One of the notable changes in the post-financial crisis market is the rise of commercial real estate collateralized loan obligations (CRE CLOs). Although many view CLOs as simply a new version of pre-crisis CDOs (collateralized debt obligations), there is no denying the surge in recent activity. According to Commercial Mortgage Alert, an industry newsletter, CRE CLO issuance nearly doubled last year from $7.7 billion in 2017 to $14.3 billion in 2018. That new market is continuing to gain traction and attract new players in both issuers and investors. Morningstar is among the latest new entrants into the field. The ratings agency announced earlier this year that it would begin rating pools of CRE CLOs. NREI talked with Greg Haddad, senior vice president, CMBS at Morningstar Credit Ratings, for insights on some of the factors driving the resurgence and what’s ahead for this sector.
NREI: Can you provide a bid of a primer? What are the key differences between CMBS and CRE CLOs, and what niche do CRE CLOS fill?
Greg Haddad: CRE CLOs are typically composed of bridge loans on transitional commercial properties, which are undergoing varying degrees of renovation or repositioning. They differ from conduit commercial mortgage-backed securities as the loan normally includes a future funding component to allow the sponsor to execute its business plan and stabilize the property, which is not permitted in a real estate mortgage-investment conduit.
The loan term is also typically shorter, with an average initial term of two to three years, with extension options available.
While some pools are static, an increasing number of CRE CLOs allow for reinvestment during the first two-three years of the transaction life, which means that as loans prepay, the issuer can (subject to eligibility criteria) reinvest the proceeds in a new loan as opposed to amortizing the senior notes.
CRE CLOs also contain structural enhancements in the form of over-collateralization and interest coverage tests that, if breached, alter the senior-sequential nature of the waterfall to divert interest and principal away from junior tranches to de-lever the most senior bonds before actual losses in the collateral pool are realized.[BM1]
NREI: What are some of the factors contributing to the comeback and growth of CRE CLOs in the current market?
Greg Haddad: Unlike the pre-crisis 1.0 deals, CRE CLO’s today are financing vehicles backed by a pool of light transitional, first mortgage loans and the issuer has significant skin in the game. They normally purchase all the non-investment grade bonds, which can be in excess of 20 percent of the deal.
A CMBS issuer is only required to retain 5 percent of a pool’s balance. This contrasts with 1.0 deals, which were cash flow arbitrage vehicles where the manager was primarily motivated by fee income and rarely invested in their own transaction. The collateral was of a “kitchen sink” with first mortgage, B notes, mezz loans, REIT preferreds and CMBS B-pieces.
On the investor side, growth of the current market has been helped by a strong demand for short duration, floating-rate paper vs. 10-year fixed-rate CMBS. On the issuer side, CRE CLO liability spreads have remained attractive relative to traditional repo lines and also offer matched term financing.
NREI: Is there growth coming at the expense of CMBS, or what other capital sources do CRE CLOs compete most directly with?
Greg Haddad: There is little impact to CMBS as CRE CLO grows as a different asset class and does not compete with the same universe of borrowers. Transitional commercial real estate collateral is also financed on bank balance sheets/repo lines. CRE CLO is another financing option for issuers in this space that allows them to match the financing to the term of the loan.
NREI: What are some of the pros and cons of CRE CLOs?
Greg Haddad: CRE CLOs offer a combination of relatively diversified exposure to commercial real estate collateral, coupled with a floating-rate, shorter duration term. For issuers, it offers them an alternative to traditional repo financing.
Somewhat of a negative is that CRE CLO collateral and the transactions themselves are more complex to analyze and surveil than conduit CMBS. Most of the loans are transitional in nature and investors need to understand and monitor the evolution of the borrower’s business plan.
The CRE CLO is also structurally more complicated than CMBS and requires modelling the transaction liabilities in a cashflow engine like Intex in order to account for the impact of IC and OC tests and the intricacies of how bonds behave under various stress scenarios. For managed pools, investors need to understand reinvestment eligibility criteria and concentration limits and how the credit profile of the transaction may change over time.
NREI: How do borrowers view CRE CLOs as a financing option?
Greg Haddad: As a rating agency, we do not interact directly with borrowers. So, this is difficult to comment on. However, given the growth of the market, borrowers seem to be agnostic as to where the financing comes from.
NREI: What are the headwinds/tailwinds for CRE CLOs in the coming year?
Greg Haddad: The CRE CLO market, similar to CMBS, is very sensitive to macro-economic pressure, which we saw towards the end of 2018 and early 2019. CRE CLO is even more, so issuers view it as an alternative to traditional repo lines only if the cost of financing is more attractive.
Tailwinds would be the continued demand for short duration, floating-rate paper that also offers a yield pickup over CMBS.
NREI: Any other notable trends impacting the space?
Greg Haddad: One trend we have seen over the past year is an increasing number of managed vs. static transactions. Managed deals can be an efficient financing vehicle for issuers that are able to take advantage of the pool’s ability to replace loans as they mature and prevent the duration of the transaction from shortening appreciably. This flexibility does come at a cost as investors require a spread premium over a static transaction, albeit one that has begun to narrow.
We also expect to see investors begin to differentiate in pricing between seasoned CRE CLO managers and first-time issuers. Currently, there is limited “tiering” in pricing as demand for CRE CLO bonds exceeds supply. Unlike CMBS, CRE CLO managers or affiliated entities are usually heavily involved in loan origination and potential workouts. This is an important dynamic that can have a significant impact on a pool’s performance. Morningstar accounts for this when we analyze CRE CLO’s by reviewing issuers and evaluating their investment team’s industry experience, as well as understanding their overall credit process and operational structure.