Rampant bull market gives way to age of care and moderation

  • 30 Jun 2008
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The remarkable feast of Japanese CMBS ended abruptly at the end of 2007, leaving investors with indigestion and little stomach for more paper. While lenders still have a taste for non-recourse loans, they are more selective and more guarded.

But the underlying property market remains solid, existing non-recourse loans are performing and CMBS ratings are intact. There is plenty of money around and to lure lenders and investors back to the table, arrangers are now offering property finance à la carte

There is little doubt that the Japanese non-recourse loan and CMBS markets got ahead of themselves from 2004 through to the end of 2007.

The market has since shrunk sharply, after the record breaking 2007 volumes, and spreads have doubled from late 2007 levels, and almost quadrupled from the tightest ever Japanese CMBS spread of 18bp in mid-2005.

In the non-recourse market, loan to value ratios (LTVs) have shrunk from about 70%-80% — and as high as 85% — to 60%-70% today, the higher end only if the underlying asset is prime Tokyo office space. Lenders are now wary of more economically sensitive property assets and tend to steer clear of the regional exposures across Japan they were taking onboard from 2004 to 2007.

There has also been a sharp reduction of liquidity in the mezzanine market for property funding. In the CMBS market, where diversity was formerly a virtue, it is now a sin; transparency and traceability are the new passwords to investors’ vaults.

Primary markets remain open, albeit muted

While the commercial property, non-recourse and CMBS markets are much quieter today, the fallout from US subprime and the global credit crisis is far less severe.

While the commercial property outlook is not quite as good as it was 12 months ago, it remains healthy. Japan’s commercial property finance market still functions today and while Japan’s CMBS market was at its most liquid in the second half of 2006 through to mid-2007, the market has priced new deals this year, and not at exorbitant spreads.

The global conditions resulted in the near complete withdrawal of foreign buyers from mid-2007 onwards. The worst of the contagion in world financial markets then just happened to coincide with Japan’s 2007-2008 fiscal year end, traditionally a quiet period in Japan’s financial markets.

The Japanese buyers, who had consumed vast volumes of CMBS paper in record breaking calendar 2007, had by early 2008 virtually exhausted their budgets for the fiscal year ending March 31, 2008 and had no little or no cash left to invest, thereby exacerbating the situation.

"That," explains Michiko Sakai, vice president, securitisation research at Deutsche Securities in Tokyo, "meant there was a demand vacuum, during which secondary market spreads at one stage were even higher than the visible levels."

Hence it was only by March that it appeared the seller’s market for Japanese CMBS really came to an end, while spreads for most other securitisation asset classes in Japan had widened only marginally or barely at all.

Playing by the new rules

Market participants have needed to rapidly adapt to the new rules of the game. "The dramatic change has produced a dramatic reaction among real estate financiers," explains Hiroyuki Takada, managing director, fixed income, Asia Pacific real estate finance and securitisation at Credit Suisse in Tokyo. "Products in favour in recent years are no longer in vogue and the diversified asset conduit is now virtually dead, apart from a few of the largest players who continue to be able to finance certain prime properties."

All of the major Japanese CMBS trends of the 2004-2007 golden era for Japanese CMBS have in 2008 therefore been in reverse, with primary CMBS issuance in 2008 through to May falling short of 2007, deal sizes falling and a total absence of mega-sized transactions.

Takenari Yamamoto, managing director in the structured finance group at Standard & Poor’s in Tokyo, believes that the market has reached an inflexion point from which it must migrate more towards the investors rather than on terms determined by the borrowers. Gone, he notes, are the pools with large numbers of properties, and those deals concluded in 2008 comprise very few underlying assets, typically less than 10.

Domestic investors have become increasingly selective, encouraged also by regulator pressure. Yukio Egawa, managing director, head of Japan securitisation research at Deutsche Securities in Tokyo, notes that as market events unfurled, domestic Japanese buyers have also focused more attention on the increased demands for due diligence demanded by Japan’s regulators in the past couple of years.

