The much-maligned collateralized debt obligation (CDO) appears to be set to play a crucial role in the refinancing of maturing commercial mortgages and the recapitalization of the recovering commercial real estate (CRE) market. Only no one is calling these deals CDOs.

CRE values have made an unexpected, yet uneven, comeback from the depths of the recession, leaving many property owners still owing too much to hold on to their shopping malls, office buildings, hotels and industrial buildings--unless new capital is introduced.

The Moody’s/RCA Commercial Property Price Index (CPPI) for October—the most recent available before ASR went to press—shows prices overall have climbed 27.7% since the November 2009 trough, but they remain 22.4% below the December 2007 peak.

Boston is the market that is closest to regaining its peak, at 1% below that level, according to the September report, with Washington, D.C., and New York are off by 5.7% and 7.5%, respectively. Los Angeles and Chicago lag, at 22.9% and 18% below their peaks, and many less-than-major markets are still struggling. (A geographical breakdown of the October data was not available as ASR went to press.)

As these loans mature, borrowers can’t rely on traditional first-lien lenders to refinance all of their debt. They either have to pay it down, bringing loan-to-value (LTV) ratios back to a level that banks are comfortable with, or obtain some kind of “rescue” financing, a catch-all term for mezzanines or other debt with equity-like characteristics, to combine with a smaller first-lien mortgage.

Rescue financings are initiated in a variety of ways. Banks may contact providers of mezzanine or other equity-like securities to play a roll in a recapitalization, or vice versa. Or the property owners themselves may instigate the transactions. Given the high property values at which CRE owners locked in financing before the financial crisis, an ever increasing and potentially vast flow of rescue or “gap” financing is likely in the offing.

“There’s likely a three-to-five year window of these transactions to come; we’re seeing the leading edge of CRE recapitalization,” said Tad Philipp, director of CRE research at Moody’s Investors Service.
Such financings may be necessary, if, for example, a $70 loan is made against a $100 property, the property’s value falls by 20%, and its LTV increases to 87.5%. If the first-lien lender requires an LTV of 70%, then the lender will only provide $56 million in debt, and to refinance the property a $14 million gap must be filled. Mezzanine and other equity-like securities can fill that gap.

Rescue capital must be financed, however, and that’s where securitization appears likely to play a vital role. Philipp pointed to $170 million and $87.5 million securitizations respectively completed recently by Redwood Trust and Arbor Realty Trust as early templates for the types of financing vehicles that are almost certain to play a key part in the recapitalization of the CRE market. Other providers of rescue capital said to be considering similar deals include H/2 Capital Partners, Prime Capital Advisers, Blackrock, and MFS Investment Management.

The Redwood and Arbor deals were marketed not as CDOs but as commercial real estate collateralized loan obligations (CRE CLOs). A CLO is a kind of CDO, and the term “CLO” can describe deals backed by corporate loans with a senior claim on an operating company’s assets. In the CRE market, however, the CLO structure has typically been used to securitize loans with a subordinated claim on a property, such as mezzanine and preferred equity. By comparison, commercial mortgage-backed securities (CMBS) have mostly pooled first-lien loans.

Market participants are careful to avoid using the broader “CDO” term, which in the past has included transactions backed by much dicier collateral. Philipp noted that the performance of CRE CLOs was superior to that of other types of CDOs during the crisis.

David Rodgers, principal at Park Bridge Financial, which advises on CRE lending issues, said that the CMBS deal structure is more efficient at securitizing standard, fixed-rate mortgages, whereas the CLO structure is much more flexible, allowing a wider variety of securities, such as mezzanine and B-notes, to be included in the pool of collateral. “If you have higher risk loans or more transitional floating-rate loans, then you can use CLO technology to finance these positions,” Rodgers said.

“These CLOs are riskier investments. You have to be real estate investor looking very closely at these loans,” he said.

