The CMBS market that fuelled property’s bull run ground to a halt, but signs of life are starting to emerge.

Until three months ago many people would not have heard of it, but CMBS is now perhaps the most important acronym in property.

Commercial mortgage-backed securities were one of the driving factors behind property’s bull run since 2001. A method of selling on debt, devised by City whizz kids, CMBS allowed banks to lend more money at lower margins, and this swill of cheap debt allowed bidders to drive prices higher and higher.

Now it is over. Mortgage-backed securities are at the centre of the liquidity crisis that has beset the financial markets and stopped banks from lending. While residential mortgage-backed securities (RMBS), tainted by US subprime loans, have been the root cause of the problem and caused greater losses, the CMBS market has suffered the consequences, and for the last few months has been closed for business.

There are signs of life, but the market is unsure as to whether tentative forays by the likes of Lehman Brothers will lead to a general blooming of confidence and a return to a semblance of normality or if the climate of mistrust will lead to a winter of discontent for the CMBS market and the property industry it has fed.

For the uninitiated, a commercial mortgage-backed security is a bond, the security for which is provided by the income on a building or group of buildings. The bond issuer, usually an investment bank, offers the bond at a spread, usually a fixed percentage above LIBOR (the London Inter Bank Offered Rate), and, as with a normal bond, pays interest to the bond holder, who can redeem their money at the end of the bond’s life.

Previously with this system, everyone was a winner. Securitising the loans they had either originated or bought allowed the banks to free up space on their balance sheets. That gave them more liquidity, so they could lend more money which, combined with the fact that they would theoretically make a profit on the bond issue, meant they could lend at a lower rate.

‘What it did was open up the capital markets to any form of property company,’ says Caroline Phillips, head of securitisation at Eurohypo.

‘Up until CMBS, property companies couldn’t get that kind of corporate credit.’

Securitisation has increased massively in the last three years, as more lenders moved into the market. Research into property lending from De Montfort University showed the level of CMBS issued grew from £4.3bn in 2004 to £18.2bn in 2006. Ratings agency Fitch puts the figure even higher, reporting that 82 deals worth $81bn (£39bn) were undertaken in 2006.


But the level of securitisation was a timebomb and in the summer it went off. The problems in the US subprime mortgage market, where the sharp increase in the number of defaults led to writedowns in RMBS issues and CDOs (collateralised debt obligations a more complex form of debt product) and then to the credit crunch, as banks refused to lend money to each other or their clients.

Up until cmbs, property companies couldn’t get that kind of corporate credit

Caroline Phillips, Eurohypo

‘CMBS as a product is perfectly suited to real estate,’ says Michiel Rang, head of real estate finance at ING. ‘But, as usual, the market ran ahead of itself, and people started lending at 90%-95% loan to value because they knew they could securitise.’

‘The primary market has been shut down for a few months, and investors are sitting on their hands,’ says Phillips.

For all the complexity of the structured finance game, the simple mechanics of supply and demand have come into play. As more and more lenders piled into the CMBS market, issuers had to offer bonds at lower and lower margins to undercut each other. At the height of the market, bonds were offered at spreads as low as 22 basis points over LIBOR, with the standard figure at around 35 basis points.

Now, with no new issues and banks unwilling to part with the money they have, spreads have ballooned, and in the secondary market they are now 50-100 basis points. This is the case with Lehman Brothers’ AAA-rated Windermere XII issue, backed by properties in Paris’s financial district, La Défense. The fact that bonds are being traded in the secondary market is a cause for optimism, but their price shows just how much the landscape has altered.

As well as these fundamentals, the basic emotion of mistrust is dominating the market.

‘Everybody in the market is suspiciously looking at each other,’ Rang says. ‘They think:

“I don’t know what is on your books so I won’t give you any money.”’

Over the summer, there was also fear that some of the special investment vehicles created by banks to sell bonds and CDOs might be forced to sell bonds at reduced prices to improve liquidity levels.

‘There was concern about forced sales, and whether that would put a downward pressure on prices,’ says Andrew Currie, director in the structured finance team at ratings agency Fitch. ‘But now there is more clarity over who will be forced to sell and who won’t, so the investors who remain know more clearly where prices should be. The market is still nervous about the possibility of new shocks, but things are starting to improve.’

Currie adds that there have been no general downgradings of the ratings of CMBS issues because of the problems in the credit market, and the quality of the bonds is not in doubt there is just uncertainty about the correct price.

But it is this uncertainty about the losses banks may be harbouring that has crippled the market. Banks are faced with the problem of what to do with loans that, when they issued them, they expected to be able to securitise, or bring in other banks in syndication partnerships.

Everybody in the market is suspiciously looking at each other

Mchiel Rang, ING

There has been much speculation about HSBC, which financed the £1.09bn purchase of its own headquarters at Canary Wharf in June by Spanish property company Metrovacesa.

In August, rumour was rife that HSBC was having trouble shifting the debt from its balance sheet, but it said at the time: ‘We are currently very comfortable with the financing options available on Europe’s most valuable building and a landmark building in London. We are not concerned about our options and no decision on any of the financing options available to us has been decided.’ HSBC has just agreed to extend the maturity on its bridge loan to Metrovacesa by one year, and the property company is considering selling asset-backed securities next year.

Putting out feelers

The first signs are emerging that the market is beginning to open up again. As well as the secondary sales undertaken by Lehman Brothers for Windermere XII, banks are putting out feelers to see if there is a market for new issues. Lehman has just released Windermere XIV, a new €1.1bn (£781m) CMBS issue backed by the income from Finnish, Italian, French and German property. The success of the sale will be a key indicator for the market.

‘This is the first deal since July that has gone all the way through the standard marketing process,’ says Currie. ‘If it does well I would expect there to be more primary issues following on behind. But it depends on the ability of the individual bank to sell bonds. Some banks have a lot of friends that they have good relationships with that they can place the bonds with: others don’t.’

He says that throughout the summer his team has been rating bonds from banks that are testing the water to see whether there is any investor appetite, but none of these products had come to the market until Windermere XIV.

The property industry has been unfortunate in that the problems in the credit market arrived at the same time that people were starting to feel that values had reached their peak. What will it take to break the stranglehold of the credit crunch, and can the CMBS market help property to once again reach the heights of the last few years?

‘The problems are due to a combination of factors, so it will need a combination of no bad news and some good news to get the market back on its feet,’ Phillips says.

‘I expect the market will be back in the first quarter of 2008,’ Rang says. ‘But it will also be on a different footing. I think we will see more transparency, with the bonds backed by one or a limited number of clearly identifiable properties.

‘But we will not see a market again like we have known over 2007.’