EUROWEEK: Real estate securitisation in Japan is about 10 years old. What instruments does it cover and what effect has it had on the underlying physical property market? In Japan, the term fudosan shokenka, meaning real estate securitisation, refers to CMBS and also encompasses real estate investment trusts (J-Reits) and private real estate funds, as well as syndicated real estate investments.
In broad terms, there are two types of CMBS: those backed by direct real estate exposures and those backed by non-recourse loans that are ultimately backed by real estate. For several years since the Japanese non-recourse loan market developed so markedly, the mainstream market has been of the latter type, dominated by the conduit funds that by last year had come to represent roughly 80% of the market.
Japan has one of the biggest real estate markets in the world despite the actual area of the country. According to the governments Cabinet Office, total real estate value in Japan was estimated at ¥2,200tr (approximately $20tr) at the end of 2005.
Historically, liquidity in the Japanese real estate market had been limited; until quite recently owners were reluctant to treat their properties as saleable assets. Also, the financing used to be plain vanilla, with recourse to the originator and lacking modern valuation methodology.
The development of non-recourse finance, CMBS and securitisation in general over the past decade has changed that situation dramatically, resulting in greatly enhanced liquidity in the real estate market.
CMBS had developed as one of the core sectors of the Japanese securitisation market, second only until the end of 2007 to the RMBS sector in terms of annual supply. We estimate that CMBS issuance in 2005 amounted to ¥1.5tr, or nearly double 2004 output. In 2006, it was nearly as high and in 2007 issuance swelled to ¥2.1tr.
In the formative years, office buildings dominated, but from about 2004 onwards there was far more asset diversity, including residential and retail property, hotels, leisure complexes and other commercial assets. As time went on, the asset pools grew much larger, the record being ¥343bn, and more diverse geographically.
With the problems in the market since late 2007, the market is again focusing on office buildings, there is a greater concentration on Tokyo, and investors far prefer fewer assets that can be easily assessed via due diligence in light of the tighter regulatory monitoring.
EUROWEEK: Could you describe the regulatory environment and its key developments?
The supporting legislative framework has largely been established over the past 10 years or so, all improving disclosure and helping improve professionalism and market transparency.In Japan, there are broadly three forms of real estate securitisation. The syndicated real estate investment scheme itself has a number of variations, but the most commonly used are the tokumei kumiai and the ninni kumiai.
The scheme was initially introduced in 1987, but grew in stature after the April 1995 Syndicated Real Estate Investment Law was implemented to enhance investor protection. The investors participate in the real estate investment through a partnership agreement, and receive dividends based on their relevant share in the investment.
Japanese real estate investment funds were technically launched in Japan with the revision of the Law on Securities Investment Trusts and Companies in November 2000, to allow for real estate and related products to be included in investment trusts. The main manifestations have been private funds and listed J-Reits, of which there are now 43 on the bourses of Japan.
Asset securitisation, or CMBS, involves the transfer of assets to a bankruptcy-remote special purpose vehicle, which issues debt to investors. CMBS transactions are typically driven by the originator (original owner of the property or real estate-backed loan), rather than the fund managers that drive investment funds.
CMBS refers both to deals backed by non-recourse loans and to those backed directly by the physical real estate or beneficial interests in it. The CMBS are issued in the form of debt, namely bonds, loans and trust certificates.
The use of the trust in Japanese securitisation schemes is common, given its tax-transparency and bankruptcy-remoteness. The trustee holds assets in trust for the benefit of the securitisation programme and ultimately the investors. The assets are segregated from the trustees assets and other assets in trust by regulation. Issuance of trust certificates via private placement has dominated Japanese CMBS in recent years.
Entities that are exposed to the equity portion of the CMBS, or at the non-recourse loan level, are called "sponsors". Sponsors as equity investors in the loan or CMBS have a strong interest in maximising their returns; hence their interest could be in conflict with debt CMBS investors.
Another factor was the change in accounting standards and the introduction of market value accounting for real estate holdings. In 2005, impaired asset accounting for fixed assets, originally announced in 2002, became fully effective.
Securitisation of non-recourse loans is no different in legal structure from that of other monetary receivables. The non-recourse loans (or bonds) are transferred to the issuer special purpose vehicle [SPV], which in turn would issue notes to or take in loans from investors.
