CMBS in a New Light

The European Commercial Mortgage Backed Securitisation (CMBS) market is flourishing, with more finance directors choosing to use the capital markets, with their low costs of borrowing, to obtain finance.

According to one market participant, annual European CMBS issuance has grown around 400% over the last five years. The UK market has accounted for around 50% of such transactions, followed principally by Italy, France, Germany and the Netherlands.

As well as multi-jurisdictional transactions, and with changes brought in under the German Banking Act in July, the German securitisation market is likely to become even more buoyant.

Although one of the main recent drivers behind this expansion has been the tightening of margins earlier this year, it does not seem with margins now softening and widening that the trend is likely to end anytime soon.

The benefits that CMBS can bring to a borrower of lower costs of funds, as compared with more traditional bank lending, have often been regarded by borrowers as coming at too great a price, in particular due to the perceived need for a very strict property management regime with limited flexibility.

Recently, however, the UK market has accepted an increased degree of flexibility, both in terms of the portfolio's holding structures at the beginning of the deal and its management as the deal continues.

THE MALL TRANSACTION

The issuance by The Mall Funding PLC in May 2005, in a transaction arranged by Credit Suisse First Boston, was believed to be the largest sterling CMBS to date.

The property portfolio consists of 22 shopping centres situated throughout the UK, and it is estimated that the transaction has saved the borrower (The Mall Limited Partnership) approximately £6m per year in funding costs.

However, what is principally significant about the Mall transaction is not so much the size of the issuance or the cost savings, but rather the steps it represents in terms of flexibility (both in terms of the existing structures placed within the securitisation and the portfolio's ongoing management) at the same time as achieving a triple-A rating.

HISTORIC STRUCTURES

Property holding structures in other European jurisdictions are unlikely to present as many complexities as in the UK, where property investment has seen a number of innovative structures developed over the years in an attempt to deal with changes in stamp duty law and illiquidity.

For instance, with a view to deferring stamp duty, the borrower may have acquired beneficial ownership of the property only, the legal title being held, for example:

• By the seller on trust for the borrower
• By nominee companies established to hold the legal title on trust for the seller, with the seller agreeing to sell its interest to the borrower, and the borrower then acquiring the shares of the nominees

At the same time, in the absence of a tax-exempt UK Real Estate Investment Trust (REIT) broadly offering investors the same tax treatment as direct investment in the property itself, property investors have sought tax efficiency in the likes of English limited partnerships and Offshore Property Unit Trusts (OPUTs).

These types of vehicles have also been popular for minimising transfer taxes. This has resulted in the appearance of further property holding structures, such as:

• Where the borrower is an English limited partnership, two nominees of the borrower holding the property on trust for the borrower
• In the case of OPUTs, offshore trustees holding the property as trustees of the OPUT, in which the borrower is a holder of units

While the UK CMBS market has been no stranger to English limited partnerships and, more recently, OPUTs, the Mall transaction for the first time brought to the market a combination of tax-driven structures, an English limited partnership as the borrower, together with a variety of OPUTs.

TRANSACTION ISSUES

From a legal perspective, such structures give rise to varying degrees of complexity for a rated transaction.

Technical issues concerning, for example, the insolvency of trustees and beneficiaries, the ability to 'overreach' the interests of beneficiaries on a sale of the property to a third party upon the enforcement of security, 'overriding' interests of borrowers, and, on the tax side, the possibility of UK income tax resulting in reductions in cash flow all had to be considered for the Mall transaction.

Innovative structural and tax solutions needed to be found, while satisfying the rigorous security requirements for an investment grade securitisation.

Moreover, with UK property holding structures increasingly likely to take the same sort of form as those adopted by the Mall, at least prior to the introduction of a viable UK REIT, the structural and tax solutions used on the Mall transaction will have wider applications for UK deals.

MANAGEMENT FLEXIBILITY

The ability to operate as closely as possible to their existing model was a significant factor for the Mall. Although CMBS does require a fairly inflexible asset pool, the Mall was able to secure a greater degree of flexibility than would traditionally be available in a CMBS transaction. In particular:

Disposals: the transaction contemplates future property disposals, subject to a release premium, to ensure that the Mall is able to deal with the properties as they would like (within certain limits).

Same-day substitutions: these effectively enable the Mall to remove and replace potential development properties within the transaction with other equally valued properties.

Acquisitions: the Mall benefits from a permitted level of substitutions / acquisitions of 15% per year / 40% for the life of the deal before being required to consult the rating agencies.

Adjoining land development: in recognition of the Mall's desire to be able to expand existing sites by developing adjoining land, adjoining land acquisition and development are permitted (again, within certain limits).

Naturally, such flexibility did require certain safeguards to be put in place for the benefit of investors. In common with many of the more recent CMBS structures, the Mall transaction was supported by a robust property portfolio and financial covenant package including:

• A day-one debt leverage of approximately 52% of the value of the property portfolio the leverage being maintained on subsequent acquisitions using funds realised on a disposal of property within the portfolio
• An ICR trigger, both forward looking and historic, of 1.3 times
• Concentration covenants set at 6% of total net rental income for an individual tenant and 25% of total net rental income for any five occupational tenants

THE FUTURE

Investor appetite for European CMBS is showing little sign of waning.

Property owners who have to date been cautious of taking advantage of the CMBS market, with its perceived limitations, may take a fresh look, and transactions such as the Mall may help to provide guidance and to dispel some of the preconceptions and fears for would-be CMBS borrowers in Europe.