Don’t Fight the Fundamentals on US High Yield
Last week, Morgan Stanley successfully brought the first public German Multifamily CMBS deal (HAUS - Eloc 39) to market since 2013. Despite coming to the market in the middle of the summer, the deal has attracted strong demand across the capital stack. With a margin of 65 bps, the AAA priced tighter than any other CMBS transaction this year (possibly tighter than any since the end of the GFC), including logistics CMBS which performed well during the COVID-19 crisis. However, HAUS- ELOC 39 still priced wider than Prime RMBS deals. As usual for CMBS bonds, the investor benefits from the Euribor floor. Accordingly, the total pricing is about 40 bps higher, bringing the discount margin to 1.05%.
Let’s take a step back and examine German Multifamily CMBS as an asset class. Within the German buy to let market, one landlord often owns large residential blocks. If financed by a bank, the loans used to purchase the property could be securitised as German Multifamily CMBS. The attributes of German Multifamily CMBS places the asset class somewhere between CMBS and RMBS. It is characterised by excellent historical performance, and the peak of public issuance came just before the GFC in 2006 at more than €12bn. Since 2012 we have seen only a handful of deals like the ones from Gagfah, but the last deal amortised in 2016. The market has been quiet since. We have remained an active investor since the GFC, as we were before. In the CMBS world, Prime German Multifamily properties have, according to Moody’s, the lowest yields compared to other subclasses like office, retail, logistics underlining the low risk and stable performance of the asset class.
The German house price index increased yearly by more than 10%, similar to other European markets, which have seen record growth in the last 12 months, fuelled by central bank stimulus. More than half of the Germans rent their home, the second-highest rate amongst OECD countries. A robust German economy, a significant increase in house prices over the last decade and good welfare support with a furlough scheme in place for decades, coupled with the granular residential tenant base in these deals, results in a low credit risk for this asset class. Good asset quality and low concentration risk make this asset class so attractive. From a fund perspective, it provides diversification benefits, as there are virtually no public German RMBS deals offered in the market, with most lenders acquiring funding through the ‘Pfandbrief’ market.
Germany has more stringent regulations and infinite lease terms, so tenants can typically cancel their lease after three months, whereas the landlord has minimal rights to cancel a lease. Likewise, regulation limits the opportunity to increase rents to current market levels.
So, whilst vacancy rates for this asset class are typically below 5%, HAUS - Eloc 39 surpasses that figure intentionally by some margin, at 33% due to the same regulatory environment, which is positive for this portfolio. The rents for most of the flats are still low, so the empty flats are renovated and then re-rented at much higher levels to allow the sponsor to lift its potential.
Most of the features in Eloc 39, like the pro-rata amortisation of the notes, are consistent with other CMBS deals. It is worth noting that the notes benefit from a step up after five years, a typical RMBS feature that you would not expect to see in a CMBS deal. Brookfield recently acquired this €470 m portfolio mainly located in North-Rhine Westphalia and Lower Saxony. All properties are from the 70s, and as many flats are still not renovated, it is not a surprise that 42% have an EPC rating from D to F (F is 30%). So, even giving the renovation plans the benefit of the doubt adding a momentum score, the Environmental score within the ESG framework will be way below market average. Currently, 37% of the flats in the portfolio have been renovated.
Over the next two years, the business plans to continue renovating until 75% of properties reach the same threshold. It is precisely this business plan that makes HAUS - Eloc 39 different to a ‘normal’ German Multifamily CMBS deal. So, while we appreciate the granularity and stability of the underlying cash flows that support the outstanding performance of the asset class and also believe that Brookfield will get the portfolio to this stage in the next two years, the pricing does not reflect that the portfolio is not yet in this state. Additionally, the sponsor has the free option to refinance on cheaper terms after two years.
The loan reminds us of a refurbishment loan in this specific transaction, which motivates us to ask if it should be financed on a bank’s balance sheet rather than by the CMBS market. Fees and cash flows from the sponsor to the lender aren’t 100% clear, and this deal has all the likelihood of getting refinanced as soon as possible if they meet the business plan, which is reminiscent of a bridge loan.
We hope to see more typical German Multifamily transactions in the public market or the refinancing of Eloc 39 in two years.