Real estate: A sting in the tail

"Having a two-year tail crystallizes risk at a single point in time [year 7 to 9]. This runs the risk that triple-A bonds could be downgraded to D if the assets cannot be sold within this timeframe" Ronan Fox, S&P

The worry for any CMBS investor is that the pool will have to be unwound quickly in fire-sale conditions. And the structures of the earlier CMBS transactions in Europe greatly increased the risk of this by incorporating a relatively short tail period. US CMBS structures tend to have roughly 10-year expected maturities but up to 20-year legal finals. However, European deals have traditionally been much shorter, with roughly seven-year expected maturities and nine-year legal finals. This means that if bondholders cannot be paid at expected maturity, the assets must be sold within that two-year tail period in order to meet payments due at the legal final.

The difference between the two is down to the fixed-rate nature of the US CMBS market, which can accommodate a long period in which to work a deal out. But the floating-rate nature of European CMBS means that investors are very reluctant to take on too much extension risk. Two years might be plenty of time in a hot market but in a downturn it could be a very different story. "Two years isn’t that long in a recession," muses a veteran of the US real estate markets. "Things get ugly for a while."

The shortcomings of a short tail have been graphically illustrated by the ill-fated Hoteloc transaction, which reaches its final legal maturity in May this year. The deal reached its expected maturity in May 2005 with the underlying loan unpaid, and the servicer therefore had two years to sell the assets. Buyers were found for three London hotels in the pool but at well below the release price. And until very recently, with the legal final looming, things were not looking good. Contracts were, however, exchanged for the sale of the rest of the portfolio to Curzon Hotels in February and the sale was completed in late March, narrowly avoiding a bond default.

Hotel assets are relatively rare in European CMBS and the Hoteloc deal (given its associated fraud) is not representative of the wider market. But it does illustrate what happens when the servicer is forced to sell assets over a short space of time. "Having a two-year tail crystallizes risk at a single point in time [year 7 to 9]," explains Ronan Fox, managing director at Standard & Poor’s in London. "This runs the risk that triple-A bonds could be downgraded to D if the assets cannot be sold within this timeframe." Fox explains that shorter tail periods in Europe are a by-product of the early years of the CMBS market, when investors wanted CMBS structures to fit into a traditional ABS framework that they understood. But he adds that there are now relatively few deals going out with two-year tails – most are now around three years.

Indeed, the recent Sainsbury’s sale-leaseback deal, BL Superstores, had a five-year tail. "The rating agencies have taken an overly optimistic view of tail risk in European CMBS," claims the US real estate veteran. "There is significant cliff risk at the stated maturity and the interest of the junior and senior noteholders may not be aligned in the subsequent workout process." Fox rebuts any suggestion that the agencies do not take full account of tail risk, emphasizing that short tails are investor-driven. "When we suggest to arrangers that they consider longer tail periods, they tell us that their investors prefer the status quo," he says. And when asked whether he thinks market participants are becoming increasingly cognizant of the need for longer tail periods in European CMBS structures, he does not hesitate to say "No". Whether or not the experience of the Hoteloc transaction will do anything to change their minds is as yet unclear.