Fundamentals suggest more upside for high yield bonds
Last week Blackstone, sponsor of many CMBS transactions, issued a notice to request a 12-month extension to the February 2023 final maturity date of its FROSN 2018 transaction, citing ongoing macroeconomic instability and market volatility.
The deal is a securitisation of a single €530m loan, advanced by Citi and Morgan Stanley and secured on a variety of Finnish office and retail assets. After years of stagnant CMBS issuance, the 2018 deal was a huge success and signalled something of a revival for the market. The loan was partly used to acquire Sponda, one of the largest listed real estate firms in Finland, and represented a unique opportunity for Blackstone to increase its investment in the Nordic region.
At closing the FROSN 2018 portfolio included 63 commercial real estate (CRE) properties of mixed quality, with an overall occupancy rate of over 70% and a total market value of around €890m acquired at 66.6% loan-to-value, implying around €300m of capital invested. According to Blackstone's business plan, the vacancy rate was going to be reduced by lease re-gearing, active management, and selling “non-core” assets. Five years ago, I personally put on my warmest coat and travelled to Finland to view these properties and conduct our due diligence on the management company.
In the time since that visit the management has been rather busy, both in securing new leases and selling properties more quickly than we anticipated. Through 2019 and up until just before the pandemic struck in Q2 2020, the sponsor sold more than 15 properties resulting in debt repayment of approximately 50% of the original value. The assets sold were some of the largest by market value in the portfolio, but also some of the best quality ones (i.e. not particularly “non-core” in our view). Further deleveraging was made tougher by the COVID-19 pandemic and the lack of liquidity in the real estate market, and the FROSN 2018 mezzanine bonds were hit with a three-notch rating downgrade by DBRS due to a deterioration in performance. Any attempt there might have been to refinance the transaction last year would likely have failed due to the unfriendly market environment created by record-high inflation and Russia’s invasion of Ukraine.
According to the RNS notice requesting the maturity extension, “The Sponsor and Sponda have presented a proposed business plan to the Servicer which will be implemented if the Maturity Extension is granted and is intended to maximise value for Noteholders by way of disposals and/or refinancing and to ensure that the Senior Borrowers and assets are in a more favourable position at the Extended Senior Loan Maturity Date.” As part of the maturity extension, the sponsor has proposed a 1.25% increase to the senior loan margin to 3.7% over 3-month Euribor, as well as the prepayment of the loan with all proceeds from sales and the completion of a sales milestone within six months of the vote. More detail about the business plan was given on a call scheduled by Sponda on Tuesday, though this was only for current bondholders.
This seems to be a good outcome for senior bondholders (though perhaps less so for mezzanine ones), and it is not the first time we have seen Amend & Extend (A&E) in the CRE/CMBS space or more generally forbearance measures shown by servicers to retain loans in primary servicing. During the COVID-19 pandemic, for example, forbearance actions included waiving covenants, delaying new property valuations and extending loan maturity dates, among other measures.
However, the challenges the pool currently faces might still be outstanding in 12 months’ time. The assets are largely ‘tier two’ offices and the occupancy is very poor. Demand for premier offices and buildings with excellent amenities (especially if they’re energy efficient) that offer value for employees has remained consistent, but demand for secondary properties has declined. In addition to that, the volatile interest rate environment and increased cost of debt capital has put all yields under pressure. The latest valuation in December 2021 valued the pool at €513.5m, implying an overall capitalisation rate (a measure of effective one-year yield) of around 5%, though obviously this is now out of date and it wouldn’t be a surprise to see a further haircut as a result of the high capitalisation rates and poor occupancy rates of the properties in the pool.
In our view the sponsor could have done more to avoid this situation, and we believe the risks associated with illiquidity, volatility, and outcome uncertainty outweigh the return we would receive from holding the bonds, so we were happy to divest all our FROSN holdings last year.
As the famous song says: let it go, let it go, turn away and slam the door.