Hybrid High Yield/CMBS Bonds Help Fill Europe’s Real Estate Funding Gap

CRE Finance World, Summer 2013

Hybrid High Yield/CMBS Bonds Help Fill Europe’s Real Estate Funding Gap Karl Balz s Europe’s commercial real estate debt market enters its sixth year of “credit crunch” disruption, it is increasingly clear that traditional bank lending will not be able to meet the demand for new finance. The bank debt available at present is largely provided by German banks with funds raised in the Pfandbriefe market. The reliance of these banks on Pfandbriefe restricts them to providing low LTV debt on prime properties in amounts typically below £100 million. The insurance and private equity/fund sectors have yet to make an impact in direct real estate lending. European CMBS has shown the first signs of recovery with three publicly offered deals since 20111, but it will be some years before it reaches the volumes previously seen in the market. Other than CMBS (which has just begun to re-emerge), none of these sources of debt are expected to be available for secondary assets, peripheral locations, distressed borrowers or anything but the most simple property types to any significant extent, at least in the short-term. Over the same period that the market for real estate debt has shrunk, the market for high yield debt has seen considerable growth with annual European issuance volumes varying between €30 and €50 billion and global annual issuance volumes averaging at over $300 billion driven, inter alia, by investor demand in a low interest rates environment. Development of the High Yield/CMBS Hybrid Market 1. Centre Parcs In early 2012, a £1.01 billion investment grade issue by UK holiday park operator Centre Parcs sowed the seed for what now seems an obvious move to bridge Europe’s real estate funding gap in the high yield markets. This transaction, although not a high yield in itself, was notable for issuing long-dated fixed rate bonds which are rare in the traditionally five-year floating rate European real estate debt market. The make-whole and early redemption premiums required in the market for fixed rate debt have historically not been widely accepted by European real estate borrowers who expect to be able to sell or refinance their assets without restriction or penalty. The terms of this transaction were seen as showing that European real estate owners were finally ready to change their traditional models and accept new terms to secure finance in a changing market. 2. Four Seasons The next step came in June 2012 with a £525 (£350 million senior secured and £175 million senior notes) issue by vehicles2 established by Terra Firma to secure the financing for the acquisitions of the UK Four Seasons nursing home business. Similar to the Centre Parcs transaction, this deal formed part of the refinancing of a CMBS which previously financed the assets. Unlike Centre Parcs CRE Finance World Summer 2013 40 which can be seen as an unusual form of a CMBS deal with certain high yield features, the Four Seasons deal was a classic New York law-governed high yield issuance on standard high yield terms. 3. Annington The most important development to date is the issue in November 2012 by the Annington Homes Group3 of £550 million of PIK notes backed by the equity interest in a large portfolio of residential property occupied by married UK defence services personnel and leased to the Ministry of Defence4. The transaction was issued to partly finance the acquisition by Terra Firma of the part of the business held by Nomura. This transaction, too, is associated with CMBS transactions. Here, the PIK note issuer receives cashflow primarily from the holding company of two CMBS bond issues with significant outstanding transactions. The initial purchaser extensively pre-marketed the PIK notes to both real estate debt and high yield investors. Investors therefore had the rare opportunity to comment on early drafts of the transaction documents, a process which resulted in a number of innovative changes being made to the otherwise standard high yield terms. These changes largely reflect (i) the relatively passive nature of real estate businesses compared to the more complex operating businesses of traditional high yield bond issuers and (ii) techniques and structures commonly seen in real estate financing. The most important of these changes include: • No ratio debt in the Limitation on Indebtedness Covenant. • No Consolidated Net Income based Restricted Payments or Built-up in the Restricted Payments Covenant; i.e., the flexibility to make Restricted Payments is static and does not increase in line with financial performance. • Introduction of a cash sweep and trustee controlled accounts at issuer-level for certain proceeds available exclusively for repayment of the notes. • Creation of an order of priority of payment (waterfall) for the use of certain funds by the issuer/the restricted group. • Addition of real estate typical reporting to bondholders. • Elimination of some baskets and other provisions not relevant to a real estate business. Comfort as to other standard requirements of real estate debt investors (including limitations on operating costs and capital expenditure and ensuring that the group acts appropriately to refinance its debt) was provided through the covenant packages in the underlying CMBS transactions the benefit of which indirectly extends to the high yield investors as it applies to a large part of the asset pool. A Partner Paul Hastings Conor Downey Partner Paul Hastings Charles Roberts Partner Paul Hastings


CRE Finance World, Summer 2013
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