Is the European CMBS market set for a revival?
The impact of the covid-19 pandemic on financial markets has been compared by many to the aftereffects of the post-2008 financial crisis, and for good reason. Reed Smith partners Jason Richardson and Iain Balkwill ask whether European commercial mortgage-backed securitisation will survive, or whether the pandemic has sounded a second death-knell for this form of securitisation.
New issuance of European CMBS fell off a cliff in 2020 as a result of the impact of the covid-19 pandemic. From €2.9 billion of new issuance in 2018 across more than 13 transactions, there was less than €2bn of new issuance across only five transactions in 2020, the lowest level of new issuance since 2017.
However, although the covid-19 pandemic was of course the main driver for the drop in transaction volumes – as property-level cash flows and valuations declined significantly and government support measures for tenants distorted the property markets across Europe – an examination of the European CMBS market and its regulation since the global financial crisis should give some indications as to how it could recover, flourish and thrive.
Building up a regulatory foundation
The regulatory landscape for securitisations in Europe changed dramatically as a result of the global financial crisis beginning in 2008. This culminated in the Securitisation Regulation 2017 (SR), the Capital Requirements Regulation 2013 (CRR), the Alternative Investment Fund Managers Directive (AIFMD) and the directive on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II).
The SR requires European issuers and investors to ensure that securitisation transactions that they issue or invest in contain certain features. These include: risk retention in one of a specified number of ways by the originator, original lender or sponsor; enhanced due diligence requirements for “institutional investors”; specified disclosure and reporting obligations for the originator, sponsor or SPV; enhanced credit granting requirements; and prohibitions on resecuritisations.
Arrangers of European CMBS transactions embraced the SR requirements and included the necessary features in their deals. However, that does not mean that the SR did not have an impact on the development of the European CMBS market.
Although most of the provisions of the SR had a neutral effect on CMBS as compared to other securitisation asset classes, one aspect of the SR has put CMBS at a competitive disadvantage as, compared with other securitisation asset classes, it is not possible for a CMBS to benefit from the STS (Simple Transparent Standardised) designation which is available for certain other asset classes. STS transactions can benefit from lower capital charges and thus may achieve better pricing.
However, the SR states that CMBS are not eligible for STS treatment, on the basis that the transaction structures and the underlying assets themselves are not deemed to be sufficiently simple, transparent or standardised. This puts CMBS at a competitive disadvantage compared to other securitisation asset types, although it is hard to quantify the impact.
There is currently no proposal for the SR or the applicable capital rules to be amended to enable CMBS transactions to be capable of qualifying for STS designation. The recently approved “quick fix” amendments to the SR and CRR did not include any provisions targeting CMBS transactions.
The CRR, AIFMD and Solvency II each set out the capital requirement rules applicable to investments in financial assets by institutions subject to their regulation. These rules also put CMBS at a disadvantage compared to other investment types backed by the same underlying real estate collateral.
For example, the CRR provides that a direct participation in a senior loan collateralized by a real estate asset will have a lower capital charge than an investment in a AAA-rated securitisation note collateralized by the same senior loan. This is notwithstanding that the AAA-rated notes will benefit from the subordination of the subordinated classes in the structure.
This incentivises certain institutional investors to take direct positions in loans rather than invest in CMBS notes. There are no current proposals to amend the CRR in relation to this point, so CMBS will continue to be at a competitive disadvantage in this respect.
The impact of Brexit on the European CMBS market will take time to manifest itself and was overshadowed by the impact of the Covid-19 pandemic in any event. At the end of the Brexit transition period on 31 December 2020, the UK onshored the SR into local law – subject to certain minor modifications, principally to reflect the fact that the UK was no longer a member of the EU –pursuant to the European Union (Withdrawal) Act 2018, as amended by the European Union (Withdrawal Agreement) Act 2020, and as supplemented by the Securitisation (Amendment_(EU Exit) Regulations 2019.
Although some of the modifications were helpful, they were not intended to benefit any particular asset class or provide any significant divergence from the corresponding EU rules in a way which would give the UK CMBS market a competitive advantage.
So, while one consequence of Brexit is the possibility of regulatory divergence by the UK from European regulations including the SR to give the UK a competitive advantage, so far the UK government has not made any such proposals that are likely to have any effect on the development of the UK CMBS market.
The new kids on the block
A recent development in the European CMBS market was the issue of the first transactions that satisfied environmental, social and governance (ESG) investment criteria.
The first such transaction was the River Green Finance 2020 DAC CMBS transaction, which securitised a loan secured on a Paris office building with the necessary green credentials to enable the CMBS issuer to apply the ICMA Green Bond Principles and market the transaction as a “green” bond. The second was Sage AR Funding No.1 PLC, closing in October 2020, which securitised a portfolio of social housing assets and enabled the issuer to apply the ICMA Social Bond Principles to the investment, thus qualifying the CMBS notes for ESG treatment.