Park Bridge specializes in this type of due diligence. Rodgers said that on future CLO transactions the firm plans to compete for assignments as the operating adviser, which oversees the activities of the special servicer and in some cases issues quarterly reports updating investors about the status of each loan in the pool.

Another reason for using a CLO structure, according to Manus Clancy, a senior managing director at Trepp, which provides CMBS and commercial mortgage information, analytics, and technology, is that CLOs have historically provided the manager with some discretion in moving assets in and out, whereas CMBS deals are static.

In addition, he said, CLOs in the past have been “partially dark,” allowing managers to raise $500 million when only having $400 million committed on day one. “Meaning they’re out there looking for loans even on day one,” Clancy said, noting CMBS deals are done on a conduit basis and the assets tend to be much more homogenous.

At this juncture, the re-emergence of CRE CLOs is a boon for property owners whose loans are running up against their maturities.

“The CRE industry would be in trouble if it didn’t have the assistance of the securitization world, which is a massive source of liquidity—not just in the mezzanine space but in the primary mortgage space as well,” said Dan Fasulo, managing director and head of research for Real Capital Analytics.

And investors are clearly interested in the premium CRE bonds provide. The volume of the CMBS market, which typically securitizes primary, first-lien mortgages, was anticipated early in the year to reach $30 billion in 2012, although the volume touched on $50 billion as year-end approached. Market observers see 2013 volume reaching as high as $70 billion, up from earlier forecasts of $45 billion.

Both the Arbor and Redwood offerings were oversubscribed.

Unlike CMBS conduits, CRE CLOs can include a wide variety of assets, including pieces of other securitizations, and the junior debt typically purchased by CRE CLO managers is not for the faint-hearted. Financiers such as hedge fund manager Bill Ackman have bought mezzanine debt at steep discounts with the intent of using it to gain control of a property. Because mezzanine loans are secured by a subordinated interest in the property or a preferred interest in the entity that owns the property, if the first-lien borrower defaults on the loan, the mezzanine provider can step in to take over the property by paying off the mortgage. Otherwise, it will see its position wiped out.

Ultimately, Ackman failed in his attempt to wrest control in 2010 of Stuyvesant Town after purchasing $45 million of its steeply discounted mezzanine debt. The junior debt appeared likely to be wiped out as the property approached bankruptcy, when senior lenders stepped in to purchase the debt from him.
The assets that CLOs purchase are likely to become riskier as the lending cycle heats up. For now, however, they comprise mostly newly originated junior debt, and the intent of companies such as Redwood and Arbor is much more straightforward: achieving higher yields.

Mike McMahon, a managing director at Redwood, said the Mill Valley, CA-headquartered real estate investment trust (REIT) had made approximately $290 million in mezzanine-type loans that were sitting on its balance sheet. Seeking additional financing, it decided to split the debt into a $170 million senior tranche to sell to investors while keeping a $120 million junior tranche on its books.

The large subordinated portion prompted Moody’s and Kroll Bond Rating Agency to give the senior bonds investment-grade ratings of Baa3 and BBB-minus, respectively. McMahon said the underlying mortgage loans yielded roughly 10% on average, and the senior bonds priced for a coupon of 5.62%.

“That increased the yield on the junior bonds to north of 13%,” McMahon said, adding that there were “half a dozen institutional money managers in the deal.”

McMahon also said that most, if not all, of the loans in the securitization were made in conjunction with a senior lender, such as a bank, insurance company or CMBS lender. “Those lenders generally made the 65% LTV loan, while we made the next approximately 10% in the form of a mezz loan, and the borrower put in 25%,” McMahon said. “The plan was to get some permanent, structured financing on our portfolio [of loans], so we could increase the return on our retained piece.”

The CLO also provides an attractive source of financing to Redwood. Steven DeLaney, director of special finance research at JMP Securities, said in a Nov. 29 client note that the deal’s leverage of 1.5 times enables Redwood’s commercial mortgage subsidiary to originate a CRE loan portfolio as big as $750 million, comprising $300 million in equity and $450 million in senior financing.