Sale-and-leaseback transactions, and the CMBS deals that were launched in the early stages of the CMBS market from 1999 to about 2003, are often backed by direct exposures to real estate. CMBS originated for the purpose of financing property development also often falls in this category.
Simply put, a CMBS of this type would involve the direct transfer of the real estate or beneficiary interests from the originator to the issuer SPV, which in turn issues asset-backed bonds or loans to the investor. The originator is often the master tenant, or the sole tenant in a property (a sale-and-leaseback structure), and continues to be involved in the securitisation scheme.
CMBS involving direct transfer of real estate or beneficial interests in property trusts to an issuer SPV is likely to be more complicated in structure. Given the complexity of ensuring bankruptcy-remoteness or true sale and coping with tax issues, the structure may involve a series of SPVs.
EUROWEEK: Can you explain the internal cashflows, and how investors are repaid?
Debt investors receive principal as the properties in the pool are sold or the non-recourse loans are repaid. The principal redemption of the CMBS will match the cashflows of the underlying loans; usually, a part of the CMBS note principal will be scheduled to amortise during the life of the transaction.
The remaining principal would be repaid in a lump sum, known as a balloon payment, at the end of the term. If a loan is prepaid, the CMBS principal would be prepaid as well.
A tail period of typically two years after the scheduled redemption of the final loan is provided, to allow for time to dispose of the underlying property in case of loan default.
In a typical multi-borrower CMBS, the scheduled amortisation of principal takes place sequentially from the most senior tranches down to the lower tranches. In other words, the overall transaction delevers over time.
More recently, however, there has been greater variation in principal redemption structures. Deals may employ a pro rata structure in which principal is distributed to all tranches on a pro rata basis; controlled amortisation; or a variation of this where a predetermined amount of principal is allocated to the junior tranches before the senior note is fully paid down.
These structures were employed in recent years as a result of tighter spreads on the underlying loans, and the subsequent need for the arranger to reduce negative carry risk in the CMBS. Under a sequential-pay structure, the senior notes pay down first, leaving the CMBS with the higher coupon-paying notes.
Prepayments are usually allocated on a pro rata basis. Balloon payment at the end of each underlying loan term may be allocated on a sequential or pro rata basis. Again, the pro rata scheme is effective in reducing negative carry risk.
Defaults, on the other hand, are allocated on a reverse-sequential basis, from the lowest tranche to the most senior tranche in the capital structure. Collections on defaulted loans are distributed on a sequential basis.
Cash reserves are typically provided to cover liquidity risk. Also, the master servicer may provide advances to cover for temporary shortfalls in cashflow at the loan level (such as tenant lease payments). There are also some cases where the servicer would also provide advances to cover for temporary payment shortfalls at the note level, for the most senior tranche.
EUROWEEK: How is the collateral assessed?
A standard loan backed by commercial properties assumes refinancing, and therefore would have a balloon payment at the end of the term. The borrower may choose to reduce the balloon amount by amortising part of the loan on a scheduled basis using lease payments during the loan term.
Non-recourse loans are typically three to five years in maturity. There have been cases of loans with maturities of up to seven years, or even 10 years, but these have been limited.
Loans can be prepaid, but usually subject to certain conditions, which may vary significantly, depending on the agreement between the borrower, sponsor and arranger. Typical prepayment provisions include a lock-out period of one to two years, during which the borrower may not prepay the loan. After that, the loan may be prepaid, subject to a fixed penalty payment.
In some cases, no prepayment penalty is required, and the loan may be prepaid freely on any payment date.
Some loans may have call features embedded, for the benefit of the lender. The purpose of a clean-up call for the notes may be to mitigate the risk of a few small or weak properties being left in the portfolio, or the risk of negative carry.
Negative carry risk in a conduit CMBS with a sequential redemption structure is high over time, as the senior tranches are paid down and the higher-yielding tranches remain.
Loans may carry triggers to protect lenders, addressing the debt service coverage ratio [DSCR] or loan to value ratio [LTV].
There are many variations, but in a typical structure, if a trigger is breached, payments to equity investors are terminated and excess cashflows are trapped to provide additional credit support to the lenders. These funds are released when the trigger is cured. If the trigger is breached twice or three times in a row, the loan enters early amortisation.
To mitigate temporary shortfalls in cashflow, cash reserves or a letter of credit may be embedded at the loan level. This feature may or may not be required by the rating agency, depending on the diversification of the tenant base. Further liquidity support may be provided through payment advances, usually by the master servicer.
