CRE CLO technology is languishing in the toolbox. A combination of high interest rates, a mispriced legacy book, an anxious investor base and no real need to refresh capital until borrowers start borrowing again is largely responsible. When a tool just doesn’t work anymore, you don’t throw it away, you fix it. I like this particular tool. The CRE CLO was, and will again be, the best match term, non-marked to market leverage technology in the CRE space and simultaneously represents the best alignment of interests between deal sponsor and investor. It just doesn’t, as currently configured, work right now.
Transactional volume in the CRE non-stabilized or bridge space has crashed as deals don’t pencil and as many property owners remain attached to the magical thinking that the macroeconomic conditions of the past decade will return any moment. Sub four cap rates, sub 1% SOFR…yippee! Here’s a newsflash. Absent the arrival of some truly ugly black swan, as I was discussing in last week’s commentary, the current high interest rate and high cap rate environment in CRE financing is likely to persist well into 2024. Even then, if you’re expecting a return to the halcyon days of 2020, I think you’re fooling yourself.
It’s not that nothing is happening out there. Some transitional mortgage loans are getting done and perhaps if one takes off one’s glasses and squints hard enough, some green shoots might be perceptible; green shoots suggesting a return to some level of financial health in our marketplace. Nonetheless, right now, assets are not getting repriced fast enough and transactions are not getting done rapidly enough to reliquefy a functioning, let alone robust, CRE CLO marketplace and it’s hard to see when that will happen.
Things change, of course. They always do. (Except, I would have said it was virtually certain that Tucker and Don would continue to dominate the chatospheres over their respective alternate universes forever…whoops!)
Some things could reinvigorate the CRE CLO market more rapidly than otherwise might be expected. The return of the Fed Put might give us rapidly falling interest rates. That would make a difference. The problem, of course, is that rapidly reducing Fed fund rates probably indicates something awful has happened, so I’m not sure that’s a great trade. The inventory of commercial real estate assets could reprice faster than I currently expect. It took an incredibly long time for the detritus of the GFC to be cleared out of the system. Could it happen faster this time? If the lending community, writ large, decides that enforcing their loan documents and selling collateral rapidly is cheaper than can-kicking, that could help reset the stage for renewed transactional volume faster than I expect. If the warehouse lenders start to tighten the screws (something which appeared to have begun last summer and then rapidly went away…not a happy thought, but a thing), that could also change the calculus, causing a considerable number of non-accretive securitizations to get done to refresh capital.
So, with my Captain Obvious hat firmly on, I will observe that the market will either slowly, or more quickly, revert to ruddy health sometime during the next couple of years and, when it does, we’ll pull the CRE CLO we have grown to love back out of the toolbox and deploy it with vigor and a certain jubilation.
But are we fated to simply wait around for current trend lines to be disrupted? Must we tolerate this inability to function without capital market leverage, to refresh capital and deal with mispriced assets for years? Are we stuck with only the tools we’ve got in the toolbox? Maybe not.
Tools can be repurposed. Here are a couple of ideas.
The CRE CLO technology could become a solution for a high-yield investors looking for exposure to commercial real estate seeking to marry up with a warehouse lender which might be looking to lighten the load. Look, the warehouse lending business has, for years, been based on a trade in which the warehouse accumulates collateral and the repo borrower/seller ultimately conveys that collateral into a CRE CLO in which the warehouse lender becomes the banker. That trade has collapsed as the conventional CRE CLO market has slowed to a crawl and presumably there are an awful lot of warehouse lenders who would be delighted to reduce risk in their warehouses.
It is more than conceivable that this circle could be squared by using CRE CLO technology to create a senior/subordinate structure in an ongoing repo warehouse. Oh sure, there are other ways to do this, including things like simple participation, but the CRE CLO has some unique advantages which might make it attractive. Structurally, this gets done by moving the buy side of a repo into a vehicle which issues a senior and a subordinate note. Both notes could be variable funding notes (VFN) to facilitate a repo which must continue to refresh capital for its underlying customer. If the repo is in a runoff phase, of course, the notes could be static. The advantage of the structure is twofold: First, there is an overall reduction of risk. If the warehouse lender’s attachment point pre this runup in Fed Funds rate had been 50%, it might now be 70% or more and the sale of subordinate interest, while pricey, could right-size loan to value. Second, the transaction should provide a material risk-based capital pickup as what the bank will be holding after this transaction is certainly a securitization position. The senior note might even (gasp) be ratable, but that might be a bridge too far.
The transaction could be serviced by the bank who would continue to face the customer even providing special servicing as a separate workstream on the transaction. Presumably, the holder of the subordinate note would hold major decision/directing certificate type rights and indeed could provide special servicing with the bank in what amounts to a master servicer/primary servicer role. Of course, not all warehouses would permit this type of transaction, without the underlying borrowers’ consent, but my guess is that the underlying user of capital could be incented to facilitate the transaction given current economic conditions.
