Getting More from CMBS

In recent years retailers have been innovative in using CMBS (commercial mortgage backed securities) directly and indirectly as a key part of their financing strategies.

Earlier transactions, including the Sainsbury's Highbury and Dragon transactions, were long term, fully amortising and credit linked to the rating of the retailer. These transactions are usually known as credit tenant lease (CTL) deals.

CTL DEALS

The move to transactions where none of debt was directly credit linked to the rating of the underlying retailer had its origins in two key factors.

Firstly, the ratings of retailers were generally at the lower end of investment grade or in speculative grade, and the cost of such of debt was a material consideration for issuers.

Secondly, for investors, fully credit-linked transaction in Europe fell somewhat out of favour as linked tranches had suffered a series of downgrades as the credit quality of the underlying retailers came under some pressure.

In addition to the usual downward pressure on ratings of single-tenant retailers, investors also perceived a risk that retailers might be subject to a highly leveraged buyout.

Following such a buyout the issuer credit rating might be subject to material downgrades and ICR might be withdrawn altogether. A credit-linked CMBS note in this environment would be directly affected.

LINKED TRANCHES

In circumstances where a CTL transaction is linked to an ICR rating that is withdrawn, it is likely that the rating agencies in a CTL-linked tranche would also withdraw ratings.

The twin pressures of capital efficiency and investor concerns suggested a new transaction structure might be appropriate with perhaps lower levels of debt than a traditional CTL but, in return, tranched through the capital structure, and, if possible, achieving ratings that were delinked from the retail tenant.

The Eddystone Finance plc and Longstone Finance plc transactions were milestones in the development of CMBS transactions of this type. These transactions were carried out by J Sainsbury PLC itself in March 2006 on portfolios of supermarkets it owned in the UK.

The ratings on the two transactions exceeded J Sainsbury's rating (BBB-/Neg/A3) and took the structural developments of the delinked tranche to their logical conclusion – a transaction where none of the debt is credit linked to the tenant.

The transaction was innovative in that J Sainsbury repaid all of its unsecured debt and replaced it with a secured CMBS financing.

The two transactions comprise portfolios of J Sainsbury supermarkets with medium and long-term financings. The absolute level of leverage is low at 56% initial rated debt to market value for Longstone and 60% for Eddystone at A.

Both transactions are structured to allow investors to get access to the underlying real estate in a manner not dissimilar to a traditional CMBS in the event that rent is unpaid.

The ratings in Vanwall Finance plc exceed the rating of its tenant to an even greater degree, as the tenant was not rated at all. This was the first transaction that Standard & Poor's assigned a full delinked rating with the transaction rated in February 2006. Its six tranches were rated from AAA to BBB-. The parent of the tenant, Toys R Us Inc was rated B-.

This transaction financed a portfolio of UK Toys R Us stores and a distribution warehouse. The sponsor, Bain, KKR and Vornado had also refinanced a number of global portfolios. The UK transaction was backed by a unique portfolio of mostly freehold out-of-town stores.

For completeness, I should mention British Land's Werretown transaction – the founding father of tranches rated higher than the rating of tenant was refinanced in February 2006 with additional liquidity and an extended legal final.

The restructured transaction, BL Superstores Finance Plc, enabled the issuance of six tranches rated from AAA to BBB, all of which are higher than the rating of the tenant, again J Sainsbury. The stores were predominantly sale and leasebacks from J Sainsbury.

Using the real estate balance sheet to optimise corporate financing is clearly logical for asset-owning intensive businesses. These structures permit companies to retain ownership of their real estate whilst raising cost-effective financing. Several more transactions in this area are expected in the next two years, particularly in the UK, the Netherlands and Germany.