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CMBS conduits ride the rapids of demand

29 Apr 2007

Investment banks’ lending conduits have transformed the European commercial

mortgage backed securities market. Having scoured the UK for deals, the banks are now hunting for opportunities on the continent and as far afield as eastern Europe.

But in their eagerness to exploit this booming market, are the banks putting too much pressure on structures? Chris Dammers reports.

he big growth market of the past two years in European structured finance has been commercial mortgage backed securities.

Investment banks’ conduit lending operations have driven CMBS from being a fringe asset class in securitisation to a Eu65bn market, second only in size to residential mortgages.

Investors have poured in, searching for higher yield than is available on RMBS and diversified exposure to Europe’s booming commercial property markets.

The banks have come half way to meet the investors, too, by improving their post-launch reporting, making CMBS more attractive.

Barclays Capital estimates that investor demand for CMBS will grow by 44% in 2007 to reach about Eu95bn.

Traditional agency CMBS, even supplemented by the huge securitisations of rented housing in Germany, has not provided anything like enough supply to meet that demand.

Instead, investment banks have been setting up programmes to originate and securitise loans. Almost every major investment bank now engages in this activity and most have issued their own CMBS at least twice.

Twenty-one conduits issued 51 CMBS transactions in 2006, selling Eu36.9bn of paper. These figures are up from 17 conduits, 36 deals and Eu23.8bn of CMBS in 2005.

"The fact that volumes have grown so much is a double plus for us," says Clive Bull, director in the commercial real estate group at Deutsche Bank in London. "First of all, it means that a portfolio manager really does think he’s going to see a bunch of deals, because the market is so much bigger than it was a few years ago. Secondly, when he goes to his investment committee he can portray CMBS as a major part of the ABS market. Why should he be cut out of 15%-20% of the ABS market?"

Besides the overall increase in output, the most visible trend has been the relative decline of the UK as a source of collateral. In the first years of the European conduit market, the deals were all backed almost entirely by loans secured on properties in the UK.

Last year, the UK’s share of European CMBS fell below 50% for the first time. Partly this was because German rented housing securitisations and pan-European conduits swung into gear.

But pickings are getting slimmer in the UK. The bull run in property prices has pushed yields so far down that it is no longer so attractive for equity investors to buy property using debt finance.

London office properties have the lowest returns of any European market, although rental growth is strong.

While yields were still falling, there was a continual incentive for property owners to refinance their debt at lower loan-to-value ratios and hence on more advantageous terms. But now, yields are bottoming out, so the only reason to refinance is that banks are willing to offer better terms for the same risks.

"On the smaller loan side we’ve had to be as aggressive as we can on pricing," says Bull. "Beyond that it’s a question of moving up the size spectrum. We’re still originating small loans, but to keep the UK volume up we’ve had to add in some additional resources to focus on large loans as well."

Continent comes into its own

This year, London’s conduit bankers will be looking across the Channel for growth.

France has so far produced a meagre share of CMBS, but that is set to increase. Two French banks have recently joined Société Générale in the conduit market — Calyon and Natixis, which has two programmes.

Moreover, pressure to avoid falling prey to private equity funds may push more French companies to monetise the gains on their property portfolios.

Already, property investors Colony Capital and Bernard Arnault have teamed up to buy a 9.8% stake in Carrefour, the supermarket chain, prompting speculation that it might spin off some of its Eu15bn-Eu20bn real estate portfolio.

However, CMBS issuance will remain constrained by the tenant-friendly nature of French leases and rival sources of finance.

"The commercial banks in France are very aggressive and always have been," says Bull. "It’s very tough to get loans done competitively there."

Conduit bankers’ most hotly tipped market is not France but Germany, where banks have been investing heavily in infrastructure.

"The market where the balance is tipped most in favour of the CMBS lender is Germany," says Bull. "Their domestic banks have either taken a beating in terms of credit losses, or determined that they’re overexposed to Germany relative to the rest of the world. They have reallocated their new lending to other countries so they’re not as aggressive as balance sheet lenders are elsewhere." (See separate article on German CMBS on page 5.)

Chunks from the east

Perhaps a spicier addition to CMBS deals is collateral from central and eastern Europe. While issuance from the newest wave of EU member states remains sporadic, the high yields on offer relative to more established commercial property markets have attracted a flood of equity investors and lenders have followed them eagerly.

Since the start of 2007 handfuls of Polish and Bulgarian collateral have gone into Credit Suisse’s Cornerstone Titan 2007-1 deal and Deutsche Bank’s Deco 14 – Pan-Europe 5. It was only a small fraction of each deal as the rating agencies apply strict haircuts to such loans.

