Since rental income is fixed, at least for a time, there is strong motivation for property-owning borrowers and lenders alike to agree upon interest outgoings that are also fixed. In the US, it is conventional for stabilised income-producing properties to be financed with fixed-rate loans that cannot be prepaid. Any borrower seeking to sell a property is obliged to replace it with adequate risk-free security (defeasance). This has given rise to a predominantly fixed-rate CMBS marketplace in the US. In Europe, such "call protection" does not apply, and borrowers are entitled to prepay their loans. This introduces the problem of "negative convexity", according to which fixed-rate lenders face greater prepayment risk just as interest rates fall and more competitive loans enter the market. Whereas this may prevent a fixed-rate investment from increasing in value, the converse, negative effect on bond values caused by rising interest rates, is not allayed. This asymmetry means that fixed-rate lenders would effectively be required to provide borrowers with interest rate optionality, and charging for this in the coupon would raise the headline cost of borrowing.
To avoid the intrusion of negative convexity on European CMBS, banks have structured transactions to issue floating-rate bonds, which allows their investors to bear voluntary prepayment risk at no cost other than the upfront costs associated with reinvesting and any margin compression. The interest rate mismatch caused by fixed rental income being ultimately financed by variable rate CMBS is hedged, typically using swaps contracted either by the borrower (for a floating-rate loan) or the issuer (for a fixed-rate loan). However, this only transfers negative convexity from a lender to the swap counterparty. If the swap is not to be entered into at an above-market rate, such asymmetry will need to be offset, which is accomplished by requiring borrowers to provide an indemnity for any positive value of the terminating swap contract to the counterparty at the time a loan is prepaid. Consequently, a degree of call protection is, in effect, embedded in loans that underlie European CMBS. This result has been achieved by creating a visible interest rate mismatch, caused either by fixed-rate mortgage loans being funded with floating-rate bonds, or fixed rental income being financed by floating-rate loans.
Such a solution works when European borrowers choose to prepay, but may breakdown when prepayment is triggered by loan acceleration, in which case the indemnity offered wholly relies on the value of the security posted. Since the indemnity ranks at least equally with the debt, the incurrence of breakage costs can cause bond recovery proceeds to diminish. Such an outcome is consistent with conditions of falling swap rates and rising property yields, which is precisely the scenario being experienced now in Europe. Having averaged around 5% in the last five years, 3-year UK swap rates are now close to half that level; meanwhile, yields on many property types, including the important London office sector, have jumped to levels not seen in the last five years. It is arguable that a divergence between swap rates and rental yields is not sustainable over the long term, given the influence borrowing costs have over the value of real estate. Nonetheless, it may persist for some time, especially because the influence of swap rates on all-in borrowing costs has fallen to an extreme low, owing to unprecedented bank rationing of money and unusually elevated credit margins.
While the commercial property market is reportedly holding up better in the US, market differences between the US and Europe should not be overestimated. US fixed-rate bondholders are not inoculated against interest rate risk because there can be no call protection against involuntary prepayment, which will prompt a need to reinvest recovery proceeds during a period of sharply lower bond yields. One notable difference is that an early redemption of fixed-rate US bonds causes market losses, and is therefore not a direct concern for servicers. However, in Europe, the effect that falling swap rates and property values have on principal recoveries may well encourage servicers to adapt their strategies, and even postpone accelerating impaired debt until swap breakage costs have amortised sufficiently, or even been extinguished at swap maturity. Any disparity between US and European servicing on such a basis was most likely not intended by lending units and possibly not expected by European CMBS investors.
"Further delays in responding to evidence of loan impairment will undoubtedly frustrate many investors, certainly those who fear that by prolonging exposure to the real estate market, savings made on swap breakage costs will be outweighed by property value declines." says Andrew Currie, managing director of Fitch's CMBS team. "That being said, an element of caution would be understandable among servicers left the thankless task of forecasting which of these risks will prove the greater."
