While the commercial mortgage-backed securities () market in the United States has grown rapidly over the past decade and is expected to reach a record $120 to $130 billion this year, securitization in Europe and Asia is still in its infancy stage.
Investors and borrowers in several countries are just now beginning to realize the advantages of CMBS: liquidity, higher yields and favorable financing rates. But a perceived lack of transparency, or financial disclosure by borrowers, concerns investors in non-U.S. CMBS.
“We've seen rapid growth in global CMBS, but transparency and borrower diversity need some improvement,” acknowledges Hans Vrensen, head of CMBS research at Barclays Capital in London.
As the CMBS market grows, borrowers are obtaining competitively priced debt, Vrensen explains, while fixed-income investors are able to diversify their holdings and achieve higher yields in real estate than alternative investment vehicles.
Filling a void
London-based fund management house Henderson Global Investors, for example, chose securitization for its new fund, the Caspar Property Fund, rather than pursue traditional bank loans. The Caspar Property Fund was not only Henderson's first CMBS, but also the first securitization completed with the Royal Bank of Scotland's new CMBS product, dubbed the European Property Investment Conduit (EPIC). The total value of the Caspar portfolio, which consists of 61 office, retail and industrial properties near London, was 1.05 billion Euros.
The Caspar Property Fund was created when Henderson's clients restructured their initial investment by consolidating their properties from three funds into one fund and refinancing all of the properties. Securitization enabled the clients to decrease their equity stake in the fund.
“We looked at going to a typical bank lender, but it didn't offer the advantages offered by CMBS,” explains Desmond Jarrett, client director with Henderson Global Investors. The firm was attracted to to CMBS pricing and bond availability. The Caspar Property Fund securitization illustrates a growing trend in the United Kingdom, Continental Europe and Japan: the increasing acceptance of CMBS as a finance alternative by borrowers and strong investor demand for bonds.
By the numbers
CMBS volume in Europe grew 149% to 21.2 billion Euros during the first half of 2005, more than the total volume for all of 2004, according to Moody's Investors Service. More than 30 CMBS transactions ranging from 46.2 million Euros to 4.37 billion Euros closed during the six-month period, compared to 14 transactions with an average size of 500 million Euros for the same period last year, reports Moody's.
Total European CMBS issuance for the year could eclipse 35 billion Euros, forecast several industry experts. In Japan, meanwhile, the CMBS market is expected to reach $10 billion, a 30% increase over 2004, according to industry experts.
So far this year, roughly $8 billion worth of CMBS transactions have closed. Refinancing of existing CMBS deals and a fairly active investment sales market have accounted for much of the rapid rise in the volume of CMBS issuance, according to Tetsuji Takenouchi, senior vice president of Moody's.
Despite the growth in European and Asian securitization, the CMBS markets continue to be dominated by single-borrower transactions, which concerns many industry experts. A single-borrower transaction is a CMBS pool consisting of several loans secured by properties that have only one owner rather than the bulk of CMBS deals in the U.S. that include hundreds of loans held by several borrowers.
“The [primary] concern with single-borrower deals is concentration risk,” says Charles Roberts, a partner with Cadwalader, Wickersham & Taft LLP. Roberts also is co-chair of the international division for the Commercial Mortgage Securities Association, a trade organization that advocates the securitization of commercial properties.
“Single-borrower deals usually indicate less property diversity, although that's not always the case. The thought is that if something goes wrong, all the eggs are in one basket. Investors in the U.S. have stayed away from single-borrower and single-property deals.”
During the first half of the year, 80% of all CMBS transactions in Europe were single-borrower, according to Moody's. The preponderance of single-borrower transactions in Europe and Asia is a stark contrast to the U.S. CMBS market, industry experts say.
In fact, the term “conduit” does not have the same meaning in the global CMBS market as it does in the U.S. market, where a conduit is an organization that originates commercial mortgage loans with a mix of borrowers, property size and type and geographic location. Outside of the U.S., conduits are used to describe any commercial lending transaction where the loans end up securitized.
Investors view granularity, a term used to describe CMBS deals with multiple borrowers and properties, as a preferred investment, says Caroline Philips, managing director and head of securitization at Eurohypo AG. “Investors do like granularity as there is perceived to be lower event and concentration risk,” she explains.