“With a huge CRE loan refinancing pipeline of over $1.5 trillion over the next five years, Redwood should have plenty of opportunities for additional middle market CRE lending where loan yields have held up much better than in other debt or fixed-income markets,” DeLaney wrote.

He added that Redwood’s all-in funding costs will likely be more than 6% when issuance costs are included, but it should still earn a net interest spread of about 3% on the levered portion of the portfolio.
“[Redwood] will receive fresh cash to continue to grow and diversify its CRE portfolio and will boost the return on equity through the application of modest leverage,” DeLaney said.

UBS Securities led the transaction and Wells Fargo Securities acted as co-manager. The private placement was secured by a portfolio of 30 collateral interests tied to 76 underlying properties comprising multifamily, office, hospitality, retail, self-storage, and mixed-use properties.

The Arbor deal, split into a $87.5 million senior portion sold to investors and a $37.5 million equity portion retained by the REIT, comprises 18 whole loans and A-notes on multifamily properties. Placed by Sandler O’Neill, the notes priced at 339 basis points over one-month LIBOR, excluding fees and transaction costs, and for two years the deal allows the principal proceeds from repayments of the collateral assets to be reinvested in qualifying replacement assets.

The Arbor offering didn’t securitize loans defined as mezzanine. However, said Philipp, from Moody’s perspective a portion of the securitized loans carried LTV ratios above the level that typically marks straightforward debt. He added that some transactions are more clear cut because there is a loan carrying a 70% LTV, and the next 10% is a mezzanine position.

That distinction does not exist in Arbor’s transaction, but when securities exceed an LTV of 70% they begin to exhibit equity-like characteristics, and the loans in the REIT’s securitization fit that mold. “Some rescue or gap loans are leveraged enough where a portion appears to be crossing into the equity zone—they’re not technically equity, but they’re beginning to get to that area in terms of risk,” Philipp said.

Another benefit of CLO funding is that traditional lenders such as banks are typically unwilling to fund debt securities with LTVs higher than 70%, and if they do the restrictions tend to be significant. In addition, those lenders will likely want recourse to the property.

“CLO technology allows you to fund at close to the same amount of leverage—maybe not quite as much—but the costs may be less, and it’s non-recourse,” said Rodgers. He added that because the issuer holds on to the junior portion of the deal and absorbs first losses, “the sequential structure allows bondholders to choose lower leverage over recourse.”

In addition, financing from banks may carry a different term than the CRE CLO’s underlying loans, so that if rates jump there may be a mismatch between those loans’ cash flow and the financing rate. “One of the reasons portfolio lenders like CRE CLOs is they lock in matched-term financing. If the weighted average life of their loans is three years, the weighted average life of their securities issuance is also three years,” Philipp said. “So for lenders who are looking to finance their portfolio, it takes a lot of capital markets risk off the table.”

Investors are heavily protected in the Redwood and Arbor offerings, but the deals nevertheless represent a  willingness to consider more complicated and potentially riskier deals as today’s low rates push them in search of yield.

Clancy noted CMBS spreads have rallied furiously since June and benchmark rates remain at historical lows, allowing issuers to save hundreds of basis points even at the triple-A level.

“That forgives a lot of sins,” Clancy said, adding that market participants assumed that many of the loans done in 2006 and 2007 would never be refinanced and would have to be worked out in bankruptcy. Now, property values have rebounded for many marginal properties and are nearly in the black, making refinancing—especially with the help of mezzanine lenders—a real possibility.

“With rates so low, borrowers who were on the ropes before are much more willing to say, ‘Let me stay in this deal and try to recapitalize the property,’ as opposed to two or three years ago when they were ready to turn in the keys or have the property foreclosed on,” Clancy said.

The other trend, he said, is that CRE investors are becoming more confident and willing to move beyond the “class A trophy properties in the 24-hour cities—even a bit ‘frisky’.” Clancy pointed to a recent $27.3 million, 10-year CRE loan made to Detroit’s One Kennedy Square that priced at 5.15%.

