We have been writing off and on about the restoration to good graces of the commercial real estate CLO since the early days of this current recovery, and it’s important to keep the conversation going. Hey, if Pete Rose can get into the Hall of Fame (and as MLB is embracing gambling, that cannot but happen, right?), the full restoration of the reputation of the CRE CLO cannot be far behind.
First, let’s just stop and get some definitional clarity here for those of you who actually have a life. Fundamentally, the CRE CLO is a device that provides match-term leverage for a portfolio lender, though the technology can be used for other purposes. Loans are pooled, investment-grade securities are sold to investors, and the loans are repaid from debt service payments. Customarily, the sponsor retains all of the equity and junior debt, creating structural leverage to enhance returns on the dollars invested in the structure.
It’s really a warehouse funded by the capital markets. As such, it provides for an excellent alignment of interests between investors and the sponsor, who holds the bottom of the capital stack. The sponsor is in it for the long haul, managing financial assets for its benefit and the benefit of the investors alike.
At the end of the Great Recession, we began to retest the use of this technology. We argued at that time, and still contend, that this is terrific financial engineering which aligns the interests of the sponsor and the investors better than any other product in the securitization space. The structure facilitates the active management of a portfolio of commercial mortgage loans. Mortgage loans are not static, immutable things best left to their own devices—rather, to continue to maximize the performance of a pool of loans, and to ensure continuity of returns, the mortgage loans should be managed. This structure facilitates that active management, and that’s a good thing if you are an investor. Moreover, the market knows how to value commercial real estate loans, and the market knows how to assess the quality of management. It simply isn’t that hard to look at the quality of the assets and the quality of the management and conclude that the transaction is a really good deal for all involved.
Okay, prior to the Great Recession, this technology was badly misused. Unfortunately, any technology can be deployed in the service of bad ideas as well as good. (I’m not going with the “guns don’t kill people, people do” analogy—I’m just saying.) Mezzanine loans, deeply subordinated mortgage debt, resi paper, synthetic exposures, CDS and CDO-squared assets were jumbled together with whole loans into a hot, swampy mess, made possible only by market participants’ collective suspension of judgment. (To be clear, I include myself in that collective insanity, and for those of you who find mass psychosis interesting, check out Madness Rules the Hour about Charleston in the lee of the Civil War. Same error, worse outcome.) These pre-Recession structures were opaque and enormously complex, and as a result, it was difficult to understand the underlying risks. At best, these were Formula One race cars made from glass and tin foil—perfectly formed, precisely engineered, sleek and fast, but sure to shatter entirely if they ever so slightly hit the wall. In the go-go mid ’00s, when the hunger for yield was at its hottest, the allure of terrific cash flows plus ratings was just irresistible. Hey, computers don’t lie, right? If the model says that it works, then by God, it works! Right?
A few years back, as we tiptoed back into this market, the original deals were static, and while the paradigmatic collateral for these structures were transitional mortgage loans, it was typically light transition; the intent was to shoulder loans to the broader conduit marketplace, where they could go when they grow up. We were very carefully and slowly un-turtling.
Now the market is blooming. Deal volume from 2013 to 2017 was a couple billion dollars a year, whereas in 2018 we are likely to see volume north of $15 billion, and some brave souls (their lips to God’s ear) have forecasted something in the range of $25 billion next year. Given the size of the conduit market these days, together with the other structural features of securitization, $25 billion will represent a very significant portion of all private-label securitized assets.
We hear tell down here in the trenches, where the sausage is made, that significant drivers of the growth of the business include:
- Decreasing spreads on the customary CRE repo product, which makes the CRE CLO more competitive with other warehousing strategies;
- A growing awareness, particularly late in the cycle, that the certainty provided by match-term financing is an unalloyed good for prudent portfolio lenders;
- An ongoing reduction of the bad odor associated with the technology, resulting from its disastrous misuse leading up to the Great Recession (hey, the Irish have forgiven the English, right? Oops, bad example); and
- An increase in investors crossing over into the space from corporate CLOs and other structured products, who supplement the traditional CMBS investors that usually walk the CRE beat.
