Whether you are a supporter of using CMBS to finance commercial real estate or not, the simple fact is that it provides an efficient mechanism to transfer commercial real estate loan risk away from the banking sector, whilst at the same time providing much needed transparency to the commercial real estate lending market. In light of these hugely positive attributes, not only will CMBS continue to have a role in financing commercial real estate, but if market participants play their cards right, then we could once again witness the return of exponential growth of issuance.
The key to unlocking the latent potential of CMBS as a financing tool lies with continuing to build the trust and confidence of investors, regulators and market participants as a whole. Indeed, giant steps forward have been achieved on this front through arrangers taking heed of the structural reforms proposed by CREFC (Market Principles for Issuing European CMBS 2.0) and the investor principles of March 2013. The Securitisation Regulation has also acted as a beacon of best practice through encouraging and incentivising securitisation structures to be simple, transparent and standardised.
Although the European legislature’s decree that CMBS is not capable of qualifying as a simple, transparent and standardised securitisation and therefore able to reap the reward of some favourable regulatory capital treatment, the structuring of deals as simple, transparent and standardised should still be considered best practice. This is essential for harnessing the trust and confidence of the market that is ultimately required to fuel exponential growth.
If we turn to the recent crop of CMBS deals, it is apparent that there is a lot more standardisation than was the case prior to the Global Financial Crisis of 2007. However, if a more forensic review of these structures is undertaken and comparisons made across deals, then it becomes clear that structures are not as standardised as they could be. This is something that we have already identified with regard to Class X (CMBS 2.0 – Class X – variety is not always the spice of life), but the same could be said to be true with regard to payment waterfalls. High level observations of these variances include:
- Although all deals have a revenue waterfall, a principal waterfall and a post enforcement waterfall, some transactions also have an intermediate waterfall which kicks in once there has been a material default on a loan. To add to the complexity, if there is a risk retention loan in place (which is not always the case), then there will also be a corresponding loan waterfall for each note waterfall, meaning some deals could have eight waterfalls where as others just three.
- With regard to the revenue waterfalls, these do vary from one transaction to another. For example, some deals provide a separate bucket for prepayment fees where others do not. Also, in situations where there is no intermediate waterfall, there is likely to be separate buckets for the sequential application of principal and excess floating rate amounts.
- Principal in some structures is applied pursuant to a waterfall which makes provision for work-out and liquidation fees as well as caters for surplus proceeds. Other transactions are a lot simpler and only specify what amounts of principal are due to certain classes of notes and their relevant order.
- The application of principal varies widely, with some deals at one end of the spectrum having a straightforward modified pro-rata waterfall with cash trap proceeds being applied sequentially and the remainder amounts pro rata. At the other end of the spectrum, sequential proceeds are actually based on the amount of principal received on a loan based on the relevant loan’s principal amount outstanding. In addition, some transactions (but definitely not the majority) provide for the reverse sequential application of certain amounts of principal.
- With regard to liquidity support, we have seen this take a variety of forms whether by way of a reserve or a facility provided by an affiliate of the arranger or a third party (see further CMBS 2.0 IN FOCUS: Liquidity Facilities – the wild child of CMBS 2.0). Given these variances in liquidity support, this also manifests itself with different types of payment buckets across deals.
- Finally, although all deals have the essential payment components (various administrative fees, interest, principal, pre-payment fees, excess floating rate amounts, default interest) there are also a number of additional payment buckets that differ across deals. Similarly, there are also variations to the treatment of the payment of Class X amounts, especially after these have been subordinated.
When looking at the above list, it is clear that each of the points is independent and separate. If one or more of these is adjusted (even slightly), the consequence is that when you compare one transaction against another, the payment structure can look substantially different. This is especially true if you also factor in some of the nuances that we have identified with regard to the structuring of the Class X. Although on a case by case basis taking into account the underlying collateral and the benefit of a structure, then the rationale for a particular variance does becomes apparent. The issue lies with the fact that as far as payment waterfalls go there is a lack of standardisation in European CMBS.
Given that CMBS by its very nature features underlying collateral that is not hugely granular, and that to date we have not witnessed (unlike in the US) the volume of issuances that actively encourages a more standardised and commoditised approach to structuring a deal, it is inevitable that there is a level of variance as transactions are finessed, improved and structured to cater for the unique attributes of the underlying collateral whilst at the same time maximising returns. Until we reach the point in time that there is a steady flow of issuance, structures have been tried and tested and ultimately CMBS becomes more commoditised, variance in CMBS will continue to be endemic to the asset class, albeit the magnitude of variance will likely diminish as the market continues to mature.
Market participants and structurers in particular should therefore be hugely cognizant of this lack of standardisation, and although it is correct that they should be modifying and finessing transactions to improve the overall product, such changes should not be at the detriment of investor confidence. Accordingly it is imperative that where possible, material changes should be incremental and standardisation should be actively promoted not only within CMBS programmes but also across programmes. If this can be achieved, it will improve CMBS consumer confidence and with it provide the vital fuel to spur the exponential growth that the product rightfully deserves.