Commercial real estate exposure through CRE CLOs
admin | June 4, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Fixed income investors looking for exposure to commercial real estate have long invested in commercial mortgage-backed securities, or CMBS, but a new form of exposure has come into play in the last few years. Issuance of commercial real estate collateralized loan obligations, or CRE CLOs, reached $13.9 billion in 2018, up significantly from just a few years ago. CRE CLOs come with a different mix of loans, a different deal structure and generally wider spreads than CMBS, offering possible diversification or a better fit for some investment portfolios. In particular:
- The collateral is primarily comprised of 1- to 3-year, floating rate bridge loans on transitional assets. Many of the loans are extendible for up to two years and may include provisions for future funding commitments.
- Static and managed deals often include a ramp-up period of up to 6 months; managed deals include a reinvestment period typically from of 1- to 3-years, though some last for the life of the deal.
- Deal structures benefit from significantly more subordination at every rating level than is typical in conduit CMBS.
- Managers must satisfy extensive eligibility criteria when adding new assets to the pool.
CRE CLOs provide an important source of financing for transitional properties, particularly for those where the length of the transition may vary and where the CRE CLO sponsor may need to manage some elements of the loan portfolio. Transitional loans do not fit traditional CMBS, and banks can be subject to a 150% risk weight requirement for holding them on the balance sheet, compared to a 100% risk weight for CRE loans on stabilized properties. The closest securitized competition for multifamily properties may be from Freddie Mac’s value-add loan program.
Issuance and investors
CRE CLO issuance more than doubled from 2017 to 2018, from less than $7 billion in 2017 to nearly $14 billion in 2018. That increase was driven by several factors:
- Investor preference for short-duration floating rate notes during a time when the Fed was increasing interest rates, leading yields to rise and the yield curve to flatten.
- A hunt by investors for higher yields and an appetite for somewhat riskier collateral, when commercial real estate spreads in CMBS remained tight.
- REITs offering a competitive cost of financing compared to bank warehouse facilities or other traditional lenders.
Issuance in 2019 is projected to meet or surpass that from 2018. Average deal size is trending a bit higher at $680 million in 2019 versus $589 million in 2018 and $472 million in 2017, based on deals rated by Kroll Bond Rating Agency (KBRA). Sponsors are showing a strong preference for managed as opposed to static deals. Since the latter half of 2018, more deals include ramp-up periods frequently up to 180 days, with a relatively larger percentages of collateral – in some cases 25 – 30% – to be added during the ramp.
CRE CLO investors tend to span the spectrum, but are heavily weighted towards real money managers. Insurance companies, banks, and pension funds prefer the shorter duration, AAA-rated notes. Less credit restricted asset managers will often buy the lower AA and A rated pieces and hedge funds prefer the higher yielding BBB paper which can often be attractively financed in the repo market.
The loans underlying CRE CLOs
CRE CLO vehicles are primarily collateralized by non-recourse, first lien, whole mortgage loans on transitional assets. Transitional assets require varying amounts of redevelopment or renovation before the property is considered stabilized and the borrower can get long-term financing. Bridge loans are not considered permanent financing by lenders or by regulators. Borrowers are expected to repay the loans when renovations are complete and the stabilized property is either sold or the loan refinanced into a long-term loan with a traditional lender. By nature these higher-risk, higher-interest rate loans require specialized lenders with sophisticated backgrounds in transitional commercial real estate. Development projects often require flexible terms, provisions for future funding commitments, careful monitoring of business plans and the ability for lenders to work out issues with assets or make modifications prior to the loans going into special servicing.
Transitional loans also often come with future funding commitments. These commitments are contractual obligations of the original lender to provide additional funds up to a specified amount, typically based on the successful completion of specific phases of the renovation, upon meeting various performance goals, or on a contingency basis to fund e.g. leasing costs. The future funding commitments are not obligations of the issuer and it is not required that future participations be added to the pool. However, the future funding commitments when made are pari passu participation interests in the original mortgage loan. Future funding commitments when made can increase the risk and potentially reduce the recovery rate, should the loan go into special servicing, require modification or enter foreclosure. If future funds are not advanced by the lender this may also increases the risk of the loan, if e.g. the funds were not advanced due to a failure by the sponsor to satisfy a loan requirement.
These future funding participations and funded companion participations are often added to the pool during the ramp-up or reinvestment period if there are sufficient funds available, the asset satisfies the eligibility criteria, the reinvestment criteria, and any other requirements as applicable regarding acquisition or disposition. The issuer is under no obligation to add these participations to the pool.
Risk assessment of transitional loans
The ability of the sponsor to successfully execute the business plan in order to achieve stabilization, and either refinance the loan at maturity or sell the property, is one of the primary risks in bridge loans. Lenders, rating agencies and investors typically conduct in-depth assessments of the property itself, the financial statements and accounts for the property, and the business plan of the sponsor for renovations, leasing and repositioning. The loans which include future funding commitments require a higher level of due diligence, and the transition process requires ongoing monitoring and frequent reassessment.
