European CMBS is experiencing a bumper year and new deals continue to hit the market, making 2018 the strongest year for traditional, floating-rate CMBS since 2015. While investors are unlikely to lose any sleep just yet, many of these new transactions feature structural nuances that draw comparisons with transactions seen before the financial crisis.
Although there have been other bumper years since the crisis, this steady flow is expected to continue, supported by a number of factors. Conor Downey, partner at Paul Hastings, comments: “I think that there is the potential now to maintain a basic level of new issuance of around 10-15 deals totalling around €5-8bn per annum, particularly without QE. This doesn’t include retained or single tranche deals.”
Downey adds that this is largely driven by better pricing which is, in itself, being driven by quantitative easing. He says that it is now cheaper to get debt from the capital markets, with CMBS representing a cost-effective funding tool and method of generating arbitrage.
Furthermore, Downey says, “Given banks’ concerns on spread volatility, warehousing smaller loans to build up a sufficiently sized pool is not attractive” and there has also been a shortage of suitably sized loans in the last 18 months.
Now, however, there is a growing number of borrowers looking to raise debt of £200-300m, which single banks are often unwilling to do. If a borrower only wants to deal with a single lender, says Downey, “CMBS is the perfect route to fund that size of debt.”
Additionally, with CLOs seeing yield compression, investors may now be turning away from those and looking more closely at CMBS, particularly where they may have been using CLOs as a proxy. Likewise, more than 90% of legacy CMBS deals have now been paid off, driving investor appetite for fresh paper.
Downey points out however that CMBS is still not always the first choice: “One thing I would add is that CMBS pricing isn’t yet competitive for trophy assets, such as very high profile offices or retail properties, as there is very strong equity and bank demand for such assets.”
With issuance surging in the asset class, DBRS recently noted that several transactions are exhibiting structural nuances. Certain deals, for example have seen the introduction of reserve funding notes, which fund the note share part (95%) of the liquidity reserve, as seen in FROSN 2018.
The rating agency says that this is different to normal RFNs where the liquidity reserve can be drawn like any other, but in the case of the FROSN deal the RFNs are not provided by the bank. Instead, it is part of the structure and can be held by investors via a purchase of the RFN.
Iain Balkwill, partner at Reed Smith, suggests that this development isn’t as innovative as suggested. “Ultimately”, he says, “this is a question of the cost of funding for providing such a liquidity line. If providing such a facility or creating a reserve is just too expensive, then the deployment of reserve funding notes (RFNs) makes a lot of sense.”
He continues: “Historically…the liquidity piece is one part of the structure that has frequently been tinkered with, as demonstrated by the introduction of servicer advancing in 2006.” Downey equally suggests that if it is cheaper to issue the liquidity piece as bonds, it is a “no brainer” for an issuer to do so, hence the move to include RFNs in certain deals.
Another structural tweak highlighted by DBRS surrounds class X notes, such as in the FROSN 2018 and Taurus 2018-1 deals whereby a “new mechanism” is used to divert excess spread to revenue receipts.
The rating agency highlights that during the life of the deals, should the senior loans’ LTV reach above a certain level or should the debt yield decrease to less than a certain level, the class X noteholders would not receive any interest payments, but cash would be diverted to the class X interest diversion ledger.
Balkwill comments that while not overly concerned with various structural nuances, one thing that might “raise an eyebrow is that of the class X notes diversion in the Taurus 2018-1 deal where breach of financial covenants in two of the loans causes a diversion, where as in a third loan such a breach would not have the same consequence.”
He adds: “Although, on its face this may seem slightly strange, ultimately it is a good example of structuring to address underlying commercial requirements and therefore is more a point for the pricing.”
Downey comments that alternations to class X notes could lead to some investor challenges: “Amendments to class X notes are essentially driven again by the absence of LTV default covenants on particular loans. On other deals the triggers are typically material events of default and so would include breach of LTV covenants.”
He adds: “If a loan has no LTV covenants and investors want particular LTV changes to be a class X trigger, then it has to be brought at bond level. I think we may see further investor pressure for amendments to the class X notes.”
Typically, the ideal scenario for European CMBS would be greater standardisation, with the establishment of a deep pool of investors to absorb the product. Balkwill says, however, that the financial crisis stress-tested CMBS documentation and structures, so many of the structural flaws have been addressed.
In terms of what’s driving structural tweaks, Downey suggests they are ultimately sponsor-led. If the sponsor feels that the benefits of the changes it wants outweigh the resulting pricing impact, then the arranger will alter the deal accordingly.
Certain structural affectations are also potentially being driven by investors, as a result of alterations to loan covenants. Downey points out that some European private equity borrowers will not accept LTV default covenants on any of their loans, while others seek to limit the time-periods in which these covenants are effective.
