Spotlight on debt investment may outshine CMBS market

Delegates expected property debt to be the major investment focus in 2013, reports Lauren Parr

“The market is moving in a new direction,”  chair elect Peter Denton told this month’s Commercial Real Estate Finance Council Europe Autumn conference, noting that “real money buyers that used to buy CMBS are looking to get their hands on loans”. The conference addressed topics ranging from areas of opportunity, new lending and regulation, to market-boosting initiatives.

Away from CMBS, towards loans

The shift towards investing in property loans could cut out intermediaries in the CMBS market, Denton said. Regulatory pressures such as Solvency II, which comes into force in 2015, could lead insurers to lean towards the loan market, while the new requirement for CMBS issuers to retain 5% of notes has not helped this area of the market either.

Nassar Hussain, managing partner of Brookland Partners and chairman of the CREFC’s CMBS 2.0 committee, had a more optimistic prognosis for the CMBS sector. He said that following 2012 CMBS deals from Deutsche Bank, the Florentia deal and RBS’s Isobel Finance: “The timing looks good. Encouraging interest in primary CMBS issuance looks set to continue.”

He added: “If I was a betting man, I would estimate there will be between €5bn and €10bn of issuance next year. A number of deals are in the early stages. There may even be a skills shortage to meet the interest in the market to structure and distribute.”

But another panellist, Mark Nichol, a senior director of Bank of America Merrill Lynch, thought the five CMBS investors in Florentia would be the same five we’d see next year. Delegates were also cautious about new issuance, having absorbed the warning from Peter Damesick, CBRE’s Europe, Middle East and Africa chief economist, that it would be “a slow, stressful recovery”. In a vote, 80% of the audience expected CMBS volumes to be below €5bn in 2013.

Loan portfolio purchases and their financing were hot topics. The market had expected more loan portfolios to be traded this year than actually had been sold, concurred 49% of the audience in one of several voting sessions. Next year, 48% expect the same volume of sales, while 40% expect an increase. One loan buyer said non-performing loan deals are likely to go on for far longer than people think.

One big reason for the lack of loan trades is banks’ ability to fund themselves though the ECB, allowing them to avoid fire sales and pursue other strategies. The bid/ask spread for loan portfolios is not necessarily the problem, one panel agreed.

So far, apart from Project Isobel, very little syndicated exposure has come to the market. “That part of the market will have to move,” said Richard Spencer, an executive director at Goldman Sachs International. More granular portfolios are likely to emerge, he added, but this did not necessarily mean they would be harder to trade.

In terms of where loan sale opportunities could come from, Riaz Azadi, senior vice- president of Eastdil Secured, said: “Ireland has been a long time coming. “There’s enough pressure to ensure some activity in the next 18 to 24 months.” Others said Spain is an obvious place for distressed loan deals, while German banks seemed to have “locked everything up”, although the latter are expected to start unwinding collateral outside Germany over the next year.

One of the panellists felt UK banks are far ahead of southern European banks in terms of work-outs. Capita director Jim O’Leary said bad banks are a necessary part of the ongoing “grappling” with the financial crisis, despite criticism of their strategies.

Loan on loan finance: plenty of providers There is no shortage of finance for buyers of the loan portfolios being sold by financial institutions. The number of lenders competing in this area has multiplied by three since Bank of America was approached to lend on the Bundesbank’s sale of its loan portfolio, said BoAML director Gregory Clerc.

These include fixed-income desks as well as US investment banks, which can do big deals at 500-700bps margins. Hedge funds and special situation funds, seeking 11-15% all-in returns, are another funding source.

However, the cost of loan-on-loan finance is so high as to be deemed “extortionate” by one borrower. This makes it less surprising that banks will lend on non-performing loans secured against secondary property in places like Scotland, but are less willing to lend on direct property, as one panellist put it.

Borrowing costs: fair for senior

Senior debt costs – put at 300-400bps for UK property loans with a 50-55% loan-to-value level – were seen as fair by 60% of delegates. Mezzanine pricing was thought to be too expensive, however.

