Credit Suisse develops new property derivatives
INVESTORS MUST SEARCH hard to find a decent return these days, hence the attractiveness of property. In particular, US commercial real estate is hot, and it is not just Donald Trump who will tell you that. According to Colliers International’s 2006 Real Estate Forecast, the sector will experience another blockbuster year in 2006, with continued growth in office, industrial and retail real estate. Even if the US economy grinds to a standstill, the commercial real estate consultancy predicts that there will be enough momentum to carry the market through to mid-year at least. Colliers argues that the strongest seller’s market ever has built up in the first few months of this year, with demand up across all sectors, making vacancies increasingly valuable.
Cash is flowing into real estate debt and equity directly as investors are spurred on by poor returns in other sectors; portfolio allocations to the property market for diversified investors are also increasing. It is somewhat surprising, then, that until very recently it has been difficult to take a view on commercial property-backed debt in the structured finance and derivatives markets without owning the cash securities. This partly accounts for the record issuance of US commercial mortgage-backed securities in 2005, as there was so much demand for exposure to this sector.
The picture for investor exposure to commercial property has changed completely in the past 12 months. “If you wanted to have exposure to commercial property-related debt before, you basically had a choice of Reit debt or CMBS,” says Gale Scott, managing director and head of global real estate finance at Standard & Poor’s. “Now there is an increasing amount of new instruments and vehicles to accommodate the exposure appetites of a wide variety of new investors who are attracted to the sector. If you want to invest in commercial real estate, but don’t want to hold the physical properties or the securities, there are a proliferation of vehicles such as synthetic CDOs, single-name asset-backed credit default swaps and CMBX that will meet this need.”
How long the market can remain hot for is a matter of debate. Most analysts are comfortable about its strengths over the next six months. But some say US property is heading for a sudden collapse [see “Against the tide”, The party’s over for US property, this issue].
In particular, the growth of the synthetic market is creating a lot more liquidity and allowing many more investors to get involved in the asset class. Commercial property-related products are no longer the preserve of specialist asset managers, the dealer community and mortgage originators looking for risk management or financing vehicles. Now investors ranging from macro hedge funds to proprietary trading desks to corporate treasuries can take on exposure to this hot market without being CMBS or commercial property specialists. In fact they can short the market, which even a few months ago would not have been possible without owning the cash bonds.
Commercial real estate CDOs are certainly one of the most dynamic parts of the US structured finance market. Issuance tripled in 2005, and a strong CRE CDO issuance pipeline driven by new managers entering the market and high CMBS and subordinate debt issuance forecasts are likely to push 2006 CRE CDO issuance up to $22 billion, compared with $15 billion in 2005, according to Citigroup analysts.
Collateral pools and structures are evolving rapidly. Until two years ago, the only CRE CDOs available were static pools of investment-grade CMBS and Reit debt. Since then, the different types of securitized collateral have exploded as underwriters such as mortgage Reits and subordinated real estate investors have issued CRE CDOs as an efficient tool to finance a buying binge of rake bonds and B notes. There was $13 billion-worth of mezzanine loan and B note issuance last year. This is tiny compared with the $240 billion-worth of CMBS but the forward pipeline is growing.
The unrated commercial real estate assets that can now wind up in a CRE CDO are often short-term floating-rate notes that can include B loans, mezzanine loans and increasingly whole loans, credit tenant lease loans and Reit trust preferred securities. The March 2005 launch of Taberna Preferred Funding 1 was an important landmark for the market because it was the first commercial real estate CDO of trust-preferred securities.
Jeffrey Prince, US CDO strategist at Citigroup, thinks that the collateral pool will become even more diverse this year as equity in selected transactions could be released to institutional accounts by CDO managers. The fact that the latest CRE CDOs have included actively managed pools, rather than static ones, has also enabled investors to get exposure to a much greater variety of collateral. Institutional investors who are not sufficiently experienced to invest directly in subordinate real estate debt are now able to diversify their holdings into a managed commercial real estate pool.
Arbitrage options on the up
Although most CRE CDOs will continue to be financing vehicles for lenders, the number of arbitrage CDO deals done by non-specialist institutional investors and hedge funds is increasing; this can only be enhanced by the use of synthetic CRE CDOs, which emerged last year. The first deals were done by specialist property CDO managers, but the prediction is that a lot more investor-driven deals will be launched for hedge funds, banks and other asset managers, now that CDO managers are not constrained by the availability of cash bonds as collateral. “The advent of synthetic ABS and CMBS will bring a lot more investors into the CDO market as it will allow more tailored solutions and pure arbitrage deals with investors defining what the pool looks like,” says one analyst.
Rating agencies are positive about the performance of CRE CDOs to date
Ratings upgrades and downgrades of CRE CDOs in 2005: |
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| Source: Moody's, S&P, Fitch Ratings and Citigroup |
Synthetic structures will also enable the asset managers that need to have scale to enter this market and help to justify the work needed to become educated in these new specialist products. “There might be only $20 million of actual cash bonds at the triple B level of a capital structure but the synthetic market will allow them to grow a lot more exposure,” says a specialist property asset manager that has recently completed its first purely financing CRE CDO.