Real Estate or Commercial Mortgage Securitization is a form of financing whereby existing property rentals or mortgage loans backed by commercial real estate are securitized to create investment grade bonds. Efficiently priced nonrecourse debt is raised against commercial real estate assets through the process of converting illiquid financial assets, such as leases and mortgage loans, into liquid, rated securities with uniform terms. These liquid bonds may be placed with international institutional investors.
The credit risk of the debt on the property is "tranched" to establish various classes of risk (typically rated from "AAA" to "BB") to suit various investors' risk profile. The creation of higher rated securities through the tranching process results in a lower cost of capital to the real estate owner.
TRADITIONAL VS. SECURITIZED FINANCING
In traditional lending, debt service is paid from the borrower's general cash flow and the asset may be provided to the lender as security. In an event of default, if the security is found to be insufficient to satisfy the entire debt, the lender will continue to maintain an unsecured claim against the Borrower for the remaining amount due and unpaid.
Securitization differs from traditional lending in that property cash flows are the lender's only security and the lender does not have any claims against the borrower's other assets. Hence, personal guarantees are not required. Overall the structure is legally insulated from management Securitization offers borrowers and property owners multiple advantages:
1. Recourse is limited to the securitized asset thereby freeing up the balance sheet from personal guarantees and/or cross company guarantees.
2. Securitization allows for longer term financing relative to the local bank market. For example, securitization allows for principal amortization terms of approximately thirty years compared with ten years in standard local bank financing.
3. Securitization permits large financing proceeds in a single financing transaction and the ability to finance multiple properties in a single transaction.
4. Securitization allows the borrower to establish and develop a reputation in the global capital markets through the rating exercise without full disclosure of the entire balance sheet.
I. Real Estate Financing in the UAE
The UAE has traditionally been an oil-based economy with proven reserves of over 100 billion barrels. In the last decade, the economic base of the country, and particularly that of Dubai, has been successfully diversified into trade, tourism and services through a variety of government initiated development development projects in key sectors such as finance, transportation, IT, media and hospitality.
As a result, Dubai's non-oil GDP has risen to represent approximately 90 percent of its total GDP, an unmatched figure among comparable oil-rich countries in the Gulf region. The combination of liberal economic policies and government encouragement of foreign direct investment as well as considerable amounts of capital invested in infrastructure and land development (over $16 billion annually) have fueled a real estate boom in the UAE, particularly in Dubai.
The UAE commercial real estate market currently has a capitalization of $140 to 160 billion, with annual real estate and construction spending over $10 billion. This market has been growing at an annualized rate of 7 to 8 percent over the last ten years. During the same period, rents and land prices have been increasing at an average annualized rate of 5 percent, with strong occupancy rates in the prime sectors of the market.
Over the past five years, the Government of Dubai has set up some semi-private development companies to develop residential, retail and hotel properties in specially designated free zones where foreign ownership is permitted either through long-term land leases or fee simple ownership.
Real estate sales in these free zones have averaged close to $3 billion per annum in the last two years mostly financed through local banks or special purpose finance subsidiaries of the developers.
To date, the majority of financing for real estate projects in the UAE has taken three forms:
Equity investments by wellcapitalized private entities. The maximum leverage on projects is rarely more than 70 percent and averages approximately 60 percent.
Bilateral full recourse loans with local banks generally supported by personal or government guarantees.
Syndicated international bank loans. Real estate finance has generally a tenor of five to ten years on an uncapped floating rate basis linked to the Emirates Inter Bank Offer Rate (EIBOR). The financing provided to the end purchasers has been in the form of ten to twelve-year conventional mortgages or Sharia compliant installment sales contracts.
NEW MECHANISMS FOR REAL ESTATE FINANCING
Based on information on projects to date, the cumulative financing so far extended by the local banking sector in the past three years is approximately $4 to 5 billion. Given the size of the projects currently planned, there will be financing requirements of at least $3 to 5 billion per annum in the next three years.
In anticipation of these financing requirements that exceed the risk appetite and the balance sheet capacity of the local banks, the developers and regional banks are devising alternative strategies to diversify their funding sources and raise capital. These include equity recapitalization, securitization, international bank syndicated loans and regional Islamic financing (sukuks).
SECURITIZATION IN THE UAE
UAE real estate securitization is in it nascent stages. Historically, the scale of local projects has not put a financial strain on the balance sheet of the local banks. Furthermore developers have not faced strong incentive to remove assets from their balance sheets due to favorable funding rates and excess capital.