Loan-to-value ratios are not up for negotiation, claimed CREFC’s chairman, Christian Janssen, co-head of commercial real estate lending at Renshaw Bay, whose new senior debt fund would lend at LTV ratios of up to 75% on deals that might need capital expenditure. Banks’ credit depart-ments are not taking a risk-adjusted view, he said: “They either like [a deal] or don’t.”

The right to assign loans is high on the agenda for senior lenders. Denton said another feature of today’s documents is  prohibitions on borrowers buying back their own debt, while “lenders are building in property protection loans as a principle”, these being the option to provide additional finance at (a higher margin) to save a deal.

Denton was speaking in the context of this year’s launch of the CREFC’s lending principles, setting out best practice at a time when new lenders are joining banks.

“We don’t have a single lending market anymore,” Denton said. “We took the view that we needed to highlight where mistakes were made and it was clear that some really basic things had been forgotten.”

These ranged from tenancy schedules not sourced back to leases; neglecting capital expenditure assessments throughout a loan’s term; not accounting for asset management fees; and not providing for corporation tax to be paid in deals.

Denton said CREFC felt strongly that default margins “should be payable on all defaults, rather than simply payment default, because any default typically leads to a capital increase for a bank owing to slotting and Basel III”. One of the biggest mistakes lenders made in the past related to cash flow: they should focus on net operating income, not net rent, he added.

Next year CREFC wants to roll out the lending principles to Germany and France and launch a third set of guidelines covering loan intercreditor agreements.

New lenders: closing refinancing gap

The emergence of new lenders is partly responsible for closing the gap between the  debt that requires refinancing and the level of capital out there to cover it, said Hans Vrensen, DTZ’s global head of research.

Allianz Real Estate started lending its German insurance company parent’s money 18 months ago, said its head of debt capital markets, Helmut Mülhofer, in a session on new senior lending. “We invest in fixed income and everyone knows where those returns have gone. So if I can get 3.5-4% on commercial real estate I’m doing something good,” he said.

Audience members put their (hypothetical) cash on shadow banking as the place to invest, over banks and bonds. K&L Gates’ partner Andrew Petersen predicted that this industry would come under the regulators’ spotlight over the next three to five years.

Delegates declare themselves prepared to ride the wave of market regulation

CREFC’s audience was surprisingly pro-regulation; in a vote, 60% agreed that “regulatory measures being introduced in Europe and the US are a necessary corrective to an overly lax lending environment”.

They might have reconsidered after hearing Peter Cosmetatos, the British Property Federation’s director of policy, review the daunting regulatory challenges and acronyms facing commercial property. The UK and European AIFMD and EMIR/OTC derivatives have been looming for a while, but vital details are yet to be revealed.

He also highlighted recent UK Financial Services Authority proposals to limit the marketing of unauthorised collective investment schemes to retail investors. These might catch professional investors, posing a problem for any funds targeting wealthy private investors.

But there is worse to come: the FSA has likened REITs to unauthorised collective investment schemes, which shouldn’t be marketed to the general public.

US regulation could also catch unwary UK fund managers. Under the Dodd-Frank Act, funds that have US investors and derivatives, such as interest rate swaps, will be dragged into regulations meant to deal with commodity pools and forced to register in the US with the Commodity Futures Trading Commission. Then there’s also FACTA (the Foreign Account Tax Compliance Act), which might catch funds with significant US investor involvement.

In addition, the European Union and UK Treasury are consulting on introducing caps on loan-to-value and loan-to-interest ratios.

On the issue of slotting, which seeks to standardise property lending risk-weighting models, Matt Webster, HSBC’s global head of real estate, said the FSA is negotiating with UK banks on how to apply it. He believed banks’ methodology will eventually be consolidated into market guidelines.

“Slotting is not necessarily a bad thing” he said. “The issue is the timing of its introduction. There’s work to be done to make sure the criteria are consistent and reflect the risk in the market.”