As the economic effects of COVID-19 in Europe, Middle East, and Africa (EMEA) enter the seventh month, the risk of cash flow disruption in commercial mortgage-backed securities (CMBS) transactions backed by the hard-hit retail and hotel sectors increases. To date, some transactions have benefitted from sponsor support via equity injections, but most benefit from either liquidity facilities or reserve funding notes, which mitigate the risk of temporary note interest shortfalls. Among the 44 transactions rated by S&P Global Ratings, so far only one, Meadowhall Finance PLC, has drawn from liquidity support to help pay interest on the notes since the outbreak of the coronavirus.
The most common type of liquidity support found in European CMBS transactions are liquidity facilities. These are lines of credit provided by rated banks, with the size determined at closing and usually tied to the notes' outstanding debt amount. Liquidity facilities have evolved from the days of pre-crisis issued transactions (CMBS 1.0), when cash managers would draw for loan interest shortfalls instead of note interest shortfalls, which resulted in benefiting the class X notes at the expense of the senior notes. At the same time, the liquidity facility could not be drawn to cover items such as special servicing related expenses in a transaction, which resulted in note interest shortfalls as these expenses were paid senior to the notes.
In post-crisis CMBS 2.0 transactions, arrangers made changes to the liquidity facilities to address these shortcomings. Now at each interest payment date (IPD), the cash manager can draw from the liquidity facility to fund issuer expense shortfalls, property protection shortfalls, and note interest shortfalls for most investment-grade (and some speculative-grade) notes. All payments due to the liquidity facility rank ahead of interest payments and principal repayments on the notes.
These facilities generally reduce in line with the transaction amortization. Additionally, they typically include appraisal reduction mechanisms and/or drawstop events, which reduce the amount drawable. The appraisal reductions, which result in a proportional reduction of the facility commitment, are typically based on 90% of the updated market values relative to the outstanding loan amount. The drawstop event is typically triggered when the market value falls below three to five times the senior expenses and drawn liquidity amounts.
Reserve Funding Notes
The other type of liquidity support found in CMBS 2.0 transactions are reserve funding notes (RFNs), which are notes issued to fund a liquidity reserve. RFNs operate similarly to liquidity facilities in their use and rank ahead of the most senior class in the issuer waterfall.
Like liquidity facilities, RFNs also reduce in line with the transaction amortization. Additionally, RFNs have appraisal reduction mechanisms and/or drawstop events, along with restrictions on their availability to certain classes of notes or caps on amounts.
The main difference between the RFN and a liquidity facility is the cost to the transaction. Whereas a liquidity facility typically charges a 1.0% commitment fee along with an interest rate margin of 2.5% per year on drawings, the cost of an RFN is just the note interest on the issued class.
Given the market distress and the typical requirement for servicers to commission updated valuations annually or following loan events of default, we have provided examples of a typical CMBS 2.0 appraisal reduction calculation and a drawstop event below.
Appraisal Reduction Calculation
The servicer discloses an updated valuation for the properties securing loan A. The properties' value is reported to be €68.9 million, which is 35% lower than the market valuation at closing. As a result, on the next IPD, the cash manager calculates a revised liquidity commitment based on the inputs and formulas in table 1.
