Structured finance and the slow death of retail

Along with sub-prime mortgages, rating agencies, the repo market, investment banks, bank regulators, US housing agencies and (possibly) central banks, commercial mortgage-backed securities were one of the great villains of the financial crisis.

But in Europe, the asset class has been remarkably subdued ever since. Of European CMBS issued since the crash, only three have defaulted, according to Bank of America Merrill Lynch. So-called CMBS 2.0 have a default rate of just 1.3 per cent, compared to 16.6 per cent in pre-crisis deals (perhaps lower than you’d expect given, you know, the crisis).

Only a small amount of investment -- €500m -- was involved in these three defaults. What is interesting, though, is that all of them have taken place fairly recently, with two in the past year. What is even more interesting is that they all have something else in common: retail.

BAML has this week published an in-depth details of each loan. A reminder: CMBS involves taking large loans made against commercial properties and structuring them, so that different tranches reflect different levels of risk. Usefully, the loans tend to have simple, easily memorable names, connected with things like colours, or famous composers.

First, Debussy, a loan which defaulted in January 2018 after breaching a covenant, and was initially made against a portfolio of 31 warehouses. The sole tenant was Toys R Us. Need we say more. (We actually do need to say more: the transaction was linked to a pre-crisis deal, meaning, as BAML points out, it is not necessarily representative of post-crisis conditions).

Next, Orange, which was underwritten by Deutsche Bank and made in 2014 against 11 retail properties in the Netherlands. It defaulted in July after it failed to fully repay the loan on maturity. Here’s what the servicer, Situs, had to say, per BAML:

Situs noted that the valuation had flagged certain weaknesses of the portfolio including, competition in neighbouring shopping malls around some of the properties, decrease in rental income, rental levels under pressure from decrease in consumer spending, increased use of e-commerce and high levels of vacancy.

Finally, we have the Maroon loan, made by Goldman Sachs in 2017 and securitised in August last year. The loan was secured against three shopping centres in Dunfermline, King’s Lynn and Loughborough. In May, the deal defaulted after the value of the properties fell 18 per cent, increasing the loan-to-value ratio to 77.7 per cent (the covenants placed a limit at 75 per cent).

As above, the overall CMBS default rate is very low. In some cases, as with Maroon, the defaults are a function of covenants and have yet to impose losses of principal on investors. But there are still some early lessons to be drawn from these examples, especially when contrasted with what went wrong in the crisis.

BAML analysts point out that, in pre-crisis deals, “leverage was a key driver of performance while jurisdiction and property type were often less relevant”. Today, they go on, the horizon for risk is much more to do with specific types of property, especially retail [emphasis added]:

Rather than excessive leverage, we note that both defaults occurred in loans backed by retail property of less-than prime quality. The new lesson for CMBS 2.0 loans may be that we do not know what amount of leverage is appropriate for non-prime retail stock until rents and valuations stabilize, we think.

[...]

Retail property is going through a period of transition, we think, as rents rebase to new (lower) levels reflecting the shift in consumer behaviour and rise in e-commerce in some markets. It is not yet clear how much further this process has to run or where retail rents will settle. We expect tiering of rents could increase between prime and secondary quality assets. Until this rebasing is complete we think it may be difficult to judge what is a safe LTV for loans secured on retail property.

There is a risk, post-2008, of falling into a trap where all new information is parsed in relation to the “next crisis”, a hypothetical event consisting of another sudden set of financial supply chain collapses that necessitate government intervention. But what’s going on in the half-forgotten world of CMBS is more of a signal for how value is being gradually redistributed by one of history’s great shifts in communications technology.

For now, the internet is most obviously influencing retail property, via e-commerce. It is not necessarily destroying the value of physical land, but moving it around (see deals for logistics properties that Blackstone, for example, has been involved in), just like other technological developments that transformed communications did in the past.

Meanwhile, there’s a new CMBS deal in the market this week, with its own memorable name. Emerald securitises a single loan backed by three shopping centres in the North of Italy. It’s extremely small, and disproportionately worth keeping an eye on.