European CMBS was put on the map by UK landmark deals such as Canary Wharf and British Land's Broadgate in the late 1990s and hasn't looked back since. While Land Securities has continued the big players' pioneering spirit, the product is winning an ever broader variety of followers among property funds.
The exact date of the birth of the commercial mortgage backed securities market in Europe is debatable.
From the early 1990s when arrangers and originators began testing the boundaries of what was permissible by regulators, marketable to investors and made economic sense, commercial real estate became increasingly prominent in the landscape of the market.
But it was not until 1997 when the breakthrough transaction emerged on to the European stage. This was the £555m Canary Wharf securitisation led by Morgan Stanley, which was the largest single-property securitisation in the world. Having become one of the most important landmarks in Europe's financial centre, London, the development made CMBS impossible for the continent, and even those in the much more mature US market, to ignore.
Since Canary Wharf's milestone, CMBS has become a vital instrument in almost every property company's funding toolkit.
British Land, for example, entered the market at the end of the 1990s, attracted by the growing opportunities available through securitisation, especially since traditional funding routes were proving less amenable to its ambitions.
"It became increasingly clear towards the end of the 1990s that the existing unsecured and debenture markets just didn't have the depth of demand that was going to be required to continue to finance the business, which was one of the main reasons why we moved into CMBS," says Peter Clarke, joint head of asset management at British Land.
In May 1999 the company showed the depth of the market by launching its £1.5bn Broadgate securitisation and six years on, this February, it returned for a refinancing of the estate and was able to capture improved terms, reflecting the developments in the European CMBS market in the intervening period.
These have not just been in the keener pricing available to borrowers, but also in the greater structural flexibility.
"The market has become increasingly sophisticated," says Clarke. "The rating agency analysis has become more refined and they have a greater understanding of the underlying property and its risks. Different structures have been developed, for example the increase in conduit financing."
But while securitisation has become increasingly accommodating to companies such as Canary Wharf and British Land, the boundaries of what is possible in the capital markets have been pushed beyond the limits of the CMBS market.
In early November 2004, Land Securities issued £2.3bn of bonds and put in place £1.5bn of bank facilities as a financing package against a £6.2bn secured property portfolio — the bulk of its assets — in a deal that combined elements of debenture finance, CMBS and whole business securitisation.
The deal took real estate finance to a place undreamed of a decade ago. "In the dim and distant past we followed a secured debt strategy with debentures," says Martin Wood, treasurer at Land Securities in London.
"We changed our strategy in the 1990s, because we thought unsecured debt offered greater flexibility. We ended up with a cocktail of different liabilities. Unsecured and secured debt don't sit well together, and we didn't feel we were getting value out of our assets."
While property companies have used securitisation for relatively static portfolios or one-off deals, for general purposes they have continued to use unsecured bonds, bank loans or debentures because these funding instruments offer greater flexibility — although usually at a higher cost of funds.
Property developers, in their view, have been unfairly penalised by the rating agencies for the volatility of the commercial property market, and not given enough credit for their asset base.
Land Securities, with the aid of Citigroup and Clifford Chance, instead created a structure that put all the debt on a par with a set of covenants and triggers that became more stringent the lower the performance of the portfolio. In doing so it raised the firm's rating from A-/A to AA/AA and saved itself an estimated £25m a year in coupon payments.
"It is a halfway house, if you like, between a CMBS deal and a corporate deal," says Clive Bull, director, European commercial real estate group at Deutsche Bank in London. "Usually when you do a CMBS deal there is a fixed security package for the loan and a fixed set of covenants and that's it. The difference with Land Securities is that the security and the covenants adjust as the operating performance of the company or the assets change. The covenants become tighter and restrictions on sales get tougher.
"So you start off with something that is closer to being a corporate-looking loan, but if the business starts performing less well, then it starts to look more and more like a CMBS deal, and that is the neat feature about it."
However, although the deal was something of a holy grail for Land Securities, it worked because of the combination of, among other factors, the size, quality and leverage of the portfolio in question. And just as this is unique among property companies, the deal is likely to remain a one-off.