"If the country has a sovereign ceiling of single-A then we run the triple-A stresses at that level," says Rod Peletier, CMBS analyst at Fitch in London.

The raters’ caution is shared by other capital market participants, who are not sure whether the rapid property price gains in the region are solid, or whether they could be reversed at any time.

"They [central and east European property markets] have had substantial yield declines since the beginning of the century," says James Martin, a CMBS analyst at Merrill Lynch in London. "The rating agencies are scrabbling around in the dark a bit when it comes to applying a reasonable stress. Should the rating agencies go back to what yields were in recent times, or are these markets in a new paradigm? Loans from this region will probably continue to appear as small chunks [of collateral in deals] with established jurisdictions."

Secondary securitisation

The hunt for yield that underlies the expansion in demand for CMBS has even generated a new class of investor — the commercial real estate CDO, or CRE CDO.

Only a handful of transactions have been launched so far — by BlackRock Financial Management, Investec, Eurohypo and Taberna Capital Management — but several more asset managers are ramping up portfolios in the hope of launching deals.

These deals invest mainly in commercial mortgage ‘B’ loans — the subordinated loans that often accompany property loans made by investment banks and, latterly, other lenders. CRE CDOs also buy triple-B and double-B rated CMBS tranches.

But some believe managers of these deals may be incentivised to underprice the risks they are taking on, simply to get deals done.

"Assembling a viable pool of diversified ‘B’ notes at a satisfactory risk-adjusted rate of return [for a CRE CDO] is even more problematic today than six months ago," says Ronan Fox, managing director at Standard & Poor’s in London. "CRE CDO financing would allow you to buy a ‘B’ note in the 85%-90% LTV range and you could probably price [the margin on the loan] at 175bp [over Libor or Euribor] and still make a very considerable amount of money. Whether you’d be satisfied that’s sufficient compensation for the risk involved is another matter."

However, some believe the ‘B’ note market will grow, because banks will prefer to make bigger ‘B’ loans and smaller ‘A’ loans.

Barclays Capital predicts a substantial increase in ‘B’ note and mezzanine borrowing in 2007, to about Eu7bn.

As Martin at Merrill Lynch explains, this change will happen because banks can get better pricing by putting the higher LTV part of the debt in the form of a ‘B’ note than including it in the ‘A’ loan and securitising it through a deal with fat double-B and triple-B tranches.

"Double-B CMBS issuance is likely to reduce and that’s down to the fact that you can get ‘B’ loan pricing at 225bp, versus 300bp in double-B land," says Martin. "We have also seen in some transactions a reduction in supply of triple-B due to the demand from CRE CDOs for ‘B’ notes."

Risks mount up

Not all is rosy in Conduitland, however. Intense competition and plummeting property yields are causing lenders to look further afield for business — away from straightforward office and retail properties into sites that have fewer alternative users and rely more on specific operating businesses.

Healthcare properties, car dealerships, self-storage warehouses and petrol stations are some examples.

"This more ‘fringe collateral’ in our view is subject to greater [potential] market value declines," says Fox.

The raters are cautious about other trends in the CMBS market, too. "The absolute level of leverage and the absence of absolute borrower commitment in terms of hard cash is another area of concern for us," says Fox. "We’re still of the view that the intercreditor agreements in a lot of these transactions are unclear, unworkable or both."

The shortage of instances of default on securitised commercial mortgages means arrangers, rating agencies and investors are still somewhat in the dark on how workout situations would play out.

Another concern is prepayments, which have been rising due to the aggressive bull run in the property and lending markets.

To address this — and particularly to avoid the senior tranches being repaid too quickly — banks have used ever more complicated pro rata payment structures to allocate prepaid cash among their tranches.

The danger of these structures is that they can increase the risk of mezzanine noteholders running up against available funds caps.

If the higher yielding loans in a deal prepay, the structure can be left without enough spread to pay interest on the notes. To cope with this, deals have available funds caps which mean that some notes’ interest can be deferred without an event of default.

"One aspect that is completely misunderstood in the market is that on a default there is often an automatic switch to sequential [allocation of cash between tranches]," says Fox.

"The circumstances in which shortfalls are then hit are not widely understood. People model simply prepayment. They forget that if they model a default followed by prepayment they get a completely different set of outcomes. A default incidence of 0.19% is so low that it’s far from people’s minds in the current environment, but when loans do default people need to be aware that there is an increased risk of interest rate shortfalls mounting up the capital structure."

Merrill Lynch’s Structured Finance Annual Review notes that these modified pro rata structures also introduce other risks, such as "greater rating volatility over time, particularly for deals which are concentrated by loan and tenants".

29 Apr 2007