Iain Balkwill considers the revival and future of commercial mortgage backed-securities
June marks the fifth anniversary of the relaunch of the European commercial mortgage backed-securities (“CMBS”) market following the onset of the global financial crisis (“GFC”). Consequently, now would appear an opportune time to take stock of the current state of the product.
CMBS is a financial instrument that enables investors in the debt capital markets to finance commercial real estate (“CRE”). Generally speaking, a CMBS deal comprises the transfer of one or more loans to an insolvency remote vehicle that has been established solely for the purposes of acquiring loans secured by CRE. This vehicle in turn will fund the acquisition by issuing debt securities (CMBS notes) into the capital markets.
For a bank the arrangement of a CMBS transaction allows it to remove a loan from its balance sheet without having to tap the syndication market. From an investor perspective, the investment in CMBS affords it the opportunity to acquire debt securities that have the CRE risk and return debt profile that it yearns for while at the same time not requiring it to originate CRE loans. In addition, investors in CMBS benefit from credit enhancement achieved through the use of liquidity lines to cover payment shortfalls on the underlying loans, hedging to cover interest rate (and currency) risk and, depending on where they invest in the capital stack, collateralisation from the tranching of notes.
CMBS 2.0
This new era of CMBS (which is more commonly known as CMBS 2.0) has proven itself to be different to its predecessor. Deal flow over the past five years can best be described as stuttered, with a vast range in the type and size of transactions. In terms of the type of deal structure, although there have been a handful of agency deals, as with the CMBS 1.0 era, conduit deals have dominated. This has been driven by the likes of Bank of America Merrill Lynch, Deutsche Bank and Goldman Sachs re-establishing their CMBS platforms.
Drilling more into the types of CMBS 2.0 transactions that have hit the market, this era can be characterised by a series of trends. Initially CMBS transactions were comprised of simple structures consisting of single loans secured by prime CRE. These were then followed in 2013 by a market dominated by the securitisation of jumbo loans secured by German multifamily properties. Following the advent of the first multi-loan transactions in the second half of 2014, the CMBS headline for 2015 was the re-emergence of pan-European deals comprised of multiple loans secured by CRE located in a number of different European jurisdictions.
In terms of the documentation and structures deployed in European CMBS, the GFC certainly stress tested these. The corollary of this testing, when coupled with addressing the raft of regulation that has embattled the securitisation markets, has led to a marked improvement in the documents and structures utilised in CMBS 2.0. Similarly, given that credit rating agencies have become more stringent with their rating criteria and fewer counterparties now satisfy such criteria, the CMBS 2.0 era is also witnessing the emergence of a swathe of unrated deals.
Market outlook
Broadly speaking, over the past five years the European market has experienced continuous growth for the volume of primary CMBS issuance although the flow of deals can be described as anything but smooth and predictable. Indeed, last year the European market was heading towards a bumper year before concerns over the state of the Chinese economy emanated in a cessation of issuance. The volume of primary issuance for 2015 stood at approximately €5bn (£3.9bn), which is similar to the levels achieved for 2014 and therefore the market is still some way off the peak of £65bn in 2007. Turning to 2016, given that only one public-rated deal has hit the market so far this year, the renewed and heightened volatility in the Chinese capital market, the continual slide in the price of oil, the raft of disappointing UK economic data as well as fears surrounding a potential Brexit, have continued to create challenges for the re-establishment of European CMBS issuance.
Despite these inherent challenges, there are nevertheless a number of positives that market participants can take solace in. First and foremost, securitisation is slowly losing its stigmatisation, as demonstrated by the European regulators stating that they consider simple, standardised and transparent securitisation as one of the building blocks of a European capital markets union. In a similar vein, securitisation received a further boost this year with the agreement between the European legislature and the Italian government to deploy securitisation technology as a means of offloading non-performing loans (“NPL”) from Italian banks. Although it has yet to be seen how this will affect CMBS issuance, given the volume of NPLs secured by commercial real estate, this legislative proposal has the potential to be significant.
Future of CMBS
Compared to the pre-GFC era, the European CMBS 2.0 product has certainly experienced a lower volume of issuance and a slower pace of growth than its predecessor. However, market participants should be mindful of not being bamboozled by these observations. The reality is that the slow and measured pace of the evolution of the CMBS 2.0 product has ensured that the solid foundations have been put in place for CMBS to be deployed as a financing tool to fund a variety of CRE in a range of jurisdictions. Although over the past year macro-economic factors have clearly stifled primary issuance, assuming that the market can shrug these off – and fuelled by encouraging legislative tailwinds – there is every chance that we may soon witness profound and sustained growth in the European CMBS market.
Iain Balkwill is a partner in the structured finance team at Reed Smith
