Reasons for optimism in the CPI report
Against a backdrop of negative sentiment towards the global commercial real estate (CRE) market, the European CMBS sector witnessed an encouraging development with the repayment in full in May 2023 of the French mixed-use CMBS deal, Taurus 2019-1 FR, ahead of its maturity in January 2024. Given the current macro environment we consider loans with near term maturities to be particularly challenging for CRE borrowers facing tightening financial conditions, this therefore gives a useful insight into where risks lie and shows us some sponsors are taking a proactive approach in managing their risks.
Short background to the transaction; Bank of America originally provided Colony Capital with senior and mezzanine loans totalling EUR 302m to finance the acquisition of a portfolio of 206 offices and light industrial properties located throughout France. The properties, which had an initial valuation of EUR 384m, are rented by EDF (Electricité de France) - a major French state-owned supplier of electricity, gas, and heating - primarily for use by EDF subsidiary, Enedis, for the distribution of electricity and network management. The senior loan was then securitised in 2019 into the CMBS Taurus 2019-1 FR with an original Loan-To-Value of 65%, an interest coverage ratio of 3.4x and with interest rate hedging in place whereby Euribor was capped at 1.5%. In 2021, Colony Capital (rebranded as DigitalBridge) sold the portfolio to Fortress who became the new sponsor of the transaction.
According to the latest investor report in February 2023, the portfolio was in good shape, now consisting of 157 properties, with a vacancy rate that has increased to 14% from 4.6% at closing but which was not expected to grow further given Enedis’ long leases, generating steady cashflows that has helped to maintain a healthy interest coverage ratio. While our own estimates based on gross rental income gives an interest coverage ratio of 3.9x, very high for CRE. In addition, the assets are strategically important for the tenants being as they are 100% state-owned. Indeed since the transaction closed, the senior loan had amortised over time to EUR 137m reporting a LTV of 54.6% and a healthy debt yield of 15%, a measure of net operating income against the loan amount.
Negative headwinds in the commercial real estate sector should not be a surprise to investors, this sector has long been a bellwether for the economic cycle. A combination of factors such as a rise in yields of around 100 -150bps for European CRE since early 2022, a decline in property valuations and increasing fundamental concerns on certain sectors undergoing structural changes, such as offices, leading to a rise in vacancy rates and lower revenues are classic hallmarks of late cycle. These present refinancing difficulties, particularly for those with already relatively high loan-to-value ratios, low interest rate coverage ratios and approaching their maturity. This maturity wall is expected to result in a number of loan maturity date extensions to limit losses, and/or fire sales of properties at distressed levels.
A lot of negative news and extension risk appears to have been priced into the CMBS markets already and this is reflected in spreads not recovering in line with most other parts of credit in 2023. This was also the case for Taurus 2019-1 FR, where AAA to Baa3/BB originally rated notes were trading at a significant discount, reflecting spreads of 3mEuribor + 215bps to 1170bps for the senior AAA down to the most junior rated notes with a weighted average life of 1 year, before the announcement of the repayment of the deal at par.
In our opinion, when analysing CRE performance historically, several things in this transaction are important indicators that an early call surprise was possible. Historically, defaults need a catalyst such as a loan maturity or tenant roll, especially when leverage is high in sectors with structural challenges such as retail or hotels, and especially so for properties with single tenants. In the lead up to the Global Financial Crisis, CRE loans were typically originated with 80% or more LTV and CMBS structures were considered weaker than they are now, including only short workout periods after loan maturity which led to sales of properties at distressed levels. This compares to longer workout periods of at least 5 years for current CMBS structures, giving servicers much more time to work out a sale, which in turn we think will help improve the recovery prospects for bondholders. In the Taurus 2019-1 FR example, the moderate leverage and steady operating income from stable tenants with long leases in place, alongside high interest coverage ratios providing some cushion against higher rates, all provided favourable conditions for the sponsors to be able to refinance the loan at maturity.
While we continue to expect commercial real estate markets to remain under significant pressure, and we ourselves took action last year on CMBS as a result, we think that investors should avoid a one size fits all approach to credit.