European CMBS forced to the brink

The financial crisis that has engulfed much of the world since July 2007 has hit the European commercial real estate market hard. Headlines have become ever more lurid, as property values falling by a quarter prompted some investment funds to bar redemptions – £1.65 billion was withdrawn in the fourth quarter of 2007 compared to £139 million in the third, according to the Association of Real Estate Funds.

To date, the only forced sale, according to market observers, involved the UK-based Westport Land, that was unable to refinance its highly leveraged £95 million loan with Capmark Bank Europe (the former GMAC) in September. Nevertheless, some institutions are known to be slimming down their portfolios through private sales rather than high-profile public deals that would realise lower values.

Unsurprisingly, this market environment is resulting in lower commercial real estate investment transaction volumes in Europe. Figures from Jones Lang LaSalle show a fall of 13% in 2007 to around €220 billion – with much of the fall occurring in the second half. Moreover, the real estate services firm estimates that transaction volumes will decline a further 20% in 2008.

To what extent can this decline in activity be laid at the door of the credit crunch – ie an absence of finance – as opposed to broader economic pessimism? Tim Crossley-Smith, head of valuation at property consultants GVA Grimley in London, says: "Activity has certainly declined but it’s not down to a lack of funding. As a profession, we’ve been guilty of writing our epitaph too soon."

Once one of the most rapidly growing sources of finance in the European real estate market, the commercial mortgage backed securities (CMBS) market is in dire straits. But does it have the potential to fix itself? Moreover, is it necessary – at least in the short term? Indeed, could these new market conditions create opportunities for different types of investor?

CMBS: call a doctor

Figures from Moody’s Investors Service show that emerging Europe, Middle East and Africa (EMEA) CMBS issuance was strong during the first half of 2007 reaching €35 billion – an increase of 95% compared with the first half of 2006. However, in the second half of the year, spreads widened and investor demand declined. CMBS issuance became increasingly expensive and difficult to place, resulting in sharply lower new issue volumes in the second half of 2007. Full-year EMEA CMBS volumes were 14.6% lower than 2006 at €59 billion.

"There has been a dearth of European CMBS over the last six months," says Richard Curtis, head of European ABS and structured products bond syndicate at WestLB in London. "The deals that have come to market have struggled and it’s arguable whether any paper was actually distributed to investors. Effectively, there is no secondary trading resulting in a complete market failure and it is unclear what will bring the market back to life." Moody’s expects that just €30 to €35 billion of new issuance will come from EMEA this year – assuming no further substantial shocks to the global capital markets.

"We will probably see lower leverage and more conservative structures" Birgit Specht, Citi

At the same time, the ability of many investment banks to lend is limited. For those with a large depositor base or access to long-term, high-quality markets – such as covered bonds, which have not been affected by market problems – there is less of a problem. But other banks are being forced to fund themselves at the short end, which means they can’t afford to lend. The leveraged investors have been priced out and therefore cannot compete.

As Barry Osilaja, head of debt and structuring at Jones Lang LaSalle in London, notes sourcing senior debt finance for commercial real estate has become a "challenging proposition as the securitization market has effectively been stopped in its tracks". He explains: "This has taken out a large number of conduit lenders, predominantly investment banks, from the market and has reduced liquidity with no sign yet of appetite from investors for the issued bonds."

Can CMBS be fixed? "Someone will have to blink first," says one market veteran in London. For investment banks, the options are unpalatable. The cashflows on loans originated a year ago simply won’t support the level of coupon necessary to make a deal attractive to investors. The CMBS could be offered at a discounted level that reflect what now look to be high LTVs on the underlying loans but that would require a haircut for the originating banks. Similarly, restructuring the CMBS with a smaller A tranche in order to achieve lower LTVs while retaining a larger B tranche would require banks to take a hit.

As Moody’s notes, several issuers have packaged their loan portfolios into securitization transactions and instead of selling them in the market, retained them in their bond format. These can then be used for repurchase transactions with central banks, marketed and sold at a later stage to investors. Or as one market observer cynically notes "lost in their inventories somewhere." However, not converting loans to securities remains an attractive prospect. Banks can legitimately argue that the loans will pay out at maturity and therefore do not need to be written down – unlike a mark-to-market CMBS.