Conduits lead to new era in European CMBS

CMBS: The basics | The potential pitfalls in the growth of CMBS | Is Germany finally ready to accept CMBS issuance?

The European commercial mortgage backed securities market is going through a period of huge change. It started in the mid-1990s and its annual issuance hovered around the €20 billion a year mark that it reached at the turn of the millennium. This year, though, issuance has already hit €18 billion, and is expected to reach €28 billion by year end. At the same time, competition is mounting as investment banks seize the opportunities available.

The market is split into three parts. The first involves property companies that use CMBS as an alternative form of debt funding, such as British Land’s securitization of its Broadgate office development [see Borrowers of the Year section for more details, this issue], and corporates or government entities that use it for sale-and-leaseback deals, such as British Telecom, accounting for about two-thirds of issuance. For such issuers, CMBS is attractive because it is off-balance-sheet.

A second part of the market is bank issuers, such as Eurohypo, whose business is commercial property lending. They use CMBS for funding and managing their balance sheets. This group is increasingly blurring into the third – and currently most exciting – section of CMBS: conduit issuance. Put simply, conduits are arbitrage opportunities whereby commercial loans are made and then securitized by the lender – the borrower benefits from a low cost of funds and the conduit picks up an attractive spread.

Traditionally, European real estate has been financed by commercial and specialized banks. This is changing because banks have become more cautious about what they have on their books, borrowers have become more savvy and willing to accept non-traditional forms of finance, and – most important – spreads in the bond markets have tightened to such a degree that securitization has become irresistible.

Refinancing exposures

Laurent Mitaty, vice-president in the securitization group at SG CIB in London, notes that banks are now less willing – for reasons that include the tougher capital adequacy standards laid down by Basle II – to lend from their own balance sheets. However, they are still keen to benefit from the strength of the European real estate market – hence the desire to refinance their existing exposure to the market through CMBS and channel new business the same way.

On the issuer side, there has been a change in the perception of securitization helped by changes in the structure of the market itself. In the past five years there has been substantial divestiture of real estate assets and large pools of new money entering the market in search of a safe haven. Necessarily some of those managing this new money feel somewhat differently about financing than traditional players.

That is not to say that there is not still resistance to securitization – especially among continental European players, which have been slower to embrace the market than UK property concerns. Ronan Fox, director in structured finance at Standard & Poor’s in London, says that borrowers are understandably interested in how they are going to be treated at origination and during the life of the loan.

With a balance sheet loan there is a continuing relationship between lender and borrower, and often the possibility of greater flexibility, says Fox. In addition, he says, there are still some borrowers who say ‘How could my bank sell my loan?’ when banks mention securitization, he notes. “But with larger loans, sophisticated borrowers recognize that they would probably be dealing with a syndicate of lenders in any case.”

Unsurprisingly, it is lower costs of funding that have won converts to CMBS. In the past, CMBS was priced at broadly the same level as a normal bank loan, according to Caroline Philips, head of securitization at Eurohypo in London. Now, Fox notes, for property companies – and lately funds such as Arlington Business Parks and the Mall – the cost of a capital markets deal can be “materially lower” than bank debt.

Access to capital

Although in the past such borrowers might have had to pay about 80 basis points over Libor to bank lenders, CMBS issuance can offer a cost of funds in the 10s, 20s or 30s basis points over Libor. Indeed, for some issuers such as property company Redevco it is possible to achieve pricing similar to a triple-A corporate issuing straight bonds – despite borrowing up to 60% of the value of the deal CMBS is not suitable for everyone and rarely suits real estate developers or borrowers that want to trade their portfolio and require flexibility. But it does provide access to large pools of capital and a maturity range of more than 25 years – far longer than bank debt.

For the suitable and willing, the choice is between a standalone, or agency, transaction and borrowing from a bank, which then issues through a conduit.

