15 May 2006
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Traditionally the European commercial real estate market has been dominated by European banks lending either in their own jurisdictions or on a cross-border basis. Many of the loans were made on a 'relationship' basis to longstanding clients for which the banks undertake a wide range of banking services.
Over the past five or so years a number of new and distinct factors have combined to radically change the status quo. New structures have been created for real estate lending and new instruments are available for investors in real estate debt. Simultaneously, and as an inter-related matter, new real estate lenders and new real estate debt investors have entered the market to a significant extent.
A changing market
Why is the European real estate debt market changing?
Four principal elements are combining to change the European real estate debt market. These are:
1. Basle II has increased the regulatory capital cost for banks holding large real estate loan portfolios in many countries, creating a huge incentive for regulated lenders to divest themselves of real estate risk. The capital markets, particularly asset-backed markets, have since their inception been a prime destination for those wishing to transfer regulatory risk.
2. German banks, which have traditionally been among the most prolific real estate lenders, have been less active in recent years. While at least part of this can be attributed to local economic conditions, the withdrawal of the state guarantee for the Landesbanks (although many historic debt issuance programmes continue to benefit from 'grandfathering') and the fallout from the BaFin ( the German financial services authority) investigation of provisioning for problem loans by certain banks have also been significant factors.
3. International investment banks such as Credit Suisse, Morgan Stanley, Deutsche Bank and Eurohypo have established significant real estate 'conduit' lending programmes. These programmes, which are based on similar programmes that have been established in the US for many years and now represent the largest single source of real estate finance in the US, are based on normal real estate lending. However, the loans are documented specifically to facilitate the lending investment bank to refinance itself by selling pools of such loans to special purpose vehicles (SPVs), which purchase the loans with the proceeds of an issue of commercial mortgage-backed securities (CMBSs).
The efficiencies of capital markets funding and the arbitrage opportunities that exist between capital markets costs of funds and traditional bank-led real estate lending have already allowed the conduit lenders to carve out for themselves a significant share of the European real estate debt market by enabling the conduit lenders to offer very competitive pricing and (by utilising A/B structures as described below) high advance rates. In the period since 1999, when Morgan Stanley bought out European Loan Conduit ELoC 1, the European CMBS market has grown from nothing to more than E37bn (£25.37bn) in 2005, with issuance volumes doubling in most years and expected to double again in 2006.
Additionally, conduit CMBS programmes have begun to arrange pan-European CMBS transactions. These transactions have long been seen as the Holy Grail for real estate investors wishing to spread risk across a portfolio of loans and countries, rather than making large investments in single loans and incurring the significant legal, due diligence and other costs normally associated with cross-border investments.
4. New institutional investors such as LNR Partners, Capmark (formerly GMAC Commercial Mortgage) and Anthracite, together with hedge funds such as Cheyne Capital and Cambridge Place with appetites for higher returns have been instrumental in the development of an entirely new market for European subordinated and mezzanine commercial real estate debt.
The CMBS conduit lenders have begun to specifically tailor their commercial real estate loans to enable them to 'split' the loan at a later stage between a CMBS and such an investor, with the investor taking a subordinated position in return for a higher margin through a private intercreditor arrangement. Such arrangements (known as A/B structures) enable the conduit lenders to offer borrowers higher advance rates against their properties than would typically be permissible if the whole loan were intended to be securitised.
Evolution of the new structures
The structural distinctions of CMBSs and other forms of securitisation lie principally in the servicing agreement, where sophisticated arrangements are made, often involving independent expert loan servicers, with responsibility often being divided between master servicers, whose role is similar to that of a facility agent on a syndicated loan, and special servicers, who are responsible for the enforcement and workouts of the loans. 'Servicing standards' are imposed on the servicers and are based on, but deliberately less onerous than, fiduciary obligations so as to give investors comfort that their interests are being protected when circumstances so require.
Typically, the servicing agreements also give junior investors (and sometimes B-piece lenders) consent or consultation rights on decisions as to disposals and material modifications and waivers. These junior investors are also often given the right to terminate the appointment of the servicers, this being seen as a means of ensuring the servicers perform properly. Servicing agreements become significantly more complex when the servicer is given responsibility for servicing loans on a cross-border basis. CMBS servicing has not yet received much attention from European legislators or regulators, and consequently it largely remains unclear whether any licences or approvals are needed for servicing and special servicing. As a result, arrangements are commonly made for servicing to be 'fronted' by licensed institutions or for them to be delegated to local entities.
The other key distinguishing characteristics of CMBSs lie in the extremely thorough loan and property disclosure contained in the transaction, offering circulars (which can run to more than 300 pages) and detailed reporting to investors on loan performance. Additionally, as the primary motivation for investment banks to establish conduit CMBS programmes is to take advantage of the arbitrage between capital markets costs of funds and commercial real estate lending rates, CMBSs often feature sophisticated profit extraction mechanisms.
Recent European transactions have seen the first European 'interest-only' (IO) strips used for this purpose. These are bonds that are structured to capture the difference between the capital markets and loan interest rates (on a weighted average basis) and they pay the same to the IO investor senior as to all other bondholders.
The pace of innovation in the European commercial real estate debt market seems, if anything, to be increasing. The UK Government has indicated that legislation will be introduced by January 2007 to allow for the creation of Real Estate Investment Trusts (Reits). A market of more than £1bn has developed for total return swaps (both income and capital) against the UK Investment Property Databank index, and 2006 is expected to see the first European commercial real estate CDOs. This seems certain to result in yet more new borrowers, new lenders and new structures for investing in real estate debt.
The European market is changing so quickly at present that it is is poised to overtake the US as the new centre of development for new real estate finance techniques.
Conor Downey is a partner at Cadwalader Wickersham & Taft