Soaring CMBS spreads highlight new risks on both sides of the Atlantic

Widening CMBS spreads on both sides of the Atlantic reflect an uptick in supply but also highlight that investors are increasingly wary of the latest structures and collateral, and are demanding higher compensation as a result.

Data show US spreads have widened to their highest levels in almost two years, while the latest pricing from Europe - Deco-2015 Charlemagne, a multi-jurisdiction deal - illustrates that issuers need to pay hefty premiums to place non-Triple A bonds.

Market sources told IFR this reflected heightened investor awareness of the risks ratcheting up in CMBS deals. "Complexity is creeping back into the structure and the general quality of the collateral has been deteriorating," a European investor said.

After the financial crunch, European issuers soothed investors with straightforward structures, simple collateral such as German multi-family properties, and strong sponsors. But over time they slowly reinserted risk into the deals - with weaker sponsors and secondary/tertiary properties.

"The first post-crisis issues were really investor-friendly, but this is becoming less and less the case now, which is causing investors to take a step back," one investor said.

US conduit CMBS spreads on new-issue deals rated Single A- rose as high as 275bp in July from as low as 190bp in April, according to Morgan Stanley data. The last time spreads in the middle of the capital structure were this wide was the third quarter of 2013, according to JP Morgan data.

Another factor pushing pricing power back into the hands of investors is that issuers that exclude unfavourable ratings on lower-rung tranches end up paying for it. They are able to demand beefier margins for tranches that fail to get solid ratings from at least one major agency, according to Bank of America Merrill Lynch analyst Alan Todd.

Investors Less Naive

That trend, which Todd said had now more clearly crystallised since mid-May, might indicate that investors are less naive about the quality of the underlying collateral.

The fact that, contrary to other asset classes, the CMBS segment has not bounced back from heightened global economic uncertainties - specifically negative Greek and Chinese headlines in early summer - would appear to confirm this.

With Greek debt woes on the backburner, CMBS spreads have continued to languish at wider levels. Growing concerns over real estate loan underwriting standards could explain this, one investor at a New York-based asset manager said.

"I continue to be surprised by what I see getting underwritten."

The US investor said the continued onslaught of new deals had also kept pressure on spreads. CMBS issuance of US$71bn this year is running 26% higher than the same period of 2014, according to Bank of America Merrill Lynch data.

The European primary has also witnessed a surge in supply - with two deals pricing in the same week for the first time since the crisis. Deutsche Bank had to pay plus 525bp on BBB-/BB bonds and plus 425bp on BBB+/BBB notes at the end of July to place its Deco-2015 Charlemagne deal - 145bp more than initial talk.

Single As were also priced significantly wider to initial levels, at 290bp against 220bp.

While the two bankers blamed the painful results on general market weakness and mounting CMBS supply, the European investor was more suspicious, saying: "Investors may not want to spend their time taking a long hard look at CMBS structures and collateral that have wrinkles in them." 

London's Gatehouse structures CMBS-like Islamic securitization

London-based Gatehouse Bank has structured a 100 million euro Islamic loan facility backed by direct legal ownership of property, a novel type of securitization which in some ways resembles commercial mortgage-backed securities (CMBS).

Conventional CMBS were hit hard by the U.S. sub-prime mortgage crisis seven years ago and were seen by some bankers as a source of the crisis as mortgages became non-performing.

The Islamic version developed by Gatehouse, one of Britain's six full-fledged Islamic banks, may be less unstable because, although it is based on income from commercial property, it includes actual ownership of the underlying property.

Gatehouse structured and arranged the five-year deal to fund its acquisition of property in the Paris region.

Securitization in Islamic finance is still in its infancy. Regulators in Malaysia introduced guidelines on asset-backed securities (ABS) in 2001, revised in 2004, which also cover sharia-compliant ABS.

In 2013, Munich-based FWU Group issued a $20 million Islamic bond backed by insurance policies, the first tranche of a $100 million programme arranged by EIIB-Rasmala, a venture between London-based European Islamic Investment Bank and Dubai's Rasmala Group.

Gatehouse Bank issued a 6.9 million pound ($10.4 million) covered Islamic bond backed by a property in Basingstoke in 2012.

‘Real estate is a slightly complex business’

Mumbai-based Lodha Group probably ranks as the most diversified real estate developer in the country, with homes at every price point.

It has delivered over 20 million sq ft and has over 35 million sq ft under development with a land bank of 5,300 acres.

In November, it bought the landmark MacDonald House in central London from the Canadian government for Rs 3,120 crore.

In a chat with Business Line, Abhinandan Lodha, Deputy MD of the group, spoke about the market and how the spread of his product range is an effective hedge against market fluctuations. 

Excerpts:

The markets are up, growth is down and banks are stretched. How do you see your prospects in these trying times?

We have been lucky in the sense we are Mumbai-based and 97 per cent of our value lies here. Mumbai, being an island city and the financial capital, has robust demand as long as you have a credible name to deliver. What we have been doing over the past 4-5 years is to build an organisation with a lot of credibility with both consumers and suppliers. And, we have an asset pool across the spectrum. We have an apartment for Rs 30 lakh and one for Rs 100 crore, and everything in between. We are selling something at every price point. The range enables us to hedge our whole portfolio.

How is the mix?

Forty per cent is in the affordable category, 15 per cent in aspirational and 35 per cent in the luxury segment. About 8-10 per cent is in retail, commercial and the rest.

Sales are poor in Mumbai realty…

The market has not shrunk. It has grown about 6 per cent over the past year in size.

It is just that the market share has got re-allocated and some sections of people have chosen to buy ready apartments rather than those under development due to the risk profile attached to some developers.

Reports indicate an inventory of 58 months in Mumbai. Even if discounted to 40 months, isn’t it quite high?

My only contention is that if this inventory is that high then there should be some negative movement on the price at some point of time or there would be offers given. There is generally a slowdown in sales, but the months of inventory may be a little off the mark.

We delivered 5.5 million sq ft last year and 4.5 million sq ft this year.

For example, in Lower Parel, everybody would say, if you have, on an average, 2,000 apartments to sell, it would work out to 70 months’ inventory as one cannot sell over 25 units a month there. We sold 1,200 apartments in 60 days.

In Mumbai, there is a population which wants to buy and has the money and desire to buy. So, if the market is shaken then the concept of inventory disappears.

In Palava (a 4,000-acre suburban township of the Lodhas), I was selling 40 apartments in a month when we launched it. Now, the sales are 800 units a month.

How much do sales accruals help fund your projects?

It depends on how you look at it. For someone like us it is the backbone. Our model is that we are not an asset owner but an inventory owner. We need to continuously sell like a factory where you produce and sell. We have an annual accrual of about Rs 9,000 crore.

The budget for the year?

It is around Rs 8,800 crore.

Any plans to move into other cities?

No. We have Mumbai, and Pune and London will be an important part of our business going forward. We intend only to complete the projects we had taken up in Hyderabad.

When are you going to start work in London?

By the middle of June. We will have the plans frozen by April.

There are reports of delays in some of your projects. Is it because of the economy or delays in approvals?

Real estate is a slightly complex business and the supply chain management is not as efficient as it should be. There have been delays in some of our assets. A few of our projects have been delayed and we have informed our consumers, rescheduled and delivered them.