Fall 2014 Volume 20 Number 3 www.iijsf.com The Voices of Influence | iijournals.com
Commercial Real Estate CLOs: Features That Make Them an Attractive Asset Class K IMBERLY E. D IAMOND kdiamond@lowenstein.com B y definition, a hybrid is something CURRENT LANDSCAPE FOR CMBS K IMBERLY E. D IAMOND is a counsel in the specialty that is formed by combining two LOAN ORIGINATIONS finance and lending and things of different kinds. A hybrid financial services practice In a CMBS securitization transaction, that contains the most favorable groups at Lowenstein San- CRE mortgage loans are pooled and serve as traits of its parents without the parents’ down- dler LLP in New York, the underlying transaction assets. 1 Debt secu- falls is something that is generally desirable. NY. rities collateralized by these assets are then In the structured finance and securitization issued from a trust created solely for that par- context, a new hybrid asset class known as ticular transaction. In 2007, at the height of commercial real estate (CRE) collateralized the market, the U.S. CMBS market saw more loan obligations (CLOs) is such a hybrid. A than $200 billion of CMBS issuance. 2 The CRE CLO manifests the most advantageous issuance amount fell to approximately $3 bil- characteristics of its progenitors—the com- lion in 2009 and has been steadily increasing mercial mortgage-backed securities (CMBS) over the last four years, with $86 billion in securitization transaction and the standard new CMBS issuance during 2013 and more CLO transaction—from both a structural and than approximately $20 billion in issuance collateral perspective. Moreover, CRE CLOs during first quarter 2014 (see Heschmeyer have adapted and independently evolved to [2012], citing statistics from the Pension accommodate the current landscape in terms Real Estate Association; see also, SL Capital of both providing a more resilient structure [2014a]). The CMBS market, consequently, that is attractive from a regulatory com- appears to be making a slow and steady pliance perspective and offering investors comeback. a new product that offers more yield than One reason for this stable growth in other structured products. For these reasons, CMBS issuance is because lenders are being the features of a CRE CLO may be attrac- more cautious than they were in 2007 and in tive from an investor’s perspective and may years prior with respect to the type of product also provide a private debt fund or mortgage that they are buying. Lending guidelines and REIT (real estate investment trust) with the underwriting standards with respect to the opportunity to become involved as a collat- commercial mortgage loans that are being eral originator, a collateral manager, and an financed are much more conservative than investor with respect to this segment of the they were in 2007 and earlier. Prudence market. C OMMERCIAL R EAL E STATE CLO S : F EATURES T HAT M AKE T HEM AN A TTRACTIVE A SSET C LASS F ALL 2014
and increased due diligence prevails in the marketplace maturities, with CMBS issuance expected to increase now, as lenders are more thoroughly scrutinizing the to $100 billion in 2015 (Borchersen-Keto [2013]). The geographical markets in which commercial real estate bad news, however, is that approximately one-third of properties are located before making loans on such prop- these legacy maturities that are CRE balloon loans will erties (McIntyre [2014]). Also, lenders are more closely be looking for shorter-term financing so that they can examining data, such as average rents from the markets be refinanced into a more stabilized product. To do this in which these properties are located, before approving successfully, borrowers will need access to capital. Refi- loans on such properties (McIntyre [2014]). It is poten- nancing these loans into new financing structures, such tially this heightened scrutiny and lender cautiousness as CRE CLOs, will present appealing opportunities for that has caused there to be a historically low supply of lenders. As further discussed in the following section, commercial real estate loans at this juncture. an attractive option for legacy maturity CRE mortgage loans is to refinance into either a combination of senior and mezzanine debt or to refinance into floating rate GETTING OVER THE CMBS MATURITY debt that is shorter-term in nature than typical CRE WAVE/MATURITY WALL loans—something a CRE CLO offers. Thereafter, with The commercial mortgage “maturity wave” or such an option, the ultimate take-out is in the form of “maturity wall,” also called CMBS refinancing risk or a fixed-rate loan used to collateralize a CMBS transac- balloon risk (Sober Look [2009]), refers to the more tion, an insurance company loan, or a bank balance sheet than $1 trillion in CRE mortgage loans constituting the financing. underlying collateral in CMBS securitizations of vintages from 5 to 10 years ago that are going to be coming due in WHAT IS UNIQUE ABOUT CRE CLO 2015–2017 (the legacy maturities) (SL Capital [2014b]). TRANSACTIONS AND WHY USE THEM Specifically, a number of CRE mortgage loans in these Structural Attractiveness securitizations have anticipated repayment dates (ARD loans) that will occur in the next three years. An ARD As noted earlier, a CRE CLO is a hybrid between a loan is unlike a typical balloon CRE loan insofar as non- CMBS securitization transaction and a CLO transaction. repayment of the balance of an ARD loan will not con- There are a number of structural features that make a stitute an event of default; rather, the borrower will be CRE CLO enticing. forced to have a higher interest rate and higher principal First, the underlying collateral is appealing. The payments to accelerate the loan’s amortization (see Sober constitution of today’s CRE CLO collateral is quite dif- Look [2009]). Moreover, a significant and substantially ferent from the collateral underlying CMBS transac- large number of non-ARD loans, or standard balloon tions and pre-financial crisis CRE collateralized debt loans, also have maturity dates during the next three obligation (CDO) transactions. CMBS transactions of years. At maturity for a standard CRE balloon loan, 2007 and earlier vintages often possessed “split loans” there are two options if payment cannot be made: 1) or “companion loans,” wherein a piece of a very large refinance the CRE mortgage loan or 2) sell the commer- CRE mortgage whole loan, which generally was one cial real estate property to which such loan is tied (Sober of the top 10 largest mortgage loans in the collateral Look [2009]). It is estimated that the legacy maturi- pool for a particular transaction, was split into a number ties will take time to work out, while simultaneously of different pieces, some or all of which were placed exerting downward pressure on certain U.S. commercial into other separate CMBS transactions. For instance, property markets (Sober Look [2012]). The good news in a large CRE mortgage loan that is split into five is that declining delinquency rates and a steady rise in pieces, the original CRE mortgage whole loan piece CMBS issuance are evidence that the capital markets are could be placed in one CMBS transaction while its four better positioned currently than in years past to handle other companion loans could be placed into four other these legacy maturities (Gordon [2013]). According to CMBS transactions. Notably, CMBS securitizations a semi-annual forecast from Ernst and Young and the have a REMIC/static trust structure, 3 which means that Urban Land Institute, the amount of CMBS issuance is assets in the collateral pool cannot be substituted. As a predicted to continue to climb as a result of these legacy T HE J OURNAL OF S TRUCTURED F INANCE F ALL 2014
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