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Risk Is Ramping Up in Property CLOs Revived After the Crisis

Real estate investors are bundling increasingly speculative short-term mortgages into CLOs.

(Bloomberg) --A real estate financing tool revived from the pre-crisis era is growing riskier.

Real estate investors are bundling increasingly speculative short-term commercial property mortgages into bonds known as collateralized loan obligations. The properties packaged into these deals don’t qualify for more traditional forms of financing, such as being included in commercial mortgage-backed securities, because they are being refurbished or are otherwise in a state of transition. An example may include an empty office tower undergoing renovations and waiting for new tenants.

Yield-starved investors are gobbling up CLOs in this small but fast-growing corner of the market, even as the underlying mortgages have been generating bigger losses for the owners of the properties, a sign that the debt is getting riskier. That demand underscores how the Federal Reserve risks further inflating some financial markets as it moves closer to cutting rates for the first time in a decade. Money managers are looking for an elusive combination of high yields and low risk, the same impulse that fueled demand for subprime mortgage securities a decade ago, and the first wave of commercial real estate CLOs.

Rapid Growth

About $14.4 billion of commercial real estate CLOs were sold in 2018, up 80% from the year before and 658% from 2016, according to data compiled by Bloomberg. Issuance is proceeding at an even faster clip this year, with $9 billion offered year-to-date. Eight transactions are being lined up to be issued, many of which will probably launch in July or August, Kroll Bond Rating Agency wrote in a research note last week.

As investor demand has increased, the quality of the loans that are getting packaged into the deals has decreased, according to reports from both Kroll and Moody’s Investors Service. In 2018, lenders lost around 45 cents on the dollar on defaulted loans in commercial property CLOs, up from about 43 cents in 2014, according to Moody’s. Most of those losses are usually born by the owners of the property, who are the first to get hit when mortgage payments start to shrink.

Ratings firms are responding to the growing riskiness by requiring the investment managers that build these bonds to add more safeguards to win top grades. Many commercial real estate CLOs are now being sold with a larger proportion of bonds that take losses before the top-rated portions do, to serve as a sort of cushion for buyers of the least risky CRE CLO securities.

In a deal being sold this week from Bridge Investment Group, investors in the company’s AAA rated bonds would suffer losses only after the underlying loans lost more than 49.5%. For a typical CRE CLO from 2016, losses came after declines of about 42%, according to data compiled by Bloomberg.

“As a result of the CRE CLO market taking off, there are more people who have gotten into the game, and they are getting more aggressive with terms,” said Nitin Bhasin, an analyst at Kroll. “There are more than 20 active issuers in the space. More competition leads to increased leverage, which drives down spreads on both the deals and the underlying loans.”

Chasing Yield

A $30 million loan for a student housing complex called Progress405 located near Oklahoma State University was bundled into a commercial real estate CLO in 2017. Built a year earlier, the 11 acre student-housing development featured apartments with granite countertops, private patios, and washers and dryers, not to mention on-site amenities like tanning beds.

But another 481-bed student housing complex catering to the university was in construction nearby for the following school year. By May 2017, Progress405 was only 76% occupied, while competitors were 94% full, Kroll said in a report. The property had to be taken over by a special servicer to try to turn it around.

What’s pulling investors into CRE CLOs are higher yields. A top-rated portion of such a CLO with a two-year maturity earns about 1.1 percentage points more than benchmark rates, while a slice of a CMBS with a similar maturity yields around 50 basis points over its benchmark, and typically has a much longer maturity.

CRE CLOs are simpler and safer then their crisis-era predecessor -- then known as CRE collateralized debt obligations, or CRE CDOs. But the re-branded product still has some features that worry investors and ratings firms, beyond the dicey underlying real estate properties.

For example, the issuer can sell a deal before all the loans are even chosen. During what’s known as a ramp-up period, some CRE CLO managers can acquire mortgages for the securities that they never mentioned to their investors. While there are eligibility criteria to limit the manager’s choice of properties, these criteria have “liberal parameters,” Kroll wrote in a report last month. In the past, transitional real estate assets were largely funded with short-term bank financing such as credit lines known as warehouse lines of credit, the analysts said.

In a similar kind of risk, two-thirds of CRE CLOs issued this year are actively managed, with two to three year periods where loans can be swapped in and out. In 2018, that figure was 50%, and in 2014 it was only 13%.

Complicated securities like CLOs can offer better protections for investors than simpler securities, but sometimes those safeguards offer less of a shield than investors might hope. The financial crisis was stoked in large part by notes that promised to be top rated, but ended up performing poorly. CRE CLOs aren’t likely to pose the same systemic risks as subprime mortgage bonds and related CDOs, but that doesn’t mean they’re all worth buying, said Neil Aggarwal, a senior portfolio manager and head of trading at Semper Capital.

“As an alternative in the post-crisis, next-generation mortgage sectors, CRE CLOs can at times offer additional yield and optionality, as well as compelling spreads versus traditional CMBS,” Aggarwal said. “But there’s a trade-off: given the bespoke nature and complexities within the commercial real estate loans and the structure, this sector requires careful analysis in understanding the underlying credit and structural risks.”

To contact the reporter on this story: Adam Tempkin in New York at atempkin2@bloomberg.net.

To contact the editors responsible for this story: Christopher DeReza at cdereza1@bloomberg.net

Dan Wilchins, Boris Korby

© 2019 Bloomberg L.P.

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