Real estate CDOs are roaring back, this time to fund commercial properties thrown into flux by pandemic
Wall Street’s real estate CDO machine, shunned and largely shut down since the 2008 global financial crisis, has returned.
According to BofA Global, this year will see a record increase of almost 50 billion compared to the 2020 issue.
The new generation of CRE CLOs, or Collateralized Loan Obligations, will be anchored primarily this year by loans on commercial real estate, teetering on the work-from-home trend that emptied offices and drove urban dwellers to the suburbs during the pandemic. These are unlike the CDOs of yore when Wall Street packaged billions of increasingly hard-to-sell subprime mortgage bonds and derivatives as top-rated “secured debt” or CDOs that became toxic.
With the new bonds, investors can also bet that US commercial real estate will not only survive the COVID crisis, but land on more solid ground over the next five years, given today’s low interest rates.
“People thought commercial real estate was the focus of the storm,” said Tracy Chen, director of global structured credit investing at Brandywine Global Investment Management, in a telephone interview.
“The apocalyptic scenario that everyone was talking about did not materialize.”
Instead, the pandemic means a second chance for a corner of Wall Street looking to leave a bad past behind.
CRE-CLOs are booming
BofA Global, Commercial Mortgage Alert
“Starting with early post-crisis CRE-CLOs, the structures were updated and the look had to be differentiated from the look of pre-crisis CDOs,” said Steven Kolyer, partner in the global finance group at Sidley Austin law firm.
Kolyer was involved when mortgage CDOs first emerged 20 years ago and has helped implement reforms over the past decade, including obliging CRE CLO sponsors to stand by their businesses by keeping some of the risks .
“These are different from pre-crisis CDOs that suffered heavy credit losses, mostly from subprime mortgage investments,” he said.
“The different current credit structure comes at an opportune time as underlying borrowers with ownership interests in commercial real estate are looking for ways to convert their properties from previous uses to future uses.”
Bridge to the future
Many of the loans bundled in CRE-CLOs this year have been floating rate and have been used to finance relatively stable apartment buildings where owners want flexible financing in the COVID era, including selling when prices continue to rise.
Others turned to borrowers who needed temporary funds to convert an office building, retail property, or hotel to attract new tenants.
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“Typically, transitional loans prior to COVID-19 were drawn with the expectation of cash flow disruptions,” said Greg Handler, director of mortgage and consumer credit at Western Asset Management.
That means reserving funds for “a period of time to renovate, re-let or reposition real estate,” said Handler, which “has helped alleviate the problems we saw with COVID,” including reducing the proportion of overdue loans was kept low in CRE-CLOs.
Given the boom in the sector, Handler was an investor but also told MarketWatch that his team was exploring the possibility of building its own pipeline of deals. Many of the top issuers in the sector to date have been REITs, including Arbor Realty Trust Inc. ABR
and Bridge Investment Group BRDG,
according to deal tracker Finsight.
“Of course, there will be a need to reshape the future of the office,” said Handler, also speaking about the floor plans of hotels and other types of property that are likely to change.
“Landlords and property owners need to rethink and invest more capital,” he said.
Boom like no other
Analysts said the main risks would be that lending becomes more sloppy as lenders compete for business, the weakness of the exploding multi-family sector, or unsuccessful real estate plans.
Low Interest BX: TMUBMUSD10Y
and a subdued distress helped push commercial property prices up 24% year-over-year, or about 15% above pre-COVID levels, according to the Green Street Commercial Property Price Index.
Barclays’ credit research team, led by Lea Overby, estimated in early December that around 67% of the annual collateral for CRE-CLOs was multi-family loans, with a smaller proportion coming from the office sector.
But unknowns still tarnish commercial real estate as the pandemic nears its two-year mark, including how much office space will be needed in major cities, what business travel will be like, and other concerns.
Although the expected wave of housing crisis has not yet occurred, Brandywine’s Chen has also tied “all risky assets” to central bank support, which until recently meant keeping interest rates low and monetary policy expansionary.
“The rate is still at an all-time low and it will take time to get to dangerous levels,” she said. “CRE-CLOs should benefit from this.”
With the Federal Reserve tightening, Chen believes that if inflation stays high for the next year, real estate “should be a place to hide”, especially for investors with exposure to real estate funded at extremely low interest rates rise in a rate hike cycle.
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