Real Estate Finance: Capturing collateral
The long-awaited launch of the first European CRE CDO came at the end of 2006, though not without its challenges. Helen Wray examines the backdrop to the market, and its potential for further growth.
Attracted by a prolonged period of low credit spreads and relatively minimal defaults in the credit market, real estate investors are eyeing the commercial real estate (CRE) CDO market, and in doing so are becoming ever more sophisticated in their search for yield.
According to analysts at Dresdner Kleinwort, it is these factors that have raised investor awareness of speculative-grade property instruments as a way to boost returns.
As has long been evident in the US market, CRE CDOs can offer a leveraged, diversified route into pooled commercial real estate assets as opposed to CMBS, as well as offering higher yields than other similarly rated instruments.
In addition, CRE CDO instruments offer an attractive funding source for buyers of subordinate CMBS and, in particular, less liquid property instruments such as B-notes and mezzanine loans.
It was Morgan Stanley and BlackRock Financial that eventually won the race to bring the first European CRE CDO, with the launch of Anthracite European CRE CDO 2006-1 in November last year. The €342.5m (US$448m) landmark deal allayed fears of a lack of suitable collateral and was a success at a time of continuing debate about the rating methodology behind such transactions.
Prior to the launch of Anthracite, some market participants were predicting as many as 20 deals to be launched in 2007. That optimism has subsequently been revised down, with sources predicting an average of seven deals to close this year.
“There are expected to be a number of CRE CDOs executed this year,” said Gregg Drennan, executive director on the European CDO desk at Morgan Stanley. “Some of the players that have established asset pools have been waiting on the sidelines, and now they have observed the first deal being done and how the market has received it, they are in a better position to see if it is something they want to add to their business.”
The market had to wait until March this year for the next deal – the £353m (US$681m) Glastonbury Finance 2007-1 issue via Dresdner Kleinwort. Unlike Anthracite, Glastonbury Finance did not include any B-notes and was backed by a more conservative collateral pool.
And as of late April, marketing on the €300m Investec CREA CDO 1 deal from Investec Bank had begun via joint leads Bear Sterns and Wachovia. The initial portfolio consists of residential loans (28.6%), B notes (24.2%), commercial whole loans (19.3%), CMBS (11.1%), A notes (8.3%), RMBS (6.1%) and commercial small balance loans (2.6%).
The deal is understood to include a separate revolving trust for the mortgage whole loan portfolios, which adds diversity and spread to the collateral mix. It is made up of a €235m triple-A tranche with a 7.2 year WAL rated by Standard & Poor’s, Moody’s and Fitch. The rest of the capital structure is rated by S&P and Fitch only and comprises a Class B €19.5m double-A slice with a 8.3 year WAL, a Single A rated €12m Class C tranche with a 8.4 year WAL, a Triple B rated €16.5m Class D portion with a 9.8-year WAL and a Double B rated €11.3m Class E tranche with a 10-year WAL.
So the European market is underway, but there is a long way to go. CRE CDOs have been a popular financing tool for CMBS originators in the US for a number of years, and the market there has seen significant growth. Last year, for example, there were 42 US CRE CDOs, totalling US$33bn and representing a 58% increase from the previous year.
Clearly one of the key indicators for the success of the nascent CRE CDO market in Europe is the performance and future trends for the CMBS market in the region. According to DK, the European CMBS market surged to a record-breaking €60.7bn through 78 deals, compared with €45bn in 2005.
For the moment, there is a chasm between the relative sizes of the US and European markets. But this does not mean that European investors are entirely new to these types of instruments, as European accounts have been active in US CRE CDOs for some time.
“There has already been significant demand for US CRE CDOs from European investors wanting to access that type of collateral, so the investor community in Europe is already sophisticated,” said Angus Duncan, partner at legal firm Cadwalader Wickersham & Taft. “The European market has arrived at the more sophisticated end of the market, looking at more multi-asset, managed deals.”
There is also increasing interest from US asset managers in the emerging European CRE CDO market.
Asset managers have typically used securitisation as a cost-effective funding tool. But as the popularity of the CRE CDO product grows, it could also attract interest from more esoteric CDO players, according to Scott G