B notes, C notes the subordinated portions of commercial real estate loans, the senior piece of which has already been securitized.
Mezzanine loans loans made to commercial real estate that are typically secured on equity interests owning or controlling securitized properties and possibly secured on the properties themselves subordinated to senior borrowers.
Interest advancing cash payments, most likely from the collateral manager or an affiliate, that are made to the CRE CDO SPV if the advancing agent determines there will be a shortfall in the payment of interest to rated noteholders on the next payment date.
Cure advancing cash payments from the cure advancing agent to finance cure payments permitted under intercreditor agreements relating to underlying loans to help preserve the loans (for example, payments may be made in respect of insurance or lease payments).
There has been much speculation recently about the development of a managed commercial real estate collateralized debt obligation (CRE CDO) market in Europe. It seems likely that Europe will move straight to more sophisticated managed multi-asset transactions seen in the US. In the light of the far-from-standardized multi-jurisdictional commercial real estate market in Europe, this will present certain structuring complexities.
The European commercial mortgage-backed securities (CMBS) market has grown rapidly. Issuance in 2005 was over e40 billion. By October 2006 issuance already exceeded that for the full year in 2005. This growth means that there is a good supply of CMBS and higher yielding unsecuritized tranches of real estate loans such as B notes, C notes and mezzanine loans, all of which constitute suitable collateral for CRE CDOs.
In tandem with this growth, an increasing number of US real estate investors have entered the European commercial real estate market and have begun buying junior ranking tranches in commercial real estate securitizations. These investors have been accustomed to financing their businesses through CRE CDOs. It is a natural progression for them to finance their European business in the same way.
Borrowers in European real estate financings are able to prepay, making static transactions less attractive. Managed deals enable CRE CDOs to have longer maturities and are more attractive for investors and manager/originators. Investors will look seriously at a manager's experience in the European real estate markets and a manager's abilities to source collateral for portfolio replenishment.
The implementation of the Basel II capital adequacy rules will make it less attractive for regulated financial institutions to hold lower-rated tranches of real estate debt. And there is a ready-made investor base in Europe, as European investors have been frequent buyers of US CRE CDOs. Investor education in the product should not need to be extensive.
CRE CDOs are expected to adopt a structure similar to other CDOs, although the commercial rationale for these transactions is likely to be different, driven in the early stages of the market more by financing needs than by pure achievement of arbitrage. The transaction's capital structure or borrowing liabilities will probably comprise several classes of rated securities, down from AAA/aaa to BB/bb, together with a single class of subordinated notes that will probably be retained either wholly or partly by the collateral manager (possibly in addition to some of the most junior-rated notes). Additional features not typically seen in other types of CDO will include two types of advancing common to US CRE CDOs interest advancing and cure advancing and greater focus than for other types of CDO on servicing the collateral assets.
It is likely that these advancing features will require a more active involvement in the transaction for collateral managers than is typical for other types of CDO. The collateral manager will need to make the judgement as to when and if an advance is required and, as is common to many US CRE CDOs, may itself (or through an affiliate) make any required advances. Other possibilities would include an account for the purpose of funding advances, but this would give rise to negative carry for the transaction and would be rather inflexible. Diversion of interest or principal proceeds towards funding advances might also be possible, although this would again be inflexible and likely to be looked on unfavourably by the rating agencies, who would likely impose stringent criteria to permit cash belonging to the CDO structure to be used for these types of advances.
Portfolios for CRE CDOs will probably contain fewer assets than those for other types of CDO. This will mean that structures may have an exposure to the larger assets in the portfolio. To deal with concerns over disclosure a feature common in US CRE CDOs is the disclosure of the largest assets in the portfolio in the offering document. It is expected that there will be large loan disclosure in European CRE CDOs and that this will, to an extent, follow the form of disclosure in European CMBS transactions. Confidentiality issues surrounding this type of disclosure will need careful due diligence.
|The US CRE CDO market|
As the US CMBS market developed increased complexity towards the end of the nineties, new products such as B notes, C notes, participations, mezzanine loans and preferred equity emerged. These products did not fit the rating requirements for CMBS transactions, so investors looked to the CDO market to securitize them. Initially CRE CDOs comprised static portfolios of CMBS. As the market matured, managed deals comprising subordinated tranches of commercial real estate loans developed. The terms for underlying real estate loans are highly standardized in the US market, so the rating agencies have developed a sophisticated, model-based approach to rating US CRE CDOs. There are developed standards for eligibility criteria, advancing, management flexibility and asset-level representations to be given to the CDO vehicle on acquisition of loans.
