A more sober market for commercial mortgage-backed securities is resuming in the US, but the European market seems to be struggling to reinvent itself in time to handle a looming wall of maturities.

For commercial mortgage-backed securities (CMBS), 2011 has started brightly, in the US at least. In 2010, there were fewer than 10 securitisations of commercial real estate (CRE) loans in the US, totalling no more than $10bn. Market participants expect five or six deals in the first quarter of 2011 alone, which will exceed the total value of CMBS issued last year, with the figure for the full year reaching between $40bn and $55bn. It is still a far cry from the $230bn issued in 2007, but then that level of issuance is probably not desirable.

“Nobody believes we will get back to the 2007 numbers, because there were some lending practices that were not sustainable. But reaching an annual figure of about $100bn within the next couple of years seems a realistic target,” says Ben Aitkenhead, head of US CMBS at Credit Suisse.

Stabilisation importance

The stabilisation of CRE valuations in the US is an important component of this revival. Darrell Wheeler, head of CMBS strategy at specialist mortgage-backed securities dealer Amherst Securities, calculates an 87% correlation between commercial real estate occupancy growth rates and employment growth, which turned positive in the US in late 2010 for the first time since early 2008. And Mr Aitkenhead points out that the act of Wall Street re-entering the CRE lending business itself contributes to stabilisation, as it restores lending capacity and bolsters sentiment in the real estate market.

Office and retail space deals are the most common at the moment, as hotel and multi-family residential developments were hit harder by the crisis. One significant change from the period before the crisis is that fixed rather than floating-rate loans are now in the ascendancy.

That partly reflects the extinction of most of the floating-rate CMBS investor base - managers of leveraged investment vehicles such as collateralised debt obligations, off-balance-sheet structured investment vehicles (SIVs) and asset-backed commercial paper (ABCP) conduits. By contrast, the fixed-rate CMBS investor base has proved more stable - insurance companies, large fund managers, banks and specialist hedge funds.

 “The prevalence of fixed-rate loans also speaks quite loudly to another change - floating-rate loans pre-crisis tended to be loans on what were referred to as transitional properties, which were still being leased up or converted, or had a redevelopment story. Today, the absence of floating-rate lending reflects the lack of interest from lenders in making loans on transitional properties. Fixed-rate loans on stabilised assets on relatively conservative underwriting of the cashflow of those assets are the order of the day,” says Mr Aitkenhead.

Europe falls behind

By contrast, it is not possible yet to talk of such general post-crisis trends in Europe because there have not been enough deals in the market. Deutsche Bank is apparently mulling a £300m ($486.9m) CMBS to finance private equity firm Blackstone’s purchase of Chiswick Business Park in London.

Most deals, such as the five issues from UK retailer Tesco arranged by Goldman Sachs since June 2009 - the most recent in February 2011 - have been sale and leaseback transactions allowing the issuer to monetise its operational real estate. This means the investors are more exposed to corporate credit risk, in this case one of the world’s largest retail chains, rather than the valuation risk on the underlying properties.

The first true CMBS deal in Europe in 2010 - and the first in the Netherlands since 2007 - was a multi-family issue for €350m by residential property investment fund Vesteda. Its advisors were the revived ABN Amro and Bishopsfield Capital Partners - a boutique structured credit advisory firm formed by Steve Curry and Mike Nawas, two ABN veterans who left in the months after their operations were sold to RBS.

Mr Nawas says the lag in Europe is partly historical. The US banks were never fond of real estate lending for maturities over five years, so CMBS conduits were well developed by the 1990s to provide longer-term financing via the capital markets. By contrast, Europe only moved away from single-borrower placements to the capital markets from around 2004 to 2005, leading to more aggressive loan-to-value (LTV) ratios at the peak of the boom.

“We find ourselves in Europe in a situation where the market for CMBS is so new, it has not been through a crisis before this crisis. So questions such as intercreditor disputes and recovery rates are untested in this market, but they have been tested before in the US. That means US banks have been able more quickly to estimate their losses and start lending again,” says Mr Nawas.

European volatility

As a result, the outlook for the underlying European CRE market is more volatile than in the US. Mr Nawas says pre-crisis European CMBS typically reached 85% LTV ratios, meaning the lower tranches start to go underwater if property values have fallen more than 15% since the peak of the market. For some commercial properties, especially outside of the best metropolitan areas, valuations are down by 30% to 40%, and rental streams have been badly damaged - the average vacancy rate for Dutch office space is 26%.

“Not only would property markets have to pick up quite significantly to make these pre-crisis deals fly at their current leverage, but new covenant packages are going to be much tougher, because no one is willing to lend at the debt and interest coverage ratios seen before the crisis any more. The borrowers will need to raise mezzanine and equity to refinance these deals in the future,” says Mr Curry.

The investor base for CMBS in Europe is also less developed than in the US, and was more reliant on leveraged buyers such as SIVs and ABCP conduits. Caroline Snowden, property structured finance advisor at boutique JC Rathbone Associates, says that by the peak, only 25% of investors in UK CMBS were real money funds.

Still, insurance and pension funds are interested in commercial real estate as a good match for their long-term liabilities, and that trend may be intensified by the advent of Solvency II regulation that pushes for tighter asset and liability management. Goldman Sachs apparently ran an exercise recently identifying key accounts that would be interested in stepping up CRE investment, and found at least 50 potential investors.

“Insurance and pension funds like commercial real estate. It offers good value relative to most of the fixed-income space,” says Ben Green, managing director in the European structured finance team at Goldman Sachs.

Structural flaws

To tap this investor pool, the European CMBS market will need to overcome some structuring problems stemming from its immaturity and which have emerged during its first real test. One of these is the use of interest rate swaps in securitisation special purpose vehicles (SPVs), with the swap provider ranking alongside senior debt providers if the swap is settled early and out of the money. 