“It was only a matter of time,” Downey says, “before loans with these terms appeared in CMBS transactions. This means that investors do not have the protection at loan level against declines in value that they typically receive with a default covenant; however, in most instances, cash traps or cash sweeps will be triggered. It’s natural that in such a situation, arrangers and investors may see a perceived deterioration in terms.”
Furthermore, confidence has grown in the asset class and it is only now, after a number of years, that structural nuances are starting to be seen again, such as in the transactions pre-crisis. Balkwill adds: “The structural tweaks are clearly being made to try and help the structures be more cost effective for issuers and overcome commercial constraints by all interested parties in a deal. Investor demand is certainly very strong to in effect sanction such innovation.”
A further pocket of development in Europe is the emergence of agency deals, such as Blackstone’s Pietra Uno transactions. Unlike the US, this typically involves a firm tapping the capital markets directly to finance real estate activity, without a bank’s involvement.
Agency CMBS feature several strengths and Downey says that that there is growing interest among private equity firms, as loan-on-loan funding is relatively expensive at around 300bp, with relatively low advance rates at less than 70%. CMBS, however, is currently offering funding costs of 140-170bp and advance rates of 95%, depending on the appetite for the most subordinated bonds.
Balkwill outlines further the positives of agency CMBS: “For borrowers, agency deals can be much cheaper than obtaining a loan from a bank. Also you don’t have the problem of banks exposing themselves to capital markets risk which can be fatal if there is significant change in the market between originating the loan and the point that a CMBS is ready to launch.
“A great example of this type of issue” he continues “was back in 2015 when Grexit threat, followed by the Chinese financial crisis, adversely affected CMBS pricing.”
On the downside, agency transactions can take a long time to complete and require a significant amount of expertise and staffing power. As such, only certain firms are likely to be able to execute such transactions.
Balkwill comments: “Typically the sponsor in an agency deal is going to be very sophisticated with a lot of experience with using this technology, such as Blackstone. Obviously there is not an abundance of these types of sponsors and, even then, not all of them welcome this form of finance.
“At one point” he continues, “it was thought that the agency market would be large given the regulatory pressure on banks; however, the market has failed to deliver on this latent potential, despite the fact that the first agency CMBS took place in 2013 in the form of the Toys R Us-backed Debussy deal.”
Agency deals also present several challenges such as execution risk, with borrowers at the mercy of the capital markets without certainty on the price of debt. Additionally, structuring is more difficult and complex than obtaining a bank loan and the process is more involved given the work required with rating agencies, as well as satisfaction of disclosure requirements.
DBRS notes that risk retention is also being deployed alternatively in 2018 transactions and, in one instance, an issuer took retained ownership via a separate series of notes from the CMBS issuing SPV, referred to as VRR loan interest. As a result, these loan interest note holders receive a 5% or higher share of issuer revenue and principal proceeds on a pro-rata basis with the other notes.
Balkwill comments that such risk retention strategies shouldn’t materially affect the performance of a deal and so investors shouldn’t feel unduly concerned. Downey adds that innovation around risk retention is nothing new and that it’s been standard practice for banks to try to reduce the costs of holding risk retention capital.
CMBS can often achieve better pricing if banks are willing to hold the first loss piece rather than a vertical slice, but the cost of capital will be higher in the first instance so banks have to weigh this up against pricing benefits. Agency deals are however obviously not subject to bank-type capital requirements, making them cheaper from an originator perspective.
In terms of future developments for the asset class, Downey thinks that the reemergence of the A/B structure, commonly seen in pre-crisis CMBS, is possible. This could face resistance, however, given it was seen to have caused a number of issues in legacy deals.
Balkwill suggests that we may see the emergence of more multi-loan deals, with loans featuring assets in different jurisdictions. He also suggests the market could see the return of fusion deals, as seen in 2006.
In terms of challenges to the continued success of the asset class, Balkwill says that regulation is a hurdle as it still treats CMBS harshly from a capital perspective relative to other asset classes. Despite this, he adds that deals are coming to market and that capital treatment isn’t therefore the product’s Achilles heel - but more regulatory support would still, he notes, be “welcomed.”
Downey is similarly optimistic about the future of the asset class, especially provided that QE does come to an end, as expected. He adds that a number of banks are now looking at CMBS in Europe again and he also sees a number of debt funds with large loan portfolios that are “ripe for securitising.”
He concludes that certain collateral may also become more common in Europe again: “There are a number of large hotel portfolios in the market at present and, following the success of the Ribbon CMBS, there may also be a growth in hotel CMBS.”
RB
