Europe is set to get a new type of commercial real estate investment in the coming months, one that will repackage some of the riskiest exposures to property debt available.

These instruments have been around in the US for a few years, but while that market has increased in complexity and sophistication over time, the banks and investment managers looking to launch European deals are plunging straight in at the deep end.

This fact along with the lack of homogeneity in European property financing is causing a headache for the ratings agencies.

Commercial real estate collateralised debt obligations, or CRE CDOs, mostly pool together the riskier slices of commercial mortgages with the more junior bits of commercial mortgage backed securities, which themselves repackage pools of property debt.

The point, as with all CDO strategies and many kinds of securitisation, is to cut risk through the diversity and number of debts included. Banks or managers can structure a deal in several notes, or tranches, which vary in quality. The best quality might be rated as high as AAA, while the most junior tranches, which would suffer the first losses, bear a risk many times greater than that of any of the individual pieces. These securities could all have an appeal for different investors.

The loans or CMBS tranches included have to be risky to generate enough yield to pay good returns to all levels in the CDO.

“The most important structural feature, the whole idea, is to create a high-yield transaction,” says Paul Mazataud, analyst at Moody’s, the ratings agency.

“You don’t want well-rated property assets, the idea is to have high-yield property related assets.” A previous lack of such assets is one reason why CRE CDOs have not developed in Europe as they have in the US. This has changed in recent years as banks have begun splitting subordinated pieces off the bottom of commercial mortgages. These pieces, known as B-notes, can then be sold to specialist managers.

“In Europe, there has been a real emergence of B-notes in the past few years,” says Euan Gatfield, analyst at Fitch Ratings. “Investors have been able to bid aggressively for these with one eye on what has been happening in the US market. They have been building portfolios with a CDO exit strategy in mind.”

Not only B-notes and junior CMBS tranches are likely to be included in CRE CDO deals. Many of the parties talking to rating agencies about potential deals want the flexibility to include whole mortgages, mezzanine loans and other debt related to property companies, as well as residential mortgages. Some bankers are even talking about including property derivatives in CDO structures.

The ratings agencies, which will not comment on the specifics of potential deals, have been working on ratings methodologies. They have been in discussions with potential issuers for more than a year.

The complexity of the planned deals as they are initially presented has forced agencies to make difficult decisions over whether to adopt a CDO-type approach to the ratings, based on models, or whether alternatively to treat them more like CMBS deals. This latter option requires them undertake much deeper “due diligence” on the underlying debts. Another reason for the long lead time has been the limited availability of suitable and suitably diverse assets.

“For prospective CRE CDO managers seeking to put together pools of junior debt, it has taken a considerable period of time to acquire even 20 positions at a suitable risk-adjusted return level,” says Ronan Fox, analyst at Standard & Poor’s.

Angus Duncan, a partner at law firm Cadwalader Wickersham & Taft, adds that there is also a lack of geographical diversity.

“At the moment, the main sources of B-notes and junior tranches are the UK and Germany, but as the wider European underlying CMBS market develops, we are hoping to see more granularity.”

Given the difficulty of finding the right kind of assets in the first place, one of the key issues for rating agencies and investors will be a manager’s ability to keep finding assets over the life of a CRE CDO.

“Prepayments are common in Europe and the rating agencies and investors will want to know that the manager has good access to collateral or can source its own,” Mr Duncan says. He adds that this is even more critical for CRE CDOs than it is for collateralised loan obligations, which pool leveraged loans.

It is not just the manager, but also the investor that should be expert in real estate markets, particularly since commercial property can be a volatile asset and many of the instruments set to be included in CDOs have not been tested in a downturn, says Mr Fox. “We think that resourcing this expertise in Europe will be very challenging.”

While the long struggle to get the first European CRE CDOs done should bear fruit soon, the prospects for a large market developing in Europe remain questionable.

This is the tenth in a series on capital markets innovations. View the others at: www.ft.com/wizardry

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