In order to realize the full benefits of securitization, a borrower has to issue securitized paper itself. This is not as simple as it sounds. As SG CIB’s Mitaty notes, few real estate companies are willing to take the principal risk while the deal goes through the formal rating process and an offering circular is issued – a two-month period – and undergo the burden of documentation and due diligence required.

Shirish Godbole, head of real estate finance at Morgan Stanley in London, says that borrowers that are prepared to take the risk – such as in British Land’s recent refinancing of Broadgate – get the benefit of whatever pricing is achieved. “But the flipside is that if spreads widen during the lag between preparing the deal and pricing they would have taken the loss,” he adds. In addition, they have to assume upfront costs.

A standalone deal requires substantial internal resources and a high level of transparency about the issuer’s business strategy and internal procedures. It also requires a company of a size sufficient to require a large deal. “Because of the upfront costs, anything less than around e200 million does not make sense to securitize directly,” says Eurohypo’s Philips.

Borrowers that are not large enough to go thought the rigmarole of standalone issuance, or are unwilling to do so, but are still eager to benefit from some of the price advantages of securitization, can instead access the rapidly growing conduit lending market. Although the market makes use of CMBS, from the borrower’s perspective conduits look largely like a traditional lender.

Conduits work by creating a loan that is sold to an issuing special purpose vehicle (SPV). It outsources requirements such as loan management, which includes maintaining the interests of the lender and ultimately the holders of the conduit paper and liaising with the borrower. The loan – or loans – is then refinanced by the conduit through CMBS issuance.

The difference between the cost of funds to the conduit and the lending rate to real estate borrowers is pocketed by the conduit. And that arbitrage, says Krishna Prasad, head of European structured finance research at Lehman Brothers in London, has become wider in the past year-and-a-half as bond spreads have progressively tightened and the commercial property market has boomed, increasing the demand for funds.

The pioneer of the conduit market in Europe is Morgan Stanley, which began its ELoC programme in the late 1990s and was almost the only game in town until 2003 when other investment banks took note. Now about 16 banks offer conduit lending in Europe – many having opened their doors in the past six months and often headed by ex-Morgan Stanley staff.

At the moment conduit lending is just a third of European CMBS issuance but the expectation is that it will eventually assume levels similar to those in the US, where it constitutes 80%, according to Arvind Bajaj, head of the European real estate finance and securitization group at Credit Suisse First Boston in London. “The European market will likely follow the same route – banks will head towards principal execution.”

Conduit issuers have issuance programmes – such as Morgan Stanley’s ELoC or Lehman Brothers’ Windermere  – but these are effectively just brands. Deals are structured separately and although each is originated and structured by the same issuer, it will have unique characteristics and might be co-branded with the geographical location or sector of the source of the loans, for instance Eurohypo’s Opera Finance (Scottish Retail).

Despite being largely a vanilla market, some conduits have sought to differentiate themselves on grounds other than cost. One camp of conduit lenders, including banks such as ABN Amro, Barclays Capital, Eurohypo and SG CIB, highlight the fact that CMBS issuance is used only as a tool of their business rather than its sole driving force.

Lynn Gilbert, head of European real estate finance at Barclays Capital in London, says it would still lend regardless of whether it would be possible to issue conduit paper. For borrowers, the claimed benefits of such a model are that the process is no different from a regular bank loan. Although it is serviced and managed by Barclays Capital Mortgage Services, for example, the borrower still maintains its relationship at a branch level.

This is in contrast to what might be described as the Morgan Stanley model, where banks do not have the deep relationships enjoyed by traditional lenders. “They win on price and outsource servicing to third-party specialist servicers,” says Eurohypo’s Philips. Unsurprisingly, conduit lenders that have CMBS issuance at the heart of their business strategy see the “quality of relationship” division as disingenuous.

As one banker notes, the conduit market has grown substantially and borrowers are familiar and comfortable with third-party servicers such as GMAC, Hatfield Philips, and Crown NorthCorp. “Indeed, there’s a good argument to be made for saying that because a specialized company is servicing the loan they are better at it than a bank,” he says.