If a borrower defaults on its payments under a loan, the master servicer will transfer the servicing of the loan to the special servicer. If the payment shortfalls cannot be cured, the special servicer enforces the lenders rights under the security. It may attempt to sell the properties, following certain established procedures.
Loans in a deal are typically subject to cross-collateralisation and cross-default. The cross-collateralisation feature gives the lender the full benefit of portfolio diversification, as cashflow shortfalls arising from one property can be covered by cashflows from another property.
Cross-default is typically provided when multiple loans are extended to the same borrower, which allows the borrower to realise default on all loans when one of the loans is in default.
EUROWEEK: How are the ratings calculated for CMBS of non-recourse loans?
Each loan differs in its underlying assets, leverage and cashflows, which ultimately affects the CMBS structure and required credit enhancement to achieve a certain rating for the CMBS.
In some cases, the debt portion may be tranched into senior and mezzanine loans. There was at one time talk of securitisations of mezzanine loans as well, but most of the CMBS have been backed by senior loans.
The two benchmark measures used in analysing the credit quality of loans are the LTV and DSCR.
These ratios quantify the cushion available in the loan structure to absorb shortfalls in cashflow or a decline in property value. The greater the cushion (the lower the LTV and higher the DSCR), the lower the probability of default.
LTV is the amount of financing provided against the value of the property and effectively represents the subordination level of the senior loan. The denominator, or the property value, depends on the various adjustments made by the rating agencies in line with the risk considerations we mentioned earlier. The feasibility of the LTV level is therefore dependent on the assumptions made for the valuation of the property.
DSCR is the net cashflows generated by the property, divided by the cashflow needed to service the loans or CMBS. The DSCR should be above 1 to ensure that there is enough cashflow to cover payments under the loan.
The rating agencies have a target LTV and DSCR level for each rating level, which is adjusted based on the quality of the property, loan leverage, payment structure, and so on.Senior loans benefit from credit enhancement in the form of subordination; i.e. the LTV of the senior loan can be adjusted by the amount of equity and mezzanine in the loan capital structure. Equity is usually provided by the sponsor of the loan in the form of tokumei kumiai or TK investments. Increasingly, lenders have emerged to take the mezzanine portion of the loan.
Higher subordination is a positive in that it reduces the LTV for the senior loan, ultimately backing the CMBS transaction. On the other hand, higher leverage in the loan structure implies that refinancing may be more difficult; the rating agencies appear to take this into account when adjusting target LTV.
Tranching at the CMBS level is largely affected by the subordination and credit enhancement available at the underlying loan level, as well as the waterfall or principal redemption structure of the transaction. For obvious reasons, the senior tranches in a deal structure employing a sequential-pay scheme will require less subordination than those in a pro-rata scheme, to achieve the same rating level.
On the other hand, junior tranches will require less subordination, given the higher priority of principal payments.
EUROWEEK: Are prepayments a problem for CMBS investors?
Prepayment is a major consideration, as it is closely associated with the risk of negative carry. Prepayment can also result in earlier-than-expected principal payments.
In some cases, this may be of benefit to investors the many upgrades of mezzanine tranches in recent years were due to the active prepayment and refinancing that occurred as a result of the strong real estate market and low interest rates.
Since many of the non-recourse loans in recent years have been extended to leverage a property acquisition, these borrowers in many cases tried to sell the property when the market was bullish, regardless of the initial loan term.
Rating agency performance reports indicate that prepayment levels have been high in recent years. Some loans have been repaid, or defeased, even during the initial lock-out period.
According to a Moodys study of loans backing Japanese CMBS originated between 1999 and end-March 2008, 33% of loans by number were prepaid and 2% were defeased by end-March 2008.
In most CMBS transactions, the legal final maturity date is set after the last date of payment of the underlying loan, usually by about 2 years. This is called the tail period, which addresses refinancing risk or other risks of non-payment of the underlying loans at expected maturity. If the loan cannot be refinanced, the tail period would allow for the servicer to foreclose on the property, ultimately paying off CMBS investors.Commingling risk [the risk of a deals cash being mixed up with the originators if the originator goes bankrupt] is usually minimal in CMBS, since servicing is often by third parties. However, it must be ensured that lease payments are made into the SPV account (or lockbox), or immediately transferred to this account, where the servicer can hold full control.