In the wake of the Global Financial Crisis (GFC), highly structured CRE debt transactions featuring multiple lenders and including a securitisation received a lot of criticism. There are myriad of justifiable reasons for this, but the chief complaint generally centred around the fact that at times of distress and a need for urgent action to be taken, these structures were simply not up for the job. A decade or so ago, there was no shortage of evidence to support this proposition as subordinate lenders that were out-of the money flexed their muscles to extract any value that they could, distressed borrowers found it cumbersome, time consuming and expensive to reach consensus with their lenders, whilst at the same time those charged with policing these structures (namely facility agents and servicers) more often than not found themselves between a rock and a hard place as they tried to break the deadlock. In some instances, distressed borrowers were able to exploit structural flaws to significantly strengthen their bargaining position to the detriment of lenders as a whole.
Against this chaotic backdrop it was no surprise that high profile disputes and litigation subsequently ensued, and the knee jerk reaction was a conscious move by the market to simplify CRE debt structures as a means of once again instilling trust and confidence so that CRE lending could resume at scale. However admirable this position is, the truth is that the slicing and dicing of debt secured by one or more CRE assets is not only essential but also makes a lot of sense. From a lenders perspective, it enables them to be able to invest in a CRE debt instrument that will deliver a return that is capable of quenching their risk/return appetite. For senior lenders, they also have the benefit of not only lower leverage but also take comfort from the fact that sitting behind them is a subordinate investor that is not only likely to be sophisticated with serious CRE expertise, but an investor that is strongly incentivised to take appropriate action for the greater good of the capital stack as a whole including the ability to step into the shoes of the borrower.
Assuming that tranching and potentially securitisation creates a cheaper form of debt for borrowers, then they will almost certainly welcome these structures, especially now as global economies are battered by a storm of high inflation and escalating interest rates. These techniques also have the added advantage of establishing a deeper and wider investor base to invest in CRE debt, thus removing a potential systematic risk by having too few CRE lenders channelling debt into the CRE sector.
Ironically, over the past few years, the exercise of tranching has proven itself as an essential financing tool thanks to the retraction of banks from high LTV lending, and accordingly the presence of structural mezzanine debt has become staple for highly leveraged CRE finance transactions involving banks. Equally, with the emergence of alternate lenders that are reliant on loan-on-loan financing, we have witnessed the use of structures which effectively mimic the economics and legal rights of tranching albeit under a different guise.
Fifteen years on from the GFC, it is time for highly evolved CRE debt structures to not be stigmatised, but instead actively embraced. Yes, the market has had some bad experiences, but any reservations that market participants may have can be easily nullified by the presence of a servicer appointed by all lenders, a decent servicing standard and the ability to override certain lender positions for the greater good of all. Equally, the presence of a control valuation event has always been an important test as it ensures that whilst a junior lender has no economic interest in an asset, then any rights they have burn away.
At this point in time we are at a critical juncture as we embark on a new era of higher interest rates, and with it borrowers are more receptive to more complex debt structures that will allow them a cheaper source of debt. Meanwhile, sophisticated CRE players who have focussed on CRE equity as part of their relentless search for yield during an era of super low interest rates, will have a renewed focus to invest in CRE debt given its relative returns compared to equity and the limited downside risk. It also means that a different lender base will enter the fold and with it they too will be more receptive to embrace some of these more involved finance structures in order to achieve the returns that they require. Either way you look at it, tranching has proven that despite a chequered past, it has an essential role to play in the European CRE financing market. As borrowers, lenders and investors alike grapple with high interest rates, when it comes to CRE debt structures then I would surmise that the time is ripe for CRE structures to embark on a period of rapid innovation for the greater good of all.