The regulators’ watchful eyes

Japanese regulators have a long memory of the sharp fall-out at the end of the bubble period in the country and the devastating effect that collapsing property values can have on the economy and on the financial system.

"For the past two years the regulators have become increasingly cautious about increasing exposure by deposit-taking institutions to the commercial real estate sector," Egawa elucidates. "They have been digging into the asset pools of many deals and demand that both the non-recourse lenders and CMBS investors conduct extensive due diligence."

In addition, since 2006, regulators have been tightening their monitoring of real estate-related exposures. Combined with an increasingly conservative lender base and a very watchful supervisory environment, the real estate financing market is considerably tighter than before.

The demand on CMBS investors to have analysed each of the properties underlying the non-recourse collateral in CMBS means that deals with a large number of underlying properties are out of favour nowadays. Single asset or limited asset deals are preferable for investors.

A return to specialisation

The number of real estate properties collateralising 2007 new issues amounted to roughly 1,200, totaling approximately ¥3.2tr on a Moody’s valuation basis. Like the previous year, almost 70% of the properties were located in Tokyo and office buildings dominated, representing about 50% of the new issues, followed by retail and residential.

"Through to the end of 2007," says Koji Kumamaru, managing director at Moody’s Investors Service in Tokyo, "that property type and geographic diversification helped spur the rapid growth in the CMBS market, but that trend has now reversed itself sharply, as buyers focus largely again on Tokyo and on offices."

Tetsuji Takenouchi, senior vice president and team leader for CMBS ratings at Moody’s in Tokyo, concurs: "Whereas in 2006 and 2007 the largest number of assets in one CMBS pool was sometimes more than 100 and often 30 to 50, the maximum we see now is about 10 and in practice the market clearly favours single or very limited asset deals."

Japan — haven in the storm

The tightest spreads in Japan were available when the asset pools were most diverse. That situation is also in reverse, with the widest primary spreads this decade now available as pools become more defined and more understandable. That means Japan’s CMBS market should, theoretically, represent good value.

Japan has a very different model from that in the US, and to a lesser extent the European and Australian markets. "Spreads and LTVs today are back around those prevailing at the early part of this decade," observes Jinkyu Hong, managing director of principal investment, Japan, at Merrill Lynch Japan Securities and a mezzanine funding expert. "The market has in effect returned to where it was before CMBS volumes exploded as the conduits became so active."

A glance at the graphs tracking spreads in the US, Europe and Japan tells the tale of a turn of events in Japan far less exaggerated than the turmoil elsewhere. In Europe, five year triple-A CMBS priced at its lowest at 17bp above Libor and secondary spreads blew out earlier this year to 175bp. In the US, the story was even more severe, with extremes of 19bp and 392bp reported.

Throughout 2007, spreads in Japan widened from the low 20s to low 30s as paper flooded into the market in record volumes. Then, as non-recourse lenders became more cautious amid the subprime and global credit crisis, CMBS spreads in Japan through to the spring this year spiked.

Although the Japanese secondary market is notoriously illiquid, observers report spreads spiking to about 100bp in March. In a CMBS market update published in May, the Moody’s team highlights the near 50% drop in issuance in Q1 2008 compared with the same period a year earlier. But the deals that have emerged confirm that primary spreads in April and May had settled at about 70bp, even though it was too close then to the global turmoil to call them new benchmark levels.

Takenouchi reports: "Today deals can still get done, but almost entirely with domestic investors and the foreign buyers are now very specialist, professional investors buying the lower rated, high yield tranches."

Moreover, the wider Japanese securitisation market has remained even more stable. Deutsche’s analysts note that issuance across the board in Japan in the first quarter of 2008 was down just 25% from a year earlier at ¥1.83tr. That translated to a very respectable level of primary market activity compared with US and European markets, which they report experienced declines of 83% and 81% respectively in the same period.

