Europe rides the CMBS wave

The crisis in the US sub-prime sector has given the whole industry a jolt, but Europe has not been affected. Lynn Strongin Dodds reports

In the past three years, commercial mortgage-backed securities (CMBS) have become an integral part of the European real estate landscape. Issuance continues to soar and it is no longer unusual to see a €1bn deal hit the market.

According to figures from Barclays Capital, European CMBS issuance reached €65.3bn in 2006, an impressive 50.1% rise over 2005 volumes, while the number of transactions jumped to 83 from 63. The first quarter of 2007 continued to power ahead, with issuance worth €24bn, and the investment bank predicts that the total tally for the full year could reach €76.1bn.

While CMBS is not a new concept, having arrived in the UK about 10 years ago, it has gained momentum in the past three years. This is mainly because of buoyant property prices, particularly in the office sector, as well as institutional investors' seemingly insatiable appetite for all types of real estate investments. CMBS provide another avenue for investors to gain exposure to the commercial property market as assets backing the deals range from office buildings to shopping centres, as well as residential-housing portfolios owned by commercial investors.

Moreover, as Daniel Sefcik, chief investment officer for Anthracite Capital, which is part of BlackRock, a global fund management group, and an active investor in the European CMBS market, notes: "It is also a geographical diversification play. We started to invest in the US CMBS market about 10 years ago and then the UK due to the similarity in legal structures and a common language. The country is a natural jumping off point for Europe and we are looking across the region for opportunities."

For the issuers, which are mainly banks, CMBS offers an ideal way for them to manage their balance sheet and risk exposures, according to Barry Osilaja, director, corporate finance, at Jones Lang LaSalle, a UK-based real estate services and money management group. "What we have seen is that as property prices have risen and spreads tightened, banks have increasingly taken the loans off their balance sheets, packaged them up and securitised them."

Typically, since 2004, the UK and, to a lesser extent, Germany have dominated the CMBS scene. In 2006, for example, the UK boasted the headline grabbing deal of the year - the €1.74bn Eddystone Finance securitisation of 75 supermarket properties located in England and Wales, which were let to Sainsbury, the UK-based supermarket giant.

One reason both countries have enjoyed success is because the US investment banks, which spent 30 years honing their CMBS skills in their home market, spotted their respective potential. According to Andrew Currie, senior director of Fitch Ratings in London: "The US banks had the experience and financial expertise to do these types of deals in Europe. They started first with the UK because the commercial market was strong and also that is where many of the banks are based.

"They have also gained a foothold in Germany and I think France is likely to be the next big market. Spain will be harder to crack. Although the real estate market is large, the local banks continue to dominate and are happy to hold the risk on their balance sheet." 

The UK and Germany were also natural homes for CMBS because, as Birgit Specht, managing director of securitised products strategy, Europe, at Citigroup, notes: "Over 50% of all invested European commercial property stock is located in both countries, followed by France, Italy, Spain and the Netherlands, accounting for another 30% of total invested stock in Europe. The UK market has been the most active one in recent years, but activity started shifting towards Germany and continental Europe last year, where the differential between yields and interest rates is still positive. Property investors believe that the UK is running out of steam, as the yield/rates differential has turned negative here, following a strong performance over the past few years, so they are looking elsewhere for diversification and return. They find Germany attractive because of relatively low prices, higher yields and a strong economy."

For now, all eyes are on the recently announced Netherlands-based FGH Bank's debt issue - a €3bn synthetic commercial mortgage-backed security arranged by its parent, Rabobank. According to Rabobank, the collateral of Skyline 2007 contains approximately 42% office, 18% residential, 18% retail and 18% industrial property. The pool is highly granular, with 4,590 properties, 1,472 loans and 663 borrowers. The issue will also have six classes of notes - A to F - which have been rated Aaa, Aa1, Aa2, Baa2, Ba2 and NR, respectively, by Moody's Investors Service.

While the largest portion of the debt, €2.55bn, will not be offered to investors, the deal is significant in that FGH is a newcomer to the market and the number of loans involved is vast. However, quantity does not always translate into quality and industry participants believe that as deals grow in size, investors must carefully analyse the loan pool, particularly those at the smaller end.

Hans Vrensen, head of European securitisation research at Barclays Capital, notes: "Typically a deal in Europe will have 10-30 loans with the top three to five accounting for 40-60% of the pool. The rest will consist of small loans but they are the ones that might impact the performance of lower-rated bonds. The challenge for investors today, especially those taking lower-rated tranches, is that as the deals become more granular, they need to have a detailed understanding of the different structural features and collateral of each loan in each jurisdiction."

Currie agrees, adding: "CMBS transactions are much harder to analyse than, for example, residential mortgage-backed securities, which are more straightforward. This is because CMBS are concentrated and there is no typical deal type. Investors need to spend time  looking at the individual loans and conducting research on the underlying properties such as whether, for example, they are on long or short leases and which are the vacant assets.

"The other threat is the economy and which direction house prices, interest rates and inflation will head. If interest rates increase again, particularly in the UK, this could put pressure on the mortgage market and impact the affordability of the deals. CMBS deals are predominantly driven by banks looking for efficient funding in a competitive market.

"However, while issuance might slow down if the property market turns, CMBS is a technique that banks in Europe are also using to reduce risk and manage their capital, a trend that should be here to stay."