Amid a great deal of fanfare, Europe welcomed its first commercial real estate collaterised debt obligation (CRE CDO) issue at the end of 2006. The Anthracite Euro CRE CDO, managed by BlackRock Financial Management was warmly received by investors and more deals are likely to flow in 2007.

According to a research report from Barclays Capital, citing press reports, possible issuers include US groups Wharton Asset Management, LNR Property Holdings, which is 75%-owned by investment firm Cerberus Capital Management, Wachovia Securities as well as Eurocastle Investment Limited, a euro-denominated Guernsey closed-end investment company managed by US-based Fortress Investment Group. Also on the list were UK-based firms Cambridge Place Investment Management and Investec, and Eurohypo whose headquarters is in Germany.

Analysts do not, however, predict a flood of deals. Lisa Goldbaum, Paris-based senior analyst at Moody's Investor Services, points out "that there are several similar type of deals as Anthracite in the pipeline and now that the BlackRock deal is done, it could speed up the process. However, I do not expect more than a dozen. The figure is likely to be between five to 10."

Euan Gatfield, analyst at Fitch Rating, agrees, adding that the BlackRock deal has unlocked investor interest. He cautions that there could be a time lag between the incubation period when the deals are being formulated and the issues actually coming to fruition. "It is still early days for the real estate CDO market in Europe and it may be 12 months before these deals materialise in any numbers. We expect up to a handful in the first half of 2007, from issuers already in the process of ramping up. But for the next round of CDOs, investors shouldn't hold their breath. It will take time for newer entrants to reach critical mass, and the structuring process

is pretty time-consuming."

Moreover, Gatfield and other analysts note that the supply of B-loans - junior pieces of commercial property and mezzanine debt in Europe - which comprises these types of structures, is not large enough to support huge issuance in Europe. CRE CDO structures, which made their debut in the US in 1999, include the riskier slices of commercial mortgages with the more junior tranches of commercial mortgage-backed securities (CMBS) which themselves are repackaged pools of property debt. Breaking it down, in the US, this typically has meant B-notes, junior or mezzanine real estate debt, as well as whole loans secured on commercial investment and development properties. Rated CMBS or other forms of listed real estate company debt are often also included.

In Europe, the collateral could range from whole loans secured on European commercial and residential properties, senior and junior debt secured on European commercial properties, CMBS, real estate investment trusts, property company debt rated globally and potentially non-conforming European residential mortgages.

For example, the Anthracite Euro CRE CDO deal, which involved the sale of €263.5m of debt through Anthracite Capital Inc consisted of five tranches of notes rated from AAA to BB. The group retained €66.5m equity, or first loss, piece which acts as a protective cushion to investors. At the time of going to press, the deal was still not officially completed and BlackRock declined to comment due to regulatory restrictions. However, analysts believe that others considering dipping their toes into the European CRE CDO waters would be encouraged by the apparent success of the deal in terms of pricing and the fact that it was oversubscribed.

According to Hans Vrensen, head of securitisation research at Barclays Capital, the pricing of the notes gave BlackRock a weighted average cost of capital on the rated notes in the Anthracite deal of 70bp and this compared with a weighted average spread on the assets of 346bp. This leaves 276bp of gross excess spread, which seems an attractive return for the manager.

Vrensen notes that the €142.5m ($96m) in AAA notes were priced at 27bps over Euribor, which was tighter than earlier market talk of about 30bp, suggesting strong investor demand. The €25m of the lowest rated BB notes priced at 275bp over Euribor, which compares with average spreads for BB rated CMBS tranches of 300-375bp. This may back market suggestions that investors hail more from a CDO-specialist rather than traditional real estate background.

In the past, the riskier portions of commercial property loans have traditionally not been securitised in Europe or Asia. There have been no CRE CDO deals in Asia as of yet but analysts believe this could change in 2007.

The main stumbling block in Europe so far has been the paucity of suitable European assets. CRE CDOs incur a higher cost of funds so investment in higher-yielding assets is necessary to generate attractive equity returns. Rating agency reports have noted that it has taken a significant amount of time for prospective CRE CDO managers, who are seeking to put together pools of junior debt, to acquire even 20 positions at a suitable risk-adjusted return level.

According to a report by Fitch, things are beginning to change slowly thanks to regulatory and market conditions. European commercial banks typically used securitisation to tap the capital markets to obtain regulatory relief on their residential and commercial property lending book. However, the financing tool was only used occasionally for subordinated commercial real estate loans such as B notes and mezzanine loans. This is because these assets were on the balance sheets of only a relatively small number of financial institutions and as a result, remained fairly illiquid.