These two transactions demonstrated to the market that it was possible for CMBS transactions to be “green”, which should open up the potential investor base.
It seems likely that, going forwards, sponsors and arrangers will seek to apply the relevant ICMA ESG principles wherever possible to CMBS transactions. However, not all underlying property assets will be capable of satisfying the necessary ESG requirements: this may lead in time to a divergence in pricing of European CMBS transactions, with the transactions that qualify as “green” pricing better than those that do not.
Another recent development in the European securitisation market, that could have an impact on the CMBS market, is the introduction of new products that may compete for investor attention.
One such product is the commercial real estate collateralised loan obligation (“CRE CLO”), developed in the US some years ago and now a mainstream product. So far no European CRE CLO has been launched, although a number of such transactions are in development. It therefore remains to be seen whether this is a product that will take off in Europe as it did in the US and, if so, whether it has any impact on the European CMBS volumes.
Another securitisation product that may see greater issuance volumes are synthetic securitisations, especially following the changes to the regulatory capital treatment of such products as part of the SR and CRR “quick fix” amendments. If banks start to use synthetic securitization as an alternative to syndication of loans as a balance sheet management tool, then that may have an impact on the development of the European CMBS market. However, this is unlikely to have an impact on the single sponsor/single loan “agency”-style CMBS transactions that are expected to dominate the market in the near term.
The times they are a changin’
Of the 18 European CMBS transactions that closed in 2019, 13 were single sponsor or single loan transactions that were effectively “agency” transactions, in which a major commercial real estate investor mandated a bank lender to advance a loan to a borrowing entity. That loan would then be almost immediately sold to a securitization issuer special purpose vehicle (SPV, which would issue notes with the sponsor taking some or all of the pricing risk.
This is in contrast to the pre-2008 CMBS transactions in both Europe and the US, which were –and, in the case of US CMBS transactions, continue to be – overwhelmingly multi-sponsor or multi-loan portfolio transactions, in which several loans to unrelated borrowers or sponsors are securitised in a conduit-style transaction.
Post-2008 European CMBS transactions following the crisis were driven in large part by sponsors seeking large loans to fund commercial real estate acquisition and to refinance such loans. These loans were not so lowly levered as to qualify for the treatment afforded pfandbrief-style products, but were large enough to justify the cost and expense of securitising them via a standalone CMBS transaction. The sponsors in question also took the opportunity to tap the CMBS market to diversify their own sources of funding and to conserve their bank line capacity. In these transactions, the relevant loans were therefore mandated to banks on the understanding that they would be securitised in a CMBS transaction.
By contrast, those banks that had set up CMBS conduits before the 2008 crisis, and were again arranging CMBS deals, were not originating a sufficient number of suitable loans quickly enough to compile loan portfolios of sufficient size, that would make multi-loan CMBS transactions economic without taking the pricing risk while the portfolios were being originated. The loan syndication market was active and so provided an alternative method to transfer the risk of loans that were originated off balance sheet efficiently, if required.
Now, it looks likely that the same factors favouring single sponsor or single loan transactions will apply going forwards, as the European CMBS market recovers following the covid-19 pandemic.
Indeed, the first three CMBS transactions that have closed in 2021 were all single sponsor or single loan transactions. However, while the pre-covid-19 CMBS transactions were backed by a variety of asset types, from offices to hotels and from social housing to logistics assets, it looks likely that at least in the short term, only “safe” assets such as logistics properties, data centres and other prime “trophy” properties will be securitised.
It seems likely that other asset types, such as hotels and retail properties (such as shopping centres), which have collateralised 23% of European CMBS transactions since 2019, will prove more challenging to securitise at least in the near term, and this may hit transaction volumes.
Weathering the pandemic storm
One aspect of the post-2008 European CMBS transactions that has manifested itself is the robustness of their structures in the face of the impact of the covid-19 pandemic.
Post 2008 European CMBS transactions have tended to have much less highly-levered loans than the pre-2008 transactions, and underwriting standards have been generally higher. This has meant that structures have, so far, generally held up well in the face of the impact on cashflows resulting from the covid-19 pandemic, even in transactions backed by retail and hospitality assets.
Such performance, in contrast to the performance of pre-2008 CMBS transactions, should give investors confidence in the product going forwards.
So, we can say with confidence that it is likely that the European CMBS market will recover from the impact of covid-19, but issuance levels may well be lower than the pre-pandemic levels in the short to medium term. It is also likely that the types of transaction will be similar and dominated by single sponsor/single loan “agency”-style transactions, although backed by a more limited range of property types.
Given the resilience of the market throughout Brexit and the pandemic, the new potential of ESG and new products, and the comprehensive regulation put in place since the financial crash – not to mention the encouraging signs that regulators are updating this regularly – CMBS is not set to shuffle off this mortal coil yet.
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