An example of the type of property and loan level assessment done by a rating agency when evaluating a deal is excerpted below, from a recent rating report published by DBRS on LoanCore 2019-CRE2. The deal was $1.057 billion on the cutoff date, with approximately $120.2 million of future funding commitments and $830.4 million of funded companion participations. The second largest loan in the deal is an $83.4 million loan for an office property, 183 Madison Avenue in New York, NY, with an $11.4 million future funding commitment. In addition to detailed analysis of the buildings financials, which is available in the report, the rating agency considers risks specific to the business plan itself and the experience of the sponsor. The following is from the section “DBRS Viewpoint” (page 20):
DBRS considers this loan to have moderate business plan risk. The total loan balance including future funding is 82.7% LTV based on the as-is appraised value and the DBRS DSCR is 0.87x, both indicating higher default risk. According to the sponsor, the prior owner did not focus on re-tenanting the property as leases rolled, resulting in an occupancy that is below market and below the property’s historical average. The sponsor’s business plan is to lease the property back up to its historical average occupancy of about 92.0%, in line with the submarket occupancy level as well as the average occupancy of the sponsor’s portfolio. The sponsor also believes that 119,000 sf rolling over the next five years at the property is paying below market rents ($62.43 psf on average versus 67.79 psf market rents) and presents an opportunity to mark-to-market and thus increase revenues. Finally, the sponsor intends to subdivide and repurpose the retail space, presently occupied by Domus Design Center, into smaller units and achieve significantly higher rents. The Domus Design Center lease expires in 2020 with a five-year extension option at 95% of fair market rent. Domus Design Center’s current rent of $33.47 psf is substantially below market making it unlikely that that the extension option would be exercised. However, if Domus Design Center does decide to extend its lease, it could affect the sponsor’s repositioning plans.
The loan has a total future funding component of $11.4 million, of which $6.1 million is budgeted for TI and LC costs for the lease-up of the office space. In addition, $2.5 million has been budgeted for a capital improvement program including $450,000 for the conversion of the retail space into multi-tenant use and $550,000 for Local Law 11 compliance. The sponsor intends to invest $405,000 on improving building common areas and amenities by adding bike storage on the ground floor and some common conference rooms and public work/play/meeting areas. Other major capital projects include replacing the roof lining and updating the service elevators.
The sponsor’s business plan hinges on its ability to re-lease and reposition the property. The property benefits from its high visibility and corner location as well as its landmarked status. Its tenant roster fits in with the general profile of the neighborhood and the sponsor should be able to attract other tenants in the design and fashion businesses. The sponsor has some experience in repositioning properties and has a portfolio of five assets in New York and two in both Philadelphia and New Jersey.
There is also an enhanced level of due diligence around loans on specific property types, such as student housing, as they often exhibit higher cash flow volatility than traditional multifamily properties.
Prepayment protections can include lockout periods, spread maintenance, and prepayment penalties. According to KBRA, 40% of underlying CRE CLO loans paid off within 2 years and 89% of loans securitized in CRE CLO transactions paid off in advance of their initial maturity, based on data since 2017.
CRE CLO asset pools can be geographically diverse, similar to those in conduit CMBS, though multifamily properties comprise on average 40% of collateral in 2018 vintage deals compared to 13% of non-agency CMBS (Exhibit 1). Retail properties are also less frequently securitized in CRE CLOs, making up on average only 10% of the collateral over the past five quarters compared to being 25% of collateral underlying CMBS.
Exhibit 1: Property type and geographical diversity of CRE CLOs vs CMBS
Differentiation between CRE CLOs and CMBS
CRE CLOs tend to offer higher spreads, much shorter duration, and provide greater subordination across equivalently rated tranches compared to conduit CMBS (Exhibit 2). The increased risks inherent in the bridge loans comprising CRE CLO collateral are apparent in the higher LTVs at origination, lower debt service coverage ratios while the properties are in transition, and the presence of future funding commitments attached to a majority of the loans.
Exhibit 2: Deal terms and subordination in CRE CLOs vs CMBS
Financing for commercial real estate comes from a variety of sources, but over 50% of it historically has come from US banks. New bank regulations recently implemented under Basel III categorize most of these in transition loans as High Volatility Commercial Real Estate (HVCRE). An HVCRE designation imposes a 150% risk weighting, compared to a 100% risk weighting for traditional commercial mortgage whole loans, and a 50% risk weighting for residential mortgage whole loans. Although banks may continue to be competitive in the bridge loan sector, it has become significantly more expensive from a capital perspective to hold them on the balance sheet.
