JPMorgan’s CMBS business is booming, helped by a $960m property loan for Colony Capital’s casino assets. The team tell Kathryn Tully how they pulled off the biggest CMBS deal in the gaming industry.

The bankers in JPMorgan’s commercial mortgage-backed securities (CMBS) origination business know a thing or two about the market. The team was the top bookrunner by volume in the US for the second year running in 2006, lead managing $25.9bn of new CMBS deals. However, when the bank agreed to organise a $960m floating rate loan secured by four casinos for Colony Capital last summer, a few surprises lay ahead.

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Ahead of the game: Scott Dauer (left) and Michael Mesard

Not only was the team going to try to pull off the first proper CMBS financing of casino assets – which are rather more exotic than the office blocks and shopping malls that CMBS investors typically see – but also doubts emerged about whether the assets could be considered property at all. Two were barges sitting on lakes in Mississippi, one was a four-storey riverboat on Lake Michigan. The due diligence process was going to be complicated.

Yet last October, after a thorough examination of one Atlantic City casino, the barges and the riverboat, with a total of 1535 rooms, 6394 slot machines and 200 tables for blackjack, craps and poker between them, the team pulled off the biggest CMBS deal in the gaming industry to date.

JPMorgan first started talking to Colony about the possibility of securitising some of its casino assets after the real estate investment company acquired the Atlantic City Hilton, the Resorts casino in East Chicago, Indiana, and the Resorts and Bally casinos in Tunica, Mississippi, for $1.24bn from Harrah’s Entertainment in April last year. But it was when the company started to think about refinancing the $923m of bank and bond debt associated with the acquisition that the JPMorgan team came up with a detailed proposal of how it thought this could be done.

“Colony is very familiar with CMBS from its other real estate assets,” says Scott Dauer, executive director in JPMorgan’s CMBS division and one of the origination team that worked flat out on the deal. “We had been talking to them about casinos generally and when they were looking to refinance the original acquisition financing, that’s when we started in earnest to show them alternatives, including a CMBS financing.”

Exotic asset classes

In the past couple of years, CMBS investors have come round to the idea of more exotic asset classes beyond traditional commercial property sectors, providing mobile phone tower and golf course financings, for example.

Nevertheless, the financing of complete casino business was something new and the team would need to make sure investors understood the asset class and the revenue drivers of the business. “Casinos have not been traditionally associated with real estate – people think of them more as an operating business. Within deals done in the hotel sector, there have been casino components in those loans, but this was the first deal where 100% of the business is driven by the casino operations,” says Mr Dauer.

Securitising casino businesses is not just new, but more complicated than a traditional real estate financing. For a start, a company needs a gaming licence to operate a casino. “One of the things that investors had to understand was that it’s not quite as simple as any piece of real estate where you just slap on your mortgage and can foreclose on a property if it defaults,” says Michael Mesard, another executive director in the origination team. “If a casino asset gets into trouble, you are working more or less hand in hand with the gaming authorities to sort it out.”

Another issue is whether a casino could be used for another purpose if a company was forced to take possession of the asset without impairing its value. The alternatives are more limited than for other real estate assets. “If you were unable to get a licence for Colony Capital’s Atlantic City casino that sits on the strip, you could turn it into a shopping mall and it may have the right value. You just never know,” explains Mr Mesard.

The water angle

Still, the team did not even become aware of a more pressing concern until it got into the due diligence process: three of Colony Capital’s newly acquired casinos were on water. “Mississippi requires that gaming operations have to be on water. Operators get round that by creating a man-made lake, almost like a moat, with a fixed barge on it,” says Mr Mesard. “Unless you happened to be looking out on the lake, you wouldn’t even know that you were on the water.”

That meant a lot more work to ensure that the casinos would both be considered true real estate assets for tax purposes. In the end, the fact that neither of the Mississippi casinos had engines and both were permanently fixed to the land meant that they could be regarded as real estate. The riverboat on Lake Michigan, however, could not, but the team decided that between the four assets, there were enough real estate components for the financing to be considered a real estate loan.

