Bargain Hunters Circle European CMBS

by REIT Wrecks on April 21, 2008

LONDON (Reuters) – Banks and opportunity funds are hunting for bargains among cut-price European Commercial Mortgage-Backed Securities (CMBS), raising hopes the debt market deep-freeze may be about to thaw.

Growing appetite for European CMBS could provide a breakthrough for banks desperate to free up loan book capacity by issuing new CMBS, which many see as a vital first step back towards cheaper and more flexible lending.

“CMBS is fantastically cheap. We see this as a once in a lifetime buying opportunity to pick up AAA-rated paper at amazing spreads,” said Caroline Philips, Eurohypo’s managing director of securitization in Europe.

The once-thriving CMBS market has been comatose since last summer’s credit crunch triggered a collapse in demand and enormous slack in spreads.

Credit Suisse data from March 27 showed European CMBS cash spreads were 240 basis points over the London Interbank Offer Rate (LIBOR) at AAA level and 750 basis points over at BBB, which Philips said was basically pre-credit crunch prices “with a zero on the end”.

Philips said Eurohypo, which is better known for its CMBS issuance activities, was in the middle of an acquisition spree motivated by “no-brainer” AAA CMBS pricing.

“We have bought around 100 million pounds worth of CMBS in recent months but we want to do more,” she said, adding that the bonds were bought with a view to holding to maturity because potential returns on equity were “enormous”.

Spreads at their current magnitude could indicate huge problems with the underlying credit but some investors say the CMBS sector has been hit too harshly by fallout from the U.S. subprime residential mortgage crisis and the long-anticipated end of a European property market boom.

“…Even with pressure on property values, there is currently no great pressure on security of rental income, so unless a loan is due for imminent refinancing, the loan will still be kept current…the bonds will still pay,” said Philips.

The young market for European CMBS saw the biggest output of issuance between 2005 and H1 2007, with around 135 billion euros of bonds issued, European Securitisation Forum data showed. Issuance dived to 10.7 billion euros in the second half of last year.

The bulk of these were structured on five and seven year loans and are not due for refinance until 2010 at the earliest, the same year the property derivatives market is banking on a recovery in UK property values.

“If you look at the real estate fundamentals — expected vacancy rates, yield movement — this downturn is not expected to be as bad as the last… The message we need to put across is this is not going to be the next U.S subprime sector. There will be no meltdown,” said Philips.


Cash-rich opportunistic buyers are also tempted by CMBS, adding to downward pressure on spreads.

Many of these funds are drawn by the chance to make double-digit returns on equity — returns that are now harder to grasp in bricks and mortar buys after a sharp slowdown in property capital value growth.

“We’re looking closely at buying CMBS on behalf of investors,” said one senior European real estate investment banker, on condition of anonymity.

“They may be traditional buyers of assets but debt looks so cheap at the moment. If you do not need to mark-to-market in your portfolio and you can buy AAA at 300 basis points and hold to maturity then that’s a hell of a good buy,” he said.

Marc Mogull, founder of opportunity fund manager Benson Elliot Capital Management, said he was confident European CMBS prices had “bottomed”.

“Opportunity funds go where the opportunities are and I’d expect all are sniffing around the European CMBS space right now,” Mogull said.

Mogull said he believed current AAA spreads “were not a fair reflection” of their repayment prospects and that a repricing of risk across BBB and sub-investment grade paper had been “indiscriminate”, leading to pockets of real value.

Trading has been hamstrung by a standoff between buyers and sellers over price, but Mogull said the market was close to a clearing price that could jumpstart transaction volumes and help banks to cut burdensome property loan positions.

“My view is that BBB paper will clear at spreads of 800 to 1000 basis points … From a default perspective, AAA’s look outstanding value at close to 250 basis points, even ungeared. Once people see prices sticking at these levels, we’ll see the backlog start to move,” Mogull said.

Brenna O’Roarty, director of European Strategic Research at Deutsche Bank’s property arm, RREEF, said she felt CMBS were blighted by “branding” but had potential to bounce back.

“If you look beyond the label of CMBS and focus on the coupon and the risk attached to that coupon, CMBS can look like good value,” she said.


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