Extra protection

From an investor perspective, the difference between a loan originated specifically to securitize and one that would have been made regardless is harder to establish. Gilbert says that when an investor buys bonds from Barclays Capital it gets a diversified snapshot of a typical UK property company. But Morgan Stanley and other issuers have used their conduits to issue bonds based on pools of loans as well as single loans.

In addition, as S&P’s Fox notes, loans that are originated solely for the purpose of securitization can often have protections that would not be there in traditional balance sheet loans, which are later securitized. One banker adds that investors welcome loans originated specifically to securitize because of the level of discipline implied. “With some deals, investors ask: ‘Are they keeping the good stuff on their books and selling the bad stuff?'” he says. “There’s potential for negative incentives for those types of banks.”

Investors are certainly interested in whether conduit deals are backed by a pool or a single loan. But this information is transparent and the market differentiates between the types: single-loan deals are tranched with a lower loan-to-value ratio at triple-A to reflect the relatively high risk they contain. Furthermore, while the risk might be greater in a single-loan deal, from an investors perspective such deals are easier to analyse than a pool of 10 loans with varying LTVs – where the one that might produce a loss is hard to spot.

More generally, the origination of some loans can be opaque. Some bankers admit that many borrowers are units owned by the investment banks themselves, making market share to some extent a reflection of an investment bank’s willingness to use its balance sheet. But other bankers note that while private-equity players might be affiliated to investment banks, they have a strict commitment to their shareholders and will not hesitate to choose the lowest-cost bank.

Investor demand for CMBS issuance can be gauged by the hefty levels of oversubscription on most issues. In short, the principal appeal of CMBS is yield. As bond yields have fallen in the corporate market and subsequently in asset classes such as residential mortgage backed securities, CMBS has become increasingly attractive.

Lehman’s Prasad notes that as triple-A UK CMBS is currently about 22bp over Libor – compared with 11bp over Libor for RMBS – the pick-up is significant. Similarly, triple-B CMBS is about 90bp over Libor and RMBS is 45bp to 50bp. “The differential between CMBS and RMBS has increased recently because of the softness in the broader credit market,” he says.

Meanwhile, the influx of conduit issuers is helping the CMBS market create a virtuous circle, according to Gilbert at Barclays Capital. Increased issuance means that it becomes worthwhile for investors to set up teams to analyse deals whereas it had been hard to justify the expense with just a couple of issuers.

Important details

Investors do not differentiate between conduit paper and standalone deals, according to CSFB’s Bajaj. “Some investors that bought AAA/Aaa paper on our recent €1.06 billion deal for the Mall also bought the senior class of Titan Europe 2004-1 in November, which was a conduit transaction,” he says. Rather, the important details for investors are the tenor, currency and whether an issue is fixed or floating rate. Generally, conduit deals are five to seven years while standalone deals might go to 25 years. One increasing demand from investors is secondary liquidity. However, some characteristics of CMBS make secondary liquidity a challenge: most large agency deals have just a couple of bookrunners, and many conduit programmes are sold only by the issuer. In addition, detailed information is required to deal CMBS: banks may be reluctant to invest in research in order to provide liquidity to issues other than their own.

Nevertheless, investor expectations of liquidity continue to grow. “Certainly larger deals get more attention because of the potential for secondary liquidity,” says SG CIB’s Mitaty.

“Recently there have been increased numbers of investors at each level of the transaction that are interested and educated about trading opportunities – they need to be comfortable with the bank which is bookrunner.”

Banks at the forefront of the market, such as Morgan Stanley and Lehman Brothers, will trade bonds on which they were not bookrunner. “Liquidity in bond trading depends on access to information and there continue to be some deals for which information is not available  – although information provision is getting better,” says Godbole at Morgan Stanley.

“Increased trading can only be good for the market and will reduce spread volatility. The increase in the number of banks trading bonds should help.”