This has discouraged CMBS restructurings before the final maturity of the bond for fear that noteholders’ recoveries will be hit by making substantial margin payments to the swap provider. By contrast, US SPVs tended to use interest rate caps with a fixed fee payable upfront.

“Extended hedging for the whole period of the transaction completely ties the hands of the CMBS loan servicer. Whatever structure comes back as the market recovers needs to have more flexibility. The cap fee costs more upfront, but the bank could just lend at a lower LTV and include the cap fee on top – at least it would leave you free to revisit the deal later without excessive breakage costs,” says Paul Lloyd, a senior director of loan servicing at real estate brokerage CB Richard Ellis.

A further missing component is the liquidity facility needed for the SPV, to cover any payment delays on the underlying loans that occur. Conor Downey, partner in the real estate finance team at law firm Paul Hastings, says traditional European liquidity facility providers such as Barclays, Calyon, Danske Bank and Lloyds have all pulled back from this activity recently, in expectation that it will attract higher capital charges under the Basel III liquidity rules. As a result, when the Fleet Street 2 CMBS of German retail store properties was restructured in March 2010, the new vehicle had to simply set up a reserve account with money sitting in it earning almost no return, adversely affecting the economics of the deal.

“In the US, they have a slightly different mechanism called servicer advancing. We introduced that on a few deals in Europe just before the credit crunch struck. Any servicer in Europe who could offer this facility would have a huge advantage in the CMBS market revival, as they could make a good return on this,” says Mr Downey.

Class struggles

The more profound difficulties stem from uncertainty about how restructuring mechanisms can work in Europe. As the market had not been through previous restructuring cycles, European CMBS documentation has not developed inbuilt measures to resolve disputes between different classes of creditors. On existing deals, servicers typically need a 65% to 75% vote in favour of a deal on each individual tranche of a CMBS.

Senior classes are often happy for the servicer to enforce on underlying loans and sell the properties, because A-notes are likely to stay unscathed unless underlying valuations drop very heavily. Mezzanine investors are more likely to push for the loans to run to maturity, in the hope that property valuations will stage some recovery during that period and reduce their eventual writedown.

“To get a deal, you would have to prove that going into special servicing would be detrimental to the creditors. On Fleet Street 2, we had a specific reason for the deal to happen – the underlying operating company [German retail chain Karstadt] was insolvent. The administrator for Karstadt was threatening to just shut the stores down if creditors could not agree a deal, which would have left empty properties with no rental income. By contrast, many other situations have dragged on without resolution,” says Matthew Prest, head of the European restructuring team at Moelis & Co, who worked on the Fleet Street 2 restructuring.  

Charles Roberts, a partner at Paul Hastings who also worked on Fleet Street 2, says there is a delicate balance to be struck. The Loan Markets Association is recommending stronger rights for senior creditors to push through restructurings that squeeze out junior debt. But taking this too far could discourage mezzanine investment altogether.

Refinancing wave

Whatever the solutions, they need to arrive quickly as there are significant CMBS maturity hurdles in 2011 to 2013 that will need to be refinanced (see chart). The more forward-looking companies that entered into single-borrower CMBS deals are already moving to refinance early, piece by piece.

UK business park operator MEPC recently removed one of four properties that formed part of a £470m CMBS arranged by Eurohypo, maturing in July 2012. The £102m loan on that property was prepaid and refinanced by a bilateral loan from Eurohypo, extending the maturity in the process. There was no prepayment mechanism in the original documentation but as Eurohypo was also the servicer on the deal, the bank agreed instead to use the clauses that allowed for disposal of properties.

“There is a need to bring in more variation in refinancing dates so that the refinancing risk is reduced at any one point in time. We aim to move to a situation where refinancing is something that becomes our bread and butter, having that ability to flex the debt and review our gearing levels much more frequently without major cost to the business,” says MEPC’s finance director Rachel Page.

European CMBS loans refinancing profile

Eurohypo is Europe’s largest CRE lender, and remains active in providing bank debt to the market. But Caroline Philips, head of securitisation at Eurohypo, says other banks are pulling back from the market as higher capital requirements under Basel III and tougher funding conditions begin to bite. Germany’s DG HYP, part of the DZ co-operative bank group, announced in December 2010 that it was pulling out of the UK real estate market, and the German Bank Restructuring Act passed in February 2011 may raise funding costs further for German banks.

“Margins are moving up in the loan market as liquidity is drying up. At the same time we are seeing securitisation spreads coming down in the secondary market, so at some point they will meet in the middle and primary issuance will be viable. We need it, because banks are not going to step up to the plate for all this refinancing, so the capital markets will need to do their share,” says Ms Philips.

In addition, Eurohypo is using securitisation technology to build fund-style structures, such as its joint venture with asset managers Cairn Capital and Schroders, launched in November 2010 to provide an initial £1.5bn in fresh CRE debt financing. Philip Cropper, head of real estate finance at CB Richard Ellis, says there are a growing number of opportunity funds, including those backed by sovereign wealth fund money, ready to invest in CRE at mezzanine or equity level.

This will be important, as the most overstretched borrowers, such as Irish syndicates whose loans are now the property of the National Asset Management Agency, will not be able or willing to commit new capital to bring down the leverage in CMBS deals. But there is also a hard core of deals from the late boom period that are unlikely to find any new investors. Mr Prest says these include shopping centres in secondary or tertiary locations, or underused industrial and logistics facilities that may simply be sold for site value. This means some investors will still need to absorb losses when CMBS cannot be repaid at maturity, before they can even think about investing anew.

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