In short, there is no death knell for CMBS in Japan. Quite the opposite — Merrill’s Hong, for example, notes that CMBS represents only about 25% of the real estate funding market in Japan, with property non-recourse loans and real estate-backed corporate loans on the balance sheet about 75%.

Plenty of demand for property

The physical property market also has a good story to tell. It has gravitated increasingly to the ‘outright’ buyers beginning in mid-2007. Leading European, especially German, pension funds and other specialist long real estate funds have been the beneficiaries.

Hong also sees plentiful demand for commercial property. "We estimate around $40bn of appetite for physical real estate assets this year," he explains, "whereas in the most liquid year in the Japanese commercial real estate market in the recent past only around $20bn of transactions was concluded."

But whatever happens in the months ahead, market observers cannot envisage a return to the remarkable liquidity in the 2004-2007 period.

"The golden period for the Japanese commercial real estate market is over for now," says Egawa. "We now expect the market to settle to a more normalised situation with genuine long term investors buying the underlying collateral and with far less speculative, financial arbitrage-driven activity."

It is extremely unlikely that any Japanese lenders are going to step up and become aggressive financiers in the near term. "The result will clearly be fewer and smaller CMBS transactions," Egawa says. But he concludes that "investors in the CMBS that does materialize can be confident that the underlying assets are both good quality and the underwriting standards are as high as they should be."


CMBS and ratings: still on a level playing field?


If CMBS spreads were so tight, asset pools so diverse and euphoria so pervasive in the period from 2005 to 2007, does that mean that the rating agencies were less cautious, and therefore the CMBS issued in those exhilarating times structurally impaired? The rating agencies don’t think so.

So far there has not been a single downgrade of Japanese CMBS in the past several years — recent history has been characterised by upgrades and optimism.

Takenari Yamamoto, managing director in the structured finance group at Standard & Poor’s in Tokyo, says: "As specialists in this sector of the market we remain comfortable today about the performance of rated CMBS. Beginning as far back as 2005, we already began to see apparent discrepancies between the property values implied by the purchase price and the levels where we were comfortable with and underwrote at. This means that for several years already that we have positioned the ratings of the CMBS that we cover in an appropriately defensive manner."

Yamamoto says investors have a "considerable equity cushion" in the structures the firm has rated, in the event of a downturn in the underlying market. "The real estate fundamentals remain very good and the past few years have seen rents increase sharply, especially in the best areas," he comments.

Moody’s has a similar perspective. So far, the rating agency reports that no loans underlying Japanese CMBS have experienced default; in fact it has been a story entirely of upgrades from the year 2003 onwards. It was around that time that the underlying property market began to rise sharply and the loan market moved from distressed to performing.

There continued to be many upgrades in the CMBS sector in 2007, most as a result of improved credit enhancement levels due to prepayment of the underlying loans and/or the disposition of underlying properties.

S&P’s team reports that in 2007 the CMBS and RMBS segments saw 48 upgrades among CMBS transactions and 44 upgrades among RMBS transactions. They note that most CMBS upgrades mainly reflected increased subordination levels that provide credit support to the CMBS. This was caused by active selling of the underlying real estate properties and refinancing of the underlying loans within an active real estate market in Japan.

Upgrades wane

However, there appears a consensus that fewer upgrades are expected this year as tighter refinancing and asset disposal markets mean that prepayments and dispositions are on the wane.

Tetsuji Takenouchi, senior vice president and team leader for CMBS ratings at Moody’s in Tokyo, says: "In general, delinquency in interest payments has been rare, given that loans show sound DSCR, supported by stable rentals and low interest rates. However in these less liquid market conditions since early 2008, balloon risk and credit events — relative to a borrower’s sponsor or asset manager — may now become the focus of attention."

S&P’s team reports that so far there has not been a single forced sale of property underlying any CMBS transaction, even though there has been several refinancing required already in 2008.

