The seemingly endless supply of interest in real estate investments struck an opportunistic chord with the creative forces in the structured-finance market, resulting in a brand new CDO that taps REITs. Small and mid-sized REITs, which generally have trouble accessing the capital markets due to cost concerns, were able to raise funding through a new structure in the CDO market.

The recently issued Taberna Preferred Funding I is a $790 million CDO that caused a stir among institutional investors, some of whom are not even typical CDO investors. Merrill Lynch was the sole lead manger on the CDO.

"Small companies, even though many are excellent credit quality, generally have trouble accessing the capital markets because they're small," said Merrill Lynch Managing Director Chris Ricciardi. "Fixed issuance costs are high and you don't get as much interest from investors if you have a small offering."

Taberna Preferred is a cash-flow CDO that has issued 10 investment-grade tranches rated by Fitch Ratings and Standard & Poor's. Market sources said its $371 million triple-A rated A1 tranche, with an 8.3-year average life, priced at a Libor plus 47.

Other sources familiar with the CDO explained the pool of about 20 REITs tied to the deal had market caps between $150 million to $1.5 billion. The CDO gave investors another way to invest in a slightly different portfolio of companies in the REIT space that investors generally do not have exposure to and capitalized on high interest in the real estate sector.

The collateral backing the bonds issued by the CDO are trust preferred securities, or TruPS. While TruPS are mostly associated with smaller-sized banks and insurance companies and TruPS issued by banks and insurers have been harnessed as collateral for the CDO market since 2000. But the Taberna CDO is not only the first CDO of its kind, but it marks the first expansion of the TruPs security into the REIT sector Garnering tax preferential treatments, TruPS are created when a company creates a trust and issues debt to the new entity, in this case, the CDO.

Michael I. Wirth, CFO of REIT New York Mortgage Trust, noted in a recent release that participating in the Taberna vehicle helped his firm further diversify its capital structure and raised $25 million that will go towards continued investments in the real estate sector. New York Mortgage Trust owns and manages a leveraged portfolio of residential mortgage securities and a mortgage origination business.

About half of the REITs that participated in the CDO derived from the mortgage REIT sector, a newer branch of the REIT industry, and were coupled with TruPS issued by traditional equity REITs, as well as real estate operating companies. About 3% of the CDO was comprised of CMBS collateral, sources added.

While the deal is exposed entirely to the real-estate sector, analysts at Fitch Ratings stated that the mix of types of companies within the REIT sector helped decrease risks.

"Diversity is always very important in a CDO. And whether you have all equity REITs or all mortgage REITs, there is still some diversity," said Emari Kotake, an associate director in the Credit Products group at Fitch. Fitch's VECTOR model and default and recovery assumptions account for industry concentration in a portfolio's assets," Kotake added.

REITs are diverse by the sectors in which they focus - retail, storage facilities, hotels - as well as specific regional areas and states. Furthermore, much like banks and insurance companies, there is a plethora of historical data on the industry, said Matt Gallino, a director in Fitch's REIT group.

"There have been very few defaults in the REIT universe as a whole," said Gallino, noting growth in REITs. For instance, mortgage REITs have expanded the industry to about $24 billion in market capitalization, up from about $6.5 billion in 2002.

It appears likely that more REITs of the middle market variety be able to tap the structured finance market as sources report more deals are expected this year. Sources note, however, that putting together a deal that taps 25 companies takes some time to cull together. And the stability of the TruPS-backed model in general is likely to add more fuel.

Of the 55 TruPS-backed CDOs rated by Fitch to date, none have been downgraded and two have been upgraded since they were issued. Since 2000, Fitch has rated approximately $25 billion in bank TruPS, insurance TruPS and bank/insurance hybrid TruPS.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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