Expect even more actively managed CRE CLOs to be issued this year as investors get more comfortable with the idea of managers using proceeds from the repayment of collateral to acquire new bridge loan.
Kunal Singh, a managing director at J.P. Morgan, notes that the volume of actively managed commercial real estate collateralized loan obligations exceeded the volume of static deals issued last year; he expects the proportion of actively managed deals to be even higher this year, perhaps as high as 75%.
Unlike longer term commercial real estate loans, bridge loans can be repaid early. And when one of the loans in a CRE CLO prepays, the economics of the deal quickly deteriorate unless the manager can replace it.
"The reason that actively managed CRE CLOs have gained popularity with managers is that it is a true replica of a balance sheet repo," Singh said at a panel at the Structured Finance Industry Group's annual conference in Las Vegas. "When a loan pays off" in a repo, "I don't reduce the advance rate" — the amount that can be borrowed against — "on the remaining loans," he said.
Similarly, if a large loan in a CRE CLO pays off early in the life of the deal, reducing the amount of interest earned each month, there may not be enough funds to pay the CRE CLO note holders and all of the other fixed costs associated with the deal, many of which are "front-loaded," occurring early in the life of the deal.
While static CRE CLOs are similar in many ways to CMBS, actively managed deals "take a while to be understood and accepted" by investors, according to Steven Kolyer, a partner at Sidley Austin and another panelist. They have various features designed to offset the risk that the composition of the pool will change over time, potentially resulting in a deterioration in credit metrics. For example, any new asset that is purchased is subject to numerous criteria.
In addition, any assets purchased after the close of a deal is subject confirmation by a rating agency that it is still comfortable rating the deal. Daniel Chambers, a managing director at Fitch Ratings, said this means that Fitch must be comfortable that losses would be no worse than they would be without the new loan. If Fitch feels losses would be higher, it may not rerate the deal, though it is open to discussing other changes to the deal that could offset the risk of the new loan. "It’s a higher-touch asset,” he said.
Another investor-friendly feature, according to Singh, is a strong test for overcollateralization, or the amount of excess collateral in a deal. This gives a manager incentive to remove a troubled loan from the collateral pool, which means the loan is worked out on the manager's own balance sheet, rather than in the securitization trust. "We align the structure of a deal with interests of senior note holders," he said. "The triple A investor doesn't want to deal with that noise."
Legally, it's not possible to obligate a sponsor to repurchase a bad loan, since this could threaten the bankruptcy remoteness of a deal, according to Kolyer. "But the optionality is built in," he said.