|Appraisal Reduction Calculation Example|
|Current liquidity commitment||€4.9 million|
|Updated valuation for loan A||€68.9 million|
|Outstanding loan A principal||€66.0 million|
|Unpaid interest on loan A||0|
|Total outstanding principal of all loans in transaction||€87.0 million|
|Quarterly note interest||€693,000|
|Appraisal reduction (AR) formula||Outstanding loan principal including unpaid interest on loan A less 90% of most recent appraised value of properties|
|Appraisal reduction factor (ARF) formula||(Total outstanding principal of loans less AR)/(total outstanding principal of loans)|
|Revised liquidity commitment formula||Current liquidity commitment x ARF|
|AR||€66 million – 90% (€68.9 million) = €4 million|
|ARF||(€87 million – €4 million)/€87 million = 95%|
|Revised liquidity commitment||€4.9 million x 95% = €4.6 million|
Therefore, the slight reduction of the liquidity commitment by approximately €300,000, would cover 6.6 quarters of the notes' full interest, instead of covering approximately seven quarters. The effect on the transaction is not overly dramatic despite the 35% drop in value. This mechanism would not lead to an immediate note interest shortfall. Furthermore, it benefits the more junior classes of notes as they are more likely to continue receiving interest in the short term, even if their economic interest in the transaction may have deteriorated because of the increasing risk of principal losses following the decline in property value.
Conversely, because repayments to the liquidity provider rank senior to the most senior class of notes in the CMBS waterfall, the transaction becomes more risky for the more senior noteholders.
In this example, no drawings from the liquidity facility are allowed when the property's value is less than the sum of five times the costs owed to loan finance parties, issuer priority payments, and amounts due or accrued to the liquidity provider.
Looking at a typical transaction IPD, annual senior costs typically amount to approximately 0.2% of the transaction's original size and the liquidity facility is about 6%. Assuming the liquidity facility is fully drawn and that the day 1 market loan-to-value ratio (LTV) is 60%, this would mean that the value of the property would have to decrease by approximately 80% before a drawstop event occurs. Therefore, the likelihood that a drawstop event would be triggered is minimal.
|Drawstop Event Example|
|Day 1 size of transaction||€86,900,000|
|Day 1 market value||€144,900,000|
|Day 1 market LTV||60%|
|% of transaction||Amount|
|Annual senior cost||0.2%||€167,000|
|Fully drawn liquidity facility||5.6%||€4,900,000|
|5x the above costs||29.1%||€25,300,000|
|Implied market value decrease||83.0%|
|LTV—Loan to value.|
Other liquidity facility restrictions
Some liquidity facilities only cover certain classes of notes or have caps on amounts that can be drawn for individual classes, primarily the junior classes of notes. This can benefit the senior classes as any amounts that are drawn are ultimately paid senior. Additionally, as the lower rated notes are the higher yielding notes, the cost to the transaction is also lower.
The Pandemic's Effect On Liquidity In European CMBS
The ultimate effect of the coronavirus outbreak to hard-hit sectors such as retail and hotels in European CMBS remains to be seen. However, unlike in U.S. CMBS, where servicer advancing can result in immediate liquidity interruption following updated lower valuations, European CMBS liquidity support features generally mean that absent any restrictions or caps, junior classes of notes will continue to access liquidity support at the expense of the senior classes. Furthermore, given the increasing trend of valuation waivers until next year for many transactions, it's less likely that liquidity facility sizes would decrease following an appraisal reduction. Fortunately, for the senior classes of notes, the effect of drawings for the junior classes of notes is constrained by the size of the liquidity support (generally between 5%-10% of the transaction).
While it's increasingly likely that more transactions will need liquidity support, we expect this to be contained within the retail and hotel subsectors, for now. On the flipside, we do not expect a lack of liquidity support to lead to as many note-level interest shortfalls as during the great financial crisis due to the changes made to the mechanics of liquidity support.
- U.S. And European CMBS COVID-19 Impact: Retail And Lodging Are The Hardest Hit, Sept. 28, 2020
- European CMBS: Assessing The Liquidity Risks Caused By COVID-19, May 6, 2020
- Credit FAQ: A Deeper Dive Into The Potential Credit Effects Of COVID-19 On European CMBS, April 2, 2020
- European CMBS: Assessing The Credit Effects Of COVID-19, March 24, 2020
This report does not constitute a rating action.
|Primary Credit Analyst:||Carenn K Chu, London (44) 20-7176-3854;|
|Secondary Contact:||Mathias Herzog, Frankfurt (49) 69-33-999-112;|
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