With all their homework done, in September the team got the green light to launch the deal and after that it closed in 30 days. That was quick – most CMBS deals take 45 to 60 days to close – but the timing was important because the clock was ticking. “This was pretty critical, because Colony had a fairly significant extension premium on their bank and bond financing if we missed the deadline,” says Mr Mesard. The pressure was on Colony to get its gaming licence, too. “The one wild card in this deal was how long was it going to take to get these gaming approvals, but Colony went full out and they got their gaming approvals in 30 days,” he says.

The loan, with a two-year initial term with three one-year extensions, was structured as one loan and cross-collateralised by all four properties. The investment grade portion was $650m with $310m of subordinated debt. Of the total loan amount, $10m was not securitised but left a revolving credit facility held on JPMorgan’s book, which was collateralised by the mortgage on the four properties and can be drawn down at any time. JPMorgan closed the $960m deal on October 24 last year and sold 35% to Goldman Sachs and Deutsche Bank at the end of November.

Colony was delighted with the all-in cost of funding at Libor plus 265 basis points (bp). It illustrated the cost savings that could be achieved compared with traditional bank and bond financing, which is about 50bp in spread to Libor and a further 50bp saving in origination fees. So excited was Thomas Barrack, chairman of Colony Capital, that he e-mailed all the team at JPMorgan to congratulate them and said it was “a huge, innovative breakthrough”.

More leverage

Perhaps even more crucial was the extra leverage that could be put on the asset. Traditional bank and bond financing in this sector would allow a maximum of 7.5 times debt to Ebitda (earnings before interest, taxes, depreciation and amortisation) but the Colony Capital financing achieved closer to eight times Ebitda.

An extra half turn in leverage is particularly important in the context of a leveraged buy-out (LBO), so it is perhaps not surprising that since Colony’s deal closed, two casino LBOs have been announced. Harrah’s Entertainment has accepted a $17.1bn offer from Apollo Management and Texas Pacific, and Colony Capital is also straight back in the fray as an affiliate company, bidding $4.7bn to take Station Casino private. The plan is that both will have large CMBS financing components.

That is good news for JPMorgan, which is one of the advisers to Apollo and Texas Pacific on the Harrah’s financing, but it also means there could be much broader interest from public companies in the gaming sector for balance sheet refinancings. “Most gaming operators have shied away from secured mortgage lending and have used traditional bank and bond financing, but when they start to look at the leverage levels, fees and spreads, it’s appealing,” says Mr Mesard.

Although the loan is large for this market, traditional CMBS and mezz investors snapped it up. The demand was high at launch and it traded to many more investors. In fact, Messrs Dauer and Mesard say that investors who would normally invest in the bank market as opposed to CMBS are now expressing an interest in this asset class.

It is just as well, with two of the biggest US LBO financings in the pipeline both for casinos. Deal volume in the CMBS market advanced 25% once again last year, with about $220bn of financing done in the US. That incredible growth of liquidity and capacity means that CMBS financings of LBOs are becoming increasingly common.

Liquidity question

Is there room for all this casino-backed funding, though, given that investors are still so new to it? Mr Dauer thinks so. “There’s tremendous liquidity and there’s been no concern raised on our capital markets side about capacity. In fact, we think this will grow.”

There is no shortage of business for the team. A reorganisation at the beginning of last year, in which the commercial real estate lending and CMBS groups merged, has already paid off in the referral of 41 projects from the former to the CMBS team.

It looks like they are going to stay busy. As a result of the Colony financing, JPMorgan is receiving a lot more enquiries about all kinds of casino deals. The fact that the team also managed to securitise assets that bordered between real estate and operating businesses for Colony Capital sets an important precedent for the wider market. “There’s definitely potential there to apply this in other asset classes,” says Mr Masard.

Next up could be CMBS financings of ski slopes – enough to make Mississippi barges look quite pedestrian.

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