We think this technology is robust, transparent, straightforward and adaptable to the needs of almost all portfolio lenders in the alternate lending marketplace who can’t fund their liabilities through government-subsidized deposits and access to the Fed window. When used in conjunction with repo borrowing, this is a terrific way to mitigate risk while delivering significant levered returns. Remember: repo borrowing is fantastic, and it can be your best friend, until it’s not. With repo buyers’ customary ability to terminate future purchases, effectively reprice liabilities and mark and margin (at least on credit events), the repo is very much a double-edged sword. This fact is particularly consequential in volatile markets where financial assets may lose value quickly. The CRE CLO matches your liabilities and assets in a way that can’t be otherwise found in the marketplace.
And there seems to be fairly robust bid from the investor marketplace. More crossover investors are finding their way to the space. We have always been fascinated by the resistance of the CRE CLO marketplace to managed transactions and how managed transactions price significantly wide of static deals, in light of the willingness of broadly syndicated and middle-market corporate CLO investors to buy that same product like hotcakes—even though they all have long reinvestment periods, relatively broad reinvestment criteria and rapid turnover of underlying assets. Now admittedly, non-real estate CLO products tend to have more granular pools with a larger asset count (and hence less risk associated with individual assets), but it still seems that CRE CLO investors have been over-attentive to the characteristics of the specific loans funded at the time of closing, and have not given enough attention—or credit—to the quality of the platform and the competence of the collateral manager.
So, we’re here to confidently predict that the appeal of this technology will continue to grow, and that innovation in the space will continue apace. As the market is maturing, innovation is doing what innovation does; broadening the asset classes and providing more operational flexibility to sponsors and managers. Over the past year or so, dynamic transactions permitting reinvestment of principal proceeds have become common. Most deals include material future funding, where loans with post-securitization future funding obligations are split into pari passu participations, with future advances made by the sponsor holding the non-pooled participation outside the deal. The CRE CLO manager uses principal proceeds received from natural amortization of pooled assets to purchase future funding dollars from the sponsor as loans are funded. More recently, we are seeing transactions in which principal proceeds can be used to purchase entirely new assets that meet a robust set of eligibility criteria. (Note: We have not lost our minds yet; criteria number one is: It’s a whole mortgage loan or a senior or pari passu interest in one, stupid.)
These reinvestment features are critical to creating a cost-effective financing structure for the sponsor. The underlying liabilities tend to be short-lived and prepayments and amortization will, absent reinvestment, pay off the senior (and cheaper) liabilities too soon. This leads to coupon creep for the sponsor, which is especially problematic given the significant front-end cost of a CRE CLO. Of course, the monkey-on-the-back trade here is that reinvestment only makes sense if there are things in which to reinvest. (I remain an ebullient optimist.)
We’ve learned how to accommodate future funding; we’ve learned how to accommodate pari passu and senior interests; we’ve broadened the asset categories which can be financed and lengthened reinvestment periods. But don’t mistake innovation for deteriorating credit quality. While we may certainly see CRE CLO technology adapted to finance things other than first mortgage loans (eyes wide open), the absurdities of 1.0—where returns on mortgage loan CRE CLOs were juiced through the inclusion of a variety of high-yield paper, oddball asset classes, synthetic exposures and the like—is not coming back. 1.0 taught us that those don’t work. 1.0 taught us that such transactions are more complex than can be realistically managed by bankers, investors and lawyers, and it taught us that those transactions are neither robust nor durable when systemic stress reemerges.
So what’s on the horizon? Construction lending? Hard, but possibly doable. How about other asset classes that are outside the four major food groups? Certainly. Can the technology can be adapted as an alternative to traditional conduit technology to finance stable, long-dated fixed-rate loans? Sure. Can we expect innovation in the REMIC space as an alternate tax structure to provide more liquidity deep into the capital stack and more certainty on tax structures? Yup. (Stand by on this one!) How about NPLs (speaking of end of the cycle)? Cross-border pools? Repricing features? Unrated transactions and hybrid loan/bond structures? Already here in a growing sector of the market. How about bringing back the variable funding note (VFN) at the top of the capital stack to provide funds to acquire new assets? And, while this may be a bridge too far, how about using the technology to indeed lever subordinate debt? (I know that makes everyone nervous even to say those words, but as long as it’s clear and understandable, and folks understood the risk and reward of the transaction, there’s nothing wrong with that, and as the volume of subordinate debt rises in an increasingly fraught market, the more need there will be to provide leverage against those assets.)
So it’s an interesting time with lots of bankers, investors, issuers and counsel doing meaningful and interesting work to midwife the return of this terrifically useful technology.
Have faith and stand by.