Commercial real estate collateralized loan obligation (CRE-CLO) issuance, which has been largely frozen since the beginning of March, may be starting to thaw, but the sector still faces hurdles to regaining confidence in the face of loan performance risk.
Three deals in the works pre-COVID-19 have pushed forward in recent weeks. According to Trepp, a $607-million CRE-CLO closed in May followed by a $419-million deal in early June. Another $800-million deal comprised entirely of multifamily CLO loans is currently being marketed. Because there is higher leverage and risk associated with CRE-CLOs compared to traditional CMBS, market performance is highly correlated with overall confidence in the economy, notes Catherine Liu, an associate manager at Trepp. So, it is an encouraging sign that issuers are moving forward with deals that could provide some guidance on price discovery and pave the way for additional issuance activity, she says.
CRE-CLOs typically consist of short-term, floating rate loans for assets that are in transition or undergoing some type of value-add renovation, repositioning or modification. They are considered to be a good financing tool for those situations, because of flexible structures that allows lenders to respond to changing conditions as the sponsors move through their business plans.
The pandemic derailed what had been a full head of steam for the CRE-CLO market early in 2020. The sector experienced a big jump in annual issuance volume in 2019 and there was a positive outlook for more growth. According to Trepp, the sector logged $22.4 billion in new issuance across 31 deals last year, which was a 26 percent increase from 2018’s tally of $17.7 billion across 21 transactions. Commercial Mortgage Alert reported a 39 percent spike to $19.2 billion last year. “The expectations were positive for the market. Assets have been performing well going into COVID and CRE-CLOs were still being received well by investors,” says Joe Iacono, CEO of Crescit Capital Strategies.
Like with many other facets of the economy, COVID-19 put a halt to that momentum.
“The predominant issue is that no one really knows what impact COVID will have on the various different property types and for how long,” says Iacono. In general, there are bids for most of the bond structure, albeit at very different levels versus pre-COVID-19. “Of course, as you start to go down to the more subordinate classes, BBB and BBB-, investors are more focused on how that collateral is going to perform, and whether or not they think they have adequate subordination at those levels to protect them from whatever potential default and impairment there may be on the collateral,” he says. Moving down in credit becomes more difficult, which is a similar narrative to what is happening in the CMBS market, he adds.
To bring liquidity back to the market, participants need more insight into what’s happening at the property level, which is going to take time to figure out, notes Iacono. In addition, there has been little value discovery on what assets may be worth now because very few properties have been trading. So, it is tough for bond buyers to figure out what things are worth today, he adds.
Stakeholders assess performance risk
Similar to the broader debt market, stakeholders have shifted their focus from new lending activity to assessing risk of potential loan defaults. According to Trepp, CRE-CLO delinquencies have increased from 0.2 percent at the beginning of March to 1.64 percent as of May 1. Trepp is also watching a rise in loans that are in grace periods or beyond grace periods (less than 30 days past due). Overall 3.1 percent of loans fall in this category. Still, the delinquencies are still fairly minimal compared to 7.15 percent rate for CMBS loans.
Certainly, CRE-CLO structures also have their share of risk that is magnified in an uncertain climate, notably the transitional nature of CRE-CLO assets that may lead to greater business plan execution risk in the current climate. However, there are some nuances that could help to cushion the blow for loan distress on the CRE-CLO side.
Generally, all loans have a “belt and suspenders” to mitigate risk, notes Deryk Meherik, a senior vice president at Moody’s Investors Service. One of the protective measures in CRE-CLO loans is that in effect two LTVs are used in underwriting—one on the “as is” performance and one on the “as stabilized” performance. The underwritten LTV on the stabilized performance is lower than the existing. That’s because the business plan is to create accretive value in the asset. Additionally, the majority of loans are made to acquisition properties, with material fresh cash equity by the property sponsor, he says.
Another thing that is important with a CRE-CLO is that the borrower/lender relationship is different. The lender is monitoring progress on the business plan to satisfy future funding components. “So, there is an ongoing dialogue between the lender and project sponsor as the project continues through the process towards stabilization,” says Meherik.
In addition, CLO transactions tend to involve a higher-quality assets and more sophisticated sponsors than on CMBS loans, adds Iacono. “So, on that note, the experience may be better,” he says. If there is a problem, the borrower can deal directly with their lender, versus a CMBS special servicer, who is able to be more proactive and responsive with more flexibility than CMBS, he adds. Another distinction is that loans included in CLOs tend to have substantial cash reserves set up up-front in order to be able to cover that transitional period. CMBS loans typically don’t have those cash reserve requirements because loans are generally made on stabilized assets.
Exposure to hotels, retail is lower
CRE-CLOs also tend to have more limited exposure to those property types that have been or are expected to be more severely impacted by COVID. According to a May 21 CRE-CLO report from Moody’s Investors Service, hospitality and retail account for 10 percent and 6 percent respectively of the collateral on CRE-CLOs that Moody’s rates, while multifamily accounts for about half (51 percent) with a heavy focus on workforce housing in particular.
Government stimulus has helped sustain rent collections. In the multifamily properties in the CRE-CLO portfolios that Moody’s is monitoring, for example, owners have been able to maintain 90+ percent on their rent collections. On the retail side, CRE-CLO has minimal mall exposure with retail loans generally focused on neighborhood and grocery and pharmacy anchored community shopping centers.
Office loans also represent a sizable percentage of the CRE-CLOs that Moody’s monitors, at 24 percent. "One positive in this environment is that those loans are structured with future funding that can allow the sponsor to adapt the space to the tenant needs,” says Jocelyn Delifer, a vice president and senior analyst at Moody’s Investors Service. Potentially, sponsors can use that to their advantage to make modifications to spaces to account for new ways of working in the COVID environment. “That being said, we are still keeping an eye on how vacancies are going to impact submarkets, such as adjusted vacancy numbers based on impact of unemployment,” he says.