Commercial real estate CDOs are big business in the US, where more than 42 such deals priced last year. In Europe, just two deals have come to market so far, but expectations for the market’s growth are high. Natasha de Terán explores the potential.
Commercial real estate collateralised debt obligations (CRE CDOs) are CDOs backed by riskier pieces of commercial real estate assets, such as commercial mortgage-backed securities (CMBS) and junior pieces of commercial property mortgages known as ‘B’ notes. As with other CDOs, the CRE CDO pools are split into different tranches with varying risk profiles and sold off to investors.
According to Domenico Picone, head of structured credit research at Dresdner Kleinwort, the CRE CDO market has taken off in the US largely because its has served as a useful alternative funding source for buyers of subordinate CMBS and of other less liquid speculative-grade property instruments, such as B notes and mezzanine loans. Mr Picone explains: “The growth in the US issuance has been driven by an increase in the volumes of suitable collateral available for CRE CDO managers – CMBS tranches, mezzanine loans, whole loans and B-notes – as well as by the benefits of property market fundamentals, and a broader investor base of commercial property deals.”
The US model
The CRE CDO structure is well established in the US, where 42 new deals totalling $33bn were sold last year, but in Europe, the market is still in its infancy. Only two deals with a total volume of €935m of issued notes have so far been priced in Europe – and both appeared at the end of 2006. Despite their recent arrival, there is considerable hype and excitement surrounding CRE CDOs in Europe.
Xavier Poussardin, vice-president in the corporate trust group at Bank of New York, says that the “excitement” surrounding CRE CDOs is coming from both banks and asset managers. “The banks obviously have the tools and the framework to repackage the assets, while the managers have the knowledge of the assets and the assets themselves.” Managers will see CRE CDOs as a useful way to refinance their assets, because the spreads on the assets are fairly high and the economics of the deals are quite enticing, he adds.
Andrew Bellis, director in structured credit at Merrill Lynch, believes that there should also be strong investor demand for these products. “The European CDO market is dominated at the moment by collateralised loan obligations (CLOs), and CDO investors should welcome the diversification provided by the introduction of CRE CDOs. In addition, existing US CRE CDO investors might also look to invest in the European equivalents, for diversification,” he says.
The three key ingredients for the market’s take-off are, by common consensus, in place. The banks are equipped with the structuring know-how; the issuers have a good rationale for using the CRE CDO funding route; and investors should have good appetite to buy into them. But not all believe the market will take off as fast as enthusiasts predict. Mr Picone says he expects CDO managers to explore the viability of European CRE CDOs, but does not expect them to rapidly become a new asset class in their own right.
Mr Bellis agrees: “There is a lot of talk in the market about the potential for European CRE CDOs to take off in a big way but, while the market will definitely expand, there is probably more talk than there will be deals – certainly this year.”
Market constraints
Bizarrely the main constraints that many see holding back the European CRE CDO market are similar to the drivers: namely asset availability and investor demand. “Availability of collateral is clearly going to be an issue because, although the B loan market is growing in Europe, there isn’t an endless supply of collateral to feed these deals,” says Mr Bellis. “Similarly, while investor demand is clearly perceivable, investors could quickly become saturated, and it will be a limited universe to begin with while investors get comfortable with the asset class.”
The collateral issue is a big one for the European market to overcome. European collateral is not only less abundant than in the US, but it is also ‘lumpy’, coming from different European legislations. “Documentation for B loans is complex to manage in the context of a European CRE CDO and that is another constraint on the growth of the market,” says Mr Bellis. “B loan documentation is not standard in Europe as it is in the US, so assigning these loans to a CDO can be administratively time consuming, involving numerous legal complexities.”
Because European B loans are also exposed to pre-payment risk, there is an additional level of complexity. Euan Gatfield, a director at Fitch Ratings in London, says: “Unlike in the US, there are few disincentives for borrowers in Europe to pre-pay their loans early. This creates uncertainty about the life of each loan asset that is originated or purchased. For an asset manager, it is vital to the viability of a CDO for all of the issuance proceeds to be fully invested in income-producing assets, which is harder to achieve if the assets may pre-pay at any time. A manager could be left in the unprofitable situation of having cash available to replenish the asset pool without sufficient assets available to buy. Managers may feel pressured to buy assets that they would otherwise not accept or at prices that would otherwise be unpalatable, just to keep the CDO fully replenished.”
