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Structured Credit: A turning point for European commercial mortgage-backed securities

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Commercial mortgage-backed securities (CMBS) have not experienced the same dramatic rally and tightening of spreads as that seen in the market for residential mortgage-backed securities (RMBS). One might expect that their relative cheapness would therefore make the case for investment.

Chris Redmond, an analyst at Towers Watson, points out that while the mandates his firm advises on are for broad asset-backed securities (ABS), and managers are free to take a relative-value view between CMBS and RMBS or any other asset class, the very different characteristics of the two types of security can still make RMBS the better bet.

“The big risk in CMBS is refinancing,” he says. “Because the banks’ ability to lend has been impaired and the loans are typically very large, that risk is elevated. We are uncertain as to whether this will present a big problem for the market, we just observe the risk and that makes us inclined to be cautious.”

But for investors looking at European ABS as a whole, CMBS may perversely be increasing in importance. Why? Because legacy CMBS assets are not shrinking as quickly as other ABS assets – precisely due to their bad health.

“A good portion of CMBS loan collateral is not redeeming at maturity so as an asset class, legacy CMBS will be around for longer,” says Andrea Pittaluga, real estate analyst at StormHarbour Securities. In 2012, two-thirds of loans did not refinance at maturity. “They either defaulted, or there is a stay on those loans and no or limited action has been taken as yet. There should be concern as to what will happen to them in 2013 and 2014, when they will be competing with other maturing loans for limited available financing and potentially declining property values.”

This state of affairs is particularly acute for top-of-the-market 2006-07 vintages, and Pittaluga thinks it is likely to get worse for a couple more years. This can create opportunities for distressed debt specialists looking for the fulcrum security in a structure.

“We hear about a number of distressed debt specialists talking about CMBS,” says Redmond. “For example, when a challenged CMBS approaches refinancing, a distressed debt specialist may seek to build a dominant position such that it can influence the process and securitisation structure.”

European CMBS are secured predominantly by UK and German commercial real estate loans, with small amounts issued in the Netherlands, France, Italy and elsewhere. At its height, CMBS accounted for 25% of the UK commercial real estate lending market and 10% of Germany’s. The problems in CMBS therefore reflect the wider issues in these countries’ real estate markets.

“What I envisage in 2013-14 is more of a divergence in values between prime real estate and secondary real estate in both the UK and Germany,” says Pittaluga.
In Germany there is a focus on multi-family property – corporate-owned rented apartment buildings.

“People like this asset class, but there is a focus on the quality of the real estate,” Pittaluga explains. “Some properties have close to 100% occupancy and are performing well, while others have much lower occupancy, driven by poorer quality properties or locations. There is a growing gap between prime and secondary properties compounded by the refinancing risk.”

The Taurus 2013 transaction – a Dresden multi-family transaction that saw its A-tranche price at LIBOR+100 basis points, very tight compared with other recent deals – may have marked a turning point for European CMBS, according to Craig Prosser, CMBS specialist at Landesbank Baden-Württemberg.

“There was huge demand across the transaction which totalled in excess of €1bn of bonds sold,” he recalls. “It has shown that there is still both an active primary CMBS market and plenty of customers for the paper.”

Prosser adds that all eyes are now on the significant wall of German multi-family loans, totalling around €13bn, which need to be refinanced over the next two years. The Taurus 2013 deal has shown a transparent pricing point for multi-family CMBS in Europe for both banks and borrowers.

“I suspect there will be more deals coming from the German multi-family market. In the non-family space it will be more challenging, but I can’t rule out seeing at least one or two more this year,” says Prosser.

He also adds that the secondary market should also not be neglected.

“There are still opportunities in class-A notes with pull to par having a bit further to run,” he says. “Also, in the class-A category, the synthetic CMBS deals present compelling value.
There has been a rally in cash class-A bonds but the synthetic class-A has lagged, often because more credit work is required and transactions are less transparent.”

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