The short-term nature, flexible financing requirements, and careful monitoring and servicing required of most bridge loans makes them unsuitable as collateral for standard CMBS securitization via a REMIC. A static pool of transitional loans can be financed via a CRE CLO vehicle using a REMIC, and Bancorp Bank does utilize them, but they are the exception to the rule. REMIC vehicles most commonly used in traditional CMBS securitizations impose significant restrictions on the composition of mortgage assets and the ability to replace assets after the closing date. REMIC status also prevents any material management of pool assets or modification of loans.
In contrast to CMBS REMIC securitizations, CLOs are driven by the need for flexibility. In a CLO, generally the institution that made the loan is the same one servicing it, unlike in CMBS. Because loans in a CLO can be restructured or extended, ongoing monitoring and management of the loans is required and adhering to the servicing standard is critical.
Closest comparison is Freddie Mac value-add loan securitizations
The closest comparison to CRE CLOs may be Freddie Mac’s securitization program for multifamily value-add loans. Freddie’s value-add loans are for experienced developers/operators who are rehabilitating multifamily property with upgrades in the range of $10,000 to $25,000 per unit. The targeted properties have no more than 500 total units, are in good locations, require modest repairs, and may benefit from new or improved management to bolster property performance.
The terms for value-add loans are similar to those of transitional loans underlying CRE CLOs: the loans are floating rate, interest only; no longer than three year maturities with options for up to two, one-year extensions; there are no lock-outs from prepayments but a 1% exit fee applies unless the loan is refinanced with Freddie Mac. The maximum loan-to-value (LTV) ratio is 85%, with a minimum debt service coverage (DSC) ratios of 1.10x – 1.15x depending on the market. Appraisals include both as-is and as-stabilized values, and underwriting must support a 1.30x DCR and 75% LTV based on the as-stabilized value.
Freddie securitizes the value-add loans into their K-I deals. The agency guarantee applies to the Class A securities only, as Class B, C and X are not guaranteed by Freddie Mac. The floating rate coupon on the Class A securities of a recent deal issued in October 2018, the FREMF KI03 A, was 1m Libor + 25 bp.
CRE CLO structure overview
CRE CLO asset pools can be static or managed, though sponsors are trending towards more managed deals. Structural features often include ramp-up periods that vary from 90- to 180-days, and managed deals contain reinvestment periods that typically last from 24- to 36-months, where the manager can reinvest any principal proceeds in new mortgage assets provided the assets and the pool satisfy a variety of predefined criteria. Managed deals offer additional spread to investors to compensate for the potential negative credit drift during the reinvestment period. This risk may be lower than that of corporate CLOs as there are strict eligibility criteria for the new asset, diversity requirements that the pool must meet, and note protection tests that the pool must be able to pass when the new collateral is added.
Sponsors typically take a 15-25% first loss position in the pool by retaining the speculative grade notes and all of the preferred shares/equity. The top of the capital structure is rated by Moody’s, and all investment grade through high yield tranches are rated by Kroll. Weighted average life at origination across a typical deal can vary from 1.5 years for the Aaa tranche to 5 to 7 years for the B- tranche, depending on borrower repayment and reinvestment timing, and exercise of optional extensions.
Ramp-up periods can be a feature of both static and managed deals. In recently issued deals ramp-up periods vary from 90- to 180-days. Both static and managed deals can have ramp-up periods. For managed deals the assets acquired during the ramp-up period may or may not need to be pre-identified as of the closing date. Static deals require that any assets added during the ramp are pre-identified at closing. The percentage of the principal balance of the pool that is to be added during the ramp-up period also varies widely by deal – with some deals that have ramp-up periods adding as little as 3% of total collateral, and others adding as much as 20% of total collateral during the ramp. Assets added during the ramp-up period have to satisfy the eligibility criteria outlined in the offering documents.
Managed deals include defined reinvestment periods, where proceeds from principal payments can be reinvested in new assets. The reinvestment periods typically range from 1- to 3-years, though some can last for the life of the deal.
There is a substantial amount of variability across deals as to what assets can be added during the reinvestment period. Similar to the restrictions during the ramp-up period, static deals only allow pre-identified assets to be added during reinvestment. These will frequently consist of future funding participations and companion participations of loans already in the pool. It has become more common in recent deals for managers to have the flexibility to add assets that have not been identified by the closing date. The assets added during the reinvestment period are still required to satisfy the eligibility criteria.
Eligibility criteria for adding assets to CRE CLO tends to be detailed, extensive and deal specific. Broadly speaking, the eligibility criteria for adding new assets during ramp-up or reinvestment can include, but are not limited to:
- Limits on the amount of each property type that is allowed to be in the pool.
- Geographic concentration limits by state.
- Loan size limits and dispersion index minimums.
- LTV maximums and DSC ratio minimums.