Rodney Pelletier, an analyst with Fitch Ratings, says that more multi-borrower transactions are critical to the success of the global CMBS markets. “Multi-borrower transactions will be the ultimate frontier,” he says. “It will show that the CMBS market is established.”
Transparency proves elusive
Another concern is the level of disclosure for non-U.S. CMBS deals. Borrowers outside of the U.S. aren't used to opening up their financial records for anyone and everyone to review lease terms, tenant rosters and property performance.
Nonetheless, many investors abroad expect the level of disclosure to be on par with that in the U.S. despite the differing levels of maturation and sophistication. “The level of disclosure can be difficult — that's always been a major complaint from bond investors,” Roberts says. “It's something we take for granted in the U.S.”
Indeed, transparency in financial reporting is a critical element in all CMBS markets, Pelletier says. “The lack of transparency in certain markets is a risk that needs to be overcome in order to create a truly efficient market,” he notes.
Today, there is no commonly accepted standard for investor reporting outside of the U.S. However, transparency is so important that CMSA's European chapter plans to introduce reporting guidelines for the United Kingdom at its first annual European conference in Brussels this fall.
“For bonds to be more freely traded in the marketplace, investors need to know how the properties and the bonds are performing,” says Dottie Cunningham, CEO of CMSA. The organization plans to introduce guidelines in Western and Continental Europe as well, and its Japanese chapter is working on a set of financial reporting guidelines for Japan's CMBS borrowers and investors. “We expect that it will take time (for borrowers to get used to the reporting),” Cunningham admits. “The U.S. borrowers were reluctant at first, too.”
“This is the first time that these borrowers have had reporting (responsibilities)” points out Jim Savitsky, director of businessfor Trepp LLC, a New York-based analytics firm that maintains a database of all CMBS transactions that occur in the U.S.
Recently, several investment banks have asked Trepp to create a database for European CMBS deals. Experts believe that the information will increase transparency and improve the flow of information from origination through current bond performance.
Although industry experts agree that improved reporting is important for the long-term viability of non-U.S. CMBS markets, today borrowers aren't penalized for poor disclosure.
“Right now, there's very little difference between a badly reported deal and a well reported deal — it's just a couple of basis points,” says Ronald Thompson Jr., head of asset-backed securitization and structured credit research at the Royal Bank of Scotland Financial Markets.
Nonetheless, experts believe that borrowers will be willing to sacrifice their financial privacy for cheaper financing. “The reporting requirements aren't too onerous,” says Henderson's Jarrett. “We would do a CMBS deal again.”
Important financing tool
The CMBS market is changing the way borrowers access capital globally. “In the past, borrowers were unlikely to explore borrowing money in the capital markets because of the close and long-term relationships with their banks,” says Vrensen of Barclays Capital of London.
“But many have found that borrowing money through a bank is not the most efficient way to finance a transaction.”
The availability of conduit loans is significantly affecting loan pricing and terms, just as it has in the U.S. “Conduits are offering alternatives to balance sheet lenders in Europe,” Savitsky says. “These conduits are creating a very competitive lending environment.”
For example, Henderson obtained a conduit loan for 73% of the Caspar Property Fund's value, Jarrett says, at an interest rate of 34 basis points over the six-month London Interbank Offered Rate (LIBOR). That rate compares favorably to the rate 150 basis points over LIBOR that Henderson would have paid in the traditional lending market.
Investors force tighter spreads
CMBS arrangers are able to provide CMBS loans at such a low cost because of the demand from bond investors. In fact, bond spreads tightened significantly during 2004 due to enthusiastic investment. Tight spreads mean that the cost of funds for originators and borrowers is lower, making CMBS even more attractive as a financing source. “The weighted average cost of a loan funded via securitization became less than that charged by traditional bank lenders,” explains Philips of Eurohypo AG.
However, lower spreads mean that bond investors are not compensated as much as they once were for the same risks, says Vrensen.
As of early September, the five-year European CMBS AAA-rated paper was trading at LIBOR plus 25 basis points compared to more than 50 basis points 12 months ago. With the six-month LIBOR rate at 3.91% in early September, bond investors were achieving returns of 4.16% and higher.
And it's the same story in Japan, where some AAA tranches have dropped from 50 basis points over LIBOR in 2002 to 18 basis points over LIBOR. The favorable pricing is goodfor borrowers, especially since Japan's lending environment is challenging because traditional lenders, such as the banks, are not active or aggressively lending, according to Kevin Stephenson, managing director of Asia Pacific Structured Finance for Fitch Ratings.
