Written by: Iain Balkwill, Partner Reed Smith
With approximately US $3.7 billion issued in 2014, the European market is a whopping US $78 billion short of its 2006 peak. With predictions of between US $5 billion and US $9 billion for Europe in 2015, now is an opportune time to take stock of the European CMBS market and consider what is inhibiting its growth and what is likely to drive it forward.
Following the onset of the global financial crisis (GFC) in the summer of 2007, true primary issuance of CMBS remained dormant until Deutsche Bank brought to market Deco 2011-CSPK in June 2011 (Chiswick Park). Although the deal flow since has demonstrated that CMBS 2.0 is a useful and valuable funding tool for European commercial real estate (CRE), the volume of issuance over the past few years remains disappointing. In one sense, given the turbulent and fragile European economy that has presided over this period, it is not a surprise that CMBS (a product that was badly tarnished by the GFC) has failed to balloon. However given that CMBS, like any other capital markets instrument, is a product driven by market demand, a closer look at the drivers of originators, investors and borrowers alike will inevitably shed some light on the reasons behind the subdued level of issuance.
For originators whose business model was to originate to distribute (primarily through CMBS), the decimation of the CMBS market at the onset of the GFC proved catastrophic. Unfortunately these players were left in the un-enviable position of having a significant CRE exposure on their balance sheet which they were incapable of off-loading due to tumultuous market conditions. Understandably, having been burnt by the originate to distribute model, a large number of once active players in the CMBS market either closed their CRE lending businesses or simply confined lending activities to core clients of the bank with the sole intention of holding such loans on their balance sheet. Given the significant shortage of originators with a CMBS exit in mind, it is therefore unsurprising that this has manifested itself in subdued levels of primary issuance.
With improving market fundamentals, an increasing number of market players that were formerly active in this area are announcing their intention to return to this space, which would clearly add a much welcomed boost to the level of primary issuance. Although the return by such players has been slow, they can be forgiven for being reticent, given that the following has made CMBS a lot more unwieldy:
- With Article 405 of the Capital Requirements Regulation requiring originators to retain a 5 percent net economic interest in CMBS, and given the regulatory capital requirements that apply with respect to retaining such an interest, there is now a new and significant cost to banks participating in the new vintage of CMBS deals.
- Given the cost of providing a liquidity facility, fewer third party banks are prepared to provide these. Therefore CMBS arrangers are invariably having to make internal arrangements for such a facility, creating another drag on the profitability of CMBS 2.0.
- There continues to be widespread regulatory uncertainty on both the capital treatment for holding CRE loans prior to a CMBS exit and for investing in CMBS notes.
- Given the increased breadth of CRE lenders in Europe, originators are increasingly facing stiffer competition on the sourcing of suitable CRE loans that are essential for an originator to execute a successful CMBS deal.
As demonstrated by those originators that are currently active in the CMBS 2.0 market, none of these factors can be considered insurmountable, but nevertheless they certainly make it harder and more of a challenge for banks to enter the market than was the case prior to the GFC. Although originators will continue to commit to this market, they are only likely to do so at a considered pace, the corollary of which is that the market is unlikely to witness a sudden surge of new entrants and therefore a surge in primary CMBS issuance.
One of the major impacts of the GFC on CMBS is the profound affect it has had on CMBS investors. Prior to the GFC, major investors (on behalf of banks) were the so-called SIVs (structured investment vehicles), however with a sudden rise of short term interest rates, the vulnerabilities of these vehicles were quickly exposed and with this came the vapourisation of an entire investor class. Similarly, insurance companies, who were another major investor in CMBS, have become stifled by the stringent requirements of Solvency II, which has effectively prevented them from investing in CMBS. However, despite these notable changes to the investor base, no CMBS 2.0 has so far failed due to a lack of appetite for the product and thus the diminuitive volume of CMBS 2.0 cannot be attributed to lack of investor demand.
In the pre-GFC era, the main attraction to a borrower of a CMBS loan was the hugely attractive pricing compared to balance sheet loans. As interest rates rose in the months immediately prior the GFC, the attractive price offered by CMBS loans fuelled the exponential growth of the CMBS market with increasing numbers of borrowers seeking finance through this means. However today’s market is the complete antithesis of this with interest rates at record lows which, coupled with increased competition from lenders (especially the less regulatory constrained shadow banks), has enabled borrowers to obtain financing at record low rates without the need to turn to CMBS. Consequently, despite the re-opening of the CMBS market there is not the same appetite from borrowers for CMBS loans that generated the surge of issuance in the months prior to the GFC.
What are the drivers?
Although the level of CMBS 2.0 issuance has been low compared to the levels reached at the peak of the market, this is unsurprising given how few arrangers are bringing CMBS deals to the market. Inevitably over time, the number of arrangers will undoubtedly increase, providing a much needed boost to primary issuance however such players can also be forgiven for being reticent. The successful execution of multi-loan and multi-borrower transactions during 2014 is a much welcomed boost to opening up the market for new arrangers, as such deals demonstrate the market is not simply confined to sourcing and securitising a very limited stock of large loans but it has also given the nod to the securitisation of a portfolio of smaller loans.
On the investor side, with the continued low interest rate environment, the ECB’s introduction of large scale quantitative easing, and investors’ relentless search for yield, CMBS is increasingly looking like a desirable proposition for the fixed income investor. Unfortunately, due to the stuttering and lumpy nature of issuance over the past few years, investors have been reluctant to put in place the internal resources and infrastructure required to invest in this asset class with any real volume. If however, the market can demonstrate that it is capable of delivering greater primary issuance with a smoother flow of deals, this will precipitate the deeper and stronger investor base required to absorb and competitively price the volume of deals that should hopefully be destined for the market.
The real driver for significant primary CMBS issuance is however likely to lie in the hands of the borrowers and their demand for better priced loans spurred on by a rising interest rate environment. However before CMBS becomes flavour of the month for such borrowers, the regulators will have to first clamp down on the shadow banks and through regulation erode the competitive advantage that they currently enjoy over traditional CRE lenders (although given the pace of regulatory change this is unlikely to happen anytime soon). With the levelling of the regulatory playing field and a rising interest rate environment, it is likely that borrower demand will drive the CMBS market and then once again we will see significant primary growth.
As has been demonstrated by the number and type of CMBS 2.0 deals that have hit the market since Chiswick Park, CMBS clearly has a role as a financing tool for CRE in Europe. In particular, CMBS has an integral role for financing those assets that would otherwise be more difficult (due to size of the loan or complexity of their underlying structure) for a bank to distribute in the syndication market.
It is inevitable, that with more arrangers in the market there will eventually be a greater volume of CMBS issuance. Equally with regard to the seasoned players, they will generate more deals as they become more efficient in executing transactions in various jurisdictions. However it will not be until interest rates start to rise and there has been a greater standardisation of regulations that apply to the shadow banks that we will start to see a meaningful increase in CMBS issuance. Although it is frustrating that there has not been a boom in primary issuance, this may not be a thing. The gradual growth coupled with the refining and finessing of structures that we are currently witnessing, will ultimately make European CMBS a far more sustainable and robust financing tool for CRE.