JAN 2007 VOL. 2

European CMBS Market Heads toward  €100 Billion Milestone

 

European real estate finance increasingly resembles the U.S. model. This year, Britain has joined the REIT club. Germany is expected to follow suit. On the debt side, underwriters have been even more aggressive. Issuance of commercial mortgage-backed securities (CMBS), market watchers say, could reach €100 billion this year. That would represent nearly five-fold growth since 2004 and implies an expansion rate of more than twice that of the U.S. market, which passed $200 billion (about €140 billion) in 2006.

The growth in CMBS in Europe is driven by many factors, including thriving property markets. But also it's a sign of the further internationalization of real estate finance.    
Often, European CMBS deals are packed with collateral from five or more countries, which gives debt investors added protection against economic risk in particular countries, analysts say.

CMBS investors are  a more varied lot these days, according to Hans Vrensen, director of European securitization research and lead CMBS analyst for Barclays Capital in London. Portfolio investors have joined banks in buying CMBS and European issues are being snapped up by investors from other parts of the world, including  the Middle East and Australia, according to Vrensen. 

For the European borrower, CMBS growth has also been good news for investors and developers, because it has increased competition and cut borrowing costs. “What it has done, directly or indirectly,” says Euan Gatfield, a director for Fitch Ratings in London, “is it has tightened spreads because other lenders have obviously had to remain competitive.”

Where will the growth come from? In 2007, Vrensen expects the greatest action will come from multiborrower platforms, rather than conduits, as was the case in 2005 and 2006. Other industry watchers believe that the pool may grow in part through the addition of loans from eastern Europe, Russia, and the Middle East. He notes that his annual surveys of investors have tended to be on the conservative side, so the  €100 billion landmark might even be surpassed.

Ronan Fox, a director of securitization research for Standard & Poor’s in London, says that most of the growth is due to the growing geographical expansion of origination platforms operated by European, Middle Eastern, and African commercial banks.

The fastest-growing geographical market is expected to be Germany, which accounted for 10% of issuance in 2005 and 39% in 2006, according to Barclays Capital. Much of the German volume last year was the result of 2005 property sales as corporations and local governments sold large housing estates from their portfolios to U.S. and U.K. opportunity funds. Multifamily loans as a percentage of the year’s Europe-wide total rose from 13% to 24%.  

As in the U.S., growth has attracted more underwriters—and is squeezing profits on basic CMBS deals. To restore margins, many players expect to see underwriting moving eastward. London-based underwriters are now shopping for deals in  India and the Middle East.

Gatfield says he expects to see collateral from eastern Europe and maybe even Russia in pan-European packages this year—but only in small slices in multi-borrower pools. He notes that there are still technical challenges, including establishing Western standards of assurance on property rights.

Clive Bull, a director of real estate finance for Deutsche Bank in London also expects to see some eastern European properties in CMBS packages this year.” Eastern European loans may well be included in some deals,” he says. “I would be very surprised if we saw a lot of it, though.” The biggest hurdle, Bull says, is currency risk outside the Eurozone. “You’ve got to put a currency hedge in place and that is expensive,” he explains.

The big story in the U.S. real estate finance industry--collateralized debt obligations (CDOs)--is just getting off the ground in Europe. Unlike CMBS securitizations, CDOs take the cash flow from a mix of assets, including mezzanine loans and other short-duration and un-rated pieces. Also, CDOs are not based on a fixed pool of assets. They are essentially revolving-credit packages in which managers can replace loans and instruments that are retire or fail with other equity.

In the U.S., CDO issuance jumped from $21.6 billion in 2005 to $34.4 billion last year, according to Commercial Mortgage Alert, a newsletter. Europe, on the other hand, just had its very first real estate CDO, a  €263.5 million deal by the Anthracite unit of Blackrock. a subsidiary of Merrill Lynch. At closing, the deal was securitized with German and U.K. real estate.  The five-year revolving fund was 88% filled, and future asset acquisitions can be made on real estate debt originating in the European Union, Switzerland and Norway.

TheAnthracite deal, Gatfield says, may come to been seen “as a sort of starter’s pistol for a range of potential portfolio managers and real estate specialists who have built up some exposure to subordinate debt to use the CDO as a funding tool.” Indeed, a number of other leading underwriters such as Wachovia and Merrill Lynch are also reportedly now pulling deals together.

The major impact of CDOs in the U.S. has been to create a new secondary market for loans, including so-called B pieces (subordinated debt) and construction loans that could not be securitized in conventional CMBS packages. European CMBS already offer greater flexibility than their American counterparts because there is no equivalent to the Real Estate Mortgage Investment Conduit (REMIC) tax rules. The REMIC rules make it difficult for U.S. issuers to substitute collateral as loans mature or are paid off.

In Europe, Gatfield believes the CDO will be used mostly to satisfy demand for higher yield through the securitization of riskier pieces.  Such loans have been absent from most European CMBS deals over the last 18 months, according to a recent Fitch report. This suggests to Fitch analysts that these loans are now being placed directly with specialist investors.

However, Fitch reports that demand for B-note ratings is growing, which leads analysts there to conclude that the banks may be gathering collateral for more CDOs.

The reserve requirements under the new Basel II bank rules may also make holding riskier debt more expensive for banks, and the CDO may prove to be a good way to get that debt off their books.

Looking ahead, Gatfield sees much more growth ahead. In Europe CMBS accounts for 10% to 20% of the mortgage market, vs. 26% in the U.S. On the other hand, experts note, there are limitations that U.S. issuers do not face, including underwriting across multiple jurisdictions. But, Vrensen says, whatever the growth rate, a healthy CMBS market “is a very clear benefit for investors.”