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Getting a Handle on Real Estate CDOs

Rating agencies make bigger commitment to growing form of issuance

Commercial real estate CDOs (collateralized debt obligations) are clearly becoming a more popular investment vehicle. The first such instruments, sold in 1999, were limited to static pools of CMBS B-notes, the subordinate portion of commercial mortgage-backed securities pools. But since 2004, real estate CDOs have become far more flexible and now encompass various forms of rated and unrated debt including mezzanine, preferred equity and derivatives.

Analysts are responding to the proliferation of commercial real estate-backed CDOs by staffing up and refining the tools that help investors compare risks and rewards.

An estimated $12 billion in cash CDOs backed by commercial real estate debt were issued in 2005 — a significant slice of the $159 billion in total cash CDO issuance, according to the Bond Market Association. (Cash CDOs are based on cash flow from the underlying portfolio, as opposed to synthetic CDOs which typically employ credit derivatives.) The group predicts that cash real estate CDO issuance will increase by 25% to $15 billion this year compared with 8.8% growth expected in cash CDO issuance overall, making commercial real estate one of the fastest growing sectors in the CDO world.

“With CRE CDO issuance up over 100% in the first quarter of 2006 and the average deal size more than doubling, it is obvious that more investors are increasingly finding favor with CRE CDOs,” says Jill Zelter, managing director for CDOs at Fitch Ratings. Just this month, Fitch Ratings created a research group headed by Jenny Story to focus on commercial real estate CDOs.

In early May, Fitch’s rival, Moody’ Investors Service, deepened its commitment to the CDO rating business, too, by issuing a publication that explains its methodology for rating CDOs backed by real estate investment trust (REIT) debt.

REIT CDOs are backed by trust-preferred securities (TRUPS) and subordinated debt. TRUPS are a non-amortizing preferred stock with a 30-year maturity, can defer interest for up to five years, and can have a five- to 10-year non-call period. TRUPS are treated as debt for tax purposes, but as equity by regulators.

For institutional investors, trust preferred CDOs offer attractive risk-adjusted returns and exposure to an otherwise inaccessible market. For small to mid-sized unrated REITs which have had limited access to the capital markets, REIT CDOs are an important source of funding, according to Moody’s.

The first CDO of all-REIT trust securities hit the market in March 2005, issued by Taberna Preferred Funding I Ltd. Since then, Moody’s has been rating the instruments, using criteria similar to that which it uses for other CDO products, such as those backed by bank and insurance company transactions. (For a copy of the rating guidelines, use this link).

Rating REIT CDOs

With the rating firms paying more attention, the real estate CDO market should become more attractive to a wider range of investors. The variety and complexity of CDO structures make comparison shopping difficult — even for the institutions that purchase most of these instruments. Each deal needs to be evaluated individually, taking into account the quality of the asset manager and of the underlying collateral, says Joe Chinnici III, managing director of the structured products group at KeyBanc Capital Markets. “There are no cookie-cutter deals,” he says.

In order to rate an investment backed by unrated assets, as in the REIT CDO niche, Moody’s considers key factors including the credit quality of the REIT issuers, expected recovery rates in the event of defaults, asset correlation by industry and geography, and various models. When complete, the agency issues ratings of AAA, AA or other designations for the traunches within the CDO.

“Moody’s methodology provides the marketplace with comparisons to other comparably rated bonds, loans or securities,” says Jim Leahy, a Moody’s vice president and co-author of the rating methodology. “It also gives investors an idea of the risk and rewards potential.”

REIT CDOs are the newest phase in the continued expansion of the $30 billion trust preferred market, which also includes transactions backed by bank and insurance sector assets. Recently, hybrid CDOs using a combination of REIT, bank, and/or insurance assets have begun to emerge, according to Moody’s analyst Jim Brennan, who co-authored the methodology with Leahy.

“The trend is definitely going to be moving more toward these hybrid transactions.”

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