It seems likely that the European CRE CDO market (at least in the context of transactions involving B notes and mezzanine loans) will skip the more basic early transactions seen in the US market and move straight to more sophisticated managed multi-asset transactions. In the light of the far-from-standardized multi-jurisdictional commercial real estate market in Europe, this will present certain structuring complexities.
It is likely that B notes will comprise a big portion of the collateral for CRE CDOs. These assets are the subordinated pieces of real estate loans, the senior loan of which has been securitized as part of a CMBS transaction. The rights attaching to B notes are governed by intercreditor agreements between the senior lenders and the holders of these and other subordinated assets. Europe is moving towards standardization of these intercreditor arrangements, but there is no real consistency of approach across the CMBS market. Having said that, certain rights generally attach to B notes, including:
- Cure rights B noteholders will have the right to inject cash into loan structures to preserve payments on these loans;
- Enforcement rights will often be controlled by B noteholders, subject to certain financial tests protecting the senior lenders;
- Purchase options B noteholders will have the right to buy out the senior loan upon a default in the loan, enabling these holders to control the enforcement process;
- Consent rights B noteholders will have the right to consent to material changes to the loan structure, including security arrangements; and
- Servicing this will be subject to servicing standards set out in the servicing agreement, and certain rights will attach to the B notes.
Intercreditor agreements are increasingly being drafted in the optimum form for the B notes to be securitized, maximizing the control for B noteholders while retaining for the senior lenders the rights that the rating agencies will require for the senior tranche to be put into a rated CMBS transaction.
In structuring a CRE CDO, the CDO SPV must be able to take advantage of these rights, and if necessary, collateral managers and subordinated noteholders should have the right to inject cash into the CDO SPV to enable these rights to be enforced.
Rating agency approach
The European CRE CDO market has arguably been delayed by the deliberations of the three main rating agencies: Fitch, Moody's and Standard & Poor's. However, each has now published its criteria for rating CRE CDOs in Europe. For each agency, the process has been a collaboration between the CDO and CMBS desks. Fitch and Moody's have adopted model-based approaches to rating CRE CDOs, while Standard & Poor's has a more CMBS-focused approach.
As is typical for rated CDOs, the criteria for the transaction will impose limits on the different types of underlying real estate assets to be included in the portfolio. These will include geographical concentration limits as well as limits applicable to the structural nature of the underlying assets.
In these early stages of the new market, owing to a lack of diversity in portfolios (most are predominantly German and UK assets), subordination levels seem to be conservative.
How a European CRE CDO market will develop
It is likely that most early transactions will be managed by investors in subordinated debt of European commercial real estate transactions, primarily motivated by financing goals. Among these, there will initially be a lot of US-based managers. It is possible that some of the banks participating in primary lending to real estate borrowers will originate deals despite potential relationship concerns that could arise with their clients (subordinated investor/collateral manager-type market participants).
Collateral portfolios will probably comprise CMBS, B notes, C notes and mezzanine loans. Whole loans (unsecuritized loans) might play a part, although securitizing these does present additional structural complexities. The geographical focus of collateral pools will initially be Germany and the UK, but as the European CMBS market broadens, more granular portfolios should emerge.
Underlying loan documentation is not standard at the moment, giving rise to a more complex rating and legal analysis of the collateral for CRE CDOs, focusing on issues such as intercreditor arrangements transferability and hedging.
By Angus Duncan, partner at Cadwalader Wickersham & Taft LLP's London office