As was the case prior to the global financial crisis, the current driver for all new European CMBS deals stems from the adoption by investment banks of the originate-to-distribute business model for financing commercial real estate assets. This trend is showing no sign of abating in the CMBS 2.0 era with twenty of the twenty seven public CMBS deals that have so far hit the market since June 2011 being attributable to this lending model. Although this is a proven and effective mechanism for producing much needed CMBS product, it is important for market participants to be aware that these conduit deals are not the only CMBS structures in the market and that agency deals could potentially be an invaluable tool for any sophisticated borrower that is looking to directly tap the capital markets to raise cheaper finance.
In fact it was not so long ago that agency deals were considered to be the only viable means of creating European CMBS product. Shortly following the onset of the global financial crisis, a whole raft of regulation was mooted which had the consequence of subjecting the originate-to-distribute business model to intense scrutiny. Pending clarity on whether the cost of such regulation would leave this business model bereft, agency deals were considered by many as the future of CMBS given that they could be structured without the involvement of banks and thus insulated from most of the regulation that was threatening to decimate this much used business model. In the years that ensued, there has been regulatory clarity and as demonstrated by the volume of conduit style deals that are currently being brought to the market by the likes of Deutsche Bank, Bank of America Merrill Lynch and Goldman Sachs, the originate-to-distribute model has clearly weathered the regulatory storm and is now back with a vengeance.
In terms of the structuring of agency and conduit deals, although both transactions ultimately result in the issuance of notes secured by commercial real estate, the structures employed to achieve this vary. In the case of the latter, the structure involves a bank advancing a loan to a borrower which then sits on the bank’s balance sheet prior to being distributed (either by itself or in a pool of other loans) via securitisation, syndication or a combination of the two methods. Given the bank owns the loan prior to the securitisation, conduit deals will also typically contain structures that allow the originating bank to extract “excess spread”, being the difference (after taking into account expenses) between the weighted average coupon on the notes and the weighted average interest received on the underlying loans. Agency deals on the other hand remove the role of the bank as an intermediate lender, thus are structured in such a way that the borrower through an affiliated entity (the note issuer) will directly raise finance by issuing CMBS notes into the capital markets.
Although we are now seeing a greatly welcomed resurgence of conduit deals, it is important to note that the originate-to-distribute business model, is not as compelling as it once was given the regulatory costs associated with holding commercial real estate loans on the balance sheet (prior to distribution), the balance sheet cost of retaining a material net economic interest of 5 per cent. of issued notes as well as the expense of meeting the exorbitant cost of a liquidity facility. However despite this drag on costs, the originate-to-distribute model has proven itself to be profitable and will increasingly become more profitable assuming that bond prices continue to tighten, there continues to be an increase in the volume of issuance and arrangers manage to keep the temporal period between origination and distribution to a minimum.
Meanwhile coupled with the rise of conduit deals to prominence, agency structures have once again fallen into their shadows. Although it is fair to say that both these structures have their merits and weaknesses, these credentials will vary depending on from which angle these transactions are viewed. From a borrower’s perspective the most appealing feature of an agency deal is that finance raised through these structures is greatly cheaper, as they only have to service the coupon on the notes and therefore not required to stump up additional amounts to cover the payment of excess spread and any regulatory costs of the lender incurred prior to distributing the loan and satisfying the 5 per cent. retention requirement. A further appeal of these structures, is that given a borrower has created the agency structure and therefore appointed individual transaction parties to their role, then these structures inherently give a borrower a greater level of control and influence than they would otherwise enjoy in a conduit deal. As demonstrated by the CMBS 1.0 vintage of agency deals, this has proven to be invaluable in the event that a borrower ever finds itself having to consensually restructure its debt (see the restructuring of London & Regional Debt Securitisation No.1 PLC).
Although from a borrower’s perspective, the economics of such a deal would appear to be a no brainer, the reality is that the structuring of these agency deals compared to a plain vanilla financing is certainly a more time and resource intensive process which carries with it a greater level of execution risk. These risks are particularly pertinent in the case of a maiden CMBS deal, however such concerns can be off-set by the fact that a borrower could potentially derive huge benefit from the economy and efficiencies of scale of putting in place repeat financing using a similar structure with the same parties. A further drawback with an agency deal is that the amount of financing required must be large enough (typically public rated CMBS deals are in excess of €200m) to make a public rated agency deal an attractive financing proposition. Although this is a difficult hurdle to overcome and in effect reduces the universe of potential borrowers that are able to put in place a public rated CMBS deal, borrowers should remember that these are not the only type of deals in the market and that CMBS technology is regularly used to implement a smaller note issuance through the issuance of privately placed unrated notes.
The re-emergence of the originate-to-distribute model and CMBS’s role as an integral part of this has got to be viewed as an extremely positive development for borrowers, lenders and investors alike. In particular, borrowers will no doubt hugely welcome the opportunity of obtaining cheaper debt that these conduit lenders are able to provide. However for those borrowers that demand and require ever cheaper financing, then such borrowers should definitely consider rolling up their sleeves and directly tapping the capital markets with an agency CMBS. Given that in today’s market we are currently awash with cheap credit, however, these agency deals may seem a fathom too far for even the most yield hungry borrower. That said, as borrowers prepare to join a conveyor of escalating interest rates, the sophisticated and commercially savvy amongst them would do well to embrace agency CMBS technology sooner rather than later.