Life insurance policies and annuities are, in a sense, sausages filled with corporate bonds, direct and indirect real estate investments, and other investment instruments thrown in to liven things up. One of the terms that often comes up today is “collateralized loan obligation,” or CLO. Here Erika Morphy of GlobeSt.com, a Thinkadvisor sister publication, talks about how players in the commercial real estate community think about CLOs.
Earlier this spring, Kroll Bond Rating Agency assigned preliminary ratings to a commercial real estate “collateralized loan obligation,” or CLO, that LoanCore Capital Markets was taking to the market.
The CLO was backed by an eye-popping $1.1 billion in first mortgages secured by a mix of 33 properties. The portfolio consisted of multifamily, office, mixed-use, industrial, hospitality and retail assets. For the two or so years prior, commercial real estate CLOs had started to come back to the market.
But the size of this CLO deal — and to a lesser extent, its 24-month reinvestment period — surprised some observers. The commercial real estate CLO market, it had suddenly become clear, was back. Now, as the CLO market continues, to grow it will have ramifications for borrowers and lenders.
This is not to say that commercial real estate CLOs are anywhere close to their heyday before the Great Recession. In 2007 and 2008 issuance was around $35 billion a year.
The first CLOs to appear after the financial crisis arrived in 2016, when between $2 billion to $2.5 billion of CLOs were issued, according to stats from Wall Street investment banks.
Issuance climbed to about $8 billion in 2017.
This year, there are estimates that between $13 billion and $18 billion in CLOs could be issued.
Here’s a primer on how today’s CLOs are different from the CLOs created in the past, and a look at how borrowers can benefit from the return of this financing vehicle.
What Are They
CLOs are a form of securitization.
They do have some distinct differences from the more familiar commercial mortgage-backed security (CMBS).
For starters, there are tax differences: A CMBS transaction is typically done through what’s called a REMIC structure, which allows for the pass through of interest income to the ultimate investors without double taxation.
A CLO is also a pass-through vehicle, butit uses a different tax regime that allows for greater flexibility, among other things.
Why Would A Borrower Care?
Ultimately for end-borrowers, a more robust — or to be more precise, a re-emerging CLO market — means more liquidity especially for flexible and bridge loans.
Borrowers looking for term financing for, say, a 10-year loan for a stabilized property, will usually find it — or their broker will find it — in the CMBS market. CMBS, though, is very much a commodity-type of financing that is difficult to customize. Loans in a CLO, on the other hand, can be restructured or extended. So when a property is in transition — say the building is being retenanted — a loan that is being securitized in a CLO versus a CMBS is likely the better option.
Another difference: with a CLO generally the institution that made the loan is the same one that is servicing it, unlike CMBS. That too, can mean a world of difference to a borrower.
Why CLOs Have A Bad Reputation
First of all they were called CDOs, or collateralized debt obligations — there has been a bit of rebranding for this financial instrument.
The primary reason CDOs got a bad name during the downturn is that some of them were used for arbitrage instead of as financing vehicles.
Some background first: Like CLOs, CDO were used by firms that were in the business of originating loans or owning loans as a means of financing their positions. So instead of getting a warehouse line or a repo line from an investment bank, this entity would issue a CDO. Typically these would have on average 20% to 25% equity supporting the bonds that were issued.
During the recession, in many cases, the equity in CLOs was lost and even, in some cases, the bonds were lost as well. This, to be clear, was not due to a flaw in the structure and the vehicle; rather it was a reflection of what was happening in the market.
However, what some people were doing pre-recession was packaging the CDOs with securities that they already owned or had created through a CMBS transaction. Then they would approach the rating agencies and ask how much of a Triple A rating could they get if the issuer were to contribute the loans to a CDO. The rating agency would rate whatever the investment grade portion was, and then issue the loans into a CDO. Basically what these issuers did was take non-investment grade bonds and repackage them and then issue an investment grade security. The problem was, of course, that these securities were already highly-leveraged, being the subordinate bonds supporting CMBS transactions.
It should also be noted that the subordinate bonds coming off of the CMBS transactions were heavily discounted bonds, meaning they weren’t issued at par. Rather they were bonds issued at 40 or 30 cents on the dollar based on how the CMBS transaction worked. But the issuer would put them into the CDO at par. What that meant was that whatever equity was needed to support the CDO to issue the bonds was almost offset, and in many cases more than offset, by the fact that they were then contributing discount bonds at par.
In short, these issuers were taking cash proceeds out of the trade when they made the trade — and it is these deals that gave CDOs a bad name.
What Is Different About CLOs Today
The reporting has gotten better. There was no standardization of reporting pre-downturn.
But the biggest difference between pre-recession structures and the CLOs today is the collateral of the loans. Pre-recession, the collateral was a mix of first mortgages, mezzanine loans and B notes. Today, CLOs only have first mortgages as collateral — at least the ones issued so far.
Holding only first mortgages is what has truly given CLOs an added measure of safety, Joseph Iacono, chief executive officer and managing partner at Crescit Capital Strategies, tells GlobeSt.com. “That in itself reduces the risk profile because inherently first mortgages tend to be, for a variety of reasons, less risky than a mezzanine loan or a B note.”
Another change is the structure’s reinvestment rights. Pre-downturn it was typical to see a 10-year CDO vehicle to have six to seven years of reinvestment rights. Today, CLO reinvestment rights are more limited, Iacono says, although they are growing. “When they came back in 2016 or so, most of the transactions were static vehicles — they didn’t have any reinvestment rights at all. You put the loans in, as they paid off you simply paid down the bonds and then the financing was paid off and that was the end of it. Now we’re starting to see the re-emergence of reinvestment rights, ranging from two to four years, although most are in the two-year range.”
Another change, he continued, is the size of the deals. When these structures first started to re-emerge the average deal sizes were between $250 million to $400 million. Now LoanCore is bringing to market a $1 billion transaction.
Who Is Investing In CLOs And Why?
These vehicles are shorter in nature because the loans are shorter. So, investors looking for shorter duration assets have been the primary buyers. “They like the idea that they are floating rate as opposed to a fixed-rate bond,” Iacono says. And in general, investors have become more comfortable with the vehicle because of the transparency and collateral.
Another aspect that investors like, according to Iacono, is that the assets tend to be larger on an individual basis than in CMBS, which means there are less transactions in each CLO. “If you’re an investor that likes to look and touch, so to speak, the underlying collateral supporting it, there’s a lot more visibility.”
— Read SEC: Insurers to Get CDO Deal Compensation, on ThinkAdvisor.