In recent years, the commercial real estate securitization market has experienced a resurgence in issuance of commercial real estate collateralized loan obligations, with the greatest transaction volume since the financial crisis. While some worry that the re-emergence of such transactions is a harmful development for the commercial real estate capital markets, we believe that with proper motivation and continued discipline, CRE CLOs can offer benefits to both investors and issuers.
In 2016, seven different securitization sponsors each issued new CRE CLO transactions resulting in $2.5 billion of securities. In 2017, these figures grew to 13 sponsors, 18 transactions and $7.7 billion, indicating that some of issuers were beginning to access the capital markets multiple times during the year. This trend of new issuers, more transactions and greater volume has carried into 2018, and is expected to continue. So far this year, 11 issuers have executed 11 transactions, yielding in excess of $6 billion of securities.
In addition to overall market volume, transaction size also has grown. In 2016 and 2017, most of the transactions were $300 million to $400 million in size. Starting in late 2017, the market began to successfully absorb deals of more than $1 billion, with the largest post-crisis transaction to date, the $1.1 billion LNCR 2018-CRE1 pricing this May.
For investors, commercial real estate collateralized loan obligations, like other CRE securitizations, provide structured exposure to the CRE loan market and an ability to calibrate risk vs. return via the purchase of specific credit tranches of debt. CRE CLOs also offer short-duration, floating-rate securities, which can be beneficial for investors in a rising-interest rate environment.
For issuers, the CRE CLO vehicle offers an efficient alternative to warehouse lines and repo facilities for financing the business of originating short-term, floating-rate bridge loans on transitional properties. In addition to providing issuers with access to match term, non-callable, non-mark-to-market, non-recourse financing, CLO vehicles also afford issuers greater flexibility than other vehicles, such as real estate mortgage investment conduits, for securitizing commercial real estate assets.
For example, CLOs permit future funding, a feature that is particularly important for transitional assets as often additional funds are needed for the successful execution of the borrower's business plan for stabilizing the property. They also permit significant flexibility relative to on-going collateral management, including a right to purchase, and sometimes even replace defaulted or credit impaired assets.
Critics recalling pre-crisis CRE collateralized debt obligations contend CRE CLOs create the type of systemic leverage that contributed to the events of 2007-09. While this is a reasonable concern, it is important to distinguish today's CRE CLO transactions from the myriad other deals that were lumped into the broader pre-crisis CRE CDO category, as well as the collateral and structural changes that further enhance today's CRE CLOs.
One of the primary differences between today's deals and those executed in the pre-crisis years is the nature of the pool collateral. To date, all of the post-crisis CRE CLOs have been collateralized exclusively by whole loans and pari-passu participations in whole loans, which are all secured by first-mortgage liens on predominantly core commercial real estate assets. This differs dramatically from the pre-crisis CRE CDOs, which rarely were secured exclusively by whole loans, but also included subordinate mortgages or junior participations/notes and other types of debt obligations that were often unsecured or deeply subordinated in the capital stack. These prior transactions also included loans on more "off-the-run," riskier asset types like condo-conversions, land and, in some cases, even construction projects.
Simpler and safer
The nature of the collateral itself goes a long way in making today's transactions both simpler and safer as the absence of subordinate positions translates to lower overall leverage, possibly fewer defaults and less complexity if a default occurs.
The change in collateral composition also highlights the difference in motivation that drives issuers to securitization using a CLO structure. Most of those actively issuing CRE CLOs today legitimately utilize the structure as an efficient way to finance a commercial mortgage bridge-lending platform. This strategy differs from many pre-crisis issuers that saw the vehicle as a mechanism to profit from the rate and price arbitrage created by the ability to highly leverage subordinate positions through credit lift (i.e., turning part of speculative grade stand-alone positions into high investment-grade pooled collateral).
In addition to the collateral changes, structural refinements in post-crisis deals also enhance these newer transactions. One such change is a reduction in the number of individual debt tranches issued per deal. In pre-crisis CRE CLOs, it wasn't uncommon for issuers to offer as many as 10 to 15 individual tranches of debt to potential investors. This is significantly greater than the four to five tranches that categorize today's deals. The fewer tranches of issued securities coupled with higher subordination levels from the rating agencies result in any given tranche of securities having greater thickness and, therefore, more protection against losses should they occur.
Typically, all of the non-investment-grade securities are retained by the transaction sponsor. This serves to align the interests of the issuer and investors, as the issuer bears the risk associated with the first losses, if any, experienced by the trust. While this provision hasn't changed from pre-crisis transactions, what has changed is the thickness of this equity tranche as well as the manner in which control shifts from this sponsor-related first loss holder. In today's structures, the subordinate retained portion amounts to approximately 20% of the transaction balance. This represents a meaningful increase from pre-crisis levels of about 10%. In addition, although the directing holder for major decisions in the new transactions is still the holder of the most subordinate class, which is typically the transaction sponsor initially, when that class has less than 25% of its original investment at risk, the control shifts to the next most subordinate class. This is an earlier transition than in pre-crisis deals.
Another change in today's transactions surrounds the amount of discretion/latitude afforded to the issuer. Transactions issued early in the resurgence of the CRE CLO product were mostly static in nature, meaning that the collateral assets for the transaction included only assets contributed by the initial closing date. Although the market is gradually moving in the direction of more managed transactions, the parameters of new deals remain more stringent than those of the pre-crisis CRE CDOs. This includes shorter re-investment periods of one to three years as opposed to four to six years, shorter ramp-up periods and in many instances additions to the pools are limited to either delayed-close assets (loans that the issuer hasn't been able to close by the transaction's cut-off date), companion notes related to loans already in the trust or preselected assets.
Critics of structures that permit active management, assert that the flexibility of CRE CLOs can lead to negative credit migration, despite limitations imposed by the eligibility criteria that govern reinvestment. However, we believe that investors that buy securities issued by actively managed CRE CLOs with sponsors that are using the structure as a financing tool and — even more importantly — have significant CRE and capital markets experience that spans all points of the economic cycle, can actually benefit from the additional flexibility afforded to the sponsor of these products.
Joseph Iacono is CEO and Kim Diamond is head of structuring and credit for Crescit Capital Strategies, New York. This content represents the views of the authors. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.