2018 has seen a significant uptick in European commercial mortgage-backed securities (CMBS) issuance. So far, this issuance has comprised 11 transactions with a combined amount of approximately €3.6 billion, of which S&P Global Ratings has rated six.

While this is a significant improvement to last year's total issuance of €735 million in three transactions, the European market has a long way to go to catch up with the $65.7 billion of U.S. issuance that we have seen so far this year (as of end-October). Meanwhile, the average change of credit quality (ACCQ) in Europe continues to be negative compared with a positive number in the U.S., which is due to a larger number of European CMBS transactions reaching their legal final maturity date and consequently experiencing downgrades to 'D (sf)'. This report looks at the differences and similarities between the two regions, and the factors we believe are driving increased activity in European CMBS.

What's Behind The European CMBS Revival?

Collateral varies widely

As table 1 shows, this year's European CMBS transactions include a wide variety of property types from light industrial to offices, retail, and hotels. All of these are traditional property types that we have also seen in prior years. The countries featuring in the CMBS deals are also not new to the CMBS world, apart from first-timer Finland.

2017 issuance included similar property types, except for student housing, which we have not yet seen in 2018.

Table 1

The investor base widens

From our discussions with market participants, we understand that more investors are looking to invest in European CMBS, particularly in the middle and at the bottom of CMBS transaction capital structures, leading to more demand for the product.

We have learned through our conversations with market participants, though, that the investor base appears to be thinner at the top end of the capital stack than at the bottom.

With most investors' pre-crisis CMBS 1.0 books paying off in the last two to three years, an increasing number of investors are keen to retain a certain exposure to commercial real estate (CRE) debt on their books and are consequently looking to replenish their portfolios with post-crisis CMBS 2.0 opportunities (transactions issued in 2008 and thereafter or 2010 and thereafter in the U.S.).

The scope of the investor base is also broadening geographically, with increasing interest from Asia and the U.S. We believe this is largely due to investors seeking to diversify their investments into different regions, as well as opportunities resulting from the weakening of local currencies.

Underlying property fundamentals continue to be strong

According to data received from CBRE, cap rates are now below their lowest point during the previous real estate cycle in most of the central and western European markets and have been so for more than two years. This is primarily due to persistent low interest rates and we do not expect this trend to change in the short term, absent significant interest rate rises.

At the same time, on average, rental levels remain stable and vacancy rates--at least in the office markets--continue to decline. A reversal of vacancy rates, which would in turn put pressure on rents, could result from an oversupply of new products. However, although many office markets have a large amount of new construction, we do not believe that a disproportionate amount of it is built speculatively, as was the case in previous market cycles. Therefore, all else being equal, new supply should not put significant strain on office property cash flow.

Chart 1

Increasing online competition may continue to constrain retail. We expect secondary locations to see rising vacancy rates and shopping centers in unfavorable locations to lose rental value or require significant capital spending. While cap rates in the office, industrial, and residential sectors are stable or continue to decline, retail cap rates, on average, have moved out by 25 to 50 basis points (bps) in the U.K. in 2018, according to Savills.

By contrast, an ever-increasing online retail segment leads to more demand for warehouse and distribution properties, particularly in the more densely populated areas. It is therefore not surprising that we see fewer retail and more logistics assets in new CMBS deals.

Arranging banks are also shifting away from prime lending to mid-size and/or secondary loans which fit a CMBS exit, resulting in an increased 'inventory' of CMBS–able loans. Furthermore, the traditional banks' appetites and levels of comfort are growing toward advancing loans secured on 'operational' asset classes, such as care homes, student housing, and multifamily portfolios. While we are yet to see any significant exposure to these types of assets in closed CMBS transactions, we expect to see CMBS arrangers increasingly consider non-core asset classes for a CMBS exit.

Profitability is rising

In the first half of 2018, note margins on the rated classes were noticeably lower than in 2017 leading to a wider gap between what a CMBS issuer receives in interest from the loan(s) and what they have to pay as interest on the notes.

Table 2 shows how weighted-average note margins have compared with loan margins over recent transactions. While 2016/2017 transactions saw excess cash before senior expenses of less than 90 bps, it was 120bps -160 bps in the first half of 2018.

Capital market volatility has led to slightly less demand for CMBS and consequently wider note margins in Q3 2018, however, Elizabeth Finance 2018 DAC and Taurus 2018-2 UK DAC priced significantly wider. With the current level of pound sterling-denominated collateralized loan obligations (CLOs) and nonconforming residential mortgage-backed securities (RMBS) deals, we believe the widening of margins will be more pronounced for pound sterling-denominated CMBS transactions, than euro-denominated deals.

Table 2

European And U.S. CMBS Compared

Since the birth of CMBS as a commercial real estate financing tool more than 20 years ago, the U.S. market has always been bigger and in most years also more active than its European counterpart.

Direct commercial real estate investment was higher in Europe, the Middle East, and Africa (EMEA) than the Americas in 2017 ($300 billion versus $250 billion according to a Jones Lang LaSalle study). In the same year, GDP was $17.3 trillion in the EU and $19.4 trillion in the U.S. according to the World Bank.

However, Europe is highly fragmented with multiple jurisdictions and different real estate laws, not to mention the different currencies. For example, the largest of the European markets for direct commercial real estate investments—the U.K.—recorded $79.1 billion in investments in 2017, whereas the U.S. recorded an amount almost three times as high--$224.3 billion. Even the three largest eurozone markets in this ranking—Germany, France, and the Netherlands—together make up less than half the U.S. investments with only $103.7 billion.

This fragmentation makes it harder for CMBS issuers to put sizable portfolios of loans with similar characteristics together.