Most non-U.S. CMBS bonds are acquired by investors within the country of origin. For example, most European tranches are acquired by European investors including banks, money market funds, hedge funds, insurance companies and pension funds.
CMBS volume grows more quickly in creditor-friendly countries — those countries where creditors have more rights than borrowers by law. That's important to CMBS bond investors, who are more comfortable when their investments are protected.
“If you look at Europe, the U.K. and the Netherlands are considered to be the most creditor friendly,” Vrensen says. To that end, the United Kingdom continues to dominate the European market, accounting for 73% of the overall issuance volume, according to Moody's.
During the first half of 2005, 17 CMBS transactions totaling 12.2 billion Euros closed in the U.K., according to Moody's. The largest European CMBS transaction that closed during the first half of the year was the refinancing of the Broadgate Estate in London for 3 billion Euros. Other large deals were two retail transactions: Credit Suisse First Boston's issuance of 1.6 billion Euros for The Mall Funding plc, and Eurohypo's issuance of 1 billion Euros for Opera Finance.
Although France, Germany and Italy are slightly less creditor-friendly, they are still viable CMBS markets. Germany continues to grow as a CMBS market, representing 5.1% of all European CMBS transactions during the first half of 2005, an increase from 4.7% for 2004, reports Moody's.
As German banks move to lower their concentration in real estate through direct lending and move toward securitization to play in the commercial real estate arena, the CMBS market will expand quickly, Pelletier says.
Specifically, banks will find it increasingly expensive to fund commercial mortgages under the Basel II, which is the revised version of the Basel Capital Accord of 1988 that regulates capital investment.
According to Thompson of the Royal Bank of Scotland, if banks adopt the more sophisticated provisions of the new risk-based measures (and most major European and Asian bank intend to do so), they will be encouraged to weight their asset mix toward residential lending and buy more CMBS than corporate bonds.
Italy also is showing a lot of promise since the Bank of Italy revoked the moratorium on CMBS transactions earlier this year, Roberts notes.
The moratorium, in place since mid-2003, was enacted because the country lacked a suitable legal framework for commercial securitization.
Italy accounted for just 3.4% of Europe's CMBS volume in 2004, but activity increased during the first half of the year, and the country now represents 5.2% of the European CMBS volume, according to Moody's.
“A lot of countries outside of the U.S. are working to make securitization more feasible,” Roberts notes. “There's a lot of activity in Europe and Asia to promote securitization — that is something we haven't seen in the U.S.”
Jennifer Popovec is a freelance writer based in Fort Worth, Texas.
Next frontier for CMBS? China is on radar screen
The number of global hot spots for the emerging CMBS market is on the rise. While Asia and Australia have established CMBS markets that are going through typical growing pains, China as well as Eastern Europe have yet to take the plunge.
China is on every investor's radar screen because of its population growth and a substantial amount of development and lending activity. But the timeline for a CMBS market in China is uncertain. “China is going to happen faster than people think — maybe even in the next five years,” predicts Dottie Cunningham, CEO of the Commercial Mortgage Securities Association. “China's government is developing securitization laws right now because it needs capital for all the activity that is occurring.”
Industry pros expect Asian-Pacific markets such as Taiwan, Korea, Malaysia and India to develop over the next five years. “Korea is the likely next big market, though every underwriter and investor has their eyes on China,” says Ronald Thompson Jr., head of asset-backed securitization and structured credit research at the Royal Bank of Scotland Financial Markets.
In Asia, Singapore's favorable economic conditions and creditor-friendly legal environment have led to a thriving CMBS market. In 2004, Singapore closed five CMBS deals totaling $970 million. During the first half of 2005, there were three deals totaling $854 million, reports Moody's Investors Service.
Nearby, Australia's CMBS market is on the upswing after several years of stunted growth. Year to date, issuance has already eclipsed 2004's volume of 2 billion Australian dollars.
As the Asian and Eastern Europe economies mature, securitization opportunities will become increasingly attractive to investors, says Thompson. “Eastern Europe is a fascinating place that is attracting a lot of interest. If any jurisdiction is going to be looking for external capital, it would be Eastern Europe.”
— Jennifer Popovec
|FOR FIRST HALF OF 2005|
|Source: Moody's Investors Service|