The UAE legal system, a combination of Sharia and civil code jurisprudence, and overall regulatory framework have impeded the development of non-traditional financing mechanisms such as securitization. As a result, even though there is no prohibition on interest, some of the major underlying tenets of asset securitization such as the validity of future assignments are largely questionable; legal structures therefore need to be redesigned to deal with such issues.
Recently, however, real estate securitization of the existing mortgages and the future pipeline has become a viable alternative to diversify the funding sources of the developers and their finance subsidiaries for several reasons. For example, the Dirham/Dollar currency stability and increased confidence in the UAE's sovereign risk and credit quality have alleviated any currency and liquidity concerns.
Additionally, the government's attention to improving legal and regulatory policies in the property market is facilitating interest in securitization. Finally, UAE developers are facing competitive and regulatory pressures, resulting in greater focus on measurements such as return on equity and efficient balance sheet management.
In the future, it is expected that there will be increased deal information, stronger credit rating mechanisms, and a greater financial track record of performance by the developers upon which to base ratings, consequently leading to greater investor confidence and an understanding of real estate mortgage securities.
RATING FRAMEWORK FOR UAE CMBS AND RMBS STRUCTURES
The rating of the CMBS or RMBS structures is important because it facilitates the raising of financing in the local, regional and international markets.
International ratings also lend to the credibility and reputation of the borrower in these markets. The major factor in the pricing to the borrower of CMBS and RMBS products is calculated by banks and rating agencies from the loss expectations in the collateral pool supporting the issue.
The banks and rating agencies will use a structured approach to understand the risk profile of securitized debt by evaluating the collateral, originator, and servicer and transaction structure and analyze the impact of key variables on risk assessment models. The analysis typically employed assesses factors such as credit risk, liquidity risk, servicer performance risk, swap counterparty risk, guarantor risk, legal risk, sovereign risk, interest rate and currency risk, and prepayment risk.
Rating agencies have reviewed potential CMBS structures in the UAE and have given tentative/final ratings for these structures.
NATIONAL AND INTERNATIONAL RATINGS METHODOLOGIES
Rating agencies have essentially two available methodologies of rating CMBS structures, namely the National Scale Ratings methodology and the International Ratings methodology.
The former generally leads to a one to two notch higher rating of a particular issue than the latter.
The National Scale Ratings methodology can only be applied to local currency issues. This methodology is designed to provide a measure of relative creditworthiness of issuers/issues within a particular country. It should be noted that National Ratings are not designed to be compared between countries.
Also, general enhancements may be required to breach the sovereign ceiling and rating of tranches using the National Scale Ratings methodology. These include employing an international standby property manager of significant reputation, Property and Loss of Rents insurance for each property, cut through to "A" and higher rated reinsurers for Property and Loss of Rents insurance, the purchase of Interest Rate Cap in the case of floating rate borrowing, and a liquidity facility equal to a certain period of interest on the issue to ensure timely payment of interest.
The International Ratings methodology can be used for both local currency and US Dollar denominated transactions. It results in the ranking of an issue that can be used across borders and therefore reflects the creditworthiness of issuers/issues for international cross-border transactions. In addition to the general enhancements for the National Scale Rating, rating agencies have also required the following general enhancements to confirm the breaching of the sovereign ceiling and rating of tranches using the International Ratings methodology:
1. The purchase of local currency (Dirham) - foreign currency (US Dollar) swap for the entire transaction,
2. Minimum Aaa2 rated Dirham - US Dollar swap counterparty for the entire transaction,
3. Purchase of Interest Rate Cap, minimum Aaa2 rated Interest Rate Cap counterparty,
4. A liquidity facility equal to a certain period of interest on the issue to ensure timely payment of interest, and
5. Transfer and convertibility insurance to be provided by minimum Aaa2 rated counterparty for the issuance of Aaa2 rated notes.
The cost of the transaction to the borrower is lower in the case of using National Scale Ratings methodology versus International Ratings methodology.
The main reason behind this is because there is no currency swap required when using the former methodology because the issue is in local currency only.
CONCLUSION
Due to the increased size and growth rate of the UAE commercial real estate market and the need for large-scale financing for the associated projects in the region, developers and financiers are seeking non-traditional sources of financing. Based on the capabilities of origination, structuring, distribution capability of underwriters and risk analysis methodologies of rating agencies, real estate securitization of the existing mortgages and the future pipeline has become a viable alternative to diversify the funding sources of the developers and their finance subsidiaries in the UAE.
Mohamad Sotoudeh
© ABANA Review 2004
