A pioneering structure for securitizing UK property has been devised by the Grantchester Group, BZW and London law firm Wilde Sapte in a £100 million ($167 million) issue of debentures launched at the end of last year.
Many attempts have been made to turn UK property into a more liquid market. PINCs and, more recently, APUTs will be remembered by some as attempts to launch unit trusts specializing in commercial property investment. But so far the UK has lagged the US whose REIT structure (real-estate investment trust) is now commonplace. The Granchester structure does not pretend to be a way to transform commercial property into a pooled investment. It does, however, point to the possibility of establishing a conduit structure that could be harnessed to launch a note programme providing a more liquid form of property investment.
At the heart of the deal is the standard securitization mechanism: a special-purpose vehicle that issues notes backed by security taken over a portfolio of properties. But several innovations make the structure unique. The first is the flexibility which the borrowing group retains. The deal is on-balance-sheet but effectively the noteholders’ recourse is restricted to the underlying security – typical of, say, a non- or limited- recourse project financing. It would not be difficult to harness the structure for off-balance-sheet financing.
The security is not restricted to the asset value of the property portfolio but hinges on the rental stream the portfolio commands. It’s this that makes the transaction novel. “Most property-based debt financing is done on a standard loan-to-value basis with provision for the debt relative to the property being valued at least annually,” says Martin Bartlam, partner in Wilde Sapte’s structured-finance department, who advised lead-manager BZW. “Here, there is an annual valuation of the property portfolio but this is for information purposes only; the default trigger is based on a look-forward test which takes into account prospective cashflow based on rental receivables.”
Instead of using a traditional loan-to-value ratio, this structure uses a ratio of net rental income relative to the debt-service obligations. This means that the financing is not premised on the underlying property portfolio’s asset value but on the income stream it throws off.
A further innovation is the extent to which Grantchester can transfer individual properties in and out of the portfolio, subject to meeting projected cashflow ratios. Allowing Grantchester to substitute and withdraw properties, based on contracted rental income, takes advantage of its added management value. The better the lease contract Grantchester negotiates, the less property is allocated as security and can therefore be released and sold or otherwise allocated, regardless of what is happening to underlying property values as a whole. For the noteholders, the structure transfers risk from the vagaries of the property market to lease counterparties, with a small cushion by way of overcollateralization and a fall-back to the underlying property if all else fails.
“This does mark a difference in the perception of property investment as an asset”, says Bartlam, “and is reflected in the way the property and surveying bodies are moving to a valuation basis which more closely reflects the way in which other asset classes are valued, with more emphasis on discounted cashflow techniques than snapshot valuations of the property itself.”
One revelation is the comparative simplicity – given the pioneering nature of the deal – of the documentation. The default triggers are necessarily involved since they encompass detailed assessment of projected rental streams. But, for example, the ability to transfer properties in and out is facilitated by template documents to include and release properties from the security. Provided the incoming properties satisfy the cashflow requirements, it is relatively straightforward using the template for them to be admitted to the portfolio.
Concessions are also provided to reflect the nature of the market, such as the time taken to acquire and dispose of properties. So the security includes the ability to provide cash collateral to bridge the delay between disposing of one property and acquiring another in substitution.
The documentation’s basic structure did not change markedly between its creation and the issue’s launch. “There was a certain amount of market testing and modifications made to some of the detail to accommodate prospective noteholders’ views, but otherwise it remained fairly consistent throughout,” says Bartlam.
By contrast, earlier attempts to securitize UK property were complicated. PINCs (property investment certificates) and the Barkshire proposal (spearheaded by John Barkshire of Mercantile House) – both dating from 1986 – were attempts to unitize single properties, ie turn individual office blocks into unit trusts. Their structures were complicated by the need to satisfy investor protection legislation as well as minimize the impact of tax. The inherent lack of liquidity in the underlying asset made it difficult to gain authorized unit trust status, since the legislation was designed to ensure that unit trusts are able to realise investments to meet redemption demands. The tax problems ran from a double charge on the property-owning entity and the investors to the imposition of capital gains tax. These hurdles meant the structures lacked Grantchester’s elegant simplicity.
Bartlam is modest about the deal’s full potential. “People have been struggling to make this illiquid market more liquid,” he says. “Whether you attempt it at the level of the investment fund established to originate different property assets – which is, if you like, a top-down approach – or take a bottom-up approach as this deal does by looking at existing assets and devising a form of securitization, you are still turning property into notes. This structure is a fairly simple approach to creating liquidity out of an illiquid asset. But the real potential lies in the idea of establishing dedicated property conduits that buy in property-asset receivables made up of rental income and capital uplift and then securitize them out to the note market. This is all moving towards the possibility of a multi-asset, multi-seller conduit structure with a stand-alone issuer which buys in assets from a number of sources where the noteholders’ only recourse is to those assets and the issuer itself. With UK government approval of property PFI [private-finance initiative] and an increasing European property-asset pool, structuring in the property sector is in for an interesting time.”
