The use of loans backed by commercial real estate (CRE) as collateral for asset-backed CDOs in Europe might not have completely revived a rather dull market, but it has nonetheless added a sparkle that market participants believe has been missing for a while in European asset-backeds.
The tightening of ABS spreads in Europe over the past couple of years has resulted in a significant drop in the interest level for these kinds of CDOs. Leveraged loan CLOs have dominated the European structured finance landscape, and even though there has been a significant tightening in loan spreads as well, as a result of the very strong demand for loan paper, CLOs still offer greater arbitrage opportunities than ABS CDOs, said Shaun Baddeley, an analyst at Derivative Fitch in London. Thus, investors in ABS CDOs have been showing a greater interest in the more "widespread" asset classes such as commercial real estate, in the form of CMBS, B-notes and unsecuritized commercial loans.
"We have seen the number of these kinds of CDOs increase," Baddeley said. "There is a lot of liquidity in Europe and as investors look at spread premiums, they are looking increasingly at the more esoteric asset classes in order to get it."
Limited issuance
But even if commercial real estate has garnered significant interest (even taking much of the limelight away from RMBS, a very popular form of underlying collateral), sources said that, thus far, the only "pure" European CRE CDO is BlackRock Financial's 345 million ($466.30 million) Anthracite deal, which included 43% of CMBS, 46% of high-yielding B-notes and 11% in mezzanine loans. Market sources said that investment management firms Invesco and Fortress are preparing similar transactions, but thus far, Anthracite - which launched in December 2006 - is the only deal to have included a significant proportion of B-notes.
Other transactions that have launched in recent months have used CMBS, or CMBS in combination with the more popular RMBS (although of late RMBS has been affected by the recent subprime debacle in the U.S. housing finance market), and the Taberna deal in January 2007 was essentially a CDO of REIT debt, or loans made to property companies, said Angus Duncan, a partner at Cadwalader Wickersham & Taft in London. But even if there have not been that many CRE CDO deals as of yet, many investors in Europe are still interested in the securitization of commercial real estate, Duncan said. The practice allows real estate investors to finance their business and CDO investors can gain a good exposure to a portfolio of commercial real estate - a growing market in Europe.
"There have been few CRE CDO deals as yet because of the limited availability of collateral in Europe," Duncan said. "Issuance is, of course, increasing, but it will take some time to develop to a level approaching that in the U.S."
BlackRock experience
Indeed, there is no abundance of pure commercial real estate loans in Europe, but it is a growing sector and one that people are excited about, said Richard Shea, managing director at BlackRock.
"The market for creating the underlying collateral for CRE CDOs will continue to grow, and investors in these CDOs like commercial real estate because they feel comfortable that there's a hard asset securing their liabilities," Shea said. "Thus far, the experience with commercial real estate in Europe has been positive, and we are excited to continue on from here."
Shea credits much of Anthracite's success to BlackRock's in-depth knowledge of the CRE CDO. BlackRock has used the structure in the U.S. and in Europe; the firm had already launched eight CRE CDOs denominated in dollars before coming to the market with Anthracite.
"We knew it wouldn't be a problem to issue in euros because we have been a dominant player in the CRE market," Shea said. "There was also good demand for a euro deal."
But even if the market for CRE CDOs in Europe is set to grow, the one major impediment to a really robust growth is the lack of managers that can do these deals, not just because it is difficult to both source collateral for these assets and manage them, but also because a manager really needs to have in-depth knowledge of the European commercial real estate market, and the different laws governing it in different jurisdictions, Shea said.
"People need to know, for instance, how to foreclose in the U.K. and how to foreclose in France, before they can think of entering this market," he said.
While collateral is relatively scarce, the managers with experience in the European commercial real estate market, and who can access collateral easily, will be the ones managing deals in the foreseeable future, Duncan said. Prepayment rates for commercial real estate are also quicker than for other forms of collateral, at around 18 months on average, he said, so managers need to be able to access collateral fast in order to replenish their portfolios. Prepayment penalties are, however, becoming more common in Europe, although there are legal issues with these penalties in some jurisdictions, he said.
The use of commercial real estate as collateral will certainly help fuel the return of the ABS CDO, even if this does not happen very rapidly, and CLOs will continue to dominate in Europe for the near-term. Indeed, the pipeline for CLOs at this point is still more robust than it is for CMBS/CRE CDOs, however, the CMBS sector of the ABS market is certainly more heavily bid, and sources expect this trend to continue, particularly if there is further spread widening in CMBS.
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