There are ways in which the European market could get round both issues. On the pre-payment side, CRE CDO deals could be structured as cancellable transactions or, alternatively, with greater flexibility so as to allow managers to reinvest in other assets, such as asset-backed securities (ABS). Mr Poussardin suggests that one way the market could get around the lack of collateral is by including synthetics in the portfolio – say by introducing synthetic B-loan exposures to increase the size of the portfolio and its granularity. That said, Mr Poussardin believes that such a project is a medium-term one for the market to work on and a feature that will emerge once the market develops.
Understanding the risks
The risks involved in CRE CDO management and investment are not to be underestimated, although not all of them are exclusive to Europe. “The risks in CRE CDOs can be tricky and need to be properly understood and analysed correctly,” says Marco Szego, assistant vice-president at Moody’s Investors Service. “The transactions require a long lead time, not least because rating agencies need to conduct both real estate and credit analyses to rate the deals properly.”
One of the key considerations for investors is the overlap risk within the CDO’s portfolio – and many believe this will present a particular, if short-term, challenge for Europe. Mr Szego say that because the property markets in the UK and Germany are the most active in CMBS and refinancing activity occurring, it is most likely that the loans in CRE CDO transactions will come from these countries. Coupled with collateral scarcity, this could easily result in portfolios having both poor diversification and including a significant overlap between the CMBS tranches and B loans included in the deals.
“As the market increases in dimension, that overlap risk should diminish, but until then investors will need to consider the implications carefully,” says Mr Szego. He warns that because the credit quality of the loans can also often be low – with coverage ratios of little above 100% – investors will need to be cognizant of the effects that loan quality deterioration will have on their investment.
Mr Gatfield warns that if a CDO market does become rapidly established in Europe, the competition between collateral managers for assets could affect the profitability of each CDO significantly – another factor that could, if not stall the market, at least slow its growth.
Issue trends
Both transactions that have so far been launched in Europe have notably come from US CDO managers – a trend that is expected to continue. BlackRock Financial, which has significant experience in managing North American CDOs of ABS, is the manager of the Anthracite Euro CRE CDO 2006-1. The €342.5m Anthracite deal was arranged by Morgan Stanley and debuted with much fanfare last November as the first European CRE CDO. New York-based Taberna Capital Management, which had already done many similar deals in the US, debuted its Taberna Europe CDO I a month later in December. Merrill Lynch acted as arranger on the €600m deal, which differed from Anthracite by having a portfolio comprised of mainly real estate investment trust (REIT) debt. Anthracite, in contrast, had a large proportion of B notes.
Scott Goedken, investment director at LNR Partners Europe, the European arm of diversified real estate and finance company LNR Property Corporation, says his firm may also dip its toes in the European waters. “In the US, we have been very active in this market, using CRE CDOs to provide term financing for our investment portfolio. Having been investing in the European market for several years now, we have a sizeable collateral pool, so a European CRE CDO could be a logical next step.”
Hype and cautious excitement
Having developed a methodology for rating European CRE CDOs, the rating agency Moody’s hosted a CRE CDO seminar in January in London. Moody’s, which has several deals on its books, knew that interest would be strong, but the agency was still surprised by the level of interest – attendance was so strong that there was standing room only. Some are predicting that up to 20 deals could take place this year, but Moody’s Mr Szego believes that there will be just a couple of transactions launches on the market this quarter; he will make no predictions beyond.
Mr Poussardin is equally cautious. “There is a lot of hype surrounding European CRE CDOs and we have seen keen interest in the product from all around the market. That said, most of the players seem to be waiting to see who is going to do the next transaction,” he says.COMMERCIAL REAL ESTATE CDO SCHEMATIC