CRE-CLOs aren’t the only example of deals in which investors are expanding into more complex and potentially riskier terrain. Goldman Sachs recently completed a CMBS deal securitizing cash flows stemming mostly from billboard licenses in Times Square, and a few months ago J.P. Morgan completed the first of a couple of deals securitizing nonperforming commercial  loans—not seen since before the financial crisis.
Rodgers said it’s “only a matter of time before we see B-piece re-REMICs,” or deals securitizing the most subordinate tranches of other CMBS deals, another type of CDO.

Philipp acknowledged that B-piece securitizations may arrive at some point, given B-piece investors must also finance themselves. When those buyers pursued b piece securitizations that were highly leveraged prior to the market collapse, “that was viewed by most market participants as the beginning of the end, when the risk buyers cashed out,” Philipp said. He added that should b piece securitizations return, they will have to be very conservatively structured and will offer low advance rates due low recovery assumptions.
“We’re 90% back to the playbook of peak of market–not in terms of credit quality deterioration but rather the types of deals being done,” Philipp said. 

Indications of a frothy CRE market, including higher LTVs and debt service coverage ratios, and pro forma loans that essentially speculate on future cash flows, have yet to emerge in any meaningful way. “We’re nowhere near the LTV levels done in 2006 and 2007, when A notes were done at 80% and B notes and mezzanine took you up to 98%, leaving 2% equity in the deals,” Clancy said.

Rather, the recent CRE market collapse appears to still be weighing heavily on credit decisions by investors and especially the rating agencies, keeping deal terms and structures conservative.

Nevertheless, spreads on CRE-related paper still provide a premium over alternatives, prompting investors to snap up the bonds. “Between tightening spreads and the current Treasury curve, and improved confidence in CRE, it’s just a perfect storm for borrowers right now,” Clancy said.

Of course, nothing remains perfect forever, and the anticipated recapitalization of the CRE market, fueled in large part by securitization, could quickly come to an end. The well-known array of macro events that could lead to the United States re-entering a recessionary environment, ranging from the U.S. government’s so-called fiscal cliff to economic and financial difficulties overseas, could also derail the CRE market recovery. Should prices drop again, pushing LTVs higher, mezzanine lenders are likely to bow out of the market, along with any CLOs they may have been planning.

Even if the macro environment remains benign, the Dodd-Frank Act, the final rules of which regulators are still hammering out, may deliver a potentially crippling blow to the securitization market. The financial reform law requires issuers to retain at least a portion of their securitizations, to maintain some so-called “skin in the game,” and regulators currently are proposing to set that risk retention level at 5%.

Unsurprisingly, many securitization market participants view the proposal as excessively harsh and potentially counterproductive. Its premium capture cash reserve account (PCCRA) requirement, for example, essentially impounds any premiums above par that are received by the issuer, locking up that cash for the life of the security and putting it in a first-loss position. That could greatly degrade the economics that are currently prompting issuers to pursue CRE securitizations, according a July 2011 letter that the CRE Financial Council submitted to regulators.

The CRE Financial Council would like to see the PCCRA requirement eliminated, but it seeks common ground between current industry practice and most of the proposal’s provisions, such as allowing flexibility in applying the proposal’s 5% risk retention requirement.

“Failure to achieve a balanced and workable set of risk retention rules could be counterproductive and significantly restrict the overall amount of capital that is available in the CRE finance market, leading to increased costs for CRE borrowers and, ultimately, damage to economic and job growth,” the comment letter says.

Marty Schuh, director of legislation and regulatory policy at the council, said that Mary Schapiro’s resignation from the Securities and Exchange Commission chairmanship in December has left the commission deadlocked.

“It’s unlikely we’ll see anything from them until the tie can be broken,” Schuh said, adding, “I think we’re really months, not weeks, away” from a final ruling.

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