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CDO'S GO WHERE CMBS FEAR TO TREAD

The popularity of collateralized debt obligations is skyrocketing in real estate circles, especially for loans on properties that don’t meet stringent cmbs standards

By Dees Stribling

The rise of collateralized obligations as a finance mechanism in commercial real estate has been positively meteoric. In the world of corporate high finance, these CDOs have been around for about two decades, but for most of that time they did not involve real estate.

Now many do. The first CDO backed solely by commercial real estate assets came out just in 1999. In the first nine months of 2006, commercial real estate CDO volume totaled some $22.4 billion, up from about $15.8 billion for the comparable period the year before, according to Commercial Mortgage Alert. As recently as 2004, the entire year’s commercial real estate CDO total barely exceeded $5 billion.

A veritable who’s who of the biggest names in finance are jumping into commercial real estate CDOs, Deutsche Bank, Goldman Sachs and Wachovia among them. Moreover, in a sign of the structure’s coming of age, there were several first-time conferences devoted to the subject last year, such as the one the Commercial Mortgage Securities Association sponsored in September in New York City.

Why the sudden popularity? And what does the CDO structure offer retail real estate owners and operators in particular? “CMBS [commercial-mortgage-backed securities] was once the new alternative for real estate borrowers, but now it’s an established source, though not a satisfactory solution for everyone,” said Joe Chinnici, managing director of the debt capital markets and structured products groups of Cleveland-based KeyBanc Capital Markets. “For some borrowers, CDOs now offer a new alternative, one that’s more competitively priced than conventional portfolio loans but with fewer strings attached than CMBS.”

In financial parlance, a CDO refers to a range of structures that pool assets and then sell bonds deriving their income from that pool or, less commonly, from trading assets in the pool. Altogether, CDOs issued in 2005 totaled about $251 billion. There are many species of CDO, with various kinds of backing, including bonds, bank loans, residential- or commercial-mortgage-backed securities and even bonds issued by other CDOs.

CDOs backed by commercial real estate loans are often compared to CMBS. Both structures involve the pooling of real estate loans for repackaging as bonds. From the borrower standpoint, such loans, destined for securitization within either structure, are attractive because they typically cost less than loans originated by a bank, pension fund or insurance company.

Such relatively low cost of capital has benefited commercial real estate borrowers tremendously since the CMBS structure was introduced in the early 1990s, but these borrowers have also discovered the device’s limitations. For one thing, not every commercial mortgage can even enter a CMBS structure. Loans perceived as bringing too much credit risk into the conduit (as the trust that holds the mortgage pool is called) are rejected as antithetical to the goal of the CMBS structure: stability of return. Loans backed by properties with high vacancies or needing extreme renovation are unlikely to be securitized into a CMBS conduit. (A handful of these riskier mortgages do occasionally make the pool, for the sake of the minority of investors with the stomach to bear higher risk.)

But even loans with no such baggage must cope with important, perhaps painful, restrictions when they are securitized. Once a loan is pooled, the borrower lives with the strict regime established by the pooling and servicing agreement (PSA). To maintain stability, the PSA spells out the rules concerning what an owner can and cannot do with a property during the life of the loan, and it mandates stiff prepayment penalties and yield-maintenance requirements on the borrower.

It is possible to exit the structure, but this often involves the considerable cost of defeasance, in which the borrower is compelled to buy and commit government securities or some other financial asset to the conduit, yielding the same level of return.

“CMBS is the thing if price is your overriding consideration and the deal is relatively straightforward,” said Pete Marino, vice president of CB Richard Ellis-Melody, the real estate investment banking division of CB Richard Ellis. “But for a lot of deals, the restrictions imposed by the rating agencies and the conduit structure itself are too onerous.”

CDOs are gaining traction precisely because they offer a less restrictive home for deals that might otherwise go into a CMBS conduit, he points out, and because they can include deals that would never make it into CMBS in the first place.

Chinnici agrees, saying CDOs offer certain advantages. “Their terms are generally more flexible than CMBS, but less expensive — perhaps 200 to 300 basis points — than portfolio loans,” he said.

Flexibility is an especially important consideration, says Marino. “Of all the major food groups, retail is the most dynamic,” Marino said. “Retail is known for its ever-changing formats and its constant redevelopment, so there’s something of a built-in need for flexibility.”

The CDO is built for such flexibility. First, in contrast to the CMBS goal of a static pool, the CDO asset pool is generally dynamic. A CDO is usually structured such that there is a ramp-up period of as much as a year, during which the initial assets are acquired. A few years follow in which the reinvestment of principal distributions on the underlying collateral in new assets is allowed and even encouraged.

For borrowers, this dynamism means that an exit strategy can be established much more easily from a CDO pool than from a CMBS pool. One asset can leave and be easily replaced by another. In fact, the opportunities to exit a CDO mean that the structure is rightly considered a good source of short-term financing for a project.

CDOs are also open to high-risk deals from which CMBS structures tend to shy away. For the borrower, the appeal is obvious: lower pricing than a portfolio loan when lower-priced CMBS capital is not an option. For investors, CDOs offer a path to higher-risk but higher-return real estate deals that might not otherwise be available. The extra risk is mitigated somewhat through the CDO’s collateral manager, which usually brings both expertise in the underlying assets and the authority to be proactive in ensuring asset performance.

Though CDOs are unlikely to replace CMBS or portfolio loans outright, they are likely to become an increasingly important niche product. “We’ve executed several CDOs, and the borrowers have been very receptive to them,” said Marino. “They see a lot of benefit from the structure down the road, so I suspect this is just the beginning for it.” Chinnici anticipates a significant increase in commercial real estate CDO volume for this year, especially as investors warm up to them. “Most are still U.S. investors, but we’re also seeing interest from Europe and Asia,” he said.

In the long run, CDOs will form a complementary product to CMBS, Chinnici predicts. “On the investors’ side, it will offer an entrance into higher-return properties, and capital from all over the world is beginning to notice that,” he said. “On the borrowers’ side, it will be popular among deal makers, including retail real estate interests.”