By the Numbers
A primer on CRE CLO loan modifications
Mary Beth Fisher, PhD | May 12, 2023
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.
One of the hallmarks of commercial real estate collateralized loan obligations (CRE CLO) is the flexibility collateral managers have to manage the underlying pool of loans. Managers can extend, modify, remove or exchange loans through much of the life of the security. Even static deals inherit some of the flexible features of CRE CLO structures that allows issuers to protect deal performance when loans default. Unfortunately, data disclosure rules have made tracking the use of such features difficult at best, obscuring important facets of performance. CREFC’s new CRE CLO disclosure rules are an important first step in improving transparency.
A new securitization vehicle for transitional loans
The modern era of CRE CLO issuance began in about 2013 (Exhibit 1). Revived as a niche product for transitional lending, CRE CLO issuance grew slowly, then exploded during the pandemic as historically low interest rates superheated commercial real estate sales, resulting in dramatic price appreciation across many property types. The ultra-low interest rates encouraged developers willing to take on relatively riskier lease-up, rehabilitation and renovation projects, and lenders found an efficient financing channel through securitization markets.
Exhibit 1: CRE CLO issuance
Legal structure of CMBS mandates static pools, allows few modifications
Most mortgage-backed securities use a real estate mortgage investment conduit, or REMIC, tax structure. The REMIC structure and the pooling and servicing agreements both restrict CMBS from most loan modifications, substitutions or replacements. An excellent overview of these limitations is outlined in a recent Fed paper, Loan Modifications and the Commercial Real Estate Market (Appendix A). In brief, paraphrased from Appendix A, pages 50-51:
- REMICs are exempt from federal income taxes.
- Qualified mortgages must be transferred to the REMIC on its start-up day.
- The REMIC cannot add new loans or property subsequent to its start-up day.
- Substantially modified loans may be considered new loans, which would threaten the entity’s REMIC status.
- There are exceptions, including modifications made for a loan in default or reasonably foreseeable default; but even if the modification is covered by an exception, the modified loan could violate other REMIC requirements.
- The pooling and servicing agreement (PSA) for a CMBS also restricts the special servicer from most loan modifications that would allow for the deferral of interest payments.
- The PSAs also typically outline the rights for other parties to consent to modifications, which can complicate or delay approval of loan modifications.
Legal structure of CRE CLOs provides flexibility to manage pools, modify or replace loans
Lumped in with CMBS because the underlying collateral is commercial real estate loans, the CRE CLO legal and tax structure is quite different. An outstanding legal overview is available from Dechert LLP, Loan Modifications and Pool Management in a CRE CLO. Briefly summarized and paraphrased, some of the salient points are as follows:
- CRE CLOs use a tax structure for a qualified REIT subsidiary, or QRS. The QRS model provides the most flexibility for administering and modifying the high touch loans of a CRE CLO.
- In a CRE CLO, the collateral manager (in a managed deal) or the holder of the subordinate class (in a static deal) work with the servicer and special servicer to manage the collateral pool, borrower relationships, and respond to requests for modifications or other relief when conditions are distressed.
- Modifications of performing loans are allowed in a QRS, whereas they are subject to significant restrictions in both REMICs and offshore vehicles.
- Material modifications of performing loans fall into one of two broad categories: administrative modifications and criteria-based modifications.
- Administrative modifications – generally routine in nature, including modifications to exit, extension and prepayment fees; yield and spread maintenance provisions; financial covenants; reserve account balances; interest rate floors and future advance conditions.
- Criteria-based modifications – more substantive in nature, these generally include changes in interest rate; increase in principal balance; delays in payment of principal; change in maturity date; and permission for borrower to incur mezzanine debt or additional preferred equity. There are typically conditions attached that the modified loan still satisfy eligibility criteria, the note must pass note protection tests, and the rating agencies will not downgrade the securities based on the modification, among others.
- Administrative or criteria-based modifications cannot be performed on loans that are: credit-risk loans; specially serviced loans; or defaulted loans.
- The collateral manager can either choose to work out a credit risk or defaulted loan inside the CRE CLO structure, or they can direct the issuer to sell the loan or exchange it for a performing asset.
- Credit risk / defaulted sales – more common than exchanges, a sale requires the sponsor to have sufficient liquidity to pay the purchase price and put the asset on its own balance sheet. Benefits include that balance sheet workouts are simpler since modifications are limited only by the lender’s willingness to perform them; the loan does not count for purposes of note protections tests; and investors appreciate the willingness of collateral managers to protect the CRE CLO from losses.
- Exchanges – In an exchange the collateral manager can replace the loan with another asset instead of with cash. Exchanges are increasing in popularity, as they can be performed even when the CRE CLO is outside of its reinvestment period, so long as the newly acquired asset satisfies all of the eligibility criteria.
CREFC updating data rules designed for CRE CLOs
All of the flexibility around collateral pool management and loan modifications, sales and exchanges that make CRE CLOs a good financing vehicle for transitional loans, make monitoring the performance of the vehicles a challenge. Investors have long struggled to effectively and easily monitor performance of CRE CLOs because data transparency and disclosure rules have badly lagged those of other securitized products. That is beginning to change, because CREFC recently announced the CRE CLO Annex A Standard for data disclosure. This new standard increases the number of data fields that issuers will provide from 212 to 268, with many new fields specifically tailored to the CRE CLO structure. These include data on extension options and time periods for the extensions, interest rate caps and floors including their expiration dates, and more information regarding the original loan terms, fees and seasoning.
CREFC is planning a second phase of the CRE CLO reporting standards that will address the non-static nature of the pool collateral, so investors will be able to more easily track the addition and removal of loans throughout the life of the deals, and specialized fields for information regarding these transactions. It’s unclear what the timeline will be for the adoption of Annex A or the second phase of the release, but programmatic issuers are likely to adopt the new standard as soon as practicable.