- Maintaining a minimum weighted average spread to 1-month Libor, a maximum weighted average life of all loans, and limiting the maximum term of a loan extension.
- Confirmation from rating agencies that the addition of the loan will not cause a downgrade of any of the notes.
There is also an entire suite of legal and definitional criteria that the loan must meet to be eligible for inclusion. For an exhaustive list please consult the offering documents for each deal.
Note protection tests and mandatory redemptions
There are various circumstances under which the CRE CLO notes can typically be redeemed or called. Although these may vary somewhat in their particulars, deals commonly include both a mandatory redemption trigger and a clean-up call.
A mandatory redemption will occur when any note protection test outlined in the offering documents is not satisfied. The note protection tests are evaluated on all measurement dates. Measurement dates include the closing date, on the date of acquisition or disposition of any mortgage asset, prior to each payment date, on any date when a mortgage asset goes into default, and on any date at the request of the rating agencies or two-thirds of the holders of any class of notes.
The note protection test(s) include a test for overcollateralization of the offered notes in the form of a minimum par value ratio. The par value ratio is generally calculated as the net outstanding portfolio balance divided by the sum of the aggregate outstanding amount of the offered notes. Minimum par value ratios vary considerably across deals, but fall roughly in the range of 115% – 135%.
Additional note protection tests can include a minimum interest coverage ratio. A little more than half of currently outstanding CRE CLOs include a minimum interest coverage ratio as a note protection test. The interest coverage ratio is roughly defined as the expected scheduled interest income of the mortgage assets and eligible investments, divided by the expected interest payable on the offered notes. Like the par value ratio, the interest coverage ratio is evaluated on all measurement dates. The minimum interest coverage ratio in deals where one is defined is usually 120% or 1.20x.
If either the calculated par value or interest coverage ratio falls below the minimum on any measurement date, on the following payment date interest proceeds are used – in accordance with the priority of payments – to pay down or redeem the principal on the offered notes until the relevant note protection test can be passed.
The deals are typically subject to clean-up calls, where the entire deal can be called when e.g. the outstanding principal balance is 10% or less of the original aggregate outstanding amount. Given the extensive level of subordination in CRE CLOs, by the time a clean-up call is executed all of the investment grade notes or offered notes will likely no longer be outstanding.
A note on ratings
Virtually all CRE CLOs have the Class A notes rated by Moody’s, and most have the Class A and subordinate classes rated by KBRA or DBRS. The investment grade rated notes are offered for sale; those rated below investment grade and the preferred shares (which are not rated) are infrequently offered. An example of a typical CRE CLO deal structure is shown in Exhibit 3.
Exhibit 3: Example CRE CLO deal structure
The methodologies, models and criteria used by the various ratings agencies to evaluate collateral, deal structure and assign ratings is extensively detailed in documents available on each ratings agency’s website. For example, the documents that review KBRA’s methodology and models for rating securitizations of pools of multiple loans secured by one or more commercial real estate properties can be found here. Ratings criteria, property evaluation methodology, scenario analysis, default probabilities, loss severities, and required credit enhancement / subordination thresholds may vary by rating agency.
Broadly speaking, ratings are assigned to each class of securities based upon an assessment of the probability that the mortgage assets will provide sufficient funds to pay the notes, and the amount of stress each rating class should be able to withstand before incurring losses. The probability assessments are primarily based on statistical analysis of historical default rates, loss given default, diversity of the pool across property type and geography, and the asset and interest coverage required for such notes.
The ratings agencies undertake detailed evaluations of current and stabilized property values, net cash flows, occupancy and rent rates, and a variety of other loan-level characteristics that determine the credit quality of the mortgage assets. The aggregated pool is then evaluated given the structural and legal aspects of the deal, the thickness of the classes of securities being rated, and the extent to which the expected cash flows are adequate to make the payments required under a variety of stress scenarios.
A securities rating does not assess the yield to maturity that investors may experience and, in general, the ratings address credit risk and not prepayment risk. A rating is generally indifferent to the likelihood or frequency of voluntary prepayments, prepayment premiums, spread maintenance, or yield maintenance charges.
CRE CLOs provide investors commercial real estate exposure to transitional assets. Lending on properties undergoing significant renovation is migrating away from banks due to the increased capital charge associated with these so-designated high volatility commercial real estate loans. Bridge loan collateral is generally ill-suited for conduit CMBS securitization due to the strict constraints on modifications or replacement of mortgage assets in REMIC vehicles. The closest competitor is Freddie Mac has a securitization channel for value-add loans on multifamily properties. By comparison CRE CLOs provide steadier issuance across a larger number of deals, greater diversity of property types, increased spread, and the ability to invest across the investment grade ratings stack. Commercial real estate investors can diversify portfolios by including CRE CLO exposures that are shorter-duration, floating-rate notes, offering wider spreads and higher levels of subordination than typical CMBS.