Mention the term “collateralized debt obligation” and financial watchdogs immediately seize up. Real estate CDOs, or mortgages repackaged into bonds, were a big reason for the U.S. financial market’s meltdown in 2008. Following the Great Recession, they more or less disappeared from the scene. But they are now staging a comeback under a new name: collateralized loan obligation, or CLO.
In December, Blackstone Mortgage Trust issued what it called the biggest post-crisis commercial real estate CLO, at $1 billion. And last month TPG Real Estate Finance Trust, another mortgage REIT, followed suit with a $932.4 million issuance.
Overall commercial real estate CLO issuance increased to $7.5 billion in 2017, up from just $2 billion in 2016, according to financial services firm Keefe, Bruyette & Woods. And sources expect it to increase to more than $11 billion this year.
“I think you’ll see our peers continue to go there,” Starwood Property Trust’s president Jeffrey DiModica said during the company’s third-quarter earnings call, adding that the trust could issue its own CLO in late 2018 or 2019.
Last month, the sector got another boost when a U.S. court ruled that CLOs are exempt from risk-retention rules under the Dodd-Frank act.
Here’s a primer on what CLOs are and what kinds of risk they pose:
What are real estate CLOs?
CLOs are loans — in this case mortgages — repackaged as bonds. So are the more widely used commercial mortgage backed securities, or CMBS, but there are important differences between the two. CMBS tend to be 10-year, fixed-rate, lower-risk mortgages. Commercial real estate CLOs are often riskier mortgages, such as bridge or transitional loans, with a term of two to three years (and one- to two-year extension options).
CLOs are typically issued by mortgage real estate investment trusts through offshore subsidiaries (whereas CMBS trusts are organized in the U.S.). The Cayman Islands are a preferred location, said Darren Esser, who runs Wells Fargo’s commercial real estate CLO business and structured the TPG and Blackstone bond deals. The offshore structure means CLOs are treated as pass-through entities (CMBS arrive there through a different route) lowering the tax burden on bondholders.
Why do mortgage REITs issue them?
Mortgage REITs make money by using leverage, in effect borrowing money to lend it to developers. The most common way they do that is by using credit facilities with banks. Here’s how it works: Say a REIT issues a $100 million loan to a developer at a 10 percent interest rate, meaning it gets $10 million in annual payments. It then borrows $70 million from a credit facility at a lower interest rate, say 4 percent, or around $3 million. It gets $10 million per year from the developer and pays $3 million in interest to the bank, leaving it with a return of $7 million. But because it borrowed $70 million of the $100 million, it only invested $30 million of its own money. This means it makes $7 million per year on a $30 million investment — a 23 percent return and more than double the 10 percent it would have made without leverage.
Mortgage REITs have been growing their balance sheets in recent years, which has also increased their need for financing. CLOs offer an alternative to credit facilities.
They have three important advantages, according to Esser. Unlike credit facilities they are non-recourse, meaning a mortgage REIT doesn’t need to pledge other loans or assets on its balance sheet as bond collateral. And while credit facilities tend to have fixed terms of two-to-three years, CLO terms can typically be extended. That matters, for example, if a real estate developer runs into difficulties and has to delay repaying a loan from a mortgage REIT. If the REIT refinanced its loan with a credit facility, it might in turn struggle to repay its debt. If it used a CLO, it has more time to pay it back. “There’s a flexibility with these kinds of structures,” Esser said.
And finally, credit facilities often contain so-called mark-to-market provisions that force mortgage REITs to pay back part of a facility if the credit quality of the underlying loan deteriorates. CLOs don’t.
Why are they making a comeback?
Bob Foley, TPG Real Estate Finance Trust’s chief financial and risk officer, said the company has been looking at issuing a CLO for years. But “until recently it was not practical, especially for companies like TRTX that originate large loans.”
“What’s changed is the hunt for yield and rising rates,” he added. Most analysts expect interest rates to rise over the coming year. While most CMBS have a fixed interest rate, CLOs tend to come with floating yields, meaning they rise along with benchmark interest rates. That makes CLOs increasingly appealing to some investors.
Rising investor interest pushed down yields on CLOs, making them cheaper relative to credit facilities. It also made it easier to issue large bond offerings. Until recently, CLOs weren’t bigger than $600 million. Now they top $1 billion. The bigger the CLO, the lower the transaction cost per dollar raised. “There are clear economies of scale in the structured finance market,” Foley said.
In the end, issuing a CLO proved to be a lot cheaper than borrowing under the REIT’s credit facilities, Foley said.
TPG’s CLO was issued with an interest rate of 1.08 percentage points above the Libor benchmark. Meanwhile, the REIT’s credit facilities with banks have a weighted average interest rate of 2.2 percentage points over Libor, SEC filings show. Blackstone’s CLO sold for 1.21 percentage points over Libor, while its credit facilities cost 1.9 percentage points over Libor.
Some observers predict that costs could go down further as the market for CLOs grows. “Future CLOs will be more efficient, in particular with regard to the legal cost that relate to developing the technology,” Blackstone Mortgage Trust’s Douglas Armer said during the REIT’s fourth-quarter earnings call last month. “So, we think that both the cash coupons will come down given market dynamics and we also think the upfront cost will be lesser going forward.”
Should we be worried?
Today’s CLOs are a far cry from the exotic loan products that became notorious during the subprime mortgage crisis, according to Esser. Before 2008, CDOs, as they were known, often contained B notes, mezzanine loans, junk bonds and synthetic assets. Today, CLOs are exclusively senior mortgage loans, which tend to be less risky. And while pre-crisis issuers often sold off all their loans to bond investors, mortgage REITs today keep 20 to 30 percent of any CLOs they issue on their books. This, Esser claimed, creates a “nice alignment of interests” between REIT and bondholders.
“It’s a completely different animal,” Esser said. “It’s like comparing apples to gerbils.”
But even if commercial real estate bonds are less risky today, some observers worry about the bigger CLO universe. Deutsche Bank and Morgan Stanley predict $110 billion in CLOs will be issued this year. Commercial real estate loans will secure a fraction of those loans. Most will be corporate debt.
“CLOs are just CDOs in new wrapping,” University of San Diego finance and law professor Frank Partnoy wrote in a July op-ed in the Financial Times. He argued that rating agencies still use flawed algorithms to grade bonds, regulations are too lax and that junk loans packaged into CLOs may be riskier than investors think.
“Some might claim CLOs are different or smaller, or that regulators are better prepared today, or that business loans could not possibly default all at once, as home mortgage loans did,” Partnoy wrote. “But similar arguments were made about risks during the early 2000s, before they spread to the major banks and AIG, and the markets spiraled out of control.”