook 2018 report.

“The CLO (collateralised loan obligation) market has come in quite a bit as well,” explains Patrick Janssen, ABS fund manager at M&G Investments. “The main reason for that is a lot of money is flowing into ABS as investors are realising it is very cheap compared to corporate bonds. Secondly, there is a shortage of supply, particularly in CMBS.”

With pricing having tightened, securitisation is “once again competitive with the loan syndication market”, says Baltes. During the past 18 months, the real estate loan syndication market has served as the distribution channel of choice for investment banks in Europe, with an array of organisations, including debt funds, insurers and other banks, buying paper.

BAML realised the environment had become conducive to CMBS around six months ago, Baltes explains, although the bank could not simply turn the tap back on, due to the time required to source suitable financing opportunities, close loans and go through the securitisation process.

Pricing in the deal was aggressive; 10 basis points below where AAA spreads stood at the beginning of November, and 5bps lower than initial price guidance. The AAA notes, which accounted for up to 32 percent loan-to-value of the underlying facility, priced at just 85 bps.

“The spread you can achieve on bond execution is significantly lower than it was a year-and-a-half ago,” Baltes comments. In March 2016, BAML priced the AAA notes within a €317 million securitisation of Blackstone’s German Kingfisher portfolio, at 130 bps.

“Pricing was quite tight owing to a rarity premium,” explains Janssen. “The sponsor is also a repeat CMBS issuer therefore is well known in the market.”

That sponsor is Blackstone, arguably the most blue-chip of investors in the European real estate markets. The loan securitised in Taurus 2017-2 totalled £364 million, written at a margin of 220bps. Along with £72.8m of mezzanine debt, which didn’t feature as part of the CMBS, the finance funded Blackstone’s £560 million acquisition of 127 light industrial and logistics properties from Brockton Capital, which continue to be managed by M7 Real Estate.

As well as the strength of the underlying borrower, investors were no doubt drawn to the deal for exposure to the ‘last-mile’ logistics market, a sector viewed as one of the fastest-growing in the property pantheon. “The portfolio is fairly homogenous by property type, age and specification, and is well-spread geographically,” Fitch said in a pre-sale report.

Demand for the notes was strong across all tranches – more than twice oversubscribed. In total, 22 investors bought paper. “The investor base is unchanged compared with who we sold to last year. There are 30 to 40 investors in Europe willing and able to buy CMBS,” says Baltes.

Notably, the loan structure does not include financial default covenants, prior to a permitted change of control. However, the deal does feature a cash trap for excess rent if the LTV rises above 75 percent, or the debt yield drops below specified markers at varying periods of the deal’s lifespan.

Given the investor demand for the notes, the deal’s lack of covenants does not seem to be an issue for CMBS investors. One source says that such structures have been used before in CMBS, as well as syndicated loans, although another source argues that a lack of covenants does not work for all participants in the syndication market.

“Given the deal tranching, it is possible to choose how comfortable you are with this mechanism or not by choosing more or less credit enhancement,” says Janssen.

As well as the UK deal, BAML has recently closed an unrated Italian CMBS – the € 144 million Taurus 2017-1 IT. The deal is a refinancing of a loan securitised in Goldman Sachs’ 2015 REITALY transaction, which financed a portfolio of retail and cinema assets in Italy owned by Apollo and AXA.

The Italian deal is not a fully fledged securitisation; there’s a subtlety in the deal’s structuring associated with the local withholding tax regime. While in other markets non-bank lenders can participate in a simple syndication, in Italy it’s very difficult for non-banks to invest in real estate debt, leading to deals being structured as bond issues to accommodate international investment.

The €99 million Class A tranche was sold to a UK insurance company at 210bps and the €45.25 million of Class B notes were bought by Cheyne Capital Management. Pricing was in line with the country risk.

After a dormant 18 months with only private or retained deals such as the £215 million securitisation of 13 student housing properties owned by Brookfield in March this year, total European CMBS issuance will end up at €3.5 billion for 2017 according to BAML’s report.

“Competition for loans has been intense. There is a wall of capital looking to invest in real estate with more lenders than borrowers in the market. There is also a huge amount of equity out there,” says Paul Hastings’ CMBS lawyer Conor Downey on the lack of public conduit deals this year.

Coupled with a large dose of uncertainty at the start of the year, in part linked to Brexit, CMBS spreads had been too wide to offer a better funding alternative to balance sheet loans. However, at current spread levels, CMBS now make economic sense in the UK, and potentially Germany, specifically for non-prime property. CMBS could offer borrowers a 112bps cost saving on secondary assets in the UK, for example, versus financing them in the bank loan market, the BAML report says.

“Taurus 2017-2 UK has revealed that CMBS can offer borrowers significant cost savings, which we think could lead to a surge in new deal activity,” according to BAML, which cites reports that the rating agencies are currently dealing with around a dozen CMBS enquiries. Next year, BAML is forecasting £5 billion of European CMBS.

“I don’t see an explosion of deals any time soon, but in a world where quantitative easing is slowly being tailed off I can see the ingredients starting to come together for the market. The CLO market is cyclical; it is at or near the top, which means it will start to decline at some point,” says Downey.

For some investors, it makes sense to look outside Europe for deals. “We’ve learnt to accept you’re not going to see much out of Europe. Capital charges and definitions of which type of deals warrant favourable capital treatment are all over the place; unless we see standardisation there won’t be a big ABS market. CMBS will remain a small, bespoke market for years to come,” says Janssen.