Though still a drop in the bucket relative to the overall CDO market, interest in commercial real estate-backed deals has picked up to the point that mezzanine lenders are now getting into the act. RAIT Investment Trust, a mortgage REIT formed in 1998 that specializes in small mezzanine loans, plans to issue its first CDO sometime next quarter. Should that go well, it aims to issue another before the end of the year.
"The commercial real estate CDO market is growing tremendously, and issuance this year will be much higher than [the $20 billion] we saw last year," said Darrell Wheeler, global head of CMBS strategy at Citigroup Global Markets.
Its strong credit history and stable spreads make CMBS collateral attractive to CDO investors. Small commercial mortgage mezzanine loans are a different animal, however, though no one knows that game much better than Betsy Cohen, RAIT's founder and CEO. She has more than 30 years of real estate and banking experience, and was among the earliest movers in offering mezzanine commercial real estate financing. In recent years, however, a number of new competitors have entered the market.
"Mezzanine financing has gone through a metamorphosis," said Cohen. "Frankly, it was something considered relatively exotic when we started."
RAIT makes subordinated real estate loans - mezzanine and bridge loans - to borrowers whose financing requirements are not being met by traditional lenders. It focuses on small loans, typically $4-6 million, while its bridge loans normally range as high as $30 million. The company focuses on multifamily, residential, office, retail and other commercial properties.
The recent influx of willing lenders that has dipped into the mezzanine market has driven spreads tighter, and as a result, REITs such as RAIT have had to shift gears. "To capture an acceptable return on equity, you have to employ a little more leverage," said Christopher Faems, a REIT analyst at Flagstone Securities. "A big part of that decision lies in the fact that spreads on commercial real estate loans have come in. It's a little nerve racking for REITs to do those loans at lower spreads as they're not earning the risk adjusted return they once were."
Indeed, RAIT primarily funded by issuing common and preferred equity while carrying a minimal amount of leverage on its balance sheet until late last year, when it obtained a $350 million unsecured line of credit from a group of lenders led by Key Bank. It aims to achieve a debt-to-equity ratio of 1-to-1 by the end of the year, up from 0.64 times in the fourth quarter of 2005.
A combination of the changed market climate as well as improved investor sentiment toward mezzanine financing appears to be behind RAIT's effort to diversify its funding sources, including its foray into the CDO market.
Details are still slim but RAIT's first CDO, being underwritten by the Bank of Montreal, will be a $150 million cash deal. The collateral will consist of mezzanine and bridge commercial real estate loans, all sourced from RAIT's portfolio, which totaled $715 million at the end of 2005. The loans in the collateral pool are expected to be between $1 million and $25 million and represent a broad geographic area. RAIT's loan portfolio is allocated along the following lines: Mid-Atlantic, 26%; Central 37%; Southeast 24%; West 9%, and Northeast 4%. RAIT will serve as the collateral manager for the CDO.
Because the company operates as a REIT, a CDO is a better option than securitizing its loans in a more traditional fashion. "It is challenging within the REIT framework to be involved in significant purchases and sales of assets," said John Kriz, a managing director in real estate finance at Moody's Investors Service. "As the CDO market has broadened and deepened, it provides an additional option for mortgage REITs, which are always looking for new ways to address funding and interest-rate risk."
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