Investors Warm to Evolution of Commercial Real Estate CLOs

The Shift from CMBS to CRE CLOs

The staving off of the more traditional conduit CMBS issuances appears to be due to a number of factors according to market observers, such as:

• A more limited supply of 10-year-old loans to refinance in the post-crisis era; 
• The introduction of Fannie Mae and Freddie Mac’s ‘K deals’ which are platforms securitising multi-family loans in the post-crisis era;
• New lenders entering the market, such as private debt funds and mortgage REITs (Real Estate Investment Trusts) that have taken up market share as the relatively small size of loans in conduit CMBS has allowed such borrowers to encroach on the market share  conduit lenders traditionally held, whilst for single-asset/single-borrower deals that are secured on larger loans, CMBS lenders have held their ground as loan sizes are too large for most other lenders to originate; and
• Increased investor demand. As CRE CLOs tend to be short-term floating-rate issuances, secured on riskier properties than those in traditional CMBS deals, this is especially attractive to investors in a low interest rate environment as they offer investors higher yields.

In contrast to CMBS, which dominated the commercial real estate securitisation market since the credit crisis, CRE CLOs having all but disappeared in the immediate aftermath made a more steady recovery until issuance exploded from 2017 with a doubling in volume in the space of just one year. As a number of billion-dollar CRE CLO transactions began to pepper the landscape, larger players entered the space and with 2018 issuance reaching US$15.2 billion (Trepp), the expectation is that the market could hit US$19.5 billion for 2019 if the current pace sustains through the remainder of this year. Some sceptics, however, have predicted a less favorable outlook for what they see as an overheated market ripe to burst.

Much of the growth of the CRE CLO market can be attributed to the fact that the CRE industry is very sensitive to interest rates and the volume of deals proliferated in the extremely low interest rate climate of the past decade where the US Federal Reserve cut interest rates and held them at record low levels in order to stimulate economy.  This growth was further fueled by the injection of approximately US$3.5 trillion of liquidity into the US financial system from 2008 to 2014 via the US Federal Reserve’s quantitative easing programs (Thomson Reuters).

Financing strategies in the US commercial real estate sector remain in sharp focus at the current time.  The longest economic expansion on record and rapid developments in the technology sector, coinciding with the co-working phenomenon, has resulted in huge demand for office space, while at the same time, concerns exist over the potential impact of a recession on the commercial real estate market, amid news reports of over 7000 US store closures in the first half of this year.  Taking a step back to examine the growth of the CRE CLO product there are a number of other features that have proven popular in this environment, drawing new issuers, alongside managers already well established in other product areas to debut their CRE CLO offerings to the market.

Moving from Static to Managed Deals

Between 2012 and 2014, CRE CLOs were largely static deals, meaning that, upon prepayment of loans, those funds would be used to pay down the notes and there was no ability to reinvest in new assets.  Between 2014 and 2017, there was a shift from static deals to lightly managed deals which were restricted in that principal proceeds could be reinvested, but only in existing assets.  By 2017, the market was moving towards fully managed CRE CLOs which now make up a majority of issuance and enable the issuer to reinvest in completely new assets that meet the investment parameters set out in the deal documents.  This transition to managed deals provides flexibility and greater opportunities to earn yield which is attractive to investors.

Asset Quality

With first lien mortgages as assets, proponents of CRE CLOs claim they offer increased security with lower leverage, which attracts investors given the yield pickup on CMBS.  These deals are managed by highly motivated sponsors that for US regulatory reasons take down not only the requisite retention piece of equity, but often more.

Credit Quality

Investors and Borrowers