I’ve written extensively about the CRE CLO technology for a long time and why it is the best leverage technology across securitization markets. With the sponsor typically holding up to 20% of the bottom of the capital stack, it represents the best alignment of interests between sponsor and investor. For the sponsor, it provides unique, non-mark-to-market, match term financing, otherwise simply not available across CRE markets.
This technology, the tool as it were, has surely been languishing in the toolbox for the past year because of the mismatch between bond yields and coupons on legacy assets. Anything originated prior to the enormous Fed run-up last year simply cannot attain positive leverage (we need to come up with a catchy name for that unpleasant experience, like GFC . . . maybe the LAFF . . . Last Awful Fed Fantasy).
And so, the CRE floating rate market has been sitting on its hands pursuing the always alluring strategy of hope that something, without a price tag or a butcher’s bill, will happen that makes markets work again.
The unavailability of CRE CLO leverage has been tolerable, that is, tolerable the same way the absence of a pen knife in a gunfight is tolerable, for a number of reasons. On the one hand, banks providing leverage through the repo market have simply been accommodative and so leverage has been, if not abundant, at least available. Marks have been limited and consequently, margin calls have caused only modest pain. Facilities are getting extended where they might not have otherwise been, and new facilities are being made available in the marketplace by existing and new entries into the warehouse space.
Then, of course, no one is borrowing. Why then refresh capital? Coupon sticker shock, gaping disagreement between buyers and sellers as to value and a general unwillingness to plunge and look stupid in an opaquely unfathomable market has suppressed transactional velocity. Legacy loan borrowers have been sitting on their hands and not transacting if they can possibly avoid it, given the fact that many leverage assets are under water (or close to it) and the precipitous collapse of asset values means little still pencils.
While we have had a couple of deals price recently, the disconnect continues to chill market activity.
But I do have a private data set that suggests something positive might be afoot. I get readership information on CrunchedCredit on a regular basis and, within the past few weeks, an awfully large percentage of the hits have been on CRE CLO articles. We’ve seen a lot of activity on:
- The CRE CLO Repurposed: Part II
- Fix the CRE CLO, Mr. Market: Tear Down This Wall!
- Why Don’t (Enough) Investors Like CRE CLO?
- The CRE CLO Unleashed
- Prognosticators’ Regret
- A Modest Proposal: Why Can’t CRE CLOs Be More Like Corporate CLOs?
Hmmm. While I must admit a certain fondness for my own deathless prose, I figure that all those hits from a disparate selection of readers suggests that something’s stirring. Is the day of the resurgence of the CRE CLO tool’s utility maybe closer than we think?
Does it suggest that buyers and sellers will begin to transact at current cap rates and coupons such that leverage in the current environment works again? Does it suggest worrying about potential tightening in the warehouse market? Does it suggest that folks have decided that there is indeed a reason to refresh capital?
If I am right about the current economic conditions, the interregnum between the prior amiable economic conditions and return to something even remotely similar is longer than any “kick the can” bridge we can construct. In that environment, embracing the pain, taking the hit (pick your preferred metaphor) and recommencing transactional activity actually makes sense.
Well, for my own personal interest (and as I regularly say, it’s really all about me), I certainly hope so. In a healthy market, the CRE CLO technology has proved itself to be incredibly valuable. Production in the last truly economically healthy year before the LAFF (pronounced LAUGH . . . trying to build some momentum here), exceeded $40 billion. In a healthy market, that type of volume or more should be expected. The product is just too damn good to be left in the toolbox. When it pencils, it will flourish.
We’re also excited to see it come back soon because we’ve gotten a lot smarter since before the time of the LAFF in early 2021. Because of the trials and tribulations the structure has endured over the past year, and the attendant opportunity to test the machinery of the CRE CLO construct, we’ve been developing a list of fixes and innovations that we consider baking into deals on a go-forward basis. CRE CLO 3.0 will be better! New and improved!
Look, we all knew we were building the CRE CLO airplane while we flew it and, shockingly, when we flew it into the eye of the storm, bits and pieces shook off. We found, on an operational basis, that things that appeared to make good sense when deals were structured (or more likely not thought about at all), didn’t always work as well as expected in the crucible of real stress and the need to engage in active asset management. As old von Moltke (the elder and smarter one) said, “No plan survives first contact with the enemy,” and here the enemy is reality; super tight monetary conditions. We see changes that could improve the functionality for the sponsors, and indeed improve the experience for the investor community as well. All of my Dechert CRE CLO partners and senior colleagues . . . Laura Swihart, Stewart McQueen, Matt Fischer, Devin Swaney, Matt Armstrong, Gennady Gorel, Ken Hackman, Ella Smith, Bill Lee and Greg Renick have been beavering away, solving problems and compiling lists of things in need of attention as we return to the market and build out CRE CLO 3.0. We are anxious to bake these into the cake, or at least discuss them, with bankers and issuers. Just for a taste, some of these worth considering include:
- Using the new Annex A, as just recently issued by CREFC. While this remains a work in progress, it is still a significant improvement over what we had before. We recently saw it in the ReadyCap deal and clearly this will be best practice going forward. This was an easy one.
- The relationship between rate caps and things like debt service, U/W stabilized NCF DSCR and Par Value Test has simply not been clear. In a world where rate caps were just things bought for pennies with little regard for actual value, they didn’t get the attention they deserve. Now they will.
- Improved clarity around the identification and disposition of credit-impaired assets.
- Make sure, for Advisors Act purposes, the independent member of the advisory committee can consent to a full range of conflicted transactions that may arise during the course of the vehicle’s operation.
- Add a reissue/repricing mechanic following the non-call period. We did this in a few instances back before the LAFF (still trying here). This was essentially irrelevant in a stable to rising interest environment. Now that we’re perhaps at the top of the cycle, this could be a valuable functionality for the issuer and would occur at the same time when otherwise the issuer’s only other option might be to unwind the structure. This could be more efficient.
And that’s just a teaser on the things which we might consider fixing on a go-forward basis.
Look, we’ve suffered the interregnum on credit availability. Let’s at least get the benefit of a reset here. We can make the CRE CLO simpler, more robust and more functional.
So, taking comfort from my CrunchedCredit dataset that we’re getting closer to the point where some sort of re-launch of the technology at scale is contemplated, we’re starting to gear up here. When you’re ready to take a test ride, please give us a call. Cycles are cycles. This isn’t a secular change. The CRE CLO is coming back. HAPPY 4th OF JULY!