Moving with the times
Indeed, while securitisations from property companies have evolved with the wider maturing of the European ABS market, apart from the Land Securities issue they no longer capture the market's attention in the same way that they did in the late 1990s.
"There are two reasons for that," says one CMBS structurer. "One is that these large single-asset deals have been done for many years now, and so they are not particularly newsworthy unless there is something particularly special about it, like it being absolutely huge.
"The second thing is that most of them are agented transactions, so from the investment bank's point of view, it is nice for the league table, but it does almost nothing for your P&L."
This has not, however, detracted from the potential benefits that can be gained from CMBS and its strengths and weaknesses are as important as ever for those property companies and funds considering entering the market.
And while big property companies with big portfolios were in the past able to select certain assets or portfolios that would fit the rigidity of the European market's early years, a greater variety of smaller companies and funds are finding the more mature market accommodating.
"Securitisations have over time become more flexible, without a doubt," says Nassar Hussain, head of CMBS at Merrill Lynch in London. "Compared to the deals done at the inception of the market, it has moved on significantly in terms of the sophistication of the flexibility criteria, which give borrowers more discretion without having to get the approval of the rating agencies or bond trustees as frequently as they did in the past."
While the Land Securities deal provided ample evidence of this in a transaction that is hard for others to replicate, a deal for HBOS's investment arm, Insight Investment, in March showed how the market is becoming more amenable to a wider variety of players.
The deal in question was a floating rate conduit deal from NM Rothschild and Merrill Lynch, Real Estate Capital III, comprising a £139m senior tranche rated AAA by Standard & Poor's and priced at 20bp over Libor, and a £13.5m AA piece at 29bp over.
What was most notable about it was the flexibility that Insight Investment retained to manage the portfolio. "On REC III, for example, we structured 20% substitution per annum over approximately 10 years," says Hussain. "Typical securitisations have had substitutions of 15%-20% over the life of the deal.
"That transaction set a whole new benchmark in terms of flexibility. It took a long time working with the rating agencies to establish the appropriate criteria and to educate investors. There was a pricing premium to pay for that flexibility, but from the borrower's perspective paying the extra 4bp-5bp for this type of flexibility is a relatively easy trade-off."
The £152m securitisation was for Insight Foundation Property Trust, a listed offshore investment trust launched last July by Insight Investment. Philip Gadsden, head of external funds, property, at Insight in London, says that a securitisation had always been planned for the fund.
"We made the decision in the run up to launching the company that we were going to put in place a long term securitised loan facility," says Gadsden. "We just didn't have it in place when we launched the company, because it would have meant trying to do two public floats at the same time.
"So we put in place a reasonably short term bridging facility, as it happens led by Rothschild, and our absolute ambition always was that we would effectively take it out once we had closed the securitisation issue itself."
A key consideration for Insight when considering how to finance the fund was indeed the flexibility that would be available. Gadsden says that in this respect securitisation has become an increasingly attractive option.
"When you run a property portfolio," he says, "particularly if you run it reasonably actively, you are constantly reverting to your lender in one form or another to do things to your portfolio, be it selling things, buying things, restructuring leases, extending buildings, refurbishing buildings, changing planning consents — all those sorts of those things.
"The perception until a year or two ago had been that the securitised market really was quite a rigid kind of format and unless you really wanted something that was very vanilla it didn't make sense."
However, from his more recent experiences, Gadsden discovered that the situation had changed. "We found in the discussions and negotiations that we had, and the rating agencies' approach, that for the kind of facility we were looking to arrange you can end up in the current climate with something that is flexible," he says, "and gives you scope to do all the kind of things we would normally want to do without having to revert to the rating agencies every day of the week."
And while the pricing advantages that the bull run in ABS in general and CMBS specifically clearly made securitisation more competitive, it was not the overriding factor in Insight's decision.
"What we found is that you can push at the edges of portfolio flexibility quite a lot," says Gadsden. "So even though we were attracted by the cost that was clearly available from that marketplace, we were very conscious that the flexibility we needed was more important to us than the price. We did not want to end up with a straight jacketed kind of facility."
