Wow, what a year 2022 has been! Typically when I reflect on all things structured CRE related, I have more often than not found myself applying a metaphor of a roller coaster, which is suitably apt given the huge swings in market activity experienced over the past twenty years or so. 2022 has proven to be no exception, although the track itself has resembled a downward spiral rather than a thrilling ride of highs and lows. Either way you look at it, the fact is that the 2022 roller coaster ride has proven to be very different to what was promised a year ago.
Looking back at this time last year there was a palpable sense of excitement for the European structured CRE market, thanks to the fact that 2021 not only had delivered a record volume of CMBS issuance, but more excitingly, had successfully imported CRE CLO technology from the United States. Unfortunately, 2022 failed to deliver on all this promise, with CMBS issuance hitting an unprecedented low, and as for the CRE CLO product, the Starz transaction that closed in November 2021 still remains the one and only deal to have graced the European market. Although the industry (once again) could be forgiven for wallowing in pity, I would profer the view that despite a disappointing level of deal activity, 2022 has nevertheless laid the foundation that the market will reap the benefits from in the years ahead.
What I have witnessed first hand is that there is tremendous appetite for CRE CLO technology thanks to its many positive characteristics. After all the CRE CLO product, when compared to loan-on-loan financings, offers a lower weighted average interest rate, higher advance rates as well as a fair level of flexibility when dealing with the underlying loans. With the abrupt halt to the era of ridiculously cheap debt, we now enter (or should I say return) to an environment where higher interest rates are the new norm. This will not only improve profitability for the banks, but also means that alternate lenders can no longer afford to simply rely on loan-on-loan facilities and repo lines to fund their CRE lending activity in a market where CRE CLO technology offers more favourable economics. For those alternate lenders that want to remain competitive, they risk failing to embrace (or at the very least consider) this technology at their peril.
Buoyed by the success of CRE CLO’s in the United States, 2022 has been an educational journey as market participants have sought to understand more about the intricacies of how CRE CLOs work, how they differ from their CMBS cousin, and figure out in what way they can be properly used as a funding tool for their business. The huge interest in the CREFC Europe conference in May (CMBS & Beyond) was testament to this, as well as the plethora of thought leadership pieces that have been published throughout the year. Similarly, thanks to a blow-out in capital market spreads, banks and alternate lenders alike have been delivered a stark reminder of the perils of holding loans on their balance sheets without the potential of having structured takeout embedded as an important exit strategy.
As for underlying collateral level, we are witnessing bridge financing receiving a heightened level of attention with a number of factors contributing to this. Chief amongst these is the fact that the loan origination market continues to be challenging. Compared to the position over the past few years, there has been a marked increase in the cost of credit which can be attributed to market volatility, a heightened level of uncertainty as well as some lenders closing their lending books until conditions improve. To add insult to injury, the exorbitant price of interest rate caps has added to these financing costs, and with it borrowers are once again embracing interest rate swaps as an interest rate hedging strategy. Furthermore, on the equity side, a combination of rising cap rates and looming concerns over a significant economic downturn has had a negative impact on property valuations, which in turn has had a direct impact on the amount of debt that a lender is willing to lend but also the purchase price that a seller can command as part of any sales process. The corollary of these woes is that there is little impetus for borrowers to tie themselves into expensive term debt which is difficult to extricate themselves from, without being burdened by prepayment penalties and potential close-out payments under a swap. Bridge financing would appear to be the perfect solution for those borrowers that are in the unenviable position of being forced to raise fresh debt whilst at the same time looking to ride-out the current wave of volatility.
Bridge financing also has the added advantage of affording borrowers the breathing room to reposition and stabilise transitional assets, and thus enable them to qualify for a cheaper form of long term debt. In this regard there is no shortage of transitional properties and volumes are likely to increase further as a consequence of landlords embracing best practices of ESG, re-positioning properties following the fallout of Covid, the eradication of voids as tenants succumb to the macro-economic stress as well as repurposing properties to meet ever changing consumer patterns and behaviours. The fact is that bridge finance has an integral role to play in being able to provide borrowers with the space required to execute their business plans and somehow stave-off being burnt by market volatility. These stark facts will reverberate for proponents (like myself) of CRE CLO technology; after all, it is the financing of transitional assets and bridge loans that has fuelled the exponential growth of the US CRE CLO market.
Taking all these factors together, as we look ahead to 2023 and beyond, although the capital markets look like they will continue to be challenging in the coming months, in the medium to long-term, I would profer that 2022 has shown us that there is a genuine need to embrace CRE CLO technology at scale, and there is a willing market to do this. Ultimately, just over a year on from Europe’s first CRE CLO, the market cannot only be said to be wiser and smarter about the product, but the anecdotal evidence points to the fact that there is a genuine need for this type of structured product to play an integral role for financing European CRE CLO.
As for my personal hopes and predictions, I hope that I never again find myself comparing the structured CRE market to a roller coaster ride, but instead find myself using metaphors more akin to supersonic space travel. In terms of my predictions, well the resounding fundamentals of the CRE CLO product continue to make absolute sense (a point that has been brought into sharp focus and magnified by the current macro-economic environment) and the US market continues to be a shining example of the hugely important role that CRE CLO technology can play in financing CRE. and therefore My prediction therefore, is that it is now time for the European CRE CLO market to take its seat and brace for lift-off.