Fast forward to today and Basle II's impending new capital weighting regime. Although this may make it more expensive for banks to invest in B notes, current monetary conditions are already triggering a transfer of those assets to the non bank sector. As the report notes, "cheap money and the consequent bull run in the bond market have prodded traditionally high grade institutional investors down the credit curve". Some of these specialist investors have in turn been buying less liquid speculative-grade investments, including B notes and mezzanine loans in the expectation of being able to securitise them.

In many ways, Europe and the US share the same issues - yield hungry investors searching in every corner for performance. As Jack Foster, director of global real estate at Franklin Templeton Institutional, notes: "There is strong appetite for securitisation in Europe. In the past, the only way investors could get exposure to real estate was through equity. Now we are seeing the development of the market and different vehicles such as real estate investment trusts, opportunity and other value added funds. CDOs are a natural progression from CMBS as the market matures and investors are looking to diversify their investments."


t is unlikely, however, that European CRE CDOs will follow the same development path as the US market. The main difference, of course, is that Europe is a fragmented market not only in terms the underlying commercial real estate itself but the various legal, regulatory and tax regimes scattered across the region. Other challenges include the high levels of prepayment in the CMBS market as well as the limited experience of the originators. The US, on the other hand, is a large, sophisticated and more importantly homogenous market which has standardised agreements and laws, not to mention a long history of securitising different types of assets.

As for which countries will lead the CRE CDO pack, Foster believes that the UK and Germany, which are the main source of B notes and junior tranches of debt, will see the most activity in the foreseeable future. They are both home to the most sophisticated real estate markets in Europe and have enjoyed buoyant growth on the CMBS front.

According to figures from the European Securitisation Forum (ESF), the industry trade group, the European CMBS market overall reached new heights for the first nine months of 2006, reaching a weighty €34.2bn, up 36.7% from €25bn for the same period in 2005. The ESF predicts that the industry is on course to overtake 2005's record €45bn of issuance and hit the €50bn or over mark.

The German sector was one of the leading lights with copious amounts of property being bought and sold. The multi-family housing segment continues to be the hottest segment. The ESF data report notes that for the first nine months, Germany was the second most active country in Europe with €6.2bn worth of issuance - a number which has already overtaken its 2005 levels. The country's most significant deal was Deutsche Bank's €1.56bn securitisation of 10 loans secured on 499 commercial properties in Germany, Switzerland and the Netherlands.

The UK, on the other hand, was the star performer, in terms of both volume and number of transactions. It accounted for a hefty two-thirds or €22.7bn of the total European CMBS issuance for the first three quarters of 2006 on the back of a booming commercial real estate market. The country grabbed the headlines with the €1.74bn Eddystone Finance securitisation of 75 retail supermarket properties located in England and Wales which were let to UK supermarket chain Sainsbury.

As for the US, the CMBS continues to steam ahead, with analysts predicting issuance to close 2006 considerably higher than the record figure in 2005 of $170bn (€129.2bn). Figures from Commercial Mortgage Alert showed issuance for the first nine months of 2006 was 23% higher year over year. The growth in the CRE CDO market is also expected to reach new heights in 2006 of about $40bn and beat 2005's lofty levels. Issuance in 2005 had been eye catching at $21bn, which was more than triple the seemingly paltry figure of $6.5bn set in 2004.

According to Hugh Hall, chief operating officer of US-based Gramercy Capital Corp, after seven years of development, growth in the US market is being fuelled by more innovative and sophisticated structures such as revolving CDOs collateralised by commercial real estate loans (CREL). These include transitional floating-rate whole loans, subordinated B notes, and mezzanine debt revolving commercial real estate loan CDOs.

Hall says: "We are seeing a great deal of interest in these types of products and we have not yet scratched the surface. I think these structures will be the next thing as the industry matures and investors continue to look for diversification."

According to a report by Fitch, the main advantage of the revolving CDO over a static CDO structure is the ability to reinvest principal in additional collateral when loans prepay, mature, or are sold. The reinvestment of collateral allows issuers to amortise the cost of securitisation over a longer period and also allows them to structure a specific maturity. Transitional floating-rate whole loans and subordinated debt such as B notes and mezzanine debt are not as conducive for inclusion in CMBS transactions, particularly if they consist of floating-rate obligations with limited lockout provisions and significant prepayment risk.