However, even as a percentage of total commercial real estate debt, CMBS is less popular in Europe than it is in the U.S. Based on information from the Federal Reserve, SIFMA, the CRE Finance Council (CREFC), and CBRE, CMBS usage (as a percentage of total commercial real estate debt) is about 16.6% in the U.S. but only 5.5% in Europe.

Consequently, as presented in table 3, there are almost 10 times as many U.S. and Canadian CMBS loans and transactions than there are European CMBS deals and more than 10 times as many ratings (these statistics refer to transactions rated by S&P Global Ratings only).

Table 3

Transaction structures differ by region

Due to the large book of legacy transactions, U.S. CMBS deals are smaller, on average, than their European counterparts. There are many longer-term U.S. conduit transactions outstanding that have amortized over time and now only have a comparably small portion of their initial debt outstanding. Table 4 illustrates how CMBS structural features differ by region.

Table 4

Most notably, the popular U.S. conduit CMBS part, which accounted for 55% of U.S. CMBS issuance in 2017, does not exist in that form in Europe. This is mainly because of the fragmentation of the market that we describe above. A large portion of U.S. CMBS issuance also comes from the "Freddie program," where the U.S. government-owned Federal Home Loan Mortgage Corporation (Freddie Mac) purchases loans backed by multifamily housing properties and finances these purchases via the issuance of CMBS bonds. European CMBS statistics do not benefit from a similar program.

Notable transaction features that differ on the two sides of the pond include the interest type, the payment frequency, and the larger share of pro rata pay in Europe.

Another feature that directly affects performance and profitability in CMBS is the liquidity support. In North America, servicers will typically step in if there is a shortfall in note interest (if the shortfall is recoverable). Therefore, servicers are oftentimes rated or have this obligation backstopped by a rated entity. By contrast, European CMBS mostly benefit from a designated liquidity facility, which the issuer can draw on to make up for note interest shortfalls. These facilities, however, require payment of a fee, even if not used, which affects excess cash flow in the transactions.

More upgrades than downgrades in the U.S., vice versa in Europe

As shown in table 3, a significantly higher amount of EMEA loans are in special servicing than in the U.S., and the senior loan delinquency rate in Europe is also much higher. These factors are related, as our analysis shows.

The gap primarily stems from the minimal new issuance in European CMBS 2.0 deals and much more activity in the U.S. Therefore, the remaining book of CMBS in Europe includes a larger share of CMBS 1.0 transactions, which are mostly past their expected maturity date. Moreover, in these transactions, the higher credit quality loans have typically repaid, leaving the lower credit quality loans outstanding. Consequently, the average rating in that cohort is lower.

For this same reason, Europe also has a higher share of its CMBS ratings in the 'CCC' and 'CC' rating categories (see charts 2 and 3). We assign these ratings when there is a high likelihood of principal losses. Additionally, the European CMBS market also has a larger share of credit-tenant-lease (CTL) transactions, where the rating is linked to the tenant occupying the underlying properties. These deals typically do not achieve 'AAA' ratings. Of the 60 outstanding transactions that we rate in Europe, 11 are CTLs with the ratings ranging from 'AA-' to 'BB+'.

Chart 2

Chart 3

North America CMBS have recently seen more upgrades than downgrades. The opposite scenario is the case in Europe. This is not necessarily indicative of differences in the performance of the underlying real estate collateral. In the two regions, real estate market performance has been very similar. However, as the U.S.' book of transactions comprises a higher percentage of transactions with multiple loans (most notably the conduits), a partial deleveraging of these transactions from loan repayments leads to higher credit enhancement in the middle of the capital structure, which in turn results in upgrades. In Europe, when a loan repays, it typically means that the entire transaction repays and we would just withdraw the ratings. For further information on our ratings approach to CMBS, please refer to the criteria articles listed in "Related Criteria" below.

Chart 4

Chart 5

Finally, pro rata pay, which is more common in European transactions, will usually lead to credit enhancement remaining stable across the capital structure, and consequently does not lead to upgrades.

As chart 6 shows, Europe's increasing CMBS defaults results directly from the shrinking CMBS book. With fewer and fewer ratings, each additional default will account for a higher percentage of the rated universe.

Chart 6

Related Criteria

• Asset Isolation And Special-Purpose Entity Methodology, March 29, 2017
• Ratings Above The Sovereign - Structured Finance: Methodology And Assumptions, Aug. 8, 2016
• Principles For Rating Debt Issues Based On Imputed Promises, Dec. 19, 2014
• Global Framework For Assessing Operational Risk In Structured Finance Transactions, Oct. 9, 2014
• Counterparty Risk Framework Methodology And Assumptions, June 25, 2013
• Global Rating Methodology For Credit-Tenant Lease Transactions, July 22, 2013
• Insurance Criteria For U.S. And Canadian CMBS Transactions, June 13, 2013
• European CMBS Methodology And Assumptions, Nov. 7, 2012
• CMBS Global Property Evaluation Methodology, Sept. 5, 2012
• Rating Methodology And Assumptions For U.S. And Canadian CMBS, Sept. 5, 2012
• Criteria Methodology Applied To Fees, Expenses, And Indemnifications, July 12, 2012
• European CMBS Loan Level Guidelines, Sept. 1, 2004

Related Research

• European CMBS Monthly Bulletin (October 2018), Oct. 26, 2018
• 20 Years Of European CMBS: Where We Came From And Where We're Going, Aug. 29, 2018
• Application Of Property Evaluation Methodology In European CMBS Transactions, April 28, 2017
• Application Of CMBS Global Property Evaluation Methodology In U.S. And Canadian Transactions, Sept. 5, 2012