The securitized blanket

The growth of the CMBS market in the US is fueling ever larger private equity real estate deals—can Europe be far behind? By Paul Fruchbom

The story of the mortgage backed securities (MBS) market begins with one of the most severe periods of financial distress in recent US history—and a group of loud, fat Italian men.

In his classic Wall Street memoir Liar's Poker, Michael Lewis told the tale of 1980s greed gone rampant, of traders gorging on five-gallon vats of guacamole and throwing phones at unsuspecting trainees. But he also wrote about the beginning of the residential mortgage backed securities market, which was effectively created by a small, motley band of slovenly dressed traders at Salomon Brothers led by Lewis Ranieri.

The RMBS market exploded in the early 1980s following the dramatic tightening initiated by the US Federal Reserve Bank and the concomitant rise in interest rates. As the nation's savings and loans began to hemorrhage money, thrift managers were forced to unload their portfolios of residential mortgages— and Ranieri and Co. were often the only buyers in town. When the S&L industry finally collapsed a few years later, the Resolution Trust Corporation used the securitization of single family residential mortgages as a model to sell the billions of dollars worth of commercial mortgages it now held.

Out of distress, of course, comes opportunity and over the past decade and a half, the CMBS market has grown to be one of the most significant capital sources in the real estate sector—according to Standard & Poor's, the industry now rivals commercial banks as a real estate financing source. Though the CMBS sector was hard hit by the Russian debt crisis of 1998 and the corporate scandals of 2002, issuance levels have grown every year since. In 2005, the global market saw a record $240 billion worth of issuance according to Commercial Mortgage Alert, an increase of approximately 85 percent over the prior year, driven by historically low interest rates, aggressive lending and growing interest in the real estate asset class from institutional investors. In 2006, industry practitioners predict those trends could continue, perhaps pushing the market even higher.

In a recent research note, Kim Diamond, a managing director in Structured Finance Ratings at Standard & Poor's Ratings Services, wrote: “Issuance could match or exceed 2005 levels, and fundamentals should remain strong for all asset classes.”

As one of the largest buyers of real estate in recent years, opportunity funds are taking advantage. Though CMBS financing comes with several downsides, including restrictions on the use of the underlying real estate and limitations on when an asset can be sold, the attractive pricing and the amount of leverage available to private equity real estate firms is allowing them to go after bigger and bigger targets.

One of the most notable deals to tap the CMBS market was the $6 billion acquisition of Toys “R” Us by Bain Capital, Kohlberg Kravis Roberts and Vornado Realty Trust. The consortium reportedly divided the company's 900 stores into three categories, the first of which will continue to be used in ongoing operations and was therefore used as collateral for an $800 million CMBS loan. At the time of the deal, industry observers noted that the use of CMBS financing—and the strength of the market— was one of the keys that allowed the bidders to win the auction.

More recently, The Blackstone Group made waves in the CMBS market when it announced the acquisition of office REIT CarrAmerica for $5.6 billion. The deal will reportedly include debt financing of $4.25 billion, which is widely expected to be securitized by the lending consortium in the CMBS market. If successful, it will represent the largest single-borrower securitization ever.

Blackstone, given the size of the deals the private equity firm has recently pursued, has been extremely active in the CMBS market, most notably in its acquisition of hotels. The firm's purchases of Wyndham International and LaQuinta Hotels are expected to generate more than $1 billion each in CMBS volume.

And Blackstone has not been alone in tapping the frothy CMBS market to finance its hotel acquisitions. Just recently, Citigroup was reportedly awarded a $3.8 billion loan package for two Colony Capital deals: the $1.7 billion purchase of the Raffles hotel chain and the $3.3 billion acquisition of Fairmont Hotels, which the LA-based opportunity fund purchased in conjunction with Saudi Prince Alwaleed bin Talal. A significant piece of the financing package is expected to be securitized.

Across the Atlantic, the growth of CMBS has been equally dramatic. According to Commercial Mortgage Alert, CMBS issuance outside the US, a majority of which occurs in the European market, has increased from $12 billion in 2000 to approximately $70 billion in 2005, double the previous year.

“There has been a big shift in Europe,” says Ralf Nöcker, cohead of the real estate principal investments group at Bear Stearns. “Five years ago, CMBS had a market share of five to ten percent. Now, it has 15 to 20 percent. And given the growth of the overall market, while market share has doubled, actual volume has tripled.”

The conduit path that rules in NY has not so far been replicated in Europe.”

Despite this growth, however, the market in Europe has evolved much differently than its US counterpart. Paul Rivlin, joint chief executive officer of European investment banking at Eurohypo, points out that, unlike the US, deals are not typically sold into a conduit and immediately securitized. A more common scenario is that people tend to finance their deals in the banking market, hold the asset for several years and then refinance the property via securitization.

“The conduit path that rules in New York has not so far been replicated in Europe,” says Rivlin.

That's not to say financial institutions haven't been trying. Rivlin says that a number of firms have attempted to replicate the US model over the past several years, albeit with limited success. The reason, he says, is that the pricing and leverage available in the senior debt markets is roughly comparable to what is available in the CMBS sector.

“The European banking market is much more competitive than I understand the US market to be,” he says. “So when opportunity funds are buying properties in the first place, they generally end up with deals that are underwritten in the banking market as much as through the securitization market.”

Nöcker agrees, adding that more traditional senior debt provides private equity real estate firms with greater flexibility. And Rivlin adds that given the current state of the European real estate, investors don't want to tie their hands with a financing package that requires them to hold the assets for a long time.

“The heat in the market is acting as a bit of a disincentive,” he says.

That's not to say deals aren't getting done. While the CMBS market might not have the same size and scope of the US, opportunity funds are still refinancing some of their biggest transactions via securitization. For example, last year saw one of the largest deals done in the industry thus far: a €1.5 billion issuance to partially refinance the German residential portfolio of Thyssen Krupp, which was acquired by Morgan Stanley and Corpus Immobilien in late 2004 for €2.1 billion.

A number of other deals are in the works. Lone Star is reportedly planning to refinance a portfolio of German non-performing loans with a €1.6 billion CMBS issuance. Fortress and Starwood Capital are also planning separate refinancings of their German apartment portfolios, with issuances of €2.7 billion and €1.6 billion, respectively, expected to price this summer. And DB Real Estate, which acquired 887 office properties from Enel, Italy's biggest utility, in a €1.4 billion sale leaseback last year, is planning a €400 million issuance to partially refinance the portfolio.

And more is yet to come. Many industry analysts expect to see significant growth in the European CMBS market in the near future, propelled by activity in Germany, which has seen many of the largest real estate acquisitions of recent years. Observers point out that recent regulatory changes in German banking law as well as the introduction of Basel II, which governs European lending institutions, could create incentives for German banks to securitize their holdings. In addition, Terra Firma has reportedly been looking at how it might refinance its acquisition of the Viterra portfolio, one of the largest private equity deals ever, in the securitized market.

“There are some German residential assets that are supposed to be coming up [in the CMBS market],” says Rivlin. “I know people have been looking hard to see how the securitization of those might work.”

If they do work, there could be a shift in how CMBS financing is utilized by private equity real estate firms in Europe. For now, however, the market remains substantially different than the US, where creative debt financing and the ability to immediately securitize a deal can mean the difference between the winning bidder and the one who goes home empty-handed. In Europe, according to Nöcker, the difference is found further down the capital structure.

“The mezzanine and equity end of the capital structure is where the men get separated from the boys,” he says. “There is no latitude in the senior debt markets. That's not where the game is won or lost.”