Securitisation enables property-owning organisations with strong covenant strength to reduce borrowing costs. Graham Lloyd-Brunt shows how
Tailored leasing can enable an organisation’s strong covenant strength to be captured and/or the risk attached to a large property (and, accordingly, an important lease) to be reduced. When banks lend against rents secured by tailored leases, risk is reduced and lower borrowing costs are generated with improved securitised loan bond ratings (see chart).
Mortgage securitisation enables the benefit of loan repayments to be held by a number of investors through the purchase of bonds issued on completion of the sale of mortgage loans from a new, “conduit” company. Investors in bonds effectively look only to the covenant strength/credit risk of the relevant portfolio of mortgaged assets.
The asset portfolio may consist of commercial properties let on institutional-grade FRI leases with rents paid by a range of tenants that are independent of the landlord. The primary determinant of the loan cost and bond ratings will be the overall investment risk and valuation of the let property, taking into account the covenant strength of the various tenants and the marketability of the property.
Frequently, the underlying asset portfolio of commercial mortgage-backed securitisations are properties let following a sale and leaseback. The mechanism allows an organisation to reduce its borrowing costs by securing its own covenant strength. This is often achieved by enhancing the characteristics of the lease being used and by upgrading it from an FRI lease into a “modified leaseback lease”. All such modified leaseback leases are what are known as “credit tenant” leases, but only occasionally do these create what is known as a “triple net” lease.
There are broadly three types of modified leaseback lease, all of which focus upon maintaining tenant covenant strength and, in the case of triple net leases, maintaining rental payments in any event. According to the type of lease used, these increasingly reduce the rental payment risk (see chart).
Types of lease
● Assignment rating test leases
These allow tenant assignment, subject to the covenant strength of the assignee being equal to or greater than a rating agency rating level, usually that of the initial tenant at the grant of the lease. Telecommunications companies and banks often use this type of lease in sale-and-leaseback transactions, since, in the long term, they are likely to want to assign their leases.
● Non-assignable leases
These prohibit tenant assignment. However, they usually allow the tenant full operational freedom, including the right to underlet and to carry out any form of alterations. Supermarkets generally use this type of lease in sale-and-leaseback transactions of superstores because they will not look to assign the leases of key locations.
● Triple net leases
Triple net leases, also known as “hell or high water” or “NNN” leases, ensure that the tenant continues to pay the full rent reserved under the lease and covers all liabilities for the premises throughout the contractual term of the lease following any eventuality. In the UK, triple net leases have been used in transactions involving broadcasting properties and in one loan in respect of two offices of a bank.
Creating triple net leases
Triple net leases allow rating agencies to focus on the credit strength of the original tenant without having to consider the risk factors, such as frustration, compulsory acquisition and insurance cover, that normally affect leased property. The fewer the properties there are in a transaction, the more important these risks become. The rating agencies must take these into account in transactions with other types of modified leaseback lease.
Triple net leases incorporate an absolute rental obligation – a “non-frustration clause” – by which the tenant is obliged to pay rent irrespective of any damage to the leased premises or the access to them, their compulsory acquisition or even lease frustration. They should provide, in specific and unequivocal terms, that the tenant has no right to set off rents through the exercise of legal or equitable remedies.
The imposition of such an absolute obligation on the tenant arises from the Law Reform (Frustrated Contracts) Act 1943. This allows contractual provisions to override the potential frustration of a contract. Significantly, there is no case law on this legislation in the context of real estate leases and, accordingly, the effectiveness of non-frustration clauses in leases is not beyond question. The incorporation of such a clause leads inextricably to the lease being personal to the original parties, with alienation prohibited.
The following additional issues need to be addressed when dealing with modified leaseback leases.
Additional issues
Since assignment-rating tests and non-assignable leases often allow tenants to retain the obligation to insure, standard rent cesser terms need to be amended so that rent cesser is available to the tenant only upon the landlord receiving loss of rent insurance payments. (Triple net leases do not provide for rent cesser.)
Whatever type of modified leaseback lease has been used, landlord independence from the tenant must be ensured throughout the contractual term of the lease. (The tenant’s group of companies will have a strong incentive to see the tenant’s lease determined by way of landlord forfeiture or surrender because such a lease determination would destroy the tenant’s rental payment obligations.) This can be achieved through the inclusion of negative pledges from landlord borrowers in their loan agreements and by lender charges over the landlord’s shares in the tenant, if both come within the same group of companies.
Structure with care
As can be seen from the above, the possible enhancements to FRI leases are varied. However, with careful structuring, modified leaseback leases can help to achieve substantial borrowing savings for property-owning organisations that have strong covenant strengths.
Graham Lloyd-Brunt is a real estate partner at Berwin Leighton Paisner LLP
|
What is real estate debt securitisation? |
|
● Essentially, real estate debt securitisation is a process whereby one or more debts are divided into separate units of debt constituted by notes ● In general, securitisations are arranged through an official stock exchange and the notes are therefore tradeable ● Trading takes place between institutions, although an institution may hold the notes it originally acquired throughout their life ● Denominations are generally in units of £10,000 ● Each unit of debt represented by the notes gives the registered holder the right to receive interest at a stated rate (which may be fixed or floating) on stated dates ● The registered holder is also entitled to receive repayment of the debt on a stated date or, more frequently, repayment by tranches over a stated period, each partial repayment being due on a stated date ● There may be, and frequently are, many different classes of note issued at the same time, each carrying a different interest rate and each representing debt that is repayable at different times and over different periods |
