Europe's first CDOs backed by commercial real estate (CRE CDOs) are expected to hit the market this autumn. Investec last week announced its GBP200 million ($378.4 million) commercial real estate CDO, kicking off the market for this asset class in Europe. Meanwhile, three other deals are expected to follow this year, market sources said.
But as the much-anticipated structure comes to the continent, rating these deals is still proving difficult.
According to Standard & Poor's, CRE CDO structures have been in existence for approximately seven years in the U.S., with issuance this year climbing to 65 billion ($82.3 billion). The underlying collateral now includes B-notes, junior or mezzanine real estate debt and whole loans secured on commercial investment and development properties. Rated CMBS or other forms of listed real estate company debt are often also included.
European bank managers have been gearing up to copy this U.S. success. Some European banks are already prepping for the market to take off by opening warehouse facilities for potential real estate CDO managers (ASR, 6/5/05). Fitch Ratings said that the market is likely to initially be dominated by shops with prior experience in managing CDOs of European ABS or U.S. CRE CDOs, but could later expand to include investment bank principal finance desks, commercial banks real estate arms and pure hedge funds.
The collateral
In Europe, the collateral could range from whole loans secured on European commercial and residential properties, senior and junior debt secured on European commercial properties, CMBS, REITs, property company debt rated globally and potentially nonconforming European residential mortgages.
But the availability of suitable European assets has been an issue in the development of this market segment. CRE CDOs incur a higher cost of funds so investment in higher-yielding assets is necessary to generate attractive equity returns. S&P said it has taken a significant amount of time for prospective CRE CDO managers, who are seeking to put together pools of junior debt, to acquire even 20 positions at a suitable risk-adjusted return level.
In recent years, banks have begun splitting subordinated pieces off the bottom of commercial mortgages. These pieces, known as B-notes, have received a great deal of attention in the runup to the expected launch of the European CRE CDO market and greatly figure into the pools that have been reviewed by the rating agencies.
"Despite explosive growth in multiborrower CMBS in the last 18 to 24 months, the issuance of BB' and B' rated bonds has all but dried up, suggesting that bankers can achieve tighter execution by carving out B-notes from individual commercial loans and placing them with specialist investors," Fitch analysts reported. "The demand for ratings assigned by Fitch on the B-notes is on the rise, both from end-investors and from selling banks - most probably in anticipation of a CDO exit."
But S&P analysts said that the nascent nature of the European B-note market would lead any credit analyst to a cautious view of its evolution, particularly as the structures have never been tested under any recession.
A lack of uniformity in European property financing could also add a level of difficulty in rating these deals. Many European CMBS issues and commercial property loans involve issuers, borrowers, properties and legal documents across multiple jurisdictions and the loans and securities themselves also use a variety of structures to address local law and tax concerns. In general, intercreditor agreements are not standardized in Europe.
According to a S&P report on European CRE CDOs, a number of the agreements that it has reviewed in connection with senior loans are either "unclear, unworkable, or both." "Our concerns in this area all relate to the practical application of intercreditor agreements," said the report. "If the parties spend a year in the courts trying to resolve the position, we are of the view that recovery proceeds will take the twin hits of both legal costs and continued erosion in asset value as the court battle progresses."
Interest in the product
Both Fitch and S&P have received several requests regarding the potential for European CRE CDOs. Fitch said that it has devised a methodology capable of analyzing these transactions that incorporates analysis from across the CMBS, RMBS and CDO disciplines.
"Rating debt secured on static pools of European CMBS with fewer than 20 loans is not particularly easy," S&P analysts said. "Rating CMBS debt secured on evolving pools of assets adds further challenges. Expressing a rating opinion on an ever-changing pool of junior debt is, frankly, very difficult."
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