"Even if spreads are higher on refinancing than on the original deal, cap rates on the properties offer a sufficiently high carry above the current risk-free rate that even fairly stressed borrowers should be able to manage in this environment," explains Yamamoto. "Even if those deals in certain instances cannot be refinanced there is plenty of end demand for the physical assets out there among buyers. This is quite different from the 1990s when such demand was extremely limited."

There are nevertheless some modestly bearish indications creeping into the real estate market. Moody’s reported this year that office space supply has generally been tight in Tokyo and its suburbs, but that there are some signals of retail sector weakening and condominium sales have slowed. However, the firm also notes that major real estate companies are well positioned due to their financial and business strengths.

Given the general situation, there seems little doubt that the heyday for Japanese non-recourse loans and for CMBS is over, at least for the moment. "There are numerous deals outstanding that will be in need of refinancing and it is inevitable that those deals will be refinanced at less aggressive LTVs, at higher spread levels, at much more lender friendly terms," notes Chinatsu Hani, senior director and head of securitisation research at Merrill Lynch in Tokyo.

So far, the leverage in each CMBS issue has not been falling. But the LTVs of the new non-recourse loans underlying new issues have been cut back, sometimes substantially.

Assuming the physical property market remains slow, and that lenders and CMBS investors remain cautious, the question now is whether the situation may affect defeasance trends and exit strategies for loans at maturity.

"However," says Koji Kumamaru, managing director at Moody’s in Tokyo, "CMBS is structured with tail periods, no less than two years in advance of their legal final maturity, so even if the underlying loans default it does not mean a CMBS default. But the situation is clearly one we will scrutinize in the months ahead."

Of CMBS rated by Moody’s, about ¥540bn in loans will mature in 2008. By ‘mature’ Moody’s means either the CMBS transaction itself or an underlying loan in a CMBS transaction reaching its ‘expected’ maturity date, instead of its legal maturity. By April this year, ¥190bn of the ¥540bn had been repaid at or in advance of their maturity dates without delinquency.

"Nevertheless, we will be watching defeasance trends carefully in light of the credit tightening among non-recourse lenders and the hugely diminished volumes in the CMBS market," says Takenouchi. "In the US, defeasance recorded their highest levels in 2007 but then slowed sharply during the second half of 2007. We also anticipate a fall in defeasance activity in Japan."

Moody’s also notes that there is also about ¥260bn of sale-and-leaseback deals — issued by companies about five to seven years ago — due to mature this year. "With these deals," says Kumamaru, "there should not be much concern at their balloon because the sponsor companies have improved their performance and the appreciation in real estate values [over that extended period] should support flexible exit strategies. The sponsors can buy back the underlying real estate, sell it to a third party, or refinance the matured loans."

Built-in liquidation targets

Moody’s further explains in its May report that in Japanese CMBS some deals are structured with the intention to liquidate underlying real estate portfolios by the loan maturity date. In general, these deals have stipulated targets for the liquidation of property or prepayment of loans in a covenant package.

A liquidation hurdle is therefore specified at every payment date. If the borrower cannot pass the hurdle, the waterfall switches to turbo until the borrower clears the next hurdle, which is typically higher than the previous one, by next payment date.

In the past, most borrowers liquidated the assets, or prepaid their loans, in advance of the hurdles. As at the end of 2007, none of the underlying loans of the outstanding CMBS deals had defaulted, but for a limited number the performance triggers that suspend dividend payments to equity holders have been hit.

In addition, some collateral properties suffered from poor occupancy rates or net cashflows substantially lower than initial expectations. One of the asset classes exhibiting such a negative performance is of residential properties located on the fringes of Tokyo or in local cities outside the Tokyo’s metropolitan areas.

"CMBS performance trends for liquidation deals have thus far been positive," says Kumamaru. "However, a few transactions have recently not passed each hurdle, partly because the gap between bid and offer prices has widened. From another perspective, regarding defeasance, the recent increase in transactions employing non-sequential-pay structures may moderate the upward ratings drift we have seen since 2003."
  • 30 Jun 2008

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