The tranching and splicing of debt secured by commercial real estate (CRE) is likely to become an increasingly important part of the CRE lending market as it begins to grapple with the sobering reality of a breaking wave of refinancings coupled with a serious deterioration in valuations.
Indeed, such a development would be the very antithesis of everything the market experienced in the wake of the Global Financial Crisis (GFC), where highly structured CRE debt transactions featuring multiple lenders (including CMBS and CRE CDO issuers) received widespread criticism when the market learnt to its peril that at times of distress and a need for urgent action to be taken, these structures were simply not up to the job. Indeed, a decade or so ago, there was no shortage of evidence to support this proposition as subordinate lenders that were out-of the money flexed their muscles to extract any value that they could, distressed borrowers found it cumbersome, time consuming and expensive to reach consensus with their lenders, whilst at the same time those charged with policing these structures (namely facility agents and servicers) more often than not found themselves between a rock and a hard place as they tried to break the deadlock between competing interests. In some instances, distressed borrowers were able to exploit structural flaws in intercreditors to significantly strengthen their bargaining position to the detriment of lenders as a whole.
In today’s market where we have a macro-economic outlook dominated by high inflation, escalating interest rates, rising cap rates and a marked deterioration in the value of CRE, for those borrowers that are in the uneviable position of having to refinance their debt, then they will have little choice but either inject fresh equity into the structure or failing that assume a greater amount of leverage which will likely involve embracing more sophisticated tranched finance packages. This will undoubtedly add an additional layer of complexity to any refinancing situation, as not only will existing corporate structures (ideally) need to be restructured to accommodate the additional leverage, but also the practical realities of dealing with more than one lender (and a swap provider) will make any refinancing situation a lot more involved.
Another important point to appreciate here, is that when it comes to CRE debt structures the market’s thinking will also need to evolve. Over the past decade new financings featuring multiple lenders have not only had to learn and fix the shortcomings of the pre-GFC structures, but have also had the benefit of doing this in a sanguine lending environment dominated by low interest rates, rising property prices and a plentiful supply of cheap credit. Given the challenging credit conditions, these structures are likely to be subject to a long awaited litmus test and with it both new shortcomings but also positive features of this new crop of structures will be identified. As we look forward and continue to finesse these intercreditor structures and build on the lessons of the past, it is imperative that the market continues to be nimble and receptive for innovation as the practical realities of distressed situations and challenging CRE headwinds come to the fore.
At this point in time we are clearly at a critical juncture as the market adapts to the stark reality of addressing a significant wall of refinancing against an extremely challenging and uncertain macro-economic backdrop. Central to this new era of lending, will be the fact that borrowers will have little choice but be more amenable to complex debt structures in return for a higher quantum of leverage. Ultimately, the tranching of CRE debt has proven that despite a chequered past, it has an essential role to play in the European CRE financing market and therefore as the European debt wave of refinancings begins to break, now is the time for the industry to build on the lessons learnt from the past and embrace the technology for the greater good of the CRE market as a whole.