How about a multiseller structure? We’ve been down the path on this a couple of times with clients and while no one has pulled the trigger, the structure appears viable. Issuers could buddy up (God knows we do it as a matter of course in the conduit securitization marketplace). Yes, I know that the knock on this strategy has always been that in a CRE CLO, one needs to eat more of one’s own cooking, and in a multiseller structure, someone else’s cooking, too. That’s an issue that can be fixed in the structure.
Essentially, this could get done between a sponsor with multiple advised funds, or between entirely unrelated lenders. The predicate is, of course, highly motivated sellers who get over their natural conviction that their collateral is way better than everyone else’s and an intellectual and emotional ability to come to some agreement on relative value. That won’t be easy, but necessity is the mother of invention, right? If there’s simply an inadequate velocity out there in the lending market to build one’s own pool, this might be an answer. Each lender would convey collateral into the vehicle through a baby REIT which would in turn transfer the collateral into a QRS issuer. Each seller would get its proportional share of REIT stock, its proportional share of the cash proceeds of the securitization and, of course, its proportional share of the beneficial ownership interests in the non-investment grade securities through its ownership of the REIT stock. Each of the contributing parties would be responsible under its own MLPA for breaches of rep and warrant. On the other hand, it would be fair and reasonable to share the positive economics of the vehicle through the REIT stock as that stock was allocated based on the agreed fair value of the contributed collateral and, of course, on the assumption that all loans are money good. An upstream partnership would be used to specially allocate any losses that may occur to the seller who contributed that loan.
The multiseller structure obviously can create interesting advisory questions and would entail some complex and perhaps difficult negotiations. But given an understanding between the parties of fair value, it certainly is doable. In a market where we have insufficient deal flow to go one’s own way, this could be an answer.
Note that, except for the fact that there are multiple sellers in the structure, the deal would otherwise look, in all other respects, conventional, from the investors’ perspective.
How about breaking down the artificial wall that exists between the CRE CLO and the corporate CLO? Why not add a sleeve of middle market or broadly syndicated CLO assets to a vehicle which also has a sleeve for CRE? Adding non-homogeneous collateral into a CRE CLO might, surficially carry with it a whiff of the fatal alchemy of the pre-GFC CRE CDOs whose witches’ brew failed spectacularly, but that’s a false equivalence. If we don’t have enough repriced and resized CRE to put into a pure play CRE CLO, we could add corporate paper which perhaps is (or perhaps is not) tied in some way to the CRE sector. Corporate CLO issuance is robust and pricing is, at least by the lights of the CRE market, damn good. Could a regular way commercial real estate issuer purchase this paper in open market transactions to fill out its offering and could that provide all-in better leverage, better pricing and attract more investor interest? This would give the sponsor some leverage on its existing CRE CLO loan portfolio and keep the sponsor’s name in circulation in the investor marketplace as a regular issuer (which could be important when transactional activity repairs). This is rather reminiscent of early RTC securitizations when the FDIC added cash and cash-equivalent collateral to the deals to draw in investors to this new technology.
In the meantime, if we import some corporate CLO-type collateral into our vehicles, might we incorporate a little corporate CLO technology? Let’s face it, the corporate market has always been more amiably structured from the sponsor’s perspective than the CRE market, less focused on a granular loan-by-loan analysis, more willing to embrace the value of good active management and hence more willing to tolerate ramps and reinvestment. A reinvestment feature that would preserve the relative proportions of the corporate and mortgage assets or indeed permit the collateral manager to migrate more commercial real estate assets into the structure as the market opens up and product becomes available might be very attractive.
Corporate paper tends to be shadow rated and both ratings agencies and investors appear to have a certain fondness for it, at least when compared to CRE assets. The structure could end up with better diversity, tighter ratings attachment points and better pricing.
I know that as I’m saying this, that some investors, not always the most forward-thinking bunch, might simply refuse to engage. Run away, run away! But perhaps if a few private deals could get done and done successfully, it could wet their whistle. Similarly, the ratings agencies would have a cow dealing with the conflicting ratings methodologies of the CRE CLO and the corporate CLO marketplace. The two approaches of assessing credit risk and everything else are wildly different. But hey, in this torpid market, they have time on their hands, too. Figure it out.
Might there be other strategies out there that bring back leverage, bring back match term non-marked-to-market leverage to our marketplace? Markets aren’t immutable and neither are tools. When we need a new tool, we build one. It’s time we look at our toolbox and think about modifying old tools or building new ones. Is all this hard? Sure. But as Sherlock famously said, “When you have eliminated the impossible, whatever remains, however improbable, must be the truth.”
It really beats the hell out of waiting around for the markets to come back, doesn’t it?