Gadsden says that with a portfolio of 70 or 80 properties and over 200 tenancies, there is simply too much going on for anything less. "If you've got to revert to a lender for an approval each time we want to do something then we just couldn't do it, so it wouldn't work," he says. "We were very, very clear right from the outset that if this was going to be a viable option, we had to push at the edges of what had been done before."
Not surprisingly, Insight was delighted with the result. "Frankly you can argue that our facility is even better than a straightforward bank facility, and certainly no worse," he says. "And yet we have captured what we think is very, very attractive pricing. So for us it was a bit of a win-win situation."
Not quite a free lunch
There nonetheless remains a certain play-off between the different aspects of what borrowers are looking for. Insight, for example, was able to achieve many of its ambitions because of low 41% initial leverage, an LTV covenant of 60% and an ICR covenant of 1.5 times — many single-borrower CMBS transactions have no LTV covenant and most start at levels of leverage and with cashflow coverages that would have breached Insights.
"There are still costs for flexibility," says Andrew Currie, CMBS analyst at Fitch in London. "There is a cost with the rating agencies in terms of the credit enhancement that is expected, and also a cost with investors for the uncertainty that is associated with a pool that could change over time compared to a static one that is easy to understand.
"However, I'd agree that there has been more flexibility in some of the transactions recently."
Currie says that this flexibility has not necessarily come from changes to the ways that deals are rated, but is simply a by-product of the market's maturity.
"From our perspective where there is flexibility we stress the transaction to assume that the flexibility is used to its worst possible extent," he says. "If the borrower can take out good properties and replace them with bad, then we assume that they do that, and obviously that has an impact on the feedback that we give. So I think that flexibility can be costly to a structure.
"But maybe whereas in the past an arranging bank was very uncertain about what the rating agency would say yes to and no to, and so would tell a borrower that flexibility was impossible, now the market has moved on a little bit, everyone is a bit more experienced and they are more comfortable advising their client that some flexibility is possible.
This, says Currie, means that while having flexibility will cost a little bit more, that cost premium is still less than if a borrower went to a balance sheet lender and simply asked for a normal bank loan.
A level of comfort
As well as borrowers with portfolios large enough to launch their own transactions — whether agented or through a conduit programme — an increasing number are also turning to conduit lenders rather than traditional balance sheet lenders.
Curzon Global Partners, a real estate investment management company, is one of these and Ronan O'Donoghue, director at the firm in London, says that there are two main reasons for this trend.
"Firstly, they are growing in numbers," he says. "Every finance house has a CMBS part to it now and even some of the traditional lenders that you wouldn't immediately assume had conduit programmes have set them up, with Eurohypo being a prime example.
"Furthermore, they can be very flexible and they give borrowers access to very competitive pricing. If you've got the right transaction with the right kind of qualities then you can get some very good pricing."
For players like Curzon this flexibility is just as important as for borrowers like Insight or Land Securities, and O'Donoghue is in accord with the observation that the market is becoming more accommodating.
"Traditionally one of the complaints about dealing with conduit lenders was that they were a little inflexible on certain terms and conditions," he says. "Hedging, for instance, was always an area in which they weren't as flexible maybe as other lenders. But the situation has evolved."
And the improvements in pricing and flexibility have resulted in the whole range of potential borrowers becoming relaxed about their loans entering the securitisation market. After signing up with a conduit lender, players like Curzon may not even know if their loan has ended up as part of a CMBS or remained on a bank's balance sheet.
"Initially in the US, borrowers were a little sceptical as to why their loans were being securitised, but they quickly became comfortable with the idea," says Arvind Bajaj, head of CMBS origination and distribution for Europe at Credit Suisse First Boston. "In the US, a borrower is concerned about whether it is a lender they trust, whether the lender provides good economics and whether it is a lender they can have a long term relationship with. Once they are comfortable, the lender is normally given relative freedom to do what they think is best with the loan."